Instructor s Manual Publice Finance. HARVEY

Chapter 1 - 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 1 - Introduction 1.

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. 2.

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. 3.

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 do 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.

4.

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.

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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. 5.

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.

6.

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 2 – Tools of Positive Analysis 1.

The reality that astronomers are trying to understand is not influenced by any “policies” that astronomers might implement. That is, planets and stars do 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.

2.

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.

3.

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 2

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(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. 4.

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.

5.

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 – do larger deficits cause higher interest rates, or do higher interest rates cause larger deficits (since, by construction, one of the largest items in the federal budget is interest on the debt).

Chapter 4 – Public Goods 1.

a.

Wilderness area is an impure public good – at some point, consumption becomes nonrival; it is, however, nonexcludable.

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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). 2.

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.

3.

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.

4.

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

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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. 5.

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.

6.

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 do 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.

7.

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 do 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

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likely that the private sector would be less responsive than the public sector. The notion of commodity egalitarianism, however, is a stretch for museums. 8.

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

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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 A

C

D

BA ep

9.

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.

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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 5 - Externalities 1.

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 do about automobile emissions (or any other environmental problem), because it provides no framework for evaluating the tradeoffs that inevitably must be made.

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2.

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.

3.

4.

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.

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c.

The supply of vouchers is vertical at 140 billion. The demand curve is downward sloping. For every gallon of gasoline, you either have to buy a voucher or use up one of your own. In either case, this increases the opportunity cost by 75 cents. FIGURE 5.4c – Tradeable vouchers for oil

PVOUCHER S

$0.75

D

140 billion

QVOUCHER

5.

The per-unit taxes, which range from 12-27 cents per ounce, are far below the marginal external cost of $1.19 per ounce. Although the deadweight loss is smaller than with no tax at all, the allocation is still far from the socially efficient level. The current allocation produces too much alcohol at too low of a price.

6.

By establishing a market for air pollution rights, the Chicago Board of Trade has applied the Coase Theorem. The potential efficiency of the outcome may be laudable, but the distributional impact may be unpalatable to some.

7.

a.

When the Little Pigs hog farm produces on its own, it sets marginal benefit equal to marginal cost. This occurs at 4 units.

b.

The efficient number of hogs sets marginal benefit equal to marginal social cost, which is the sum of MC and MD. At 2 units, MB=MSC=13.

c.

The merger internalizes the externality. The combined firm worries about the joint profit maximization problem, not the profit maximization problem at either firm alone. Thus, the LP farm produces 2 units, the socially efficient amount.

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d.

8.

Before the merger, the LP farm produced 4 units. By cutting back to 2 units, it loses marginal profit of $3. On the other hand, the Tipsy Vineyard’s profits increase by $20. Thus, profits increase by $17 altogether.

Private Marginal Benefit = 10 - X Private Marginal Cost = $5 External Cost = $2 Without government intervention, PMB = PMC; X = 5 units. Social efficiency implies PMB = Social Marginal Costs = $5 + $2 = $7; X = 3 units. Gain to society is the area of the triangle whose base is the distance between the efficient and actual output levels, and whose height is the difference between private and social marginal cost. Hence, the efficiency gain is ½ (5 - 3)(7 - 5) = 2. A Pigouvian tax adds to the private marginal cost the amount of the external cost at the socially optimal level of production. Here a simple tax of $2 per unit will lead to efficient production. This tax would raise ($2) (3 units) = $6 in revenue.

9.

In the absence of persuasive evidence on positive externalities for higher education, there is no reason for the government to provide free tuition. True, taxes on wages may distort education decisions (see Chapter 16), but virtually all taxes distort some decision making, and it is unlikely that it is optimal to subsidize tuition at 100 percent.

10.

a.

By regulating the number of permits to 50 units, then the demand curve implies that 50=100-10P, or P=$5.

b.

Because it would cost ACME more money to reduce pollution than buy a permit ($8 versus a market price of $5), ACME buys the permit. By doing so, it saves $3 in costs. Chapter 6 – Political Economy 1.

a.

Below, the preferences for Person 1 and Person 2 are drawn. Same procedure is used for the other three people.

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b.

C wins in every pairwise vote. Thus, there is a stable majority outcome, despite the fact that persons 1, 2, and 3 have double-peaked preferences. This demonstrates that although multi-peaked preferences may lead to voting inconsistencies, this is not necessarily the case.

2.

The votes by the Senators from the northeast and south to subsidize each other’s interests are consistent with the logrolling model. The senators from the affected states made the deal for advantage their constituents at the expense of other regions.

3.

a.

Three percent a year.

b. Assuming that the public sector uses only labor as an input, the price of the public good increases by three percent a year. c.

The size of government increases. For further discussion of this phenomenon, see the paper by W. J. Baumol, “Macroeconomics of Unbalanced Growth: The Anatomy of Urban Crises,” American Economic Review, 1967.

4.

Yes, it is consistent, because the theory says that when unanimity is required, no decisions are likely to be made. A majority system might be more suitable, although it is subject to cycling and other problems.

5.

If these figures are true, then the predictions of the median voter theory are not accurate – that is, majority voting will not reflect the preferences of the median voter but rather the median participating voter. The reason for this is because of the different turnout rates for individuals in different income categories. Consider this simple example: suppose that voters have single-peaked preferences, and they are trying to determine how much should be spent on national defense. Their preferences are listed as follows: Andrew: $500

Bob: $700

Charlie: $850

Allison: $600

Bill: $750

Cathy:

Anne:

Beth: $800

Cheryl: $1,000

$650

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The median voter theorem predicts that a majority vote will result in $750 being spent on defense (which is reflective of Bill’s preferences, since he is the median voter). However, if there are different participation rates by different groups (in this case, the groups are determined by the first letter in the person’s name), then the preferences of the median voter (Bill) are no longer reflected in the majority vote. Suppose that Andrew and Anne don’t vote – then a majority vote will result in $800 of defense spending. 6.

When there is a vote over five options, there is the chance that a potential majority vote is split between four relatively preferred options, and the fifth option wins. The winning option may have been voted down if it had been a two-way vote with any of the other options. Further, if preferences are not single-peaked, cycling and inconsistent public decisions may emerge.

7.

Given the U.S. experience with the Budget Enforcement Act of 1990, we would expect the EU deficit limits to be ineffective. We would expect “accounting tricks” to mask the size of the deficits (such as itemizing various budget items as “unexpected emergencies”), and if that didn’t work, we would expect the deficit rules to be ignored. This is apparently what is happening. When Germany exceeded the deficit target, no moves were taken to levy the required fines.

8.

Since rents, by definition, are the returns above a normal return, then when the licenses are put on the market, their price will be the value of the rents. Hence, the owner of the peanut license, whoever he or she is, only makes a normal return. Put another way, the license is an asset that earns a normal rate of return. If the peanut license system were eliminated, efficiency would be enhanced. But the elimination would, in effect, confiscate the value of this asset. It is not clear that this is fair. One could also argue that when someone buys this asset, the purchase is with the understanding that there is some probability that its value will be reduced by elimination of the program; hence, it is not unfair to do so.

9.

a.

With the demand curve of Q=100-10P and a perfectly elastic supply curve at P=2, then the milk is sold at a price of $2, and a quantity of 80 units is sold.

b.

The marginal revenue curve associated with the inverse demand curve P=10(1/10)Q is MR=10-(1/5)Q, while the marginal cost curve is MC=2. The cartel would ideally produce a quantity where MR=MC, or 10-(1/5)Q=2, or Q=40. The price associated with a cartel quantity of 40 units is P=10-(1/10)*40, or P=6.

c.

The rent associated with the cartel is the product of the marginal profit per unit and the number of units produced. The marginal profit per unit of milk is $4 (=$6 price - $2 marginal cost), while 40 units are produced. Thus, the rents equal $160.

d.

The most the cartel would be willing to contribute to politicians is the full economic rent of $160. The cartel situation, the quantity of milk produced is too low from society’s point of view. The deadweight loss triangle is computed using

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the difference between the cartel output and competitive output as the “base” of the triangle, and the difference between the cartel price and competitive price as the “height.” Thus, the triangle is equal to (1/2)*(80-40)*($6-$2)=$40. e.

As Figure 6.5 in the textbook shows (page 130), the deadweight loss could now go as high as the sum of the conventional deadweight loss and the rents, or $160 rents + $80 DWL = $240. This is because, as noted on page 131, “rent-seeking can use up resources – lobbyists spend their time influencing legislators, consultants testify before regulatory panels, and advertisers conduct public relations campaigns. Such resources, which could have been used to produce new goods and services, are instead consumed in a struggle over the distribution of existing goods and services. Hence, the rents do not represent a mere lump-sum transfer; it is a measure of real resources used up to maintain a position of market power.”

10.

Niskanen’s model of bureaucracy is illustrated in Figure 6.4 of the textbook. In the aftermath of September 11th, the new concerns over food safety would likely shift the V curve upward (that is, the value placed on each level of Q). Assuming that C curve (costs per unit of Q) does not change, then this shift increases the actual number of food inspectors hired. It is also likely that the slope of the V curve changes, with each marginal unit of Q becoming more valuable. Thus, the V curve not only “shifts” upward, but becomes steeper as well. Both of these effects – the shifting of the V curve and the change in the slope – lead to greater values of Q under the bureaucracy model. The change in the slope leads to a greater value of Q*, the efficient level of output. Thus, the optimal number of FDA employees and the actual number of FDA employees are likely to rise.

11.

The lesson in The Economist, that Democrats flourish when they move toward the center, is basically a description of the median voter rule.

Chapter 7 – Income Redistribution: Conceptual Issues 1.

Utilitarianism suggests that social welfare is a function of individuals’ utilities. Whether the rich are vulgar is irrelevant, so this part of the statement is inconsistent with utilitarianism. On the other hand, Stein’s assertion that inequality per se is unimportant is inconsistent with utilitarianism.

2.

a.

b.

