Question

Suppose that you have a job with a wage of $25 per hour. The job is extremely flexible: you

can choose to work any number of hours from 0 to 2,000 per year. The income tax system

is as follows.

•Income up to $10000: no tax.

•Income from $10000 to $30000: 20% tax rate.

•Income from $30000 up: 30% tax rate.

(a) Draw a graph in leisure hours/consumption space, showing your opportunity set with

and without the tax system. Label the intercepts, slopes, and coordinates of the kinks

if there is any.

(b) Suppose that you choose to work 1,500 hours per year. What is your marginal tax

rate? What is your average tax rate? Show your work.

(c) Compare your situation that you choose to work 1,500 hours under the above tax

system with the one that there is no tax at all at any level of income.

(i) You would work more if there is no tax. Draw a set of indifference curves on a

separate graph as in (a) that reflect your choice with tax (work 1,500 hours) and

without tax (work more than 1,500 hours). Which effect dominates: income or

substitution effect?

(ii) You would work less if there is no tax. Draw a set of indifference curves on a

separate graph as in (a) that reflect your choice with tax (work 1,500 hours) and

without tax (work less than 1,500 hours). Which effect dominates: income or

substitution effect?

Answer 1