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# Answers to Questions in Public Economics Chapters 20 to 34 Peter Abelson Chapter 20

4 5

## Introduction to Public Finance

The tax paid on \$60,000 would be (\$20,000 0.20) + (\$40,000 0.35) = \$18,000. The average tax rate would be 30 per cent. No, this is a progressive tax rate structure. The average tax rate rises with income. With an income of \$20,000, tax is \$3500 and the average tax rate is 17.5 per cent. With an income of \$30,000, tax is \$6000 and the average tax rate is 20.0 per cent. The marginal tax rate is always higher than the average tax rate.

## Chapter 21 Incidence of Taxation

6 (i) At equilibrium Qd = Qs. Before tax, equate demand and supply and obtain Qd = 50 4p = 30. The market clearing price is \$5. (ii) After a tax of \$4 per unit is imposed on suppliers, they still supply 30 units (supply is perfectly inelastic). Demand is unchanged. So consumers pay \$5 and purchase 30 units. But producers receive only \$1 after paying the tax. Producers bear all the costs because supply is completely inelastic. Suppose that the tax is levied on consumers: Qd = 50 4(Ps+4) = 30. It follows that 4Ps = 4, so Ps = 1. Pc = 5 (as before). (iii) The tax raises 30 \$4 = \$120 revenue. 7 (i) In equilibrium, Qd = Qs, 80 3Pd = 40 + Ps. But Pd = Ps. Therefore, the 4P = 40. The pre-tax price is \$10 and 50 units are supplied. (ii) Posttax, 80 3Pd = 40 + 1(P-2), where the tax is placed on the producer. The post-tax demand price is \$10.5 and the price that producers receive after tax is \$8.5. Consumers purchase 48.5 units. (iii) of the tax is paid by the producer given by Ps / T = \$1.50, while the consumer pays Pd / T = \$0.50 The tax paid is \$97.00 Consumers pay \$24.25. Producers pay \$72.75.

Peter Abelson

26/10/2013

(i) With no taxation, the present value (PV) of income = \$40,000 + \$40,000 / 1.05 = \$78,095.

The PV of consumption = \$30,000 + (10,000 1.05) / 1.05 + \$40,000 / 1.05 = \$78,095. With no tax on income, PV of Bruces consumption = PV of earnings (ii) (a) With tax of 20% on income

PV of income with no saving (consumption) = (\$40,000 0.8) + (\$40,000 0.8) / 1.05 = \$62,476 PV of consumption with saving = (\$40,000 0.8) \$10,000 + (\$40,000 0.8) / 1.05 + (\$10,000/1.05) + (\$10,000 0.05* 0.8)/1.05 = \$62,380 (b) With tax of 20% on consumption PV of consumption = (\$30,000 0.8) + (\$40,000 0.8) / 1.05 + (\$10,000 1.05 0.8) / 1.05 = \$62,476 (iii) (a) With low tax rates and a low rate of interest, a tax on income marginally discriminates against saving. (b) With a tax on consumption there is no discrimination against saving. 9 Showing by an example. Suppose that Qd = 100 4P and that Qs = -20 + 2P. Then if Qd = Qs, P = \$20 and Q = 20. Suppose that a tax of \$4 is imposed on consumers, Qd = 100 4(Ps+4). Solving for Qd = Qs, we find that Ps = \$17.33 and Q = 14.66. Ps is the price paid to suppliers. The consumer pays a price of \$21.33 including \$4 tax. Now suppose that a tax of \$4 is imposed on producers, Qs = -20 +2(Pd-4). Solving again for Qd = Qs, we find that Pd = \$21.33 and Q = 14.66. Pd is the price received by suppliers (and paid by consumers). However, the supplier receives \$17.33 after tax.

