Macroeconomics Final Exam Practice Problems: Income Taxes

(The attached PDF file has better formatting.)

The final exam problems compare various tax systems. Each tax has two effects:

! The income effect causes people to work more.

! The substitution effect causes people to work less.

The income effect is difficult to measure. Taxes pay for government programs, which pay
for people’s needs.

Illustration: A person earns $50,000 of pre-tax income. The government imposes a $5,000
head tax (lump-sum tax), which has no substitution effect. The person receives $45,000
after-tax, and has an incentive to work more.

Suppose the tax funds a national health insurance system. For the same private insurance,
the person might pay $10,000. After adjusting for the value of health insurance, the
person’s wealth increases after the tax, and the person works less.

Some exam problems compare two tax systems with the same total tax revenue. The
government services are the same under both programs, but the income and substitution
effects differ for each worker.

Take heed: If the exam problem does not mention the value of the government programs
to the taxpayer, assume the tax is used for foreign aid (such as helping residents of Sudan)
or foreign wars that have no effect on the taxpayer’s work effort.

Taxes on labor income are of several forms:

! Flat tax on all income. The marginal tax rate is the statutory tax rate.
! Progressive tax on all income. The tax rate is generally linear from Y% to Z%. Know
how to compute the marginal tax rate from the statutory tax rate. The mathematics is
straight-forward: differentiate the tax liability with respect to pre-tax income. If the tax
rate increases with income, the marginal tax rate exceeds the statutory tax rate.
! A tax credit for low income workers makes the tax more progressive.
! A two-tiered flat tax (Y% on one range and Z% on another range) has different marginal
tax rates in each range.

Take heed: Taxes are a critical part of the macroeconomic model. The textbook does not
show the mathematics, since many college students can not handle differentiation and
integration. The final exam problems give simple tax systems and ask for the income and
substitution effects.
*Question 1.1: Marginal Tax Rates

Workers’ pre-tax wages in Country W are a uniform distribution from $0 to $100,000.

The labor force has 10,000 persons with an average of 2,000 work-hours a year.

In 20X7, Country W has a flat tax rate of 20%.

To reduce income inequality, the government changes the tax code for 20X8 so that

! Workers earning $0 receive a $10,000 tax refund (a negative tax liability).

! The tax refund declines linearly to zero as the worker’s earnings increase to $100,000.
! Income is taxed at a flat rate of 40%.

Illustration: Esther earns $25,000 pre-tax.

! 20X7: Esther pays $25,000 × 20% = $5,000 and keeps $20,000 after-tax.
! 20X8: Esther keeps (1 – $25,000 / $100,000) = 75% of the $10,000 tax refund and
pays tax of $25,000 × 40% = $10,000. Her net tax is $10,000 – 75% × $10,000 =
$2,500. Her after-tax income is $25,000 – $2,500 = $22,500.

What are the marginal tax rates in 20X7 and 20X8?

20X7 20X8
A 20% 40%
B 40% 50%
C 20% 50%
D 40% 40%
E 20% 60%

Answer 1.1: C

20X7: For a flat tax of 20%, the marginal tax rate is the tax rate of 20%.

20X8: For a flat tax of 40%, the marginal tax rate is the tax rate of 40%. Workers also
return the tax refund of $10,000 linearly as 10% of their income. The combination is a 50%
flat tax rate.

The marginal tax rate is the slope of the graph, where the horizontal axis is pre-tax income
and the vertical axis is the tax liability. In 20X8, the tax liability is

$10,000 × Y / $100,000 + Y × 40% = 50% × Y

Intuition: A person earning $0 gets a tax credit of $10,000, and a person earning $100,000
get no tax credit. The tax credit has a 10% tax for all taxpayers.

! Pre-tax income is a uniform distribution from $10,000 to $110,000.

! The tax rate is 50%, not 40%.
*Question 1.2: Marginal Tax Rate

People earn $100 million in 20X7 and pay a flat tax rate of 20%. Each person earns
between $20,000 and $60,000 a year (pre-tax), with an average of $40,000 per person.

To make the income tax more progressive in 20X8, the government makes the tax rate 0%
for the first $20,000 of income and 40% for the next $40,000 of income.

! Joseph earns $35,000 a year (pre-tax) before the change in the tax rate.
! Benjamin earns $40,000 a year (pre-tax) before the change in the tax rate.
! Ephraim earns $45,000 a year (pre-tax) before the change in the tax rate.

The marginal tax rate affects people’s incentives to work. The amount they work affects
the total tax they pay.

