Department of Economics, Suffolk University
EC421/721: PUBLIC FINANCE
Personal Income Tax
Answers to this assignment are due back by Tuesday, March 23, 2004. Graduate students should answer all of the
questions; undergraduates should answer 1.a, 1.b.a, and 2a. through 2.c (or more, if you wish).
1. Brief Questions
a. In principle real capital gains constitute part of income. So why do tax systems not tax capital gains using the
same rates as the personal income tax, and at the time the capital gains accrue?
b. True or False? Indicate giving reasons.
a. Taxing interest income creates incentives for higher savings.
b. A progressive income tax structure creates a disincentive for taking risks. However, this problem can be
solved completely by allowing loss carry-forward for up to three years.
2. Personal Income Tax
Note: This problem involves some drudgery, but it is exactly the sort of exercise that tax analysts have to undertake.
This “tax calculator” is best set up on a spreadsheet.
Assume that the personal income tax system uses the following rates:
Income bracket Tax rate
Under $10,000 0%
$ 10,000 - 10%
$30,000 - 20%
$60,000 - 30%
a. Graph the marginal and average tax rates for this tax structure, assuming that there are no deductions,
exemptions or tax credits.
b. Using the information tabulated on page 2, calculate how much revenue this tax will bring in, assuming that
there are two million households in the country.
c. Under pressure from the middle class the government allows mortgage interest to be deducted before
calculating taxable income.
(i) Explain what effect this has on the progressivity of the tax system.
(ii) How would your answer differ if only the first $7,000 of mortgage interest were deductible?
(iii) An economist proposes an unlimited tax credit, of 20% of the mortgage interest paid, in place of any
mortgage interest deduction. Compared to (ii), would this make the tax more or less progressive?
d. A visiting scholar suggests that only labor earnings (wages, salaries) should be taxed using the rates given here,
and all other income (interest, dividends, etc.) should be taxed at a flat 20%. What effect would this have on
the progressivity of the tax system (relative to b. above)?
e. A journalist proposes that the mortgage interest deduction be phased out for high-income households.
Specifically, for every dollar of income above $50,000, the mortgage deduction will be reduced by 10 cents
compared to what it would otherwise have been. What effect would this have on the progressivity of the tax
system (relative to b. above)? Graph the new marginal tax rates for this tax structure and compare them to
those shown in a.
f. The tax commissioner proposes that tax filers may either deduct their actual mortgage interest, or a “standard
deduction” of $1,800. What effect would this have on the progressivity of the tax system? On revenue?
Income bracket Mean income % of % of Mortgage Family
($) income h'holds Interest size
($) from wages in bracket
Under 10,000 8,000 100% 7% $100 2.8
10,000 - 15,000 95 10 400 4.6
16,000 - 18,000 90 13 600 4.3
20,000 - 23,000 85 18 900 4.0
24,000 - 26,000 80 13 1,400 3.5
30,000 - 34,000 75 12 2,400 3.0
40,000 - 45,000 70 10 3,800 3.0
50,000 - 55,000 65 7 5,300 3.2
60,000 - 66,000 60 5 7,000 4.0
70,000 - 75,000 55 3 9,100 4.4
80,000 - 88,000 50 1 11,700 4.7
100,000 - 160,000 50 1 27,000 5.5