(a) Determine effect of a decrease in income tax on consumption and labor supply. Explain your results in terms of income and substitution effects. Show the income and substitution effect in a graph. (b) Is your answer in (1) consistent with the observation that hours of work in European countries is about 30% less than in the U.S, while the average income tax rate is about 60% in European countries and 40% those in the U.S.? Under what condition?
Suppose that the government imposes a proportional income tax on the representative consumer’s wage income. That is, the consumer’s wage income is w(1 − τ )(h − l) where τ is the tax rate.
(a) Determine effect of a decrease in income tax on consumption and labor supply. Explain your results in terms of income and substitution effects. Show the income and substitution effect in a graph.
(b) Is your answer in (1) consistent with the observation that hours of work in European countries is about 30% less than in the U.S, while the average income tax rate is about 60% in European countries and 40% those in the U.S.? Under what condition?
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