The Study of The Welfare Effect of The Income Tax and The Excise Tax

Spring 2013 Econ 567 Project #2 Wei Zhang & Qing Tian
The study of the

welfare effect of the
income tax and the
excise tax
Wei Zhang
Qing Tian
April 16, 2013
1
Table of Contents
I. Background and Introduction..3
II. Methodology..4
III. Model Setup and Results .5
1) Excise tax on single good..5
1.1) Excise tax on good 1........5
1.2) No tax imposed.....................6
2) Income tax on consumer...6
3) Excise tax on good 1 and good2...8
IV. Further Discussion....9
V. Conclusion...11
VI. Reference....12
VII. Appendix.......13
2
Background and Introduction
The debate between the income tax and the excise tax has always been a hot topic.
The excise tax and the income tax are used interchangeably within one country. The
income tax is collected directly on personal income. Adding an income tax will
decrease the disposable income and thus the budget constraint for the individual. The
excise tax will be charged on the price paid by consumers and thus creating a gap
between the price faced by consumer and the price face by producer. The tax revenue
is the price difference times the quantity of goods sold. However, which tax will
generate a higher utility for people while keeping the same tax revenue?
The objective of this project is to simulate a model using GAMS to examine the
welfare effect of adding an income tax and an excise tax under a one consumers
circumstance. Further, we provide some discussion as to how our model can be
extended to explore the effect of these two taxes under a community with identical
individuals.
We first examine our model under the one-consumer case intuitively with a graph.
Assume in a closed economy with two goods, good 1 and good 2. Good 1 are on the
horizontal axis and 2 are on the vertical axis. Also, assume the price of good 2 and
income are held constant. AB is the initial budget line. Q1 is the initial equilibrium.
We add a 50% excise tax on good 1. Then the new price will be twice than the old
price. So the new budget constraint will be AC. C is on the middle point of OB. Then
Q2 is the new tangent point between indifference curve and budget line.
Now, if we add an income tax on this individual, his or her personal income will
decrease and thus the budget line declines. The budget line will shift parallel inward
toward the origin because the prices of good 1 and good 2 are not changed. Q3 will be
the new equilibrium.
3
From the figure 1, we can see that Q3 is on a higher indifference curve than Q2.
Therefore, we reach a conclusion that the income tax is more preferable than the
excise tax in a one consumer circumstance.
Figure 1 The budget constraint curves and the consumers

indifference curves in a one-agent situation
Methodology
The relative effect on welfare of an excise tax and an income tax is compared in a
single-agent, two-good economy using computer modeling in GAMS. This model is
based on the argument made by Milton Friedman in his 1953 paper: The Welfare
Effects of an Income Tax and an Excise Tax. Our model supports his main conclusion
that with equal tax revenue, an income tax is superior to an excise tax. Using the same
set up, we also modified the model to examine how we could possibly fully reverse
the welfare loss of an excise tax by imposing tax on both goods outputs. Specifically,
the welfare of this economy under three policy scenarios will be analyzed:
(1) A sudden excise tax imposed by government on good 1; no income tax.
(2) Income tax imposed on consumer producing the same tax revenue as in (1); no
excise tax.
(3) Excise tax on both good 1 and good 2 producing the same tax revenue as in (1);
no income tax.
4
General Model Setup and Results
Assume a closed economy consists of a single consumer and the production of two
goods. The preferences of the consumer satisfy the axioms of consumer choice, and it
can be represented with the following Cobb-Douglas utility function:
U = 1 21 ;
with C1 and C2 represents the consumption of good 1 and good 2.
Also, the consumer subjects to budget constraint:
Y = 1 1 + 2 2;
with p1 and p2 represents the pre-tax price of good 1 and good2. For simplicity, we
assume that the pre-tax price of good 1 and 2 are equal, perfectly inelastic and
normalized to 1: p1=p2=1.
We also assume that the tax revenue collected by government is used to buyback the
leftover production after consumption of private sector. In addition, for simplicity, we
assume the government is keeping the tax revenue constant, i.e. government is not
paying tax for buying goods, the price it faces is always the same.
1.1) Situation (1) Excise tax on good 1, no income tax:
1.A. Parameters and Initial Values Assigned.

