Public Economics Problem Set 1

László Sándor
Central European University

1 Tax reform in Hungary

1.1 The income tax
Hungary has a system of progressive income taxes rising linearly in its two brackets (with the minimum
wage exempt, and a threshold at Ft1.5m, which is cca. 75% of average earnings) by 18% and 36%.
This yields 19% of the revenues of the central budget. The rates have been lowered recently, though
with the revenue needs of the central budget, the tax burden has not eased (due to some reforms of
deductions). With all this, my problems are twofold. First, as the two brackets concern the lower end of
the distribution, the system is progressive very early on. Actually, with the social security contributions,
the marginal tax rate is over 70% on some with low incomes. This seems unjusti…able for me. Moreover,
it strongly encourages tax evasion (or discourages work), and it is expected to contribute to the unusual
distribution of stated incomes with the mode at the minimum at a steady decline above.
Whatever problems I have with the current system with perversely high marginal rates for some low
incomes, I could imagine a system of declining marginal rates, but with some income exempt, or actually
a negative income tax for low earners, which could still be progressive overall. Instead, the main means-
tested bene…t of Hungary today complements personal income to the threshold of eligibility, which means
a 100% marginal income tax e¤ective. This has an absurd disincentive e¤ect.
Also, this point leads to my second major problem: the lack of family taxation. Some right-wing
parties have already proposed this, to no avail. Any demographic or religious arguments notwithstanding,
I simply recognize a schizophrenic stance from the state on the matter of family resources. Concerning
means-tested bene…ts, or for o¢ cials’income worthy of public interest for that matter, it subscribes to
the view of obvious resource pooling within families. However, it does not account for it when it comes to
taxation, which is inconsistent— and in my opinion, unfair. It is even worse in the case of some bene…ts,
which a¤ect the poorest, of course, when eligibility is de…ned (partly) on family income, but only personal
income is corrected to some level.
Admittedly, a family tax system is di¢ cult to account. That said, the Hungarian income tax system
is already complicated, which not only obfuscates fairness considerations, but also raises the costs of
collecting the revenue, with no obvious bene…t of any …ne-tuned fairness (concerning deductions and
exemptions, especially). Though I would not go as far as some proponents of postcard-like tax returns,
the economic e¢ ciency of tax collection is an issue by itself.
As an aside, it is an interesting economic question how one could justify (or maybe, just rationalize)
the low wages in the public sector, which practically mean high taxes on public servants’income. It is
all too much conspicuous how the medical profession cannot accept that burden.

1.2 Consumption taxes

According to EU rules, the discretion of Hungary on the main consumption tax, the VAT is somewhat
limited. It has a main rate of 20% with a special one of 5% and some services exempt, and it is already
the largest single source of government revenue, accounting for 29% of the whole for the central budget.
On recent …scal policy concerning the VAT, my criticism concerns the yearly changes, which unnecessarily
disrupt price signals and in‡ation expectations.
However, as I truly understand the argument for consumption taxation (the incentive to save and
invest; the taxation of any earned income), it is probably wishful thinking, yet I see some scope for
even higher consumption taxation: as the tax burden on the now old was not clear-cut under Socialism
(prices were just as much distorted and subsidised as ‘untaxed’ wages), the intergenerational problem
of introducing such taxation is not as obvious as in Western countries. Also, since the incomes earned
since the introduction of income taxation are subject to much suspicion, the usual arguments about the

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resistance of the present generation might not stand. All these might be a reason why the role of indirect
taxes has been already higher in Hungary than in all but a handful of countries.
Of course, because of the black market, a consumption tax might not be easily collected fairly, yet this
is no disadvantage in comparison with the income tax. The analyses of tax evasion routinely compare
the incomes reported for the tax authorities and the bases for the VAT (which is basically expenditure),
and the estimated di¤erence is the fourth or third of GDP, to the VAT’s side.

