Applied Problem: Income Inequality

The following questions are meant to illustrate important economic considerations in designing policies aimed at reducing income inequality: specifically, taxes on the rich.

In addition to the course readings:

Creedy, 2010, "The Elasticity of Taxable Income: A Non-Technical Summary" may be a useful resource.

Mankiw, 2010, "I Can Afford Higher Taxes. But They'll Make Me Work Less" provides a provocative perspective.

The net-of-tax or retention rate of income is defined as:

Income retention rate = (1-)

In other words, the proportion of taxable income that remains after taxes.

The elasticity of taxable income ("eta") is defined as follows:

where z denotes reported income, and (%"delta") denotes percentage changes.

a)What potential margins of adjustment might the elasticity of taxable income represent? Name at least 3 margins. (3pts)

b)Explain whymight be an important parameter for policy? (Hint: For instance, in estimating how much revenue might be raised by increasing top income tax rates. 3pts)

The President/Prime Minister of Unequaland is concerned about the rise in income inequality in his/her/their country. A proposal has been put forth to increase marginal taxes on the highest income earners. Unequaland, unequal as it is, nevertheless already has a progressive income tax system.

c)In two sentences or less, explain what it means for a society to have a "progressive" tax system. (3pts)

Currently, the top marginal tax rate in Uequaland is 30%.

d)What is the net-of-tax rate for top earners in Unequaland? (2pts)

The new proposal would raise the top marginal tax rate to 80%.

e)What would the net-of-tax rate be if the proposal were implemented? (2pts)

Your team has been tasked with estimating the potential revenue raised by this policy. Suppose that the policy would apply to everyone with incomes above $1,000,000 per year. All other tax rates would remain unchanged. Suppose there are approximately 1,000 millionaires in this country, with an average income of $2,000,000.

f)Assuming, probably naively, that , how much additional revenue would you estimate from this policy? Note that we are interested in the change in revenue, not total revenue. (5pts)

The President and his/her/their constituents are greatly excited by the prospect of using this revenue to fund sorely needed public investments, including infrastructure, education, and health care. Cognizant of the long-term costs of populism (despite short-term political gain), He/She/They are committed to delivering on campaign promises. As such, they insist on probing the robustness of the policy to alternative assumptions.

You note that economists have attempted to estimate the potential responses to a change in top marginal taxes, including possible tax-evasion and reduced economic activity in Unequaland, and published many studies on potential values of Across a range of studies, you note that has been estimated to be between and 0.4.

g)Assuming that , how much revenue would you estimate will be raised by this policy? (Be sure to show your work. For simplicity, assume that no current millionaires are induced to earn less than $1m due to the policy: that is, assume for simplicity that everyone above $1m earns $2m before the proposed policy. 5pts)

h)Is the expected revenue figure smaller or larger? By how much? Explain why these two estimates are so different.

A member of your team notes that, in neighboring Ruleoflawland, a recent measure that increased funding for tax enforcement reduced tax evasion by 50%. Suppose that half of all changes in reported income due to increased taxes arise from tax evasion, and that implementing a similar tax enforcement policy in Unequaland would cost $10m.

i)Should people recommend implementing such a policy? Be sure to support your answer with an estimate of the cost-effectiveness of the tax enforcement policy. Assume that represents the best-guess for Unequaland without any changes in tax enforcement. (5pts)