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    Problem Set 9

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    Siham Buule
    Donald owns two flats and wants to take out a loan, but faces collateral and budget constraints. The problem set examines: 1) How Donald's intertemporal budget and collateral constraints are affected by taxes and a potential deal with the IRS to pay taxes with his second flat. 2) How a US corporate tax cut from 34% to 21% would impact the user cost of capital and investment rate. Learners are asked to calculate the new user cost and predict if the investment rate will rise given it was previously 20%.

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    Problem Set 9

    Uploaded by

    Siham Buule
    51 views2 pages
    Donald owns two flats and wants to take out a loan, but faces collateral and budget constraints. The problem set examines: 1) How Donald's intertemporal budget and collateral constraints are affected by taxes and a potential deal with the IRS to pay taxes with his second flat. 2) How a US corporate tax cut from 34% to 21% would impact the user cost of capital and investment rate. Learners are asked to calculate the new user cost and predict if the investment rate will rise given it was previously 20%.

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    Donald owns two flats and wants to take out a loan, but faces collateral and budget constraints. The problem set examines: 1) How Donald's intertemporal budget and collateral constraints are affected by taxes and a potential deal with the IRS to pay taxes with his second flat. 2) How a US corporate tax cut from 34% to 21% would impact the user cost of capital and investment rate. Learners are asked to calculate the new user cost and predict if the investment rate will rise given it was previously 20%.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    51 views2 pages

    Problem Set 9

    Uploaded by

    Siham Buule
    Donald owns two flats and wants to take out a loan, but faces collateral and budget constraints. The problem set examines: 1) How Donald's intertemporal budget and collateral constraints are affected by taxes and a potential deal with the IRS to pay taxes with his second flat. 2) How a US corporate tax cut from 34% to 21% would impact the user cost of capital and investment rate. Learners are asked to calculate the new user cost and predict if the investment rate will rise given it was previously 20%.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    of 2

    EC1B3 Problem Set 9

    due on Sunday at 6 PM

    Important: if you have any doubts about the exercises, please post a question on Piazza.

    Learning outcomes:
    - Intertemporal consumption decisions with imperfect credit markets

    - Investment decisions

    Question 1 (Donald and the IRS)


    Donald lives for two periods. He inherited two flats in New York. The first flat is H 1 square
    meters, the second flat is H 2 square meters. The price per square meter of the two flats is the
    same: p1= p2=1. Flats can only be sold in the second period, no matter who owns them. He
    would like to get a loan from Deutsche Bank to finance his upcoming political party. Deutsche
    Bank only lends money if customers post some assets as collateral. Donald’s income in the
    current and the future period is y= y ' =1. Donald does not pay taxes (t=t ' =0). The interest rate
    in the credit market is r . Donald sees current and future consumption as perfect substitutes. His
    indifference curves are therefore straight lines corresponding to the equation u=ac+ c ', where u
    is the level of happiness. Assume a> 1+ r .

    a) Derive the intertemporal budget constraint for Donald, and the collateral constraint that
    he faces. Draw it in a diagram with current consumption on the horizontal axis, and
    future consumption on the vertical axis. Explain.

    b) What would be the optimal choice for Donald? Illustrate it using a diagram and explain
    your reasoning.

    c) The IRS, which is the agency in charge of collecting taxes, discovers that Donald owes
    some unpaid taxes to the government. Donald has to pay t=0.5 in the first period, and
    '
    t =0.5 in the second period. How does the intertemporal budget constraint, the collateral
    constraint and the optimal choice for Donald change?

    d) Donald tries to strike a deal with the IRS: in the first period, Donald will give the
    government his second flat in New York (the one with size H 2) instead of paying the
    taxes due in the current and future period. How would this deal change the intertemporal
    budget constraint and the collateral constraint for Donald with respect to question c? How
    would his optimal choice of current and future consumption change?

    e) Calculate the minimum size H 2 that the second flat must have for the IRS to accept this
    deal. Explain the intuition.

    f) Calculate a condition that H 2 must satisfy so that Donald is better off by striking the deal
    than by paying taxes. Explain the intuition. [Hint: you need to establish if Donald can
    reach a higher indifference curve with the deal, and remember that the indifference curve
    is given by u=ac+ c ' ]

    g) Based on your answers to questions e and f, will there be a deal? Explain why or why not.

    h) How would your answer to question g change if the price of the second flat were still
    p2=1, but the price of the first flat increased to p1 >1?

    Question 2 (Short question: Investment and corporate tax cuts)

    The US government in 2017 reduced the corporate tax rate from 34% to 21%.
    a) Assume the user cost of capital before the tax cut was 12%. What the user cost will be
    after the tax cut?

    b) Will the investment rate increase? Assume the investment rate was 20% before the tax
    cut.

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