1

Problem Set 7 ECN 131 Public Finance Prof. Farshid Mojaver

Taxes on Risk Taking and Wealth 1-What are the three ways in which capital gains are subsidized over interest-bearing savings accounts in the U.S. tax code?

2-Suppose that a politician argues that capital gains should be taxed at a lower rate than other forms of income in order to protect investors against inflation. What do you think of this argument? Can you think of any inconsistencies in it? Is there an alternative approach to deal with the inflation problem? Explain.

3-Suppose that Jack owns a warehouse in a rapidly expanding part of a town. Because of the location of the warehouse, it has increased in value from $300,000 (the price Jack paid) to $400,000 (the price Jack would get if he were to sell it). The doctor has recently told Jack that he has one year to live and the doctor is always right about such things. The capital gains tax rate is 25%. Jack's wealth will be distributed among his children when he dies. The warehouse is not currently being used. Jack must decide whether to sell the warehouse now (and pass the cash on to his children) or take it with him to his grave. Assume that there is no estate tax but that the capital gains tax code is the same as that currently in place in the United States. a. What is the socially efficient thing for Jack to do? Explain your answer. Be sure to describe the tax implications of your answer as well. b. What would you advise Jack to do? Explain your answer. Be sure to describe the tax implications of your answer as well.

4-Suppose that you have a wealthy friend who is 60 years old and wants to know how to pass on her wealth to her children without paying more than necessary in taxes. What suggestions do you have?

5. What is the empirical evidence on whether capital gains tax cuts lead to permanent increase in capital gains realizations? What does this evidence imply for the prospects of lowering capital gains taxes as a long-term revenue-generation tool?

6. When Bill died, he left $700,000 in cash (generated from labor earnings) and a house worth $500,000 to his children. He originally paid $100,000 for this house. Assume the estate tax rate is 50% and the capital gains tax rate is 30%. Evaluate the argument that the estate tax represents double taxation of Bill’s income.

7. Why does the property tax, as implemented in the United States, provide a disincentive for property owners to improve their property? How would a land tax alter these incentives? 2

Corporate Taxation 1. You are a manager of a company that just spent $80,000 to purchase a piece of equipment that is expected to function for six years. If you can borrow money at 7%, what is the present discounted value of the depreciation allowance under the following circumstances: a. You can expense the investment. b. You depreciate using straight-line depreciation methods. c. You depreciate over four years using accelerated straight-line depreciation methods. d. You depreciate using an augmented accelerated method in which half of the asset value is depreciated immediately and the other half is straight-line depreciated over the remaining three years.

2. Suppose that the per-period marginal benefit to you of purchasing new machinery is MB = 24 - 6K, where K is the number of units of machinery purchased. The depreciation rate is 15% and the dividend yield is 10%. a. What amount of capital will you purchase? Why? b. What amount of capital would you purchase if there were a 20% tax rate on cash earnings minus labor costs?

3. Suppose that dividend yield is 6%, depreciation is 12%, and the corporate tax rate is 35%. What would be the marginal cost of each dollar of machinery investment under the following situations: a. Firms are allowed to expense the machine. b. There is an investment tax credit of 8%.

4. Why are equity holders more likely than debt holders to want firms to engage in risky investments?

5. You conducted a research study and found that corporations that finance their investments with a larger ratio of debt to equity tend to pay higher rates of interest to lenders. Why do you think this practice occurs?

6. Suppose that the corporate tax rate is 25%, there is an investment tax credit of 10%, the depreciation rate is 5%, and dividend yield is 10%. The official depreciation schedule is such that the present discounted value of depreciation allowances is 40% of the purchase price of the machine. a. Calculate the per-period marginal cost of each dollar that the firm spends on the machine. b. If the marginal benefit per period is MB = 40 – 0.6K, where K is the number of dollars spent on the machine, what is the optimal amount of machinery purchased? c. How would your answer change if the investment tax credit increased to 20%? 3

Tax Reform 1. Imagine that a $30,000 investment in a good is expected to return you $25,000, and your marginal tax rate is 30%. The government is considering an investment tax credit that reduces the price of the investment. How large would the percentage reduction in the price of the investment have to be for you to make this investment?

2. Suppose that the world is populated by people who are identical in every dimension except for their savings behavior. People live for two periods, earning $500 in the first period and nothing in the second period. The income tax on labor earnings and interest income is 40% and the interest rate earned on savings is 8%. There are two types of people—those who consume everything in the first period and those who choose to split their consumption equally between the two periods. a. How much tax would each type of person pay under these conditions? b. Suppose that the income tax is replaced with an 80% consumption tax—for every $1 in consumption the person must pay 80¢ in tax. Does this make the tax system more equitable between these two types of people? Why or why not?

3. Consider two consumption tax systems: (a) one in which all goods are taxed at the same rate, and (b) another in which the “necessities” are not taxed and “luxuries” are taxed at a higher rate. Compare the equity and efficiency of these two systems.

4. Suppose that a nation is considering adopting a national sales tax of 25% on all goods in place of the progressive income tax currently in place. a. If the politicians want to use a sales tax but also want the tax to be progressive, what could they do? Evaluate this option in terms of what you know about optimal commodity taxation. b. Would all groups be affected by the transition to a consumption tax in the same way? Explain.

5. Suppose that the government is considering replacing the current income tax system with either a national sales tax or a value-added tax. Would one of these alternatives be more desirable than the other in terms of compliance? Explain.

6. President Bush is hoping to introduce a major tax reform during his second term. On Nov. 15, the New York Times ran two op-ed pieces suggesting different ways to reform the tax system. Here is an excerpt from each: “Why not cut the payroll tax? The Social Security payroll tax is the biggest tax burden faced by poor Americans; cutting it would put more money in their pockets. Such a move would also stimulate hiring, since employers shoulder half the burden of the tax. This plan could be kept revenue-neutral by merely raising the amount of wages subject to the tax - now capped at $87,900.” —Dalton Conley, NYT 11/15/04

“America should return the income tax to its pre-World War II status—a relatively low- rate simple tax on a thin slice of the wealthiest Americans. Rather than repealing the alternative minimum tax, as many have urged, Congress should repeal the regular income tax. Enacting a value-added tax - a tax on sales of goods and services collected at all stages of production - at a rate of 14 percent would finance an income- tax exemption of up to $100,000…Wealthier families, meanwhile, would face a vastly simpler income tax at a 25 percent rate on income of more than $100,000 after deductions for charitable contributions, home mortgages, medical expenses, and state and local taxes.” –Michael Graetz, NYT 11/15/04 b) One of these quotes contains an outright misstatement. Identify it, and explain what is actually known on the topic. c) For each reform, write 1-2 paragraphs on the likely effects on: a. equity b. efficiency