Ec 201: Class 8

Tim Besley
March 9, 2022

1 Exercise: to be prepared before the class

Consider a population of 99 individuals with three income levels 3 (the poor),
9 (the middle class) and 48 (the rich). There are equal numbers in each
income group. The government can choose among three possible income tax
rates: 10%, 20% and 50%. The proceeds of the tax are rebated back as a
transfer to all individuals equally, i.e. each individual receives
total tax revenue
.
99
1. What is the post tax and transfers income of an individual of each
income level for each of the three possible tax rates?

2. Which tax rates are Pareto efficient?

3. Which tax rate should be chosen according to a maximin social welfare

function?

4. Suppose that two parties are competing to win an election (they care
only about winning). Each party can announce a tax rate which they
will implement if they win. Suppose that the tax choices from the two
parties form a Nash equilibrium. Which tax rate will be chosen in
political equiilbrium?

5. Suppose that only 1/3rd of the poor and middle income groups actually
vote. Then what tax rate will prevail as a political equilibrium in the
model describe in the previous question?

1
6. Suppose that the poor have the poor to organize a referendum to choose
the tax rate and can propose a choice between any two out of the three
possible tax rates. The tax rate will be whatever gets a majority in the
referendum.

(a) What will be the tax rate chosen? Explain.

(b) Does this mean that a democracy with full participation by rich,
poor and middle class is not good for the poor?
(c) What would happen if the rich could propose the referendum?