An increase in government purchases financed by an increase in the marginal tax rate on labour income, decreases the quantity of labour supplied, if the:

Question

Quizplus · Accepted Answer

When the marginal tax rate on labour income increases, the opportunity cost of leisure increases, leading to a negative substitution effect (people work less as work becomes relatively more expensive compared to leisure). On the other hand, the increase in government purchases leads to an increase in income, which has a positive income effect (people work more as they have more income to spend on consumption). If the negative substitution effect is bigger than the positive income effect, the overall effect on labour supply will be a decrease.

An Increase in Government Purchases Financed by an Increase in the Marginal