Suggested Solutions to Assignment 3 (Optional)

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1 EC313 Taxation Instructor: Sharif F. Khan Department of Economics Wilfrid Laurier University Fall 2012 Suggested Solutions to Assignment 3 (Optional) Total Marks: 50 Read each part of the question very carefully. Show all the steps of your calculations to get full marks. 1. [10 Marks] The nation of Fishkasar has a tax rate of 10% on the first 20,000 walops (the national currency) of taxable income, then 25% on the next 30,000 walops, then 50% on all taxable income above 50,000 walops. Fishkasar provides a 4,000-walop exemption per family member. a. Jamil s family has three members and earns 50,000 walops per year. Calculate the family s marginal and average tax rates. The first step is to compute Jamil s family s taxable income: before exemptions, its income is 50,000. It gets a 4,000-walop exemption for each of the three family members, for a total of 12,000 in exemptions. Hence, taxable income is 50,000 12,000 = 38,000. Since this is between 20,000 and 50,000, the family faces a 25% marginal tax rate. To compute the average tax rate, first compute the total tax liability. The first 20,000 of taxable income is taxed at 10%. The next 18,000 is taxed at 25%. The total tax is thus.1 20, ,000 = 2, ,500 = 6,500. The average tax rate is thus 100% 6,500/50,000 = 13%. b. Boba s family has five members and earns 85,000 walops per year. Calculate the family s marginal and average tax rates. Boba s family s taxable income is 85, ,000 = 65,000. This is greater than 50,000, so the family is in the 50% marginal tax bracket. The family s total tax liability is.1 20, , ,000 = 17,000. Its average tax rate is thus 100% 17,000/85,000 = 20%. Page 1 of 6 Pages

2 c. Suppose that Fishkasar changed its tax code to a flat tax of 30% with an 8,000-walop per family member exemption. Would this change in the tax system make the system more progressive, more regressive, or neither? The flattening of the marginal rate schedule tends to make this change less progressive. Indeed, the flat 30% marginal rate structure is not progressive at all: any two families with positive taxable income will face the same marginal tax rate, regardless of their income. On the other hand, the increase in the per-family-member exemption tends to make the average rates more progressive. For simplicity, consider two single-member households with incomes of 8,000 and 12,000 walops, respectively. Under the old system, the first would have an average tax rate of 400/8,000 = 5% and the second would have an average tax rate of 800/12, %, so the tax is system was slightly progressive in this income range. Under the new system, the first would have no tax liability and hence a 0% average tax rate; the second would have an average tax rate of 30% 4000/12,000 = 10%. So the new system is more progressive in this income range. 2. Suppose that the U.S. personal income tax system became a flat tax system, in which all taxpayers paid a certain percentage of their incomes in tax, and in which there are no exemptions or deductions. In which way(s) could this flat tax be more regressive than the present U.S. system? In which ways could it be more progressive than the present system? [5 marks] On its face, this tax is more regressive than the current system because poorer taxpayers would pay exactly the same marginal tax rate as wealthier taxpayers. This system might be more progressive than it looks, however, given the elimination of exemptions and deductions. Wealthier taxpayers would lose their home interest deductions, tax-preferred savings mechanisms, and other benefits; wealthy entrepreneurs would lose their business expense deductions. The antiprogressive nature of tax deductions the fact that deductions are more valuable to high-bracket taxpayers would end. As a result, some wealthier taxpayers may be more harmed by this change than the less wealthy. 3. Why should casualty losses or large medical expenditures be fully tax-deductible only under certain circumstances? [5 marks] The justification for allowing deductions for casualty losses or large medical expenditures is based on the idea that people should pay taxes based on their ability to afford them. According to the Haig-Simons definition of income, only income that increases a person s ability to consume should be taxed. Catastrophic losses reduce a person s ability to consume and so, out of fairness, should reduce their tax liability. In some cases, however, expenditures on medical care might represent utility-increasing consumption. A person who obtains nonessential medical care, such as cosmetic procedures, has actually increased consumption. In some cases, casualty losses should not be fully deductible under the Haig- Simons measure either. Some casualty losses are not random but rather are part of the Page 2 of 6 Pages

