Income taxes are lowered when the economy is at full employment, which is most likely? A. Quantity of Labour is likely to increase and potential GDP increase B. Quantity of Labour is likely to increase and potential GDP decrease C. Quantity of Labour is likely to decrease and potential GDP increase D. Quantity of Labour is likely to decrease and potential GDP decrease
I will guess A b/c the lower tax increases take home pay so it will induce more people to enter the labor force. Given more people working, earning, and spending potential GDP should increase.
A. That was my exact reasoning as well.
I also answered A. Apparently it’s wrong. “Correct” Answer is D The ‘explantation’ (i think this is complete rubbish) is… The lowering of the tax at full employment will reduce the supply of labour (with higher take home pay and the economy at full employment there is less incentive to work harder) and this reduction in the supply of labour will reduce potential GDP Anyone agree with this? My reasoning is that if you reduce income tax, you effectively increase effective wage rates (indeed as they say, take home pay is now higher), thus in my mind, at a higher wage rate more people are willing to supply their labour I’m aware the econonomy is at full employment, however, there will be people who were unwilling to supply their labour at the old wage rate, who would be now be willing to particpate at what is effectively a higher wage rate, workforce expans as supply of labour increases and potential GDP increases. Also it could be forgiven if the point of the question was to catch you out because…the tax cut, means people supply additional labour at the margin (i.e. overtime) this does not increase potential GDP, but rarther causes GDP to increase beyond potential in the short run. However, their answer says GDP will fall and labour supply will fall… It seems to me they are making some misguided reference to the backward bending labour supply curve, which to my mind isn’t even covered in the level 1 sylabus.
Robert0s Wrote: ------------------------------------------------------- > I also answered A. > > Apparently it’s wrong. “Correct” Answer is D > > The ‘explantation’ (i think this is complete > rubbish) is… > > The lowering of the tax at full employment will > reduce the supply of labour (with higher take home > pay and the economy at full employment there is > less incentive to work harder) and this reduction > in the supply of labour will reduce potential GDP > > > Anyone agree with this? I do, but that DEPENDS on the shape of the indifference curve of the individual workers, which is a pretty strong assumption when you’re referring to the economy as an aggregate of everyone’s earning efforts. Remember that there is a trade-off between two goods when you have limited resources, in this case leisure and work. The less you have of one, the more you have of the other. In this case you have 24 hrs in a day, it’s up to you how much you spend working and how much you spend outside of work. So you can view leisure as a commodity, if to you LEISURE IS AN INFERIOR GOOD, then the more you work (the more $$ you make, or when taxes go down) the less leisure you want to buy. Similarly, if to you as a worker LEISURE IS A NORMAL GOOD, then the more money you make (more hours, or here LESS taxes), then you buy more of it, and you choose to work less. You guys all assume that leisure is a Giffen good (i.e. inferior good), and in the answer they’ve assumed that leisure is a normal good. Bottom line: crappy question, move on.
See, I completely understand that. Which is why (as I mentioned) the labour supply curve IS backward bending… BUT - this is only at very high levels of income where people substitiute lesiure for additional income. This effect would NEVER dominate within the population as a whole So i don’t agree with your explanation, or theirs. Also, it doesn’t really depend on the shape of the indifference curve, the effect of steep vs shallow would be neglible, it depends on the budget line of the indidual, the higher the earner, the more likely they are to find a new and higher indifference curve which is tangential at a combination of more leisure and less hours worked than before the tax cut.
I do agree however, its a crap question.
If I see this question in the exam…I would still mark A. I completely agree with Robert’s explanation…
Robert, I agree with you that it’s the high earners who generally have backward bending curves. If I saw the question on the exam, I’d also probaby mark A just because it’s the other effect that dominates in the general population. Point well taken. My intent was to provide a bit of an intuition as to what might be happening, and I bet not many people get into the nitty-gritty of microeconomics when they see questions like this.
D is the correct answer. Think about it this way -> you work 60 hours a week and make $1,000 each week. Your boss comes in one day and gives you a small raise to $1,150 per week for your 60 hours. Are you going to start working 65 hours or 55 hours? Assuming you were at equilibrium at 60 hours for $1,000 your new equilibrium will be 55 hours for $1,000
I think the point was made before that it depends on the workers indifference curves. For some people that may be the case that they can 1) choose to work less hours and 2) be more happy with the same amount of money and more free time, vs more money and less free time. but that isn’t necessarily the case. Since economies push through full employment all the time, eg… Alberta, in Canada currently, I’d tend to think the most likely consequence is that a workforce as a whole isn’t going to balk at the prospect of more money.