Public Economics and Public Finance – Spring 2024

Problem Set 6/7 – Personal Income Taxes & Taxes and Labor Supply

Question 1

Kevin’s marginal tax rate is 35 percent and he itemizes his tax deductions. How much is a $700 deduction worth to him? How much is a $700 refundable credit worth to him?

Question 2

Ed and Wendy are a married couple with no children. Each earns $60,000 per year, and their combined household adjusted gross income is $120,000. John and Kristen are also married and have $120,000 in combined household  adjusted gross income and no children. However, Kristen earns all of the income; John does not work. To answer  this question, use the 2018 tax rates for individuals with different filing status below.

a) How much income tax does each couple owe? Assume that both take the standard deduction of$12,000 ($24,000 combined) and that they are married, filing jointly.

b) What is their marginal tax rate? What is their average tax rate? Assume both families had no “above-the-line” deductions (like tuition expenses), i.e., adjusted gross income = gross income.

c) Does either couple pay a “marriage tax?” Does either couple receive a “marriage benefit?”

Question 3

Suppose that the government introduces an Earned Income Tax Credit such that for the first $8,000 in earnings, the government pays 50¢ per dollar on wages earned. For the next $3,000 of earnings, the credit is held constant at $4,000, and after that point the credit is reduced at a rate of 20¢ per dollar earned. When the credit reaches zero, there is no additional EITC.

a) Draw the budget constraint that reflects this earned income tax credit for a worker who can work up to 4,000 hours per year at an hourly wage of $20 per hour. Mark all intercepts, kink points, and slopes.

b) Illustrate on your graph the portions of the budget constraint where the labor supply effects of the policy are positive (i.e., work more), negative, or ambiguous, relative to the “no policy” status quo.

Question 4

For which group of workers is the substitution effect associated with a tax increase more likely to outweigh the income effect: primary earners or secondary earners? Explain.