Exam Question

The other morning, I was doing my stretching while listening to Morning Edition on NPR. One of the stories involved NPR gathering five economists of different political persuasion and giving them the task of finding areas of agreement for a mythical candidate for President to propose. Listening to the rest of the story, which included two of the areas of agreement, gave me the inspiration to frame an examination question for a fictitious class I am teaching, namely Econ 398 – The Effects of Income Taxation on the National Economy as a method of encouraging discussion. The question follows, along with a bit of tongue in cheek fun.


You have 50 minutes to answer the following questions. When finished, or when the time has expired, please turn your Blue Book in to the proctor at the front of the room. Remember, points will be deducted for misspellings and egregious grammatical errors. Good luck, and enjoy the weekend.

Question: Recently, five economists were asked to arrive at a consensus for steps to be taken to amend the Internal Revenue Code. Two of their proposals were to eliminate the mortgage interest deduction and eliminate the corporate income tax. Based on the above, please:
a) indicate whether you agree with either or both of these proposals;
b) identify the economic rationale underlying the proposals; and
c) support your answer to question a) by applying the identified rationale to the proposals given above.


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17 responses to “Exam Question

  1. rd liebst

    This will be an interesting game and one I need more time then I have at the moment. Will try to get back later…. Rat, I come here to think and you make me think longer then I have the time to!

  2. I have no credentials and probably shouldn’t comment on a subject I’m totally unqualified to speak about.

    But when did that ever stop me from having an opinion!?

    To the question about eliminating the corporate income tax —

    There is no evidence to show that reducing taxes causes economic activity. There is evidence that corporations are sitting on huge stockpiles of money but all they seem to be spending on is whatever brings the greatest profit. Taking their stockpiles of money out of America seems to be bringing them the greatest return. This has nothing to do with tax rates. We can look at recent history to show proof that low tax rates don’t equal economic prosperity. We’ve all seen the charts and graphs and the history of tax rates and their affect on how well we prospered. Taxes today are at the lowest rates for over 60 years so if tax cuts were the answer what in hell was the question?

    I hope both you, 6176, and PrairiePond have time to weigh in and give me lessons. I love it when you guys talk economics.

    • wicked

      I give that answer a thumbs up.

    • rd liebst

      Fnord if that is the case that you have no credentials and shouldn’t comment on a subject then Fox news has a time slot for you! Gee I just got home from my wife and I going out to celibrate our wedding date and wouldn’t you just know when I turn on the TV. It is fox and totally in denial of reality! And to think there are those who actually think that is factual and the truth! So sad it just is not even funny..

  3. An Elite Obsession

    by Paul Krugman October 21, 2012, 2:32 pm

    David Dayen makes a very good point, which I missed: during the Hofstra debate, in which questions were posed by members of the public rather than the Beltway elite, there wasn’t a single question about the deficit. Not one. The public really doesn’t care.

    And you know what? Neither do financial markets, which continue to lend to the U.S. government at incredibly low rates.

    Meanwhile, the results from austerity are in — and it’s now clear that the adverse economic impacts of austerity in a depressed economy are much worse than the elite imagined (although Keynesian economists knew better), and are in fact so severe that austerity is largely self-defeating, having little impact on the budget deficit even in the short run because reduced revenue takes away much of the initial savings. Once you take long-run effects into account, austerity is almost surely self-defeating.

    Yet deficit fever, with demands for spending cuts right away, has dominated policy discussion for almost three years, with all the Very Serious People believing that by pounding on this issue they were demonstrating their Very Seriousness.

    An Elite Obsession – NYTimes.com#postComment

  4. The tax cut policies of Bush2, which Romney wants to double down on, do indeed make a very few who are already very rich even richer!

  5. prairie pond

    Gotta do an interview in a few minutes, so I may have to do this in two parts.

    I do not think we should eliminate the corporate income tax. The argument for doing so is partly supply side and trickle down, which is the more money businesses make, the more they will hire and the greater overall taxes they pay. So far, over the last thirty years, that has proven to be patently false. As Fnord notes, they tend to just stockpile cash or spend on leveraged buyouts. Hiring is almost entirely a function of demand, not profit. Businesses don’t hire just because they have a bunch ‘o cash. They hire because demand justifies increased production, which, in turn must justify more hiring and not just using up existing capacity or spending on more automation.

    Whenever we talk about economic activity, we don’t just measure the amount of money in the economy or in the coffers of corporations and individuals. There is also a velocity component which means money must move, and it must move at a certain speed, the higher the better for the most part. In other words, when money stops moving and stays parked in the bank accounts of corporations and wealthy individuals, the economy is essentially constipated. The money must move and circulate in order to create demand. No circulation, no demand. No demand, no hiring. So… the economy is either spiraling upward and growing, or spiraling downward and stagnating or shrinking.

    The other reason people say we should eliminate corporate income tax is because they just pass it on to consumers who pay it in higher prices. There is some truth to the fact that corporations add the cost of taxes into their pricing structure. But they also add the cost of materials and labor, so… no one is suggesting giving them materials or labor for free… why taxes? The corporations use the roads, get protection from police and fire departments, benefit from public education, use the sewer and water systems, etc. They get all the benefits of public works and public programs, so why should they get a pass on paying their fair share for those services and benefits? Taxes are just a cost of doing business like any other expense. Eliminating them has just allowed more stockpiling of cash. Such elimination has not resulted in lowered consumer prices or increased hiring. Nope, just more profit.

