Public Economics
Lecture 09: Taxation III
Income Taxation
Dr. Jonathan St¨abler
Masaryk University
Faculty of Economics and Administration
Fall 2024
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Outline of Lecture
1. Overview Income Taxation
2. Consumption-Leisure Trade-Off
3. Theoretical Effects of an Income Tax
4. Empirical Evidence on Income Tax Effects
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Overview Income Taxation
▶ Definition: A direct tax imposed on individuals or entities based on their income.
▶ Purpose:
− Revenue generation for public goods and services.
− Redistribution of wealth to address income inequality.
▶ Key Features:
− Progressive vs. regressive structure: Higher income, higher tax rate vs. higher income,
lower tax rate.
− Deductions and credits: Reduce taxable income or taxes owed (e.g., EITC, child tax
credit, charitable contributions, etc.).
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Outline of Lecture
1. Overview Income Taxation
2. Consumption-Leisure Trade-Off
3. Theoretical Effects of an Income Tax
4. Empirical Evidence on Income Tax Effects
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Consumption-Leisure Trade-Off
▶ Concept: Individuals face a trade-off between labor (earning income for
consumption) and leisure (non-working time).
▶ Key Idea: Time is a finite resource, and allocating more time to leisure reduces
income for consumption, while working more increases consumption but reduces
leisure.
▶ Implications for Policy:
− Taxes and benefits can shift the trade-off.
− High marginal tax rates may reduce the incentive to work, but not necessarily (income
vs. substitution effect).
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Utility Function and Indifference Curves
▶ Utility Function:
U = f (C, L)
− Captures the satisfaction (utility) derived from consumption C and leisure L.
− Assumption: More consumption and more leisure increase utility (C and L are
”goods”).
▶ Indifference Curve:
− Represents all combinations of C and L that yield the same utility (e.g., 25,000 utils).
− Example: A person is indifferent between:
− C = $500, L = 100 hours of leisure.
− C = $400, L = 125 hours of leisure.
− Points on the same indifference curve provide equal satisfaction.
▶ Illustration: Indifference curves show trade-offs individuals are willing to make
between consumption and leisure while maintaining the same level of happiness.
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Utility Function and Indifference Curves
Source: Borjas and Van Ours (2010)
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Budget Constraint: Consumption and Leisure
▶ A person’s consumption (C) and leisure (L) are constrained by:
− Time: Total hours available to divide between labor and leisure.
− Income: Derived from both labor and nonlabor sources.
▶ Time (T) is allocated between work (h) and leisure (L), such that T = h + L
▶ Nonlabor Income (V ): Income independent of working hours (e.g., property
income, dividends).
▶ Gross Labor Earnings (wh): Product of hourly wage (w) and hours worked (h).
▶ Net Labor Earnings ((1 − τ)wh): Depend on the tax rate τ → (1 − τ)wh
Budget Constraint:
C = (1 − τ)wh + V
←→ C = (1 − τ)w(T − L) + V
→ Expenditures on goods (C) must equal labor earnings plus nonlabor income.
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Budget Constraint
Source: Borjas and Van Ours (2010)
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Optimal Choice
Source: Borjas and Van Ours (2010)
▶ Utility Maximization: The
worker selects the combination
of goods and leisure that
maximizes utility (U∗) while
adhering to the budget
constraint.
▶ Optimal Choice: At the
utility-maximizing point (P),
the budget line is tangent to
the highest attainable
indifference curve.
▶ Example: 70 hours of leisure,
40 hours of work, and $500 of
goods.
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Outline of Lecture
1. Overview Income Taxation
2. Consumption-Leisure Trade-Off
3. Theoretical Effects of an Income Tax
4. Empirical Evidence on Income Tax Effects
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Income Tax Shifts the Budget Constraint
Source: Gruber (2005)
▶ Income taxes reduce the after-tax
wage, changing the slope of the
budget constraint (opportunity
cost of leisure decreases).
▶ Example: A 30% tax reduces
Ava’s after-tax wage from $12.50
to $8.75, pivoting her budget
constraint inward and decreasing
consumption at the same leisure
level (from C1 to C2).
▶ Taxes lower the return to work,
potentially reducing labor supply
by incentivizing more leisure.
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Substitution and Income Effects on Labor Supply
▶ Substitution Effect: A lower after-tax wage reduces the price of leisure,
incentivizing more leisure and less work.
▶ Income Effect: Lower after-tax earnings reduce overall income, leading to
individuals working more (as they want a higher income).
▶ Overall Effect: The substitution and income effects pull labor supply in opposite
directions, making the net impact of taxation on work hours uncertain.
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Illustration: Income Effect on Labor Supply
▶ Income Target Example: Ava works to buy 1 Vinyl per week.
− Vinyl costs $20, Ava earns $5/hour ⇒ works 4 hours.
− With 20% tax, after-tax wage drops to $4/hour ⇒ works 5 hours.
▶ Outcome: Despite the lower wage, Ava works harder to meet her target income.
− Income Effect: Ava works more due to a fixed income target.
− Result: Quantity of labor supplied increases.
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Substitution and Income Effects on Labor Supply
Source: Gruber (2005)
▶ In Panel (a), the substitution
effect of taxation dominates,
increasing leisure and reducing
labor supply.
▶ In Panel (b), the income effect
dominates, leading to more work
and less leisure as Ava aims to
maintain consumption.
▶ The shape of the labor supply
curve depends on the relative
strength of substitution vs.
income effects, with potential
upward or downward slopes.
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Labor Supply Curve
Source: Figure 2-11 (Borjas and Van Ours, 2010)
▶ The labor supply curve (b) shows the
relationship between the wage rate and
hours worked, derived from the
utility-maximization problem.
▶ At low wage rates (e.g., below $20),
substitution effects dominate, and
individuals may choose to work less after a
tax increase, while at higher wages (e.g.,
above $20), income effects dominate,
causing an increase in hours worked.
▶ A backward-bending labor supply curve
arises.
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Ambiguous Theoretical Effects of Income Taxes on Labor Supply
▶ No Clear Theoretical Prediction: The overall effect of income taxes depends on
whether the substitution or income effect dominate.
▶ Work Hour Constraints: Many labor markets impose restrictions on adjusting
hours, such as fixed schedules due to production requirements (e.g., manufacturing
lines), limiting workers’ ability to align hours with their optimal labor supply.
▶ Overtime Pay Rules: Laws requiring higher pay for hours beyond 40/week
increase costs for firms, discouraging longer work hours and reducing responsiveness
of labor supply to after-tax wages.
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Outline of Lecture
1. Overview Income Taxation
2. Consumption-Leisure Trade-Off
3. Theoretical Effects of an Income Tax
4. Empirical Evidence on Income Tax Effects
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Empirical Evidence on Income Tax Effects
Primary Earners (Main source of household income):
▶ Low responsiveness to wage changes.
▶ Work decisions are largely unaffected by taxes due to fewer outside options.
Secondary Earners:
▶ High responsiveness to wages.
▶ However, most response stems from labor force participation, not hours worked.
▶ Tax rates influence secondary earners’ decisions to work or not work at all.
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Thank you and good luck for the final exam!
Jonathan.Stabler@econ.muni.cz
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References I
Borjas, G. J. and Van Ours, J. C. (2010). Labor economics, McGraw-Hill/Irwin Boston.
Gruber, J. (2005). Public Finance and Public Policy, Worth Publishers.
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