A midwestern state aids its institutions of higher education by giving a credit against its income tax equal to 50 percent of any gift to such institutions (subject to a limit of $50 credit per person). Two residents of that state, Mr. Blue (in the 10 percent federal tax bracket) and Ms. Jones (in the 35 percent federal tax bracket), each contribute $100 to an eligible state university.

a. How much will the state tax liabilities of each change as a result of their gifts?

b. State income tax payments and contributions to charitable organizations (such as universities) are both currently deductible from the base used to compute federal tax liability. How much will federal tax liability change for Mr. Blue and Ms. Jones as a result of their contributions?

c. Considering changes in both federal and state tax liabilities, what is the net after-tax cost of Mr. Blue’s and Ms. Jones’s gifts? ( Hint: Subtract the changes in state and federal liabilities from $100.)

d. Suppose the state program changed from a credit to a deduction. If the state tax rate was a flat 3 percent, how much would state liability for Mr. Blue and Ms. Jones change?

e. From the previous computations, which approach (credit or deduction) do you suppose universities in the state would favor? Why?