Suppose Congress is considering raising the top federal marginal tax rate from 35% to 40%. Senator Jones believes the elasticity of taxable income is large. Senator Smith believes the elasticity of taxable income is small. (Both believe the elasticity is positive.) The Congressional Budget Office estimates the effects of the tax proposal using each Senator’s assumptions.

 

b) Consider a family that earns $120,000 per year, pre-tax. Suppose their marginal tax rate on income is 25%. The government is considering raising the tax rate to 40%. Suppose that the elasticity of taxable income is 0.5. What would the change in deadweight loss arising from this tax increase be? c) What would the change in tax revenue be if we assumed that this family continued to earn $120,000? d) What would the actual change in tax revenue be? Please give a numerical answer. (Hint: %A(1-7)= -0.2) e) Senator Laffer argues that the tax increase will actually result in a reduction in revenue. How large would the elasticity of taxable income need to be in order for the tax increase to result in a decrease in tax revenue?