1. The supply of labor (and other factors) in and out of a city is more elastic than the supply of factors to the nation as a whole. Therefore, an income tax reduction at the city level is likely to lose less revenue than such a reduction at the federal level, ceteris paribus. Just as one can think of ―welfare-induced‖ migration for poor households, one can think of
―tax-induced‖ migration for businesses and possibly workers. If the city lowers tax rates (and other cities do not respond accordingly), then one imagines that a number of businesses will enter that state and spur economic activity.
2.
If individuals view their loss in the labor income taxes as offset by the benefits of public services, labor supply falls by AB hours. This is the compensated change in hours with respect to a change in the net wage rate.
3.
4. The effect of the change in the highest marginal tax rate on the individual’s budget constraint is demonstrated below:
Income
Leisure
The resulting change in the tax rate moves part of the budget line out to the new, dotted budget constraint. This policy has an effect on labor supply analogous to the effect of an increase in an individual’s wage rate on labor supply: it is theoretically ambiguous. The reason for this ambiguity is that there are two competing effects -- a substitution effect which acts to decrease leisure, and an income effect which increases leisure. The decrease in the tax rate makes leisure more expensive, so the substitution effect dictates that less of it is to be consumed. However, there is extra income provided by this tax cut, and the income effect makes the individual want to consume more leisure. These two competing effects make the overall change in labor supply ambiguous. Existing empirical work suggests that for prime age males, the income and substitution effects more or less cancel each other out. For working wives, the substitution effect dominates, meaning that the reduction in marginal tax rates would tend to increase their labor supply.
The effect on savings can be demonstrated using a diagram illustrating the change in the intertemporal budget constraint that results from this tax change:
Future Consumption
E E’
Current Consumption The policy moves the endowment point from point E to E’, and it changes the slope of the intertemporal budget constraint, which is equal to [1 + (1-t)r], where ―t‖ is the tax rate, and ―r‖ is the real interest rate. Once again, the overall effect of this policy on
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savings will be ambiguous, since there are again competing income and substitution effects. The extra income gained from the tax cut will make this individual want to opt for more consumption in both periods (now and in the future), so this will cause savings to increase (intuitively, the individual will consume some of her extra income now, and some in the next period). However, the tax cut will also change the slope of the budget line. This causes a substitution affect which makes consuming in the current period more expensive (so savings will increase), but it causes income to rise, which makes this individual want to consumer more in the current period. The counteracting effects make it difficult for us to say what will happen to overall savings. Econometric work suggests that changes in marginal tax rates have little effect on individual saving.
Lastly, the effect on tax revenues will be negative (a decrease in the tax rate will have a direct effect in this case). However, this decrease will not be as pronounced as we might think. First, to the extent that some individuals work more, taxable income will increase.
More importantly, individuals will opt for more taxable income instead of nontaxable income as the tax rate falls. For instance, since fringe benefits are like non-taxable income, an individual will prefer them to cash payments (which are taxable) when the tax rate is high. However, the opposite is true when the tax rate falls. Thus, although with a lower tax rate less revenue is collected from a given tax base, this decrease is somewhat counteracted by the increase in the base itself. That said, there is no evidence that the increase in the base would be large enough to make the tax self-financing.
5. The interest rate cut may be successful at stimulating consumer spending. Reducing the rate of return on savings reduces the opportunity cost of current consumption, which tends to increase current consumption and lower saving (the substitution effect). On the other hand, the fact that the interest rate is lower makes it harder for a saver to achieve any future consumption goal (the income effect), so the effect may be to increase saving and reduce current consumption. The policy will have the desired results if the substitution effect dominates the income effect.
6. Increasing tax rates will not increase tax revenue if European tax rates are on the right-hand side of the Laffer Curve (Figure 18.6), where the tax rate exceeds tA.
7. A rational person will increase savings in reaction to reduced interest rates, as suggested by the financial columnist, if the income effect is stronger than the substitution effect.
This would result in a downward-sloping supply of savings curve.
8. The individual receives a benefit equal to the market rental value of the house because he lives in the house. Whether he lives in the house or not, he receives a net benefit; the only difference is that when he rents out the house, he explicitly receives the rent in cash, while if he lives in the house, he effectively pays himself. Implicit or not, it is still income, and under a Haig-Simons income tax, it should be taxed.
9. a. The supply curve is given by S = -100 + 200wn. The gross wage is w = 10, and the net wage is wn = (1-t)w = (1-t)10. The difference, then, between the gross and net wage for any tax rate is w - wn = 10t. This is the tax collected per hour of work.
