ECON 305  Tutorial 7 (Week 9)

Questions for today:

Ch.9 Problems 15, 7, 11, 12
MC113

Tutorial slides will be posted Thursday after 10:30am, on

http://www.sfu.ca/~haiyunc/teaching.html.

H. K. Chen (SFU) ECON 305  Tutorial 7 (Week 9) July 2,3, 2014 1 / 24

AQ1. Ch.9 Problem 1

A consumer's income in the current period is y = 100, and income in the future
period is y0 = 120. He or she pays lump-sum taxes t = 20 in the current period
and t0 = 10 in the future period. The real interest rate is 0.1 per period.

(a) Determine the consumer's lifetime wealth.

In present value terms, lifetime wealth is
y0 − t0 120 − 10
we = y − t + = 100 − 20 + = 180.
1+r 1 + 0.1

(b) Suppose that current and future consumptions are perfect complements for
the consumer and that he or she always wants to have equal consumption in the
current and future periods. Draw the consumer's indierence curves.
Indierence curves for perfect complements is L-shaped
Utility function generating these curves has the form

U (c, c0 ) = min{αc, αc0 }, α > 0.

H. K. Chen (SFU) ECON 305  Tutorial 7 (Week 9) July 2,3, 2014 2 / 24

AQ1. Ch.9 Problem 1
c0
242

c = c0
198

115.18 E1 U2
110 E2
94.24 U1

80 94.24 120 180 220 c

115.18
AQ1 (c) AQ1 (d) AQ1 (e)
H. K. Chen (SFU) ECON 305  Tutorial 7 (Week 9) July 2,3, 2014 3 / 24
AQ1. Ch.9 Problem 1

(c) Determine what the consumer's optimal current-period and future-period

consumptions are, and what optimal saving is, and show this in a diagram with
the consumer's budget constraint and indierence curves. Is the consumer a
lender or a borrower?
Intertemporal budget constraint:

we = c + (1 + r)−1 c0 ⇒ c0 = 0.91(180 − c). (1)

Given the utility function, optimality occurs when

c = c0 . (2)

Solving (1) and (2) for c, c0 , we get c = c0 = 94.24.

Saving in current period is s = y − t − c = −14.24. Therefore the consumer
is a borrower.
Draw

H. K. Chen (SFU) ECON 305  Tutorial 7 (Week 9) July 2,3, 2014 4 / 24

AQ1. Ch.9 Problem 1

(d) Now suppose that instead of y = 100, the consumer has y = 140. Again,
determine optimal consumption in the current and future periods and optimal
saving, and show this in a diagram. Is the consumer a lender or a borrower?
Present value wealth is now
120 − 10
we = 140 − 20 + = 220.
1 + 0.1
Optimality condition (c = c0 ) and budget constraint (c0 = 0.91(220 − c))
together imply
c = c0 = 115.18, s = 4.82.
The consumer now is a lender. Draw
(e) Explain the dierences in your results between parts (c) and (d).
Consumer switches from borrower in (c) to lender in (d) due to a suciently
large increase in the current period income.

H. K. Chen (SFU) ECON 305  Tutorial 7 (Week 9) July 2,3, 2014 5 / 24

AQ2. Ch.9 Problem 2

An employer oers his or her employee the option of shifting x units of income
from next year to this year. That is, the option is to reduce income next year by x
units and increase income this year by x units.

(a) Would the employee take this option (use a diagram)?

Suppose t = t0 = 0. Initial lifetime wealth is

we0 = y + (1 + r)−1 y0 .

Lifetime wealth after the shift is

we1 = y + x + (1 + r)−1 (y0 − x)

= y + (1 + r ) −1 y0 + x 1 − (1 + r ) −1

if r > 0
| {z } | {z }
=we0 >0

we1 > we0 whenever r > 0, and so the employee should take the option,
provided that interest rate is positive.

