# 5. LO 4 Suppose, as in the federal income tax codefor the United States, that the representative con-sumer faces a wage income tax with a standarddeduction. That is, the representative consumerpays no tax on wage income for the first x units ofreal wage income, and then pays a proportionaltaxt on each unit of real wage income greater thanx Therefore, the consumer's budget constraintgiven by C wh -D + if wh- D=x., orC (1-wh-D+ tx+ if_wCh = D2Now, suppose that the government reducestax deduction x Using diagrams, determine theeffects of this tax change on the consumer, andexplain your results in terms of income and substitution effects. Make sure that you consider twocases. In the first case, the consumer does not payany tax before x is reduced, and in the secondcase, the consumer pays a positive tax before xis reduced

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Step 1

Case 1

In the first case when consumers do not pay taxes earlier, a reduction in tax deduction can have two effects. That is if real wage income earned by a labor is still less than the amount of x than there will be no change on the consumer. In the second situation when tax deduction reduces to a point where wage income earned by the consumer is greater than the tax deduction than he is required to pay more and hence leads to the changes shown in the diagram below. In the ...

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