2.11 Consider the policy described in Problem 2.

10, but supposa that instead of announcing

and implementing the tax at time 0, the government announces at time 0 that at t1,
investment income will begin to be taxed at rate 𝝉.

Draw the phase diagram showing the dynamics of c and k before/after t1. Can c change
discontinuously at t1?

Before the tax is put in place, the equations governing the dynamics of the economy are:

𝑐̇ (𝑡) 𝑓 ! (𝑘(𝑡) − 𝜌 − 𝜃𝑔)

= 𝑎𝑛𝑑 𝑘̇ (𝑡) = 𝑓2𝑘(𝑡)3 − 𝑐(𝑡) − (𝑛 + 𝑔)𝑘(𝑡)
𝑐(𝑡) 𝜃

The condition required for 𝑐̇ = 0 is given by 𝑓 ! (𝑘) = 𝜌 + 𝜃𝑔. The capital accumulation
equation is not affected when the tax is put in place at t1.

Since the after-tax rate of return will be (1 − 𝜏)𝑓′(𝑘(𝑡)), the households maximization yields
to the following growth rate of consumption:

𝑐̇ (𝑡) (1 − 𝜏)𝑓 ! 2𝑘(𝑡)3 − 𝜌 − 𝜃𝑔

=
𝑐(𝑡) 𝜃

The condition required for 𝑐̇ = 0 is given by (1 − 𝜏)𝑓 ! (𝑘) = 𝜌 + 𝜃𝑔. The pre-tax rate of
return 𝑓 ! (𝑘), must be higher, and thus, k must be lower for 𝑐̇ = 0. Therefore, at t1, the 𝑐̇ = 0
moves to the left.

The dynamics of the economy are governed by the original equations until the tax is put in
place. At t1, when the tax is put in place, c cannot jump discontinuously because everyone
knows ahead of time that the tax will be implemented. A discontinuous jump in c would be
inconsistent with the consumption smoothing implied by the household intertemporal
optimization. The household would not want c to be low (high marginal utility) today knowing
that c will jump and be high (low marginal utility) tomorrow. The household would like to
smooth consumption between the two instants in time.
What must c do at time 0?

Consumption cannot jump at t1. When the tax is implemented, c must jump to a point that
for sure will end in the new growth path at point ENew. That is for example in point X.
At X, c is too high to maintain the stock at k* and begins falling. Until the tax is implemented,
the economy is governed by the original equations that ensure 𝑐̇ = 0. The economy is then
to the left of 𝑐̇ = 0 so consumption starts rising.
At point Y it is right in the new saddle path and the tax is implemented, now the economy is
governed by the new 𝑐̇ = 0. Thus, c starts falling, the economy moves to the new saddle path,
eventually reaching the new point ENew

Draw the paths of c and k as functions of time

Following the time paths for consumption per unit of effective labor and capital per unit of
effective labor.
2.12 Using the phase diagram to analyze the impact of unanticipated and anticipated
temporary changes.
a) At time 0, the government announces that it will tax investment income at rate 𝝉 from
time 0 until some later date t1; thereafter investment income will again be untaxed.

We know from previous exercise that consumption cannot jump at t1. Everyone know ahead
of time that the tax will end then and a discontinuous jump in c would be inconsistent with
consumption-smoothing behavior implied by the household optimization. For the economy
to return to a balanced growth path we must be on the original saddle path at t1.

Before the tax is put in place, the equations governing the dynamics of the economy are:

𝑐̇ (𝑡) 𝑓 ! (𝑘(𝑡) − 𝜌 − 𝜃𝑔)

= 𝑎𝑛𝑑 𝑘̇ (𝑡) = 𝑓2𝑘(𝑡)3 − 𝑐(𝑡) − (𝑛 + 𝑔)𝑘(𝑡)
𝑐(𝑡) 𝜃

We know by 𝑓 ! (𝑘) = 𝜌 + 𝜃𝑔 that 𝑐̇ = 0. The capital accumulation equation (and 𝑘̇ = 0) is

not affected by the tax. However, 𝑐̇ = 0 it is affected. Between t0 and t1, the condition for 𝑐̇ =
0 is that (1 − 𝜏)𝑓 ! (𝑘) = 𝜌 + 𝜃𝑔. Therefore, between t0 and t1, f’(k) must be higher, and k
must be lower, in order for 𝑐̇ = 0. That is, between t0 and t1, the 𝑐̇ = 0 moves to the left.

When the tax is put in place the economy is still on the 𝑘̇ = 0, but it is on the right of the new
𝑐̇ = 0. At time t0, c must jump up so that the economy is in a point like X. Then c and k start
falling, the economy crosses the 𝑘̇ = 0 line and so k starts growing.
The intuition is as people anticipating the removal of the tax on capital and being willing to
accumulate capital again. X must be such that given the dynamics, the economy must be at
point Y at t1.

