PS6s-W08.doc

Ans the precautionary saving model would predict

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Ans) The precautionary saving model would predict larger effects of this policy change since that model accounts for the fact that saving is motivated in part by a person's desire to self-insure against risk as well as to smooth consumption over time. The government's proposal in this case would increase the risks people face; people would thus increase saving to compensate for the increased risk. Empirical evidence is consistent with the precautionary saving model in this regard; several studies have found that as social insurance programs are expanded (reducing risks), savings are reduced. 5. Suppose that you are going to save \$1,000 of your income for one year, after which you  will spend it along with any accumulated interest you earned. Assume that your marginal  income tax rate is 50%. Consider the following two options: Option 1: Invest in a regular savings account earning 10% interest. Option 2: Invest in an IRA earning 10% interest. Determine the after-tax value of your savings a year from now under both options. If the amounts are the same, explain why they're the same. If the amounts are different, explain why they're different. Ans) Under Option 1, you pay taxes both on your contribution of \$1,000 and on the interest earned on your savings. Consequently, you invest \$500. It earns \$50 in interest, of which you pay \$25 in taxes. As a result, one year from now you will have \$525. Under Option 2, you do not pay taxes initially on your contribution of \$1,000. Therefore, you earn \$100 in interest. You pay 50% of the withdrawal in taxes, equal to \$550. One year from now you will have \$550. 4

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The amounts are different for two reasons. The first is that in the IRA, you earn interest on income that would have been taxed away if you had invested in a regular savings account. Second, in the IRA you don't have to pay taxes on the interest earned, whereas you do have to pay such taxes if you invest in a regular savings account. 6. Suppose that Lilistan has two types of citizens: low-income citizens (income = \$20,000)  and high-income citizens (income = \$80,000). Interest income is currently taxed and each  type of citizen saves 10% of his or her income for retirement. The government is  proposing to allow citizens to put money into an Individual Retirement Account where the  contributions would be tax-deductible and interest would accumulate tax-free.  Withdrawals would then be taxed as income. The government currently wants to set a  \$5,000 annual limit on the accounts. Discuss the effect of this policy on the saving choices of both the low-income and high-income citizens in terms of both income and substitution  effects as well as the overall effect.
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• Spring '16
• Taxation in the United States

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