For this question, ignore wealth effects on labor supply. Assume only the substitution effect
(the relative benefit of work vs leisure) affects hours worked.

Who works more hours, who works fewer hours, and who works the same hours?

Joseph Benjamin Ephraim

A more more more

B more same fewer
C more fewer fewer
D fewer same more
E fewer fewer fewer

Answer 1.2: E
*Question 1.3: Marginal Tax Rate

People earn $100 million in 20X7 and pay a flat tax rate of 20%. Each person earns
between $20,000 and $60,000 a year (pre-tax), with an average of $40,000 per person.

To make the income tax more progressive in 20X8, the government makes the tax rate 0%
for the first $20,000 of income and 40% for the next $40,000 of income.

! Jacob earns $35,000 a year (pre-tax) before the change in the tax rate.
! Rachel earns $45,000 a year (pre-tax) before the change in the tax rate.

The marginal tax rate affects people’s incentives to work by the substitution effect. Their
net after-tax income affects their need for cash (the income effects). The amount they work
affects the total tax they pay.

Which of the following is true?

A. Jacob pays less tax in 20X7; Rachel may pay more or less
B. Rachel pays more tax in 20X7; Jacob may pay more or less
C. Both Jacob and Rachel pay less tax in 20X7
D. Jacob pays less tax in 20X7; Rachel pays more tax
E. Both Jacob and Rachel may pay more or less tax in 20X7

Answer 1.3: A

Jacob pays less tax in 20X7; Rachel may pay more or less

To solve this problem, we determine

! The total tax each person would pay if he/she worked the same amount.
! Whether each person works more or less in 20X8 than in 20X7.

We reason through each scenario.

! If the same work leads to less tax and the person works less in 20X8, he/she surely
pays less tax.
! If the same work leads to more tax and the person works less in 20X8, he/she may pay
more or less tax.
! If the same work leads to more tax and the person works more in 20X8, he/she surely
pays more tax.
! If the same work leads to less tax and the person works more in 20X8, he/she may pay
more or less tax.
A higher marginal tax rates induces a person to work less, though we don’t know how
much less. Raising the marginal tax rate from 20% to 40% may induce a person to work
one hour less or not to work at all at the 40% marginal tax rate. For example,

! Raising the tax rate from 1% to 2% has a small effect on the hours worked.
! Raising the tax rate from 50% to 100% causes the person to stop working.

The marginal tax rate increases for both Jacob and Rachel, so both work less in 20X7.
The decrease in work lowers pre-tax income. One is tempted to reason that:

! If the marginal value of leisure is small, the decrease in work is small, and the pre-tax
income declines little.
! If the marginal value of leisure is large, the decrease in work effort is large, and the pre-
tax income declines much.

This reasoning is a good way to start, but it is not well worded. At equilibrium, the marginal
value of leisure equals the marginal variance of the work income. Raising the marginal tax
rate reduces the marginal variance of work income. To determine how much less the
person works, we examine the slopes of the value of leisure and work income.

! If the value of leisure and of work are relatively flat (the marginal value varies little by
amount of work or leisure), a decrease in the after-tax wage causes a large decrease
in work effort.
! If the value of leisure and of work are relatively steep (the marginal value varies greatly
by amount of work or leisure), a decrease in the after-tax wage causes a small
decrease in work effort.

Take heed: For the final exam, focus on the intuition. The exam problems do not compute
the exact amount by which work effort increases or declines.

We also consider the income effect.

If Jacob’s work hours do not change, his after-tax income is

! 20X7: $35,000 × (1 – 20%) = $28,000

! 20X8: $35,000 – 40% × ($35,000 – $20,000) = $29,000

Jacob has more income in 20X8, so the income effect induces him to work less.

If Rachel’s work hours do not change, her after-tax income is

! 20X7: $45,000 × (1 – 20%) = $36,000

! 20X8: $45,000 – 40% × ($45,000 – $20,000) = $35,000

Rachel has less income in 20X8, so the income effect induces her to work more.
The substitution effect causes Rachel to work less. We don’t know which effect is stronger,
so we don’t know if she works more or less.

Take heed: Some exam problems separate the income effect from the substitution effect,
giving easier problems. For your exam preparation, first examine each effect separately.
The exam problems are not intricate, and they do not test mathematical ability. If you
understand the concepts and review the practice problems, you can solve exam problems.
*Question 1.4: Marginal Tax Rates

A country has a flat income tax, so the total tax revenue is the pre-tax income times the tax
rate. The government wants to maximize the total tax revenue. An increase in the tax rate

A. Raises total tax revenue.

B. Lowers total tax revenue.
C. Lowers total tax revenue at low tax rates and raises total tax revenue at high tax rates.
D. Raises total tax revenue at low tax rates and lowers total tax revenue at high tax rates.
E. Has little or no effect on total tax revenue.

