Department of the Treasury, IRS 1987

“Tax Rates and Tables for Prior Years” Rev 9-87 The main mechanism that the supply siders proposed was that lower income taxes would increase the incentive to work. To analyze this claim, we need to investigate how the decision to supply labor depends on income taxes. As with our analysis of consumption, we look at labor supply by thinking about the behavior of a single household. We then suppose that the household can be taken as representative of the entire economy. Labor Supply Each individual faces a time constraint: there are only 24 hours in the day, which must be divided between working hours and leisure hours. An individual’s time budget constraint says that, on a daily basis, leisure hours + working hours = 24 hours. The labor supply decision is equivalently the decision about how much leisure time to enjoy. This decision is based on the trade-off between enjoying leisure and working to purchase consumption goods. People like having leisure time, and they prefer more leisure to less. Leisure can be thought of as a “good,” just like chocolate or blue jeans or cans of Coca-Cola. People sacrifice leisure, working instead, because the money they earn allows them to purchase goods and services. To see this, we first rewrite the time budget constraint in money terms. The value of an hour of time is given by the nominal wage. Multiplying through the time budget constraint by the nominal wage gives us a budget constraint in dollars rather than hours: (leisure hours × nominal wage) + nominal wage income = 24 × nominal wage. The second term on the left-hand side is “nominal wage income” since that is equal to the number of hours worked times the hourly wage. Because wage income is used to buy consumption goods, we replace it by total nominal spending on consumption, which equals the price level times the quantity of consumption goods purchased: (leisure hours × nominal wage) + (price level × consumption) = 24 × nominal wage. This is the budget constraint faced by an individual choosing between consuming leisure and consumption. Think of it as follows: it is as if the individual first sells all her labor at the going wage, yielding the income on the right-hand side. With this income, she then “buys” leisure and consumption goods. The price of an hour of leisure is just the wage rate, and the price of a unit of consumption goods is the price level. Finally, if we divide this equation through by the price level, we see that it is the real wage (the wage divided by the price level) that appears in the budget constraint: leisure hours × real wage + consumption = 24 × real wage. It is the real wage, not the nominal wage, that matters for the labor supply decision. Toolkit: Section 16.1 “The Labor Market” You can review the labor market in the toolkit. Changes in the Real Wage What happens if there is an increase in the real wage?