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					                                     Department of Economics, Suffolk University
                                         EC421/721: PUBLIC FINANCE
                                                                                                      Jonathan Haughton
                                                                                                            Spring 2004

                                       ASSIGNMENT 5
                                    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

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