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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 lowtech
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 dened by
Frank Ramsey.)
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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.
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e. (6 points) State the criterion of vertical equity; JCC.
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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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"mt-s7) 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 Ingrids budget constraint below with hours of leisure on the x-
axis and consumption on the y-axis.
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301950 .. 9) 0 I" _ b. ('6 points) Assume a tax system has just been implemented where those are three
Plddr \dx'illdb ' marginal tax rates; for earnings between ll and $10,000 the marginal tax rate is
. ; ibimg 3%, for earnings between $10,000 and $40,000 the marginal tax rate is 20%, and
"if: 10;} Q} qe (W, for earnings above $40.0001he marginal tax rate is 30%. Now draw Ingrids newi
wq 000 budget constraint on the original graph. (label carefully the y-intcrccpts, x-
" l mtcrcepts and the slopes)
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' " ' 'fléefnr' c. (6 points) What are the income and substitution clients of the tax in words (I do
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d. (6 points) Before the tax was introduced Ingrid was working 300 hoursfyear and
after the tax she worked 250 hoursayear. Which eect 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}? I » I. Q
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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 y-axis. Label the budget constraint careJlly including the
slope. - - N F
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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)
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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?
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Part 11: Short Answer
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(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
rst $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 Larrys savings choices). Can we
deduce whether he would spend more or less now?
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1. (10 points)The Earned Income Tax Credit (EITC) .\ Y; (<3 bv\\" f)
a. WhatistheElTC? , . .\ 3N6. . "5
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b.
In theory, does the EIT'C increase or dectease labor supply? Describe in " '*
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a. Explain in detail two different vehicles offered to workers to save for retirement.
Be sure to include why these are advantageous to workers.
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b. Wiil you use either of these vehicles when you begin to earn an income? Why or
Why not? Please explain in detail.
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