Ramesh lives two periods. His earnings in the present are 100; in the future they are 75.6.
Question:
a. Suppose that Ramesh’s earnings are subject to a 25 percent tax. Suppose also that interest earnings are taxed at the same rate and inter-est paid is tax deductible. Using our life- cycle model, show that this tax generates an excess burden.
b. Suppose now that interest payments are not tax deductible. Does this tax generate an excess burden if Ramesh is a borrower?
c. Now assume the tax in part a is scrapped in favor of a consumption tax. What consumption tax rate would yield the same tax revenue? Does this tax distort the choice between present and future consumption?
d. Now assume the consumption tax in part c is instituted, but the deduction of interest payments remains. Does this tax distort the choice between present and future consumption?
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a We can conclude that an income tax generates an excess burden if it creates a tax wedge between th...View the full answer
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