To maximize W, set marginal utilities equal; the constraint is Is + Ic = 100. So, 400 - 2Is = 400 - 6Ic. substituting Ic = 100 - Is gives us 2Is = 6 (100 - Is ). Therefore, Is = 75, Ic = 25. If only Charity matters, then give money to Charity until MUc = 0 (unless all the money in the economy is exhausted first). So, 400-6 Ic = 0; hence, Ic = 66.67. 14

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Giving any more money to Charity causes her marginal utility to become negative, which is not optimal. Note that we don’t care if the remaining money ($33.33) is given to Simon or not. If only Simon matters, then, proceeding as above, MUs. 0 if Is = 100; hence, giving all the money to Simon is optimal. (In fact, we would like to give him up to $200.) c.

MUs = MUc for all levels of income. distributions of income.

Hence, society is indifferent among all

3.

The main conceptual problem with the poverty gap is that it doesn’t account for the income effect on labor force participation rates. The poverty gap is calculated assuming there are no behavioral responses; e.g., that labor income would remain unchanged even after the income was transferred to the poor population, but economic theory predicts that this will not be so. In fact, if the poor household were given enough income to bring it out of poverty, we would believe that the household would work less as a result of receiving this transfer. This complicates the analysis, of course, because once the household works less, then it will generate less labor income, thus lowering its overall income. This means that the poverty gap actually understates the amount of money necessary to alleviate poverty in the United States. In addition, the poverty gap is based on the official poverty line, which is thought to be an ad-hoc measure of the true “needs” of a family.

4.

A day care center is an example of an in-kind compensation. The figure below is similar to Figure 8.2 in the text. The original budget line is G1 H1 If the employee received $5,000 cash, the budget line moves to G2 H2 . An employee who uses the day care center may not be $5,000 better off. The employee consumes at point A, but would be better off at point B, which represents consumption after a cash transfer of $5,000.

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5.

6.

7.

a.

This would increase the incomes of the providers of computer equipment and the individuals who maintain the equipment. In the long run, this might also increase the incomes of the students who use the equipment. Moreover, giving a laptop to all seventh graders (rather than poor seventh graders) may simply “crowd-out” computer transfers from parents to children. One could imagine that nowadays many children do have a computer at home, paid for by the parents. This government transfer may simply result in less parental transfer to the child.

b.

Providing free after-school programs for children in impoverished families largely acts as an in-kind transfer for poor, working households. The program is of little value for unemployed households, as the alternative would be childcare at home. For those who are employed, and paying for childcare, this program provides an alternative and effectively changes the after-tax, after-working-cost wage. This also may affect work behavior on the extensive margin. The likely “losers” from such a program are childcare providers, who see a reduction in demand for their services. In principle, this reduction in demand could lower the hourly childcare cost for all workers with children, though this effect is likely to be modest because most impoverished families do not have a very large labor force attachment and, thus, their effect on the childcare market as a whole is likely to be small.

a.

False. Society is indifferent between a util to each individual, not a dollar to each individual. Imagine that UL=I and UJ=2I. Then each dollar given to Jonathan raises welfare more than the same dollar given to Lynne.

b.

True. The social welfare function assumes a cardinal interpretation of utility so that comparisons across people are valid.

c.

False. Departures from complete equality raise social welfare to the extent that they raise the welfare of the person with the minimum level of utility. For example, with the utility functions UL=I and UJ=2I, the social welfare function W=min[UL,UJ] would allocate twice as much income to Lynne than Jonathan.

Initially the price of food was $2 and the price of other goods was $1. The black market for food stamps changes the price of food sold to $1. In Figure 7.2 of the textbook, as one moves to the “northwest” from point F, the segment will now have a slope (in absolute value) of 1 rather than 2. The black market may make the individual better off if the best point on her budget constraint AFD was initially at the corner solution of point F, and the black market certainly does not make her worse off. It is important to note that the black market does not always make the recipient better off. If the (absolute value) of the marginal rate of substitution (MRS) were between 1 and 2, the indifference curve would not “cut” into the new part of the budget constraint with the black market.

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FIGURE 7.7a – Black market where food stamps are sold for fifty cents on the dollar, no better off

Other Goods

Sell food stamps for other goods on black market

A

F U0

D Food Stamp Allotment

Food

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If the MRS were less than (or equal to) 1 in absolute value, the person would be made better off and would reduce food consumption by selling the food stamps on the black market. FIGURE 7.7b – Black market where food stamps are sold for fifty cents on the dollar, higher utility

Other Goods

Sell food stamps for other goods on black market

A

F

U1 U0

D Food Stamp Guarantee

Food

8.

Pareto efficient redistribution is a reallocation of income that increases (or 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 and raise both of their utility. With Sherry’s initial utility function of US=100YS1/2, her utility with $100 of income is US=100($100)1/2, or US=1,000. With Marsha’s initial utility function of UM=100YM1/2+0.8US, her utility with $100 of income is UM=100($100)1/2+0.8(1,000), or UM=1,800. If the social welfare function is additive, then initial welfare is W=US+UM=1,000+1,800=2,800. If $36 is reallocated from Marsha to Sherry, then Sherry’s income is now $136 and Marsha’s is now $64. With Sherry’s utility function, her utility with $136 of income is US=100($136)1/2, or US=1,166.190. With Marsha’s utility function, her utility with $64 of income is UM=100($64)1/2+0.8(1,166.190), or UM=800+932.952=1,732.952. In this case, Sherry’s utility increases from 1,000 to 1,166.190, while Marsha’s utility falls from 1,800 to 1,732.952. Social welfare increases with this redistribution, going from 2,800 to 2,899.142. Thus, this redistribution increases social welfare, but is not Pareto efficient redistribution. Chapter 8 – Expenditure Programs for the Poor

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1.

a.

Note that the figure below shows the correct shape of the budget constraint, but the numbers themselves are outdated. With a wage rate of $10 per hour, Elizabeth earns $100. Because the deduction in California is $225, none of her earnings are counted against the $645 welfare benefit. Thus, her total income is $745 (=$100+$645).

b. The actual welfare benefits collected by a person equals B=G-t(Earnings-D), where B=actual benefits, G=welfare grant, t=tax rate on earned income, and D=standard deduction. Thus, (Earnings-D) is the net earnings that are taxed away in the form of reduced benefits. When benefits equal zero (B=0), the expression becomes 0=G-t(Earnings-D), which collapses to: Earnings=G/t+D. This is known as the “breakeven formula.” In the California context here, the expression becomes Earnings=$645/0.5 + 225, or Earnings=$1,515. With a wage rate of $10 per hour, this corresponds to 151.5 hours of work per month. c. The diagram shows the correct shape of the budget constraint, but the “577” figure should be replaced with “645” and the “9” hours should be replaced with “22.5”. d. The diagram above shows one possibility – in this case, Elizabeth is both working and on welfare – but she collects a reduced welfare benefit in this case. 2.

One could gather data on the earnings of those in the program, as well as earnings data from nonparticipants. Regress the earnings variable on demographic variables and other factors that determine earnings (such as education and experience), and a variable that indicates whether the individual participated in the training program. Factors that affect local employment conditions, such as unemployment levels, may help explain earnings, but they may also explain participation in the program. The econometric strategy should be chosen carefully to account for this. 19

Part 1 – Getting Started

3.

If the quantity of leisure consumed by X appears as an argument in the utility function of Y, then X’s consumption of leisure creates an externality. If the externality is negative (i.e., Y likes X to work), then a wage subsidy of X might induce him to work the efficient number of hours. Alternatively, a workfare program might achieve the same goal by simply forcing X to work. However, to the extent that the feasible quantity of labor supply is determined less through market incentives now, workfare would be less efficient.

4.

He participates in the public housing program as long as P1P2ca>cef.

5.

As illustrated below, the budget constraint with food stamps has a “notch” in it, similar to the analysis of Medicaid in Figure 8.9 of the textbook. At the notch, the marginal tax rate is greater than 100%. One key difference from the figure in the textbook is that the marginal tax rate on earned income for Medicaid is 0% until the “Medicaid notch,” while the marginal tax rate on earned income for food stamps is 24% until the “food stamp notch.” The reason the food stamp notch exists at all is that there is a “gross income test,” where a recipient is ineligible if income is higher than the limit. The characterization in the Rosen textbook on page 189 that “at some point near the poverty line, food stamps worth about $1,250 are suddenly lost” implicitly assumes that childcare costs are quite high. This is likely to be true for many households. In the year 2004, this monthly (annual) gross income limit was $1,994 per month ($23,928 per year) for a family of four, while the monthly guarantee was $471 ($5,652 per year). Assuming the family had earnings at the limit of $1,994 of earnings during the month, and after applying a 20% earnings deduction and a $134 monthly standard deduction, the household would receive a monthly (annual) benefit of $32 ($384). We arrive at this number using the equation B=G-t(E-.2E-D)=471-.3(.8*1994-134)=$471$438.36=$32.64, which is then rounded down to $32. In this case, B=actual benefits received, G=food stamp guarantee, t=tax rate, E=earnings, and D=standard deduction.

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Increasing annual earnings by $1 from $23,928 to $23,929 would reduce food stamp benefits from $384 to $0; hence the “food stamp notch.” This notch would be even higher if the household qualified for a childcare deduction, child support deduction, or shelter deduction. The childcare deduction ranges between $175 and $200 per child per month. Assuming this family of four consisted of a mother and three children, each with $175 of monthly childcare costs, then B=G-t(E-.2E-D-C)=471-.3(.8*1994-134525)=$471-$280.86=$190.14, which is then rounded down to $190. The modification here is that C=childcare costs. This amount corresponds to an annual food stamp benefit of $2,280. Figure 8.5 below draws the budget constraint using annual levels for the food stamp program, using 2004 rules and assumes no childcare expenses.

Other Goods or Annual Income

FIGURE 8.5 – The food stamp “notch” with 24% tax rate on earned income

Food stamp notch; eligibility determined separately from benefits. Notch = $384

Statutory food stamp maximum = $5,652

$23,928

Leisure

6.

