In the consumption savings model, assume that lump-sum taxes are zero and the ut
ID: 2735445 • Letter: I
Question
In the consumption savings model, assume that lump-sum taxes are zero and the utility function is given by U(c, c') = log c + log c'. Suppose the government taxes on interest earnings i.e. borrowers face interest rate r while lenders face interest rate (1 - t)r.
What is the effect of introducing the tax rate on the consumer's budget constraint? Draw the constraint for borrow and lender.
What is the effect of the tax on a consumer who was initially a lender and is still a lender after the tax? (explain in terms of income and substitution effect)
Explanation / Answer
1) Introducing tax rate will result the consumer's budget constraint to move/shift inwards. Overall Consumption of consumers will decrease/fall. People will consume less units with the increase in taxes.
2) If the consumer who was initially a lender and is still a lender after the tax, then the effect of tax on such consumer will be that they will shift to consumption for other alternative goods (Substitution effect).
Income will decrease for such consumer who was initially a lender and is still a lender after the introduction of taxes. (Income effect).
There will be no effect of introducing taxes on the consumer who is borrower.