53065494 instructor s manual publice finance

www.elsolucionario.net Chapter - Introduction Instructor’s Manual to accompany Public Finance, Seventh Edition, by Harvey S Rosen Suggested Answers to End-of-Chapter Discussion Questions Some of the questions have no single “correct” answer – reasonable people can go off in different directions In such cases, the answers provided here sketch only a few possibilities Chapter - Introduction a Putin’s statement is consistent with an organic conception of government Individuals and their goals are less important than the state b Rehnquist makes a clear statement of the mechanistic view of the state a A person with an organic conception of the state might react favorably, arguing that even if an individual owner is worse off because he must show only French movies, the nation is better off because it achieves more unity b A libertarian would certainly reject this policy and the reasoning behind it there is no “national interest” independent of the interests of individuals, and people should have the right to run their lives in the way that they prefer including seeing whatever movies they want c A social democrat would try to balance these two aims, and it is hard to predict how he or she would come out The mechanistic view of government says that the government is a contrivance created by individuals to better achieve their individual goals Within the mechanistic tradition, people could disagree on the obesity tax Libertarians would say that people can decide what is best for themselves - whether to consume high calorie food - and not need prodding from the government In contrast, social democrats might argue that people are too short sighted to know what is good for them, so that government-provided inducements are appropriate a If the size of government is measured by direct expenditures, the mandate does not directly increase it Costs of compliance, however, may be high and would appear as an increase in a “regulatory budget.” b It’s hard to say whether this represents an increase or decrease in the size of government One possibility is that GDP stayed the same, and government purchases of goods and services fell Another is that government purchases of goods and services grew, but at a slower rate than the GDP One must also consider coincident federal credit and regulatory activities and state and local budgets www.elsolucionario.net www.elsolucionario.net Part – Getting Started The inflation erodes the real value of the debt by 0.021 x £311 billion or £6.5 billion The fact that inflation reduces the real debt obligation means that this figure should be included as revenue to the government The federal government grew by $450 billion However, because the price level went up by 16 percent, in terms of 2001 dollars this amounted to a real increase of $224 billion (=$1.86 trillion - 1.16*$1.41 trillion=$1.86 trillion-$1.64 trillion) Note that the increase in prices of 16 percent in the Rosen text (p 18) differs from official sources According to the 2004 Economic Report of the President (Table B-60), the CPI-U was 177.1 in 2001 and was 144.5 in 1993, an increase of 22.5 percent, not 16 percent If one uses these numbers, government spending increased in constant 2001 dollars from $1.72 trillion in 1993 to $1.86 trillion, or $140 billion As a proportion of GDP, federal spending in 1993 was 21.2 percent and in 2001 it was 18.2 percent Hence, by one measure, the size of government fell and by the other measure, it grew To get a more complete answer, one would want data on the population (to compute real spending per capita) Also, it would be useful to add in expenditures by state and local governments, to see if the total size of government fell Also, although it would be harder to measure, one would want to try to gain some sense of how the regulatory burden on the economy grew during this time period Chapter – Tools of Positive Analysis The reality that astronomers are trying to understand is not influenced by any “policies” that astronomers might implement That is, planets and stars act any differently when they are being analyzed, whereas people can change their behavior Moreover, the parameters with which astronomers must deal are constant over time (at least in the “short-run” of hundreds of years), while the parameters in economics can quickly change over time and across geography A change in the marginal tax rate changes the individual’s net wage This generates both an income effect and a substitution effect As long as leisure is a normal good, these effects work in opposite directions Hence, one cannot tell a priori whether labor supply increases or decreases One could ask taxpayers to describe how they would change their behavior under the proposal, but it is hard to imagine that this would yield useful results In a social experiment, a control group would confront the status quo, and an experimental group would face the new tax regime This is clearly infeasible Econometric investigation of labor supply seems the best approach, particularly if data associated with past changes in tax rates can be brought to bear on the problem Generally, economic outcomes are affected by a number of variables some of which are observed and others of which are unobserved Economists often cannot perform controlled, randomized experiments, which makes it difficult to assess how any single variable affects a given outcome Moreover, even in the cases when experiments are run www.elsolucionario.net c The federal budget would decrease if grants-in-aid were reduced However, if state and local governments offset this by increasing taxes, the size of the government sector as a whole would not go down as much as one would have guessed www.elsolucionario.net Part – Getting Started The text points out the pitfalls of social experiments: the problem of obtaining a random sample and the problems of extending results beyond the scope of the experiment Participants in the study had found it to their advantage to be a part of the experiment, which may have resulted in a self-selected population unrepresentative of the wider group of health care consumers In addition, the RAND Health Insurance Experiment was of limited duration, after which the participants would move to some other health plan This design could induce certain behavior in the short-run that would not necessarily be present if the health insurance coverage were permanent rather than transitory Further, physicians’ “standard practices” are largely determined by the circumstances of the population as a whole, not the relatively small experimental group First, it is important to note that the numbers on page 32 of Rosen’s text actually show the surplus, not the deficit That is, the negative surplus of $221.2 in 1990 is actually a deficit, while the positive surplus of $236.4 is a surplus There is a very weak, negative relationship between surpluses and interest rates (the correlation coefficient is -.043), or put differently, a weak, positive relationship between deficits and interest rates However it is expressed, it is weak by “eyeballing” the data, it might appear that larger deficits lead to lower interest rates (for example, by comparing the data from 1980 with the data