Econ 132

Fall 2021
Juliana Londoño-Vélez

Midterm

October 26

Student Name:

Student ID:

• Closed book/notes exam. No laptops, phones, tablets, or any other electronic device
allowed.

• Write your answers clearly and in dark ink so that your responses are legible. No
pencils, except for graphs.

• You must submit your solutions using the exam packet provided.

• This exam contains a total of 30 points.

Do NOT open this test until instructed to do so.

1 True/False/Uncertain Statements [14 points]
Determine whether each statement is true, false, or uncertain and explain why. Explain your
answer fully based on what was discussed in class. All the credit is based on the explanation.
Answers with no explanation will receive no points. [2 points per question]

(a) The Pareto coefficient a is 1.5 in the United States and 3 in Denmark, indicating income
inequality is higher in the United States than in Denmark. If the elasticity of taxable
income for high-income earners is 1 in both countries, then the optimal top income tax
rate is 40% in the United States and 25% in Denmark.

TRUE: The optimal top income tax rate is ⌧ = 1/(1+a·e). If e = 1, then ⌧ = 1/(1+a·e) =
1/(1 + 1.5 ⇥ 1) =40% in the US and ⌧ = 1/(1 + a · e) = 1/(1 + 1.5 ⇥ 3) =25% in Denmark.

(b) The static labor supply model max u(c, l) subject to c = wl + R explains well how labor
force participation of single women has evolved in the US since the 1970s.

UNCERTAIN. The participation gap between single women with and without children
closed between the early 1990s and the early 2000s. During this decade, the US reformed
its transfer system and changed from welfare to workfare. In principle, the shift from
traditional welfare programs to the EITC should have encouraged employment of single
mothers. However, in class (Lecture on labor supply and taxes, slides 22+) we learned
from Kleven that the increase in labor force participation for single mothers may not have
been solely due to the EITC. Instead other factors may have also influenced labor force
participation (welfare reform, booming economy, and changing social norms).

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(c) Last month, top Democrats released legislation that would raise taxes by $2.9 trillion.
The proposal includes increasing the top personal income tax rate from 37% to 39.6% and
the top capital gains rate from 20% to 25%. Therefore, we should expect capital gains
realizations to increase in 2021.

TRUE. To avoid the higher capital gains tax rate, people with accumulated and unrealized
capital gains will have an incentive to realize them before the new legislation is passed
to benefit from the lower rate. This is what happened in 1986 and 2012 after the
announcement of increases in taxes on capital gains the following year.

(d) US taxpayers bunch in response to first kink point of the EITC, validating the standard
economic model of labor supply.

FALSE. US taxpayers only bunching in response to the firsk kink point of the EITC;
there is no bunching for all other kink points. Moreover, taxpayers who bunch are mostly
self-employed workers who can modify their income to maximize their tax refurnds. Saez
2010 shows that wage earners do not bunch in response to the EITC, perhaps due to
misinformation or other optimization frictions. Therefore, bunching reflects tax evasion,
not a labor supply response. Chetty et al (2013) showed that in placed with more
information about the EITC, wage earners are more likley to target the EITC plateau,
which implies that there are indeed labor supply responses to the EITC.

(e) If the taxable income of high-income taxpayers is very elastic to taxation, it is best for
the government to keep taxes low to minimize real distortions.

UNCERTAIN. If the elasticity of taxable income (ETI) is high due to labor supply
responses to taxation, then indeed the optimal top income tax rate should be low because
⌧ = 1/(1 + a · e). However, if the ETI is high because of avoidance responses (e.g., re-
timing, shifting) or evasion, then it is best for the government to eliminate tax loopholes
and improve the enforcement environment before modifying the tax rate. Moreover, if the
government places a low social marginal welfare weight g on high-income earners, then
" ⌧.

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(f) Female labor supply is influenced by social norms, especially regarding child care.

TRUE. There are social determinants of female labor supply. For instance, female labor
force participation increased 25% during WW2 planned economy. Moreover, female
earnings su↵er a long-run child penalty. The magnitude of this penalty is correlated
with social norms regarding attitudes towards mothers with young children working full
time.

(g) Absolute poverty in the US has not decreased despite robust GDP growth, perhaps due to
rising inequality. In fact, the United States has one of the highest absolute poverty rates
among OECD countries.

FALSE. It is true that absolute poverty in the US has not decreased despite strong
economic growth and that one possible reason is rising inequality: while the average
income of the top 1% has increased significantly, the average income of the bottom 50% has
stagnated over the last decades. However, the United States has one of the highest levels
of relative—not absolute—poverty among OECD countries. Almost no one is considered
poor in the US today according to the World Bank’s definition of absolute poverty.

