Prof. Farshid Mojaver Name: ANSWER

5

Midterm 1

ECN131: Public Finance

Nov 06

Prof. Farshid Mojaver Name: ANSWER

(18 pts) 1) Using examples and graphs

a)  Show that a cut in TANF benefit can increase labor supply.

b)  Show that a cut in TANF benefit does not necessarily increase labor supply

c)  Show that a cut in benefit reduction rate can decrease labor supply (carefully illustrate substitution and income effects).

Ans.

a)

b)

c)

(16pts) 2) Measurement using statistical methods

a)  How can one measure the magnitude of labor supply in response to a cut in TANF benefits using Time Series Analysis or Cross-Section Analysis?

b)  When are TSA and CSA most useful?

c)  What are the shortcomings of these two statistical methods?

d)  How can Panel Data Analysis help to reduce such problems?

Ans)

a)  In both TSA and CSA we try to explain labor supply of needy families using TANF as an independent variable in a regression analysis. In TSA the regression is done over time assuming that observed changes in labor supply are caused by changes in changes in TANF. In CSA the regression is done at one point in time assuming the observed differences between people’s behavior is caused by differences in the TANF received.

b)  TSA is most useful when there are sharp changes in TANF. CSA is most useful when the needy families are similar to each other in terms of their relevant characteristics such as their taste for leisure.

c)  It is difficult to interpret TSA results as causal because so there might be so many other potential explanations available. Changes in labor supply might be correlated changes in TANF but not due to them. The problem with CSA is that the results may represent different choices made by people with different tastes, and not changes of behavior in response to changes in TANF as we would like to see.

d)  PDA traces labor supply responses of people with different characteristics over time. So this method acknowledges that part f the observed differences in labor supply is due to different characteristics of the recipients and can measure that. By tracing the behavior of classes of individuals PDA can measure the response of different people to changes in TANF benefits over time. This method is better than CSA and TSA but it is still subject to some of the objections that we raised against TSA.

(18 pts) 3) Suppose that Jean is an unskilled worker who currently is making the market wage of $5.00 per hour, and that the market for unskilled labor is competitive. Suppose further that the government is proposing to increase a payroll tax to fund changes to Social Security and is debating whether to levy the tax on employers or workers.

a.  Assume there is no minimum wage. If Jean could lobby the government, what position should she take regarding whether the tax should be levied on employers or employees? Explain.

b.  Should the presence of a $5.15 per hour minimum wage change Jean's position? Why or why not?

Ans)

a.  Jean should be indifferent by the second rule of tax incidence that states that the side of the market on which the tax is levied does not affect tax incidence.

b.  Jean should indeed change her position. If the tax is levied on workers, the pre-tax wage will rise (the exact amount depends on the elasticities of supply and demand) and the after-tax wage will fall. However, if the tax is levied on the firms who hire the workers, the minimum wage means that they will be unable to lower the wage. Consequently, firms will bear all of the tax. Since Jean would prefer to have her employer bear the tax, she should lobby the government to levy the tax on employers.

(9 pts) 4) Alternative Minimum Tax

a)  What is AMT?

b)  Why was it established?

c)  How will its application change over time, and why?

Ans)

a)  The Alternative Minimum Tax (AMT) is an additional tax schedule that applies to taxpayers who have a very high ratio of deductions and exemptions to total income.

b)  It was signed into law in 1969 and was strengthened in 1986. It was established to ensure that all wealthy households paid some amount of income tax.

c)  None of the AMT figures in the law were indexed to inflation, so as nominal wages have risen over time, more and more taxpayers have become subject to the AMT. By 2010, one-third of all taxpayers will be subject to the AMT for that reason.

(20 pts) 5) Haig-Simons definition of income

a)  What is the ideal tax base according to H-S definition? Name three examples of “incomes” that should be considered in the tax base by such definition but they are not in our current tax system.

b)  How can the H-S definition of income help horizontal equity? Illustrate your point with an example.

c)  Name a deviation from H-S criterion in our current tax system that violates vertical equity.

d)  Name a deviation from H-S criterion in our current tax system that is based on fairness grounds.

e)  Name a deviation from H-S criterion that leads to economic inefficiency.

Ans)

a)  Ideal tax based according to H-S definition is the value of net changes in individual’s power to consume. This includes all sources of potential increases in income such as unrealized capital gains, inheritances, and imputed rents from owner occupied houses.

b)  H-S definition treats homeowners and renters equally and thereby helps with horizontal equity.

c)  Deferred taxes, exclusion of gifts or inheritance from federal tax all work against vertical equity.

d)  Large medical expenses and deductions for dependents are deviations based on fairness grounds.

e)  Deferred taxes lead to lock-in effect which is economically inefficient.

(20 pts) 6) You are hired by the Commonwealth of Massachusetts to evaluate the recent welfare reform put in place by the state, which made it very unpleasant to be on welfare by imposing harsh training requirements on those on the program. Specifically,

Massachusetts wonders if the harsher requirements induced women to supply additional labor supply, and hence earn more in labor income. Welfare is only available to single mothers in the state. Fortunately for you, welfare was reformed for residents of Boston in 1995, but not for residents of Springfield (a town in western Massachusetts) until 1997. For your evaluation, you are provided the following data on the average monthly earnings of different groups of women in the two cities for two years, 1994 and 1996.

City / Year / Marital Status / Earnings
Boston / 1994 / Single Mother 175 / 175
Boston / 1994 / Married Mother 290 / 290
Boston / 1996 / Single Mother 210 / 210
Boston / 1996 / Married Mother 300 / 300
Springfield / 1994 / Single Mother 120 / 120
Springfield / 1994 / Married Mother 200 / 200
Springfield / 1996 / Single Mother 125 / 125
Springfield / 1996 / Married Mother 210 / 210

(7  pts) a. Propose a difference-in-difference (DD) estimator of the impact of the 1995 welfare reform in Boston (use single mothers in Boston as the treatment group and married mothers in Boston as the control group).

(7 pts) b. What assumptions are required for the DD estimator to be valid?

(6 pts) c. Show a scenario under which the assumptions would be violated.

Solution

(7 pts) a) Assumes that married mothers in Boston MB (who aren’t subject to the welfare reform) are a valid control group for single mothers in Boston.

estimate of the causal impact of the welfare change

(SB96- SB94) – (MB96 - MB94) = (210-175)-(290-300) = 45

One way of thinking about this is assuming that married mothers are a valid control group, that in the absence of reform, single mothers’ earnings would have fallen by 10; since single mothers’ earnings actually increased by 35, their earnings increased by 45 over what they would have increased in the absence of reform.

(7 pts)b) For this estimate to be an actual causal estimate, our regular diff-in-diff assumptions must hold: in the absence of welfare reform, earnings would have changed by the same amount for single mothers and married mothers.

Another acceptable way of saying this is that the time bias for married and single mothers was the same over the period.

(4 pts)c) This could be violated if

The trend in earnings for single and married mothers is not parallel over the period (so that in the absence of reform, earnings would have increased by more for single mothers anyhow)