from 2000) One clearly would need more data to investigate this question One would want to look at deficits relative to some benchmark, such as GDP One would want to express both interest rates and deficits in real terms, rather than nominal terms One would like to control for other factors that can affect interest rates, such as monetary policy and the level of economic activity Finally, one would want to determine which way the causality runs – larger deficits cause higher interest rates, or higher interest rates cause larger deficits (since, by construction, one of the largest items in the federal budget is interest on the debt) Chapter – Public Goods a Wilderness area is an impure public good – at some point, consumption becomes nonrival; it is, however, nonexcludable www.elsolucionario.net (e.g., the Negative Income Tax experiment or the RAND Health Insurance Experiment), a number of unintended behaviors can arise because people know they are in the experiment for a short amount of time and because of lack of generalizability In the medical example here, brain impairment may be due to a number of factors that are either observed are unobserved Ecstasy users clearly are not a random sample of the population, but are likely to differ in terms of their attitudes towards risk, their discount rates, and potentially many other ways Hence, one cannot definitively conclude whether brain impairment is due to Ecstasy or some variable that is correlated with Ecstasy use There are numerous non-experimental methods that may be helpful in inferring the causal effect of Ecstasy For example, if there were a plausible “instrumental variable” (perhaps the punitiveness of the drug laws in a state) that was correlated with the supply of Ecstasy but not otherwise correlated with the outcomes of interest, one may be able to estimate the causal effect of Ecstasy on long-run developmental problems www.elsolucionario.net Part – Getting Started b Water from a municipal water supply is both rival in consumption and excludable My consumption of water precludes you from consuming the same water, thus it is rival The municipality can control who consumes water by shutting off the flow to customers, thus it is excludable This is a useful question for showing that not all publicly owned facilities are public goods c Medical school education is a private good d Television signals are nonrival in consumption e An Internet site is nonrival in consumption (although it is excludable) We assume that Cheetah’s utility does not enter the social welfare function; hence, her allocation of labor supply across activities does not matter a The public good is patrol; the private good is fruit b Recall that efficiency requires MRSTARZAN + MRSJANE =MRT MRSTARZAN=MRSJANE =2 But MRT=3 Therefore, MRSTARZAN + MRSJANE >MRT To achieve an efficient allocation, Cheetah should patrol more A pure public good is nonrival in consumption, thus it is necessary to determine whether or not this is the case with the highway That is, if the additional cost of another person “consuming” the highway is zero, then it is a public good So, as long as the highway is not congested, then it can be considered to be a public good However, adding another motorist to an already congested roadway can cause traffic jams that cost motorists more time to travel the highway, which would represent nonzero costs to having an additional person use the highway Therefore, the congestion of the roadway determines whether or not we could designate it as a public good Note that we are assuming throughout that the highway is nonexcludable To determine whether or not the privatization of the highway is a sensible idea, it is necessary to consider the advantages and disadvantages of such an action First, if the market structure is such that privatizing the highway would result in a monopolist in control of the highway, then this would be inefficient Also, it would be difficult for the government to write a complete contract for maintaining the highway, which would also cause inefficiencies that would result from the privatization of the road However, if the government owns the highway, it might not have the appropriate incentives to maintain it properly In such a case, even ownership by a private monopolist might be a sensible solution The benefits of maintaining the incomes of the poor accrue largely to the recipients of welfare, not to society as a whole Thus, it is implausible to think of welfare (or the administration of the welfare system) as a public good Unless there is a “warm-glow” from income redistribution, there is little basis for thinking that the provision of TANF, Medicaid, public housing, or food stamps offers much in terms of benefit to society as a www.elsolucionario.net www.elsolucionario.net Part – Getting Started A lower cost is a necessary (but not sufficient) condition to conclude that prisons should be privatized A policy maker should be concerned both with costs and quality of prisons Although, in principle, one could write a contract that is concerned about the quality of prisons (e.g., whether the prisoners are treated decently, whether security is adequate, and so on), Hart, Shleifer and Vishny (1997) note that it is sometimes impossible to write a complete contract because one cannot specify in advance every possible contingency The key is whether the administration of prisons is a fairly “routine” activity where complete contracts can be written, or whether there are too many contingencies As noted on page 65 of the textbook, the experimental results of Palfrey and Prisbrey (1997) suggest that there is some free riding, but some people contribute Those authors found that, on average, people contribute a portion of their resources to the provision of a public good, and there is some free riding That was the case in Manchester, Vermont Also, Palfrey and Prisbrey found that when the experimental game was repeated, people were more likely to free ride This also happened in Manchester in the second year, participation was less There is no compelling reason for museums to be run by the government from the theory of public goods; thus, it is appropriate to think about privatization Admissions to museums are clearly excludable And viewing the artwork is also rival, because there is congestion when too many people are consuming the good Thus, museums may be thought of as a private good rather than public good In the United States, many great museums are run privately (not for profit), and they seem to quite well In terms of private versus public production, the text points out that this decision should be based on relative wage and material costs in the public and private sector, administrative costs, diversity of tastes, and distributional issues There is no compelling reason to think the private sector would have higher costs than the public sector In regards to diversity of tastes, a profit-maximizing private sector museum would likely be more responsive to consumer tastes than the public sector – e.g., adopting new technologies that make the museum more enjoyable for the typical customer In regards to distributional issues, it is www.elsolucionario.net whole In terms of administration of welfare, it is hard