Suppose the government of Washington is considering the addition of a new tax on

Question

Suppose the government of Washington is considering the addition of a new tax on firms. You have been called in to provide expert analysis on how such a tax would effect employment of labor. There are 3 proposals the government is considering:

1. A tax on every hour an employee works (e.g., “X” cents per hour).

2. A tax on some percentage of the value of the firm’s buildings, land, and machinery (e.g., “Y” percent of the total property value).

3. A tax on every unit of output a firm produces (e.g., “Z” cents per unit of output).

While all the plans have the potential to reduce employment opportunities, which plan would probably have the most favorable impact on employment of labor? Briefly explain your reasoning.

HINT: Compare the plans in terms of their scale and substitution effects.

Explanation / Answer

1. When a tax would be levied on every hour of employee work, it would become costly for firms to use labor intensive techniques of production where more labor in used than capital in production as input. This tax will make the firm to employ and substitute labor with capital hence to which demand of labor will be reduced and wage rate may also fall.

2. Because on imposition tax on property, now employers will be incurring more cost than before. Thus, employers who were using capital intensive methods would try to switch to labour intensive techniques as much as possible. To which machines and equipments will be then largely replaced by employers in large firms so as to protect themselves from such tax. This will increase the demand of the labor in the labor market and wage rate may also increase.

3. A tax on every unit creates no disparity on usage of capital goods or labor in production. This will reduce the production level thus also reducing labor demand and wage rate.

The tax imposition on total property value would make conditions of workers more favourable than others as it will increase the demand of labor in market.

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