For an individual who is not working while on welfare, in this case the highest indifference curve touches the budget constraint on the right vertical axis. Note that the marginal rate of substitution (MRS) does not necessarily equal the after-tax wage rate at the time endowment – rather, it is possible that the person would want to consume more leisure than the time endowment but is obviously constrained from doing so.

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Other Goods

FIGURE 8.6 – Individual is on welfare and does not work at all

Statutory TANF benefit

U0 MRS>(1-t)w

Leisure

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7.

In all cases, the demand curve for housing slopes downward. a. If the price of low income housing gets bid up but there is no increase in the stock of housing, then the supply curve is perfectly inelastic, e.g., vertical.

PHOUSING

FIGURE 8.7a – Demand curve shifts outward, perfectly inelastic supply S

P1

P0

D1 D0

Q0

QHOUSING

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b.

PHOUSING

If there is no increase in the price of housing, but there is an increase in the stock of housing, then the supply curve is perfectly elastic, e.g., horizontal. FIGURE 8.7b – Demand curve shifts outward, perfectly elastic supply

P0

S

D1 D0

Q0

Q1

24

QHOUSING

Part 1 – Getting Started

c.

PHOUSING

If there is an increase in both the price and quantity of housing, then the supply curve slopes upward. FIGURE 8.7c – Demand curve shifts outward, upward sloping supply curve

S P1 P0

D1 D0

Q0

Q1

QHOUSING

According to Sinai and Waldfogel, there is partial crowding out, consistent with case c above. Although the underlying housing stock itself is probably quite inelastic in the short-run, the number of rental homes can be more elastic as (potential) landlords convert vacation homes or vacant homes into rental units. 8.

a.

When Eleanor’s hours (earnings) go from 0 to 1,000 ($0 to $8,000), she qualifies for an additional earned income tax credit (EITC) worth $3,200 (=0.4*8,000). Thus, her income goes up from $0 to $11,200. Note to instructors – the distinction between earnings and income may cause confusion in the students’ answers.

b.

When Eleanor’s hours (earnings) go from 1,000 to 1,500 ($8,000 to $12,000), she qualifies for the maximum EITC (according to Figure 8.8 in the textbook). She receives the full EITC when her earnings exceed $10,510, at which time the credit equals $4,204 (=0.4*$10,510). The earnings between $10,510 and $12,000 face neither a subsidy nor phase-out from the EITC. Thus, her income goes up from $11,200 to $16,204.

c.

When Eleanor’s hours (earnings) go from 1,500 to 2,000 ($12,000 to $16,000), she moves into the range where the EITC is phased out. According to Figure 8.8

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in the textbook, she receives the maximum subsidy of $4,204 until her earnings exceed $14,730. For the marginal earnings between $14,730 and $16,000, the EITC is reduced at a 21.06% tax rate. Thus, her EITC falls by $267.46 from $4,204 to $3,936.54 (=4,204-0.2106*(16,000-14,730)). Her income rises from $16,204 to $19,936.54. Chapter 9 – Social Insurance I: Social Security and Unemployment Insurance 1.

With adverse selection, insurance contracts with more comprehensive coverage are chosen by people with higher unobserved accident probabilities. To make up for the fact that a benefit is more likely to be paid to such individuals, the insurer charges a higher premium per unit of insurance coverage.

2.

There are many possible implications of a voluntary Social Security system. One possibility is that people would save less for retirement, betting that society would not put up with having great numbers of elderly poor. Part of the effect of the Friedman program, then, would depend on the government's credibility when it promises not to bail out people who do not save enough to survive during retirement.

3.

Use the basic formula for balance in a pay-as-you-go social security system: t =(Nb/Nw)*(B/w). Call 1990 year 1 and 2050 year 2. Then t1 = .267*(B/w)1 t2 = .458*(B/w)2 It follows that to keep (B/w)1=(B/w)2 we require t2/t1=.458/.267=1.71. That is, tax rates would have to increase by 71 percent. Similarly, to keep the initial tax rate constant, we would require (B/w)2/(B/w)1=.267/.458=0.58. Benefits would have to fall almost by half.

4.

If Social Security benefits are partially taxed for those who have other income over a certain level, then there is an implicit means test in receiving full, untaxed benefits. However, there is no explicit means test for eligibility for the program. Everyone receives benefits, though some recipients must pay some tax on them. Thus, the two statements are somewhat inconsistent with each other.

5.

Austen’s quote seems like it could relate adverse selection, but perhaps more likely, to moral hazard. The quote “If you observe, people always live forever when there is any annuity to be paid them” in a sense sounds like they act differently (e.g., better diet, more exercise, etc.) when an annuity is to be paid – the idea of moral hazard. In contrast, adverse selection suggests that people who expect to live a long time to be the ones who purchase annuities. A recent paper by Finkelstein and Poterba (NBER working paper, December 2000) found that “mortality patterns are consistent with models of asymmetric information” and that annuity “insurance markets may be characterized by adverse selection.”

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6.

Equation (9.1) relates taxes paid into the Social Security system to the dependency ratio and the replacement ratio, that is, t=(Nb/ Nw)*(B/w). If the goal of public policy is to maintain a constant level of benefits, B, rather than a constant replacement ratio, (B/w), then taxes may not need to be raised. If there is wage growth (through productivity), then it is possible to maintain B at a constant level, even if the dependency ratio is growing. By rearranging the equation, we can see that B=t*w*(Nb/ Nw)-1. That is, increases in wage rates (the second term) offset increases in the dependency ratio (the third term). Thus, constant benefits do not necessarily imply higher tax rates.

7.

The statement about how the different rates of return in the stock market and government bond market affect the solvency of the trust fund is false. If the trust fund buys stocks, someone else has to buy the government bonds that it was holding. So, there is no new saving and no new capacity to take care of future retirees.

8.

Diamond and Gruber’s calculations suggest that the additional year of work (and delayed retirement) lowers the present discounted value of expected Social Security wealth by $4,833. If the adjustment were actuarially fair, Social Security wealth would neither rise nor fall. Since wealth falls, the adjustment is actuarially unfair.

9.

For those who argue that the scheme for financing Social Security is unfair because people with low earnings are taxed at a higher rate than those with high earnings, the key issue is that the cumulative payroll tax of 12.4 percent is capped for each person, after which the payroll tax is zero (this ignores the 2.9 percent uncapped Medicare tax, however). The earnings ceiling in 2004 is $87,900. Hence, Social Security payroll taxes as a share of earnings fall after the ceiling is passed – thus, the Social Security payroll tax may be thought of as regressive. The opponents to this view note that the above analysis only focuses on taxes paid, not benefits received. As shown in Table 9.3, Social Security redistributes from high earners to low earners, and the formula for the primary insurance amount offers extremely high replacement rates to very low earners, and much lower replacement rates to high earners. Thus, the net tax payment (taxes minus benefits) is likely to be progressive, not regressive. One critical assumption in this kind of analysis is how one computes lifetime benefits – e.g., do we assume that low earners and high earners live the same number of years?

10.

Let G stand for the individual’s gross earnings. The question assumes that the person faces a marginal tax rate of 15% and a payroll tax of 7.45%. Thus, the person’s after-tax earnings (denoted by N) are N=(1-tearn-tpayroll)G, or N=(1-0.15-0.0745)G, or N=0.7755G. It is assumed that the gross unemployment benefits, U, are equal to 50 percent of beforetax earnings, or U=0.5G. Net unemployment benefits, B, take out income taxes, so B=(1tearn)U=(1-tearn)0.5G=(1-0.15)0.5G=0.425G. The percentage of the individual’s after-tax income that is replaced by UI is therefore equal to B/N, or 0.425G/0.7755G, which is approximately 54.8%. Unemployment benefits are about 55% of the individual’s previous after-tax income. The effects of unemployment insurance on unemployment are a matter of considerable debate. While the high replacement rates from UI may increase the duration of unemployment, the longer search time may reduce recurrence of unemployment by allowing time for a worker to find a better job match. Empirical

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studies seem to show that the hazard rate into employment spikes up around the time that benefits run out – perhaps suggesting that job matches are not really improving. Chapter 10 – Social Insurance II: Health Care 1.

The quotation contains several serious errors. First, concern with health care costs does not mean that health care is not a “good.” Economists do not care about the cost of health care per se. Rather, the issue is whether there are distortions in the market that lead to more than an efficient amount being consumed. Second, it makes a lot of difference how money is spent. One can create employment by hiring people to dig ditches and then fill them up, but this produces nothing useful in the way of goods and services. Thus, employment in the health care sector is not desirable in itself. It is desirable to the extent that it is associated with the production of an efficient quantity of health care services.

2.

a.

Those who have a relatively high probability of needing the insurance are the ones who are most likely to buy it. This raises the premium, which in turn, leads to selection by people who have an even higher probability of using it. The cycle continues until the price is so high that virtually no one purchases the policy.

b. Employer-provided health insurance is deductible to the employer and not taxed to the employee. c.

3.

a.

Because of the tax subsidy, individuals may purchase more than the efficient amount of health insurance. That is, they “over-insure.” An interesting example of how the tax system leads to overinsurance is given in a recent Wall Street Journal (January 19, 2004) article by Martin Feldstein. He gives an example of two different California Blue Cross health plans – identical in all respects except for the deductible and annual premiums. The low-deductible plan (the “generous” plan) has a deductible of $500 per family member, up to a maximum of two and an annual premium of $8,460. Thus, the maximum out-of-pocket expense is $1,000. The high-deductible plan (the “less generous” plan) has a deductible of $2,500 per family member, up to a maximum of two, and an annual premium of $3,936. Thus, the maximum out-of-pocket expense is $5,000. Note that the premium savings of $4,524 actually exceeds the maximum incremental deductible payment of $4,000 (which would only occur if the family had very high health expenses). In principle, the high deductible plan is unambiguously better. But the traditional tax rules could lead an employer to choose the low deductible policy. If the employee faced a marginal tax rate of 45% (the sum of federal, state, and payroll tax rates), then if the $4,524 premium saving was turned into taxable salary, the individual’s net income would only rise by $2,488. Thus, families with high expected medical expenses do better with the “generous” plan, even though it is more costly in terms of premiums. Dd=4.22–(0.044)(50)=2 visits per year. Total expenditure =(2)(50)=$100

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b. Now the individual pays only $5 per visit. Dd = 4.22 – (0.044)(5) = 4 visits, with out-of-pocket costs of $20. Insurance company pays ($45)(4) = $180 Total expenditure = $200, double its previous level. 4.