1.3 Corporate taxes

Taxes on business still provide the central government 17% of its revenues. The low corporate tax rate
of 16% (20% in some cases, 10% for very small businesses) has been the subject of some debate recently,
however, I …nd it acceptable that such a small open economy should compete for capital in‡ows, especially
if comparable domestic resources are scarce. Also, corporations do not seem to use that many public
goods that they should be taxed anything that high, to my opinion. If appropriate fees and prices would
be set for the use of services, where feasible, corporations could be left alone. The income generated
there is still taxed when it reaches any member of the Hungarian society, and even once more when they
consume it.

1.4 Corrective taxes

The central government already raises 12% of its revenue from excises. However, the reasoning behind
them are sometimes closer to Ramsey’s than Pigou’s. When the rest of the tax system is tuned to strive
for a fair distribution of the tax burden, I …nd these taxes unnecessarily messing up those issues. These
taxes can easily by regressive.
Nevertheless, the taxes on some obvious externalities are absent or surprisingly low. This leads to
egregious ine¢ ciencies. A proper tax or fee for using roads, especially in densely populated areas or ones
disrupting nature, could be much higher taking into account how much more people pay for silent and
green residential areas or “livable” cities. Instead, most car tra¢ c is subsidised in the form of public
roads.

1.5 Estate taxes

Interestingly, the decades-old Anglo-Saxon terminology for the inheritance tax, viz. the "death tax",
emerged recently in the programme of a small party keen on burnishing its Conservative credentials.
Though the tax is indeed levied on sums already taxed, this fact does not render it any di¤erent from
other types of taxes that accumulates on value while it is raised from some productive activity in the
economy until it is spent on something causing utility.
On the other hand, the reasoning that inheritance disrupts incentives to invest in human capital
and to imitate peers, makes sense, I think. Unlike the issue of family taxation, which considers families
living together in households, the transfer of large fortunes to independent relatives should be taxed in
order to promote equal opportunity in the economy. In addition, an inheritance tax is a simple tax, not
particularly discouraging saving or e¤ort in the …rst case. With di¤erential rates for various types of
relatives inheriting, an estate tax can be a fair and simple instrument to raise government revenue.

1.6 Tax evasion

In general, several wise changes would be possible to reduce the exceptionally unequal and unfair alloca-
tion of the tax burden in the Hungarian society. Rises of the minimum wage, of payroll taxes and of social
security contributions have all been tried to allow less leeway to hide income. However, such instruments
make much less sense in the legal part of the economy. To stop accounting labour income as capital
income, an equal tax on returns on both kinds of capital (human and physical) is sometimes proposed.
Generally, I could accept the reasoning, however my preferred rate would be 0% on both, accompanied by
a consumption tax. The erosion of the tax base, mainly by accounting consumption as some cost of some
business, could be only deterred by enhanced investigations and harsher punishment. A simpli…cation of
rules and perhaps some wealth tax could widen the frustratingly narrow tax base in Hungary. Also, in
order to equal a tax on the employed and the self-employed, the …ve-year-old “simpli…ed business tax”
could be abolished.
All told, the cheapest and soundest of “tax reforms”nowadays is a campaign for “fair play”in public.
Not having much to do with economic incentives, not much could be expected out of it, though some

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internalised rules or norms could improve the situation, however irrational the norms could apparently
be.

2 True or False or Uncertain

2.1 A two-factor world economy.
False (unless the ‘small country’is not negligible). If the expected return on capital is exogenous, and
capital owners easily …nd investments with such returns abroad, the net return on capital cannot fall in
the small country either. Though the gross return, the marginal product of capital must rise accordingly,
capital owners face no losses or costs, but the capital out‡ow results in lower labour productivity, what
translates into lower wages domestically. The immobile labour force cannot adjust. Thus all incidence of
this “capital tax”falls on domestic labour. (We discussed this as an application of Harberger’s two-sector
model.)

