IES, Solution General Economics- III, 2015
What is the Laffer Curve?
The Laffer Curve is a theory developed by supply-side economist Arthur Laffer to show the relationship between tax rates and the amount of tax revenue collected by governments. The curve is used to illustrate Laffer’s argument that sometimes cutting tax rates can increase total tax revenue.
The Laffer Curve is based on the economic idea that people will adjust their behavior in the face of the incentives created by income tax rates. Higher income tax rates decrease the incentive to work and invest compared lower rates. If this effect is large enough, it means that at some tax rate, and further increase in the rate will actually lead to decrease in total tax revenue. For every type of tax, there is a threshold rate above which the incentive to produce more diminishes, thereby reducing the amount of revenue the government receives.
What are merit goods?
Merit goods are those goods and services that the government feels that people will under-consume, and which ought to be subsidised or provided free at the point of useso that consumption does not depend primarily on the ability to pay for the good or service.
Merit goods and services create positive externalities when consumed and these 3rd party spill over benefits can have a significant effect on social welfare. Market failure occurs when merit goods and services are under-consumed under free market conditions.
Policy intervention can help either through offering financial incentives (e.g. consumer or producer subsidies) or through behavioural nudges and information campaigns designed to change our choices.
What Is Hedonic Pricing?
Hedonic pricing is a model which identifies price factors according to the premise that price is determined both by internal characteristics of the good being sold and external factors affecting it. A hedonic pricing model is often used to estimate quantitative values for environmental or ecosystem services that directly affect market prices for homes. This method of valuation can require a strong degree of statistical expertise and model specification, following a period of data collection.
How Hedonic Pricing Works
The most common example of the hedonic pricing method is in the housing market, wherein the price of a building or piece of land is determined by the characteristics of the property itself (e.g., its size, appearance, features like solar panels or state-of-the-art faucet fixtures, and condition), as well as characteristics of its surrounding environment (e.g., if the neighborhood has a high crime rate and/or is accessible to schools and a downtown area, the level of water and air pollution, or the value of other homes close by).
The hedonic pricing model is used to estimate the extent to which each factor affects the price of the home. When running the model, if non-environmental factors are controlled for (held steady), any remaining discrepancies in price will represent differences in the good’s external surroundings. With regards to valuing properties, a hedonic pricing model is relatively straightforward as relies on actual market prices and comprehensive, available data sets.
What is Race to the Bottom?
The race to the bottom refers to a competitive state where a company, state or nation attempts to undercut the competition's prices by sacrificing quality standards or worker safety, defying regulations, or paying low wages. A race to the bottom can also occur among regions. For example, a jurisdiction may relax regulation and compromise the public good in an attempt to attract investment, for example, the building of a new factory or corporate office.
The tax interaction effect Environmental taxes and regulations tend to discourage economic activity because they raise the costs to firms of producing output. Typically, this leads to a lower overall level of employment and investment in the economy. These “spillover” effects of environmental policies in labor and capital markets add to the distortions created by the tax system. The resulting economic cost has been termed the tax-interaction effect.
- Shadow Price:- A shadow price is an estimated price for something that is not normally priced in the market or sold in the market.
- It is often used in cost-benefit accounting to value intangible assets, but can also be used to reveal the true price of a money market share, or by economists to put a price tag on externalities.
- Shadow pricing is inexact as it relies on subjective assumptions and lacks reliable data to fall back on.
5. An incomplete market is one where some of the necessary conditions for market formation exist, but not all of them. In the case of incomplete markets, some entrepreneurs may enter the market because profits are possible. However, the firms that do start-up will only satisfy a small proportion of potential demand. In these incomplete markets, total supply is insufficient to meet the needs of consumers. In such cases a market may form, but will fail to develop completely - in other words it is an incomplete.
6. Discuss the main recommendations of 14th Finance Commission. (12.5 Marks)
(General Studies Mains Paper III- Economy: Indian Economy and issues relating to planning)
Model Answer :
Article 280 of the Constitution of India requires the Constitution of a Finance Commission every five years, or earlier. For the period from 1st April, 2015 to 31st March, 2020, the 14th Finance Commission (FFC) was constituted by the orders of President on 2nd January, 2013 and submitted its report on 15thDecember, 2014.