Table1. Parameters of good 1 excise tax model
Name Description Initial Value
Alpha Shift parameter in utility 2.89[1]
Beta Share parameter in utility 0.5[2]
Y Income (budget constraint) 100
P1 Price of good 1 faced by 1/(1-t)[3]
consumer
P2 Price of good 2 faced by 1
consumer
U0 Initial utility level 100
C01 Initial consumption of 30[4]
good 1
C02 Initial consumption of 40
good 2
T tax rate 50%
5
Note: [1] Alpha is calculated (by GAMS) using the equation: Alpha = U0/
(01 011 ). The level of alpha does not affect the conclusion of
our model.
[2] Beta is 0.5 is assumed for simplicity, as well as the same pre-tax price
(price facing supplier) of both goods.
[3] Price facing consumer*(1-t) = Price facing supplier =1.
[4] Initial consumptions of good1 and good 2 are constructed so that they
satisfy the budget constraint. It only provides the GAMS with a start point to search
for solution and their levels do not affect the conclusion of our model.
1.B. Variables and Equations for GAMS
U: Utility level.
C1: Consumption of good 1.
R: Tax revenue.
1. Utility Function: U = alpha 1 21 .

2. Budget Constraint: Y = 1 1 + 2 2 .
3. Tax Revenue collected: R = t 1 1 .
We use GAMS to maximize utility, i.e. objective utility function 1; subjected to
budget constraint (function 2). We also want GAMS to calculate the excise tax
revenue collected by government under the maximized utility condition, given the
tax rate t.
1.C. Results Summary (for full output, please refer to appendix)

Table 2. Utility Maximization Results of one good excise tax model
Variable Solution value
U 102.062
C1 25
C2 50
R 25
1.2) No tax:
Under the same utility function (alpha and beta calculated in 1.1)), but with no tax
imposed by government, the same program was ran to look at the maximized utility
under no tax condition. Results are presented in the following table:
6
Table 3. Utility Maximization Results under No Tax condition.

U 144.500
C1 50
C2 50
Without tax, under the same budget constraint and utility function, the maximum
utility level is 144.500; while with tax imposed on a single good, the maximum utility
is 102.062. There is a welfare loss due to the imposition of tax.
2) Situation (2) Income tax on consumer
2.A. Parameters and Initial Values
Table 4. Parameters of Income Tax Model

Alpha Shift parameter in utility 2.89
Beta Share parameter in utility 0.5
Y Income (budget constraint) 100-R[5]
consumer
consumer
U0 Initial utility level 100
C01 Initial consumption of 35[6]
good 1
C02 Initial consumption of 40
good 2
R tax revenue 25[7]
Note: [5]. Income tax imposed on consumer leads to an equal reduction in the amount
of budget constraint for consumption.
[6]. Initial consumption of good1 and good 2 are constructed so that they
satisfy the new budget constraint and new prices faced by consumer.
[7]. Tax revenue of income tax should equal to tax revenue of excise tax from
situation (1).
U: Utility level.
7


We use GAMS to maximize utility of consumer, subjected to the new budget
constraint (reduced by the amount of income tax revenue). Also note that since
there is no excise tax, the price faced by consumer (P1 and P2) equals the price
faced by supplier (pre-tax price p1 and p2). P1=P2=1.
2.C. Results summary (for full output, please refer to appendix)

Table 5. Results of Income Tax Model

U 108.375
C1 37.5
C2 35.5
Now we can compare the utility maximization results of situation (1)-single excise tax
on good1 and situation (2)-income tax on consumer. When we assume the same
consumer preference (the same utility function in terms of alpha and beta) and the
same tax revenue collected, the maximized utility for single excise tax situation is
102.062; while for income tax situation, it is 108.375. Thus there is a larger social
welfare loss when excise tax is imposed on a single output comparing to the same tax
imposed on consumer income.
3) Situation (3) excise tax on good 1 and good2
3.A. Parameters and Initial Values

Table 6. Parameters of Two-Excise Tax Model
Alpha Shift parameter in utility 2.89
Beta Share parameter in utility 0.5
Y Income (budget constraint) 100[8]
R tax revenue 25[9]
Note: [8]. Since there is no income tax, the budget constraint is restored to the original
level.
8
[9]. The total tax revenue collected from good 1 and good 2 should equal to tax
revenue in situation (1) and (2). This will be reflected in the tax revenue
equation discussed below.
U: Utility level.
P1: Price of good 1.
P2: Price of good2.
t1: tax rate on good 1.
t2: tax rate on good 2.

