(52)
[LO5] Using the facts from the previous problem, what will happen to the
government’s tax revenues if Song chooses to spend more time pursuing her other
passions besides work in response to the tax rate change and earns only $75,000
in taxable income?
What is the term that describes this type of reaction to a tax
rate increase?
What types of taxpayers are likely to respond in this manner?
If Song only earns $75,000 of taxable income, she would pay only $18,750 of
tax under the new tax structure (i.e., $75,000 x .25).
Thus, the government’s
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Chapter 01 - An Introduction to Tax
tax revenues would decrease by $1,250 (i.e., $18,750 - $20,000).
This is an
example of the substitution effect, which may be descriptive for taxpayers
with more disposable income.
(53)
[LO5] Given the following tax structure, what tax would need to be assessed on
Venita to make the tax horizontally equitable?
Taxpayer
Salary
Total Tax
Mae
10,000
600
Pedro
20,000
1,500
Venita
10,000
???
Horizontal equity means that two taxpayers in similar situations pay the
same tax.
Thus, to make the tax structure horizontally equitable, Venita
should pay $600 in tax.
(54)
[LO5] Using the facts in the previous problem, what is the minimum tax that
Pedro should pay to make the tax structure vertically equitable based on the tax
rate paid?
This would result in what type of tax rate structure?
Mae’s average tax rate is 6 percent.
Average Tax Rate =
ome
TaxableInc
TotalTax
=
000
,
10
$
600
$
= 6%
To be vertically equitable with respect to tax rates, Pedro should pay a tax rate
higher than 6 percent.
A 6 percent tax rate on Pedro’s $20,000 taxable income
would result in $1,200 of tax (i.e., 6% x $20,000 = $1,200).
Thus, Pedro must pay
more than $1,200 tax (e.g., $1,201) for the tax structure to be vertically equitable
(i.e., to generate a tax rate more than 6 percent).
(55)
[LO5] Using the facts in the previous problem, what is the minimum tax that
Pedro should pay to make the tax structure vertically equitable with respect to the
amount of tax paid?
This would result in what type of tax rate structure?
To be vertically equitable with respect to the amount of tax paid, Pedro
should pay more in tax dollars than Mae because he earns more taxable
income than her.
A strict interpretation of this definition would suggest that
the tax is vertically equitable if Pedro pays 1 more dollar in tax than Mae
(i.e., $601).
However, this would result in a regressive tax structure (which
most people would argue are not vertically equitable).
A less strict
interpretation of vertical equity (based on dollar amounts) is that Pedro
should pay more tax than Mae but at the same tax rate (i.e., a proportional
or flat tax rate structure).
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Chapter 01 - An Introduction to Tax
(56)
[LO5] Consider the following tax rate structure.
Is it horizontally equitable?
Why or why not?
Is it vertically equitable?
Why or why not?
Taxpayer
Salary
Total Tax
Rajiv
10,000
600
LaMarcus
20,000
600
Dory
10,000
600
The tax rate schedule is horizontally equitable because those taxpayers in the
same situation (Rajiv and Dory) pay the same tax ($600).
The tax is not
vertically equitable because the taxpayer with a greater ability to pay
(LaMarcus) does not pay more tax, nor does he pay a higher tax rate.