Public

Finance

Tools of
Positive
Analysis

Harvey S. Rosen

Department of Economics
Princeton University

Slide 1

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Tools of Positive Analysis

The impact of various government
policies on economic behavior.
The use of modern statistical tools
to study public policy issues.

Slide 2

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Role of Theory:
Example the effect of tax on labor
supply (1)

? Relationship between Income tax rates and

labor supply
? Increase in tax rates decrease in labor
supply
Tax rates changes, but so do other factors:
Non-labor income (give examples!)
Changing attitudes of people
therefore need to know independent effect
of changes in tax on labor supply
Slide 3

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Example: Tax and Labor Supply (2)

Theoretical explanation on the effect of
tax rate changes on labor supply:
$ w = wages per hour (price of leisure)
t = tax on wage income
net wage : $(1-t)w = $ w - tw

Slide 4

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Example: Tax and Labor Supply (3)

Wage = opportunity cost of leisure
The effect of tax rate changes on labor supply
can not be a priori determined, because
there is the:
Substitution Effect: Consume more leisure,
work less, because leisure is cheaper.
And another simultaneous effect:
Income Effect : Assuming leisure is a normal
good: less y; less leisure and more work
Slide 5

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Example: Tax and Labor Supply (4)

Total Effect:- Empirical Analysis
- Depends on which effect
dominates
- If income effect
dominates: .............
- If substitution effect
dominates: ...................
Slide 6

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Methods of Empirical
Analysis
Interview studies
Social and laboratory experiments
Econometric analysis
All attempts to measure both the
direction and size of the effect of
government policy changes on
behavior
Slide 7

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Interview Studies
1.
Interviews (could only get peoples
perception)
Experiments (social)
- sample selection problems
sample must be representative of the
population
- may react differently (people in the
sample)
Slide 8

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Laboratory Experiments

smaller scale
cheaper
more bias
artificial environment

Slide 9

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Econometric Studies (1)

L = 0 + 1 Wn + 2 A + 3 X1 + 4 X2 +
Where: L (hours work)
Wn (net wage = w tw)

1= 0 (Wn no impact on L)
1> 0 ( Wn L )
1< 0 ( Wn L )
Simplified model: L = 0 + 1 Wn +
fig. 2.1 page 27 (Rosen, 2005)
Slide 10

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Econometric Studies (2)

Pitfalls of Econometric Analysis:
Sub-sample of different people may have different
reactions to different situations.
Example: - Married women vs. Married men
- Young vs. Old
Parameters may change over time 1960s equation
result would be different than 1990s equation
result.
For regression equation to be reliable, must include
all relevant variables, e.g : non-labor income
Difficult to estimate/to regression

Slide 11

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Econometric Studies (3)

Pitfalls of Econometric Analysis:
Correct functional form of the
regression equation
Difficulties in measuring the variables
correctly
Simultaneity problems: w might affect
hours worked and simultaneously
hours worked affect wages
Slide 12

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