to say whether or not it should be publicly or privately administered Private administration might be less costly On the other hand, private administrators might have an incentive to deprive deserving individuals of benefits in order to cut costs It could be difficult to write a contract to prevent this kind of behavior, because one cannot specify in advance every conceivable set of circumstances under which welfare should be granted This kind of subjectivity was present in the 1960s, when caseworkers had a great deal of discretion in terms of which households to offer assistance to This subjectivity led to accusations of discrimination and, from the 1970s onward, there has been far less subjectivity in terms of defining eligibility Since that time, eligibility is fairly mechanically related to income, assets, family structure, and a number of other observable factors Given the current system, it seems less difficult today to monitor a private firm than it would have been in the 1960s www.elsolucionario.net Part – Getting Started likely that the private sector would be less responsive than the public sector The notion of commodity egalitarianism, however, is a stretch for museums If households are allowed to supplement public education with private lessons, then the budget constraint in Figure 4.5 of the textbook is modified by drawing a line starting at point x (consuming only public education) that runs to the southeast and is parallel to AB The figure below is then similar to the analysis of in-kind benefits like food stamps FIGURE 4.8a – Supplement public education with private lessons Other Goods A BA ep Education www.elsolucionario.net www.elsolucionario.net Part – Getting Started If parents pay for the public schooling (rather than perceiving it as being free), and the schooling was paid for with a lump sum tax, then the budget constraint shifts in by an amount that depends on the household’s share of the tax burden If the household’s tax burden exactly equals the cost of public school, the budget constraint is no longer the line segment AB but rather the segment CDB, where the segment DB runs along the original budget constraint, except that the minimum amount of schooling consumed is eP FIGURE 4.8b – Parents pay for “free” schooling Other Goods C D BA ep Education In this case, the apartment’s temperature is a public good because for the “society” of Rodolfo and Mimi, the temperature is nonrival and nonexcludable Both get to “consume” a warmer house, and neither can exclude the other from this The marginal benefit for society is the sum of Rodolfo’s and Mimi’s marginal benefit – e.g., $20 at 66 degrees, $17 at 67 degrees, $13 at 68 degrees, $8 at 69 degrees, and $4 at 70 degrees The marginal benefit for society equals the marginal cost at 67 degrees; for temperatures higher than that, the marginal cost is greater than the marginal benefit for society www.elsolucionario.net A www.elsolucionario.net 10 Thelma’s marginal benefit is MBTHELMA=12-Z, and Louise’s is MBLOUISE=8-2Z The marginal benefit for society as a whole is the sum of the two marginal benefits, or MB=20-3Z (for Z≤4), and is equal to Thelma’s marginal benefit schedule afterwards (for Z>4) The marginal cost is constant at MC=16 Setting MB=MC along the first segment gives 20-3Z=16, or Z=4/3, which is the efficient level of snowplowing Note that if either Thelma or Louise had to pay for the entire cost herself, no snowplowing would occur since the marginal cost of $16 exceeds either of their individual marginal benefits from the first unit ($12 or $8) Thus, this is clearly a situation when the private market does not work very well Also note, however, that if the marginal cost were somewhat lower, (e.g., MC≤8), then it is possible that Louise could credibly free ride, and Thelma would provide the efficient allocation This occurs because if Thelma believes that Louise will free ride, Thelma provides her optimal allocation, which occurs on the second segment of society’s MB curve, which is identical to Thelma’s MB curve (note that Louise gets zero marginal benefit for Z>4) Since Louise is completely satiated with this good at Z=4, her threat to free ride is credit if Thelma provides Z>4 Chapter - Externalities Classical economics explicitly requires that all costs and benefits be taken into account when assessing the desirability of a given set of resources, so Gore’s statement is false The notion that rescuing the environment should be “the central organizing principle for civilization” provides no practical basis for deciding what to about automobile emissions (or any other environmental problem), because it provides no framework for evaluating the tradeoffs that inevitably must be made www.elsolucionario.net Part – Getting Started www.elsolucionario.net Part – Getting Started a The number of parties per month that would be provided privately is P b See schedule MSBp c P* Give a per-unit subsidy of $b per party d The total subsidy=abcd “Society” comes out ahead by ghc, assuming the subsidy can be raised without any efficiency costs (Cassanova’s friends gain gchd; Cassanova loses chd but gains abcd, which is a subsidy cost to government.) a If you know who was cooking, the externality is easy to identify, and depending on how many students are involved, the costs of negotiation should be fairly small b It is unlikely that property rights could be enforced in terms of catching tropical fish on the Amazon River The question states that hundreds of divers illegally catch these fish and sell them on the black market If the property rights were given to the divers, it is not clear who is actually harmed (perhaps “society as a whole”) by the depletion of exotic fish Given the large number of people who are harmed (in a small amount), and the large number of people who are engaging in this activity, it is not clear how bribes would flow from “society” to the “divers.” c There are too many farmers and too many city-dwellers for a private negotiation d Too many people are involved for private negotiation and impossible to figure out how to transfer bribes a The price of imported oil does not reflect the increased political risk by effectively subsidizing authoritarian regimes like those in Saudi Arabia b The tax would estimate the marginal damage (e.g., the increased instability in the Middle East, etc.) by importing oil from Saudi Arabia www.elsolucionario.net www.elsolucionario.net Part – Getting Started With respect to grant policy, by this stage of the course, the students should have little trouble manipulating the indifference curve diagrams But they may not realize the implications of these diagrams – federal attempts to stimulate certain kinds of spending can be frustrated by adjustments that states and localities make in other parts of their budgets The new material on the block grants for welfare contained in the 1996 welfare reform can be used to illustrate this point SAMPLE MIDTERM EXAM I Part I (6 points each) Indicate whether each of the following statements is true, false, or uncertain, and explain your answer Your grade will depend primarily on the quality of your explanation If a word or phrase is underlined, your answer must include a concise definition of the word or