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A senator wants to raise tax revenue and make workers better off. A staff member proposes raising the payroll tax paid by firms and using part of the extra revenue to reduce the payroll tax paid by workers. Would this accomplish the senator's goal? Explain.
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Chapter 6
Supply, Demand, and Government Policies
How Markets Work
Firm Behavior and the Organization of Industry
Markets and Welfare
Abdulhanan A.
May 20, 2021
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this question is asking us if a payroll tax can be used to raise tax revenue without hurting laborers. So to answer that will take a look at our labor market. I'll draw quantity, access and it price axis just to clarify. In labor markets, the price is the wage and the good is labor. So we'll draw labor supply labour demanded by the firm. And before any tax comes into the picture, this would be our equilibrium point. We can label the equilibrium quantity as Q one and label the equilibrium price as p one. Now when a tax is introduced, assuming all over things are equal, it will be viewed by the producer or the firm as an increase in the price they have to pay. They have to pay Mawr to make their goods. So by the law of demand, this increase in the price will move them leftward along the demand curve. Let's say they reached this point here and we can label the new quantity of labour they demand as que Tu and the effective price of labour weaken label as P two. Now when firms are producing less, it will also reduce the quantity supplied of labor. It will follow down to this point here, and the wage received by workers will fall to this point to this value p three. So this triangular shape in here is called the tax wedge, and what it shows is that part of the tax burden is held by the firm, and part of the tax burden is held by the laborer. The firm has to effectively pay a higher wage for what they're making, but the laborer has to effectively receive a lower wage for the labour they're providing. So even though this tax was meant to help laborers, it does end up hurting laborers. No matter which party you put the tax on, it will affect both of them. So it is not possible to use this payroll tax and not also hurt the workers.
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