2.2 Commodity taxes and ‡at supply curve

False. This special case makes supply-side considerations easy, as producer prices (thus, surplus or
pro…ts) cannot change, tax only makes a wedge between producer and consumer prices. Still, the resulting
change is a change in uncompensated or Marshallian demand, and the change in consumer surplus is a
theoretically unattractive measure for the welfare analysis. It is still higher than the equivalent variation
and lower than the compensating variation. Either the original or the …nal utility level seems fair and
justi…ed for the policy-maker, the analyst should pick the respective measure of change in consumer
welfare, i.e. the compensated or the equivalent variation. The di¤erence with the collected revenue will
show the deadweight loss of the tax, a good e¢ ciency measure. However, the di¤erence between the
inappropriate and the appropriate measures is small for small taxes.
In any case, a general equilibrium incidence analysis would provide the state-of-the-art answer.

2.3 The optimal Pigouvian tax scheme

True. As far as I can understand an “optimal Pigouvian tax”as one that actually …lls the gap between the
social and private marginal net bene…ts, the corrected prices indeed implement the full-information free
market e¢ cient outcome. However, if I should take the cases of uncertainty or inappropriate redistribution
as valid counterexamples (i.e. the tax’s supposed optimality does not cover these issues), it is easily
possible that the tax does not implement the planner’s optimum. If the government was uncertain about
the social costs or bene…ts and had not picked the optimum, the tax scheme would not correct this
mistake but simply implement a case with under- or overregulation. Also, even if the government would
…nd the full-information equilibrium fair enough to set as a goal for policy, with a corrective tax it would
need some redistribution of the tax revenue even to implement the “otherwise natural outcome.” With
these quali…cations, I still judge the statement to be true.

2.4 Housing subsidies in two years

True. Poterba’s asset pricing model is appropriate for this kind of analysis. A rise in the subsidies is
equivalent to a upward shift in the q_H;t = 0 curve, and it would justify higher housing prices as well
as a larger stock of residential assets, once implemented. For any consistent expectations, the economy
should …nd itself on the new saddle path on the day the law takes e¤ect. This is possible if once the
news break, housing prices jump to some q 0 , and according to the dynamics under the ongoing policy,
q_H;t > 0; H_ t > 0, housing prices rise along with the stock expecting the policy. Then prices should start
falling on the day the subsidies are implemented and the economy is on the new saddle path, steadily
increasing its housing stock with declining prices because of the gradually ful…lled demand. All in all,
the hypothesized story of a steady decline right after the immediate jump in prices is impossible under
rational expectations. Whether it was indeed a bubble or some other irrationality is not certain, however.
Still, I would call this statement basically true. (Actually, the story would be rational without a bubble
if the subsidies were immediately implemented. Then the economy would jump right to the saddle path
and see steadily declining prices. But here prices (and demand, and supply) must rise even after the

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initial jump as the stock and price should rule out arbitrage opportunities all along the path and on the
day of implementing the policy.)

3 Optimal commodity taxation

The economy is characterized by the following relationships:
" 1 1
1 2
U (c1 ; c2 ; L) = c1 " + c2 L; (1)
" 1 1
"; ; 1; 2 > 0;
w = p1 = p2 = 1; (2)
1 c1 + 2 c2 = R:
(For the sake of tractability, I consider only internal solutions and constraints as strict equalities.)

3.1 a)
3.1.1 The demand for the two consumption goods
The consumers solve the following constrained optimisation problem facing consumer prices q1 = p1 + 1 =
1 + 1 , q2 = p2 + 2 = 1 + 2 as well as (2):
max U (c1 ; c2 ; L)
c1 ;c2 ;L

