Question

SCENARIO INTRODUCTION

Use the information provided below to complete the questions.

Suppose a small economy has two income tax rates: 20% for all income up to $50,000 and 30% for any income earned above $50,000. Suppose that the economy has a Government Budget for this year (year 1) of $70,900.00, and a total of five individuals earning the following income: Carla $28,000, Ben $49,000, Jennifer $50,000, Donnie $75,000, Maria $110,000. In chapter 5 we saw that GDP can be calculated in two ways, via the expenditure approach or the income approach, and that when the income approach is used, there must be adjustments made to National Income, specifically adding the Consumption of Fixed Capital and a Statistical Discrepancy. For the sake of simplicity, let's imagine that National Income is equal to GDP, in other words the Consumption of Fixed Capital and the Statistical Discrepancy are equal to zero.


CALCULATING TAX REVENUES - YEAR 1
1. Calculate the Total Tax Revenues. a) what would be the total tax revenue paid by each of the five citizens? b) what is the total tax revenue for the small nation? (16 points)

2. What is the small Nation's Income in year 1? (6 points)

3. What percent of the Nation's Income does the Total Tax Revenue represent? (6 points)

4. In year 1, does the economy have a balanced budget, a budget surplus, or a budget deficit. Accompany your response with the corresponding dollar amount. (6 points)

CALCULATING TAX REVENUES - YEAR 2
5. Now assume that a recession (triggered by a reduction of Aggregate Demand) causes each of the five incomes to fall by 20%. In other words, income is 80% of what they used to be. Given the lower income, a) what would be the total tax revenue paid by each of the five citizens? b) what is the total tax revenue for the small nation? (18 points)

6. What is the Nation's Income in year 2? (6 points)

7. In year 2, what percent of the Nation's Income does the Total Tax Revenue represent? (6 points)

8. Suppose that the Government Budget remained the same in year 2. Is the economy experiencing a balanced budget, a budget surplus, or a budget deficit, in year 2? Accompany your response with the corresponding dollar amount. (6 points)

PUTTING IT ALL TOGETHER - PART 3
9. Using the answers for part 1 and part 2. Explain how this progressive tax structure (20% and 30% tax brackets) acts as an automatic stabilizer. (10 points)

10. Using the answers for part 1 and part 2. What is the size of the recessionary Gap? In other words, what is the dollar value of the GDP that is being lost (not produced) because of the recession? (10 points)

11. Assuming a Marginal Propensity to Save (MPS) of 20% or 0.20, use the Keynesian Multiplier to determine the additional amount of government spending required. (10 points)

Answer 1

Step-by-step explanation:

a) Carla pays 20% of $28,000 which is $5,600.

Ben pays 20% of $49,000 which is $9,800.

Jennifer pays 20% of $50,000 which is $10,000.

Donnie pays 20% of the first $50,000 of income which is $10,000 and 30% of the remaining $25,000 which is $7,500, making a total of $17,500.

Maria pays 20% of the first $50,000 of income which is $10,000 and 30% of the remaining $60,000 which is $18,000, making a total of $28,000.

b) The total tax revenue for the small nation is $70,900, since that is the government budget.

2) The small nation's income in year 1 is the sum of the incomes of all five citizens, which is $312,000($28,000 + $49,000 + $50,000 + $75,000 + $110,000).

3) The total tax revenue represents 22.7% ($70,900 ÷ $312,000 x 100%) of the nation's income.

4) The small economy has a budget deficit of $0.00, since the government budget is equal to the total tax revenue.

5)

a) Carla pays 20% of 80% of $28,000 which is $4,480.

Ben pays 20% of 80% of $49,000 which is $7,840.

Jennifer pays 20% of 80% of $50,000 which is $8,000.

Donnie pays 20% of the first $50,000 of income which is $10,000 and 30% of 80% of the remaining $25,000 which is $6,000, making a total of $16,000.

Maria pays 20% of the first $50,000 of income which is $10,000 and 30% of 80% of the remaining $60,000 which is $14,400, making a total of $24,400.

b) The total tax revenue for the small nation is $60,720.

6) The small nation's income in year 2 is the sum of the incomes of all five citizens, which is $249,600 ($22,400 + $39,200 + $40,000 + $60,000 + $88,000).

7) The total tax revenue represents 24.3% ($60,720 ÷ $249,600 x 100%) of the nation's income.

8) The small economy has a budget deficit of $10,180 ($70,900 - $60,720), since the total tax revenue is less than the government budget.

9) The progressive tax structure acts as an automatic stabilizer because during a recession, when incomes fall, the amount of tax revenue collected also falls. This provides some relief to taxpayers who are experiencing lower income and helps to lessen the severity of the recession.

10) The size of the recessionary gap is the difference between the income in year 1 and the income in year 2, which is $62,400 ($312,000 - $249,600).

11) The Keynesian Multiplier is 1 ÷ (1 - MPS) = 1 ÷ (1 - 0.20) = 1.25. To determine the additional amount of government spending required, we can use the following formula:

Change in GDP = Multiplier x Change in Government Spending

Since the recessionary gap is $62,400, the change in government spending required is:

$62,400 = 1.25 x Change in Government Spending

Change in Government Spending = $49,920.

Therefore, the additional government spending required is $49,920.