Economics 314: Public Finance

Problem Set 2 and Practice Exam 2 Summer 2014

Submit Q1 to Q5 on Monday, July 21 for Grading (Problem Set 2)

Q1. Suppose the demand for gasoline is given by QD=20-3p. Assuming supply is perfectly
elastic and given by MC=2, find the following:
a) The equilibrium price and quantity
b) In the U.S., gasoline is taxed on a per gallon basis, and the tax is paid by suppliers. Suppose
the tax is $1 per gallon of gasoline. After the tax is imposed, what is the new equilibrium price
and quantity?
c) What is the tax burden on consumers and producers? How do these compare and why?
d) Calculate the deadweight loss of the tax.
e) Suppose the tax is increased from $1 to $2 per gallon. What is the extra deadweight loss
associated with this tax increase?
f) How does the deadweight loss of the tax increase from $1-$2 compare to the deadweight loss
from the tax increase from $0 to $1? Why is this case?

Q2. What is the theoretical justification for the Laffer curve? Basing your view on the empirical
evidence described in the text, should the United States raise or lower its tax rates in order to
increase tax revenues? Explain.

Q3. What is the difference in terms of efficiency between imposing a tax starting from the
welfare optimum, as compared to imposing the same tax starting from an already existing
distortion in the economy? Show in a figure and explain.

Q4. Bobs Bees is a small boutique honey manufacturer in Massachusetts. Bobs neighbor is
Jons Jams. The more honey Bob produces, the more jam Jon is able to produce; that is, there is a
positive production externality.
a) Suppose that the government of Massachusetts imposes a new tax on jam and honey
production. Will the deadweight loss of this tax be greater, smaller, or the same as if there were
no production externality? Explain.
b) How would your answer change if the production externality were negative (perhaps because
Bobs bees sting Jons jam -makers)?

Q5. The city of Johnstown decides to build a new stadium to attract a basketball team from the
city of Rosendale. One economic advisor suggests that the stadium should be financed by a 2-
year sales tax of 10%, while another advisor suggests that the stadium should be financed with a
20-year sales tax of 1%. Assume that the interest rate is zero. Which approach will yield a more
efficient outcome? Why?

Q6. Suppose that the government of Michconsin imposes a tax on cheese curd production. When
will the efficiency costs of the tax be greater, in the short run or in the long run, and why?

Q7. The government of Washlovia wants to impose a tax on clothes dryers. In East Washlovia
the demand elasticity for clothes dryers is 2.4 while in West Washlovia the demand elasticity
is 1.7. Where will the tax inefficiency be greater? Explain.

Q8. On a recent visit to Amsterdam, you noticed that houses facing the canals are tall, deep, and
extremely narrow. Your host tells you that this is a consequence of builders desires to avoid
taxes. Describe a tax system that would induce this kind of behavior.

Q9. You are a consultant to the government of Buttony. The government has decided to cut taxes
on either apples, bananas, or mangoes, and it wants your input on which fruit would be the best
choice for a tax cut. It provides you with the following information. What is your
recommendation, and why?

Fruits Unit Price Sales(000) Unit Tax Marginal tax
revenue (000
dollars per $1
extra tax)
Marginal
deadweight loss
(000 dollars per $1
extra tax)
Apples $1 100 $0.10 20 5
Bananas $2 100 $0.25 30 20
Mangoes $4 50 $0.15 10 20

Q10. Luxury goods often have much higher elasticities of demand than do goods purchased by a
broad base of people. Why, then, are governments more likely to tax luxuries than these staple
goods?

Q11. Consider a social insurance program that is financed by a payroll tax. How does the
incidence of this tax differ if the benefits of the insurance program are restricted to workers,
rather than if the benefits are available to all citizens? Under what circumstances will these
differences be particularly large?

Q12. Festwalia has two types of workers: low-skill workers, who earn $10 per hour, and high-
skill workers, who earn $20 per hour. The government of Festwalia currently imposes a 20%
proportional tax on all labor earnings. It is considering replacing this tax with a new, progressive
tax. The new tax system will raise the same total revenue as the original system, but it will do so
by taxing the high-skill workers at a rate above 20% and exempting the low-skill workers from
paying any tax at all. Will this new, progressive tax system be more or less efficient than the old,
proportional tax system?