The present tax system has two parts The first part subsidiz

The present tax system has two parts. The first part subsidizes workers’ wages. The government pays each worker $2 per hour extra for each hour that they work in a week in the labor market up to a maximum payment of $40 per week. The second part is a tax on labor earnings. A 20% tax is placed on labor earnings above $400 per week (the government subsidy is not counted as earnings in this calculation). For this question, assume that leisure is a normal good for all workers.

a) Boris works at a job that pays $10 per hour. He has no non-labor income. He can work at most 60 hours per week and the price of food is $1 per unit. Assuming that he consumes only food and leisure, graph Boris’s budget constraint under the present tax system. If Boris works 50 hours per week, how much food does he buy?

b) Congress is considering a change to the tax system. A bill has been put forward to eliminate both the subsidy and tax. That is, if the law passes the government will play no role in the labor market. On your graph from part a), graph how this bill would change Boris’ budget constraint. What is your prediction for how this change would affect his hour of work?

c) How would your prediction of how Boris would change his hours of work after the tax change differ if he was originally working 30 hours per week? 10 hours per week?

Solution

If he works 60 hours of labour, his wage income will be 60*10 = 600

He will have to pay 20% as tax and net income will be 480 and he can buy 480 units of food.

If he works for 4 hours, his income will be $40 and he will get a subsidy of $2 per hour extra i.e. for two hours and net income by orking for 3 hours will be $38.

Between 4 hours to 40 hours income will be number of hours*wage rate.

By plotting the combination given below, we can get his budget constraint.

b) If there are no taxes or subsidies then budget contraint will change as follows:

c) If he was originally working at 30 hours per week, his busdget contraint will be as follows