Public Economics: HW5

March 10, 2021

Problem 1. Are the following statements true or false? Explain why!

a. The theory of optimal commodity taxation argues that equal tax rates should be set
across all commodities so as to maximize efficiency by “smoothing taxes.”
b. The theory of optimal commodity taxation argues that percentage reduction in con-
sumption of a taxed good should be equal across all taxed goods.
Solution.
a. False. The optimal theory does not argue that we need to “smooth” taxes to minimize
efficiency loss. Instead, we need spread taxes across all goods depending on compensated
price and cross price elasticities of that goods to keep tax rates relatively low on all goods.
So, the optimal tax rate are not necessary should be equal across commodities. It is also
should be mentioned that there no possibility to tax absolutely all goods due to existence of
untaxed goods, for example, such as leisure.
b. The answer depend on presence of the redistributive motive condition. If the Ram-
sey model is considered and tax rates are determined solely by efficiency considerations, the
indexes of discouragements must be equal across goods at the optimum because they are con-
nected withe the fixed value for the government of introducing a $1 lump sum tax. However,
equity motives result in the goods consumed primarily by the poor facing less of a reduction
in demand due to subsidising them at the expense of richer consumers.
Problem 2. Consider an economy where a representative consumer derives utility from
consumption of cereal (c) and from watching movies (m). The individual’s budget constraint
is qc c + qm m = I − wL, where w is the wage rate, I is income, and qi (i = c, m) are consumer
1 1 1
prices. The individual utility function is U = c 2 m 4 L 8 . Assume that the government imposes
commodity taxes on c and m at rates tc and tm in order to collect revenue R. The government
chooses tax rates to maximize consumers’ welfare. Assume that I = 4 and R = 1. Assume
also that leisure is untaxed and that producers prices are fixed and normalized to 1 s.t.
qi = 1 + ti , i = c, m.

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 a. Specify the consumer’s problem. Find the optimal demands as functions of prices and
income.
b. Set the government’s problem. Calculate the optimal Ramsey tax rates.
c. According to your result in part b, should a uniform taxes on c and m be used? Why?
d. Could the Inverse Elasticity Rule be used in this case to calculate the optimal Ramsey
tax rates? Explain why. If yes, then apply it. Does it give the same result as in part b?
Explain why.
Solution.
a. The consumer’s problem is
1 1 1
U = c 2 m 4 L 8 → max
c,m,L

s.t. qc c + qm m = I − wL.

The Lagrangian for consumer’s problem is

1 1 1
L(c, m, L) = c 2 m 4 L 8 − α(qc c + qm m − I + wL) → max .
c,m,L

The FOCs 1 1 1 1 1 1
m4 L8 c2 L8 c2 m4
1 = αqc 3 = αqm 7 = αw.
2qc c 2 4m 4 8L 8
The demand is then
4I 2I I
c∗ = m∗ = L∗ = .
7qc 7qm 7w
b. Firstly, for simplicity, rewrite the demands as
dc dm dL
c∗ = m∗ = L∗ = ,
qc qm w
4I 2I I
where dc = dm = dL = .
7 7 7
The government’s problem is
1 1 1

∗ ∗ ∗ dc2 dm
4
dL8
V (c , m , L ) = V (qc , qm , w, I) = 1 1 1
→ max
tc ,tm
qc2 qm4 w 8
dc dm
s.t. tc + tm = R,
qc qm
where qc = 1 + tc , qm = 1 + tm .
The Lagrangian for government’s problem is
1 1 1
dc2 dm
4
dL8 dc dm
L(tc , tm ) = 1 1 − λ(tc + tm − R) → max .
qc qm w 8
2 4
1 qc qm tc ,tm

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 The FOCs 1 1 1
1 dc2 dm
4
d8 dc qc − tc dc
− 3 1 L1 = λ
2 q2q4 w8 qc2
c m
1 1 1
1 dc dm d 8
2
dm qm − tm dm
4

− 1 5 L1 = λ 2
.
4 q2q4 w8 qm
c m

Solving as a system of equations we can obtain

1 1 1 1 3 1
1 qc2 dm
4
d8 1 dc2 qm4 d 8 dm dc
− 1 1 L1 = λ = − 1 3 L1 ⇒ 2 = .
2 d2 q 4 w8 4 q 2 d4 w8 qm qc
c m c m