Examining Figure 10.1, we can see why health care costs increased for the state of Tennessee. As insurance coverage increases, this lowers the cost of medical expenses for those who were previously did not have insurance, which increases the overall amount of medical services they consume. Before receiving insurance, these people demand Mo units of medical services, and the amount they pay is represented by the area OPoaMo. But after receiving insurance coverage, they demand M1 amounts of medical services, paying only OjhM1, while their insurance pays jPobh. The increase in insurance payments is sizable for two reasons – first, by providing coverage, it pays for the majority of the already sizable medical expenses incurred by this group, and second, the introduction of insurance makes the group consume even more medical services. In short, if the people who designed the Tennessee program had realized that the demand curve for medical services is downward sloping, they would not have been surprised at the consequences of their program. To explain why HMOs have been unable to contain long-run health care costs, it is necessary to consider the effect of technology on health care costs in the long-term. The inherent problem is that the market for medical care places a large premium on using the latest and most-developed medicines and machinery for treating patients. These technologies tend to be expensive. Hence, while introducing HMOs can lead to a once and for all decrease in the rate of change in health care costs, there is nothing that an HMO can do to lower the cost of continually providing the latest in medical treatments.

5.

The goal of making the Medicare prescription drug benefit a one-time, permanent decision is to reduce the adverse selection problem (note: the current “Medigap” program operates in this manner to some extent – a senior citizen has choice over all 10 of the Medigap plans for only a short period of time after they turn 65, after which they may be denied based on their health). Imagine a cohort of people turning age 65 and becoming eligible for the Medicare drug benefit. If the decision to enter (or exit) could be made every year, then healthy senior citizens would have a strong incentive to wait until they became unhealthy and needed drugs, and then enter the prescription drug program (presumably resulting in economic losses for the program). Similarly, when people who were collecting the prescription drug benefit became healthy, they would have a strong incentive to “opt-out” of the program. By making the decision opt-in at the beginning or not at all, the healthy younger seniors are likely initially cross-subsidizing the older seniors. Note that this “opt-in at the beginning” works because bad health and older age are positively correlated with each other. If, for example, younger seniors used more drugs (and perhaps older seniors used more inpatient care, etc.), then older seniors could simply stop paying annual premiums and give up their option of being in the program. If this scenario held empirically, this would exacerbate the adverse selection problem and the opt-in scenario would not completely solve the adverse selection problem.

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6.

The budget constraint initially has units of Medigap on the x-axis, and other goods on the y-axis. Given initial prices of $1 per unit for each good, and $30,000 of income, the budget constraint has a slope of -1, and the intercepts on both axes are at 30,000 units. It is assumed that the initial utility maximizing bundle consumes 5,000 units of Medigap, hence the indifference curve is tangent at (5000,25000). All of this is illustrated in the figure below. FIGURE 10.6a – Medigap choice without minimum standards

Other Goods 30,000

25,000

U0

5,000

30,000

31

Medigap efficiency units

Part 1 – Getting Started

After the “minimum Medigap” mandate, the consumer can either choose 0 units of Medigap or 8,000 or more units of Medigap. Thus, part of the budget constraint is eliminated (though the overall shape remains the same as before). After the mandate, the point (0,30000) is available, as well as all of the points to the southeast of the point (8000,22000). Clearly, the person’s utility must fall since the preferred choice, (5000,25000) is no longer available. If the person attains a higher level of utility as (0,30000) compared with (8000,22000), the person chooses to not purchase Medigap. In this case, the marginal rate of substitution is no longer equal to the price ratio. This is illustrated below. FIGURE 10.6b – Medigap choice with minimum standards; no Medigap is purchased

Other Goods 30,000

25,000

U0 U1

22,000

5,000

8,000

30,000

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Part 1 – Getting Started

7.

a.

The gross price of insurance is $2, but since insurance is bought with pre-tax dollars, the effective price of insurance is (1-t)P, where t is the marginal tax rate. Since Connor’s marginal tax rate is 25%, the effective price of insurance is lower, only (1-.25)*$2, or $1.50 per unit. At $1.50 per unit, and using the demand curve of Q=100-8P, this implies that Connor buys Q=100-8($1.50)=88 units of insurance.

b.

If insurance is no longer excluded from taxation, the effective price rises to $2 per unit. In this case, Connor buys Q=100-8($2)=84 units of insurance.

c.

The exclusion of health insurance from taxation lowers its effective price – as long as the demand for health insurance slopes downward, then lower prices lead to higher demand for insurance. This can be viewed as “over-consumption” if the assumptions of the First Fundamental Welfare Theorem hold, which suggests that the private market allocation without subsidies or taxes yields the Pareto efficient allocation. On the other hand, there may be (weak) reasons based on the Fundamental Welfare theorem, there should be a tax subsidy for health insurance. The main reason would probably be if we thought that health insurance had positive externalities, which might be possible with communicable diseases. There are other reasons why government intervention may be warranted in health insurance markets (e.g., asymmetric information), but it is not obvious that these reasons lead to the tax subsidy we observe in the U.S.

Chapter 11 – Cost Benefit Analysis 1.

Yes, one really must ask these questions, although it may seem distasteful. Otherwise, there is no way to determine which safety precautions are sensible.

2.

The increased time spent at the inspection must be counted as a cost of the program. One reasonable way to estimate the value of the time would be to use the average wage rate in the state, and multiply this by the incremental waiting time of 105 minutes.

3.

The present value of $25/.10 = $250. The present value of the perpetual annual benefit = B + B/(1 + r) + B/(1 + r)2 + … = B (r + 1 - r)/r = B/r.

4.

a.

1,000=80/ρ ρ =.08

b. If the money comes from consumer spending, use after-tax rate of interest as the discount rate: 80 - 1,000 = 600 > 0. .05 The project is admissible.

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If the money comes from investment, use before-tax rate of interest as the discount rate: 80 - 1,000 = -200 < 0. .10 The project is not admissible. In the “mixed case,” for a discount rate, take a weighted average: .6 x 10% + .4 x 5% = 8%. 80 - 1,000 = 0. .08 There is no net advantage to undertaking the project. c. Benefits = 80/.04 = 2,000. Present value of project = 2,000-1,000=1,000. d. If inflation is fully anticipated, and if market interest rates increase by 10 percentage points, nothing changes in real terms. 5.

a.

Bill is willing to pay 25 cents to save 5 minutes, so he values time at 5 cents per minute. The subway saves him 10 minutes per trip, or 50 cents. The value of 10 trips per year is $5. The cost of each trip is 40 cents, or $4 per year. The annual net benefit to Bill is therefore $1. The present value of the benefits = $5/.25 = $20; the present value of the costs is $4/.25 = $16.

b. Total benefits = $20x55,000=$1,100,000. Total costs = $16x55,000 = $880,000. Net benefits = $220,000. c. Costs = $1.25 x 55,000 = $68,750. Benefits =($62,500/1.25) + ($62,500/1.252) = $90,000. Net benefit = $21,250.

6.

d.

The subway project has a higher present value. If a dollar to the “poor” is valued the same as a dollar to the “middle class,” choose the subway project.

e.

Let λ = distributional weight. set 220,000 = -68,750 + λ [(62,500/1.25) + (62,500/1.252)] λ = 3.21 This distribution weight means that $1 of income to a poor person must be viewed as more important than $3.21 to the middle class for the legal services to be done.

The report for the Czech government that simply computed the savings to the government for retirees from smoking is inadequate. After all, if one simply counts as “benefits” money saved from transfers, then having all of the retirees die would be considered an enormous benefit. What this analysis obviously missed is the “value of

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life.” If one computed the value of a life simply based on lost earnings, however, the retirees would suffer no loss. As the textbook mentions on page 255, this method is rejected by most economists. The method that is frequently used by economists is the “value of a statistical life,” which (among other things) compares compensating wage differentials to the probability of death. Viscusi and Aldy (2003) find that the value of statistical life ranges between $4 million and $9 million. One could convert these values from a lifetime into each year of life, to form some estimate of the “cost” of smoking. 7.

As discussed on pages 257-8 of the textbook, one of the “games” that cost-benefit analysts play is viewing the wages paid to labor as a benefit not a cost. This is clearly wrong. The fact that 1,000 people need to be hired to do the recycling in New York is a cost of the program, not a benefit.

8.

Currie and Gruber (1996) find the cost of the expansion per life saved was approximately $1.6 million. According to Viscusi and Aldy (2003), the value of a statistical life is between $4 million and $9 million. If all of these calculations are correct, then the Medicaid expansion passes a cost-benefit test. Chapter 12 – Taxation and Income Distribution 1.

The incidence of the subsidy depends on the elasticities of the supply and demand curves. Here the price received by sellers increases from P0 to P1. Buyers also benefit – their price falls from P0 to P2. In evaluating the claims that energy subsidies to low-income families do not benefit industry, the figure below could be modified by shifting the demand curve rather than the supply curve. Nonetheless, what is clear from the diagram is that demand is relatively inelastic, while supply is more elastic. Thus, the subsidies to low-income families do benefit the industry.

2.

These reports about demand sensitivity suggest that there is a very elastic demand curve for goods sold over the Internet. Because of this high elasticity, the incidence of a tax levied on Internet sales is primarily borne by producers, not consumers.

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3.

4.

One expects that those factors that are used intensively in tobacco production will bear the burden of the tax. Assuming, for example, that tobacco production is capitalintensive, one expects owners of all capital (not just those with investments in tobacco) to bear some of the burden.

5.

a.

