COLLEGE OF BUSINESS, HOSPITALITY AND TOURISM STUDIES

DEPARTMENT OF ECONOMICS, BANKING & FINANCE FIN702 PUBLIC FINANCE TRIMESTER 3 2011 TUTORIAL QUESTIONS 8 1. Define the following terms: a. Excess burden a loss of welfare above and beyond taxes collected. b. Equivalent variation a change in income that has the same effect on utility as a change in the price of commodity c. Lump sum taxes a tax whose value is independent of the individuals behavior. d. Theory of the second best in the presence of existing distortions, policies that in isolation would increase efficiency can decrease it and vice versa. e. Ramsey rule to minimize total excess burden, tax rates should be set so that the tax induced percentage reduction in the quantity demanded for each commodity is the same f. Inverse elasticity rule for goods that are unrelated in consumption, efficiency requires that tax rates be inversely proportional to elasticitys g. Vertical equity distributing tax burdens fairly across people with different abilities to pay h. Horizontal equity - people in equal positions should be treated equally i. User fee price paid by users of a government provided good or service 2. Which of the following is likely to impose a large excess burden?

a. A tax on land - The supply of land is fixed, or perfectly inelastic, so there is no excess burden because the lower price that sellers receive does not cause quantity supplied to fall. b. A tax of 24% on the use of cellular phones. - The use of cell phones is probably fairly price-elastic, which implies that the excess burden could be large. c. A subsidy for investment in high tech companies - It is possible that companies could identify themselves as high-tech in order to receive the subsidy. Thus, the supply is quite elastic, and there will be substantial excess burden. d. A tax on soda bought in a cup or glass but not bought in a bottle or can - Consumers and sellers will likely agree to avoid cups and glasses in order to avoid the tax. A tax that is easily avoided does not have much of an impact, except to create some inconvenience, and does not raise revenue. e. A 10cent tax on a deck of cards that contains no more than 54cards - Card companies can easily increase or decrease the number of cards in a pack, avoiding the tax and reducing the excess burden.

f. A tax on blueberries - There are many good substitutes for blueberries. Therefore, their demand is quite elastic, and a tax on them will have a substantial excess burden, relative to the size of revenues collected.
3. Suppose that your neighbor is willing to pay you $100 to do some home repairs for her. You would be willing to do the job for $80, so you strike a deal. Now suppose that the government levies a tax of $25 on all home repair transactions. You pack up your gear and leave your neighbors home, because it is no longer worthwhile for you to do the job. As a result of your leaving the job, you do not have to pay the $25 tax. Relate this scenario to the concept of excess burden.

Prior to the tax, you and your neighbor are both made better off by the trade. After the introduction of the tax, the work does not get done even though you would be willing to accept the wage that your neighbor is willing to pay. This loss of a potentially beneficial trade that is not compensated by an increase in tax revenue (in fact, no tax is collected) is exactly the idea of excess burden.
4. Iran subsidizes gasoline, leading to a price to consumers that is one-fifth the market price. Use Figure 15.6 to explain the efficiency implications of this policy.

If Iran subsidizes gasoline, the price of gasoline goes to (1-s)PG. Rectange ovur is the subsidy paid by the government, while osur is the increase in consumer surplus from the subsidy. The excess burden is svu, the amount of the subsidy that is paid but does not translate into consumer surplus.
Price

D D

PG

o (1-s)PG r

v u

5. In 2004, Congress r voted to subsidize the purchase of capital goods in the manufacturing sector. u Nonmanufacturing industries are not eligible for the subsidy. Discuss why this subsidy would lead to an inefficient allocation of capital between the manufacturing and nonmanufacturing sectors. (Hint:

Reinterpret the horizontal axis as measuring the total amount of capital in the economy, and the two curves as measuring the value of marginal product of capital in the respective sectors). Also show on your diagram the amount of excess burden generated by the manufacturing subsidy.

