QUIZ 4: Macro Winter Question 1. Would you expect a country to have a larger Deficit/GDP ratio or a Debt/GDP ratio?

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1 Name: QUIZ 4: Macro Winter 2011 You must always show your thinking to get full credit. Question 1 Would you expect a country to have a larger Deficit/GDP ratio or a Debt/GDP ratio? You would expect the Deficit/GDP ratio to be smaller than the Debt/GDP ratio. Actually much smaller given that the Deficit represents the flow of government outlays in excess of fiscal revenues that need to be financed with additional Public Debt. The total (cumulated) stock would give you the current Public Debt of the country (orders of magnitude larger than the Deficit). Would you expect a country to have a larger Actual Deficit/GDP ratio or a Structural Deficit/GDP ratio? (5 pts. in total) Assuming that the country employs automatic stabilizers, it really depends if the country is in a recession or in a boom. In case of a recession actual deficits are going to be larger than structural deficits because tax revenues are low and transfers are high relatively to their values at potential output. In case of a boom actual deficits are going to be smaller than structural deficits because tax revenues are high and transfers are low relatively to their values at potential output. Question 2 Identify what is correct and incorrect in the following statement:

2 A deficit during a war can be a good thing. First, the deficit is temporary, so after it is over, the government can go right back to its old level of spending and its old level of taxes. Second, since the evidence supports the Ricardian equivalence proposition, the deficit should help stimulate the economy during wartime, helping in smoothing taxes over time. (10 pts.) A deficit during a war can be a good thing : Correct. A deficit would help to smooth taxes over time. The government does not need to finance the government increased expenditures as a result of the war in the same period they are taking place. Since taxes generate distortions, it is good that the government is able to smooth the tax increase over time by incurring deficits during the war. The deficit is temporary, so after it is over, the government can go right back to its old level of spending and its old level of taxes : Incorrect. During the war the government incurs deficits and increases its debt. In the future the government cannot go back to its old level of spending and its old level of taxes because it has to repay for the deficits incurred during the war. Since the evidence supports the Ricardian equivalence proposition : Incorrect. Empirical evidence does not support the Ricardian equivalence proposition. the deficit should help stimulate the economy during wartime : Incorrect. According to the Ricardian equivalence proposition, consumers will expect future taxes to increase and therefore they will already decrease consumption in the present according to these prospects. helping in smoothing taxes over time : Incorrect. If, According to the Ricardian equivalence proposition, consumers decrease consumption in the present as a result of their expectation about future taxes to increase, the goal of smoothing taxation over time won t be achieved.

3 Question 3 Determine if the following statements related to Government s Budget Deficit and IS curve are TRUE or FALSE. 1. Tax cuts shift the IS curve to the right. True. Income tax cut: for the same level of output disposable income increases due to a reduction in income taxes. Desired saving decrease and the real interest rate clearing the goods market increases. The IS shifts to the right. Investment tax cut: for the same level of output desired investment increases due to a reduction in user cost of capital. The real interest rate clearing the goods market increases. The IS shifts to the right. 2. Automatic Stabilizers make the IS curve flatter. False. This is a complex answer so you will receive full credit even if you just mention that automatic stabilizers will affect the desired saving curve without adding information on the effect of their introduction on IS. Fiscal policy influences the slope of the IS curve. The marginal propensity to consume (MPC) out of disposable income is one of the determinants of the slope of the IS curve, through the desired saving curve in the goods market. Let us focus on income taxes as automatic stabilizers. The marginal propensity to consume is affected by taxing Y. Let s show it. This is also derived in Appendix 9.A of the book. Recall that the IS curve can be represented as: S = Y - C(r) - G = I(r) (The goods MKT equilibrium) and setting NX = 0. Rearranging the IS can be represented as Y = C(r) + I(r) + G (1) Let us assume for simplicity two reasonable linear expressions for I and C: I(r) = a - b*r C(r) = d + MPC*Y*(1-t) - j*r (so S = Y C(r) - G is increasing in r) where a, b, d, MPC, j are parameters. Now replace I(r) and C(r) in (1). Y = d + MPC*Y*(1-t) j* r + a b*r + G or 1/(j + b)*[y (1-MPC*(1-t)) (d+a+g)] =r (2) (2) is our IS.

4 Therefore, the IS curve is STEEPER as a result of the Automatic Stabilizers. The intuition is that with automatic stabilizers the change in real interest rates that makes the goods mkt be at equilibrium at two different levels of output (say Y and Y ) is larger than the change in r that occurs without automatic stabilizers. Savings increase more when you move from Y to Y if you have automatic stabilizers than if you don t. 3. The deficit fluctuates procyclically with GDP. False, they are counter-cyclical (they correlate negatively with output) because of automatic stabilizers. 4. The progressive tax system contributes to the fall of Real Tax Receipts by a smaller percentage relative to real GDP during recessions. False. This is because expenditures rise and receipts fall during recessions. Real tax receipts fall by a greater percentage than real GDP during recessions. This is mainly because of the progressive tax system (the larger the income the larger the tax rate you pay). Therefore, Progressive tax system will reduce tax receipts by a LARGER % relative to GDP during recessions. 5. If government spending is unchanged, a decrease in taxes must eventually be offset by increase in taxes in the future. The longer the government waits to increase taxes, the higher the eventual increase in taxes. True, since the government will need to pay the debt soon or later, the amount taxed is going to increase proportionally to what needs to be paid the public to service the debt plus the principal. If an amount of spending (G) is financed by issuing government bonds B (= G) today, the taxes that are going to be necessary to pay out the debt next period are T = B(1+r), the following period T = B(1+r)(1+r), etc Question 4 In the Papaya Republic the income tax law exempts income of less than $ The tax rate that applies to income between $10000 and $30000 is 25% and income above $30000 is taxed at a 35% rate. (10 pts.)

5 a) Compute the average tax rate and the marginal tax rate of a day laborer in Papaya Republic whose sole income is $ per year in wages. Compute the average tax rate and the marginal tax rate of a lawyer earning $ in Papaya Republic. Day laborer s average tax rate is = (10000* *.25)/20000 = 12.5% Day laborer s marginal tax rate is = tax on the marginal dollar of income = 25% [ income bracket]. Lawyer s average tax rate is = (10000*0+( )*.25 + ( )*.35)/50000 = 24% Lawyer s marginal tax rate is = tax on the marginal dollar of income = 35% [30000 and over income bracket]. b) Suppose that the Minister of Finances of Papaya decides to introduce a new tax bracket, taxing income above $40000 at a 45% tax rate. How does your answer at point a) changes? Day laborer s rates are unchanged. Lawyer s new average tax rate is = (10000*0+( )*.25 + ( )*.35 + ( )*.45)/50000 = 26% Lawyer s new marginal tax rate is = tax on the marginal dollar of income = 45% [40000 and over income bracket]. c) What is the likely effect of the change in the tax code at point b) on the labor supply decision of the day laborer? What about the lawyer? The day laborer s supply is unaffected by the change in the tax code. Neither average nor marginal tax rates are changing for him. The lawyer experiences however a change of both average and marginal rates (they increase). The effect is ambiguous since positive changes in the marginal tax rate (for given average tax rate) tend to discourage people from working by cutting their after-tax wages [substitution effect leisure is cheaper], while positive changes in the average tax rate (for given marginal tax rate) tend to encourage people to work by cutting their after-tax income [income effect consume less goods and less leisure i.e. work more].