Set 2000 – 200P = 200P, so P = $5 and Q = 1000 packs

b. Consumer price = Producer Price + $2. Let P be the producer price. 2000 – 200 (P + 2) = 200 P. Producer receives $4 per pack; consumer pays $6 per pack. Quantity sold = (200)(4) = 800 packs. Tax revenue = (tax/pack)(no. of packs) = (2)(800) = $1600. 6.

The equilibrium price can be calculated by setting the quantity supplied equal to the quantity demanded: (i) (ii)

QD = a - bP QS = c + dP

If QD = QS, then the equilibrium price can be determined as follows: a − bP = c + dP a − c = (b + d ) P a −c P= b +d

The equilibrium output can be determined by substituting the equilibrium price into either the supply or demand equation.

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Substituting into the demand equation: Q = a − bP  a −c  Q = a − b  b + d 

Substituting into the supply equation: Q = c + dP  a −c  Q = c + d  b +d 

If a unit tax of u dollars is imposed on the commodity, then it doesn’t matter which party it is imposed upon (the consumer or producer); the new equilibrium will be the same in PC =

a 1 −  Q b b

P CT =

a 1 −  Q + u b b

either case. If the unit tax is imposed upon the consumer, then the price the consumer pays is u higher than the price received by the supplier. The consumer’s price without the tax, PC, and price that includes the tax, PCT, are: Similarly, the price received by the producer in the absence of the tax, P P, is u lower than the price received with the imposition of the tax, PPT. These prices are expressed below: c 1 P P =  Q − d d 

c 1 P PT =  Q − − u d d 

The equilibrium that prevails after the imposition of the tax can be found by setting PCT = PP or PC = PPT -- in the end, both approaches will yield the same answer. First, we can derive the solution setting PCT = PP: P CT = P P

Next, setting PC = PPT:

a 1 c 1 −  Q + u =  Q − b b  d d  a c 1 1  + + u =  + Q b d b d  da + bc + dbu  b + d  = Q db  db  da + bc + dbu Q= b+d

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P C = P PT a 1 c 1 −  Q =  Q − − u b b  d d  a c 1 1  + + u =  + Q b d b d  da + bc + dbu  b + d  = Q db  db  da + bc + dbu Q= b+d

Therefore, both approaches lead to the same outcome. 7.

Equation (12.1) relates progressiveness, v1, to average tax rates. Assume throughout that I1>I0>0. Then progressivity is measured by v1=[(T1/I1)- (T0/I0)]/(I1-I0). With a $300 lump sum tax refund for all earners, the progressivity changes to v1’=[((T1-300)/I1)- ((T0300)/I0)]/(I1-I0). Rearranging, we have v1’= v1+[(300/I0)-(300/I1)]/(I1-I0). Thus, the progressivity differs only by the second term, [(300/I0)-(300/I1)]/(I1-I0). This second term is positive because (300/I0)>(300/I1). Thus, v1’>v1, and average tax rates increase with income by more when a $300 lump sum tax refund is given. Intuitively, the average tax rate falls by more for a low-income person from a lump sum tax reduction. Equation (12.2) relates progressiveness, v2, to the elasticity of tax revenue with respect to income. Then progressivity is measured by v2=[(T1-T0)/T0]/[(I1-I0)/I0]. With a $300 lump sum tax refund for all earners, the progressivity changes to v2’=[(T1-300-T0+300)/(T0-300)]/[(I1I0)/I0]= [(T1-T0)/(T0-300)]/[(I1-I0)/I0]. Note that v2’ differs from v2 only by the term (T0300). Thus, the numerator of v2’ is larger than v2, while the denominator is the same. Thus, v2’>v2, and the tax system is more progressive under the second measure as well when the lump sum tax refund is given.

8.

The equation T=-4000+.2I is somewhat similar to the exercise in Table 12.1 on page 277 of the textbook. If we follow the text and define progressivity with respect to average tax rates rather than marginal tax rates, then the average tax rate equal ATR=(-4000/I)+.2 for any income level. Clearly this average tax rate converges to ATR=20% as income gets large, and is lower for lower income levels. Replicating Table 12.1 for the tax system given here, we get: Income $2,000 3,000 5,000 10,000 30,000

Tax Liability $-3,600 $-3,400 $-3,000 $-2,000 $2,000

Average Tax Rate -1.80 -1.13 -0.60 -0.20 0.066

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Marginal Tax Rate 0.2 0.2 0.2 0.2 0.2

Part 1 – Getting Started

9.

With the schedule T=a+tI, the average tax rate as a function of income is ATR=T/I=(a+tI)/I=(a/I)+t. A progressive tax system, using equation (12.1), means that the average tax rate goes up with income, or dATR/dI>0. Taking derivatives, dATR/dI=a/I2>0, which implies –a>0 or a1 or εD0, which always leads to the same decision as before. The Wall Street Journal’s assertion that “high marginal tax rates discourage incentives … to invest in one’s human capital with additional training or education,” implicitly assumes a more complicated model. There are several ways in which this basic cost-benefit analysis could be modified to get such a result. For example, in focusing on the nature of the costs of the human capital investment, it is assumed that C represents only forgone earnings, and therefore a tax lowers the cost (as well as the benefits) of getting training. Imagine instead that C=C1+C2, where C1=deductible costs, such as forgone earnings, and C2=non-deductible (or partially-deductible) costs, such as college tuition. With the imposition of taxes, the net benefit of training now becomes (1-t)(B-C1)-C2t2, and the higher tax rate applies to the incremental earnings from training, but

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not the previous lower earnings. In this case, the net benefit now becomes (1-t1)B-(1t2)C. Relative to the case with a proportional tax, this expression is smaller, and not necessarily positive. Finally, to the extent that taxes lower labor supply, this will tend to reduce the return to human capital accumulation and lower the amount undertaken. 7.

One extreme possibility is that there will be no new personal saving—people just shuffle assets from taxable to nontaxable accounts. It is more likely that there will be some new saving, although less than the amount by which the IRA limits are increased. Hubbard and Skinner (1996) conclude that a good guess is that 26 cents per dollar of IRA contribution is new saving. Many of the studies that look at the “reshuffling” of assets examine IRA limits of $2,000; many employees today would have a current 401k limit of $13,000 (along with a Roth IRA limit of $3,000 per person); thus a married couple with two workers may be able to contribute as much as $32,000 in tax-deferred plans. It may be the case that with the dramatic increase in the limits over time, the additional saving is not infra-marginal.

8.

The statement is correct. When there is full loss offset, the tax system will tend to reduce the risk as well as the return to risky investments. The effect on risk taking is therefore ambiguous. With less than full loss offset, the tax system does not reduce risk as much, which tends to bias the individual against risky investments, other things being the same.

9.

a.

The supply curve is given by S=-100+200wn. The gross wage is w=10, and the net wage is wn=(1-t)w=(1-t)10. The difference, then, between the gross and net wage for any tax rate is w-wn=10t. This is the tax collected per hour of work. The tax revenue for any given hours of work is then the product of the tax collected per hour of work and the labor supply curve: tax revenue=10t*(100+200(1-t)10)=-1,000t+20,000t-20,000t2=19,000t-20,000t2. The tax rate t=0.7 is beyond the revenue maximizing point (this can be shown by computing tax revenue for a slightly lower tax rate, like t=0.69.

b.

Taking the derivative dTax Revenue/dt=0 yields 19,000-40,000t=0, or t=(19,000/40,000), or t=0.475 as the revenue maximizing tax rate. Chapter 17 – The Corporation Tax

1.

This statement suggests that corporations are people with independent abilities to pay, a view that parallels the legal status of corporations. Economists believe that only people have an independent ability to pay.

2.

a. b.

c.

The real value of depreciation allowances, Ψ of equation (17.1), falls. When Ψ falls, the user cost of capital increases. Index appreciation allowances.

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3.

If the $20 million is expensed, the firm gets a deduction of $20 million in the current year. If the $20 million is depreciated, the deductions are spread over time (in a way that depends on the specifics of the depreciation schedule). The present value of the future flow of deductions is less than $20 million. Because the package design will yield benefits that extend over a period of time, it would seem sensible to view it as a capital expenditure. If so, depreciation is appropriate, and the IRS was right.

4.

Under a strict Haig-Simons rule, there would not be any separate corporate tax at all. Given that there is a corporate tax, the spirit of the Haig-Simons criterion is that different forms of corporate income should be treated the same way. The partial dividend exclusion at the personal level can be rationalized in Haig-Simons terms. Given that the income that generated the dividends has been taxed once (at the corporate level), then excluding part of it at the individual level seems appropriate.

5.

Under the proposal from the Wall Street Journal article, dividends would be totally exempt from taxation. On the other hand, interest income would be taxed at the individual level. Thus, the statement “Abolishing the tax in both places not only ends the double taxation of dividends but creates the same incentives for equity and dividends as for debt and interest. Voila! A level playing field.” is only partially correct. The playing field would not be level; now, rather than the tax system favoring debt finance over equity finance, the reverse is true.

6.

A retroactive rebate of the alternative minimum tax for corporations would simply be a lump sum transfer. Thus, according to neoclassical theory, such a rebate would not have an effect on investment, because it does not affect the user cost of capital. The user cost of capital depends on current individual and corporate tax rates, after-tax rates of return in the capital market, economic depreciation, depreciation allowances, and investment tax credits. None of these is affected by the AMT rebate described in the text. Moreover, because the firms involved in the AMT rebate were very large, it is hard to imagine that the rebate would relax liquidity constraints either.

7.

O’Neill’s statement that, as chief executive of Alcoa, he “never made an investment decision based on the tax code,” is problematic for the shareholders of Alcoa. It makes no sense to ignore tax incentives when making business decisions; that is, after-tax returns are what matter. O’Neill’s lack of tax sophistication likely lowered the value of Alcoa relative to what it would have been had he taken account of the tax system.

8.

The MIPS financial instrument, which could interchangeably be called debt or equity, would be attractive to a corporation because firms would want tax authorities to view the instrument as debt because the interest paid is tax deductible. On the other hand, firms want potential investors to view the instrument as equity, because more debt makes the firm a riskier investment. Although the tax law might be forced to view this MIPS instrument as debt, there is no reason why investors in the market (or credit rating

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agencies) would then view it as equity, however. In principle, investors and credit agencies should be able to see through such accounting gimmicks, though in practice, the accounting scandals showed that this was not the case. 9.

