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EC313

Taxation
Instructor: Sharif F. Khan

Department of Economics
Wilfrid Laurier University
Winter 2012

Suggested Solutions to Assignment 2 (Optional)


Total Marks: 45

Read each part of the question very carefully. Show all the steps of your calculations to
get full marks.
1. [5 Marks]
What do we mean when we say that correlation does not imply causality? What are
some of the ways in which an empirical analyst attempts to disentangle the two?
Correlation merely means that two events tend to occur together; causality means that
one event causes the other. Correlation can occur when a third event causes both of the
other events. For example, ice cream consumption and air-conditioning use tend to
happen together. They are correlated, but their relationship is not causal. A third event,
hot weather, causes the other two events. The point of much empirical work is to control
for possible variables that might cause other events (that are not causally related) to occur
together. Randomized trials, regression analysis of data that include control variables, and
quasi-experiments are all ways to investigate causal relationships by controlling for other
possible mechanisms that might influence the variables of interest.

2. [5 Marks]
A researcher conducted a cross-sectional analysis of children and found that
average test performance of children with divorced parents was lower than average
test performance of children of intact families. This researcher then concluded that
divorce is bad for childrens test outcomes. What is wrong with this analysis?
This is a clear example of using correlation to infer causality. Perhaps the causality is
reversed: it could be that parents of children who perform poorly on tests feel stressed,
which leads to higher divorce rates, or a third variable might explain both events: perhaps
residence in a close-knit community both enhances scholastic performance and deters
divorce. In either case, we would observe lower scores among children with divorced
parents, but in neither case would the divorced parents be the cause of the lower scores.
In assessing the results of any study, researchers should consider all possible explanations
for what was observed and then control for alternative explanations.

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3. [5 Marks]
What are some of the concerns with conducting randomized trials? How can quasiexperiments potentially help here?
Randomized trials are expensive: the validity of each study relies on the law of large
numbers, and the greater the number of participants needed, the more expensive the data.
It may be possible to run trials only by recruiting voluntary participants for them. If the
people who respond to recruiting efforts differ in some way from the rest of the
population, the results of the experiments may be unrepresentative of effects on the
population at large. Attrition can also pose problems. It may be impossible to prevent
some participants in a study from leaving town or otherwise ceasing to participate. If this
attrition is nonrandom, it can undermine the initial randomization of the experiment and
lead to biased results. Human subject approval is required to subject people to
experimental practices, since subjecting individuals to intrusive or dangerous procedures
can raise serious ethical concerns.
Quasi-experiments allow researchers to take advantage of naturally occurring changes.
For example, tax laws change periodically. Researchers can observe behavior before and
after a tax-law change to investigate its effects. In some instances, where every taxpayer
in a jurisdiction is affected by a change, there are sufficient numbers of participants to
create a valid experimental pool. And there is no need to divide the participants into
control and treatment groups because the date of the change divides the sample.
Similarly, some changes in laws affect one group of people but not another group; thus,
the legal distinction may create a control (unaffected) group and a treatment (affected)
group.
4. [5 Marks]
You are hired by the government to evaluate the impact of a policy change that
affects one group of individuals but not another. Suppose that before the policy
change, members of a group affected by the policy averaged $17,000 in earnings and
members of a group unaffected by the policy averaged $16,400. After the policy
change, members of the affected group averaged $18,200 in earnings while members
of the unaffected group averaged $17,700 in earnings.
a)

How can you estimate the impact of the policy change? What is the name for
this type of estimation?

The question here is one of differences in changes: both groups experienced a


change in earnings, but it is not immediately obvious whether either group
experienced a bigger change. The appropriate approach to estimate the impact
on each group is called a difference- in-difference estimator.

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Treatment group difference: $18,200 $17,000 = $1,200


Control group difference: $17,700 $16,400 = $1,300
Difference in difference estimator: $1200 $1300 = -$100
Thus, we estimate that the impact of the policy change was to lower earnings by
$100.
b)

What are the assumptions you have to make for this to be a valid estimate of
the impact of the policy change?

The essential assumption you have to make is that trends in earnings would
have been the same for the two groups had there been no policy change. If, for
some reason, one group would have experienced larger income growth than the
other in the absence of the policy change, then the difference in difference
estimate will be biased.
5. [5 Marks]
It is commonly taught in introductory microeconomics courses that minimum wages
cause unemployment. The federally mandated minimum wage is $7.25, but
approximately 12 states have higher state-mandated minimum wages. Why cant
you test the minimum wages cause unemployment theory by simply comparing
unemployment rates across states with different minimum wages? Can you think of
a better way to test it?
The problem with this test is that all states are not the same. Different states
have populations with different characteristics and different preferences. Some of
these characteristics may be related to both the choice of the state-level
minimum wage and the unemployment level. For example, consider states with a
large number of people who have taken an economics course. People in these
states may be inclined to favor low minimum wages (based on what they were
taught in their introductory micro class) and also may find it very easy to get a job
(they have studied economics, after all!). This would lead us to observe a
relationship between unemployment rates and minimum wages across states
even without any of the direct causation suggested by economic theory.
A better way to test this would be to look at how unemployment rates changed
after a
new minimum wage law was passed in one state compared with the change in
unemployment rates in a nearby state that did not change its law. This is the
approach taken, for example, in Card and Krueger (1994).

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6. [20 marks]
Consider a TANF program with an income guarantee of $5,000 and a benefit
reduction rate of 50%. Sarah can work up to 2,000 hours per year at $10 per hour.
Sarahs utility function is:

U = 100 ln(C ) + 175 ln(L )


where U is utility, C is consumption and L is leisure.
a. Write down the equations for Sarahs budget constraint under this TANF
program and draw her budget constraint.
b. Derive Sarahs optimal combination of C and L. Illustrate the results on a
diagram.
Suppose that the government has lowered the TANF guarantee to $3,000. But it has
kept the benefit reduction rate unchanged at 50%.
c. Write down the equations for Sarahs budget constraint under this new
TANF program and draw her new budget constraint.
d. Derive Sarahs new optimal combination of C and L. Illustrate the results on
a diagram.
e. Find out the change in Sarahs optimal work hours because of this new
TANF program. Is Sarah better off or worse off under this new program?
Why?
See Appendix to Chapter 2 (pages 60-61), Figure 2-9 and Figure 2-10 (page 42) of
the textbook (3e) for the answer to this question.

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