The Federal tax code allows businesses but not individuals to deduct the cost of
ID: 2766138 • Letter: T
Question
The Federal tax code allows businesses but not individuals to deduct the cost of health insurance premiums from their taxable income. Consider a company named HeadBook that could either spend $5000 on an insurance policy for an employee named Vanessa or could increase her annual salary by $5000 instead.
a. As far as the tax code is concerned, HeadBook will increase its expenses by $5000 in either case. If it pays for the policy, it incurs a $5000 health care expense. If it raises Vanessa’s salary by $5000, it incurs $5000 of salary expense. If HeadBook is profitable and pays corporate profit taxes at a marginal 35 percent rate, by how much will HeadBook’s tax liability be reduced in either case?
The firm will pay $ less in taxes.
b. Suppose that Vanessa pays personal income tax at a marginal 20 percent rate. If HeadBook increases her salary by $5000, how much of that increase will she have after paying taxes on that raise? $
If Vanessa can only devote what remains after paying taxes on the $5000 to purchasing health insurance, how much will she be able to spend on health insurance for herself? $
c. If HeadBook spends the $5000 on a health insurance policy for Vanessa instead of giving it to her as a raise, how many more dollars will HeadBook be able to spend on Vanessa’s health insurance than if she had to purchase it herself after being given a $5000 raise and paying taxes on that raise? $
d. Would Vanessa prefer to have the raise or to have HeadBook purchase insurance for her? (Click to select)Vanessa would prefer to have a raise in her annual salary.Vanessa would prefer to have HeadBook purchase insurance for her.
Would HeadBook have any profit motive for denying Vanessa her preference? (Click to select)NoYes
e. Suppose the government changes the tax law so that individuals can now deduct the cost of health insurance from their personal incomes. If Vanessa gets the $5000 raise and then spends all of it on health insurance, will her tax liability change? (Click to select)NoYes
How much will she be able to spend on health insurance? $
Will she now have a preference for HeadBook to buy insurance on her behalf? (Click to select)YesNo
Explanation / Answer
a. As far as the tax code is concerned, HeadBook will increase its expenses by $5000 in either case. If it pays for the policy, it incurs a $5000 health care expense. If it raises Vanessa’s salary by $5000, it incurs a $5000 of salary expense. If HeadBook is profitable and pays corporate profit taxes at a marginal 35 percent rate, by how much will HeadBook’s tax liability be reduced in either case?
Answer
Corporate profit tax is paid on accounting profit, which is the difference between revenue and expenses. Since either option will increase the firm’s expenses by $5000, it will lower the firm’s accounting profit by $5000. This means that the firms will pay 0.35*$5000 = $1750 less in taxes in either case.
b. Suppose that Vanessa pays personal income tax at a marginal 20 percent rate. If HeadBook increases her salary by $5000, how much of that increase will she have after paying taxes on that raise? If Vanessa can only devote what remains after paying taxes on the $5000 to purchasing health insurance, how much will she be able to spend on health insurance for herself?
Answer
Since her marginal tax rate is 20 percent, Vanessa will pay $1000 of taxes on her $5000 raise (=0.2 x$5000). That will leave her with only $4000 to spend on health insurance.
Part c: c. If HeadBook spends the $5000 on a health insurance policy for Vanessa instead of giving it to her as a raise, how many more dollars will HeadBook be able to spend on Vanessa’s health insurance than if she had to purchase it herself after being given a $5000 raise and paying taxes on that raise?
Answer
If HeadBook uses the $5000 to purchase health insurance for Vanessa, it will be able to spend $1000 more than Vanessa would after paying income taxes on a $5000 raise. Recall from part b, Vanessa only had $4000 after taxes to purchase insurance
. Part d: d. Would Vanessa prefer to have the raise or to have HeadBook purchase insurance for her? Would HeadBook have any profit motive for denying Vanessa her preference?
Answer
Vanessa would prefer to have HeadBook purchase insurance for her rather than receiving the raise and having to pay 20 percent of it as taxes before spending the remainder on health insurance. Since HeadBook’s profit is the same in either case, it would not have any profit motive to deny Vanessa’s preference.
E
Suppose the government changes the tax law so that individuals can now deduct the cost of health insurance from their personal incomes. If Vanessa gets the $5000 raise and then spends all of it on health insurance, will her tax liability change
Vanessa’s tax liability will not change. She will have $5000 to spend on health insurance. She will no longer have a preference for HeadBook to buy insurance.
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