After t1, the original 𝑐̇ = 0 line governs the dynamics again. The economy returns to the
original saddle path, returning to the original balanced growth path at point E.
b) At time 0, the government announces that from time t1 to some later time t2, it will tax
investment income at rate 𝝉; before t1 and after t2, investment income will not be taxed.

From previous exercises we know that consumption cannot jump at t1 or t2. Consumers know
ahead of time that the tax will be implemented at t1 and removed at t2. A jump in c at any
point in time would be inconsistent with the consumption-smoothing behavior, that is
optimal for intertemporal household’s optimization. For the economy to return to a balanced
growth path, it must be somewhere in the original saddle path at t2.

Between the periods t0 to t1 and after t2, the equations governing the dynamics of the
economy are:

𝑐̇ (𝑡) 𝑓 ! (𝑘(𝑡) − 𝜌 − 𝜃𝑔)

= 𝑎𝑛𝑑 𝑘̇ (𝑡) = 𝑓2𝑘(𝑡)3 − 𝑐(𝑡) − (𝑛 + 𝑔)𝑘(𝑡)
𝑐(𝑡) 𝜃
At t0, when the tax is announced. Consumption must jump up so that the economy is at point
X, in which it will still be on the 𝑐̇ = 0 locus but above 𝑘̇ = 0 locus, so k starts decreasing.
Then we are on the left of 𝑐̇ = 0 and c starts increasing to the upper-left part of the diagram.

At t1 the tax is implemented, 𝑐̇ = 0 locus moves to the left as derived in previous exercises,
at that moment the economy was at some point Y, still above 𝑘̇ = 0 but in the right to the
new 𝑐̇ = 0. At this stage k falls and so does c.

At some moment the economy crosses the 𝑘̇ = 0 and k begins to rise, as people begin to
accumulate capital before the removal of the tax on capital income at t2, as expected. Point X
must be chosen such that given the dynamics of the system, the economy is at Z at t2. Then,
the economy moves up the original saddle path, returning to the original balanced growth
path E.
2.17 Diamond. Social security in the Diamond model. Consider a Diamond economy where
g is zero, production is Cobb-Douglas and utility is logarithmic.

a) Pay-as-you-go social security. Suppose that the government taxes each young
individual an amount T and uses the proceeds to pay benefits to old individuals; thus,
each old person receives (𝟏 + 𝒏)𝑻
a. How, if at all, does this change affect equation (2.61) giving 𝑘"#$ as a function
of 𝑘" ?
The individual faces the following optimization problem with the pay-as-you-go social
security:
1
𝑚𝑎𝑥𝑈 = 𝑐$," + @ A𝑐
1 + 𝜌 &,"#$
Subject to: 𝑐$," + 𝑆" = 𝐴𝑤" − 𝑇
𝑐&,"#$ = (1 + 𝑟"#$ )𝑆" + (1 + 𝑛)𝑇

Rearranging, we obtain the intertemporal budget constraint:

𝑐&,"#$ 𝑟"#$ − 𝑛
𝑐$," + = 𝐴𝑤" − 𝑇
1 + 𝑟"#$ 1 + 𝑟"#$
$#'
A consumer with logarithmic utility will consume a fraction &#' of the lifetime wealth when
young.
1+𝜌 𝑟"#$ − 𝑛
𝑐$," = @𝐴𝑤" − 𝑇A
2+𝜌 1 + 𝑟" + 1
Rearranging,
1+𝜌 𝑟"#$ − 𝑛
𝑆" = 𝐴𝑤" − @𝐴𝑤" − 𝑇A − 𝑇
2+𝜌 1 + 𝑟" + 1

1 (2 + 𝜌)(1 + 𝑟"#$ ) − (1 + 𝜌)(𝑟"#$ − 𝑛)

𝑆" = @ A 𝐴𝑤" − 𝑇
2+𝜌 (2 + 𝜌)(1 + 𝑟"#$ )

(2 + 𝜌)(1 + 𝑟"#$ ) − (1 + 𝜌)(𝑟"#$ − 𝑛)

𝐷𝑒𝑛𝑜𝑡𝑒 → = 𝐵"
(2 + 𝜌)(1 + 𝑟"#$ )
Then the equation becomes
1
𝑆" = @ A 𝐴𝑤" − 𝐵" 𝑇
2+𝜌
The capital stock in t+1 is the total savings of the young in t, converting into units of effective
labor yields
1 1 𝑇
𝐾"#$ = 𝑆" 𝐿" → 𝑘"#$ = @ A O@ A 𝑤" − 𝐵" ∗ Q
1+𝑛 2+𝜌 𝐴
Real wages with a Cobb-Douglas production function
𝑤" = (1 − 𝛼)𝑘"(
Substituting into our capital stock per units of effective labor
1 1 𝑇
𝑘"#$ = @ A O@ A (1 − 𝛼)𝑘"( − 𝐵" ∗ Q
1+𝑛 2+𝜌 𝐴

We get the capital stock per units of labor in the second period as a function of the capital
today with pay-as-you-go social security system.
 b. How, if at all, does this change affect the balanced-growth-path value of 𝒌?

