A firm operates in a state that has a corporate income tax rate of 5% and is deductible from the federal taxes. If the incremental federal tax is 34%, then the combined effective tax rate is 35.9%

a. true

b. false

The answer is b. false

Explanation:

Call X as the adjusted gross income before taxation. The corporate income tax is 0.05 * X. Given that the incremental federal tax rate is 34% after the state corporate income tax and because the state corporate income tax is deductible from the federal taxes, the incremental federal tax is 0.34 * (X - 0.05 * X). Therefore: 0.34 * (X - 0.05 * X) = 0.34 * 0.95 * X = 0.323 * X. The combined effective tax rate should be 32.3%.