14 May ECON 5402
ECON 5402
Public Economics: Taxation
Problem Set 2
Carleton University, 2015 Fall
Till Gross
For this problem set, you can work with your classmates, but everybody should hand in their own
copy. Please indicate on your copy who you are working with. I recommend to start working on it
on your own and then compare results with your classmates. When you derive your answers, please
make clear what the answer path is supposed to be. This assignment is due on November 6
th
.
1 Welfare Losses and Tax Incidence
There is a small open economy with two types of agents, high-skilled and low-skilled. The utility
function is type-independent and of the form
U(c, `) = c
?
`
1-?
.
c is consumption and ` is leisure. Agents have one unit of time. Perfectly competitive firms produce
the consumption good according to the function
Y = (l + k)
ah
1-a
,
where l and h are low- and high-skilled labor. k is the amount of capital in the economy, which is
supplied by foreigners such that the rate of return is equal to r
*
. To guarantee that the high-skilled
earn more and that capital is utilized, assume that r
* < a and r
* < aa(1 a)
1-a. The price of
consumption is one and goo
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