s.t. q1 c1 + q2 c2 = wL = L;
which yields the Lagrangian
" 1 1
1 2
L (c1 ; c2 ; L) = c1 " + c2 L + (L q1 c1 + q2 c2 ) :
" 1 1
The …rst-order (necessary) conditions for an internal optimum are
@L (c1 ; c2 ; L) 1 1
= c1 "
q1 = 0; (3a)
@c1 "
@L (c1 ; c2 ; L) 2
1
= c2 q2 = 0; (3b)
@c2
@L (c1 ; c2 ; L)
= 1+ = 0; (3c)
@L
@L (c1 ; c2 ; L)
= L q1 c1 + q2 c2 = 0: (3d)
@
Using (3c) in (3a) and (3b) yields
"
"
c1 = q1 ;
1

c2 = q2 ;
2

4
which in (3d) give
"
"
L= q11 "
+ q21 :
1 2

3.1.2 The government’s maximisation problem

As a benevolent government would maximise (indirect) utility subject to its revenue needs, it will con-
centrate on the indirect utility function of the consumers in terms of the taxes (everything else being
…xed or the consumers’choice), which is

!
" "
" "
v ( 1; 2) = U q1 ; q2 ; q11 " + q21 =
1 2 1 2
1
"""1 "
1 " 2 "
= q1 + q2 q11 "
q21 =
" 1 1 1 2 1 2
" # " #
1 " " 1
1 " " 2
= q11 "
+ q21 =
" 1 1 1 1 2 2
"
" 1 " 2
= q11 "
1 + q21 1 =
1 " 1 1 2 1 2
"
1 " 1
= q11 "
+ q21 :
" 1 1 1 2

Consequently, the government’s maximisation problem is

"
1 " 1
maxv ( 1 ; 2) = q11 "
+ q21 (4a)
1; 2 " 1 1 1 2
s.t. 1 c1 + 2 c2 = R: (4b)

3.1.3 Is this tax scheme the best possible?

Among linear tax schemes on the given quantities, de…nitely. Any tax on labour (or leisure) could be
normalized to result in the same problem as above. Could some non-linear taxes or, for instance, a wealth
tax be more desirable? A lump-sum tax would not cause any deadweight loss, for that matter, so it would
be more e¢ cient, or better, for sure.

3.2 b)
3.2.1 The relative value of the two tax rates
Setting a Lagrangian for (4),
L ( 1; 2; ) = v ( 1; 2) (R 1 c1 ( 1) 2 c2 ( 2 )) = (5a)
"
1 " 1 " 1 1
= (1 + 1) + (1 + 2) (5b)
" 1 1 1 2
!
"
"
R 1 (1 + 1) 2 (1 + 2) (5c)
1 2

the necessary conditions are

@L ( 1 ; 2 ; ) @v @c1
= + c1 + 1 = 0; (6a)
@ 1 @ 1 @ 1
@L ( 1 ; 2 ; ) @v @c2
= + c2 + 2 = 0; (6b)
@ 2 @ 2 @ 2
@L ( 1 ; 2 ; )
= 1 c1 + 2 c2 R = 0: (6c)
@

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By dividing (6a) and (6b), using the form in (5), we get the ratio we are after:
" "
"
(1 ") " 1 1 "
(1 + 1)
"
(1 +
" " 1
1 1 1) + 1 ( ") (1 + 1)
= 1;
(1 ) 1
(1 + (1 + 2) + 2 ( ) (1 + 2)
1 2
2) 2

" 1
(1 +
" (1 + 1) 1+ ( ") (1 + 1)
1)
1
= ;
(1 + 1
2) (1 + 2) 1+ 2 ( ) (1 + 2)

1 " 1+1 1
1= ;
1 1+
2
2

1 2
1 " =1 ;
1+ 1 1+ 2
1
1+ 1
= :
1+
2
2
"

3.2.2 Relation to the Ramsey results

Since here the income is endogenous to customers, our derivation from class do not apply readily. However,
the …nal result is similar to the general two-good case from there: the relative value of the tax rates is
inversely related to the elasticities. If these are equal, the tax rates are equal, if one is lower, the
corresponding good is taxed with a higher tax.

