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 percent to 30 percent, 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.)

Question

What will be an ideal response?

Answer 1

Under the current income tax, Junior has $60,000 of income after tax. If the income effect is descriptive and Congress increases tax rates so that Junior's average tax rate is 30 percent, Junior will need to earn $85,714.29 to continue to have $60,000 of income after tax.
After-tax income = Pretax income (1 ? tax rate)
$60,000 = Pretax income (1 ? 0.30)
Pretax income = $60,000/0.70
Pretax income = $85,714.29
Junior will pay $25,714.29 in tax ($85,714.29 × 0.30). Accordingly, if the income effect is descriptive, the tax base and the tax collected will increase.
If Junior only earns $60,000 of taxable income, he would pay $18,000 of tax under the new tax structure (i.e., $60,000 × 0.30). Thus, the government's tax revenues would decrease by $2,000 (i.e., $18,000 ? $20,000). This is an example of the substitution effect, which may be descriptive for taxpayers with more disposable income who can afford to earn less and maintain a style of living.