Question

The Child Tax Credit prior to 2018 provided a subsidy to families with children and was part of the US Federal Income Tax code. For married couples filing jointly, the credit was $1000 for each eligible child and was phased out at the rate of 5% for income above $110,000. For a family with four children and no other non-wage income besides the credit, answer the following questions. Assume no other taxes/subsidies.

A) Draw the annual budget constraint with and without the tax credit program, assuming that full income is $300,000/year.

B) Calculate the breakeven level of earnings under the program.

C) Using indifference curve analysis, describe how the program would likely affect a person's labor supply if the person's earnings in absence of the program were less than $110,000. Explain.

D)  Using indifference curve analysis, describe how the program would likely affect a person's labor supply if the person's earnings in absence of the program were less than $150,000.

Answer 1

Since the answers to only Question’s C and D are requested, therefore answering only C and D.

For representation and easier understanding, I have drawn an indifference curve to explain the answer better.

Answer (C):

From the above diagram, we can see that with Tax credit, the indifference curve of a person would be higher at AB, whereas, with reduced or phased out tax credit, the indifference curve would now adjust only fewer goods, commodities and services and achieve a lower level at CB. As per the given statement, if a person’s income is less than $110,000, then he would be given a tax credit of $1000. Now, as per the question, if a person who was earlier getting the tax credit as his income was less than $110,000 and now the tax credit has been removed, this would mean that the person would lose some amount of his fixed income from Tax credit source. This would mean that the individual’s budget constraint would be affected, as the free money is now no more available. The individual will therefore have to reduce his expenses and contact his budget constraint in such a way so that the reduced income of $1000 can now be adjusted with a sacrifice of consumption few commodities or services. From the above diagram, we can see that with the removal of the tax credit, the expenditure of the individual is now contracted from AB to CB.

Since the answers to only Question’s C and D are requested, therefore answering only C and D.

For representation and easier understanding, I have drawn an indifference curve to explain the answer better.

Answer (D): From the above diagram, we can see that with Tax credit, the indifference curve of a person would be higher at AB, whereas, with reduced or phased out tax credit, the indifference curve would now adjust only fewer goods, commodities and services and achieve a lower level at CB. As per the given statement, if a person’s income is $150,000, then he would be given a tax credit of ($1000- 5% of (150000-110000) = (1000-2000), i.e. the individual received no ax credit. For such an individual with income of $150,000 and now the tax credit has been removed, this would mean that the person would not lose any amount of his fixed income, as he anyway did not receive any Tax credit earlier. This would mean that the individual’s budget constraint would be not be affected. The individual will therefore continue to lead his current set of expenses and his budget constraint would also remain the same. In the above diagram, the budget constraint for an individual will remain at AB, as it was earlier.