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Name ________________________________ Last 4 PSU ID____________ Final Exam: Econ 304 -Fall 2012 EACH QUESTION IS WORTH 130 POINTS DO THIS QUESTION IF...

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Name ________________________________ Last 4 PSU ID____________ Final Exam: Econ 304 –Fall 2012 EACH QUESTION IS WORTH 130 POINTS DO THIS QUESTION IF A HEADS IS FLIPPED 1. There has been a great deal of debate about taxes, tax rates, and what to do about them. Almost two years ago, the following article surfaced where President Obama backed a corporate tax cut. See excerpt below. Obama Backs Corporate Rate Cut Along With Tax Simplification January 26, 2011, 12:03 AM EST By Ryan J. Donmoyer and Peter Cohn Jan. 26 (Bloomberg) -- President Barack Obama called on Congress to cut the top U.S. corporate tax rate for the first time in 25 years “without adding to our deficit,” a sign that businesses will have to give up tax breaks in exchange for lower rates. The top marginal corporate tax rate, or the rate paid on the last dollar of income earned, has stood at 35 percent since 1993. We now fast forward to the present and we see that gridlock is alive and well in Washington since nothing much has changed in nearly two years. The excerpt from the article below is quite current. 12/3/2012 Top U.S. Firms Are Cash-Rich Abroad, Cash-Poor at Home By KATE LINEBAUGH Emerson Electric Co. has $2 billion of cash in the bank. But this year it had to borrow money in the U.S. to help buy back shares, distribute dividends and even pay its taxes. That's because "substantially all" of Emerson's cash is in Europe and Asia, according to the company's filings with securities regulators. The maker of power-plant and data-center equipment could always bring that cash back home, 1
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but it would be taxed at the 35% rate on corporate profits minus whatever tax it has already paid overseas. As a result, Emerson says, it brings its foreign cash holdings back to the U.S. only if that can be "accomplished tax efficiently." In its most recent fiscal year, that meant bringing back just $500 million, then using debt to cover other obligations. With lawmakers and the White House working to come up with a package of tax increases and spending cuts to trim the deficit and head off the "fiscal cliff," there is new impetus to change the corporate tax structure. There is also broad agreement that the current system, in which foreign earnings are kept offshore and untaxed, isn't working. But lawmakers and businesses disagree on a fix. The businesses want to pay taxes only in the country where profits are earned. They argue that being able to move their funds back to the U.S. freely would spur capital spending and help create jobs . As part of its proposal to lower the corporate tax rate to 28%, the Obama administration wants to expand the tax on foreign income to all income earned overseas. Please answer the following questions. 1. a) (30 POINTS) In this part you are to explain exactly how lowering the effective tax rate on capital (τ) will work (in theory) its way through the economy. In this discussion, you need to differentiate between the short- run and long-run. In the space below, explain, with graphical analysis, how lowering the effective tax rate on capital will influence real economic variables in the short run (hint, it’s a demand side story). Draw 4 diagrams (label them 1 through 4), with 1) a user cost ; desired capital (K*) diagram, followed by 2) a closed economy desired saving; desired investment diagram, followed by 3) an IS – LM diagram followed by 4) an aggregate supply ; aggregate demand diagram. Start at an initial equilibrium and label as point A in all diagrams, with all the associated market clearing variables denoted by subscript A. For example, in your IS – LM diagram, the interest rate that clears the goods and money market is labeled as r A with the associated output at Y A . Note that Y A , our initial equilibrium output, is below full employment output = Y B (we are in a recession, read on). Now let the effective tax rate on capital fall (same as a fall in τ) and show how all your graphs are affected. In particular, locate point B as the new (short-run 2
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