The effect of an income tax on the labor market -, Learning Economics... Solved!


The effect of an income tax on the labor market

This post was updated August 2018 with new information and examples.

We all feel the pinch from an income tax on our lives, but how does it affect the overall labor market?  The intuition behind shifts in demand and supply are a bit different in the labor market vs. shifts in the traditional goods and services market. This post will go over the effect of an income tax on the labor market, and discuss some ways to help develop the intuition of why this is important in the labor market..

Take a look at the typical supply and demand model on the left for your typical labor market.  Here S represents the supply of labor, people like you and me who apply for, and work at jobs to receive a salary.  The higher the salary offered, the more people are willing to work, either by getting a job at all, or their willingness to work more hours.  This is why the labor supply curve (the S curve) is upward sloping.  The curve D represents demand for labor.  This would be corporations and businesses that need labor as an input in their production process.  These businesses are willing to hire more labor (perhaps new people are pay them for additional hours works) if they can get it for a cheaper price, which is why the D curve slopes down.

But what happens in this labor market when an income tax is introduced? 
Let's introduce a tax on labor supply (which is us the workers) and see how it affects the market.  Consider the graph below:

You can see that the S curve has shifted up to S', this is because labor must now receive a higher salary in order to offset the newly imposed income tax.  The size of the shift is equal to the amount of the income tax, which means that we will receive the same salary as we did before at any quantity of supplied labor.  The difference is that now businesses will have to pay more to get the same amount of labor, and since businesses want to hire labor as cheaply as possible, some changes must occur.

First consider point A, our market equilibrium.  Here we have Q* amount of labor working, and receiving a salary S*.  When the tax is imposed and S shifts up, it now interacts with the D curve in a different spot, causing a change in equilibrium salary and quantity.  The new equilibrium quantity at Qt is less than it was before, because the real cost of salaries to firms has gone up.  The new equilibrium at point B results in a higher salary paid by employers which is Sp.  However, because of the tax, labor does not actually receive this salary, they instead receive salary Sr which is equal to Sp (the amount paid by businesses) minus the tax. This occurs because firms are willing to hire less workers overall because the real cost of hiring them has increased.

So an income tax results in a lower quantity of labor being supplied to the market (people either stop working, or work less hours), and a higher salary paid by employers BUT a lower salary received by employees.  An income tax has negative effects on an economy and creates a deadweight loss which means that it is an inefficient policy. However, taxes generally fund government services such as schools, roads, and the military which provide a lot of value to society so we are generally willing to overlook some of the inefficiencies of taxes in order to take advantage of the public goods that they fund..  But there are some things we can to to reduce the tax burden in our personal lives so we do not feel the pinch as much.

For example, there are tax software packages available to assist with filing your taxes to make sure you get all of the deductions and credits you qualify for.  My favorite is turbotax because of its ease of use, and it remembers my information from year to year.  You should also consult the IRS website, which maintains a useful tax FAQ.  Finally, if you are behind on your taxes, you could potentially face heavy fines and penalties.  If you missed the deadline last year, it is a good idea to file a tax extension form in order to get back into good standing with the IRS.  My good friend didn't pay taxes one year because of a study abroad trip only to have the IRS take money from his bank account (including fees and interest) five years later when he wasn't expecting it.

It's also possible for a tax to be introduced to consumers of labor (the firms and entities hiring labor). In this case the demand curve would shift down lowering the real demand for labor because firms would have to pay more for every worker they hire. This would have the same result as a tax on suppliers resulting in hire wages paid but lower wages received. This is why it really doesn't matter who pays the tax (workers or firms) because the end result will be the same.

If you want help developing the intuition--or see some examples-- of how taxes affect the supply and demand of goods and services (potentially the labor market) you can view the video below: