Junior earns $80,000 taxable income as a regional circuit stock car driver and i
ID: 2513369 • Letter: J
Question
Junior earns $80,000 taxable income as a regional circuit stock car driver and is taxed at an average rate of 25 percent (i.e., $20,000 of tax). If Congress increases the income tax rate such that Junior's average tax rate increases from 25% to 30%, how much more income tax will he pay assuming that the income effect is larger than the substitution effect? What effect will this tax rate change have on the tax base and tax collected? What will happen to the government's tax revenues if Junior chooses to spend more time pursuing his other passions besides work (e.g. earns only $60,000 in taxable income) in response to the tax rate change? What is the term that describes this type of reaction to a tax rate increase? (Round your answers to two decimal places.)Explanation / Answer
Answer:
Current taxable Income = $80,000
Tax @25% =$20,000
Income after Tax = $60,000
If income effect is higher than the substitution effect, Junior would maintain target level income after tax of $60,000.
After-tax income = Pre-tax income (1 - tax rate)
=> $60,000 = Pre-tax income (1 - 30%)
Pre-tax income = $60,000 / 70%= $85,714.29
As such Junior need to earn $85,714.29 to continue to have an after tax income= $60,000
Income tax he will pay= 30% * $85,714.29= $25,714.29
Increase in Income tax payment = $25,714.29 - $20,000 = $5,714.29
The effect of tax rate change on tax base and tax collected are as follows:
Tax base will increase to = $85,714.29
Tax collected will increase to = $25,714.29
If in response to tax rate change, Junior chooses to earn only $60,000:
Income tax he would pay = $60,000 * 30% = $18,000
Hence, government's tax revenue will decrease by = $20,000 - $18,000 = $2,000
The term that describes this type of reaction to a tax rate change is Substitution effect.
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