1- The impact of tax on markets and welfare distribution. [70 points, 10 points each part]- Use supply and demand diagrams to answer the following questions. Draw new diagrams for answers to each part.
a- Show that regardless of who the tax is levied on (consumers or producers), a tax increase the price paid by consumers, decrease the price received by producers, and make the market smaller compared with a free market.
b- Show that regardless of who the tax is levied on (consumers or producers) the burden of tax will be shared between consumers and producers
c- Show that the burden of tax falls more heavily on relatively more inelastic side of the market.
d- Show that the greater the elasticity of supply and demand, the greater the deadweight loss of a tax.
e- Show that the greater the elasticity of supply and demand, the smaller the tax revenue generated by a given tax.
f- Show that, fixing elasticity of supply and demand, the impact of an increase in tax rate on tax revenue depends on whether the initial tax rate is “too low” or “too high”.
g- Show that the relatively more elastic side of the market benefits relatively less from a given tax cut.
2- The impact of payroll tax cut– [20 points, 15 points each]
[Hint: apart from the week 7 material, read “the Deadweight loss debate” on page 162-163 of the book before answering]
The most important taxes in the US economy is tax on labor. The Social Security tax, the Medicare tax, and the federal income tax are payroll taxes (see the budget infographics for more information). For a typical worker, if all forms of labor taxes are added together, the marginal tax rate – the tax on the last dollar of earning – is about 40 percent.
a- Use a labor supply and demand diagram to show that a labor tax places a wedge between the wage that firms pay and the wage that worker receive, and causes unemployment. On your graph show the deadweight loss and the tax revenue caused by tax.
b- Assume that most workers work fulltime regardless of the wage; and employers have access to cheap machines. Show that in this situation, the workers benefit relatively more from a payroll tax cut.
Sample Solution
