BIRLA INSTITUTE OF TECHNOLOGY AND SCIENCE PILANI

HYDERABAD CAMPUS
Second Semester 2021-22
Public Finance: Theory and Policy (ECON F341)
Comprehensive Exam (Closed Book)
Date: 18/05/2022
Time: 3 hours Total Marks: 40

Q1 (a) Statutory and economic incidence of the tax will be borne by the firms/producers. (1M)

Same diagram as below except that minimum wage in the question is 5$, whereas in the figure it is 7.25$.
The producer/firm cannot lower the price to 4.5$ per hour (as per the question) since it is illegal. So full tax
burden is borne by the producer/firm. Firm pays an after tax wage of 6$ (as per the question). (1M)

(1M)

Q 1 (b)

If the tax is imposed on the consumer,

Price change to producers is ΔP

= (-3/ (4 + 3))*2 = -0.86 $ (1M)

Total price change to consumers is ΔP + tax = -0.86 + 2 = 1.14 $

Consumers bear higher burden of the tax. (1M) OR

If tax is imposed on the producer,

= (4/(4+3))*2 = 1.14 (1M)

Q2 (a) The new progressive tax system will be less efficient than the old proportional tax system. (1M)

Diagram or table below (2M)

Assumption: the poor and the rich have the same elasticity of income generation with respect to the tax rate
=> a percentage rise in the tax rate lowers taxable income by the same percentage amount for both groups.

Based on this assumption, it is more efficient to tax all individuals at an equal rate, rather than to exclude
some individuals from taxation and tax other individuals at a higher tax rate to make up for the lost revenues.
Large increase in Deadweight loss in case of progressive tax is because progressive tax imposed on a
smaller tax base. Higher the marginal tax rate, higher is the marginal deadweight loss. (1M)

Q2 (b)

Without tax, equilibrium condition is 240 – 6P = ‐60 + 4P

Equilibrium price P = 30
Equilibrium quantity Q = ‐60 + 4(30) = 60
(i) A tax levied on producers changes the supply function to Q = ‐60 + 4(P‐4) (1M)
New equilibrium condition 240 – 6P = ‐60 + 4P – 16
New equilibrium price P* = 31.6
New equilibrium quantity Q* = 240 – 6(31.6) = 50.4
Change in quantity associated with the tax= 60 – 50.4 = 9.6
Deadweight loss = 1/2*tax*change in quantity = ½*4*9.6 = 19.2 (1M)
(ii) When the tax is imposed on the consumers, new demand function Q = 240 – 6(P+4)
New equilibrium condition 240‐6P‐24 = ‐60 + 4P
New equilibrium price P** = 27.6
New equilibrium quantity Q** = ‐60 + 4(27.6) = 50.4
Deadweight loss = 1/2 * tax *change in quantity = 1/2 * 4 *9.6 = 19.2
Deadweight loss remains the same, whether the tax is imposed on the producers or consumers. (1M)

Q 3 (a) In the Ricardian model of public debt, Old care about welfare of their descendants. They increase
their bequests by a sufficient amount so that their heirs can pay the extra taxes due in future. So the
consumption levels of future generation doesn’t fall. Private individuals undo the intergenerational effects
of government debt policy so that tax and debt finance are essentially equivalent. This is Ricardian
equivalence. (2M)

To test the Ricardian hypothesis, we examine the historical relationship between private savings and
government deficit (as a % of GDP). (1M)

Q 3 (b) In the Neoclassical model of public debt, when capital is internationally mobile, the debt induced
rise in interest rate leads to an inflow of funds from abroad. This increases demand for domestic currency,
causing rupee to appreciate, thus increasing the relative price of Indian exports. Hence, net exports are
crowded out rather than private domestic investment. To the extent that higher interest rates attract foreign
investment, less crowding out occurs. But burden on future generations is roughly unchanged because of
the interest they must pay to foreigners. (2M)

To test the crowding out hypothesis, we examine the historical relationship between interest rate and
government deficit (as a % of GDP). (1M)

Q 4. The six criteria used by 15th Finance Commission for horizontal tax devolution are -