Peter Abelson

26/10/2013

Finally allow a tax (commission) of \$2 imposed on both consumers and producers. Qd = 100 4(Ps+2) and Qs = -20 + 2(Pd-2). Then if Qd = Qs, Ps = Pd = \$19.33 and Q =14.66. Note the quantity sold is unchanged. The exchange price is \$19.33, but after the \$2 tax is included, the consumer pays \$21.33 and the supplier receives \$17.33. Note: a similar same result applies if the commission is a percentage figure. In this case, if the tax is imposed on consumers, Qd = 100 4Ps (1+ r) where r is the commission rate. Alternatively the commission (r) can be split between the buyer and seller.

Chapter 22

## Taxation and Efficiency

Craig is willing to work 100 hours for \$40 per hour but will receive only \$24 per hour after tax. The change in labour (L / L) = (W / W) where W represents wage and is the ordinary supply elasticity. Craig therefore reduces his labour by 20 hours: (-20/100 = 0.5 -16/40). Total income tax paid is \$1280 (80 hours \$16). The total deadweight loss (DWL) is the area between the market wage of \$40 and the compensated labour supply curve. Substituting in the compensated supply elasticity of 0.7 that allows only for substitution effects, Craig would reduce his labour by 28 hours. Approximating with a linear labour supply curve, DWL = 0.5 (100-72) (40 24) = \$224. Alternatively using the standard equation for DWL along with a compensated elasticity of supply of 0.7, DWL = 0.5 100 \$40 0.7 (0.4)2 = \$224. This is 17.5 cents for each dollar of tax collected.

(i) The pre-tax price / quantity combination occurs when Qs = Qd, 6P = 30, P = \$5. Q = 50 2(5) = 40 units. The post-tax price / quantity combination is found by equating the new supply curve Qs = 20 + 4(P - t) with demand. Hence 20 + 4(P - 3) = 50 2P, 8 + 4P = 50 2P, 6P = 42, P = \$7. The post-tax price to consumers is \$7 and Q = 36. (ii) The pre-tax consumer price is \$5, the post-tax price is \$7. Consumers bear 2/3 or \$2 of the tax, and producers bear 1/3 or \$1 of the tax. (iii) The excess burden (DWL) for consumers is given by QP. Thus 0.5 x 4 x \$2 = \$4. The excess burden (DWL) for suppliers is 0.5 x 4 x \$1 = \$2. Total excess burden is \$6.

(i) Pre tax equilibrium is given by 12 = 50 6P; P = \$6 and Q = 12. (ii) After the tax is imposed, consumers pay the same price \$6, but producers receive only \$4. The producer bears the whole burden of the tax as the price received falls by the full amount of the tax. (iii) The government raises 12 x \$2 = \$24 of taxation.

Peter Abelson

26/10/2013

(iv) There is no deadweight loss because there is no change in quantity consumed. 7 The DWL for the fall in consumption is equal to 0.5(Q) P = 0.5(Q) T. Given the tax and the elasticity, Q = 12.5. Thus DWL = 0.5 x 12.5 x \$2 = \$12.5.

## Chapter 23 Optimal Taxation and Tax Reform

4 (i) With no import tax, if world price is \$3, local demand is 81 units, domestic supply is 56 units, and imports are 25 units. With tax of \$2, market clearing price is \$5, demand is 75 units, local supply is 60 units and imports are 15 units (ii) Government raises \$30 dollars in taxation revenue. (iii) The deadweight loss is reflected in the distortion to production and consumption (EB = PQ). Production is distorted (increased costs of supply) by 0.5 x \$2 x 4 = 4, and consumption is distorted by 0.5 x \$2 x 6 = 6. Total DWL = \$10. 5 (i) Before tax, QA1 = 50 2(10) = 30. After a unit tax of \$2 is imposed, QA = 50 2(12), hence QA2 = 26. QA = 4. (ii) The ratio of deadweight loss to revenue raised is equal to 0.5(2.0 x QA) / 2 x QA2. Hence the ratio equals 4/52 = 1/13 (iii) QB1 = 100 7P = 100 7(10) = 30 (iv) To minimise deadweight loss, the percentage reduction in the quantity of each commodity consumed must be the same. Hence QA / QA1 = QB / QB1. Thus, 4/30 = QB / 30. Therefore, QB = 4 and B2 = 26. If B2 = 26, then 26 = 100 7 (10 + t) = 30 7t ; t = \$0.57 approximately.

