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Unformatted text preview: Key University of Califomia, Davis Dr. Janine LF. Wilson
Department of Economics Winter 2012 Economics 131
Midterm 2 You will have 1 hour and 20 minutes to complete the following exam. Only low—tech
calculators are allowed. Please label work clearly and explain steps thoroughly in order to
get full credit. Part 1: Problems 1. Optimal Commodity Taxation
Suppose that there are two goods in the economy: Wheat and cotton. They are neither
complements nor substitutes. Ad valorem commodity taxes are imposed. The
compensated demand elasticity for Wheat is 0.5 and the cempensatcd demand elasticity
for Cotton is l .5. a. (8 points) If the government of the above economy followed optimal commodity
tax principals, what should they consider when setting their ad valorem tax rates?
(State the key objective of using optimal commodity tax principles as deﬁned by
Frank Ramsey.) "W13 t sacrament @0006 6655? images ‘
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h. (6 points) Using the Inverse Elasticity Rule and the information that the ad
valorem tax rate on Wheat is 30%, calculate the optimal commodity tax on Cotton. 15:25— where, 4c. "\5 them misc. "4.. ‘l n. )4 (1 \ .9) \Q QM CO “*3 I ,ﬁjﬂffx’. {ids pace ekeAmmo O? (in? “£10.? {i ., a
to. 1: %_E. pixﬂgxogm e. (6 points) State the criterion of vertical equity; JCC. @3er with o. c” YC‘EACW 053* KW u. 3 i” : g 3> L O 15
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d. (6 points) Suppose that all consumers have identical preferences and income.
Given tax rates which satisfy the Ramsey Rule, is the criterion of vertical equity
violated? Explain why orwhy not. _ _ ‘ .. n
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; LS‘i‘c :{G (C. no one ‘VJCNKA hGNEJ W“: kahky \O 1;ka N193; iii "mts7) mic 2.1ngrid makes SlOthour for every hour that she works. She can work up to 2,000 hours per
year.
a. (4 points) Draw Ingrid’s budget constraint below with hours of leisure on the x
axis and consumption on the yaxis. , {f 1,. U.
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ﬂ” 301950 .. 9)“ 0 I" _ b. ('6 points) Assume a tax system has just been implemented where those are three
Plﬂddr‘ \dx'illd‘b ' marginal tax rates; for earnings between ﬁll and $10,000 the marginal tax rate is .ﬁ ; ibﬁiﬁ’mﬁg “3%, for earnings between $10,000 and $40,000 the marginal tax rate is 20%, and "if: 10;} Q} ﬁqe (W, for earnings above $40.0001he marginal tax rate is 30%. Now draw Ingrid’s newi wﬂq 000 budget constraint on the original graph. (label carefully the yintcrccpts, x
" l ’ mtcrcepts and the slopes)
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' " ' 'fl‘éefnr' c. (6 points) What are the income and substitution clients of the tax in words (I do ' " M. 141000, not want a one word answer; please explain [he logic behind the effect). \ w f H _ ‘ ‘ .__ . ,.. . __ ,. m _  ‘ "‘— r ' ’ ( “(f'5.) 10 (’0 ” rim3 “omE3 ctltttk‘liﬁj J_QC£Q\© (ji‘xlﬁliik ‘ \Exi kN‘ : 1‘ {WA
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(Luna NO “ W  d. (6 points) Before the tax was introduced Ingrid was working 300 hoursfyear and
after the tax she worked 250 hoursa’year. Which eﬁ‘ect dominated income or
substitution? Assuming that Ingrid is a married woman, is this change what you
would have predicted giVen what we know about elasticity of hours worked with respect to changes in wages}? ﬂ I » I. Q
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X(‘ it R‘C.l(;.(3 F 3.Larry lives for two periods (now and later). He will earn $150,000 “now” and $0 “later”.
The real interest rate in the market is 10%. e. (4 points) Draw the intertemporai budget constraint of Larry with now on the x axis and later on the yaxis. Label the budget constraint careﬁJlly including the slope.   N F
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V?) ‘dedd f. (6 points) A tax of 5% is imposed on all interest income. Graph the new
intertemporal constraint faced by Larry if he were to save in his period “now.”
(label the slope of the constraint) T; 507:: 5* r o Art/(v13) _
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)' g. (6 points) Describe the income and substitution effects of the imposition of the tax
assuming that he is a saver (describe in words the mechanism behind each effect).
Can we deduce whether he would spend more or less in period “now”? Iﬁcome 6%8r1 Nit“ WC W , be. @1365 poorer 30 C00 Some?) \6496 now, he Saves more Sdm¥%Ro:g§§ed ' The, @CcrechQ m the YC’mm 330 5mm 5 decreases Hoe, C" ??O(JVU (\‘Vlw 01 C\K{\ OCEAN ’
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WQQWEAgglboo} WC siege : d[ \w (\ ,.F——"'\$" he“ “30!; 31‘3"?“ (6 points) Now assume that Larry is offered an IRA that he can withdraw from
“ ater" where the burden of the tax is now only 50% of the original burden on his
ﬁrst $5,000 of savings. Staph the new constraint. What would be the income and
substitution effect of this new policy (describe in words the mechanism behind
each effect and your assumptions regarding Larry’s savings choices). Can we
deduce whether he would spend more or less “now”? — v .oqﬁﬁd mcui‘b _._..—_‘.... _ armerese~.. _
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'iiﬁiiﬂﬁa \csc— NEW. C / wk 1. (10 points)The Earned Income Tax Credit (EITC) .\ “Y; “(<3 bv\\" f) a. WhatistheElTC? , . .\ 3N6. ‘ . "5
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exam Qor wcr \ . . . . b. In theory, does the EIT'C increase or dectease labor supply? Describe in " '* C u :1} AixxnﬁCic‘?) no how much was Emmi? _. _ ‘
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C N income {:3}; @di , _ M so nit  'mCQiYY ifkaééig‘w L‘S' ' 2. (15 points) Tax beneﬁts of saving for retirement a. Explain in detail two different vehicles offered to workers to save for retirement.
Be sure to include why these are advantageous to workers. 1' ' U‘OKQQ 320% A0 \ (m Wei—163‘
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Why not? Please explain in detail. New Art: 058, ECOWINC ("€‘..<1f1)(3("\\{IN "\‘Ca
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 Fall '11
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