Final Exam 2008 EC313: Public Economics: Taxation
INSTRUCTIONS FOR PROCTORS AND STUDENTS
Make sure you have all exam pages (4 pages NOT including the cover page).
Answer all questions in the booklets provided. Be sure to clearly indicate which question
you are answering. If any answers appear to be crossed (or scribbled) out, the answers
will not be marked.
Grade allocations provided on the exam are approximate. Total marks = 150.
Your professor will not answer questions related to the content of the exam. If you feel
that a question is unclear in any way, state what you believe the question means and then
present your answers. Grades will be allocated for both your interpretation of the
question and your answer. Similarly, if you think assumptions are required to form an
answer, state those assumptions and continue.
Reasonable interpretations and
assumptions will be give fair consideration.
Proctors cannot answer questions related to the content of the exam.
You are allowed to use a non-programmable calculator. Some figures are provided at the
end of the exam.
There are 3 sections (A, B, C). Read the instructions for each section carefully.
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Part A – Pick 2 of 3 questions in this section. Each question is worth 10 marks.
Provide a definition and explain each of the following concepts. Clearly label any
diagrams. Ensure you have discussed the concept’s role or importance in the study of
public economics. If you answer more than 2 questions, only the first 2 will be marked.
A.1. (10 marks) Natural Monopoly
A.2. (10 marks) Inverse Elasticity Rule
A.3. (10 marks) Factor Substitution Effects
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Final Exam 2008 EC313: Public Economics: Taxation
Part B –Pick 3 of 4 questions in this section. Each question is worth 20 marks.
Discuss the merits of the following statements. Are they true, false, or uncertain? To
receive full credit, your answer must be based on theory and/or empirical evidence,
demonstrate a clear understanding of concepts examined in this course, and acknowledge
important implications of any policies mentioned. Whenever possible and relevant, use
clearly labelled diagrams to clarify your explanation.
B.1. (20 marks) Suppose Jill earns $20,000 per year. Jill’s husband, Jack, stays at home
and cares for their daughter Jane. Another married couple, Bob and Bill, each earn
$10,000 (for a combined income of $20,000) and have no children. Since both families
have an income of $20,000, these families should be taxed the same amount.
B.2. (20 marks) The following is from Department of Finance, referring to policy
introduced in the 2008 Federal Budget:
How the Tax-Free Savings Account Will Work
• Starting in 2009, Canadian residents age 18 or older will be eligible to
contribute up to $5,000 annually to a TFSA, with unused room being
carried forward.
• Contributions will not be deductible.
• Capital gains and other investment income earned in a TFSA will not
be taxed.
• Withdrawals will be tax-free.
Since there will be no tax paid on the investment income in or withdrawals
from these accounts, Canadians will have more incentive to save… These
savings will help increase the funds available for business investment.
B.3. (20 marks)
The Universal Child Care Benefit was first proposed by the
Conservative Alliance as part of the 2006 election platform, as an alternative to a national
daycare program. A Liberal aide (Scott Reid) criticized the plan:
“Stephen Harper’s plan on child care, has nothing to do with child care…
Don’t give people 25 bucks [a week] to blow on beer and popcorn, give
them child care spaces that work.”
B.4. (20 marks) Studies suggest that the environmental and financial cost of recycling a
plastic bottle (generally handled by public institutions) is higher than the average retail
price of a bottle of water. We should therefore place a unit tax on all sales of bottled
water, for example at 10 cents per bottle. This would make society better off.
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Final Exam 2008 EC313: Public Economics: Taxation
Part C – Answer all questions. Each of the 2 questions are worth 35 marks. Show
your work. Treat each question separately unless otherwise stated.
C.1. Background:
In 1993, the Colombian government introduced an extensive social insurance system,
providing health insurance and public pension benefits to all workers in the formal sector.
Workers in the ‘underground economy’ (informal sector) and individuals not working
would not be eligible for the health or pension benefits. The social insurance system is
financed using a payroll tax, also introduced in 1993.
Suppose labour demand and supply in Columbia’s formal labour market are defined by
the equations:
LD = 800-100w, LS = -100 + 50w
noting that wages are paid in pesos.
C.1.a. (8 marks) Assume a payroll tax of 3 pesos is paid by employers and that workers
do not value the public health insurance or pensions. Use a partial equilibrium model of
the labour market to answer the following:
(i)
Show the effect of this tax on wages and employment in a diagram.
(ii)
Describe the incidence of the tax.
(iii) Find the excess burden caused by the tax.
C.1.b. (12 marks) Assume a payroll tax of 3 pesos is paid by employers and that workers
partially value the public health insurance or pensions. That is, to employees, access to
health insurance and pensions is worth 2 pesos per hour of work. Use a partial
equilibrium model of the labour market to answer the following:
(i)
Show the effect of this tax in a diagram.
(ii)
Describe the incidence of the tax.
(iii) Find the excess burden caused by the tax.
C.1.c. (10 marks) Suppose workers for construction companies are perfectly mobile
between the formal sector and informal (underground) sector. Using a simple general
equilibrium model, describe the excess burden associated with taxing labour in the formal
sector (and not taxing the informal sector) when
(i) workers do not value access to health insurance and pensions as in (a)
(ii) workers partially value these benefits (at 2 pesos as in (b)
Use well labelled diagrams in your answer. You do not have to calculate excess burden.
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Final Exam 2008 EC313: Public Economics: Taxation
C.2. Background:
Suppose Bob can earn $10 per hour working at a gas station. He has 12 hours a day
available to work, but really prefers spending that time watching the Amazing Race
(including re-runs). He also enjoys eating chips, which cost $1 per bag. He has no other
income available to him. Bob’s utility function is defined by
U(C,A) = C*A
where C represents the number of bags of chips and A represents the hours spent
watching the Amazing Race.
C.2.a. (5 marks) How many hours will Bob choose to work?
C.2.b. (10 marks) Suppose the government introduces a 10% income tax as a flat tax.
How much more or less will Bob choose to work in response? What is the value of tax
revenues collected?
C.2.c. (8 marks) Show your results from part (b) in a clearly labelled diagram. Explain
the separate roles of substitution and income effects related to the introduction of the flat
tax. Show the excess burden in the diagram (do not calculate excess burden).
C.2.d. (7 marks) Studies have suggested a flat tax is not an optimal way to structure
personal income taxes. In a diagram, show how an optimal personal income tax system
might affect Bob’s choice of work hours. (You do not have to calculate the resulting
hours of work.)
*******************END OF EXAM QUESTIONS ************************
Some numbers that may or may not be useful:
120/2 = 60
108/18 = 6
120/8 = 15
108/2 = 54
900/15 = 60
700/15 = 46 2/3
600/150 = 4
120/3 = 40
120/18 = 6 2/3
120/9 = 13 1/3
108/11 = 9.8
150/15 = 10
50/15 = 3 1/3
500/150 = 3 1/3
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120/10 = 12
132/18 = 7 1/3
120/12 = 10
108/10 = 10.8
900/50 = 18
700/50 = 14
450/150 = 3