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Econ 426, Fall 2009 Final Exam Name: __________________________________________ Directions: You have 75 minutes, and there are 100 possible points. Write your answers in the space provided. If you need more room, indicate that and continue your answer on the back of the page. Be sure to be clear and neat, and explain your answers. 1. (65 points, 5 each) Are the following statements true, false, or uncertain? You must explain your answer clearly. a. Governments of geographically small nations often decide to generate more tax revenue by consumption taxes and less tax revenue by income taxes. b. Measures of progressivity are used to assess the extent to which a tax exhibits horizontal equity. c. Although the lowest marginal federal income tax rate is 10%, some low-income individuals face effective marginal income tax rates well in excess of 50%. d. The U.S. income tax code is strictly based on the Haig-Simons definition of income. e. If a new substitute is invented for some good, then consumers would pay a greater share of the tax burden. f. Ramsey’s Rule for optimal taxation minimizes deadweight loss, so it satisfies the principle of vertical equity. g. Consider a particular Pareto efficient allocation (call it “x”) and suppose that a different particular allocation (call it “y”) is NOT Pareto efficient. Then it must be true that all individuals like x at least as well as y. h. Suppose that a market is not currently subject to taxation and that the equilibrium in that market is NOT Pareto efficient. Then it must be true that the deadweight loss would only grow larger if a tax were imposed. i. If two goods have the same equilibrium price and quantity before any taxes are levied, and if the same tax is subsequently levied on both goods, then the deadweight loss will be greater in the market for the good with more elastic supply and less elastic demand. j. A local tax on the consumption of manufactured goods is likely to be borne almost entirely by local retailers, not local consumers. k. A tax levied on a wide range of goods is usually more efficient than a tax that raises the same revenue from a narrower tax base. l. Suppose that a product is currently subject to a unit tax of t dollars per unit, the equilibrium price is $100, and the equilibrium quantity exchanged is one million units. Then if the tax is lowered slightly to (t-δ) dollars per unit (where δ is a very small number) and the new equilibrium price and quantity are respectively (100+δ/3) dollars/unit and 1,000,001 units , then the deadweight loss due to taxation decreases by t dollars. m. Nearly 100% of the projected “fiscal gap” in the U.S. government’s future budget is due to entitlement programs like Social Security and Medicare. 2. (35 points, 7 each) Social Security and Medicare are funded by a payroll tax, which is levied upon income earned from work. By law, half of that tax is paid by worker and half if paid by their employers. In addition to the payroll tax, workers also pay an income tax on their entire income (including both income earned from work and income earned from other activities). Assume that the labor supply in this market has a constant elasticity of 3.0, and the demand for labor in this market has a constant elasticity of -2.0. a. Explain why an increase in the income tax would raise the deadweight loss caused by the payroll tax. b. Suppose that workers in some labor market face a marginal income tax rate of 20% and a marginal payroll tax rate of 5%. By what percentage would the deadweight loss of taxation in this labor market increase if the marginal payroll tax rate were increased to 10%? Explain clearly. c. What fraction of the payroll tax will be borne by workers? d. How much would workers’ take-home pay change if the law were changed so that employees were expected to contribute 75% of the total payroll tax (and employers were expected to contribute 25%)? e. The payroll tax only applies to the first $101,000 that a worker earns in a calendar year, and workers who earn more than that (and their employers) pay exactly the same amount of payroll tax as do workers who earn exactly $101,000. Now suppose that inflation raises the wage level in all occupations by 13 percent in a year, but there is no change in the payroll tax rate or the nominal earnings level ($101,000) at which the maximum payroll tax is paid. If every worker in a certain occupation earned exactly $100,000 last year (i.e., just less than $101,000), how does the deadweight loss due to the payroll tax in the occupation change as the wage rises to $113,000? Explain as precisely as possible.