    I think we should actually increase corporate taxes, and then have the government get that money back into circulation by putting it into the hands of consumers in the form of lower individual taxes or direct benefits such as student loans, food stamps, and other targeted spending programs. Even homeowner property taxes could be lowered. It could go into expanded Medicaid, Medicare or Social Security to lower the age to free up more jobs in the workplace by encouraging early retirement. ALL of those things would create more jobs and get more money circulating faster to create more demand and hence more jobs. Which would, in turn, create even more demand and more hiring, and more payroll taxes and sales tax collections.

    Don’t know if that makes much sense, but essentially what I am saying is that if corps want to sit on their cash, yes, we should take it away from them and spend it for them to get both the volume and velocity of money increasing in the economy. Socialist? No. Keynsian? Maybe. Just give corps the “spend it or lose it” ultimatum and see how fast more money gets to circulating. 🙂

  6. prairie pond

    I’ll be back to address the mortgage deduction later. Gotta get on the phone now and do those interviews. To quote Mel Brooks in Blazing Saddles, “work, work, work. Work work work work work.”

  7. prairie pond

    I think it would be a huge mistake to remove the home mortgage deduction, although I might be convinced there should be some dollar limits on it. Middle class home ownership has been a huge wealth builder over the last sixty years, and it should be encouraged. I also think the housing recovery is fragile right now, and nothing should be done to derail that fragile recovery. And, let’s not forget the associated industries such as lumber yards, home improvement stores, contractor and landscaping businesses, etc. There is a huge spinoff effect from home ownership and home improvement and all that needs to be encouraged.

    What I would be in favor of would be more mortgage regulation and things that would discourage over buying. Limiting the dollar amount on home mortgage deduction might curb some demand on McMansions, but it would also make people think twice about buying more house than they can afford. What may really be needed are some restrictions on home equity loans. When I say home ownership has been a wealth builder, that’s largely been because it builds equity. That can be cashed out as home owners move up to larger or more expensive homes, and especially as they near retirement and begin downsizing. It should NOT be regarded as free money to be used for trips to Disneyland. Mortgage lenders should also be encouraged, with both carrot and stick, to make more fixed interest loans. They can always be refinanced if interest rates go down, but mostly, if home owners get into trouble, it’s because of adjustable rates and balloon payments, equity financing and second mortgages, and simply by over buying in the first place.

    So… keep the mortgage deduction, but cap it at the interest on properties valued at over $1 million. But add more restrictions to the mortgage industry. Yes, I know people will howl about the free market and being treated like children, but the mortgage industry has proven it can not be trusted to self regulate, whether in this crisis or the S & L crisis in the 80’s. And, unfortunately, the American consumer can’t be trusted to read the fine print and make good borrowing decisions. A little more regulation could save a lot more trouble down the road.

  8. prairie pond

    So, Professor 617, do I pass? Or should I dig out my dunce cap?

  9. OK, everyone, here are my thoughts. Before I set in, remember I’m addressing theory, not actuality.

    As to the mortgage interest deduction, it results in housing prices being 5 to 10 per cent higher than they would be otherwise. Similarly, the cost of money for mortgages is about 1 % higher than the same otherwise would be. The deduction further serves as a subsidy which overwhelmingly favors the wealthy, given the higher value of the rate of taxation applied to taxable income for those folks, together with the size of the mortgage interest paid. Another consideration is the current standard deduction, which makes it more difficult to actually take the mortgage interest deduction during the latter years of the mortgage, without substantial other deductible items, which is more unlikely for those of modest incomes.

    Regarding corporate income taxation and the elimination thereof, the taxes are paid by the buyer. In effect, this makes such, as in the case of tariffs, a hidden sales tax, which is regressive, therefore adversely affecting lower income folks. Further, the elimination of such taxes makes the corporation more efficient, as the need for employing additional people who do not contribute to the business of the corporation, namely the manufacture and sale of widgets, which adds to the cost of said widgets. Finally, the elimination of such taxes would allow for reinvestment of funds into growth and more efficient production which otherwise have been used to administer the collection and remittance of such taxes.

    As I said, theory not reality. Between the two, I’d eliminate the mortgage interest deduction first as it really distorts the cost of housing, with greater benefit flowing to those who do not need it.

    I really like both responses received; many thanks to fnord and prairie pond. As this was designed much as a law school exam, there is no “right” answer. PP passes with flying colors, as does fnord. As for me, I agree with both proposals in theory, not so much in reality.

  10. prairie pond

    Thanks for this exercise, 617.

    When you have time, I’d like to know why, or maybe how, the mortgage deduction results in higher housing prices and higher mortgage rates. Not disagreeing, just that I’ve never heard that before and would like to know how that works.

    As regards the corporate income tax, how do we know the corps will reinvest that money in production and/or efficiency? What I’ve seen is that they just sit on the cash, especially if there is no demand for production or if no more efficiencies are readily seen as possible. In other words, why do they stockpile and not reinvest and keep the money moving?