Question

Indicate whether each of the following statement is true, false, or uncertain, and justify your answer.
(a) Tax is just the transfer of welfare as the sum people pays is the revenue of the government.
(b) If the elasticity of demand is 0, or there is no change in quantity traded due to taxation,
there is no excess burden of the tax.
(c) Marginal excess burden is greater than average excess burden.
(d) Imposition of Pigouvian tax to correct externality always enhances e¢ ciency on the
whole.
(e) (R & G) E¢ ciency is maximized when all commodities are taxed at the same rate.
(f) In our discussion on optimal income taxation in class, optimal áat tax rate t increases
as elasticity of labor supply increases.
(g) Higher income tax rate reduces labor supply.
(h) If an individual is a net borrower, one will reduce his borrowing with higher tax rate.
(i) If an income deduction is given for a pension saving, it will induce more saving.
(j) Income tax will reduce risk taking as it reduces the after tax return of risky investment.

Answer 1

(a) Yes, it is the transfer of welfare as the amount rich people pays transfers to the poor people through government. Tax as a source of revenue for the government becomes support for poor.

(b) False, if there is elastic demand, we have elastic demand curve which says that increasing the quantity demanded wont affect the price level.

(c) Marginal excess burden is generally higher than the average burden, as tax should be imposed on least distorting commodities first.

• A good tax system should impose taxes with least excess burden first.

• Then move on to those taxes with higher excess burden.

• Optimally, the marginal excess burden of each tax instrument should be the same.

(d) True, as Pigovian tax is a tax imposed on market on negative externalities, it is intended to make market efficient and does it by making the fine equals to social cost of that externality.

(e) True, With a lump sum tax, the income and substitution effect cancel out, so there is no change in economic behaviour and therefore no welfare loss.

(f) Uncertain, as wage elasticity of supply one uses the following formula:

Change of supply of labor in % / Change of salary in %, if this is greater than 1, then it is elastic labor supply.

Increasing the optimal tax rate for sure reduces the salary in hand. We do not know here that reduced salary will increase supply of labor or decrease it. If there is unemployment, even if reduced salary wont affect the labor supply.

(g) True, as increasing tax rates impact one in two ways :

• Income effect, which induces one person to work less because after paying tax their income reduces
• Substitution effect which induces one person to shift to leisure instead of working.

(h) True, if interest rate rises, they need to pay a higher amount of money. So people try to not to take a loan when interest rate rises.

(i) False, if there is income deduction for pension saving person, it will reduce savings because first everyone need to cover their basic cost. After spending for basic cost, they save the rest money. If income reduces, consumption remain the same, savings decline for pension.

(j) Uncertain, as it it is true that it reduces the return after risky investment but risky investment always pays huge return, increasing tax by minimal amount does not reduce your return from risky investment by that much that you reduce your level of investment.