Assume that the substitution effect dominates the income effect. When the government raises tax rates, after-tax real wage rates
A) fall, consumption decreases, and labor supply increases.
B) fall, consumption decreases, and labor supply decreases.
C) rise, consumption increases, and labor supply increases.
D) fall, consumption increases, and labor supply decreases.

Question

Quizplus · Accepted Answer

When the government raises tax rates, the after-tax real wage rate falls. This will lead to a decrease in consumption and a decrease in labor supply. This is because the individual will have less money to spend on goods and services and therefore will reduce their consumption. Additionally, the individual will be less incentivized to work due to a lower after-tax wage rate. Therefore, the substitution effect dominates the income effect, resulting in a decrease in consumption and labor supply.

Assume That the Substitution Effect Dominates the Income Effect