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2 Labor Income Taxation [16 points]
Assume that individuals have the same utility function over consumption and labor given by

U (c, l) = c + ✓ log(10 l)

where c represents consumption, l represents hours of labor, and ✓ is a given positive parameter.
Assume that the only income individuals have comes from labor and that the hourly wage rate
is given by w.

1. Write the budget constraint faced by the individual. [1 point]

c = wl

2. Set up the individual maximization problem and solve for the optimal choices of labor
and consumption. [2 points]
linear

↑ quasi
max c + ✓ log(10 l)
c,l

max wl + ✓ log(10 l)
l

FOC:
@U (·) ✓
=0)w =0
@l 10 l
w(10 l) = ✓
✓
) l⇤ = 10
w
⇤
c = 10w ✓

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3. Suppose now that the market wage w is equal to $10h/hour. Draw the consumption-labor
trade-o↵ for a representative individual. [1 points]

c = 10l

10

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 Suppose that the government introduces an Earned Income Tax Credit (EITC) such that
for the first $40 in earnings, the government pays 50 cents per dollar on wages earned.
After $40 the credit is reduced at a rate of 50 cents per dollar earned. When the credit
reaches zero, there is no additional EITC.

4. Draw the relationship between consumption and labor (Hint: there are two brackets).
Label the x and y values of the kink point, and the slope of each segment of
the graph. [2 points]
(Not drawn to scale)

c = wl T (wl)

80 10

5 c = 10l

60

15

40

l
4 8

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5. Draw the relationship between pre-tax/transfer income and post-tax/transfer income.
Label the x and y values of the kink point, and the slope of each segment
of the graph. [1 point]
(Not drawn to scale) of Ol &GEMA
z T (z) BIG Me TT

Sub If
80 1

0.5

60

i
Sub(t)

1.5

I
z
40 80

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6. For each of the two brackets in your budget constraint, indicate the sign (direction) of the
substitution and income e↵ects on an individual’s choice of labor supply. Also indicate
the sign (direction) of the total (combined) e↵ect of the two, if it is possible to know for
certain, or indicate with a question mark if the total e↵ect is uncertain. [2 points]

Bracket 1 Bracket 2

Substitution E↵ect:

Income E↵ect:

Total E↵ect:

We know from lecture that in the first bracket of the EITC, the IE is generally negative
and the SE is generally positive. In the second bracket of the EITC, both the IE and the
SE are negative:
SE: ", #
IE: #, #
Total: ?, #

However, with this specific utility function (quasi-linear), there are no income e↵ects—
Me
there are only SE. Therefore:
SE: ", #
IE: 0, 0
Total: ", #

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 7. Consider now two individuals with di↵erent relative valuations of labor and consumption.
Individual 1 has a ✓ of 45 and individual 2 has a ✓ of 20. For each of these individuals, find
the optimal choice of labor in the no-tax context and under the EITC setting previously
described. [2 points]

No tax:
45
✓ = 45 : l⇤ = 10 = 5.5
10
20
✓ = 20 : l⇤ = 10 =8
10

Under EITC:
45
Need l⇤ = 10

Calculate
e

(
✓ = 45, w = 15 : =7
to 15
45
✓ = 45, w = 5 : l⇤ = 10 =1
5
20
✓ = 20, w = 15 : l⇤ = 10 = 8.7
15
20
✓ = 20, w = 5 : l⇤ = 10 =6
5

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8. Plot the solutions you found in a consumption-labor graph for each individual separately.
Does someone bunch in response to the EITC? If so, who responds by bunching? [3 points]
(Not drawn to scale)
For individual 1 with ✓ =45:

c = wl T (wl)

B (unfeasible)

80

60 >
-
instero C
5 c = 10l
10

cunfeasible)D
15 A

40

l
1 4 5.5 7 8

Individual 1 with ✓ = 45 will bunch at the kink of the budget constraint (point C),
choosing l⇤ = 4.

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For individual 2 with ✓ =20:

c = wl T (wl)
B

A
80 10

5 C c = 10l

60

15

40

l
4 6 88.7

Individual 2 with ✓ = 20 does not bunch; they choose l⇤ = 6 with the EITC.

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9. What is the e↵ect of the EITC on the labor supply of individual 1? What does this tell
you about the relative magnitudes of the sustitution and income e↵ects? What about for
individual 2? [2 points]

Individual 1 starts in A, i.e., above the first kink point, with l = 5.5, where there are no IE
and only negative SE. This individual ends up at the kink point with l = 4. The overall
e↵ect for individual 1 is negative: labor supply decreases from 5.5 hours to 4 hours, so
SE<IE=0. The EITC has discouraged labor supply for individual 1.
Similarly, individual 2 starts with l = 8 and ends up in the second bracket with l = 6.
The overall e↵ect for individual 2 is also negative: labor supply decreases from 8 hours to
6 hours, so SE<IE=0. The EITC has discouraged labor supply for individual 2.

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