The user cost of capital (ignoring depreciation allowances and investment tax credits) is given by equation (17.4) in the textbook, C=(r+δ)/[(1-θ)(1-t)], where r=after tax rate of return in the capital market, δ=economic depreciation, θ=corporate tax rate, and t=individual tax rate. Substituting the numbers from the problem into the formula, gives the user cost: C=(.08+.01)/[(.65)*(.7)]=.1978. Since the project’s return, 30%, is higher than this user cost of 19.8%, the company does invest in the project.

Chapter 18 – Deficit Finance 1.

a.

The government borrowing to finance a Memorial Day parade increases the national debt. In designing an accounting system for the government, the borrowing in this case should, in fact, increase the national debt.

b.

The sale of the Statue of Liberty to private entrepreneurs would decrease the national debt under current measurement. In the discussion on capital spending, on pages 458-9, the exercise here is similar to the sale of nondefense federal buildings in 2002. In designing an accounting system, this transaction is simply an exchange of assets and should have no effect on the debt, rather than decreasing the debt. The current system ignores tangible assets.

c.

The law promising free (future) medical care to children under five affects future spending, not current spending. As such, it does not affect the current measurement of the debt. This is similar to the discussion of the implicit legislative promises about Social Security on page 460. In designing an accounting system, the present value of the entitlement should be counted as a current expense, so the debt should increase. The current system ignores implicit obligations.

d.

The $100 tax would reduce the size of the national debt. The implicit promise to pay Lynne back $105 next year does not increase the size of the debt, assuming this is similar to the implicit promise to pay Social Security in the future. In designing an accounting system, again, this implicit promise should be counted. Assuming the present discounted value of the of the $105 paid back next year equals the $100 tax this year, then the impact on the debt should be zero, rather than to decrease it.

e.

The $100 bond would increase the size of the national debt. The present value of these payments is the amount by which the bond contributes to the debt. In designing an accounting system for the government, the borrowing in this case should, in fact, increase the national debt.

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2.

Montyon’s assertion makes sense. Because the excess burden of taxation rises with the square of the tax rate, it is efficient to spread the increases in tax rates over time by borrowing and then repaying the debt with tax revenue. However, if there are distortions in the capital market and the borrowing crowds out capital formation, this result may not hold. If the Ricardian model holds, such crowding out will not occur, and the efficiency case for borrowing is strengthened. All this assumes that the expenditure in question is a one-time increase, such as a war.

3.

The arrival of surpluses in the late 1990s, and the subsequent spending spree, are consistent with Milton Friedman’s view of deficits and government spending. His view is that, “What is predetermined is not spending but the politically tolerable deficits.” Since the deficit is fixed, increases in revenue lead to one-to-one increases in spending.

4.

If the elasticity is zero, then taxing labor markets creates no distortion. But in the presence of taxes on capital income, crowding out in the capital market will generate an excess burden. Therefore, use tax finance.

5.

While this is a matter of opinion, one should note that the effect of a debt reduction on the economy depends on whether that implies higher taxes or reduced spending, as well as the portfolio of reductions in spending. Thus, without stipulating how the debt reduction will be accomplished, it is hard to say much about the effect on the economy.

6.

The benefits-received principle, which states that the beneficiaries of a particular government spending program should pay for it, suggests that deficit finance is appropriate for war if the benefits are received by future generations. An efficiency standpoint would say that debt is appropriate if the expenditure is temporary, and there are not major pre-existing distortions in capital markets.

Chapter 19 – Taxes on Consumption and Wealth 1.

The market value of Microsoft is a stock figure. Gross domestic product is a flow figure. It makes no sense to compare them directly. One way to make a sensible comparison would be to convert the market value of Microsoft into a flow, i.e., compute the stream of income that could be generated annually by $500 billion of wealth. Using a rate of return of 10% for convenience, this gives us $50 billion per year, considerably below Spain's GDP.

2.

The statement is misleading because it ignores the business part of the Hall-Rabushka tax. Capital incomes are generated by businesses; effectively, the H-R tax captures this income at its source. Note, however, that investment expenditures are expensed under the H-R proposal. Hence, only returns to capital in excess of normal returns are taxed.

3.

There is a fundamental confusion here. There is no reason to assume that the incidence of a general consumption tax (a VAT) will be the same as the incidence of a partial factor tax (corporate income tax).

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4.

5.

a.

For a fan giving a million-dollar ball to McGwire or Sosa, there would be a federal gift tax liability. Depending on the fan's circumstances, it could reach $150,000 or more. The person receiving the gift owes no tax.

b.

If the fan keeps the ball, the fan would owe no tax now. But the ball would become part of his or her estate, taxable after death under the estate tax.

c.

The fan can avoid tax entirely by giving the ball to a charity, since he could entirely deduct the value of the ball from his taxable income. The charity could sell the ball; the proceeds from the sale would not be taxed.

d.

If the fan sells the ball, the fan owes tax on the net proceeds, just as the seller of any property would. The transaction would put the fan in the highest tax bracket, so that the marginal tax rate on the proceeds would be 39.6 percent.

e.

If the fan holds onto the ball for a year, it becomes a long-term capital asset, subject to the maximum capital-gains tax rate of 28 percent. Unless the fan thinks that there is going to be a substantial drop in the market value of the ball, he or she should hold onto it for a year.

a.

The expression “What you earn is what you keep” is false, because a consumption tax is equivalent to a tax on wages. The two are related by the expression (1+τ )=1/(1-t), where τ =consumption tax rate and t=income tax rate.

b.

The expression, “Investment and savings would soar” may be true. A consumption tax raises the return to saving, but because of the conflict between income and substitution effects, one cannot know whether or not this will increase saving. Figures 16.9 and 16.10 in the textbook illustrate these possibilities.

c.

The statement that “There is no evading the Fairtax” is false. Evasion can be a major problem with retail sales taxes, especially at high rates.

6.

In the simplest possible case, the budget constraint is pC = wH, where p is the price of consumption, C is units of consumption, w is the wage rate, and H is hours of work. With an income tax, pC=(1-t)wH, where t=income tax rate. With a consumption tax, (1+τ )pC=wH, where τ =consumption tax rate. Thus, for any income tax rate t, we can find a consumption tax rate, τ , that is equivalent by solving the expression: (1+τ )=1/(1t).

7.

a.

Rich receives $100 in period 1 and $75.6 in period 2, while the interest rate is 8%. Thus, the present discounted value of his income stream is I=$100+ $75.6/1.08=$170. If second period consumption is $108, the discounted value of this is $108/1.08=$100. Thus, first period consumption is $70.

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b.

8.

Recall that the expression (1+τ )=1/(1-t) relates consumption taxes (τ ) to income taxes (t). Thus, if the income tax rate is t=0.25, then (1+τ )=1/(10.25)=4/3, or the equivalent consumption tax is τ = 1/3.

Under an income tax, Amy's burden is $1,000*t in the first period, and .08($800)t in the second period (e.g., her investment income is taxed). Shirley's burden is identical in the first period, $1,000*t, but is lower in the second period, equal to .08($700)t. This is because Shirley consumed more in the first period and saved less. Thus, Amy has a higher lifetime tax burden because she has higher investment income. Under a proportional consumption tax, Amy and Shirley have the same lifetime tax burden, $1,000*τ , where τ is the consumption tax rate.

Chapter 20 – Public Finance in a Federal System 1.

2.

a.

To the extent that autos tend to be used within a given jurisdiction only, it would make sense for states or localities to control pollution regulations. To the extent that a given car is driven in many states, or that pollution created in one jurisdiction affects residents in another, it would make sense for the federal government to be in charge.

b.

To the extent that the negative externalities of a landfill affect only people who live nearby them, then local or state regulation is appropriate.

c.

Provision of weather satellites would make most sense for the federal government.

d.

Public refuse collection seems a natural function for local government.

e.

In the case of airport security, inter-jurisdictional externalities are present. If one airport in one community does not have adequate security, it affects the security of individuals at airports in other jurisdictions. Thus, a federal role is appropriate in this situation.

Yes. David bore the burden of the tax increase while Jonathan did not. Because the future tax payments are incorporated into the price of the house, Jonathan was able to purchase the (same) house at a lower price. The previous owner effectively “pays” the tax.

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3.

c.

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4.

The theory of federalism indicates that one of the main purposes of decentralization is to allow people to select bundles of public services and taxes that suit them. The more diverse their tastes, the greater the benefits of being able to pick different bundles, and hence, the greater the benefit to decentralization. Hence, the finding is consistent with our theory.

5.

The figure looks essentially like Figure 20.6 (without segment JH). What actually happens to spending on education depends on the income elasticity. The government need not increase spending on education by the full amount of lottery money collected because the rest of the state revenue is fungible. Thus, if previously 20 percent of general state revenue had been spent on education, after the lottery is implemented, perhaps only 17 percent of general state revenue is spent on education.

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6.

In the figure below, the (constant) marginal cost of hiring a firefighter is C. The demands for the two communities are D1 and D2. Suppose that initially the quantity is set at Q0. After decentralization, each community hires firefighters up to the point where the marginal benefit equals marginal cost, i.e., where their respective demand curves intersect C. This is at Q1 for community 1 and Q2 for community 2. Community 1 gains abc. Community 2 gains dbe. Community 1 gains more because its demand curve is more inelastic.

7.

The “user-fee” view of property taxes regards property taxes as payment for local public services. The statement “its presence would raise property values and the extra tax revenues would easily repay the construction costs” reflects this view -- that people pay for the recreational services made available by the part with their property taxes. The statement is not consistent with the “traditional view” or the “new view,” both of which ignore the local services aspect.

8.