Substitute this expression in the budget constraint

dm dm
2tc + tm =R
qm qm
2tc dm − R
⇒ tm = .
R − dm
Substitute the obtained expression back into the equation deduced from the FOCs
dc
  tc dc − R
dc dc 2tc dm − R dc 2dm
qc = qm = 1+ = +
2dm 2dm R − dm 2dm R − dm
 
tc dc dc R
⇒ 1 + tc − = 1−
R − dm 2dm R − dm
   
R − dc − dm dc −1
⇒ tc = −1
R − dm 2 R − dm
dc R − dm 2dm − 2R − dc
⇒ tc = − − = =
2(R − dc − dm ) 2(R − dc − dm ) 2(R − dc − dm )
2R − 2dm − 2dc + 3dc 3dc
=− = −1 − .
2R − 2dc − 2dm 2(R − dc − dm )
 
3dc
dm −2 − −R
R − dc − dm 2d2 − 2dm R − dc dm − R2 + dm R + dc R
⇒ tm = = m =
R − dm (R − dm )(R − dc − dm )
−2dm (R − dm ) + dc (R − dm ) − R(R − dm ) R − dc − dm + 3dm
= =− =
(R − dm )(R − dc − dm ) R − dc − dm
3dm
= −1 − .
R − dc − dm
7
Substituting the values we get tc = tm = 17
.
c. Despite the fact, that uniform taxes do not necessarily minimize excess burden because
they will not be optimal unless substantial (and typically unrealistic) restrictions are imposed

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on preferences, they are probably cheaper to administer than any others. So, if it is possible
to impose such kind of tax, it is done. In our case, εcc,l = εcm,l , goods have the same degree of
ti
complementarity with labor that means that qi
is constant and uniform taxation is optimal
to be imposed.
d. All our demand functions have the same elasticity that is equal to -1. Since that we
ti
have qi
= − λ−α 1
λ εii
= 1− α
λ
that is constant. We can derive α from FOCs in part a and λ
from FOCs in part b.
1 1
1 dm 4
dL8
α= 1 1 1 ,
2 q 2 d 2 q 4 w 18
c c m
1 1
1 qm dL8 4

λ=− 3 1 1
.
2 2 dm
4
w8
ti
Substitute them into qi
and get the following expression

dm dc
2 =
qm qc
which was be obtained in part b because the Inverse Elasticity Rule was also derived from
the FOCs. Since that, the following reasoning is similar and answer will be the same: tc =
7
tm = 17
.
Problem 3. Consider two consumers with preferences

U1 (x1 , x2 ) = 3x1 + x2 ,

U2 (y1 , y2 ) = y1 + 3y2 ,

where x1 , x2 denote the consumption of good 1 and good 2 by consumer 1 and y1 , y2 denote
the consumption of good 1 and good 2 by consumer 2. The incomes of consumers are M1
and M2 where M1 < M2 . The government imposes commodity taxes on good 1 and good 2.
Its revenue requirement is R > 0. Assume that producer prices p1 = p2 = 1.
a. Calculate the demand for good 1 and good 2 for each consumer as a function of income
and consumer prices. [Hint: You can use graphical solution method.]
1 q1
For parts (b), (c), (d), and (e) assume that consumer prices are such that 3
< q2
< 3.
b. Write down the government revenue constraint.
c. Assume that the government chooses tax rates to maximize social welfare. Assume
that social welfare is equal to log(U1 ) + log(U2 ). Set the government’s problem. Find the
optimal commodity taxes: t1 and t2 .
d. What might be the reason to collect taxes when R = 0? What are the optimal
commodity taxes (t1 and t2 ) in this case?

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 e. Calculate the optimal taxes when R = 0, M1 = 1, and M2 = 2. Check whether
1 q1
condition 3
< q2
< 3 is satisfied. Calculate how the utility of consumer 1 changes and how
the utility of consumer 2 changes after taxes are imposed.
q1
f. Could the government achieve redistribution by imposing taxes such that q2
< 13 ?
Solution.
a. The consumers’ problems

U1 (x1 , x2 ) = 3x1 + x2 → max

x1 ,x2

s.t. q1 x1 + q2 x2 = M1

U2 (y1 , y2 ) = y1 + 3y2 → max

y1 ,y2

s.t. q1 y1 + q2 y2 = M2 .

