With an increase in government purchases financed by an increase in the marginal tax rate on labour income, the change in labour supply depends on whether the:

Question

Quizplus · Accepted Answer

An increase in the marginal tax rate on labour income will increase the opportunity cost of leisure, leading to a negative substitution effect. At the same time, the increase in government purchases will increase the demand for labour, leading to a positive income effect. Whether the labour supply increases or decreases depends on which effect dominates. If the negative substitution effect is bigger than the positive income effect, labour supply will decrease. Therefore, the correct choice is A.

With an Increase in Government Purchases Financed by an Increase