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Matthias Doepke - Marcroeconomics - Chapter 13

Chapter 13 The Effect of Taxation Taxes affect household behavior via income and substitution effects. The income effect is straightforward: as taxes go up, households are poorer and behave that way. For example, if leisure is a normal good | Chapter 13 The Effect of Taxation Taxes affect household behavior via income and substitution effects. The income effect is straightforward as taxes go up households are poorer and behave that way. For example if leisure is a normal good then higher taxes will induce consumers to consume less leisure. The substitution effect is trickier but it can be much more interesting. Governments levy taxes on observable and verifiable actions undertaken by households. For example governments often tax consumption of gasoline and profits from sales of capital assets like houses. These taxes increase the costs to the households of undertaking the taxed actions and the households respond by adjusting the actions they undertake. This can lead to outcomes that differ substantially from those intended by the government. Since optimal tax policy is also a subject of study in microeconomics and public finance courses we shall concentrate here on the effect of taxation on labor supply and capital accumulation. When modeling labor supply decisions we are going to have a representative agent deciding how to split her time between labor supply and leisure. Students might object on two grounds First that the labor supply is quite inelastic since everyone more or less works or tries to and second that everyone puts in the same number of hours per week and the variation in leisure comes not so much in time as in expenditure so that richer people take more elaborate vacations . The representative household stands for the decisions of millions of underlying very small households. There is to name only one example mounting evidence that households change the timing of their retirement on the basis of tax policy. As taxes increase more and more households choose to retire. At the level of the representative household this appears as decreasing labor supply. As for the observation that everyone puts in either 40 hours a week or zero this misses some crucial points. The fact is that jobs differ .