Originally, the effective state price of $1 spending on welfare recipients was $0.50 with a one-for-one federal match rate. If the federal match rate changes to two-for-one, the effective state prices of $1 spending falls to $0.33, or a 34 percent change in the price. Using Baicker’s (2001) elasticity estimate of 0.38, a 34 percent change in price should increase state spending by 12.92% (=0.38*34%). LECTURE TIPS

Chapter 1 Decisions about public policy cannot be made on the basis of economic analysis alone. Value judgments are also required. The purpose of the beginning part of Chapter 1 is to make this

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point, and to try to force the students to think hard about the values they bring to bear on public policy problems. One point I emphasize in class is that even the way we formulate our questions depends on value judgments. For example, the question that economists in the United States and United Kingdom usually ask is, “Under what conditions is it a good idea for the government to intervene in the economy?” I ask the students what question might be asked if the course were being taught in a socialist economy such as Cuba. There the question might be, “Under what conditions is it a good idea to allow the private sector to undertake an activity?” The lecture on the second part of the chapter should try to convey some sense of the scope of government activity. About a third of the GNP goes through the public sector; most students do not realize that government is that large. The lecture should also emphasize the arbitrariness involved in selecting a measure of public sector size. To make the issue more concrete, one can relate it to current debates over various “mandates.” While any given measure may convey useful information, no single measure can tell the whole story. I try to emphasize that this is a theme that will be recurring in the course – it is often difficult to measure things we care about; this fact does not mean that we should abandon attempts at measurement, but it does mean that we have to be cautious in interpreting data. Chapter 2 Students should come away from this chapter realizing that just because economists disagree on many issues does not mean that economists are stupid or dishonest. One point to emphasize is that in this respect, economists are pretty much in the same boat as practitioners in other disciplines generally considered to be more “scientific,” e.g., medicine. Just remember the controversy over whether drinking coffee “causes” cancer of the pancreas. In recent years there have been more attempts to answer economic questions with experiments. It might be interesting to use this chapter’s summary of Rouse’s work on the Milwaukee voucher experiment as the basis for a classroom discussion of the advantages and disadvantages of experiments in economics. Chapter 3 After I distinguish between “positive” and “normative,” I find that students tend to equate “normative” with “not subject to rational discussion.” This is a good opportunity to remind students that it is possible to have rational discourse about value judgments, despite the fact that it is impossible to prove “scientifically” that one set of values is better than another. My students are intrigued by Edgeworth Boxes and the notion of Pareto efficiency. It pays to go through this material very carefully. If many of your students have seen the Edgeworth Box analysis of exchange efficiency in a previous course, you may want to go through the analysis of productive efficiency in class. Students have been seeing the production possibilities curve since practically their first day in economics; now they will know where it comes from. One way to provoke discussion on the topics in this chapter is to discuss the longstanding controversy over

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whether to abolish the National Endowment for the Arts. Many students support this and related programs but find it hard to articulate just why. A discussion of paternalism and policy toward cigarettes is another way to students thinking. Chapter 4 This is the first chapter on the expenditure side of the budget. I have found that there is a tendency for lectures in this part of the course to degenerate into a mere cataloging of programs, without a central theme. The text tries to counter this tendency, but it helps in lecture to keep coming back to the basic question raised in Chapter 3: From the point of view of welfare economists, is this program sensible? With respect to the material on public goods, I find that students often have problems understanding the necessary condition for Pareto efficiency in their provision. As preface, I began with some intuition of the following kind – given that everyone must consume the public good, it only makes sense to increase its provision by a unit if the sum of the marginal values that each person puts on an extra unit exceeds the marginal cost. Next, review carefully why “marginal value” corresponds to the familiar notion of marginal rate of substitution, and “marginal cost” corresponds to marginal rate of transformation. Then it is easy to get to the final step, that the sum of the MRSs must just equal the MRT. Students are very interested in the issue of privatization. I try to relate current controversies over whether some particular service should be privatized to the theory of public goods. Example: Should welfare be administered by private companies? The text takes advantage of the HartShleifer-Vishny incomplete contracts framework to analyze the choice between public and private production. My hope is that students will find this a compelling and coherent way to think about privatization issues. To bring the material close to home, try discussing the material on public versus private provision of education. The material on preference revelation mechanisms is relatively difficult for many students, which is why it has been place in the appendix to this chapter. My experience is that, even after students have read this material, they need to be led through it a step at a time. As above, it helps to keep reminding students that “MRS” corresponds to “marginal benefit,” and “MRT” corresponds to “marginal cost.”

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Chapter 5 Although environmental externalities are critically important, it is important for students to realize that externalities come up in other contexts as well. Some of the new examples include Lojack devices on cars and the conservation of elephants in Zimbabwe. I find that students tend to think that any activity that is “desirable” produces positive externalities, and therefore should be subsidized. The book emphasizes that for a subsidy to be efficient, the activity must produce, on the margin, a benefit that exceeds the return to the producer of the activity. Still, this point requires emphasis in class. Ask the students whether they think that medical school educations should be subsidized and, if so, why. It is important for students to realize the difficulties involved in implementing the models for dealing with externalities. Sometimes it is hard to determine even whether or not a particular substance causes harm. The controversy in early 2001 over standards for arsenic in water might be a good topic to discuss in this context. Chapter 6 This chapter is divided into two major sections - the first on direct democracy and the second on representative democracy. I prefer to give a separate lecture on each part, but to stress the linkages between the two problems. (For example, the median voter theorem derived in the direct democracy context gives predictions on the outcomes of election contests.) Virtually all of the students have heard of “logrolling” and tend to assume that is a bad thing. It is, therefore, a good idea to go patiently through the example in which a logrolling system improves efficiency. Of course, the efficiency-decreasing case should also be discussed. Ask the students which case they think is more realistic in their community. Public discussions of statutory and constitutional measures to reduce government spending continue to be lively. Ask the students if they favor a balanced-budget amendment. Chapter 7 The material on the optimal income distribution exemplifies the interplay between economics and philosophy. Philosophy determines the form of the social welfare function; economic analysis shows how to maximize this welfare function subject to the relevant constraints. Students often have strong views on the “fair” distribution of income. One can have a good class discussion by getting the students to try to rationalize their feelings using the framework of welfare economics. After the discussion of the inferiority of in-kind transfers to cash, students always ask why we have in-kind transfers. This is a good opportunity to relate income distribution policy to the public choice issues raised in Chapter 6. That is, Chapter 6 discussed logrolling and special interest groups; it is useful to analyze how these factors have influenced the formulation of income maintenance policy.

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Chapter 8 This chapter stresses the changes in welfare policy introduced in 1996 and the preliminary research on their impact. Students can be asked whether they think that workfare requirements are good social policy, and whether it makes sense to allow the states a bigger role in determining welfare policy. Such a discussion also provides an opportunity to anticipate some of the federalism issues that will arise toward to the end of the course. Income maintenance issues provide a good opportunity to show how the economist’s standard leisure-income model sheds light on the labor supply incentives of welfare. It is also a good opportunity to review the points about methodology raised in Chapter 2. Just why is it so hard to find out whether the welfare system creates long-term dependence, whether AFC increases divorce rates, etc.? Chapter 9 This chapter devotes a substantial amount of space to a potentially confusing topic – the privatization of Social Security. It is important to stress in this lecture that merely investing the Social Security surplus in the stock market will not make future retirees better off. Any serious privatization scheme requires some mechanism for increasing social saving. And given that political and ethical considerations require that obligations to the current generation of retirees be met, this probably means some kind of additional taxation. In addition to discussing the nuts and bolts of Social Security, it is important to relate this program to broader themes in the course. In particular, why should this kind of “insurance” be provided publicly? What kind of market failure is created in the presence of adverse selection? Is the government program better than the free market alternative? Chapter 10 It is important to emphasize that even though health care decisions are often made under conditions of great uncertainty, this does not mean that the tools of positive economic analysis must be discarded. Rather, these tools must be modified to take the uncertainty into account. Thus, for example, the principal-agent model allows discussion of the incentive problems that arise when physicians act as patients’ agents. My students tend to have very strong preconceptions about the reasons for the increase in health care costs. To begin the discussion of this matter, I ask the students why they think that the health care sector has been increasing relative to the size of the GDP. Then I ask them how they would test whether their views are correct. This provides a segue into a discussion of Newhouse’s analysis of the sources of growth in health care costs. In the context of this discussion, it is always important to emphasize that it is not obvious whether health expenditures are “too big.” In recent years, the discussion of health care policy has moved away from global reform to incremental change. Students might be asked whether they think that incremental change is

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sufficient to develop “good” health care policy. A discussion of reform options for Medicare might be helpful in this context. Chapter 11 There is a tendency for students to think that cost-benefit analysis allows one to make a “scientific” unambiguous choice among projects. The tricky part of this material is to disabuse the students of this notion, but at the same time convince them that cost-benefit analysis is a useful tool. It is the only way to force an analyst to explain systematically why he or she favors a project. The students find the material on the value of life to be intriguing. It is useful to keep reminding the students that this is not merely an academic issue. The problem comes up, for example, whenever there is a lawsuit after an air disaster. It is important to emphasize that, in this and other contexts, one cannot avoid explicitly or implicitly putting a value on life. I find that it is also useful to discuss the material on the problem of double counting in benefitcost analysis. The text’s discussion of land values can be amplified with an explicit algebraic discussion of the capitalization of benefits into land prices. A side benefit of such a discussion is that is provides another illustration of the usefulness of present value analysis. This edition contains a new extended example of cost-benefit analysis. The question is whether reductions in class size have benefits that exceed their costs. This is an issue on which the students are likely to have strong opinions, and I have found it worthwhile to work through the example in class carefully. Chapter 12 This is the first of three chapters on tax analysis. The emphasis in these chapters is providing a theoretical framework for thinking about tax policy issues. The danger in presenting this theoretical material all at once is that students will get impatient to see it applied to the actual tax structure. I have tried to avoid this danger by putting a lot of examples into the text. In particular, in light of the current interest in public policy toward cigarettes, I have included a number of examples dealing with cigarette taxation. I have also framed the discussion of international taxation in terms of “globalization” which may increase its appeal to students. Many students have seen in an earlier course the standard tax incidence analysis done in a supply and demand framework. My experience is that although such students can shift the relevant curves, they don’t know why they are doing it. Thus, it pays to begin with a patient discussion of the distinction between the price paid by consumers and the price received by producers, and why this leads to a new “effective” demand curve after an excise tax is levied. I find that working through the partial equilibrium analysis with an explicit algebraic example is often helpful. Posit specific linear supply and demand curves, and demonstrate how a unit tax of a specified amount changes: a) output and b) price paid by the consumer. This will make the incidence model seem more concrete.

