CBE Public Finance 2 — Questions and Answers
Question 1: Which concept describes the condition where a tax system collects the same revenue but imposes the least possible excess burden on the economy?
- Revenue maximization
- Optimal taxation (Correct answer)
- Tax neutrality
- Fiscal equivalence
Correct answer: Optimal taxation
Optimal taxation theory seeks to design tax structures that raise required revenue while minimizing deadweight loss and distortions to economic behavior.
Question 2: A state government increases its sales tax from 5% to 7%. If the price elasticity of demand for taxed goods is -0.8, what is the expected effect on tax revenue?
- Revenue falls because demand drops more than the rate increase
- Revenue rises because the rate increase outweighs the demand reduction (Correct answer)
- Revenue stays the same due to inelastic demand
- Revenue falls due to complete tax shifting
Correct answer: Revenue rises because the rate increase outweighs the demand reduction
With price elasticity of -0.8 (inelastic), a 40% rate increase leads to only an 32% quantity decrease, so total revenue increases.
Question 3: The Tiebout model of local public finance predicts that households will:
- Prefer federal provision of all public goods
- Sort themselves among jurisdictions based on preferred tax-service bundles (Correct answer)
- Always demand more public services than governments supply
- Ignore local tax rates when choosing where to live
Correct answer: Sort themselves among jurisdictions based on preferred tax-service bundles
The Tiebout model suggests households 'vote with their feet,' moving to localities that offer their preferred combination of taxes and public services.
Question 4: What does the concept of 'tax expenditure' refer to in public finance?
- Direct government spending on tax administration
- Revenue losses from preferential tax provisions such as deductions and exemptions (Correct answer)
- The cost of collecting taxes relative to revenue raised
- Spending financed by deficit rather than taxes
Correct answer: Revenue losses from preferential tax provisions such as deductions and exemptions
Tax expenditures are revenue losses attributable to special tax provisions that allow exclusions, deductions, credits, or preferential rates relative to the normal tax structure.
Question 5: Under a progressive income tax with a top marginal rate of 37%, a taxpayer in the top bracket earns an additional $10,000. Their tax liability increases by approximately:
- $10,000
- $3,700 (Correct answer)
- $2,200
- $5,500
Correct answer: $3,700
The marginal rate applies only to the additional income earned in that bracket, so $10,000 × 37% = $3,700 additional tax.
Question 6: The Wagner's Law of increasing state activity predicts that as a nation's per capita income rises:
- Tax revenues as a share of GDP remain constant
- The public sector grows relative to the overall economy (Correct answer)
- Private sector spending crowds out government spending
- Government spending on defense dominates fiscal growth
Correct answer: The public sector grows relative to the overall economy
Wagner's Law states that public sector spending grows proportionally faster than GDP as economies develop, partly due to rising demand for public goods and social insurance.
Question 7: Which measure best captures the extent to which a tax system redistributes income from higher to lower earners?
- The statutory marginal tax rate
- The Reynolds-Smolensky index (Correct answer)
- The Laffer curve elasticity
- The benefit principle coefficient
Correct answer: The Reynolds-Smolensky index
The Reynolds-Smolensky index measures the difference between pre-tax and post-tax Gini coefficients, capturing the redistributive effect of the tax-benefit system.
CBE Public Finance 2
Which concept describes the condition where a tax system collects the same revenue but imposes the least possible excess burden on the economy?