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Economics/Macroeconomics : Wage taxes



I was wondering what happens if tax is applied to wages in an economy. Let's say the current wage is $5/hr. If i apply a $2/hr tax to that wage, does the wage level effectively become $7/hr for the firm?

If i were to draw a diagram to show the change in wage level, would i simply move the curves from the $5 to $7/hr positions to account for the tax?

The answer is a little more complicated than that.  First, we have to look at the difference between short term and long term.  Companies will continue to produce so long as it is profitable, which means that even if costs go up, they will continue to produce.  Since wages and prices are both sticky (meaning that they don't respond immediately to changes in market forces), that means your proposed tax would increase the cost for the firm, reducing producer surplus in the short term.  In the long term, however, all things are responsive, so wages and prices will have responded properly.  If you look at real wages for the vast majority of the population (wages adjusted for inflation), you'll notice that they remain generally stagnant.  So, as costs increase, so do prices, and wages increase as a result in order to maintain that constant level of real wages.

To summarize so far, in the short run, that tax decreases producer surplus, and increases tax revenues that SHOULD (but usually aren't) reinvested into national growth in a manner that creates jobs and wages (thereby resulting in increased company revenues) through development of national growth projects such as infrastructure (reducing costs for companies), ensuring a positive return on investment not only on government expenditures (as measured by rate-adjusted revenues), but also for companies and people, as growth is stimulated and inflation mitigated.  In the long-run, especially as those tax revenues are used improperly as shown in negative ROI, the tax contributes more to inflationary pressure, causing a decrease in the purchasing power of the currency.

The other thing we have to consider is tax deductions.  Wages are a deductible expense.  So, a company that pays $10/hour on wages can deduct that entire amount from their taxable income.  Assuming a company is profitable in any given year, they don't actually incur the entire cost of those wages.

Hopefully that helps with your question.


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Michael Taillard


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