3. Tax Revenue: R = t (1 1 + 2 2 ).
4. Price of good 1: P1 = 1/(1 t1)
5. Price of good 2: P2 = 1/(1 t2)
We use GAMS to maximize utility of consumer, subjected to both the budget
constraint and the constraint that under t1 and t2, the total tax revenue collected
from good 1 and good 2 should equal income tax revenue in previous cases. Price
faced by consumer for good 1 is determined by t1; price faced by consumer for
good 2 is determined by t2.
3.C. Results summary (for full output, please refer to appendix)
Table 7. Results of Two Excise Tax model
Variable Solution Value
U 108.375
C1 37.5
C2 37.5
P1 1.333
P2 1.333
t1 25%
t2 25%
9
From this result, when excise tax is imposed on both outputs no income tax, the
maximized utility condition is achieved when C1=C2 and t1=t2, which makes
intuitive sense given the form of the utility function. Also, the maximum utility level
under this two excise tax condition is now 108.375, which equals that of the income
tax situation. The social welfare loss of excise tax is partially restored (to the level
equal to that of the income tax situation) when tax revenue is evenly extracted from
both outputs.
Further Discussion
The analysis applied to one consumer is adequate to say that the income tax is more
preferable than the excise tax. However, the interpretation is not sufficient when we
apply it to the community level. Assume we have a community with identical
individuals who have same income and tastes. Also, we need to take into account of
the technical possibilities. GH is the production possibility frontier. AB is the budget
constraint and Q1 is the initial consumption equilibrium. It is at the situation when the
rate of substitution in consumption is equal to the rate of substitution in purchase and
in production. If the income taxes collected are giving back to individuals as a per
capita subsidy, then Q1 in figure 2 remains unchanged. If the revenue collected is used
to produce other good, say good 3, if we fix the amount of good 3 produced, the effect
of an income tax and an excise tax will be the same because the production possibility
frontier depends on the amount of good 3 not how the tax revenue is collected.
When the excise tax is imposed, there is a difference between the price paid by
consumers and price sold by producers. So the new equilibrium needs to be
determined by not only the consumption indifference curve but also by the production
possibility frontier. Then the new equilibrium will be on a lower indifference curve.
From the figure 2, we can see that Q4 is lower than Q1. Therefore, similar to the one
consumer scenario, at full competitive equilibrium, the income tax is more preferable
than the excise tax.
However, if the equilibrium is at Q4, say some monopoly exists, imposing an excise
10
tax on good 1 will converge to the price level between consumers and producers, and
thus reach the equilibrium at Q1. That is, in this case, the excise tax is superior to the
income tax. Further discussion is needed to validate this proof using more sophisticate
programming in the future.
Figure 2. The production possibility frontiers and indifference curves

in a community with identical individuals
Conclusion
By using GAMS, we simulated three scenarios of the effect of the income tax and the
excise tax on the welfare in a single agent economy. When collecting the same
amount of tax revenue, the income tax is superior to a single excise tax in terms of
maximized utility for consumer. This conclusion holds under the situation when the
excise tax is only imposed on one good. When the excise tax is collected equally on
two goods, then the welfare loss through the excise tax can be restored fully.
However, when consider the model on a community basis with identical individuals;
the proof may need further explanation. The income tax may not always be superior
to the excise tax. When the economy starts from the full competitive equilibrium, the
income tax will generate higher utility. On the other hand, if the initial starting point is
not at the full competitive equilibrium, the income tax may not give the higher
welfare. It would be interesting to further extend our model and discuss the effect of
two types of taxes on social welfare at the community level.
11
Reference
Gilbert, J., Tower, E. An Introduction to GAMS Modeling for International Trade

Theory and Policy.
Friedman, M. The Welfare Effects of an Income Tax and an Excise Tax. Journal of
Political Economy Vol. 60, No. 1 (Feb., 1952), pp. 25-33
12
Appendix: GAMS outputs for three policy scenarios:
Situation (1) Exercise tax on good 1:

