Question

Ira’s only source of income is from working. He can work as many hours per day as he wishes (up to a maximum of 24 hours) at a fixed wage rate of $10 / hour.

a. Initially, assume that there is no income tax.

  Draw Ira’s budget constraint.

b. Now suppose, that the government introduces a tax rate of 50 cents in the dollar. Suppose that leisure is a normal good that tax ends up reducing Ira’s hours worked. Show in your diagram the effect of the tax on Ira’s budget constraint and possible indifference curves for his initial and final consumption.

c. Now suppose, that the government decides to make the first $40 per day (or 4 hours worked) tax-free. Beyond this point, income is tax at a rate of 50 cents in the dollar. On a separate diagram, draw Ira’s budget constraint. Assume that Ira chooses to work 8 hours per day.

How much tax would the government collect?

d. Now suppose, that the government replaces the tax analyzed in part (c) with a 25 percent tax rate on all income.

Which tax would Ira prefer?

Which would raise more tax revenue?

Answer 1