H. K. Chen (SFU) ECON 305  Tutorial 7 (Week 9) July 2,3, 2014 6 / 24

AQ2. Ch.9 Problem 2

c0
(1 + r)we1
(1 + r)we0 slope = −(1 + r)

y0

y0 − x
we1
y y + x we0 c

H. K. Chen (SFU) ECON 305  Tutorial 7 (Week 9) July 2,3, 2014 7 / 24

AQ2. Ch.9 Problem 2

(b) Determine, using a diagram, how this shift in income will aect consumption
this year and next year and saving this year. Explain your results.
The shift in income creates a pure income eect (shifts budget constraint
outwards in a parallel fashion).
Thus, both c, c0 will increase.
Saving will increase:
c0 = y0 + (1 + r)s
Since c0 increases while y0 decreases, s must increase for the equality to hold.

H. K. Chen (SFU) ECON 305  Tutorial 7 (Week 9) July 2,3, 2014 8 / 24

AQ3. Ch.9 Problem 3

Consider the following eects of an increase in taxes for a consumer.

(a) The consumer's taxes increase by ∆t in the current period. How does this
aect current consumption, future consumption, and current saving?
c0 An increase in tax causes
budget constraint to shift
(1 + r)we0 inwards.
Consumption in both
(1 + r)we1 periods will drop.
Saving also goes down:
E1 E0 Consumption smoothing
y0 implies that c will
decrease by an amount
less than ∆t
Recall s = y − t − c

y − ∆t y we1 we0 c

H. K. Chen (SFU) ECON 305  Tutorial 7 (Week 9) July 2,3, 2014 9 / 24

AQ3. Ch.9 Problem 3

(b) The consumer's taxes increase permanently, increasing by ∆t in the current

and future periods. Using a diagram, determine how this aects current
consumption, future consumption, and current saving. Explain the dierences
between your results here and in part (a).
c0 A permanent increase in tax
shifts budget constraint
(1 + r)we0 inwards.
Consumption in both
periods will drop.
Saving is ambiguous.
E0
y0

E2
y0 − ∆t

y − ∆t y we0 c

H. K. Chen (SFU) ECON 305  Tutorial 7 (Week 9) July 2,3, 2014 10 / 24

 AQ4. Ch.9 Problem 4

Suppose that the government introduces a tax on interest earnings. That is,
borrowers face a real interest rate of r before and after the tax is introduced, but
lenders receive an interest rate of (1 − x)r on their savings, where x is the tax
rate. Therefore, we are looking at the eect of having x increase from zero to
some value greater than zero, with r assumed to remain constant.

(a) Show the eects of the increase in the tax rate on the consumer's lifetime
budget constraint.
c0 Tax on interest income
(1 + r)we slope = −(1 + r) causes lender's budget
constraint to pivot down
(1 + (1 − x )r )y + y0
slope = −(1 + (1 − x)r) around initial endowment.
E
Budget constraint for
y0 borrowers doesn't change.

y we c

H. K. Chen (SFU) ECON 305  Tutorial 7 (Week 9) July 2,3, 2014 11 / 24

AQ4. Ch.9 Problem 4

(b) How does the increase in the tax rate aect the optimal choice of
consumption (in the current and future periods) and saving for the consumer?
Show how income and substitution eects matter for your answer, and show how
it matters whether the consumer is initially a borrower or a lender.
c0 Consumer is unaected if
(1 + r)we initially a borrower.
If initially a lender,
(1 + (1 − x )r )y + y0 A and post-policy
B
consumption bundle is at
C
point C,
y0
E
then there will be
substitution eect (A → B)
and income eect (B → C).
c0 decreases as a result, but
y we c eect on c (hence s) is
ambiguous and depends on
shape of utility
H. K. Chen (SFU) ECON 305  Tutorial 7 (Week 9) July 2,3, 2014 12 / 24
AQ5. Ch.9 Problem 5

A consumer's income in the current and future periods are y and y0 , respectively.
He pays taxes t and t0 in the two periods. The consumer can borrow and lend at
the real interest rate r. This consumer faces a constraint on how much he can
borrow. That is, the consumer cannot borrow more than x, where x < we − y + t,
with we denoting lifetime wealth. Use diagrams to determine the eects on the
consumer's current consumption, future consumption, and savings of a change in
x, and explain your results.
c0 Saving is unaected.
(1 + r)we
There is a borrowing constraint B̄.
Budget line becomes vertical at B̄.
y0 − t0 If borrowing constraint is binding,
E IC touches budget constraint at the
kink.
x If borrowing constraint not binding,
we c
the usual tangency condition
y − t B̄
applies.
we − y + t

