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Wanna Argument?
Taxes - to cut or not to cut?
Work to live, or live to work?
Tax cuts are frequently quoted as a supply-side policy. The argument is that if the rate of tax is cut people will work harder as they are getting to keep more of each extra pound they earn. If this cut in the marginal rate of tax does make people work harder, then this should make the economy more productive and increase the potential level of
output of the economy. We can see this in the diagram below, where are higher level of aggregate supply enables the economy to produce a higher level of output without any inflationary pressures:
However, would you really work harder if the marginal tax rate were cut? It is possible that people may decide to work less as they can earn the same amount of money by working less. The exact impact of the tax cut depends on the income and substitution effects of work and leisure. The substitution effect of a wage increase will always tend to make people work harder and take less
leisure time as they will substitute away from leisure time that has effectively become more expensive. However, the income effect could go in either direction. The income effect of a wage increase will either be positive and make people work even harder to earn more, or it may make people work less as they can earn the same amount. The overall effect on people's effort is therefore the
combination of the two effects. One possible outcome is the backward-bending supply curve shown below:
As wages increase above a certain point less work will actually be done as work is an inferior good and leisure becomes more highly valued at the margins. The income effect has gradually become opposite to the substitution effect and starts to outweigh it at a wage level of W2. This causes the supply curve to bend backwards.
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