Public Economics: Week 8

Definitions to know:

 The Laffer Curve

 The Earned Income Tax Credit
o The hours effect vs participation effect on the supply of labor
 (Commodity) tax incidence
 Ramsey-rule/Inverse elasticity rule of commodity taxation
 Luxury tax rule of commodity taxation
 Broad-based rule of commodity taxation

Short answer questions:

What is the optimal income taxation trade-off that governments face when deciding income tax
rates? Be clear about the two objectives a government with a progressive social welfare function
may encounter.

Would the imposition of a proportional tax increase or decrease hours worked? (Hint: you
MUST consider the size of the income effect relative to the substitution effect. It may help to
break this problem down according to the two case scenarios where the: 1.) income effect
dominates, and; 2.) the substitution effect dominates)

Would the imposition of a tax credit increase or decrease hours worked? (Hint: you MUST
consider the size of the income effect relative to the substitution effect. It may help to break this
problem down according to the two case scenarios where the: 1.) income effect dominates, and;
2.) the substitution effect dominates)

What is the predicted theoretical impact of the Earned Income Tax Credit on hours worked in the
following stages of the budget line: 1.) not in the labor force; 2.) working in the phase-in stage;
3.) working in the plateau region; and 4.) working in the phase out stage. Be sure to graphically
draw ALL stages and before/after indifference curves for each region.

Empirically, has the EITC been attributed with a significant change for number of hours worked
for primary earners already in the labor force? What may explain this empirical outcome?

How does the elasticity of demand/supply influence tax incidence for commodity taxation? Use
a graphic comparing the influence of a tax on an elastic vs inelastic demand OR supply curve to
illustrate your case (hint: drawing a tax wedge will help).

Graphically outline how new commodity taxes produce larger deadweight losses than pre-
existing ones.
Graphically depict that a commodity tax produces less of a deadweight loss when imposed on an
inelastic demand curve, relative to an elastic demand curve.

For commodity taxation, what type of a tax rule should governments follow if they want to
maximize revenues AND minimize consumption distortions? Is this tax rule equitable?

What is the equity/efficiency trade-off for policy makers when deciding between a Ramsey rule
vs a luxury-goods rule for commodity taxation?