H. K. Chen (SFU) ECON 305  Tutorial 7 (Week 9) July 2,3, 2014 13 / 24

AQ6. Ch.9 Problem 7

Suppose that all consumers are identical, and also assume that the real interest
rate r is xed. Suppose that the government wants to collect a given amount of
tax revenue R, in present value terms. Assume that the government has two
options: (i) a proportional tax of s per unit of savings, in that the tax collected
per consumer is s(y − c); (ii) a proportional tax u on consumption in the current
and future periods, so that the present value of the toal tax collected per
0
consumer is uc + 1uc+r . Note that the tax rate s could be positive or negative. For
example if consumers borrow, then s would need to be less than zero for the
government to collect tax revenue. Show that option (ii) is preferable to option (i)
if the government wishes to make consumers as well o as possible, and explain
why this is so. [Hint: Show that the consumption bundle that consumers choose
under option (i) could have been chosen under option (ii), but was not.]
The hint suggests us to appeal to the weak axiom of revealed preference
(WARP).

H. K. Chen (SFU) ECON 305  Tutorial 7 (Week 9) July 2,3, 2014 14 / 24

AQ6. Ch.9 Problem 7

Quick review of WARP

c0 Suppose there are two consumption
bundles A and B.
Both are aordable under red budget
A
constraint, where A is observed to be
chosen.
B
B is aordable under blue budget
constraint and observed to be chosen,
while A is not aordable.
c
We conclude that A must be preferred
to B, because when both A and B are
aordable, A is chosen over B.

H. K. Chen (SFU) ECON 305  Tutorial 7 (Week 9) July 2,3, 2014 15 / 24

AQ6. Ch.9 Problem 7

In this question, the two tax schemes induce two dierent budget constraints.
Let (c1 , c10 ) be the consumption bundle chosen under scheme that taxes
savings, and (c2 , c20 ) the bundle chosen under scheme that taxes
consumptions.
We need to show that (c1 , c10 ) is aordable under the budget constraint
induced by consumption taxes; and since it's not chosen, it must be inferior
to (c2 , c20 ).
Therefore, the tax scheme that induces (c2 , c20 ) is preferred from the
consumer's perspective.

H. K. Chen (SFU) ECON 305  Tutorial 7 (Week 9) July 2,3, 2014 16 / 24

AQ6. Ch.9 Problem 7

Budget constraint under savings tax is

c10 y0
c1 + = y+ − s ( y − c1 ) . (1)
1+r 1+r
Budget constraint under consumption taxes is

c20 y0 c0
 
c2 + = y+ − u c2 + 2 (2)
1+r 1+r 1+r
c0 y0
 
⇒ (1 + u) c2 + 2 = y+ . (3)
1+r 1+r

Since tax revenue is the same under both schemes,

c0
 
R = s(y − c1 ) = u c2 + 2 . (4)
1+r

H. K. Chen (SFU) ECON 305  Tutorial 7 (Week 9) July 2,3, 2014 17 / 24

AQ6. Ch.9 Problem 7

From (4), it follows that

 −1  −1
c0 c20 c0
  
u = R c2 + 2 ⇒ 1+u = R + c2 + c2 + 2
1+r 1+r 1+r
eq. (2) & (4)
 −1
y0 y0
 
=======⇒ = y+ y+ −R
1+r 1+r

Evaluate (c1 , c10 ) in budget constraint under consumption tax (3):

c10 y0

(1 + u) c1 + Q y+
1+r 1+r
−1 0 
y0 y0 y0
  

c
1
y+ y+  −R c1 +  = y+
1 + r 1 + r  1 + r 1+r


H. K. Chen (SFU) ECON 305  Tutorial 7 (Week 9) July 2,3, 2014 18 / 24

AQ6. Ch.9 Problem 7

Therefore, (c1 , c10 ) is exactly aordable under the consumption taxes scheme.
But (c2 , c20 ) is chosen over (c1 , c10 ).
We thus conclude that consumption taxes is preferred to tax on savings.
Despite the mathematics, the intuition is simple:
Tax on savings changes the slope of the budget line, thus creating income and
substitution eects.
The consumption taxes in this question are equivalent to a lump-sum tax,
which creates a pure income eect, and hence lead to no distortion in
consumer's behavior.