3 expected cost of living in a particular location. Parts of Florida are prone to hurricane damage; parts of California are susceptible to earthquake damage. Those are known risks and so tend to reduce the price of property in those locations. Thus, property owners in these areas have already had their consumption increased because their housing costs are lower than the costs of identical housing in low-risk locations. Realization of the known risk simply offsets the increased ability to consume. Expenditures for medical care or casualty loss should be fully tax-deductible only when they are unexpected, not voluntary or controlled by the recipient, and do not increase consumption. 4. Professor Slither attended the Antarctic Economic Association meetings. She is able to fully deduct from her taxes the hotel expenses that she incurred, but can deduct only half of the meals expenses that she incurred. Why does the U.S. tax code make this distinction? Does this tax policy make sense, from a Haig-Simons perspective? [5 marks] Business deductions for meals were the target of a lot of negative publicity, resulting in a political response to limit them. The perception was that people were wining and dining at the taxpayers expense. A Haig-Simons perspective would consider business expenditures to be legitimate deductions from taxable income to the extent that they reduce the taxpayer s ability to voluntarily consume. Given this view, allowing full deductibility for hotel expenses but not meals makes some sense. A person does not reduce his or her housing expenses by staying in a hotel on a business trip. The mortgage or the rent at home must still be paid, so this business expense is in addition to the individual s base consumption of housing and thus reduces his or her ability to consume. In addition, for many people, staying in a fancy hotel on a business trip can be a treat, increasing utility. To the extent that the hotel provides greater utility for the traveler than staying home would, perhaps it should be included. This, of course, would be impossible to calculate. Meals, on the other hand, replace consumption that people would have had to provide if they were not on a trip. Because they would have had to eat regardless of the trip, this expense does not reduce other consumption dollar-for-dollar. Page 3 of 6 Pages

4 5. [5 marks] Your roommate and you had identical high school grade point averages and SAT scores. In many respects, one would expect that you would be equally successful. But because you chose economics as a major and your roommate chose geology, you will be paying a larger amount of tax in the future than your roommate will because your income will be higher. Is this attribute of the tax code vertically equitable? Is it horizontally equitable? Vertical equity requires that the person with the higher income pay the higher tax. If the economics major earns more than the geology major, then according to this principle the economics major should pay the higher tax. Horizontal equity requires that people with similar ability to pay should pay the same tax. In this case, measuring ability to pay solely by salary, they should pay different tax amounts. The difference in salaries, though, was generated solely by the choices the roommates made, presumably with information about the expected return to different majors. An argument could be made that any difference in their salaries is attributable to compensating wage differentials: the lower-wage major receives nonmonetary satisfaction from his or her job sufficient to offset the monetary wage difference. In other words, total compensation to the two majors (monetary plus nonmonetary) must, by definition, be equal. Any difference in monetary wage is made up in nonmonetary amenities. That argument supports the claim that this difference in tax liability is inequitable, as taxes are levied only against monetary wages. 6. [5 marks] The government of Utopia plans to offer a transportation tax credit in which families receive a share of their expenditures on transportation to and from work or school as a reduction in their tax bill. Utopia is considering two forms of this tax credit, one that is fully refundable and one in which the tax credit is limited to the amount of taxes the family pays. Which form of the tax credit is more progressive? Explain. It is more progressive to allow for a refundable tax credit than to limit the credit to taxes actually paid. Unless a tax credit is fully refundable, families whose incomes are so low that they do not owe any income taxes do not receive the credit. Critics of refundable tax credits might claim that it isn t a tax refund if you haven t paid taxes in the first place, but this is not quite correct. Everyone pays some taxes, whether in the form of sales taxes when they purchase goods or in the form of increased prices when taxes are passed through to the consumer. Thus, a fully refundable tax credit sent to families who have not paid income taxes will offset other taxes they have paid. Page 4 of 6 Pages

