Policy Application: Tax Deductions and Tax Credits: In the U.S. income tax code, a number of expenditures are “deductible”. For most tax payers, the largest tax deduction comes from the portion of the income tax code that permits taxpayers to deduct home mortgage interest (on both a primary and a vacation home). This means that taxpayers who use this deduction do not have to pay income tax on the portion of their income that is spent on paying interest on their home mortgage(s). For purposes of this exercise, assume that the entire yearly price of housing is interest expense.
A: True or False: For someone whose marginal tax rate is 33%, this means that the government is subsidizing roughly one third of his interest/house payments.
(a) Consider a household with an income of $200,000 who faces a tax rate of 40%, and suppose the price of a square foot of housing is $50 per year. With square footage of housing on the horizontal axis and other consumption on the vertical, illustrate this household’s budget constraint with and without tax deductibility. (Assume in this and the remaining parts of the question that the tax rate cited for a household applies to all of that household’s income.)
(b) Repeat this for a household with income of $50,000 who faces a tax rate of 10%.
(c) An alternative way for the government to encourage home ownership would be to offer a tax credit instead of a tax deduction. A tax credit would allow all taxpayers to subtract a fraction k of their annual mortgage payments directly from the tax bill they would otherwise owe.
For the households in (a) and (b), illustrate how this alters their budget if
k = 0.25.
(d) Assuming that a tax deductibility program costs the same in lost tax revenues as a tax credit program, who would favor which program?
B: Let x1 and x2 represent square feet of housing and other consumption, and let the price of a square foot of housing be denoted p.
(a) Suppose a household faces a tax rate t for all income, and suppose the entire annual house payment a householdmakes is deductible. What is the household’s budget constraint?
(b) Now write down the budget constraint under a tax credit as described above.