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ECO 425 Homework 4 Complete A+ Answer

Eco 425 Homework 4

Question
1. (10 points) The lecture described how taxing income may change
savings behavior. Suppose instead that the government taxed
consumption.
To be specific, suppose we have a two-period model. An individual earns
labor income Y0 =$100k at time zero, and earns no labor income at time
1. The individual may consume or save that income. Savings grow at rate
r=.03. For every dollar of consumption, the individual pays the tax rate?
=.30 to the government.
a. Graph the two-period budget constraint for consumption. What is the
slope? Is this tax distortionary?
b. The government modifies the consumption tax somewhat so that the
first $20k of consumption in each period is tax free. Now graph the
budget constraint.
2. (20 points) Claim: The Mortgage Interest Tax Deduction is a
regressive policy. A simpler, better policy that could achieve the same
goals would be a home ownership tax credit that applies equally to all
homeowners regardless of income or the value of the home. In a miniessay (300 words) state whether you agree or disagree with that claim
and explain your reasoning.
3. (40 points) In lecture, we assumed that when a homeowner borrows,
the entire the value of a home would be borrowed. In fact, a borrower
would need to put a down payment on the mortgage a cash payment
up front for part of the value of the home. An additional simplification of
the lecture was to not take into account the fact that for a mortgage you
pay the interest + some fraction of the principal. This is so at the end of
the loan all the money borrowed will have been repaid. Take a look at the
following mortgage calculator linked below to help answer the following.
http://finance.yahoo.com/calculator/real-estate/hom03/
The value of the property is $500k, the interest rate is 3% (approximately
the correct interest rate as of this writing), and the length of the loan is
30 years (360 months). The marginal tax rate for the homeowner is 33%.
Leave other values on the table at the default settings. Assume the
individual has $500k cash on hand, and any of this money that remains
after taking the mortgage/making mortgage payments is invested at the
interest rate 3%. The value of the property also grows at rate 3% per year,
and this growth is not taxed. This means that as the borrower repays the
loan and starts building principal, the value of that principal goes up at
the same rate as other investments. Finally, assume that the years
mortgage payment is paid to the bank from cash on hand at the START of
the year. This turns out to be important if we want to make comparisons.
i. Suppose there is no MITD, and the homeowner borrows the full value
of the property. For the first year
a) How large is the annual mortgage payment? How much interest has

been paid on the mortgage?

b) How much principal has been accumulated by the borrower? What is
the value of the principal at the end of the year?
c) The amount of the annual mortgage payment from part a) was paid at
the beginning of the year. That reduces the cash available to invest. How
much cash gets invested? What is the pre-tax value of the cash
investment at the end of the year? How much tax is owed on this
investment? What is the after-tax value of the investment after one year?
d) Add up the values of all the investors assets at the end of year one.
How has this value changed over the year?
ii. Suppose there is a MITD, the homeowner borrows the full value of the
property. Repeat a-d from part i.
iii. Not surprisingly, you hopefully saw in ii that the deduction is a boon
to the homebuyer. Now, suppose the buyer makes a down payment of
20%, or $100k. Assume the MITD is not available. She invests the
remaining cash at 3%. Repeat a-d from part i. in this case.
iv. Once again, suppose the buyer makes a down payment of 20%.
Assume the MITD is available. Repeat a-d.
v. Comment on/compare your results for the different cases.
4. (30 points) A corporation produces output with a market price of $200
per unit. The marginal product of capital is 1/(2K), where K is units of
capital, with each unit assumed to cost $1. (So when we talk about capital
in this problem, units and $ value are equivalent.) The life span of the
capital is 5 years, implying the straight line depreciation rate?=.2. The
financing cost of capital is?=.05.
a. If depreciation and financing costs are not included in accounting
costs, what is the optimal level of capital for the firm?
b. If the corporate tax is 35%, what is the optimal level of capital?
c. If depreciation at a rate?=.2 is included in accounting costs, what is the
optimal level of capital? [Hint: remember to calculate the present value
of the deduction. Use.05 for the discount rate.]
d. For c., what is the effective corporate tax rate?
e. The firm is going to borrow the money for its capital purchases. The
interest paid on the debt can be added to accounting costs. Suppose it
turns out that the present value of this expense is.10 for every dollar of
capital purchased. What is the optimal level of capital now?
f. For e., what is the effective corporate tax rate?
ECO 425 Homework 4 Complete A+ Answer