phrase A consumption-efficient allocation of resources is socially desirable Suppose that everyone has a utility function that depends only on his or her income Then the value of a utilitarian social welfare function is maximized when everyone has the same after-tax income Under the 1996 welfare reform, each state receives a fixed grant from the federal government to pay for its income maintenance policies However, for each dollar of its own money that the state spends on welfare, the federal grant is reduced by a dollar Under the Social Security system, an individual’s retirement benefits are directly proportional to the amount of payroll taxes that he or she has paid into the system Former President Clinton once proposed that individuals between the ages of 55 and 64 be allowed to buy into the Medicare system if they so choose This is a good example of how social insurance can solve the adverse selection problem Political economy models of bureaucratic behavior assume that a bureaucrat’s goal is to maximize the welfare of the citizens Part II Your answers to the following questions should take advantage of the relevant economic tools (10 points) Several months ago, the newspaper USA Today published an article that was critical of the large amount of money that the government spends to subsidize the energy industry In response, a spokesman for the industry observed, “Some of the alleged subsidies don’t even go to the industry For example, the government provides money to low-income families to help pay 72 www.elsolucionario.net Part I is worth 36 points Part II is worth 24 points www.elsolucionario.net Part – Getting Started heating bills.” Evaluate this response carefully Your answer should include an appropriate graphical model (14 points) Stanley and Wendy both operate factories along a lake Stanley produces an output X In the process, he pollutes the lake, which increases the costs of production for Wendy Assume that the total damages to Wendy increase in proportion to the amount of X that Stanley produces SAMPLE MIDTERM EXAM I: SUGGESTED ANSWERS Part I (6 points each) False An allocation of commodities is said to be consumption-efficient when the only way to make one consumer better off is to make another worse off, given fixed quantities of the various commodities We cannot know whether such an allocation is socially desirable without explicit ethical judgments relating to equity False A utilitarian social welfare function says that social welfare is a function of the utilities of everyone in society Even if all that utility depends on is income (so that incentive issues are not relevant), additional assumptions are needed to get the result These include identical utility functions and diminishing marginal utility of income False Each state gets a grant from the federal government, but the grant is not reduced by the amount that the state spends on welfare False The schedule that relates benefits received to payroll taxes paid is progressive As a lifetime taxes increase, benefits increase less than in proportion False Adverse selection occurs when the people who are most likely to benefit from a given insurance policy are also the ones who are most likely to purchase it Under the Clinton plan, enrollment is optional in this age group Those who are most like to be sick are the ones who would be most likely to participate, so the program does not solve the adverse selection problem False While it is not clear exactly what objective bureaucrats have, political models generally assume that bureaucrats are trying to maximize their own utility, which is related to the size of the agency they administer 73 www.elsolucionario.net a Draw a sketch that depicts this situation b Show the amount that Stanley produces, and show the socially efficient amount for Stanley to produce c On the diagram, show the Pigouvian tax that will induce Stanley to produce the efficient amount, and the amount of revenues collected by the tax www.elsolucionario.net Part – Getting Started (10 points) Just as is the case for a tax, it does not matter which side of the market a subsidy is applied to The beneficiary depends on the elasticities of the demand and supply curves This can be illustrated either with a supply-demand diagram or a formula which shows that the equilibrium outcome is independent of whether the subsidy is received by producers or consumers (14 points) This is essentially the model of Figure 5.4 in the text, except that the marginal damage curve is horizontal (because the problem stipulates that the total damage is directly proportional to the amount of output) SAMPLE FINAL EXAM I The maximum number of points is 110 Please answer every question Your answers should make use of the tools of economics and the material presented in this course, including diagrams and/or formulae where appropriate You are advised to include a minimum of irrelevant material in your answers Points will be subtracted for all incorrect statements you make Part I (40 points) Indicate whether each of the following statements is true, false, or uncertain, and explain your answer Your grade will depend primarily on the quality of your explanation If a word or phrase is underlined, your answer must include a concise definition of the word or phrase “I promise to lower income tax rates And I won’t have to cut spending, because the lower rates will induce so much economic activity that tax revenue will rise.” This promise would be more credible coming from a candidate for governor of a state than from a candidate for president of the country Over time, health care costs in the United States have been increasing This is due primarily to the fact that the population has been aging Suppose that a public good is provided in a Pareto-efficient amount It is possible that different members of society will place different values on the last unit of the public good that they consume Rent-seeking models of government behavior assume that the goal of policymakers is to maximize a social welfare function 74 www.elsolucionario.net Part II www.elsolucionario.net In a pay-as-you-go social security system, the dependency ratio equals the replacement ratio Under the Hall-Rabushka flat tax, each individual completes a tax return that includes his or her wages and capital income, no deductions are allowed, and total income is taxed at a constant rate Consider a tax system that is neutral with respect to marital decisions In general, such a system will lead to a situation in which two families with equal total family incomes will pay different amounts of tax Under current law, corporations may deduct payments of interest to their bondholders Disallowing this deduction would bring the tax base into closer alignment with the Haig-Simons definition of income (12 points) What is the Tiebout model? What are the key assumptions behind the model? Are they realistic? 