Economics 031-001: Third Quiz

Instr. José-Víctor Ríos-Rull

Apr 10, 2000

Instructions:

• Answer all sections of this test. This is a 45 minute/45 point exam.
• Graphs are helpful. Carefully label the graphs if you use them.
• Write all answers in the blue books provided. Show all work.
• Write your name and your instructors name in every blue book that you use.
• This exam is given under the rules of Penn's Honor System.
• All blue books, blank or filled, must be handed in at the end of this exam. No blue books may be taken from this room.

Good luck!

1. (7 points) Imagine two countries that differ in the rules that restrict otherwise benevolent governments in their ability to set taxes at different dates. Illustrate how the welfare of the citizens of the two countries may differ.

   In the country with commitment the government can give believable guarantees to the citizens that it will not tax excessively future returns to investments. As a result, citizens undertake those investments. Without commitment, citizens may not undertake productive investments because the government will tax in the future the returns to investments because in the future doing so is non-distortionary. As a result citizens of the country where the government can commit are better off.

2. (8 points) Suppose an economy is comprised of only two markets: one for food and the other for housing. Show the effects of a 100% tax on food. Make sure that you show the indifference curves. Indicate how would you measure the excess burden of taxation.

   Do the graph. If food is on the horizontal axis, the new budget set cuts the horizontal axis on a point have the distance to the origin compared to the bedget set without taxes. It cuts the vertical axis on the same point.

   By using the indifference curves implied by the tax on food and by a lump sum tax that collects the same amount.

3. (3 points) Why is the payroll-tax not a lump sum tax despite the fact that all things bought are affected by the lower labor income?

   What is key is that even though a payroll tax acts as a tax on the consumption of all things that are bought, it does not affect leisure. Leisure is therefore not taxed, which means that not all goods are treated symmetrically, so it is not a lump sum tax.

4. (2 points) What is more unequal in the US, wealth or labor earnings? What statistic could you use to make this point (you do not have to give numbers).

   Wealth. The Gini index for example.

5. (3 points) State the main point raised by the Ricardian proposition.

   Under certain conditions, the timing of taxation is irrelevant. It does not matter whether the government balances its budget every period or whether it runs a deficit today by having low taxes and will have high taxes tomorrow that people will pay with the proceeds of the returns to the savings of todays taxes.

6. Imagine the demand for cars is x = 100 - p, while the supply is x = 2 p. Further imagine, that the government is considering raising a tax of $10 per car. Compute

   1. (2 points) Price and quantity with and without tax.

      p = 33.3, x = 66.66.

      p = 40 (including tax) x = 60

   2. (4 points) Excess burden of taxation.

      33.33

   3. (2 points) Efficiency loss ratio.

      .055

7. (3 points) What are the major alternatives to taxes as sources of government finance?

   Charges for government goods or services. Debt financing. Inflation (printing money). Public enterprises such as lotteries. Donations.

   Indicate whether these statements are true or false and why

8. (4 points) If the market supply of labor services is perfectly inelastic, a tax on labor income will reduce the net wages received by workers by the full amount of the tax per labor hour.

   True. Workers work the same amount regardless of wages. So now they will work the same. The supply is vertical. The demand is inclined. The vertical difference implied by the tax now ocurrs at the same quantity as before.

9. (3 points) Imagine that the marginal tax rate for a payroll tax is seven percent on all wages up to $60,000 per year. The marginal tax rate for wages in excess of $60,000 per year is zero. This payroll tax is therefore a regressive tax.

   True. Past $60,000 the fraction of income payed is decreasing.

10. (3 points) Existence of commitment on the part of a government allows it to implement lump sum taxation and hence avoid time inconsistency.

    False. Whether lump sum taxation is feasible or not has nothing to do with commitment. It has to do with the things that are taxable under the law.

    Multiple choice question

11. (1 point) A proportional income tax has an average tax rate that
    1. always is less than the marginal tax rate.
    2. always exceeds the marginal tax rate.
    3. equals the marginal tax rate at first and then becomes less than the marginal tax rate.
    4. always equals the marginal tax rate.

    D.