GAMS Rev 240 WEX-WEI 24.0.2 x86_64/MS Windows 04/14/13 16:55:20 Page 1
General Algebraic Modeling System
Compilation
1 *Situation 1 government suddenly impose an exercise tax on goods 1

2
3 *Define the indexes for the problems
4 SET I GOODS /1,2/;
5
6 *Create names for parameters
7 PARAMETERS
8 ALPHA Shift parameter in utility
9 BETA(I) Share parameters in utility
10 Y Income (Budget Constraint)
11 P(I) Price of goods faced by consumer
12 U0 Initial utility level
13 C0(I) Initial Consumption level
14 t tax rate;
15
16 *Assign values to tax rate
17 t=0.5;
18 P('1')=1/(1-t);
19 P ('2')=1;
20 Y=100;
21 U0=Y;
22 C0('1')=30;
23 C0('2')=40;
24 BETA(I)=1/2;
25 ALPHA=U0/PROD(I,C0(I)**BETA(I));
26
27 *Create names for variables
28 VARIABLES
29 U Utility level
30 C(I) Consumption levels
31 R Tax revenue;
32
33 *Assign initial values to variables, and set lower bounds
34 U.L=U0;
35 C.L(I)=C0(I);
36 C.LO(I)=0;
13
37 R.L=10;
38
39 *Create names for equations
40 EQUATIONS
41 UTILITY Utility Function
42 BUDGET Budget Constraint
43 TAX Tax Revenue;
44
45 *Define equations
46 UTILITY..U=E=ALPHA*PROD(I,C(I)**BETA(I));
47 BUDGET..Y=E=SUM(I,C(I)*P(I));
48 TAX..R=E=t*P('1')*C('1');
49
50 *Define the model and solve
51 MODEL UMAX1 /ALL/;
52 SOLVE UMAX1 USING NLP MAXIMIZING U;
53
COMPILATION TIME = 0.000 SECONDS 3 Mb WEX240-240 Feb 14, 2013
14
Equation Listing SOLVE UMAX1 Using NLP From line 52
---- UTILITY =E= Utility Function
UTILITY.. U - (1.66666666666667)*C(1) - (1.25)*C(2) =E= 0 ; (LHS = 0)
---- BUDGET =E= Budget Constraint
BUDGET.. - 2*C(1) - C(2) =E= -100 ; (LHS = -100)
---- TAX =E= Tax Revenue
TAX.. - C(1) + R =E= 0 ; (LHS = -20, INFES = 20 ****)
15
Column Listing SOLVE UMAX1 Using NLP From line 52
---- U Utility level
U
(.LO, .L, .UP, .M = -INF, 100, +INF, 0)
1 UTILITY
---- C Consumption levels
C(1)
(.LO, .L, .UP, .M = 0, 30, +INF, 0)
(-1.6667) UTILITY
-2 BUDGET
-1 TAX
C(2)
(.LO, .L, .UP, .M = 0, 40, +INF, 0)
(-1.25) UTILITY
-1 BUDGET
---- R Tax revenue
R
(.LO, .L, .UP, .M = -INF, 10, +INF, 0)
1 TAX
16
Model Statistics SOLVE UMAX1 Using NLP From line 52
MODEL STATISTICS
BLOCKS OF EQUATIONS 3 SINGLE EQUATIONS 3

BLOCKS OF VARIABLES 3 SINGLE VARIABLES 4
NON ZERO ELEMENTS 7 NON LINEAR N-Z 2
DERIVATIVE POOL 10 CONSTANT POOL 17
CODE LENGTH 11
GENERATION TIME = 0.000 SECONDS 4 Mb WEX240-240 Feb 14, 2013
EXECUTION TIME = 0.000 SECONDS 4 Mb WEX240-240 Feb 14, 2013
17
Solution Report SOLVE UMAX1 Using NLP From line 52
SOLVE SUMMARY
MODEL UMAX1 OBJECTIVE U

