Question

ONLY PROBLEMS (d) AND (e) NEED ANSWERED. THANK YOU.

Consider the market for labor is segmented into the market for low skilled labor and the market for high skilled labor. If the low skilled labor market is given by the following function: labor demand: w = 35 – 0.005L; and labor supply is 4000. If the high skilled labor market is given by the following functions: labor demand: w = 400 – 2L, and the labor supply function is given by   w = 160 + 1.2L. The hourly wage in both is given by w, and L is the number of workers.

(a)    Show both numerically and with corresponding graphs (for the two markets) the equilibrium wages and number of workers in the low skilled labor market and the high skilled labor market.

(b)   Suppose the government needing to provide some basic services decided to place a tax on labor income and chooses a progressive tax structure where it taxes the low income earners at a rate of $3 per labor hour, and the high income earners at rate of $112 per labor hour. Compute the total revenues the government will get from this tax scheme and the deadweight loss associated with this.

(c)    Suppose instead the government decides to use a flat tax of 24% of the equilibrium wage for labor in all markets. Again compute the total revenues to the government and the deadweight loss associated with this.

(d) ***NEEDS ANSWERED***

Discuss the efficiency and equity attributes of both policies. In general if the government wanted to focus on minimizing the deadweight loss from taxation, what should be the optimal labor income tax policy providing tax revenues in the same range as in (b) and (c) above? Are there any problems with this policy? Explain.

(e)    ***NEEDS ANSWERED***

What if the government decides to focus more on reducing income inequality through its tax policy and tries to tax only the high income earners, what are the two revenue generation problems with this policy? Explain.

Answer 1

d)

Generally taxing would help governments to revenue when high skilled labor where marginal utility for consumption would be less compared to taxing low skilled labor whose marginal utility is less.

The optimal labor income tax policy would be where the ratio of marginal utility of individual from income and MR is the marginal revenue from taxing would equal for both rich and poor. With a flat rate, it would increase the inequality of income of rich and poor.

e)

If only high income earners are taxed the two revenue generation problems would be

a)

People would report less income and try to avoid income tax which would reduce the tax revenue for the government

b)

It would discourage high skilled workers to earn more and their by it would reduce tax revenue for the government.