Your state introduced a tax cut in the year 1999. You are interested in seeing whether this tax cut has led to increases in personal consumption within the state. You observe the following information:
Year . Consumption in your state
1994 .......... 300
1996 .......... 310
1998 .......... 320
2000 .......... 350
a. Your friend argues that the best estimate of the effect of the tax cut is an increase in consumption of 30 units, but you think that the true effect is smaller, because consumption was trending upward prior to the tax cut. What do you think is a better estimate?
b. Suppose that you find information on a neighboring state that did not change its tax policy during this time period. You observe the following information in that state:
Year . Consumption in neighboring state
1994 .............. 260
1996 .............. 270
1998 .............. 280
2000 .............. 300
Given this information, what is your best estimate of the effect of the tax cut on consumption? What assumptions are required for that to be the right estimate of the effect of the tax cut? Explain.