3 Capital Taxation

Consider a model in which individuals live for two periods and have Cobb-Douglas utility

functions of the form U(C1,C2) = C^aC^(a-1) where a = 0.5. They earn income of $1,000 in the

first period and save S to finance consumption in the second period. The interest rate, r, is 5%.

d) Draw the new graph under the 20% tax on labor income. Explain any differences between

the new level of savings and the level. What can you say about the income and substitution

effects?

e) 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?)

f) Draw the new graph under the 20% tax on interest income. Explain any differences

between the new level of savings and the level compared to the no-tax scenario, paying

attention to any income and substitution effects.

g) Returning to the labor income tax in part (a): What consumption tax rate would result

in the same effects as the 20% labor income tax rate?