For this exam problem, interpret low tax rates as a tax rate that approaches zero and high
tax rates as a tax rate that approaches one. The actual demarcation point depends on
other characteristics of the economy and the workers. Barro believes the dividing point is
somewhere between 50% and 75%

Answer 1.4: D

We use the following reasoning:

! At a zero tax rate, the total tax revenue is zero, so an increase in the tax rate increases
the total tax revenue.
! At a 100% tax rate, people don’t work, since they keep none of their earnings, and total
tax revenue is zero. A decrease in the tax rate induces some people to work, so total
tax revenue increases.

Illustration: Suppose workers earn $10 an hour. If the tax rate is zero, people work 2,000
hours a year. If the tax rate is Z%, people work (1 – Z%) × 2,000 hours a year.

~ If the tax rate is 10%, people work 90% × 2,000 = 1,800 hours a year. Total tax
revenue is 10% × $10 × 1,800 = $1,800.00 per worker.
~ If the tax rate is 11%, people work 89% × 2,000 = 1,780 hours a year. Total tax
revenue is 11% × $10 × 1,780 = $1,958.00 per worker.

At low tax rates, total tax revenue increases as the tax rate increases.

~ If the tax rate is 90%, people work 10% × 2,000 = 200 hours a year. Total tax revenue
is 90% × $10 × 200 = $180.00 per worker.
~ If the tax rate is 91%, people work 9% × 2,000 = 180 hours a year. Total tax revenue
is 91% × $10 × 180 = $162.00 per worker.

At low tax rates, total tax revenue decreases as the tax rate increases.

Intuition: At a 0% tax rate, total tax revenue is zero. At a 100% tax rate, people do no
work, since they keep nothing of what they earn, and total tax revenue is again zero. At
rates between 0% and 100%, people do some work, so total tax revenue is positive. We
infer that at low tax rates, total tax revenue increases from zero to a positive amount, and
at high tax rates, total tax revenue decreases from a positive amount to zero.

Algebra: In the example here, people work 2,000 × (1 – Z) hours, where Z is the tax rate.
The total tax revenue is 2,000 × (1 – Z) × Z. The partial derivative with respect to Z is
2,000 × (1 – 2Z).

~ If Z < 50%, the partial derivative is positive and total tax revenue increases.
~ If Z = 50%, the partial derivative is zero and total tax revenue stays the same.
~ If Z < 50%, the partial derivative is negative and total tax revenue decreases.

The incentive effects are stronger when the tax rate is progressive. This illustration uses
flat tax rates, with weaker but still evident effects.

In countries with high marginal tax rates, such as Switzerland, total tax revenue decreases,
because people have less incentive to work. If the tax rate were lower, the government
would have more tax revenue and the workers would have more after-tax income.

Jacob: If reducing the tax rate causes people to work more and raises total tax revenue,
the government has more money for social programs. Why would anyone oppose a tax
reduction?

! Conservatives want to reduce the tax rate.

! Progressives want more total tax revenue for social programs.

Rachel: Progressive tax rates reduce income inequality. Many people don’t like inequality.
They would like everyone to be wealthy. But if not everyone can be wealthy, they prefer
everyone to be poorer if it reduces economic differences.
*Question 1.5: Income and Substitution Effects

In 20X7, Country W has a flat tax rate of 20%.

To reduce income inequality, the government changes the tax code for 20X8 so that

! Workers earning $0 receive a $10,000 tax refund (a negative tax liability).

! The tax refund declines linearly to zero as the worker’s earnings increase to $100,000.
! Income is taxed at a flat rate of 40%.

Abigail earns pre-tax income of $33,333 in 20X7. What are the income and substitution
effects on her labor hours if each is considered separately.

Illustration: Choice A says:

! If the substitution effect is zero, the income effect causes her work hours to decrease.
! If the income effect is zero, the substitution effect causes her work hours to increase.

Income Effect Substitution Effect

A Fewer Hours More Hours

B More Hours Fewer Hours

C Fewer Hours Fewer Hours

D More Hours More Hours

E No Change Fewer Hours

Answer 1.5: E

Abigail has pre-tax income of $33,333 in 20X7.

! 20X7: The tax liability is 20% × $33,333 = $6,667

! 20X8: The net tax liability is 50% × $33,333 – $10,000 = $6,667

As worked out above, a tax refund that decline from $10,000 to $0 is like a tax refund of
$10,000 and an extra 10% tax rate.

