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Marginal Tax Rate Estimated

Suppose a firm I equally likely to earn $2 million this year or lose $3 million. The firm faces a tax rate of 40% on each dollar of taxable income, and the firm pays no taxes on losses. In this simple one-period scenario, ignore the carryback and carry forward rules. The firm's expected taxable income is thus a loss of $500,000 calculated as .50(- $3) + .50($2). What is the firm's expected marginal rate?

Suppose a second firm is equally likely to earn $3million this year or lose $2 million. This firm also faces a tax rate of 40% on each dollar of taxable income (and the firm pays no taxes on losses0. Again in this simple one-period scenario, ignore the carryback and carry forward rules. The firm's expected taxable income is thus a profit of $500,000 calculated as .50($3) + .50(-$2).
- What is the firm's expected marginal tax rate.
- Why is the first firm's marginal tax rate not 0%?
- Why is the second firm's marginal tax rate not 40%?

Solution Preview

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For firm 1, expected profit = 0.5(-3)+0.5*(2) = -1.5+1 = -$0.5 million

For every change of $1 million profit, net change in tax liability = (-0.5+1.0)*0.4 = $0.2 ...

Solution Summary

Expected marginal tax rate estimated in two scenarios.

$2.19