Answer to Question #167179 in Economics for Banda jackson

Question

The consumer faces the problem of maximizing U=In (C1)+In(C2) subject to two constraints. First, his income in the first period will either be spent on consumption or saved, so that C1+S=M where M is first period income.

Second, his consumption in the second period will be his savings and the interest earned on his savings: C2=S (1+r). These two constraints can be combined into one by substituting for S: C2=(M−C1)(1+r).

a) If the Income (M) = K200 and r=20% calculate for C1, C2 and Saving (S)

b) The government imposes a 5% tax on labor income. Solve for the new optimal levels of C1, C2, and S. Explain any differences between the new level of savings and the level in part (b), paying attention to any income and substitution effects.

c) Instead of the labor income tax, the government imposes a 20% tax on interest income. Solve for the new optimal levels of C1, C2, and S. (Hint: What is the new after-tax interest rate?) Explain any differences between the new level of savings and the level in (b), paying attention to any income and substitution effects.

d) Returning to the labor income tax in part (b): What consumption tax rate would result in the same effects as the 5% labor income tax rate?

Answer 1

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