Class 13: "That's Voodoo Economics"

For question 1 assume the economy's tax system looks as follows:

Income Tax Percent

0-20,000 0%

20,001-30,000 20%

30,001-50,000 40%

All income above 50K is taxed 60%

1. Suppose you make an annual salary of $60,000. How much would you pay in Federal income tax? Now suppose you boss offered to give you a $5,000 salary bonus (perhaps a promotion/raise) if you'd take on an important extra task that would require you to work some late nights or early mornings. How much of this $5,000 would you get to keep after taxes?

2. Ron says that if the government cuts tax rates by 20 percent, the tax revenue the government collects will not correspondingly fall by 20 percent. Rather it will fall some amount less than 20 percent, and in fact, revenues could even rise after the tax cut. His buddy George calls this "voodoo economics" and thinks Ron is nuts. Role play Ron and explain your logic to George.

3. A key point of supply-side economists is that tax cuts will grow the economic pie (real GDP). Draw the labor market and production function graphs and demonstrate the effects of a tax cut that increases incentives to work, save, and invest. Show that the economic pie, i.e. full employment level of real GDP (Yf*), is larger than before the tax cut.

4. Draw the Laffer Curve and EXPLAIN in sentence form what it says/implies.

5. Suppose the government tax rate is a flat 50 percent. Current GDP is $10 Trillion and hence revenue collected by the government is $5 Trillion. Suppose we cut the tax rate to 40 percent. Under the assumption that no one would change their behavior, how much will this tax cut cost in lost revenue? Supply-siders argue that such a tax cut would increase economic growth since it would increase incentives to work and investassume that this tax cut causes the economy to grow 5 percent increasing GDP (and hence the tax base) to 10.5 Trillion. How much does the tax cut cost in terms of lost revenue next year? (Hint: what is 40 percent of 10.5 Trillion? Compare this to your original $5 trillion in revenue.)