Find the demand for good 1 and good 2 for each consumer. We know that if the utility
function is linear the optimal demands are depend on slopes of the utility level and the budget
q1 M RS1 q1 M RS1
constraint, so if q2
< M RS2
, the consumer will consume only good 1, and if q2
> M RS2
, the
consumer will consume only good 2. Therefore, the demand functions are
 q1
 0
 >3
∗ q2
x1 = M q1
 1
 <3
q1 q2

M q1
 1
 >3
∗
x2 = q2 q2
q1
 0
 <3
q2
q1 1

 0
 >
y1∗ = q2 3
M q1
 2
 <3
q1 q2
M q1

 2
 >3
y2∗ = q2 q2
q1 1
 0
 <
q2 3
1 q1 M1
Since 3
< q2
< 3, the optimal demands for these consumers x1 = , x2 = 0, y1 = 0,
q1
M2
y2 = .
q2
b. The government revenue constraint is

t1 (x1 + y1 ) + t2 (x2 + y2 ) = R

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 M1 M2
t1 + t2 = R.
q1 q2
t2 R M1 t1
Thus, = − .
q2 M2 M2 q1
c. The social welfare is
   
3M1 3M2
log(U1 ) + log(U2 ) = log(3x1 + x2 ) + log(y1 + 3y2 ) = log + log =
q1 q2

= 2log(3) + log(M1 ) + log(M2 ) − log(q1 ) − log(q2 ).

The Lagrangian for the government’s problem is

 
M1 M2
L(t1 , t2 ) = 2log(3) + log(M1 ) + log(M2 ) − log(q1 ) − log(q2 ) − λ t1 + t2 −R → max
q1 q2 t1 ,t2

Note that q1 = 1 + t1 and q2 = 1 + t2 . Maximization of the Lagrangian w.r.t t1 and t2

gives the following FOCs:  
1 M1 q1 − t1 M1
=λ
q1 q12
 
1 M2 q2 − t2 M2
=λ .
q2 q22
   
t1 t2
⇒ M1 1 − = M2 1 − .
q1 q2
t2 t1 M1 − M2 + R t2 M2 − M1 + R
Substitute and get = , therefore, = .
q2 q1 2M1 q2 2M2
Find the optimal tax rate
t1 M1 − M2 + R M1 − M2 + R
= ⇒ t1 = ,
1 + t1 2M1 M1 + M2 − R
t2 M2 − M1 + R M2 − M1 + R
= ⇒ t2 = .
1 + t2 2M2 M1 + M2 − R
d. The reason to collect taxes when R = 0 might be redistribution purchasing power
(incomes) between consumers if there is inequality in order to obtain optimal social welfare
by subsidising poor consumers at the expense of richer consumers. At this case the optimal
commodity taxes are
M1 − M2 M2 − M1
t1 = , .
M1 + M2 M1 + M2
e. Substitute the value and get t1 = − 13 , t2 = 13 .
 
q1 1 + t1 1 1
= = ∈ ;3 .
q2 1 + t2 2 3

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 (1) (0) 3M1 3M1 3M1 − 3M1 − 3M1 t1 3
∆U1 = U1 − U1 = − = = ,
1 + t1 1 1 + t1 2
(1) (0) 3M2 3M2 3M2 − 3M2 − 3M2 t2 3
∆U2 = U2 − U2 = − = =− .
1 + t2 1 1 + t2 2
q1
f. If the government impose taxes such that q2
< 13 , it becomes too expensive for the
M2
consumer to buy y2 and he begins consume only y1 = q1
. Since that, the government’s
budget constraint has been as follows
 
M1 M2
t1 + = R = 0 (for redistribution case).
q1 q1

As we can see the same tax rate is imposed on the consumers, that means that either both
of them will pay this tax to the government and R > 0, or both of them will be subsidised by
the government and R < 0, or none of this and R = 0. Therefore, there is no redistribution
between consumers.