3.3 The case when " = =1

In this case the utility function (1) has the limit

U (c1 ; c2 ; L) = 1 log c1 + 2 log c2 L:

(One could refer to the separability to two CRRA utilities for this. E.g. or in‡ate the …rst term to a
fraction, and use l’Hopital’s rule:
e e
e+1 e+1
1 nc1 1 c1 log c1
" 1
1
lim c1 "
= lim = lim = 1 log c1 :
"!1 " 1 e!0 e e!0 1
This is a common Cobb-Douglas case nested in a quasilinear form with the numeraire, viz. labour priced
1.)

3.3.1 The tax rates

Thereby the consumers’problem has the Lagrangian

L (c1 ; c2 ; L) = 1 log c1 + 2 log c2 L + (L q1 c1 + q2 c2 )

with the necessary conditions

1
= q1 ;
c1
2
= q2 ;
c2
1 = ;
L = q1 c1 + q2 c2 ;

thence the solution

1
c1 = ;
q1
2
c2 = ;
q2

6
and a …xed labour supply
L= 1 + 2:

Hereby the indirect utility function is

1 2
v ( 1; 2) = 1 log + 2 log 1 2:
1+ 1 1+ 2

The government’s problem has the Lagrangian

1 2 1 2
L ( 1; 2; )= 1 log + 2 log 1 2 R 1 2 ;
1+ 1 1+ 2 1+ 1 1+ 2

which yield the conditions

!
1 1 1 1
= 2 ; (7a)
1+ 1 1+ 1 (1 + 1)
!
2 2 2 2
= 2 ; (7b)
1+ 2 1+ 2 (1 + 2)
1 2
R = 1 + 2 : (7c)
1+ 1 1+ 2

By simpli…cation of (7a) and (7b),

1
1 = 1 ; (8a)
1+ 1

2
1 = 1 ; (8b)
1+ 2

but then
1 2
= :
1+ 1 1+ 2
Together with (7c), this gives us the tax rates

1 2 R
= = ;
1+ 1 1+ 2 1 + 2

which are simply the share of the intended government revenue in the overall production (or income) in
the economy.
(For 1 and 2 itself, by simple rearranging 1 = 2 = 1 +R2 R .)

3.3.2 The shadow cost of raising revenue

This marginal cost (of raising revenue in term of utility) is simply the Lagrange-multiplier in the govern-
ment’s constrained optimum, which comes from (8) as
1 1 1 + 2
= = R
= ;
1 1+
1
1 1 + 2 R
1 1+ 2

which is the proportion how much larger personal incomes would be absent taxation (thus it is larger
than 1). Obviously, this rises in the intended revenue, so the marginal cost rises as taxes rise.
Since the quasilinear utility is in the units of leisure, which is priced to 1, the change in the indirect
utility minus the raised revenue is just as good a measure of the e¢ ciency loss as it would be the case
with the expenditure function. The marginal change we derived for the indirect utility function will be
just one unit di¤erent from the marginal deadweight loss:

DW L ( 1 ; 2) = [v (0; 0) v ( 1; 2 )] R ( 1; 2) ;

@DW L @ (v + R) @v @L R
= = 1= 1= 1= :
@R @R @R @R 1+ 2 R
Therefore the marginal deadweight loss is just one unit less the calculated marginal cost (as the raised
revenue is valuable in the usual analysis). Of course, it is still positive. Furthermore, it still rises with
the intended revenue, of course.

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4 Corrective taxation
Take N households with
N
X
N 2
Ui = xi ( + e) x + yi pxi e xj :
2 i j=1

4.1 a)
4.1.1 Producer surplus
Firm pro…ts are simply revenue minus costs, or pN xi c (N xi ). If this is a closed economy and thus
pro…ts are revenues of the households, pro…ts end up in y. Because of the quasilinearity of the consumers’
preferences and their symmetry (denote N x = X), because of most reasonable social welfare function
would be equivalent to a sum of the utilities, in which only costs would turn up:
N2 2
SW F = N x ( + e) x + I + pN x c (N x) pN x N 2 ex =
2
= X X 2 + I c (X) (N 1) eX; (9)
2
where I is the available money in the economy apart from the industry of x.

