Suppose you operate a very profitable sole proprietorship (keep dreaming). Your current year marginal tax rate is 40%, but you expect it to increase to 50% next year due to legislative changes. Your business includes exclusive rights to distribute microcomputer software packages in specified geographical areas. Your typical gross margin on software sales for the pro- grams distributed is an impressive 50%. The end of the year is approaching, and you wonder whether a special price reduction to promote sales in the current tax year would be desirable. You assess that a 10% across- the-board price reduction for the remainder of the year will generate $400,000 of new sales, but $800,000 of normal sales for the rest of the year will be made at a 10% discount. Moreover, $1,000,000 of next year’s sales will be cannibalized. That is, a 10% price cut will result in $1,000,000 of next year’s product line being sold this year for $900,000, and $800,000 of normal sales for the rest of this year will yield only $720,000 in revenues, but you will also pick up $400,000 in new sales this year.
a. How much better or worse off would you be before and after tax if you employ the year- end sales strategy and it goes according to plan? Your customers fall roughly into three categories: corporations whose tax rates typically will not change from this year to next year; individuals who are not entitled to tax deductions for the purchase of your software; and small businesses, many of which face tax-rate increases similar to yours. Assume such businesses take tax deductions for the purchase of software in the year the software is acquired.
b. How are these customers likely to respond differently to the temporary price cut?