1    Review questions

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

1. A bread manufacturer increasing production and therefore driving up the price of wheat is an example of a negative production externality.

2. It’s possible for government intervention to raise total contributions to a public good above the private market outcome.

3. Welfare analyses are really only possible for expenditure policies.

4. One benefit of using the Marginal Value of Public Funds (MVPF) to evaluate a proposed expenditure is that we do not have to simultaneously consider the cost of raising revenue to fund the expenditure.

2    Problems

2.1    MVPF of Income Tax Rate Changes

A core empirical pursuit in public economics is the analysis of what happens when marginal income tax rates change.

In this question, we will walk through the construction of the MVPF for changes in the marginal income tax rate at different points of the income distribution. The MVPF of a tax cut for a particular group of people–usually a particular income bracket–tells us the welfare gain of the tax cut to that population per dollar of net cost to the government.

Consider a $1 tax cut to a particular income bracket.  Assume that individuals are pri- vately optimizing and that there are no indirect impacts of the policy change.

(a) What is the willingness to pay for this tax cut?

(b) What is the mechanical cost to the government?

(c) Which elasticity do we need to estimate to be able to calculate the fiscal externality?

Hendren and Sprung-Keyser (2020)1  draw on existing causal estimates to conclude that for every $1 of revenue raised from a 1993 tax increase on top earners in the US, the government lost $0.46 in revenue as a result of behavioral responses that reduced top earners’ taxable income.

(d) What was the net cost to the government of this tax change?  Hint:  Note that this is a tax increase rather than a tax cut.

(e) What is the implied MVPF of the marginal income tax rate change for top earners?

Now let’s consider a tax cut at the bottom of the income distribution.

Hendren and Sprung-Keyser (2020) estimate the fiscal externality from an increase in the Earned Income Tax Credit (EITC). When individuals increase their labor supply in response to the increase in this tax credit, they receive more benefits in the form of this credit (costing the government budget), but also use fewer alternative government benefits such as food stamps.

Hendren and Sprung-Keyser (2020) suggest that for every $1 of mechanical cost due to increased EITC benefits, the government spent $0.11 less on other benefits.

(f) What is the implied MVPF of an increase in the EITC?

(g) How does this value compare to the tax change for high earners? What does that imply about our social planner?

Hendren and Sprung-Keyser (2020) estimate that the fiscal externality from the Reagan tax cut of 1981 was − 1.51.

(h) What is the implied MVPF of this tax cut?

(i) What does it mean when an MVPF is negative?

2.2    Public Goods

The city of Sydney is considering building a new sports arena. Assume the city has two residents:  Benjamin and Hannah.  Sydney will fund the new sports area soley from the individual contributions of these residents.