Summer 2018 examination

EC325
Public Economics

Suitable for all candidates

Instructions to candidates

The paper is divided into TWO sections. Candidates should answer FIVE short questions from Section A
and THREE long questions from Section B. Section A has a weight of 40% (each question is worth 8
marks). Section B has a weight of 60% (each question is worth 20 marks). Candidates are advised not to
spend a disproportionate amount of time on any one question.

Time Allowed Reading Time: 15 minutes

Writing Time: 3 hours

You are supplied with: No additional materials

You may also use: No additional materials

Calculators: Calculators are not allowed in this examination

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 SECTION A (Short Questions): Answer five questions (8 marks each).

1. Policymakers in the US have repealed a mandate that required that all individuals
purchase private health insurance. Explain the likely effect of this policy on insurance
prices. Explain how the policy could reduce efficiency in the market for health
insurance.

2. Many governments levy taxes on alcohol and tobacco. These taxes are sometimes
called “sin taxes.” Which assumption(s) of the First Welfare Theorem must fail in
order to justify such taxes as efficiency-enhancing policy interventions? Explain your
answer.

3. Empirical evidence suggests that default options may have a significant impact on
individuals’ choices. Provide an example of such empirical evidence and explain why
this contradicts the standard rational choice theory of individual behaviour.

4. The US and the UK have recently experienced rapid growth of private, for-profit
universities. What, according to New Contract Theory, are the potential costs and
benefits of private provision of university education, relative to more traditional
public/non-profit provision?

5. What is an ordeal mechanism? Under what assumptions can such mechanisms

increase the targeting efficiency of welfare programs?

6. What is the Laffer rate? Explain why the Laffer rate represents an upper bound on
the optimal tax rate under any social welfare function.

7. The Greek government is examining its taxation of top income taxpayers. Consider
the high income Laffer rate in Greece:

Where ! is the elasticity of taxable income of high income taxpayers in Greece and "
is the coefficient of the Pareto distribution of income in Greece. Imagine that
estimation of the ETI by the tax administration gives !=.7 in Greece, and " = 2.
Compute the revenue maximizing tax rate. The tax rate in Greece on top income
taxpayers is .5. Would you necessarily recommend to the government to decrease
the top income tax rate? What other policy recommendation could you make to the
government? Explain.

8. Can the race between education and skill-biased technological change fully explain
the recent rise in labor income inequality in developed countries?

9. Explain why under the assumptions of the second theorem of welfare economics,
there is no trade-off between equity and efficiency. Explain why in practice it is
complicated to redistribute endowments, and why this leads to a trade-off between
redistribution and efficiency.

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 SECTION B (Long questions): Answer three questions (20 marks each)

B.1: The Practical Provision of Public Goods

Suppose a municipal government is considering whether to construct a public park. There

are two types of people. Type A individuals would use the park often, and so would be
willing to pay $100 each to have access to the park. Type B individuals would never use the
park, and so would be willing to pay nothing for it. There are 100 Type A individuals and 200
Type B individuals. The cost of building and maintaining the park is $9,000. (Both types have
the same income, and income effects are negligible.)

a) Is it efficient to build this park? Explain your answer. [7 marks]

b) Suppose the government wanted to fund the construction and maintenance of the
park using Lindahl pricing. How might this work? What is the main practical difficulty
with implementing Lindahl pricing in this type of situation? [5 marks]

c) Suppose the government decides to pay for the park with uniform lump-sum taxes,
so that every individual paid the same amount. Relative to the situation where
individuals contribute nothing and the park is not built, would this policy generate an
increase in utilitarian social welfare? Explain your answer. [8 marks]

B.2 Regression Discontinuity and Unemployment Insurance Benefits

A new study Nekeoi and Weber (2017 AER) examines the effect of unemployment insurance
(UI) benefits on the duration of unemployment. The study uses the fact that, in Austria,
workers who are over the age of 40 when they lose their job are eligible for an additional 9
weeks of unemployment insurance benefits. Figure 1 plots the average nonemployment
duration by age at layoff in this population, while Figure 2 plots the average wage change (in
percentage terms) between workers’ old jobs and the new jobs they find upon leaving
unemployment.

a) Under what identifying assumptions can we interpret the result in Figures 1 and 2 in
terms of the causal effect of expansions of UI benefits? [5 marks]

b) What does Figure 1 tell us about the moral hazard cost of expansions of UI benefits?
How does our interpretation of the result depend on assumptions about labour
market imperfections? [10 marks]

c) What does the result in Figure 2 imply about labour market imperfections? What
does it imply about the costs and/or benefits of UI benefits expansions? [5 marks]

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 Figure 1: Nonemployment Duration by Age at Layoff

Source: Nekoei and Weber (2017 AER)

Figure 2: Wage Change between Jobs by Age at Layoff

Source: Nekoei and Weber (2017 AER)

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 B.3 The EITC

The Earned Income Tax Credit (EITC) is a major transfer program to low-income
families with children. Figure 3 shows the EITC credit amount focusing on single
families with children, before and after the EITC expansion that took place with the tax
reform act of 1986. Your task is to use this figure to understand the impact of the EITC
on earnings for these households.

1. Discuss the general shape of the EITC amount schedule. What is the rational
for starting with a (proportionally) low tax credit amount, increasing it, and then
bringing it back to zero? Explain in particular, how this shape may address the
issue of transfer programs keeping individuals out of work. Would the EITC
necessarily increase total aggregate labor supply in the labor market? [8 marks]

2. Table 1 shows the estimates from Eissa & Liebman [1996] of the labor force
participation responses of single mothers to the expansion of the EITC,
following TRA86. Explain the empirical strategy and identification assumption
underlying their study. Discuss the potential sources of bias to their estimates
of the effect of EITC on labor force participation of single women. [5 marks]

3. Figure 4 below shows the schedule of the EITC in 2008 for families with two
children, and also reports the density function of the distribution of earnings
for wage earners with two children and self employed individuals with two
children. [Note: the density function gives, for each level of income, the total
number of individuals who report this level of income in their tax return.] Use
the figure to discuss the impact of the EITC on the labor supply for wage
earners and for self employed respectively. Could other behavioural
responses than labor supply explain the difference in the response to the
EITC schedule between wage earners and self-employed? Explain. [7 marks]

Figure 3: The EITC Schedule, before and after TRA86 for single families with children

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 Figure 4: The EITC Schedule, and the density function of the distribution of earnings for
wage earners and self employed

Source: Saez AEJ 2010

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 B.4 Capital Income, Wealth Inequality and Capital Taxation

a) Discuss the long term historical evolution of capital to GDP ratio in developed
countries. Discuss the long term historical evolution of the capital share (i.e. the
fraction of national income going to capital). In what sense is the recent evolution of
the capital to GDP ratio and of the capital share incompatible with a Cobb-Douglas
production function at the aggregate level? What elasticity of substitution between
capital and labor in the aggregate production function could rationalize these recent
evolutions [7 marks]

b) Discuss the long term historical evolution of top wealth shares in developed
countries. Discuss the long term historical evolution of the inheritance flow (i.e. the
fraction of inherited wealth in the total stock of wealth). What relationship between
the rate of returns on asset r and the growth rate of gdp g might rationalize these
long term evolutions? Explain. [5 marks]

c) It is often argued that the elasticity of capital income with respect to the net of tax
rate is very large, and this in turn may limit the ability of governments to tax capital.
Based on the evidence of the effects of TRA86 on taxable income in the US, explain
why the large elasticity of capital income may be driven by income shifting. What
tools could government use to reduce this elasticity then? [8 marks]

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