McGraw Hill’s Essentials of Federal Taxation 2022 Edition 13th Edition by Brian Spilker Solution ma
Kobe’s forecast is based on static forecasting (i.e., he is ignoring how taxpayers may alter their activities in response to the tax law change). Given that taxpayers are likely to substitute purchases of other vehicles for SUVs (i.e., the substitution effect), Kobe’s proposal is likely to result in a large discrepancy in projected and actual tax revenues.
[LO 5] What is the difference between the income and substitution effects? For which types of taxpayers is the income effect more likely descriptive? For which types of taxpayers is the substitution effect more likely descriptive?
The income effect predicts that when taxpayers are taxed more (e.g., tax rate increases from 22 to 24 percent), they will work harder to generate the same after-tax dollars. The substitution effect predicts that when taxpayers are taxed more, they will substitute nontaxable activities (e.g., leisure activities) for taxable activities because the marginal value of taxable activities has decreased. The income effect is likely to be more descriptive for taxpayers with insufficient income to meet their necessities, etc. for their desired standard of living. The substitution effect is likely to be more descriptive for taxpayers with sufficient income to meet their necessities and to sustain their desired standard of living.
[LO 5] What is the difference between horizontal and vertical equity? How do tax preferences affect people’s view of horizontal equity?
Horizontal equity means that two taxpayers in similar situations pay the same tax. Vertical equity is achieved when taxpayers with greater ability to pay tax, pay more tax relative to taxpayers with a lesser ability to pay tax. One can view vertical equity in terms of tax dollars paid or in terms of tax rates.
Governmental units provide tax preferences for a variety of reasons – e.g., encourage investment, social objectives, etc. Whether one views these tax preferences as appropriate or not, greatly influences whether one considers a tax system to be fair in general and specifically, horizontally equitable. Specifically, if one views a tax preference as being inappropriate, this would adversely affect one’s view of horizontal equity.
[LO 3, LO 5] Montel argues that a flat income tax rate system is vertically equitable. Oprah argues that a progressive tax rate structure is vertically equitable. How do their arguments differ? Who is correct?
Vertical equity is achieved when taxpayers with greater ability to pay tax, pay more tax relative to taxpayers with a lesser ability to pay tax. One can view vertical equity in terms of tax dollars paid or in terms of tax rates. Proponents of a flat income tax or sales tax (i.e., proportional tax rate structures) are more likely to argue that vertical equity is achieved when taxpayers with a greater ability to pay tax, pay more in tax dollars. Proponents of a progressive tax system are more likely to argue that taxpayers with a greater ability to pay should be subject to a higher tax rate. This view is based upon the argument that the relative burden of a flat tax rate decreases as a taxpayer’s income (e.g., disposable income) increases. Which is the correct answer? There is no correct answer. Nonetheless, many feel very strongly regarding one view or the other.
[LO 3, LO 5] Discuss why evaluating vertical equity simply based on tax rate structure may be less than optimal.
Although tax rate structures can be used, in part, to assess vertical equity, focusing on the tax rate structure solely ignores the role that the tax base plays in determining vertical equity. Indeed, focusing on the tax rate structure in evaluating a tax system is appropriate only if the tax base chosen (e.g., taxable income, purchases, property owned, etc.) accurately portrays a taxpayer’s ability to pay. This can be a rather strong assumption. Consider the sales tax. Although taxable purchases typically increase as taxpayers’ total incomes increase, total incomes typically increase at a much faster rate than taxable purchases. Thus, the gap between taxable purchases and total income widens as total income increases. The end result is that the effective tax rates for those with a greater ability to pay are lower than those taxpayers with a lesser ability to pay. Regressive tax rate structures are generally considered not to satisfy vertical equity (unless one is a strong advocate of the belief that those with a greater ability to pay simply should be paying a higher tax, albeit at a lower rate). In sum, evaluating vertical equity in terms of effective tax rates may be much more informative than simply an evaluation of tax rate structures.