Income distance, population (2011 census), geographical area, forest and ecology, demographic
performance and tax effort. (3M)
The vertical imbalances have been worsening in recent years due to two main reasons –

 COVID pandemic resulting in shortfall in tax revenue and rising expenditure on social security,
education & health (1M)
 Share of surcharges and cess in Gross Tax Revenue of Centre has shot up. Centre does not need to
share revenue proceeds from Cess and surcharges with the states. (1M)

Q 5. Tax revenue in 2020 = 400*16 = 6400

Tax revenue in 2021 adjusted for inflation = 500 *18 / 1.15 = 7826.09

Change in tax revenue = (7826.09-6400/6400) * 100 = 22.28%

Change in real GDP = 3%

Tax Buoyancy = 22.28/3 = 7.43 (1M)

For Tax Elasticity, we assume that there is no change in tax rate.

Then, Tax revenue in 2021 adjusted for inflation = 400* 18 / 1.15 = 6260.87 (1M)

Change in tax revenue = (6260.87-6400/6400)*100 = -2.17%

Tax elasticity = -2.17/3 = -0.72 (1M)

Q 6. Peltzman Model argued that provision of free public education can actually lower educational
attainment in society through inducing choice of lower quality public schools over higher-quality private
schools.

Assumption: the more individuals spend, the higher quality education they can buy for their children

The public schools provide some fixed level of expenditure and thus of fixed quality E f. If parents want
education of higher quality than Ef, they should send their kids to private schools. By sending their children
to private school, however, parents forgo their entitlement to free public education for their children.

As a result, some parents who might desire higher quality education for their children decide not to use
private schools; they reduce their desired education to take advantage of free public education.

Explain diagram with respect to Families X, Y and Z.

Family X moves from bundle X to C. Family Y moves from bundle Y to C (crowding out).

Family Z choice remains intact at bundle Z, even after introduction of free public education.

If group Y is big enough relative to group X, total educational spending (and thus educational quality) would
fall for society as a whole when free public education is introduced. (2M)
 (2M)

Q7. (a) Coase Theorem states that when there are well defined property rights and zero transaction costs,
then private bargaining/negotiations between the party creating the externality and the party affected by the
externality can bring about the socially optimal market quantity. Government has a limited role, only to the
extent of establishing property rights. (1M)

Explain any two of the problems listed below: (2M)

Assignment problem: In many cases, it is impossible to assign blame for externalities to one specific entity.

Holdout problem: Shared ownership of property rights gives each owner power over all the others.

Free rider problem: When an investment has a personal cost but a common benefit, individuals will
underinvest.

Transaction costs/negotiating problem: Hard to negotiate when there are large numbers of individuals on
one or both sides of the negotiation.

Q 7 (b) Free market output is where demand = supply

2P – 240 = 1200 – 4P
P= 240, Q = 240 (1M)
SMB P = (1200-Q)/4
SMC P = (240+Q)/2 + 12
Socially optimal output is where SMB = SMC; Q*= 224 (1M)
Negative externality Overproduction by 240-224 = 16 units
Q 8. (a)

RACHEL MONICA PHOEBE

Rank Points Rank Points Rank Points
DAM 2 12 3 4 1 18
PARK 1 20 2 6 2 12
METRO 3 8 1 30 3 10

Under majority voting, park wins. Rachel wins. (1M)

Park vs. dam, park wins.

Park vs. metro, park wins.

Under plurality voting, park wins. Rachel wins. (1M)

Dam = 2+3+1 = 6

Park = 1+2+2 = 5 (lowest sum of ranks)

Metro = 3+1+3 = 7

Under point voting, metro wins. Monica wins. (1M)

Dam = 12+4+18 = 34

Park = 20+6+12 = 38

Metro = 8+30+10 = 48 (highest sum of points)

Q 8. (b) Monica is engaging in voting strategy by allocating a major proportion of her total points (3/4) to
the metro, thus manipulating the final outcome to be in her favour. (1M)

Majority voting is the best voting rule in the presence of voting strategy. (1M)

----------------