Question

Suppose you expect to earn $10 this year and $10 next year. Each dollar you earn this year can be either spent or saved at an interest rate of 10%. If you want to spend more than $10 this year, you can borrow money at 10% interest and repay it next year. Next year, you plan to pay your debts (if any), then spend all your earnings and all your savings (if any).

1. Draw your budget line between “dollars spent this year" and “dollars spent next year".

2. Suppose the government imposes a 50% income tax on all your earnings this year and next year (not including your interest earnings). Draw your new budget line.

3. Suppose the government imposes a 50% sales tax on everything you buy this year and next year. Draw your new budget line.

4. Suppose the government imposes a 50% income tax on all your earnings this year and next year, including your interest earnings. Draw your new budget line.

5. True or False: If interest earnings are not subject to income tax, then an income tax and a sales tax will lead you to spend exactly the same amount both this year and next year.

Answer 1