10 (6 points) In Russia, the prices of commodities such as food and clothing are set in a free market, but housing is heavily subsidized by local governments A two-bedroom apartment in Moscow, for example, might rent for $1.50 per month (Utilities and other fees increase the cost to about $35.) “Because of subsidized rents, some tenants live in larger apartments than they need and might not otherwise afford.” Explain how this situation relates to the concept of excess burden, and illustrate with a diagram 11 (6 points) In 1997, House Republicans proposed that capital gains be indexed for inflation Newsweek’s Wall Street editor stated that this was unfair to wage earners: “Inflation pushes up salaries, too But would paychecks get the same generous treatment? Nope No inflation indexing.” [Sloan, 1997, page 59] Compose a letter to Newsweek in which you comment on this statement 12 (9 points) According to conventional welfare economics, under what conditions is a government intervention in the economy appropriate? (There is no need to explain the conditions; just list them Be specific; don’t simply answer “market failure.”) In one of the budgets that he submitted to Congress, former President Clinton proposed a multi-million dollar program to subsidize training to day-care workers Consider each criterion you listed above and indicate whether or not it provides a rationale for this government intervention 13 (9 points) In the current debate over the public policy toward the tobacco industry, some politicians seem particularly interested in punishing the industry for its bad behavior, and other politicians are primarily interested in deterring smoking Consider the following two policy options: 1) a large lump-sum tax Part II 75 www.elsolucionario.net Part – Getting Started www.elsolucionario.net Part – Getting Started 14 (9 points) “It is undesirable for an economy to be to the right of the peak of the Laffer Curve, because the peak depicts the socially optimal tax rate.” Comment on this statement 15 (7 points) The Hope Scholarship credit is a tax credit of $1,500 per student for qualified expenses associated with each of the first two years of higher education The credit is phased out linearly for AGIs between $80,000 and $100,000 (Thus, when AGI exceeds $100,000 the family is ineligible for the credit.) Consider a family in the 28 percent tax bracket that has two children who qualify (i.e., the family is eligible for a $3,000 tax credit) What is the family’s effective marginal tax rate between $80,000 and $100,000? 16 (12 points) In a recent op-ed piece in an undergraduate newspaper, a student once argued that the U.S should move to a privatized Social Security system To finance the payment of benefits to the elderly during the transition, he proposed raising the federal tax on gasoline by $2.50 per gallon a One justification the student gave for the gasoline tax is that driving leads to “higher prices for good and services.” According to the theory of externalities, if this fact is true, is it alone a justification for taxing gasoline? Explain carefully b The student noted an alternative policy for financing benefits during the transition would be a federal sales tax However, he characterized that option as “unimaginative (sic)…What good would a sales tax do? Discourage buying?” On the basis of efficiency, which is to be preferred, a gasoline tax or an equal yield general sales tax? Explain carefully what you mean by “efficiency” in your answer Which tax would be fairer? Again, explain your definition of “fair.” c The student also noted that gasoline taxes are much higher in Europe than in the U.S., and that consequently, “Europeans a fraction of the driving that Americans for noneconomic purposes, but they make nearly as many trips to work and for other economic purposes.” What does the student mean by the distinction between “economic” and “noneconomic” uses of gasoline? Suppose that it were possible to tax these two uses of gasoline at different rates In order to minimize excess burden, how would you set the tax rates? SAMPLE FINAL EXAM I: SUGGESTED ANSWERS Part I (5 points each) 76 www.elsolucionario.net that must be paid by the tobacco companies; 2) a large unit tax on cigarettes Which tax is more suitable for achieving each objective? Explain carefully www.elsolucionario.net True The effect of a tax reduction on tax revenues depends upon the elasticity of the taxed activity with respect to the tax rate The elasticity of a factor of production to a state is greater than the elasticity of a factor to the country as a whole, because a factor can migrate from a state in response to a tax increase This is easier than migrating from the country That said, even for a state, it is not clear the elasticity is sufficiently large that a tax decrease would be self-financing False The graying of American is not sufficient to explain the long-term increase in health care costs Many investigators believe that the main cause is changes in technology True The condition for the efficient provision of a public good is that the sum of the marginal rates of substitution equal the marginal rate of transformation This does not require that MRSs be the same Put another way, everyone must consume the same quantity of a public good, but there is no need for everyone to value the last unit by the same amount False Rent-seeking models assume that individuals seek to use the political system to obtain financial returns that are above the market rate of return (“rents”) In general, this is not consistent with maximizing a social welfare function False The dependency ratio is the ratio of the number of people being supported by social security to the number of workers The replacement ratio is the ratio of social security benefits to prior earnings The correct statement is that, under a pay-as-you-go system, the dependency ratio times the replacement ratio equals the social security tax rate False Under the Hall-Rabushka flat tax, each individual’s tax return includes only his or her wage income There is an exemption depending on family size There is a business-level tax at the same rate; the base of the business tax is revenues minus purchases of material inputs minus wages True, providing that marginal tax rates vary with income According to the Haig-Simons criterion, income during a given period is the increase in potential to consume According to this criterion, business income must be measured net of the expenses incurred in producing it Interest is such an expense Hence, according to H-S principles, it is appropriate for business to deduct interest and for it to be taxable at the individual level The statement is false (12 points) The Tiebout model shows that, under certain assumptions, the ability of individuals to move among jurisdictions produces a market-like solution to the Part II 77 www.elsolucionario.net Part – Getting Started www.elsolucionario.net Part – Getting Started 10 (6 points) The subsidy induces people to consume housing in excess of its social marginal cost, which is inefficient, and generates an excess burden Alternatively, the cost of the subsidy is greater than the benefits received This is depicted graphically in Figure 13.6 in the text 11 (6 points) Dear Editor: Under the personal income tax, wages have effectively been indexed since the mid 1980s This has been accomplished by provisions that increase bracket widths, the standard deduction, the personal exemption, etc., by changes in the CPI On the other hand, no steps have been taken to index capital income In short, your writer’s statement is