Question

Song earns $148,000 taxable income as an interior designer and is taxed at an average rate of 20 percent (.e., $29,600 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 $111,000 in taxable income? O Government's tax revenues would decrease by $1850 Government's tax revenues would increase by $1850 O Government's tax revenues would decrease by $2100 Government's tax revenues would increase by $2100 Government's tax revenues would remain unchanged hat is the term that describes this type of reaction to a tax rate increase?

Answer 1

If Song only earns $ 111,000 of taxable income, she would pay only $27,500 of tax under the new tax structure (i.e., $110,000 x .25).

1. Thus, the government’s tax revenues would decrease by $2,100 [i.e., $27,500 – ($148,000*0.2)].
2. This is an example of the substitution effect.
3. Taxpayers with more disposable income are likely to respond in this manner.

Note: When government changes tax, there are two impacts – substitution and income effect. In this case, the government has increased tax rate. In this case, the tax rate increase of 25% on 20 equates the income decline.