Anderson, PUBLIC FINANCE
Chapter 14
End-of-chapter problems with solutions
1. Draw a graph of a firm in a monopolistically competitive industry illustrating
demand, marginal revenue, marginal cost, average variable cost, and average total
cost. Identify the firm’s profit in the diagram. Now, explain the impact of a tax on
profit. Does the tax affect the firm’s output? Does the tax affect the price the firm
charges for its product?
Answer:
MC
ATC
Profit
D
MR
A tax on profit would reduce the profit earned by the firm, but would have no
effect on the profit-maximizing quantity or price.
2. How does a corporate income tax affect firms that operate in a perfectly competitive
industry? Are the conclusions reached in the previous question applicable in this
situation?
Answer: Since a firm in a perfectly competitive industry earns zero economic
profit in the long-run, there is no profit to tax. In the short-run there may be an
economic profit in which case the conclusions apply.
3. Galactic Industries Inc. has experienced a very good year with an increase in profit of
$32 million this year. Using equation 14.1 explain the potential implications for
dividends and investment.
Answer: An increase in profit on the left-hand-side of equation 14.1 must be
balanced by a change on the right-hand-side in either increased dividends or
investment equaling $32 million.
4. ProAgra Inc. had net income of $550 million in the year 2001. Use the corporate
income tax rate structure in Table 1 to compute the tax liability of the company.
Answer: Tax = 5,150,000 + .38(550,000,000 - 15,000,000) = 208,450,000.
5. EndRun Inc. had net income of $12 million in 2001. Use the corporate income tax
rate structure in Table 1 to compute the tax liability of the company.
Answer: Tax = 3,400,000 + .35(12,000,000 - 10,000,000) = 4,100,000.
6. Consider a tax imposed on labor in a labor-intensive industry and not on other sectors
of the economy. An example is Britain’s Selective Employment Tax that was applied
to labor-intensive service industries. Explain the impact of that tax on the demand for
labor, being sure to explain the factor substitution effect, the output effect, and the net
effect.
Answer: Quantity of labor demanded falls.
Cost of labor in the service industry rises.
Output Effect
Factor Substitution Effect
Relative price of output in service
Quantity of labor demanded falls.
industry rises.
Output of service industry falls relative to
other industries.
Service industry is relatively labor
intensive.
Quantity of labor demanded falls.
7. Senator Maize from Iowa has recently submitted a bill in the state legislature that
would reduce the rate of taxation applied to capital in the agricultural sector of the
economy. He believes that this bill will not only be good for corn producers, but will
also increase the demand for farm implements. As a policy analyst working for the
legislative fiscal office, you are given the assignment of writing a summary of the
likely impact of this piece of legislation. Use what you know about the general
equilibrium effects of a partial factor tax and explain the likely impacts of this tax
reduction. (You will have to make an assumption about the factor intensity of the
agricultural sector of the economy.)
Answer: Quantity of capital demanded rises.
Cost of capital in the agricultural sector falls.
Output Effect
Relative price of output in agricultural
sector falls.
Output of agricultural sector rises relative
to other sectors.
Agricultural sector is relatively capital
intensive.
Quantity of capital demanded rises.
Factor Substitution Effect
Quantity of capital demanded rises.
8. Suppose that OZ Inc. is a large multi-national firm based in Kansas (producing brains,
hearts, and courage) with annual worldwide net income of $60 million. OZ has 75
percent of its payroll and 90 percent of its property in Kansas, but just 1 percent of its
sales.
a. Compute the amount of net income that would be taxable in Kansas using the
three-factor apportionment formula.
b. Compute the amount of net income that would be taxable in Kansas using a
double-weighted sales apportionment formula.
c. Compute the amount of net income that would be taxable in Kansas using a
sales-only apportionment formula.
d. Explain what factors policymakers in Kansas should consider as they debate
what apportionment formula to apply.
Answer:
a. Apportionment formula: (.75+.90+.01)/3 = 0.553. Apportion 55.3% of net
income to Kansas, resulting in $33.2 million in taxable income.
b. Apportionment formula: (.75+.90+.01+.01)/4 = 0.4175. Apportion 41.75% of
net income to Kansas, resulting in $25.05 million in taxable income.
c. Apportionment formula: 0.01. Apportion 1% of net income to Kansas,
resulting in $0.6 million in taxable income.
d. While heavily weighting the sales factor reduces taxes for multi-national or
multi-state firms based in the state, the reduction in revenues has budget
consequences. Those firms also need state services and infrastructure in order to
be competitive. Policymakers must balance the desire to make Kansas an
attractive place for export-oriented firms with the need to fund basic state services
that make the state an attractive place for those same firms. In addition,
policymakers must be aware of the needs of firms that produce products primarily
for distribution within the state.