4.1.2 Demand for x

Every household solves its problem
N
X
N 2
max xi ( + e) x + mi e xj
xi ;mi 2 i j=1

s.t. pxi + mi = yi ;
which yield the necessary conditions for an (internal) optimum that
+e N xi e = p;
mi = y i pxi :
The individual demand for good x is
p
xi (p) = ; (10)
N
while the aggregate demand will be
p
X (p) = N xi (p) = : (11)

4.1.3 The meaning of e

The term e is an externality of everybody else’s consumption of x, while the private marginal utility of x
is a N x. A positive e means a reduction in all others’utility in proportion with one’s consumption,
while it cancels out in the own utility. For a negative e, vice versa.

4.2 b)
4.2.1 The competitive equilibrium with a …xed marginal cost
As price-taker …rms maximise pro…ts and all costs have the form c(x) = cx for whatever producer h,
maxpxh cxh
xh

yields of course the expected relation p = c. Individual and aggregate demand will be according to (10)
and (11):
c
xcomp = ;
N
c
Xcomp = :

8
4.2.2 The social optimum
However, if (9) were maximised, the optimal amount of X would come from

@
X X2 + I cX (N 1) eX = 0;
@X 2

XSO c (N 1) e = 0;
c (N 1) e
XSO = : (12)

Obviously, the social optimum sets a lower level of the good with a negative external e¤ect. (Or higher
if e < 0.) Clearly, the competitive market equilibrium is not the social optimal one (unless e = 0).

4.3 c)
4.3.1 The socially optimal allocation
That allocation is the on derived for comparison for the competitive one in (12). Each individual should
be allocated an Nth fraction of this aggregate amount:

c (N 1) e
xSO = : (13)
N

4.3.2 The optimal corrective tax

The optimal corrective tax is such that q = p + = c + consumer prices implement the amount (13) for
individual demands (10). (Note that since what is taxed away is fully rebated, I neglect to account for
this transfer. Also, I do not derive the optimal taxation from …rst principles, as it is known to implement
the social planner’s choice with prices for the competitive setting.)

c c (N 1) e
xi (c + ) = = xSO = ;
N N

comp = (N 1) e: (14)

4.4 d)
When good x is supplied by a single monopolist, the …rm will set its producer price p knowing that
aggregate demand will follow (11) with some consumer price q = p + , so it will solve

maxpX (q) cX (q) : (15)

p

4.4.1 The equilibrium outcome

When no tax is levied on the consumption of good x, the price is set to
p p
maxp c ;
p

2p c
+ = 0;

+c
p= :
2
Of course, for this price,
c
xmon = :
2N

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4.4.2 The optimal Pigouvian tax
As I argued already in Section 4.1.1, the …rm’s pro…t does not a¤ect social welfare for such quasilinear
utility and closed economy. Again (9) is maximised with respect to X, which of course has the same
solution as before in (12).
maxpX (p + ) cX (p + ) ;
p

2p c
+ = 0;

+c
p= :
2
+c+
+c 2 c c (N 1) e
X (p + ) = X + = = = XSO = :
2 2
The optimal tax follows as
mon = 2 (N 1) e ( c) : (16)
Comparing (14) and (16):

comp = (N 1) e > mon = 2 (N 1) e ( c)

m
( c) > (N 1) e;

which must be the case until the socially optimal output in (12) positive. Thus the optimal tax on the
product of the monopoly is strictly lower, which happens because its optimal supply is already below the
free market outcome without the tax. The optimal Pigouvian tax might turn out to be a subsidy, if the
monopoly output would be below the socially optimal output. (Or 2 (N 1) e < ( c) from (16).)

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