Summer 2005 examination EC426 Public Economics 2004/2005 syllabus only not for resit candidates SOLUTIONS Instructions to candidates Time allowed: 3 hours This paper contains twenty-one questions and is divided into three sections of which two are relevant for any particular candidate. Answer two short questions and one long question from section A. Answer two short questions and one long question from EITHER section B OR section C. Each short question has a weight of 10% (of the overall mark) and each long question a weight of 30%. In multipart questions, answer all parts. Calculators are not allowed in this examination. LSE 2005/EC426 Page 1 of 5
SECTION A 1. What role is played by the "hidden characteristics" problem in the design of taxes? Illustrate in the case of the income tax. 2. How and why does the Lindahl reaction function, in a two-person public good economy, differ from the reaction function in a Nash-Cournot equilibrium? Discuss the differences between the two equilibria. 3. Define yardstick competition and discuss its potential usefulness as a regulatory instrument. 4. What insights are provided by the incomplete contracts approach to the (public versus private) provision of public services? 5. Explain the difference between entitlement and end-state approaches to making and evaluating the case for government intervention. Show how the Rawlsian max-min and Benthamite welfare criteria can be subsumed within the general Bergson-Samuelson welfare function. Does either criterion provide a good argument for equality of outcome? Discuss the ways in which the above welfare approaches might be used to provide a coherent basis for inequality measurement. What practical issues would have to be addressed in order to implement these approaches 6. Optimal commodity taxation Define marginal deadweight loss and discuss the usefulness of the concept (e.g., in considering tax reforms or interpreting the Ramsey rule). Discuss how the generalised Ramsey rule derived by Coady and Dreze (2002) differs from the original Ramsey rule. In what ways can the generalised Ramsey rule be used to summarise the general principles of optimal taxation? 7. Uncertain tax policy and investment What issues arise in attempting to model uncertainty in future taxes on investment? How does this uncertainty in tax policy affect firms investment decisions? What are the implications of the nature of uncertainty for the impact of increased uncertainty on firms and on the government? LSE 2005/EC426 Page 2 of 5
SECTION B 8. How does the "sequential dominance approach help in making distributional comparisons where needs differ? 9. Use a simple model to explain the relationship between long-run wealth inequality and (i) the distribution of families by size and (ii) the tax rate on intergenerational transfers of wealth. 10. The analysis of tax compliance usually focuses on individuals reporting their incomes. What issues are raised if one extends the analysis to compliance by firms? 11. Assess the case for using quantity regulation (e.g., tradeable emission permits) as environmental policy instruments for reducing harmful emissions. 12. It is sometimes suggested that standard optimal income tax theory requires falling marginal tax rates at high-income levels. Evaluate the validity of this suggestion. What guidance does optimal income tax theory give on the taxation of low incomes? 13. Explain how the theory of clubs can be used to construct a model of local public goods. Why might the transformation frontier between local public goods and private goods be non-convex? Consider a two-jurisdiction world where individuals differ according to their (exogenous) and the public goods that are local to each jurisdiction are provided in one jurisdiction by voluntary contribution from the residents and in the other jurisdiction by local taxation, where the tax rate is decided by voting. Describe the types of equilibria that may emerge. 14. Tax-based savings incentives Is there a market failure justification for savings incentives? What does the life-cycle model (with heterogeneous individuals) imply about the likely effects of tax-based savings incentives such as Individual Retirement Accounts (IRAs) in the US and Individual Savings Accounts (ISAs) in the UK? Does the empirical literature on the impact of IRAs support the lifecycle model? Discuss. LSE 2005/EC426 Page 3 of 5
SECTION C 15. What is the theory of Purchasing Power Parity? Assuming away official barriers to trade and non-competitive market structure, discuss a potential explanation for the gigantic differences in prices (expressed in the same currency) between developed and less developed countries? 16. Consider an unanticipated permanent decrease in money supply in the context of Dornbusch s overshooting model. Explain the dynamics of the nominal exchange rate following the monetary shock. 17. What factors explain the massive inflow of capital in Latin America at the beginning of the 1990 s? 18. Explain the Home Bias in the portfolios of industrial-country investors. Discuss two explanations for the bias. 19 Consider a neo-classical small open economy with two composite goods, tradables (T) and non-tradables (N); total factor productivities in each sector are given by A T and A N. The equilibrium conditions in this economy are: (i) A T f (k T )= r (ii) A T [f(k T )- k T f (k T )]= w (iii) pa N g (k N )= r (iv) pa N [g(k N )- k N g (k N )]= w where p is the price of the non-tradable composite relative to the price of the tradable; the price of the tradable composite good is normalised to one; k i i=t,n is the capital labour ratio in the tradable and non-tradable sectors, respectively; r is the international real interest rate in terms of tradables. Labour is mobile across sectors but there is no international mobility. Capital is perfectly mobile both across sectors and internationally. Briefly explain these equilibrium equations. Compare the economic effects of an increase in productivity in the tradable sector with those of an increase in productivity in the nontradable sectors. Suppose the rest of the world introduces tariffs on imports for the tradable goods produced in this economy. How will this affect the capitallabor ratio and the wage rate in this economy? 20 Consider a large open Ricardian economy with a continuum of tradable goods indexed by z Є [0,1] and one factor of production, labour, available in fixed quantities L in Home and L* in the rest of the world. In Home a unit of good z can be made out of a(z) units of labour; in the rest of the world, a unit of good LSE 2005/EC426 Page 4 of 5
z can be made out of a*(z) units of labour. There is perfect competition in the provision of all goods. The equilibrium conditions of the model are: (i) (ii) w/w*=a(z) w/w*= (L*/L) z/(1-z) where A(z)= a*(z)/a(z) and goods have been order along [0,1] so that the relative Home labour requirements increase with z (i.e., A (z)<0). Explain briefly the equilibrium conditions. Use the model to discuss the effect on production and real wages at Home resulting from an increase in relative foreign labour supply (L*/L). In light of your answer in b) discuss why many groups in developed countries (for example in the US), have expressed concern about growing exports from China and demanded higher levels of protection. 21 With the aid of a formal model or otherwise, answer the following: What is the debt overhang? What is the debt Laffer curve? What solution has Jeffrey Sachs proposed to solve the debt overhang problem? Discuss objections to this solution. Discuss the possibility of debt buybacks by debtor countries as a solution to the debt overhang. LSE 2005/EC426 Page 5 of 5