The horizontal distance OO measures the total amount of capital available in society. Any point along OO represents some allocation of capital between the manufacturing sector and the non-manufacturing sector. Assume that firms allocate capital between the two sectors to maximize total incomes. It follows that the value of the marginal product of capital is the same in both sectors. In the graph below, equilibrium occurs where OK* units of capital are devoted to the non-manufacturing sector and OK* units of capital are devoted to the manufacturing sector. Now assume that a subsidy is available for the purchase of capital goods in the manufacturing sector, but not in the non-manufacturing sector. The subsidy raises the rate of return on capital in the manufacturing sector to (1+s)VMP MANU and causes an increase in the allocation of capital to the manufacturing sector to OKS, along with a decrease in the allocation of capital to the non-manufacturing sector to OKS. The lost income to the nonmanufacturing sector is aced, while the income gained by the manufacturing sector is abde. The excess burden is triangle abc, the amount of the subsidy that comes from lost income in the non-manufacturing sector.
$ $

a VMP1 b (1+s)VMPMANU VMPMANU VMPNON-MANU e KS Capital used in the nonmanufacturing sector K* Capital used in the manufacturing sector c

(1+s)VMP2 VMP2

d O

6. In an effort to reduce alcohol consumption, the government is considering a $1tax on each gallon of liquor sold (the tax is levied on producers). Suppose that the supply curve for liquor is upward sloping and its equation is Q =30,000P (where Q is the number of gallons of liquor and P is the price per gallon). The demand curve for liquor is Q=500,000-20,000P.

a. Draw a sketch to illustrate the excess burden of the tax. Do calculations to find the excess burden. Show graphically the excess burden generated by the $1 unit tax. (Hint: compare the losses of both consumer and producer surplus to tax revenues.)

Before-tax equilibrium: P = $10 and Q = 300,000 After-tax equilibrium: P = $10.60 and Q = 288,000 Consumers pay $10.60 and producers receive $9.60.

Excess Burden = (12,000)($0.60) + (12,000)($0.40) = $6,000.

P Tax revenue S $10.60 $10 unit tax $9.60 Excess burden

D0 D1 288,000 300,000

b. Suppose that each gallon of liquor consumed generates a negative external cost of $0.50. How does this affect the excess burden associated with the unit tax on liquor?

If the negative external cost were equal to $1 per gallon, then a $1 tax would achieve an efficient allocation and would create no excess burden. With a negative external cost of $0.50 per gallon, there is still an excess burden associated with a $1 per gallon tax, but it is smaller since the efficient level of output in this market would be between 288,000 and 300,000.
7. Indicate whether each of the following statements is true, false, or uncertain, and explain why: a. A proportional tax on all commodities including leisure is equivalent to a lump sum tax - It

is true that a proportional tax on all commodities (including leisure) is equivalent to a lump sum tax.

b. Average cost pricing for a natural monopoly allows the enterprise to break even, but the outcome is efficient-- It is true that average cost pricing for a natural monopoly allows

the enterprise to break even, but the outcome is inefficient. c. Toms workplace provides free access to a fitness room; Jerrys does not. Horizontal equity requires that Tom be taxed on the value of having access to the fitness room - One notion of horizontal equity is that people in equal positions should be treated equally by the tax system. Under this traditional notion of horizontal equity, the fact that Toms workplace provides free access to a fitness room suggests this kind of compensation should be taxed; Jerry pays full taxes on his compensation while Tom does not. Another notion of horizontal equity relies on the utility definition of horizontal equity. This concept says that if two individuals have the same utility without taxes, they should have the same utility with taxes, and the taxes should not affect the utility ordering. One implication of the utility definition is that any existing tax structure does not violate the notion of horizontal equity if individuals are free to choose their activities and expenditures. If Tom and Jerry have free choice between the two different jobs (and identical preferences), then the net after-tax rewards (including amenities) must be the same at both jobs; otherwise there would be migration. In this case, the before-tax wage on Toms job adjusts for the fact that there is a fringe benefit.
8. Suppose that a town is considering a project to install new underground water pipes. Some of the costs are fixed in the sense that they do not increase with an increase in the amount of water consumed. For example, pipes deteriorate over time, independent of the volume of water flowing through them. Hence, it is impossible to pay for the investment in the pipes by charging consumers an amount based on the marginal cost of the water they consume. Under these circumstances, what might an efficient pricing system look like?

Efficiency generally requires setting price equal to MC, but doing so here would result in a price lower than the average cost, which would be unsustainable. In this case, the problem of paying for fixed costs could be solved by charging a price equal to MC and levying a lump sum tax to pay for the fixed costs associated with the pipes.