Fiscal Policy (Pt.1)

Question 1

The government deficit can be defined as excess expenditure over taxes, financed by bonds sold in financial markets:
Tt − Gt = Bt − qtBt+1
In order to reduce a deficit, governments can
A) Increase the tax base
B) Increase expenditure
C) Reduce the price of its bonds
D) Pay outstanding bonds earlier

Answer 1

A) Increase the tax base

Question 2

If in a model economy the present value of all household consumption equals the present value of all labor income of that household minus the present value of all government expenditures in the economy, then it must be the case that
A) The economy is a closed economy
B) Taxes in the economy are lump sum
C) No ponzi conditions hold for the government and private households
D) All of the above are true

Answer 2

D) All of the above are true

Question 3

The main idea of Ramsay taxation is to calculate tax levels such that
A) Government revenue is maximized
B) Firm’s profits become zero
C) Government expenditure is financed in every period
D) Government expenditure is financed in every period creating minimum distortions in the economy

Answer 3

D) Government expenditure is financed in every period creating minimum distortions in the economy

Question 4

Consider the equation qt = FV/(1 + rt)^n. Can rt be negative? Infinity?

Answer 4

rt cannot be negative, at that point it’s better to hold cash. rt can be infinity however, when a government’s likelihood to repay becomes zero.

Question 5

Consider the government’s lifetime budget constraint:

X∞ q0,tGt + B0 = X∞ q0,tTt
t=0 t=0

Does the equation fail if government spending Gt is random?

Answer 5

The equation always holds, it’s an accounting expression!
However, it may be difficult to use it as a guide.

Question 6

Why does Ricardian Equivalence fail if agents have borrowing constraints?

Answer 6

[from slide 19, adding constraints as in HAIM] With borrowing constraints, agents cannot borrow against bonds (Bt+1 ≥ 0), which means that in that period they stop looking at the lifetime constraint and only consider present resources. In that period, the timing of taxes matters, as higher taxes lead to lower consumption.

Question 7

Optimal taxation: can you write a budget constraint using ONLY lump sum (or ’per head’) taxes?

Answer 7

[from slide 26, modifying the BC]:
ct + kt+1 + qtbt+1 ≤ wtlt + (1 + rt − δ)kt + bt − Tt

Question 8

Optimal taxation: can you write a budget constraint using ONLY consumption taxes?

Answer 8

[from slide 26, modifying the BC]:
ct(1 + τct) + kt+1 + qtbt+1 ≤ wtlt + (1 + rt − δ)kt + bt

Question 9

Optimal taxation: why are there no taxes to profits of the firm?

Answer 9

[from RBC slides] because of constant returns to scale +
perfect competition, firms make zero profits.

Question 10

Optimal taxation: what do you think of the statement “Gt is not valued” in slide 31? How would the model and its implications change if it were?

Answer 10

Gt is not valued in the sense that it does not enter the utility function, and therefore it is pure “wasteful” government spending:
U(.) = U(ct, lt)
If Gt enters utility, that changes the marginal utility of consumption and leisure, and therefore the optimal path of taxes:
U(.) = U(ct, lt, Gt)