wrong: Indexing capital income would not advantage it relative to wage income because wage income is already indexed Rather, the proposal would bring the treatments of wage and capital income into parity 12 (9 points) According to conventional welfare economics, government intervention in the economy may be appropriate in the presence of market failure due to market power, adverse selection, externalities or public goods In addition, even if markets are operating efficiently, government intervention may be appropriate to secure a distribution of income that is consistent with society’s ethical views The subsidy will tend to increase the incomes of the individuals who receive the training To the extent that there are more daycare workers, this may lower their overall wages, benefiting the people who hire them It is not clear that either group is particularly deserving from an income distribution point of view It is hard to imagine that adverse selection is an important issue in this market; to the extent it is, there is no reason why a training subsidy would deal with the problem Neither does an important externality appear to be present – if families want better trained daycare workers, then they will be willing to pay more for workers who have such training so there will be a private incentive to undertake such training 13 (9 points) A lump sum tax will reduce profits of the companies, without changing their price and output decisions A unit tax will increase prices paid by consumers, lower prices received by producers and lower the quantity exchanged The magnitudes of these effects depend on the demand and supply elasticities To 78 www.elsolucionario.net local public goods problem The Tiebout model assumes the government activities generate no externalities, individuals are completely mobile, people have perfect information with respect to each community’s public services and taxes, there are enough different communities so that each individual can find one with public services meeting her demands, the cost per unit of public services is constant, and that public services are financed by a proportional property tax The assumptions obviously are not totally realistic However, there is a lot of mobility in the American economy, and several of the empirical implications of the model (e.g., tax and expenditure capitalization) appear to be consistent with the data www.elsolucionario.net Part – Getting Started 14 (9 points) An economy to the right of the peak of the Laffer Curve would be able to raise the same amount of revenues with a lower tax rate and therefore a lower excess burden Hence, it cannot be efficient to be to the right of the peak of the Laffer Curve However, it does not follow that the peak is in the best point for society The peak is where tax revenues are maximized Determination of the optimal tax system depends on a wide array of social and economic considerations For example, those who believe that the government sector is too large should presumably be quite happy to see tax revenues reduced below the maximum 15 (7 points) The $3,000 credit is phased out over a $20,000 range Hence, for each dollar earned in this range, the individual loses a credit of $0.15 The effective marginal tax rate is the statutory marginal tax rate plus the loss of the credit: 28+.15=.43 16 a (4 points) The fact that some activity increases (or decreases) prices in other markets is not justification for government intervention The key issue is whether the activity influences the welfare of other individuals or firms in a way that is external to the market b (4 points) Excess burden increases with the square of the tax rate on a commodity One can therefore reduce total excess burden by spreading the tax over a variety of commodities, which a sales tax would Alternatively, by constraining the rates that apply to a set of commodities to be zero, the gasoline tax does not allow one to follow the Ramsey rule for minimizing excess burden If fairness refers to horizontal equity, then a gasoline tax does not seem very fair – two individuals with similar abilities to pay can end up with very different tax burdens (assuming that the incidence of the tax is on consumers) With respect to vertical equity, one would need more information However, to the extent that a sales tax would end up taxing commodities that have a higher income elasticity than gasoline, it would have a more progressive impact on the distribution of income (again assuming the incidence of the tax is on consumers) c (4 points) Presumably all driving, whatever the purpose, is increasing the utility of the individual who undertakes it Hence, elimination of “noneconomics” driving entails a social cost Indeed, to the extent that the demand for gasoline for “noneconomics” driving is elastic with respect to its price, Ramsey principles suggest that it may be desirable to tax it at a relatively low rate, if that is possible 79 www.elsolucionario.net the extent that demand is inelastic, cigarette consumers will bear the burden of the tax without much of a decrease in cigarette consumption www.elsolucionario.net Part – Getting Started SAMPLE MIDTERM EXAM II A Pigouvian tax is any kind of tax levied on pigs Suppose that a program is available that would make the poorest person in society better off by a small amount, and everyone else in society worse off (but still better off than the poorest person), except for a few rich individuals who would become even more wealthy According to a Rawlsian social welfare function, society should implement the program If the assumptions of the Coase Theorem hold, then divorce rates in states with no-fault divorce laws should be the same as the divorce rates in other states with fault-based laws Conventional welfare economics suggests that, because income maintenance programs for the poor are associated with moral hazard, it is undesirable for the government to sponsor such programs As long as all individuals have single-peaked preferences and all eligible voters participate, then the outcome of a referendum conducted by majority voting will reflect the preferences of the median voter The government would ease the burden of taking care of the baby-boomers when they retire by using the money in the Social Security Trust Fund to invest in the stock market (14 points) In a hypothetical society, the government has decided to right the historic wrongs done to vertically challenged (i.e., “short”) people Part of the program involves subsidizing the purchases of stilts by short people Specifically, each pair of stilts purchased by a short person receives a subsidy of s percent To finance this subsidy, each pair of stilts purchased by someone who is tall is taxed at a rate of t percent Part II Assume that i) the relevant supply curves are perfectly horizontal so that the price to short people falls by exactly s percent and the price rises by exactly t percent; ii) there are no other taxes, subsidies or market imperfections in the economy; and iii) the economy’s only inputs, capital and labor, are each fixed in supply 80 www.elsolucionario.net Part I (6 points each) Indicate whether each of the following statements is true, false, or uncertain, and explain your answer Your grade will