TYPE NLP DIRECTION MAXIMIZE
SOLVER CONOPT FROM LINE 52
**** SOLVER STATUS 1 Normal Completion

**** MODEL STATUS 2 Locally Optimal
**** OBJECTIVE VALUE 102.0621
RESOURCE USAGE, LIMIT 0.047 1000.000

ITERATION COUNT, LIMIT 8 2000000000
EVALUATION ERRORS 0 0
CONOPT 3 Feb 14, 2013 24.0.2 WEX 38380.38394 WEI x86_64/MS Windows
CONOPT3 version 3.15I

Copyright (C) ARKI Consulting and Development A/S
Bagsvaerdvej 246 A
DK-2880 Bagsvaerd, Denmark
The model has 4 variables and 3 constraints

with 7 Jacobian elements, 2 of which are nonlinear.
The Hessian of the Lagrangian has 2 elements on the diagonal,
1 elements below the diagonal, and 2 nonlinear variables.
** Optimal solution. Reduced gradient less than tolerance.
CONOPT time Total 0.038 seconds

of which: Function evaluations 0.005 = 13.2%
1st Derivative evaluations 0.000 = 0.0%
LOWER LEVEL UPPER MARGINAL
---- EQU UTILITY . . . 1.000

---- EQU BUDGET -100.000 -100.000 -100.000 -1.021
18
---- EQU TAX . . . EPS
UTILITY Utility Function

BUDGET Budget Constraint
TAX Tax Revenue
---- VAR U -INF 102.062 +INF .
U Utility level
---- VAR C Consumption levels
1 . 25.000 +INF EPS

2 . 50.000 +INF .
---- VAR R -INF 25.000 +INF .
R Tax revenue
**** REPORT SUMMARY : 0 NONOPT

0 INFEASIBLE
0 UNBOUNDED
0 ERRORS
USER: GAMS Development Corporation, Washington, DC G871201/0000CA-ANY

Free Demo, 202-342-0180, sales@gams.com, www.gams.com DC0000
**** FILE SUMMARY
Input C:\Users\Wei Zhang\Documents\gamsdir\projdir\Untitled_2.gms

Output C:\Users\Wei Zhang\Documents\gamsdir\projdir\Untitled_2.lst
19
Situation (2) Income tax:

Compilation
1 *Situation 3 government suddenly impose an incom tax

2
5
7 PARAMETERS
9 BETA(I) Share parameters in utility
11 P(I) Price of goods faced by consumer
14 R Tax revenue same as tax revenue in situation 2
;
15
17 P(I)=1;
18 R=25;
19 Y=100-R;
20 U0=Y;
21 C0('1')=35;
22 C0('2')=40;
23 BETA(I)=1/2;
24 ALPHA=2.89;
25
27 VARIABLES
28 U Utility level
29 C(I) Consumption levels;
30
31
33 U.L=U0;
34 C.L(I)=C0(I);
35 C.LO(I)=0;
36
20
38 EQUATIONS
40 BUDGET Budget Constraint;
41
43 UTILITY..U=E=ALPHA*PROD(I,C(I)**BETA(I));
45
21
UTILITY.. U - (1.54476997825381)*C(1) - (1.35167373097209)*C(2) =E= 0 ;
(LHS = -33.1338984777669, INFES = 33.1338984777669 ****)
BUDGET.. - C(1) - C(2) =E= -75 ; (LHS = -75)
22
U
(.LO, .L, .UP, .M = -INF, 75, +INF, 0)
1 UTILITY
C(1)
(.LO, .L, .UP, .M = 0, 35, +INF, 0)
(-1.5448) UTILITY
-1 BUDGET
C(2)
(.LO, .L, .UP, .M = 0, 40, +INF, 0)
(-1.3517) UTILITY
-1 BUDGET
23
MODEL STATISTICS

CODE LENGTH 11
24
SOLVE SUMMARY




Bagsvaerdvej 246 A


---- EQU UTILITY . . . 1.000

---- EQU BUDGET -75.000 -75.000 -75.000 -1.445
25

---- VAR U -INF 108.375 +INF .
U Utility level
1 . 37.500 +INF .
2 . 37.500 +INF EPS

