Review Mid-term #3
Econ 344
April 2011
Terms and concepts
Tax expenditure
Tax credit
Tax deduction (standard and itemized)
Lock-in effect
Bracket creep
Tax indexing
Nominal interest rate
real interest rate
Tax shifting
Tax incidence
Regressive vs. progressive tax rates
Excess burden (dead weight loss)
Ramsey rule
Inverse elasticity rule
Vertical equity
Horizontal equity
Alternative Minimum Tax (AMT)
Intertemporal Choice Model (with 2-period consumption/savings, know mechanics)
Labor-leisure model (know mechanics)
Income and substitution effect in saving and labor model
Accelerated depreciation
Expensing
Tax life
Economic life
User cost of capital
Capital gains
Debt financing vs equity financing
Crowding out hypothesis
1. Suppose that the spouse of the primary earner in the household is considering joining
the labor force. The spouse currently cares for two children and, if employed, would earn
$20 per hour for 40 hours per week. The cost of child care would be $10 per hour for 50
(not 40) hours per week. Assume that the marginal tax rate on work is 50%. Assume that
child care is tax deductible and that child care at home is NOT imputed and taxed. What
is the after-tax, after-child care value of working per week?
a. $100
b. $0
c. $150
d. $300
e. none of the above
Ans c
2. The market demand for super-sticky glue is Q = 240 – 6P and the market supply is Q =
–60 + 4P.
a. Calculate the deadweight loss of a tax of $4 per unit levied on producers of supersticky
glue.
Deadweight loss is calculated as the area of a triangle, the height of which is the dollar
amount of the tax and the base of which is the change in quantity purchased resulting
from the tax.
First, determine the change in quantity associated with this tax. Without the tax,
equilibrium
is 240 – 6P = –60 + 4P, or 300 = 10P. Equilibrium price is $30, so equilibrium
quantity is –60 + (4 × 30) = 120 – 60 = 60.
A tax levied on producers changes the supply function to Q = –60 + 4(P – 4) because
the price the producers can keep from any sale is reduced by $4. Recalculating
equilibrium,
240 – 6P = –60 + 4P – 16, or 316 = 10P. Equilibrium price is $31.60, so equilibrium
quantity is 240 – 6(31.60) = 50.4.
The change in quantity is 60 – 50.4 = 9.6, so the area of the deadweight triangle is ½
(9.6)(4) = 19.2.
b. How does deadweight loss change if the tax is levied on consumers of supersticky
glue?
Intuitively you would expect the deadweight loss to be exactly the same. The legal
liability for the tax does not change the economic incidence of the tax.
In this case, the height of the triangle is still the $4 tax. When the tax increases the
price a consumer must pay, the new demand function is Q = 240 – 6(P + 4). The new
equilibrium condition is 240 – 6P – 24 = –60 + 4P, or 276 = 10P.
Price is $27.60, and quantity is –60(4 × 27.60) = 50.4, exactly the quantity that resulted
when the tax was imposed on the producer.
3. inter-temporal model
Jesse earns $82,000 in the current period, but his income will drop to $19,170 in
period 2. Sketch his inter-temporal budget line assuming a 6.5 percent rate of
interest and draw an indifference curve to illustrate optimal consumption in both
periods assuming he optimally chooses to save $40,000 in the current period.
Show the effect of a 50 percent tax on interest income assuming the substitution
and income effects cancel each other out. Calculate and label all relevant values
in your graph.
This is a 2 period saving model.His endpoints are $80k in period 1 and $80,000 plus
19,170 in period 2 before interest earnings.
When you add in 6.5% interest on the $80k , (80,000 * .065= $$5,200) that endpoint
becomes $104,370. The pt of tangency is at $40,000 of period 1 income.
A 50% tax on interest income lowers earnings by $2600 to $101,770. With income and
substitution effect cancel out, he stays at $40,000 of period 1 consumption
4. Suppose that you can earn $16 per hour before taxes and can work up to 80 hours per
week Consider 2 income tax rates, 10% and 20%
a. On the same diagram draw the 2 weekly consumption-leisure budget constraints
reflecting the 2 different tax rates.
b. Draw a set of representative indifference curves such that the income effect of the
tax increase outweighs the substitution effect.
c. Draw a set of representative indifference curves such that the substitution effect of
the tax increase outweighs the income effect.
(SEE BELOW)
5.
6. Ch 18 rosen#5---taxation
Great Britain’s Finance minister announced a cut in interest rate from 3% to 2%
on a popular tax free saving plan. The goal was to increase consumer spending.
Using the inter-temporal model (life cycle model of consumption behavior),
discuss whether the proposal would achieve the Finance minister goal.
Lowering the interest rate will cause consumption to rise through the
substitution effect while the income effect causes savings to increase.
Depending on which effect dominates will determine the outcome.
7. Arguments for fundamental tax reform
a. improve tax compliance
b. make tax code simpler
c. improve tax efficiency
why doesn’t it happen?
-Political pressure---strong interest groups
Economic pressure-economic benefits to groups