depend primarily on the quality of your explanation If a word or phrase is underlined, your answer must include a concise definition of the word or phrase www.elsolucionario.net Part – Getting Started After the subsidies and taxes are imposed, a Is the allocation of resources production efficient? That is, is the allocation on the production possibilities curve? b Is the allocation of resources consumption efficient? That is, is it on the contract curve in an Edgeworth Box with individuals’ consumption of various commodities measured along the sides? c Is the allocation of resources Pareto efficient? SAMPLE MIDTERM EXAM II: SUGGESTED ANSWERS Part I (6 points each) False A Pigouvian tax is a tax levied to correct an externality It is equal to the marginal damage (positive or negative) at the optimum True According to a Rawlsian social welfare function, social welfare equals the minimum of the utilities of all the individuals in the society This program does increase the utility of the worst-off individual and, hence, increases social welfare True According to the Coase Theorem, provided that transaction costs are negligible, an efficient solution to an externality problem is achieved as long as someone is assigned property rights, independents of who is assigned those rights Applied to a marriage, the theorem implies that divorces will occur as long as it is efficient for them to occur No-fault and fault states have different rules for assigning the property rights, but according to the Coase Theorem, all this affects is the settlement, not whether the divorce occurs False Moral hazard is when an individual’s behavior is affected by the fact that he is insured It is doubtless true that social insurance programs such as income maintenance affect behavior This does not imply, however, that the government should refrain from implementing such programs It does mean, however, that there will be a tradeoff between efficiency and equity goals, and this should be taken into account in design of the program True Preferences are said to be single-peaked when utility consistently falls as a voter moves away from her most preferred outcome When preferences are not single-peaked, then a stable majority voting equilibrium may not exist False By itself, such an action will not increase total national saving Thus, the capital stock will not be any bigger than it was before, productivity in the future 81 www.elsolucionario.net Explain your answers carefully www.elsolucionario.net Part – Getting Started will be no higher, and it will be no easier to provide for the consumption of the retired boomers Part II (14 points) a b c Yes, because there are no taxes or subsidies on inputs No, because short and tall people have different MRSs No, because it can’t be Pareto efficient if it isn’t also consumption efficient Part I (5 points each) Indicate whether each of the following statements is true, false, or uncertain, and explain your answer Your grade will depend entirely on the quality of your explanation If a word or phrase is CAPITALIZED, your answer should include a concise definition of the word or phrase 10 An IN-KIND TRANSFER can never increase a person’s utility as much as a cash transfer or equal dollar value ADVERSE SELECTION is a prime reason for why the government should not provide universal health insurance In any insurance scheme, co-insurance (e.g., a deductible) reduces MORAL HAZARD problems The cost-benefit ratio is a reliable guide when it comes to comparing the value of two different projects COMMODITY EGALITARIANISM follows as a logical extension of the concepts embodied in Nozick’s minimal state In order to secure neutrality with respect to global investment decisions, U.S multinational corporations should be allowed to deduct tax payments made to foreign governments If the HAIG-SIMONS DEFINITION OF INCOME is used as the tax base, then one should be allowed to deduct from taxable income any amounts According to the traditional view of the property tax, the part of the tax that falls on land is progressive If the United States eliminated the corporate income tax and replaced it with a VALUE-ADDED TAX, then the U.S savings rate would increase A possible problem with a federal fiscal system is that taxes levied by decentralized communities are unlikely to be efficient from a national point of view 82 www.elsolucionario.net SAMPLE FINAL EXAM II www.elsolucionario.net Part – Getting Started Part II Answer each question, taking advantage of the appropriate tools of economic analysis Each question is worth 12.5 points (12.5 points) Several years ago, gasoline taxes were increased substantially In all newspaper accounts, this was termed a regressive tax since poor people spend a greater fraction of their income on gasoline than rich people a What assumption about demand and supply elasticities underlie these assumptions? b In 1974, motor vehicle fuel consumption fell by nearly percent in the aftermath of the first Arab oil embargo In 1980, motor vehicle fuel consumption fell by percent as oil prices jumped over 70 percent How should we reconcile these facts with the assumptions made by the newspapers about the incidence of the gasoline tax? c Environmentalists argue that gasoline taxes should be raised because of the negative externalities associated with automobile pollution How might we alter our estimate of the regressivity of the gasoline tax in light of this externality? 12 (12.5 points) Many economists have argued that the corporate and individual income taxes should be integrated Explain what integration means What would the effect of integration be on national saving, economic efficiency, corporate investment and corporate financial policy? 13 (12.5 points) There has been considerable controversy in recent years over the appropriate way to ensure the viability of Social Security into the 21st century That has led to changes in the funding structure of the system a Describe the two alternative ways of funding a national retirement system such as Social Security Which type of funding method is used in the United States? b Under the funding system that prevailed in the United States until the middle 1980s, how was private saving affected by the existence of the Social Security system? If different aspects of the system affected private saving differently, be sure to note this c What elements of the payroll tax contribute to its perceived regressivity? Are there any offsetting progressive elements of the system? d What economic reasons might justify a nationally organized and mandated retirement system such as Social Security? 