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Chapter 13 It pays to spend some time developing an intuition for why taxes create excess burdens before doing any formal analysis. I find that going over the extreme case discussed at the beginning of the chapter is a big help. That is, when a tax drives demand all the way to zero, clearly it generates no revenue, yet it lowers welfare. Thus by distorting choices, a tax can create a burden in excess of the revenues it generates. After making this point, next go through the indifference curve analysis very carefully. Once this is done, the students will understand why excess burdens arise, but they will still have no idea how they can actually be measured. At this point, the (compensated) demand curve analysis of excess burden should be done. This discussion should emphasize that with knowledge of the relevant supply and demand elasticities, excess burdens can be calculated. Remind students that the tools of positive analysis, discussed in Chapter 2, can be used to find these elasticities; hence, the concept of excess burden is operational. Chapter 14 This chapter discusses a number of issues that arise in the design of a tax system; you will have to pick and choose with respect to the ones you emphasize in lecture. I like talking about the Ramsey Rule for several reasons. First, it is a nice application of marginalistic logic, and it reinforces the material on excess burden from the previous chapter. Second, it leads to an interesting counterintuitive result – neutral taxation is not necessarily efficient. Third, it shows how empirical work is needed to make theory useful – without knowing the relevant behavioral elasticities, one doesn’t know that set of tax rates will in fact lead to proportional reductions in demand for all taxed goods. Students find the material on tax evasion to be interesting. There always seems to be someone famous in the newspaper who is being prosecuted for tax evasion. I like to stress that although tax evasion may be undesirable from a social point of view, this is not necessarily the case. As noted in the text, it depends on whether evaders’ utilities appear in the social welfare function, and on the supply elasticities of labor to the “underground” and “above ground” sectors. The material on the optimal punishment for evasion also allows discussion of a philosophical issue raised earlier in Chapter 7 – do we care only about outcomes or the processes used to generate them, as well? The model of the efficiency consequences of partial factor taxation has been considerably simplified in this edition. However, it still needs some patient explanation in class, particularly about why the area under the value of marginal product schedule is the value of total product. Chapter 15 Some of your students have never filled out a tax return; those who have done so probably have not had to itemize deductions, be concerned with IRAs, etc. In short, you cannot take for granted that your students are aware of the basic mechanisms of computing income tax liability. Figure 15.1 is designed to put the income tax system as a whole in perspective. Some time should be devoted to discussing it before turning to the details of the system.

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Despite the material on the differences between average and marginal tax rates in Chapter 12, some students will still think that being in the 28 percent bracket means that the average tax rate is 28 percent. This needs to be explained carefully. Also, the differences between statutory and effective marginal tax rates need to be stressed. This is particularly important after the 1997 income tax act, which introduced a number of credits and deductions that are phased out as income increases, thus increasing effective marginal tax rates. Chapter 16 For many students, the most difficult subject in this chapter is the effect of taxation upon saving. As a first step, take a poll of the students to see whether they think a tax on interest will increase, decrease, or leave saving unchanged. Then indicate that you will examine this question theoretically using a life-cycle model. Before going through the graphical analysis, give some intuition for the life-cycle model. For example, explain why it is quite likely that the students will be borrowers early in their careers, when their long-term prospects exceed their current income. When covering the graphical analysis of intertemporal choice, it is important to emphasize the formal similarities between it and the standard theory of choice between two goods. In particular, the slope of the budget constraint gives the opportunity cost of one good in terms of the other. Another topic that is fun to cover in lecture is the Laffer Curve. Most students have heard of it, but do not know its relationship to economic theory. The discussion should emphasize that whether we are on the “wrong” side of the Laffer Curve depends fundamentally on the elasticity of supply of labor, among other things. In this context, however, it is important to note that, in recent years, the academic discussion has shifted a bit away from labor supply and to taxable income more generally. That is, there are ways other than labor supply in which a reduction in tax rates can generate increases in taxable income (e.g., fewer nontaxable fringe benefits and more cash in compensation packages). Chapter 17 Many students have heard about “depreciation allowances,” “tax shelters,” “investment tax credits,” etc., but they are regarded as esoterica that cannot possibly by understood by people other than tax specialists. Hence, there is a special feeling of satisfaction when these concepts are mastered. My experience is that a very patient approach to this material pays off. For example, in teaching depreciation allowances, explain precisely how much a given depreciation schedule is worth to a firm each period. Then show how taking present value can collapse this stream of tax reductions into a single number. Given the recent public attention to international tax issues, students are quite interested in finding out about the rules relating to international business activity. Hence, you may want to spend some time in lecture discussing transfer pricing and why the problem is so complicated.

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Chapter 18 The national debt currently receives more attention than any other public finance issue. It is important to emphasize at the outset that there is a certain arbitrariness in measuring the debt. This issue can be made relevant with two different examples. Recently, the federal government has been running surpluses. This is taken as a sign that U.S. public finance is in good shape. Should it be? Second, deficit accounting has taken on new importance in Europe, where a country’s ratio of deficit spending to GDP must be below some value to enter the European Union. The idea is to make sure that EU members are disciplined in their fiscal affairs. Is this a sensible approach? My lectures on debt emphasize that formally it is not a “new” problem. That is, debt is just a particular way of collecting revenue, and hence the standard tools of tax analysis (suitably modified) can be used to analyze the efficiency and equity consequences of debt finance. Chapter 19 These days there is a lot of talk about replacing the income tax with some kind of consumption tax. The flat tax, in particular, is something that many of my students want to hear about. Learning about the relationships between the Forbes flat tax and more conventional consumption tax alternatives, such as a VAT, is something that the students enjoy. It is useful to spend a few minutes on the possible implications of a value-added tax for U.S. “competitiveness.” Specifically, one often hears arguments that if the corporate tax were eliminated and replaced by value-added tax, the United States would be able to export more goods. The fallacies of this position are discussed in the text; the students generally like to hear them discussed. A lot of attention has been focused recently on the estate tax, in part because the Bush administration proposed its elimination. Estate taxation raises a lot of interesting ethical as well as economic issues, and is a good topic for class discussion. Chapter 20 Discussing fiscal federalism provides an excellent opportunity to bring together many other parts of the course – public goods, externalities, income distribution issues, and public choice, among others. The material on public education is particularly useful in this contest. Hence, when I lecture on this material, I like to emphasize that although the institutional material is new, these institutions can be analyzed using familiar basic tools. The material on the property tax provides a good opportunity to review the theory of tax incidence. That is, remind the students that tax incidence depends on assumptions on how markets work, and the “three views” are really just three different assumptions on the appropriate way to view the market of the commodity being taxed. In my discussion of the “traditional” view, I find that it is important to emphasize that the demand for housing depends on permanent income, and the elasticity of demand with respect to permanent income is probably close to one. Hence, even if one holds the traditional view, the property tax is probably not regressive.

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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 is worth 36 points. Part II is worth 24 points. 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. 1.

A consumption-efficient allocation of resources is socially desirable.

2.

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.

3.

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.

4.

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.

5.

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.

6.

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. 7.

(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

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heating bills.” Evaluate this response carefully. Your answer should include an appropriate graphical model. 8.

(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. 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.

SAMPLE MIDTERM EXAM I: SUGGESTED ANSWERS Part I. (6 points each) 1.

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.

2.

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.

3.

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.

4.

False. The schedule that relates benefits received to payroll taxes paid is progressive. As a lifetime taxes increase, benefits increase less than in proportion.

5.

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.

6.

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.

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Part II. 7.

(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.

8.

(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. 1.

“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.

2.

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.

3.

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.

4.

Rent-seeking models of government behavior assume that the goal of policymakers is to maximize a social welfare function.

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5.

In a pay-as-you-go social security system, the dependency ratio equals the replacement ratio.

6.

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.

7.

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.

8.

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.

9.

(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.

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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. 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 do a fraction of the driving that Americans do 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)

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1.

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.

2.

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.

3.

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.

4.

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.

5.

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.

6.

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.

7

True, providing that marginal tax rates vary with income.

8.

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.

9.

(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.

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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. 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

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the extent that demand is inelastic, cigarette consumers will bear the burden of the tax without much of a decrease in cigarette consumption. 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 do. 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.

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SAMPLE MIDTERM EXAM II 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. 1.

A Pigouvian tax is any kind of tax levied on pigs.

2.

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.

3.

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.

4.

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.

5.

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.

6.

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.

7.

(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.

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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?

Explain your answers carefully. SAMPLE MIDTERM EXAM II: SUGGESTED ANSWERS Part I. (6 points each) 1.

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.

2.

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.

3.

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.

4.

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.

5.

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.

6.

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

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will be no higher, and it will be no easier to provide for the consumption of the retired boomers. Part II. (14 points) 7.

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.

SAMPLE FINAL EXAM II 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. 1. 2. 3. 4. 5. 6. 7. 8. 9. 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.

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Part II. Answer each question, taking advantage of the appropriate tools of economic analysis. Each question is worth 12.5 points. 11.

(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 do rich people. a.

What assumption about demand and supply elasticities underlie these assumptions?

b.

In 1974, motor vehicle fuel consumption fell by nearly 4 percent in the aftermath of the first Arab oil embargo. In 1980, motor vehicle fuel consumption fell by 6 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?

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14.

(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) 1.

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.

2.

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.

3.

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.

4.

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.

5.

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.

6.

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.

7.

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.

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8.

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.

9.

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,

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integration would remove the incentives for “excessive” retained earnings that characterize the current system. 13.

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 do not respond to real, after-tax returns. Thus, there is no reason to expect that personal savings would fall.

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