Question

A decrease in the income tax rate has a ________ effect on the labour supply if the ________ effect dominates.

• A. negative; income
• B. positive; substitution
• C. positive; income
• D. negative; substitution

Answer 1

The Correct Option is A, B

A decrease in the income tax rate affects the labour supply in two ways: through the income effect and the substitution effect. When the income tax rate decreases, individuals have more disposable income, which means they might feel they don't need to work as many hours to maintain their desired income. This is called the income effect, which can lead to a negative effect on labour supply as individuals might choose to work less.

However, a decrease in income tax also makes working more financially rewarding since individuals get to keep more of their earnings. This is called the substitution effect, which encourages individuals to work more hours because the opportunity cost of leisure is higher. Therefore, the substitution effect leads to a positive effect on labour supply.

If the income effect dominates, the overall impact on labour supply will be negative. Conversely, if the substitution effect dominates, the impact will be positive.