Chapter 12 Problems and Applications 12. Each of the following expenditures is a

Question

Chapter 12 Problems and Applications

12. Each of the following expenditures is a deduction
for the purposes of calculating a person’s
federal income tax liability:
a. Mortgage interest
b. State and local taxes
c. Charitable contributions

If the income tax base were broadened by
eliminating these deductions, tax rates could be
lowered, while raising the same amount of tax
revenue.

For each of these deductions, what would
you expect the likely effect on taxpayer behavior
to be? Discuss the pros and cons of each deduction
from the standpoint of efficiency, vertical
equity, and horizontal equity. Would you keep
or eliminate the deduction?

Explanation / Answer

a. If the deduction for mortgage interest were eliminated, fewer people would desire to hold mortgages or purchase homes. This would impact housing markets and housing values. The removal of this deduction will likely improve vertical equity because higher income households tend to hold larger mortgages and thus currently get larger deductions. It would also improve horizontal equity because homeowners would be treated equally. Efficiency would improve for two reasons: less distortion in incentives and a smaller amount of paperwork in filing taxes. b. Omit part b… c. If the deduction for charitable contributions were eliminated, fewer dollars would be donated to charities. This would reduce the provision of some public goods (such as public television). Vertical equity would be improved, assuming that charitable contributions are positively related to income. Horizontal equity would also be improved because individuals in similar circumstances would pay the same level of taxes, whether or not they donated to charities.

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