ECON 6010 2022 S2 Problem Set 4
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Problem Set 4 - Solutions
ECON 6010 2022 S2
1 Review questions
Indicate whether each statement is true, false, or uncertain, and give a brief explanation.
1. In countries with a progressive, stepwise linear income tax schedule, most people have the same average tax rate and marginal tax rate. False. Except for the lowest tax bracket, the average tax rate will be lower than the marginal tax rate.
2. The results from Kleven et al. (2014) support the idea that estimated elasticities will be bigger in response to larger changes in the tax rate. True. Kleven et al. (2014) find a population-wide elasticity estimate of 0. 12 for labor income when focusing on the largest tax reform studied (in 1987), but only an elasticity of 0. 02 when considering the smaller tax reforms of the 1990s and 2000s.
3. Third-party information reporting is a primary determinant of tax compliance. True. See, e.g., the statistics from the US that we presented in class as well as Kleven et al. (2011) .
4. The classic Allingham-Sandmo model predicts that higher tax rates increase tax evasion. Uncertain. Changes in the tax rate have both an income and subsitution effect, and these effects work in oppose directions. The income effect pushes toward less evasion while the substitution effect pushes toward higher evasion. The overall effect is uncertain.
2 Problems
2.1 Tax Evasion
You have data on consumption and reported incomes for wage and salary earners and for the self-employed. You find that wage and salary earners have consumption spending of 70 cents for each dollar of reported income. Self-employed people have consumption spending of 90 cents for each dollar of reported income. How much higher is true income for the self-employed people than reported income? What assumptions did you have to make to do the calculation?
Income for the self- employed is 28% higher than reported. Assumptions are those discussed in lecture for Pissarides and Weber (1989) .
2.2 Consumption Taxation
One of the primary production goods in the small fictional country of Waupaca is bread. The production chain is as follows. A farmer grows wheat, which is then sold to a miller to make flour. The miller sells the flour to the baker, who makes bread. The baker then sells the bread to consumers.
The table below gives the sale and purchase price for the series of sales necessary to make 10 loaves of bread (that is, 10 loaves of bread sell for $100).
Agent |
Purchase Price |
Sale Price |
Farmer |
$0 |
$20 |
Miller |
$20 |
$50 |
Baker |
$50 |
$100 |
(a) Waupaca has a 10% retail sales tax. What is the total tax owed? How much is
remitted by the farmer? The miller? The baker?
Total taxes owed = $10, all remitted by the baker.
(b) Why is retail often thought of as “the weakest link in the production and distribution chain?”
As Joel Slemrod and Jon Bakija note, consumers have no incentive to make sure retailers are remitting their sales tax, and retailers have no incentive to remit aside from the thread of audit.
(c) Waupaca decides to change from a 10% retail sales tax to a 10% value-added tax (VAT). What is the tax liability for the farmer under the VAT? What about for the miller and the baker? What is the total tax owed? How does it compare to part (a)?
Farmer owes $2; miller owes $3, baker owes $5. Total tax owed = $10, which is the same as in part (a) .
(d) The miller decides to be dishonest and only reports $40 in sales to the tax authority. How much tax do they remit? How does that change the tax liability for the honest farmer and baker?
The dishonest farmer would remit $2 in tax. The honest farmer’s liability is unchanged; the honest baker would now be responsible for $6 in tax liability.
(e) What is one method Waupaca could use to help increase compliance with its sales
tax if it switched to a VAT? Why does this method increase compliance?
Waupaca could implement the “invoice” method. With this method, each firm is liable for tax on its total sales, but it can also claim taxes already paid by its suppliers as a credit against the liability.
2022-09-19