0 INFEASIBLE
0 UNBOUNDED
0 ERRORS

**** FILE SUMMARY

26
Situation (3) Exercise tax on both good 1 and good 2:
Compilation
1 *Situation 3 government impose equal excise tax on two goods to achieve ta

rgeted tax revenue
2
5
7 PARAMETERS
9 BETA Share parameters in utility
13 P0(I) Initial Price of goods faced by consumer
14 R Tax revenue same as tax revenue in situation 2
;
15
16
18 R=25;
19 Y=100;
20 C0(I)=30;
21 P0(I)=1.33;
22 BETA=1/2;
23 ALPHA=2.89;
24
25
27 VARIABLES
28 U Utility level
29 C(I) Consumption levels
30 t(I) tax rate
31 P(I) Price of goods faced by consumer;
32
34 C.LO(I)=0;
35
27

37 EQUATIONS
39 BUDGET Budget Constraint
40 TAX Total Tax Revenue on two goods equals R
41 PRICE1 Price of good 1
42 PRICE2 Price of good 2
43 Price3 Price equals;
44
46 UTILITY..U=E=ALPHA*PROD(I,C(I)**BETA);
47 PRICE1..P('1')=E=1/(1-t('1'));
48 PRICE2..P('2')=E=1/(1-t('2'));
49 PRICE3..P('1')=E=P('2');
51 TAX..R=E=SUM(I,t(I)*P(I)*C(I));
52
53
54
28
UTILITY.. U + (0)*C(1) + (0)*C(2) =E= 0 ; (LHS = 0)
BUDGET.. (0)*C(1) + (0)*C(2) + (0)*P(1) + (0)*P(2) =E= -100 ;
(LHS = 0, INFES = 100 ****)
---- TAX =E= Total Tax Revenue on two goods equals R
TAX.. (0)*C(1) + (0)*C(2) + (0)*t(1) + (0)*t(2) + (0)*P(1) + (0)*P(2) =E= -25 ;
(LHS = 0, INFES = 25 ****)
---- PRICE1 =E= Price of good 1
PRICE1.. - (1)*t(1) + P(1) =E= 0 ; (LHS = -1, INFES = 1 ****)
---- PRICE2 =E= Price of good 2
PRICE2.. - (1)*t(2) + P(2) =E= 0 ; (LHS = -1, INFES = 1 ****)
---- Price3 =E= Price equals
Price3.. P(1) - P(2) =E= 0 ; (LHS = 0)
29
U
(.LO, .L, .UP, .M = -INF, 0, +INF, 0)
1 UTILITY
C(1)
(.LO, .L, .UP, .M = 0, 0, +INF, 0)
(0) UTILITY
(0) BUDGET
(0) TAX
C(2)
(.LO, .L, .UP, .M = 0, 0, +INF, 0)
(0) UTILITY
(0) BUDGET
(0) TAX
---- t tax rate
t(1)
(.LO, .L, .UP, .M = -INF, 0, +INF, 0)
(0) TAX
(-1) PRICE1
t(2)
(.LO, .L, .UP, .M = -INF, 0, +INF, 0)
(0) TAX
(-1) PRICE2
---- P Price of goods faced by consumer
P(1)
(.LO, .L, .UP, .M = -INF, 0, +INF, 0)
30
(0) BUDGET
(0) TAX
1 PRICE1
1 Price3
P(2)
(.LO, .L, .UP, .M = -INF, 0, +INF, 0)
(0) BUDGET
(0) TAX
1 PRICE2
-1 Price3
31
MODEL STATISTICS

CODE LENGTH 43
32
SOLVE SUMMARY




Bagsvaerdvej 246 A

** Warning ** The number of nonlinear derivatives equal to zero

in the initial point is large (= 63 percent).
A better initial point will probably help the
optimization.

33
---- EQU UTILITY . . . 1.000

---- EQU BUDGET -100.000 -100.000 -100.000 -1.445
---- EQU TAX -25.000 -25.000 -25.000 1.445
---- EQU PRICE1 . . . -40.641
---- EQU PRICE2 . . . -40.641
---- EQU Price3 . . . EPS

TAX Total Tax Revenue on two goods equals R
PRICE1 Price of good 1
PRICE2 Price of good 2
Price3 Price equals
---- VAR U -INF 108.375 +INF .
U Utility level
1 . 37.500 +INF EPS

2 . 37.500 +INF .
---- VAR t tax rate
1 -INF 0.250 +INF .