If Abigail works the same hours in 20X8, her net tax liability is the same as in 20X7, so the
income effect is zero.

If the substitution effect is zero, the income effect by worker is

! A worker who earns less than $33,333 pays less tax and works fewer hours.
! A worker who earns more than $33,333 pays more tax and works more hours.
The marginal tax rate is higher in 20X8 than in 20X7 for all workers. The substitution effect
causes all workers to work fewer hours.
*Question 1.6: Income and Substitution Effects

Abigail earns pre-tax income of $33,333 in 20X8. What are the income and substitution
effects on her labor hours if each is considered after the other has its effect.

Illustration: Choice A says:

! After the substitution effect, the income effect causes her work hours to decrease.
! After the income effect, the substitution effect causes her work hours to increase.

Income Effect Substitution Effect

A Fewer Hours More Hours

B More Hours Fewer Hours

C Fewer Hours Fewer Hours

D More Hours More Hours

E No Change Fewer Hours

Answer 1.6: B

Abigail has pre-tax income of $33,333 in 20X7.

! 20X7: The tax liability is 20% × $33,333 = $6,667

! 20X8: The net tax liability is 50% × $33,333 – $10,000 = $6,667

The marginal tax rate is higher in 20X8 than in 20X7 for all workers. The substitution effect
causes all workers to work fewer hours.

Because of the substitution effect, Abigail works fewer hours in 20X8. Her net tax liability
is smaller than in 20X7, so her after-tax income is lower and the income effect makes her
work more hours.
*Question 1.7: Income Effect

In 20X7, Sarah, Rebecca, and Leah earn pre-tax income of $30,000, $40,000, and
$50,000, respectively.

From the income effect alone (not the substitution effect), will they work more or fewer
hours in 20X8?
Sarah Rebecca Leah

A Fewer Fewer Fewer

B More More Fewer

C Fewer More More

D Fewer No Change More

E More No Change Fewer

Answer 1.7: C

Consider Rebecca, who earns $40,000 in 20X7.

! In 20X7, she pays tax of 20% × $40,000 = $8,000.

! In 20X8, she keeps 1 – 40% = 60% of the tax refund. She pays tax of 40% × $40,000
= $16,000. Her net tax liability is $16,000 – $6,000 = $10,000.
! She has less after-tax income in 20X8. By the income effect, she works more hours.

Similar analysis for Sarah and Leah give Choice C for the answer.
*Question 1.8: Substitution effect

In 20X6, Sarah, Rebecca, and Leah earn pre-tax income of $30,000, $40,000, and
$50,000, respectively.

From the substitution effect alone (not the income effect), will they work more or fewer
hours?

Sarah Rebecca Leah

A Fewer Fewer Fewer

B More More Fewer

C Fewer More More

D Fewer No Change More

E More No Change Fewer

Answer 1.8: A

The marginal tax rate increases from 20% to 50% for all workers, so all workers work fewer
hours by the substitution effect.
*Question 1.9: Marginal tax rates

Country W and Country Z have identical labor forces, with workers earning pre-tax incomes
in a uniform distribution from $0 to $100,000. Neither country yet has an income tax.

To finance the costs of reversing global warming, both countries levy an income tax.

! Country W imposes a flat 20% income tax for all workers.

! Country Z imposes a progressive income tax that rises linearly from 0% at $0 of pre-tax
income to 30% at $100,000 of pre-tax income.

For a person earning $50,000, what are the marginal tax rates in Countries W and Z?

Country W Country Z

A 20% 15%
B 20% 30%
C 20% 60%
D 40% 30%
E 40% 60%

Answer 1.9: B

Let Y be the pre-tax income.

In Country W:

! The tax is 20% × Y.

! The marginal tax rate is M(20% × Y)/MY = 20%.

The marginal tax rate equals the tax rate for all workers.

In Country Z:

! The tax rate is 30% × Y / $100,000.

! The tax is Y × 30% × Y / $100,000 = 30% × Y2 / $100,000.
! The marginal tax rate is M(30% × Y2 / $100,000)/MY = 60% × Y / $100,000.

For a person earning $50,000, the marginal tax rate is 60% × $50,000 / $100,000 = 30%.
*Question 1.10: Average tax rates

Country W and Country Z have identical labor forces, with workers earning pre-tax incomes
in a uniform distribution from $0 to $100,000. Neither country yet has an income tax.

To finance the costs of reversing global warming, both countries levy an income tax.

! Country W imposes a flat 20% income tax for all workers.