The tax revenue for any given hours of work is then the product of the tax collected per hour of work and the labor supply curve:
tax revenue = 10t*(-100+200(1-t)10)
= -1,000t + 20,000t -20,000t2
= 19,000t - 20,000t2
The tax rate t = 0.7 is beyond the revenue maximizing point (this can be shown by computing tax revenue for a slightly lower tax rate, like t=0.69.
b. Taking the derivative:
dTax Revenue/dt=0
yields 19,000-40,000t=0, or
t = (19,000/40,000), or
t = 0.475 as the revenue maximizing tax rate.
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Chapter 19 – The Corporation Tax
1. A corporation may use retained earnings to increase dividends, but shareholders pay additional income taxes as a result. Even though the franchises weren’t particularly profitable, it may have been in the shareholders’ best interest to purchase them instead of paying additional dividends.
2. a. The real value of depreciation allowances, of equation (19.1), falls.
b. When falls, the user cost of capital increases.
c. Index appreciation allowances.
3. If the $20 million is expensed, the firm gets a deduction of $20 million in the current year. If the $20 million is depreciated, the deductions are spread over time (in a way that depends on the specifics of the depreciation schedule). The present value of the future flow of deductions is less than $20 million. Because the package design will yield benefits that extend over a period of time, it would seem sensible to view it as a capital expenditure. If so, depreciation is appropriate, and the IRS was right.
4. The user cost of capital, C, in Equation 19.4 is:
C = (r + )/[(1 - )x(1 – t)]
Where t is the individual tax rate on dividend income. Suppose Lee Enterprises can lend their money out and receive an after-tax rate of return of 10 percent. Assume that they could also buy a new printing press that would experience economic depreciation of 2 percent annually. Ignoring taxes, the printing press would have to generate a 12 percent return to cover depreciation. If the corporate tax rate is 35 percent and the marginal rate on dividends is 20 percent, the printing press would have to earn a before-tax return of 23.07 percent to give Lee Enterprises the same after-tax return as lending money at 10 percent. Reducing the marginal rate on dividends lowers the necessary rate from 23.07 percent to 21.7 percent, therefore making it more likely that the purchase of a new printing press would be a profitable investment. If Lee Enterprises did not immediately buy more presses, this does not prove that the lower tax on dividends had no effect, but does imply that reducing the user cost from 23.07 percent to 21.7 percent was not enough to justify this particular investment.
5. This statement assumes that the corporate tax is equivalent to an income tax. Table 14.2 shows that a proportional tax on both capital and labor is equivalent to an income tax.
Thus, the statement assumes that the corporate tax is a proportional tax on both capital and labor.
6. A retroactive rebate of the alternative minimum tax for corporations would simply be a lump sum transfer. Thus, according to neoclassical theory, such a rebate would not have an effect on investment, because it does not affect the user cost of capital. The user cost of capital depends on current individual and corporate tax rates, after-tax rates of return in the capital market, economic depreciation, depreciation allowances, and investment tax credits. None of these is affected by the AMT rebate described in the text. Moreover, because the firms involved in the AMT rebate were very large, it is hard to imagine that the rebate would relax liquidity constraints either.
7. O’Neill’s statement that, as chief executive of Alcoa, he ―never made an investment decision based on the tax code,‖ is problematic for the shareholders of Alcoa. It makes no sense to ignore tax incentives when making business decisions; that is, after-tax returns are what matter. O’Neill’s lack of tax sophistication likely lowered the value of Alcoa relative to what it would have been had he taken account of the tax system.
8. The MIPS financial instrument, which could interchangeably be called debt or equity, would be attractive to a corporation because firms would want tax authorities to view the instrument as debt because the interest paid is tax deductible. On the other hand, firms want potential investors to view the instrument as equity, because more debt makes the firm a riskier investment. Although the tax law might be forced to view this MIPS instrument as debt, there is no reason why investors in the market (or credit rating agencies) would then view it as equity, however. In principle, investors and credit agencies should be able to see through such accounting gimmicks, though in practice, the accounting scandals showed that this was not the case.
9. The user cost of capital (ignoring depreciation allowances and investment tax
credits) is given by equation (17.4) in the textbook, C=(r+δ)/[(1-θ)(1-t)], where r=after tax rate of return in the capital market, δ=economic depreciation, θ=corporate tax rate, and t=individual tax rate. Substituting the numbers from the problem into the formula, gives the user cost:
C=(.08+.01)/[(.65)*(.7)]=.1978. Since the project’s return, 30%, is higher than this user cost of 19.8%, the company does invest in the project
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