2 -INF 0.250 +INF .
---- VAR P Price of goods faced by consumer
1 -INF 1.333 +INF .

2 -INF 1.333 +INF .
34

0 INFEASIBLE
0 UNBOUNDED
0 ERRORS

**** FILE SUMMARY

35

The Study of The Welfare Effect of The Income Tax and The Excise Tax

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Spring 2013 Econ 567 Project #2 Wei Zhang & Qing Tian

The study of the

I. Background and Introduction..3

III. Model Setup and Results .5

1) Excise tax on single good..5

1.1) Excise tax on good 1........5

1.2) No tax imposed.....................6

2) Income tax on consumer...6

3) Excise tax on good 1 and good2...8

IV. Further Discussion....9

Background and Introduction

Figure 1 The budget constraint curves and the consumers

General Model Setup and Results

1.A. Parameters and Initial Values Assigned.

1.B. Variables and Equations for GAMS

1. Utility Function: U = alpha 1 21 .

1.C. Results Summary (for full output, please refer to appendix)

Table 3. Utility Maximization Results under No Tax condition.

2) Situation (2) Income tax on consumer

2.A. Parameters and Initial Values

Table 4. Parameters of Income Tax Model

2.B. Variables and Equations for GAMS

C1: Consumption of good 1.

1. Utility Function: U = alpha 1 21 .

2.C. Results summary (for full output, please refer to appendix)

Variable Solution value

3) Situation (3) excise tax on good 1 and good2

3.A. Parameters and Initial Values

3.B. Variables and Equations for GAMS

1. Utility Function: U = alpha 1 21 .

Figure 2. The production possibility frontiers and indifference curves

Gilbert, J., Tower, E. An Introduction to GAMS Modeling for International Trade

Appendix: GAMS outputs for three policy scenarios:

Situation (1) Exercise tax on good 1:

1 *Situation 1 government suddenly impose an exercise tax on goods 1

COMPILATION TIME = 0.000 SECONDS 3 Mb WEX240-240 Feb 14, 2013

---- UTILITY =E= Utility Function

UTILITY.. U - (1.66666666666667)*C(1) - (1.25)*C(2) =E= 0 ; (LHS = 0)

---- BUDGET =E= Budget Constraint

BUDGET.. - 2*C(1) - C(2) =E= -100 ; (LHS = -100)

---- TAX =E= Tax Revenue

TAX.. - C(1) + R =E= 0 ; (LHS = -20, INFES = 20 ****)

---- U Utility level

---- C Consumption levels

---- R Tax revenue

BLOCKS OF EQUATIONS 3 SINGLE EQUATIONS 3

GENERATION TIME = 0.000 SECONDS 4 Mb WEX240-240 Feb 14, 2013

EXECUTION TIME = 0.000 SECONDS 4 Mb WEX240-240 Feb 14, 2013

MODEL UMAX1 OBJECTIVE U

**** SOLVER STATUS 1 Normal Completion

RESOURCE USAGE, LIMIT 0.047 1000.000

CONOPT3 version 3.15I

The model has 4 variables and 3 constraints

** Optimal solution. Reduced gradient less than tolerance.

CONOPT time Total 0.038 seconds

LOWER LEVEL UPPER MARGINAL

---- EQU UTILITY . . . 1.000

---- EQU TAX . . . EPS

UTILITY Utility Function

LOWER LEVEL UPPER MARGINAL

---- VAR U -INF 102.062 +INF .

---- VAR C Consumption levels

LOWER LEVEL UPPER MARGINAL

UTILITY.. U - (1.66666666666667)C(1) - (1.25)C(2) =E= 0 ; (LHS = 0)

UTILITY.. U - (1.54476997825381)C(1) - (1.35167373097209)C(2) =E= 0 ;

UTILITY.. U + (0)C(1) + (0)C(2) =E= 0 ; (LHS = 0)

BUDGET.. (0)C(1) + (0)C(2) + (0)P(1) + (0)P(2) =E= -100 ;

TAX.. (0)C(1) + (0)C(2) + (0)t(1) + (0)t(2) + (0)P(1) + (0)P(2) =E= -25 ;