When labor's marginal product rises because of a technological improvement, the demand for labor rises regardless of whether the improvement is permanent or temporary. When workers own capital, the technological improvement (whether permanent or temporary) also raises their nonlabor income, which causes the supply of labor to decrease. These two effects cause the wage to increase, while the effect on employment is ambiguous. However, if the improvement is temporary, there is a third effect-intertemporal substitution. In this case, workers recognize that the higher wage is only temporary, so workers adjust their work and vacation times, increasing their work effort during the present period of high wages and decreasing their future work effort. This intertemporal substitution causes an

Question

increase in the supply of labor. If this increase in supply more than offsets the fall in supply caused by the nonlabor income effect, the temporary technological improvement will cause a rise in employment.

(i) Compare and contrast the effects on the labor market of temporary and permanent increases in the payroll tax.
(ii) Compare and contrast the effects on the labor market of imposing a payroll tax and an income tax.

Answer 1

(i) The payroll tax will reduce both employment and the effective wage. If the tax increase is only temporary, then workers will engage in intertemporal substitution and reduce their labor supply. Thus, employment will be lower and the effective wage will be higher when the tax increase is temporary than when it is permanent.
(ii) As in part i, the payroll tax will reduce both employment and the effective wage. Unlike a payroll tax, an income tax will reduce workers' nonlabor income and lead to an increase in labor supply. Thus employment is higher and the effective wage is lower under an income tax than under a payroll tax.