Chapter 24
4

## Public Sector Borrowing and Debt

At the start of the year, the public debt is A\$375 billion in A\$ currency plus A\$125 billion in foreign currencies at then applicable exchange rates. At the end of the year, the value of the A\$ has risen by 3% so the cost of the foreign debt in A\$s has fallen by 3 per cent and is now \$125m / 1.03 = \$121.4 billion. Thus the total nominal debt is now A\$496.4 billion. However, the real cost of this debt is \$496.4b / 1.02 = A\$486.6 billion in start of year prices. The real cost of the debt has fallen by \$13.4 billion. To reduce the debt by the same amount without any inflation, government would have needed to raise tax revenue by \$13.4 million.

Chapter 28
7

## Poverty and Inequality

Plotting the Lorenz curves (LC) below indicates shows that Group B is the most equal set of incomes. For all percentages of households, the LC for Group B is closer to the 45 degree line of equity than are the other LC curves. Group A is the more unequal as the LC for Group A is always furthest from the line of equity. The LC curves do not cross at any point.

Peter Abelson

26/10/2013

100

62 56

B C A

46

Percentage of income

28 26 16 12 8 4 0

45

25

50

75

100

Percentage of households

(i) Variance shows the extent of inequality in a country by measuring the square of the extent to which incomes diverge from the mean corrected for sample size. Using the formula in Equation 28.3, for country A the variance is 111,240 while for country B the variance is 124,450. Using this measure, country A has a slightly more equal distribution of income because incomes are closer to the mean than in country B. (ii) The coefficient of variation (CV) that normalises the variance on average income. Accordingly, the measure of inequality is not sensitive to the level of income. Using the formula in Equation 28.4, the CV for country A is 0.74 while the CV for country B is 0.61. By this measure, Country B has a more equal distribution of income. (iii) These results show that the degree of inequality depends on the measure being used. Any inferences from mathematical measures of inequality must take account of the attributes of that measure.

Using the GC in Equation 28.7 and taking Ballarat males (60, 70, 80). | yi-y | = (10+20) + (10+10) + 20+10) = 80. So GC = 80 / (2 9 70) = 0.0634. Using the same method for the other groups and for the combined male and females groups (with six members), we get the following GCs: Ballarat female Bendigo male Bendigo female All males All females 0.0952 0.351 0.386 0.275 0.267

This indicates that the: Ballarat Male GC > Ballarat female GC Bendigo Male GC > Bendigo female GC But combined male GC < combined female GC.

Peter Abelson

26/10/2013

Chapter 30
5

## Income Redistribution and Social Insurance

If Clare works 20 hours per month, she receives \$500 + 0.75 (20 x \$16) = \$740 per month. Clare loses \$4 of her grant for each hour of work, so she loses all her grant if she works 125 hours per month. Her gross income would then be 125 x \$16 = \$2000 per month. Working nearly full-time (125 hours a month), she has obtained an extra \$1260 per month. The figures below show the trade-offs between income and leisure with and without a grant. If Clare has a high marginal rate of substitution of income for leisure, the relevant part of the indifference curve is relatively vertical and Clare is likely to work even with a grant. If Clare has a low marginal rate of substitution of income for leisure, the indifference curve is more horizontal and Clare may not work if the grant is available. This is illustrated in the right hand figure.

Income

Income

I2

I1

## I1 I2 Leisure Leisure With grant

No grant

Chapter 32
4

Health

(i) Four visits per year at an expenditure of \$160. (ii) 8.5 visits per year at an expenditure of \$85. (iii) If the true cost is \$40 per visit, the deadweight loss is 0.5 (40-10) (8.5- 4) = \$67.5

Peter Abelson

26/10/2013