To determine the effect of the pay-as-you-go social security system on the balanced-growth-
path value of k, we need to know what is Bt.

(2 + 𝜌)(1 + 𝑟"#$ ) − (1 + 𝜌)(𝑟"#$ − 𝑛) (1 + 𝑟"#$ ) + (1 + 𝜌)(1 + 𝑛)

𝐵" = = >0
(2 + 𝜌)(1 + 𝑟"#$ ) (2 + 𝜌)(1 + 𝑟"#$ )

Since 𝐵" > 0 we know that the introduction of the tax T shifts down kt+1 curve and reduces
the balanced-growth-path value of k*, relative to the case without the social security.

c. If the economy is initially on a balanced-growth-path that is dynamically

efficient, hoe does a marginal increase in T affect the welfare of current and
future generations? What happens if the initial balanced growth path is
dynamically inefficient?

When the economy is dynamically efficient, a marginal increase in T results in a gain to the
old generation, who gets extra benefits.
It has been proved that it reduces k* below kGR and leaves future generations worse and with
lower consumption possibilities.

If the economy was dynamically inefficient, k*> kGR, the old generations gain for extra benefits.
The reduction in k* leads to higher consumption for future generations and welfare-
improving. The introduction of the tax reduces the dynamic inefficiency caused by the over-
accumulation of capital.

b) Fully funded social security. Suppose that government taxes each young person an
amount T and uses the proceeds to purchase capital. Individuals bort at t therefore
receive (𝟏 + 𝒓𝒕#𝟏 )𝑻 when old.
a. How, if at all, does this change affect equation (2.61) giving 𝒌𝒕#𝟏 as a function
of 𝒌𝒕 ?
The individual faces the following optimization problem with the fully funded social security:
1
𝑚𝑎𝑥𝑈 = 𝑐$," + @ A𝑐
1 + 𝜌 &,"#$
Subject to: 𝑐$," + 𝑆" = 𝐴𝑤" − 𝑇
𝑐&,"#$ = (1 + 𝑟"#$ )𝑆" + (1 + 𝑟"#$ )𝑇

Rearranging, we obtain the intertemporal budget constraint:

𝑐&,"#$
𝑐$," + = 𝐴𝑤" − 𝑇 + 𝑇
1 + 𝑟"#$

Solving the maximization problem yields the Euler equation

1
𝑐&,"#$ = (1 + 𝑟"#$ )𝑐$,"
1+𝜌
Substitute Euler equation into budget constraint
1+𝜌
𝑐$," = @ A 𝐴𝑤"
2+𝜌
We get savings per person from second equation
(1 + 𝜌) 1
𝑆" = 𝐴𝑤" − V W 𝐴𝑤" − 𝑇 = @ A 𝐴𝑤" − 𝑇
2+𝜌 2+𝜌
This system of social security reduces one unit of private savings per unit taxed.

The capital stock in t+1 is the total savings of the young in t plus the total amount invested by
the government, converting into units of effective labor yields
1 1 𝑇 1 𝑇
𝐾"#$ = 𝑆" 𝐿" + 𝑇𝐿" → 𝑘"#$ = @ A O@ A 𝑤" − Q + @ A∗
1+𝑛 2+𝜌 𝐴 1+𝑛 𝐴
1 1
𝑘"#$ = 𝑤
1+𝑛2+𝜌 "

Real wages with a Cobb-Douglas production function

𝑤" = (1 − 𝛼)𝑘"(

The fully funded social security system has no effect on the relationship between the capital
stock in next periods.
1 1
𝑘"#$ = (1 − 𝛼)𝑘"(
1+𝑛2+𝜌

b. How, if at all, does this change affect the balanced-growth-path value of 𝒌?

Since there is no effect on the relationship between kt+1 and kt, the balanced-growth-path of
k is the same as it was before the introduction of the fully funded social security system.

Total investment and savings are the same in each period because now is the government
who is saving part from the young. Social security pension pays the same rate of return as
private savings, individuals are indifferent as to who does the savings.