Break problems down into smaller parts to gain a better understanding.
The way to break the problem down may be obvious, or even contained in the question. But sometimes it is useful to break the problem down in non-obvious ways.
A fairly obvious way of breaking down a problem into parts is to look step by step at how some cause has some effect. Example: what impact does reducing taxes on labor income has on wages? Look first at the impact of the tax reduction on how much workers want to work, and then look at the impact of the latter change on wages.When determining how to break down the problem in non-obvious ways, you may often want to define parts that are independent of each other. (See the example below).
ExampleWhat impact does a reduction of tax rates on labor income have on how much workers want to work?
You already know (maybe using the art of caricature) that a reduction of tax rates has two effects. There is an “income effect”: even if the worker works the same, she will be richer because she will keep more of her labor income. This may be an incentive to work less (but you are not sure at this stage). The second effect is that, in addition to the previous effect, the worker has an incentive to work more because she will keep a larger proportion of her additional labor income. This is called the “substitution effect”: it is an incentive to substitute something by some other thing (here leisure by work) because the relative price of these two things has changed, but which comes in addition to the income effect mentioned above.
It would be useful to separate the substitution effect from the income effect. In order to do it, break the tax-rate reduction into the two following parts. Consider first a fiscal reform that would consist of our tax-rate reduction and of a lump-sum tax calibrated such that the worker pays exactly the same tax as before if she does not change her work load. This may seem quite artificial, but it is constructed in order to get a pure substitution effect (since the income stays the same if the work load stays the same). Second, consider a fiscal reform consisting of giving back the lump-sum tax discussed above. In this second reform there is no change of the tax rate: the change of income does not depend on the work load. Thus, this leads to a pure income effect. And the sum of the two reforms is our tax-rate reduction.
Think about the first reform. It is clear that this reform is an incentive to work more, since the worker will keep more of additional labor income and there is no issue about increased revenue with the same work load that would make this picture fuzzy.
Let’s now forget about the first reform and think about the second reform. Since the sole change for the worker is that it makes her richer (but without changing her after-tax wage), it seems obvious that she will want to work less. But you surely can imagine a case in which she would want to work more. Maybe thanks to the money provided by the state she can take out a mortgage to buy the house of her dreams if she works a bit more, whereas she would not have enough incentives to work that bit more before that reform because it was not worth her while to work more to buy more small things (your common sense will probably tell you that this is rather exceptional, but to really understand why we will need the trick in the next post).
ExerciseWhat is the impact of rent controls?