H. K. Chen (SFU) ECON 305  Tutorial 7 (Week 9) July 2,3, 2014 19 / 24

AQ7. Ch.9 Problem 11

Suppose a consumer has income y in the current period, income y0 in the future
period, and faces proportional taxes on consumption in the current future periods.
There are no lump-sum taxes. That is, if consumption is c in the current period
and c0 in the future period, the consumer pays a tax sc in the current period and
s0 c0 in the future period where s, s0 are tax rates. The government wishes to collect
total tax revenue in the current and future periods, which has a present value of
R. Now suppose that he government reduces s and increases s0 , in such a way that
it continues to collect the same present value of tax revenue R from the consumer,
given the consumer's optimal choices of current- and future-period consumptions.

(a) Write down the lifetime budget constraint of the consumer.

Lifetime budget constraint is

(1 + s0 )c0 y0
(1 + s)c + = y+ .
1+r 1+r

H. K. Chen (SFU) ECON 305  Tutorial 7 (Week 9) July 2,3, 2014 20 / 24

AQ7. Ch.9 Problem 11

(b) Show that lifetime wealth is the same for the consumer, before and after the
change in tax rates.
Lifetime wealth is y + (1 + r)−1 y0 , which is independent of s, s0 .

(c) What eect, if any, does the change in tax rates have on the consumer's
choice of current and future consumptions, and on savings? Does Ricardian
equivalence hold here? Explain why or why not.
The change will in general aect consumption and saving decisions.
From the budget constraint, relative price of consumption is
(1 + r)(1 + s)/(1 + s0 ),

(1 + s0 )c0 y0
(1 + s)c + = y+ .
1+r 1+r
Changes in s, s0 alters the slope of the budget line, thus creating distortions in
consumer's decisions.
So Ricardian equivalence does not hold here.

H. K. Chen (SFU) ECON 305  Tutorial 7 (Week 9) July 2,3, 2014 21 / 24

AQ8. Ch.9 Problem 12

Suppose in our two-period model of the economy that the government, instead of
borrowing in the current period, runs a government loan program. That is, loans
are made to consumers at the market real interest rate r, with the aggregate
quantity of loans made in the current period denoted by L. Government loans are
nanced by lump-sum taxes on consumers in the current period, and we assume
that government spending is zero in the current and future periods. In the future
period, when the government loans are repaid by consumers, the government
rebates this amount as lump-sum transfers (negative taxes) to consumers.

(a) Write down the government's current-period budget constraint and its
future-period budget constraint.
Current period: T = L; future period: T 0 = −(1 + r)L.

(b) Determine the present-value budget constraint of the government.

PV budget constraint:
T0
L + (−L) = T +
1+r

H. K. Chen (SFU) ECON 305  Tutorial 7 (Week 9) July 2,3, 2014 22 / 24

AQ8. Ch.9 Problem 12

(c) Write down the lifetime budget constraint of a consumer.

Consumer's budget constraint:

c0 y0 − (1 + r)` − t0
 
c+ = (y + ` − t) +
1+r 1+r

where the lower case `, t, t0 are loan and taxes for an individual consumer.

(d) Show that the size of the government loan program (i.e., the quantity L) has
no eect on current consumption or future consumption for each individual
consumer and that there is no eect on the equilibrium real interest rate. Explain
this result.
Loan size does not change the PV of taxes, and does not aect interest rate.
Therefore, no change in consumptions.

H. K. Chen (SFU) ECON 305  Tutorial 7 (Week 9) July 2,3, 2014 23 / 24

MC113

MC solutions:

15: B C C D A
610: A B B B C
1113: B B A

H. K. Chen (SFU) ECON 305  Tutorial 7 (Week 9) July 2,3, 2014 24 / 24