1. The supply of labor (and other factors) in and out of a state is more elastic than the supply of factors to the nation as a whole. Therefore, an income tax reduction at the state 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
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“tax-induced” migration for businesses and possibly workers. If the state lowers tax rates (and other states 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.
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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 $300 tax rebate is unlikely to be successful at stimulating consumer spending.
According to life-cycle model, a transitory, one-time change in income will have little effect on current consumption. To induce a major effect on current consumption, need to make the tax cut permanent.
6. Note that the basic framework presented in Chapter 16 (and Chapter 11) for obtaining training weighed costs versus benefits, and the person obtained training if B-C>0. In this case, B is the present discounted value of the earnings increase, and C is the opportunity cost, namely forgone wages. If earnings were taken away at a proportional rate (and similarly, forgone taxes paid during the training period were reduced), then the training decision becomes (1-t)(B-C)>0, which always leads to the same decision as before. The Wall Street Journal’s assertion that “high marginal tax rates discourage incentives … to invest in one’s human capital with additional training or education,” implicitly assumes a more complicated model. There are several ways in which this basic cost-benefit analysis could be modified to get such a result. For example, in focusing on the nature of the costs of the human capital investment, it is assumed that C represents only forgone earnings, and therefore a tax lowers the cost (as well as the benefits) of getting training.
Imagine instead that C=C1+C2, where C1=deductible costs, such as forgone earnings, and C2=non-deductible (or partially-deductible) costs, such as college tuition. With the imposition of taxes, the net benefit of training now becomes (1-t)(B-C1)-C2<(1-t)(B-C).
With nondeductible costs, it is not necessarily true that the net benefit will be positive, so there will likely be less human capital accumulation. Another important consideration is the proportional tax assumption. Imagine instead that the tax schedule is progressive, with t1>t2, and the higher tax rate applies to the incremental earnings from training, but
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not the previous lower earnings. In this case, the net benefit now becomes (1-t1)B-(1- t2)C. Relative to the case with a proportional tax, this expression is smaller, and not necessarily positive. Finally, to the extent that taxes lower labor supply, this will tend to reduce the return to human capital accumulation and lower the amount undertaken.
7. One extreme possibility is that there will be no new personal saving—people just shuffle assets from taxable to nontaxable accounts. It is more likely that there will be some new saving, although less than the amount by which the IRA limits are increased. Hubbard and Skinner (1996) conclude that a good guess is that 26 cents per dollar of IRA contribution is new saving. Many of the studies that look at the “reshuffling” of assets examine IRA limits of $2,000; many employees today would have a current 401k limit of
$13,000 (along with a Roth IRA limit of $3,000 per person); thus a married couple with two workers may be able to contribute as much as $32,000 in tax-deferred plans. It may be the case that with the dramatic increase in the limits over time, the additional saving is not infra-marginal.
8. The statement is correct. When there is full loss offset, the tax system will tend to reduce the risk as well as the return to risky investments. The effect on risk taking is therefore ambiguous. With less than full loss offset, the tax system does not reduce risk as much, which tends to bias the individual against risky investments, other things being the same.
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.
Chapter 17 – The Corporation Tax
1. This statement suggests that corporations are people with independent abilities to pay, a view that parallels the legal status of corporations. Economists believe that only people have an independent ability to pay.
2. a. The real value of depreciation allowances, Ψ of equation (17.1), falls.
b. When Ψ falls, the user cost of capital increases.
c. Index appreciation allowances.
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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. Under a strict Haig-Simons rule, there would not be any separate corporate tax at all.
Given that there is a corporate tax, the spirit of the Haig-Simons criterion is that different forms of corporate income should be treated the same way. The partial dividend exclusion at the personal level can be rationalized in Haig-Simons terms. Given that the income that generated the dividends has been taxed once (at the corporate level), then excluding part of it at the individual level seems appropriate.
5. Under the proposal from the Wall Street Journal article, dividends would be totally exempt from taxation. On the other hand, interest income would be taxed at the individual level. Thus, the statement
“Abolishing the tax in both places not only ends the double taxation of dividends but creates the same incentives for equity and dividends as for debt and interest.
Voila! A level playing field.”
is only partially correct. The playing field would not be level; now, rather than the tax system favoring debt finance over equity finance, the reverse is true.
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
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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.