Question

Song earns $100,000 taxable income as an interior designer and is taxed at an average rate of 20 percent (i.e., $20,000 of tax). Answer the questions below assuming that Congress increases the income tax rate such that Song's average tax rate increases from 20 percent to 25 percent.  

a. What will happen to the government’s tax revenues if Song chooses to spend more time pursuing her other passions besides work in response to the tax rate change and therefore earns only $75,000 in taxable income?

• Government's tax revenues would decrease by $1,250

• Government's tax revenues would increase by $1,250

• Government's tax revenues would decrease by $1,500

• Government's tax revenues would increase by $1,500

• Government's tax revenues would remain unchanged

  

b. What is the term that describes this type of reaction to a tax rate increase?

• Price effect

• Endowment effect

• Substitution effect

• Budget constraint

• Income effect

  

c. What types of taxpayers are likely to respond in this manner?

• Taxpayers with less disposable income

• Taxpayers with more disposable income

Answer 1

a. When Song opts for pursuing his other passions he ends up earning $75,000 only as against $1,00,000. As the tax rate is now 25% he will have to pay $18,750. If the tax rate had not been changed from 20%, he would have continued to earn $1,00,000 in the same field and have paid tax of $20,000 thereon and due to this change Govt. has made a loss of $1,250.

b. Price Effect simply means that a customer will buy less when market price of the product goes up and will buy more when market price goes down.
Income Effect means that if income is high than the consumer will spend more and if its less he will spend less.
Endowment Effect is a more of a behavioral effect when the consumer always feels he is having something precious or is giving away something precious than what he is acquiring against it. Here he always considers his goods more precious even if the consideration is of the same value.
Budget Constraint This happens when the price of any goods is increased and the consumer opts for the cheaper options so as to buy the same quantity of what he was buying previously.

In this case Substitution Effect has happened. This is evident where any change in price results in change of preference of consumer to its substitute options out of choice or in hope of getting better outcomes.

c. An Increases in Tax rate will result in decreased disposable income and hence those who have higher cost of living will have to opt for alternate ways to increase their income. Thus we can say that Taxpayers with less disposable income will likely respond in this manner.