! Country Z imposes a progressive income tax that rises linearly from 0% at $0 of pre-tax
income to 30% at $100,000 of pre-tax income.

If people do not change their work hours because of the tax, what are the average tax rates
in Country W and Country Z?

Take heed: You must weight the tax rates by the pre-tax income. For persons with incomes
of $10,000 and $20,000 and tax rates of 3% and 6%, the average tax rate is ($10,000 ×
3% + $20,000 × 6%) / $30,000 = 5.00%.

Country W Country Z

A 20% 10%
B 20% 20%
C 20% 30%
D 10% 10%
E 10% 20%

Answer 1.10: B

Country W: The tax rate is 20% for all workers.

Country Z: To simplify the mathematics, we use units of $100,000. The pre-tax income is
Y, which ranges from 0 ($0) to 1 ($100,000).

! The tax rate is 30% × Y.

! The tax is Y × 30% × Y = 30% × Y2.

We integrate the tax over the uniform distribution from 0 to 1 to get total tax revenue:

I 30% × Y2 MY = 30% × a × Y3 from 0 to 1 = 10%.

The average pre-tax income is $50,000, or 0.5 in units of $100,000.

The average tax rate is 10% / 0.5 = 20%.

*Question 1.11: Average tax rates

Country W and Country Z have identical labor forces, with workers earning pre-tax incomes
in a uniform distribution from $0 to $100,000. Neither country yet has an income tax.

To finance the costs of reversing global warming, both countries levy an income tax.

! Country W imposes a flat 20% income tax for all workers.

! Country Z imposes a progressive income tax that rises linearly from 0% at $0 of pre-tax
income to 30% at $100,000 of pre-tax income.

A tax affects work effort two ways:

! Substitution effect: The tax reduces the value of each hour of labor compared to an
hour of leisure, so people prefer less work and more leisure.
! Income effect: The tax reduces total income, so people have more need for income and
work more.

The income effect and substitution effect depend on the wealth of the worker.

! The income effect is strong as low wage levels. A poor person earning subsistence
wages may work an extra hour if the tax rate rises.
! The substitution effect is strong at high wage levels. A rich person may decide to work
less if the tax reduces the net income.

If people change their work hours because of the tax, which country raises the greater total
tax revenue and which country has the greater after-tax net income?

Greater Total Tax Greater After-tax Net

Revenue Income

A Country W Country W
B Country W Country Z
C Country Z Country W
D Country Z Country Z
E Country W Equal

Answer 1.11: A

If people do not change their work hours because of the tax, the two countries have the
same pre-tax income, the same average tax rate, the same total tax revenue, and the
same after-tax income.

We group workers by pre-tax income:

! Low income workers earn less than $33,333.
! Medium income workers earn from $33,333 to $66,667.
! High income workers earn more than $66,667.

We compare the tax rates and marginal tax rates in the two countries.

The tax rate and the tax liability in Country Z are lower for people earning < $66,667 and
higher for people earning > $66,666. From the income effect,

! Low income and medium income workers pay less tax in Country Z, so they have more
after-tax income and they work fewer hours.
! High income workers pay more tax in Country Z, so they have less after-tax income and
they work more hours.

The marginal tax rate in Country Z is lower for people earning < $33,333 and higher for
people earning > $33,333. From the substitution effect:

! Low income workers have a lower marginal tax rate in Country Z, so they have a
greater preference for work over leisure and they work more hours.
! Medium income and high income workers have a higher marginal tax rate in Country
Z, so they have a weaker preference for work over leisure and they work fewer hours.

We combine the two effects by income level.

! The income effect is strong at low incomes, so low income workers work fewer hours.
! At medium incomes, both the income effect and the substitution effect causes people
to work fewer hours.
! The substitution effect is strong at high incomes, so high income workers work fewer
hours.

Empirical data supports these relations.

Tax rates in the U.S. rose from zero at the beginning of the 20th century to about 30% now.
Average personal wealth for low income workers doubled or tripled (in real terms). The
precise change depends on how we measure wealth.

Average work hours per week for low income workers declined from about 55 to about 40.

! In 1900, a poor person worked 55 hours a week to pay for food, clothing, and rent.
! In 2000, a person earns enough in 40 hours a week for food, clothing, and rent.

The substitution effect is seen from tax rate changes.

! When tax rates for high income workers rise, they work less and often pay less tax.
! When tax rates for high income workers fall, they work more and often pay more tax.
For the average tax per capita, assume one taxpayer. We use units of $100,000
The total tax revenue is number of workers times 10,000 in Country W and Country Z.

The marginal tax rates are 20% in Country W and 60% × y in Country Z,