5 7. Suppose that the government adopts a Haig-Simons comprehensive income definition. Will this make employers more likely or less likely to offer employerprovided pension plans or health insurance coverage? Why? Adoption of the Haig-Simons definition would require inclusion of employerprovided benefits in taxable income because these benefits increase employees ability to consume. Taxation of these benefits would make them less attractive to workers, so employers would not be able to substitute benefits for wages as easily as they do now. As a result, employers would be less likely to offer the benefits. On the other hand, even if the benefits were taxed, employers may be able to provide them more efficiently and thus, more cheaply than employees could obtain them in private markets. If it were cheaper to obtain group health insurance through an employer than it would be to purchase private insurance in the market, even when the benefit is taxed, then workers might remain willing to trade off higher wages for more benefits. And the total cost of hiring a worker may be less for the firm offering the benefits, in which case some employers would still provide the benefits. 8. [5 marks] Oregon has an income tax but no state sales tax, while Washington has no state income tax but does have a state sales tax. Oregon residents can deduct the state taxes they pay (the income tax payments) from their federal income taxes, while Washington residents cannot deduct the state taxes they pay (the sales tax payments). What are the equity implications of this difference? Consider two people with the same earnings and spending patterns, one of whom lives in Washington and one of whom lives in Oregon. The income taxes paid in Oregon are deductible from federal income taxes, but the sales taxes paid in Washington are not. Oregonians will therefore pay less federal tax, all else equal, than will Washingtonians. This is not horizontally equitable. Partly offsetting this horizontal equity concern is the fact that people choose whether to live in Oregon or Washington, so the equity issues are less pressing than if taxes were inequitable based on some factor over which people have no choice. Furthermore, markets adjust for these differences. People know or could know this essential difference between the two states and the implications for federal tax deductibility when choosing where to live. Housing prices and other cost-of-living components may have been adjusted to account for this apparent inequity already. For example, if the absence of sales tax has made Oregon a more desirable state of residence, then that difference should already be reflected in higher housing prices in Oregon. If this is the case, then being able to deduct income taxes in Oregon may simply offset the difference in the cost of living there. Page 5 of 6 Pages

6 9. [5 marks] The largest tax break for most Americans is the mortgage interest tax deduction, which allows home owners to deduct from their taxable income the amount of money they pay in interest to finance their homes. This tax break is intended to encourage home ownership. Compare this tax deduction to a uniform tax credit for home ownership on equity and efficiency grounds. The more expensive the home, the larger the mortgage; the larger the mortgage, the bigger the deduction. Compounding this effect is the tendency for wealthier people to live in larger, more expensive homes and face a higher marginal tax rate. Therefore, both the size and the marginal value of the mortgage deduction are higher for wealthier taxpayers. This is in direct contradiction to vertical equity. Deductions favor high tax bracket taxpayers because they reduce the base on which taxes are calculated. Sometimes a deduction can drop the base to a lower tax bracket. Even if it doesn t reduce the taxpayer s marginal rate, it reduces the number of dollars to which that taxpayer s highest bracket applies. In contrast, tax credits benefit all taxpayers equally by reducing the taxpayers tax liability dollar for dollar. As a result, tax credits do not disproportionately benefit high tax bracket payers. In addition, making the credit uniform avoids the problem of providing the largest subsidies to those living in the fanciest homes. On equity grounds, the tax credit appears to be preferred. Offsetting this benefit is the fact that housing prices vary significantly by geographic region. A credit that is generous in some parts of the country would be very small relative to housing prices in other areas. The tax credit would seem to be better on efficiency grounds as well. The mortgage deduction as it is now implemented distorts consumption behavior in favor of more expensive homes. A uniform credit would continue to encourage home ownership at some basic level (which may be justified based on the positive externalities involved) but would not subsidize McMansions. Page 6 of 6 Pages