83 www.elsolucionario.net 11 www.elsolucionario.net Part – Getting Started (12.5 points) Under current law, long-term capital gains are taxed at a lower rate than other income A proposed reform is to tax capital gains at the same rate as other income Discuss each of the following statements Defend your answers a Such a reform would cause individuals to switch toward safer investments b The tax system would be more efficient with such a reform because the tax treatment of capital gains would conform to the Haig-Simon income concept c Such a reform would improve individuals’ welfare because they could change their portfolio at lower costs d Because the overall tax on the returns to saving would be higher, personal savings would under the reform SAMPLE FINAL EXAM II: SUGGESTED ANSWERS Part I (5 points each) An in-kind transfer is a transfer in terms of goods or services as opposed to cash The statement is false An in-kind transfer can at most increase a person’s utility as much as a cash transfer of equal dollar value False Adverse selection refers to the situation that occurs when the people who are most likely to receive benefits from a certain type of insurance are the ones who are most likely to purchase it True Moral hazard is the situation that occurs when an individual’s behavior is affected by the fact that he or she is insured Co-insurance forces the insurer to bear a part of the risk and thereby reduces moral hazard False The value of the cost-benefit ratio can be changed by arbitrary decisions about whether certain attributes of a project are “costs” or “negative benefits” (or vice versa) Hence, it is not a reliable tool for comparing projects False Nozick emphasizes the use of a “good” set of rules to govern society’s operation and attacks any kind of redistribution scheme – either income or commodity False In order to make firms indifferent with respect to the country in which they invest, a full credit against foreign taxes paid is required The Haig-Simon definition says that income during a given period is the increase in an individual’s power to consume This is true for all income, whether it is actually consumed or saved Hence, the statement is false 84 www.elsolucionario.net 14 www.elsolucionario.net According to the traditional view, the part of the tax that falls on land is borne by landlords To the extent that landlords have incomes that are relatively high, this part of the property tax will be progressive Value-added is the difference between sales and the cost of purchased material inputs at each production A value-added tax is a percentage tax on value added at each stage of production Although replacement of the corporation tax with a value-added tax would probably increase the return to saving, it is not clear that this would increase the amount of saving This is because of the conflict between income and substitution effects in individuals’ saving decisions 10 True For example, suppose that capital is fixed in supply from a national point of view Then efficiency considerations suggest a relatively high tax rate However, if capital is mobile across jurisdictions, then jurisdictions will “compete” for capital, resulting in relatively low tax rates on capital 11 a There are two implicit assumptions: (i) Supply of gasoline is much more elastic than demand so that the incidence of the gas tax is primarily on the consumers; (ii) income elasticity of demand for gasoline is less than one, i.e., when income increases the budget share on gasoline falls b These facts imply that the price elasticity of demand for gasoline is definitely quite small, but demand is not completely inelastic c Our estimate of regressivity will depend on how differently the negative externality from pollution affects the rich and the poor A case can be made that the poor suffer more from pollution as they live in predominately urban and industrial areas Then, a reduction of pollution will benefit them more than it does the rich In that situation, the gas tax should be estimated to be less regressive Part II 12 Integration refers to schemes that would configure the corporate and individual taxes in such a way that dividends would not be double-taxed Under so-called full integration, all earnings of the corporation during a given year would be attributed to stockholders just as if the corporation were a partnership, whether or not the earnings were actually distributed From a theoretical point of view, the effect of integration on saving is ambiguous (See Chapter 16.) Integration would probably increase economic efficiency, because under the current system, there is a bias against investment in the corporate sector (However, to make a more definitive statement, one would need to know what types of taxes were used to make up for any revenue losses associated with the integration plan.) With respect to financial policy, integration would remove the bias toward debt financing that occurs in the present system because there would be no separate corporate tax base from which to deduct payments of interest In addition, 85 www.elsolucionario.net Part – Getting Started www.elsolucionario.net Part – Getting Started integration would remove the incentives for “excessive” retained earnings that characterize the current system 14 a Two possible alternatives are pay-as-you-go and fully funded current U.S system is a hybrid b The pay-as-you-go system affects private savings in three ways: wealth substitution effect (tends to decrease private savings), retirement effect (tends to increase private savings), and bequest effect (tends to increase private savings) Empirical evidence: Feldstein found the wealth substitution effect to dominate so that private savings was reduced by the existence of the Social Security system Revised opinion has been that Social Security has a negative effect on savings, but not a very significant effect c The payroll tax may be regressive because (i) it taxes only earned income The share of earned income in total income is much larger for the poor than for the rich; (ii) earned income is taxed only up to a ceiling so that the ratio of the payroll tax to earned income is constant for a range of income and then falls As the benefits of the Social Security system are tilted in favor of the poorer elderly people, there are elements of progressivity in the system d Adverse selection, paternalism, economizing on the decision-making costs, and income redistribution are important reasons given for a Social Security system a We know that the effect of taxation on portfolio choice is ambiguous on the basis of theory, and empirical work is inconclusive Thus, one cannot say anything definite about this b This is false for (at least) two reasons First, Haig-Simons is not necessarily the same as efficient taxation – we would need to have a Ramsey Rule solution Second, H-S income is based on unrealized capital gains The U.S tax is based on realized capital gains c This is false because the lock-in effect would be worse, not better Thus, the effect on welfare from this alone would be negative d The basic result in most of the empirical literature is that savings not respond to real, after-tax returns Thus, there is no reason to expect that personal savings would fall 86 The www.elsolucionario.net 13 ... preferences may lead to voting inconsistencies, this is not necessarily the case The votes by the Senators from the northeast and south to subsidize each other? ?s interests are consistent with... does not decrease) the utility of all consumers With these two consumers, Marsha? ?s utility increases as Sherry? ?s utility increases Thus, it may be possible to reallocate income from Marsha to Sherry... it is not obvious that these reasons lead to the tax subsidy we observe in the U .S Chapter 11 – Cost Benefit Analysis Yes, one really must ask these questions, although it may seem distasteful