Name Last 4 PSU ID Final Exam Econ 304 Fall 2012 EACH QUESTION IS WORTH 130 POINTS DO THIS QUESTION IF A HEADS IS FLIPPED 1 There has been a great deal of debate about taxes tax rates and what to do about them Almost two years ago the following article surfaced where President Obama backed a corporate tax cut See excerpt below Obama Backs Corporate Rate Cut Along With Tax Simplification January 26 2011 12 03 AM EST By Ryan J Donmoyer and Peter Cohn Jan 26 Bloomberg President Barack Obama called on Congress to cut the top U S corporate tax rate for the first time in 25 years without adding to our deficit a sign that businesses will have to give up tax breaks in exchange for lower rates The top marginal corporate tax rate or the rate paid on the last dollar of income earned has stood at 35 percent since 1993 We now fast forward to the present and we see that gridlock is alive and well in Washington since nothing much has changed in nearly two years The excerpt from the article below is quite current 12 3 2012 Top U S Firms Are Cash Rich Abroad Cash Poor at Home By KATE LINEBAUGH Emerson Electric Co has 2 billion of cash in the bank But this year it had to borrow money in the U S to help buy back shares distribute dividends and even pay its taxes That s because substantially all of Emerson s cash is in Europe and Asia according to the company s filings with securities regulators The maker of power plant and data center equipment could always bring that cash back home 1 but it would be taxed at the 35 rate on corporate profits minus whatever tax it has already paid overseas As a result Emerson says it brings its foreign cash holdings back to the U S only if that can be accomplished tax efficiently In its most recent fiscal year that meant bringing back just 500 million then using debt to cover other obligations With lawmakers and the White House working to come up with a package of tax increases and spending cuts to trim the deficit and head off the fiscal cliff there is new impetus to change the corporate tax structure There is also broad agreement that the current system in which foreign earnings are kept offshore and untaxed isn t working But lawmakers and businesses disagree on a fix The businesses want to pay taxes only in the country where profits are earned They argue that being able to move their funds back to the U S freely would spur capital spending and help create jobs As part of its proposal to lower the corporate tax rate to 28 the Obama administration wants to expand the tax on foreign income to all income earned overseas Please answer the following questions 1 a 30 POINTS In this part you are to explain exactly how lowering the effective tax rate on capital will work in theory its way through the economy In this discussion you need to differentiate between the short run and long run In the space below explain with graphical analysis how lowering the effective tax rate on capital will influence real economic variables in the short run hint it s a demand side story Draw 4 diagrams label them 1 through 4 with 1 a user cost desired capital K diagram followed by 2 a closed economy desired saving desired investment diagram followed by 3 an IS LM diagram followed by 4 an aggregate supply aggregate demand diagram Start at an initial equilibrium and label as point A in all diagrams with all the associated market clearing variables denoted by subscript A For example in your IS LM diagram the interest rate that clears the goods and money market is labeled as r A with the associated output at YA Note that YA our initial equilibrium output is below full employment output YB we are in a recession read on Now let the effective tax rate on capital fall same as a fall in and show how all your graphs are affected In particular locate point B as the new short run equilibrium 2 in all graphs assume the standard that is let output rise to YB full employment Y in this short run while holding the general price level fixed at P A PB Make sure you refer to each diagram individually explaining how and why we get to point B i e provide intuitive economic reasoning starting with how a lower effects K and why b 20 POINTS Now we are going to focus on the idea that in the longer run the influence of the decrease in the effective tax rate on capital will have supply side effects In particular argue that this new investment spurred on by the lower effective tax rate on capital will result in a positive productivity shock resulting in a higher A and K which will result in a shift upward in the production function via increasing the MPKf and MPN In the space below draw a production function with the labor market diagram below it and show what is going on in this longer run That is locate the corresponding point B from above and then show the longer run influence as point C in these two supply side diagrams What happens to N and w W P Explain in detail Are these results in the labor market consistent with the business cycle facts Now explain why output has changed give two specific reasons Note in this part of the problem do not worry about identifying point A in the labor market diagram and production function diagram since point A does not exist given the assumption that labor markets always clear at full employment i e a weakness of the classical model Be sure to label your graphs completely or points will be taken off c 20 POINTS Now show how graphs 1 through 4 are influenced by this longer run development Note again that we assume that before these longer run developments take hold the FE line in graph 3 and the LRAS in graph 4 is set at Y B Now let these longer run developments take hold i e these supply side effects and label this final equilibrium as point C Again please make sure you refer to each diagram individually explaining how and why we get to point C i e provide intuitive economic reasoning d 20 POINTS Let s pretend now that you are an economic advisor to President Obama and you are to explain to him why this policy the policy of lowering the effective tax rate on capital is preferable to increasing G and lowering T income taxes the typical Keynesian response to a weak labor market Make sure you focus and discuss in much detail how the long run results differ when comparing cutting the effective tax rate vs the Keynesian prescription of increasing G and lowering T be sure to discuss the long run implications for the Keynesians assuming no influence on labor …