1    Review questions

Indicate whether each statement is true, false, or uncertain, and give a brief explanation.

1. The excess burden of a tax is only a function of the size of the tax.

2. Who bears the burden of a tax is the same as who bears the statutory incidence.

3. When we think about how taxes impact incentives, we care about average tax rates.

4. Individuals paying net taxes will increase labor supply in response to a tax increase.

2    Problems

2.1    Tax incidence

Consider the market for coffee in Sydney.  The daily demand for cups of coffee QD  is a function of the price P given by QD  = 40, 000 − 5, 000P .  Similarly, the daily supply of coffee QS  is also a function of price: QS  = −20, 000 + 10, 000P .

(a) Determine the equilibrium price and quantity of coffee sold in Sydney each day. (b) Calculate the elasticity of demand η D  and the elasticity of supply η S .

The NSW implements a new tax on cups of coffee. The tax works as follows: at the point of transaction, the consumer is charged $0.30 above the sticker price.

(c) Who bears the statutory incidence?  (In other words, is the tax“on”consumers or producers?)

(d) Based on the values of η D  and η S  calculated above, who do you expect to bear more of the burden of the tax?

(e) What are the new equilibrium quantity and price after the tax is imposed? (f) How much tax revenue does the government collect?

(g) What is the excess burden of the tax?

(h) How is the incidence of the tax borne between producers and consumers?

2.2    Income taxation

Suppose there are two individuals: A and B with

ui (ci ,li ) = ui ((1 − τ)wi li + R,li ) for i = A,B

The government has a utilitarian Social Welfare Function. The government maximizes its SWF taking into account the response of labor supply li  (which in turn affects the size of the universal transfer R = τ · Z(1 − τ)).

(a) What is the government’s problem? Write out the full sum (i.e., don’t use 对). (b) What is the government’s first order condition?

(c) What is the total mechanical transfer?

(d) What is the total fiscal externality?

(e) Intuitively, why can we set the“effect on utility of own reoptimization” to 0?

After some algebra, we would be able to re-write the government’s FOC as τ =

where  =        zA +zB           

(f) What is the implication if  = 1? What should τ in this case?

(g) In the Rawlsian case, anyone with positive z is assumed to have zero marginal utility (from a social welfare standpoint). What should τ be in this case? Why?