The Finance Commission is required to recommend the distribution of the net proceeds of taxes of the Union between the Union and the States (commonly referred to as vertical devolution); and the allocation between the States of the respective shares of such proceeds (commonly known as horizontal devolution).
Main Recommendations of 14th Finance Commission :
· The 14th Finance Commission is of the view that tax devolution should be the primary route for transfer of resources to the States.
· In understanding the States’ needs, it has ignored the Plan and non-Plan distinctions
· According to the Commission, the increased devolution of the divisible pool of taxes is a ``compositional shift in transfers’’ – from grants to tax devolution
· In recommending an horizontal distribution, it has used broad parameters – population (1971), changes in population since then, income distance, forest cover and area, among others.
· It has recommended distribution of grants to States for local bodies using 2011 population data with weight of 90 per cent and area with weight of 10 per cent
· State grants include grant to: Duly constituted gram panchayats, municipal bodies
· Grants divided into two namely - a basic grant and a performance grant for gram panchayats and municipal bodies
· Ratio of basic to performance grant is 90:10 for panchayats and for municipalities, 80:20
· Total grant recommended is INR 2.8 lakh crore for a given year period. Around INR 2 lakh crore is allocated to panchayats and the rest to municipalities
· Commission has departed from previous conventions regarding grants-in-aid to States by Central government
· States given greater fiscal responsibility for scheme implementation
· Commission has pegged fiscal deficit target at 3.6% for 201-2016 and 3% in coming years
· Commission has estimated that between 2015-2016 and 2019-2020, the decline will be from 10.8% to 9.6% of the GDP mainly due to reduction in subsidy expenditure from 1.70% in 2015-2016 to 1% in 2019-2020
· The Commission is of the view that sharing pattern in respect to various Centrally-sponsored schemes need to change. It wants the States to share a greater fiscal responsibility for the implementation of such schemes
Environmental regulation in the United States has traditionally relied on command and controlpolicies in which regulators—typically the government—set standards or limits and apply them uniformly to a broad category of sources. There are three types of command-and-control mechanisms that regulators can choose to implement: ambient, emissions, or technology standards.
An ambient standard sets the amount of a pollutant that can be present within a specific environment. An example of this would be when a regulator sets a limit on ground level ozone [parts per million (ppm)] allowable within a city’s limits. This is also an example of an indirect regulation because although emissions from individual sources are being restricted, the ambient level is what the standard is attempting to control. Emissions standards are much more common as they seek to limit the amount of emissions released by a firm, industry, or area. It differs from an ambient standard because its use does not determine the ambient level of a pollutant in the environment; rather, it attempts to reduce the overall amount of a pollutant released on a firm-by-firm basis. Finally, regulators can choose to implement a technology-based standard which would force polluters to use a particular pollution control technology that they deem reasonably cost-effective, such as installing scrubbers on smokestacks.
Economic incentives have only recently begun to play a larger role. As regulators seek to meet increasingly costly environmental quality goals, they have begun to look at incentives as a more flexible, lower cost alternative. It is expected that the regulatory system can be made more effective by promoting environmentally efficient choices with less government interference. Incentive-based policies aim to encourage polluters to find innovative, low-cost ways to reduce their environmental emissions by offering them rewards or by doling out punishments in the form of taxes or fees, marketable permits, or liability.
Taxes or fees charge the polluter a certain amount per unit of pollution, the value of which is determined by the regulator. Marketable permits allow companies to pollute at a level that is marginally cost-effective. It allows them to buy additional permits as needed if they fail to meet their targets internally, and to sell excess permits if they exceed their internal pollution reduction targets. Liability involves establishing a precautionary level that allows for the greatest benefit to society, and holding firms to that standard if a problem arises. While more flexible than true established standards, it puts the burden on the firm to take certain levels of precaution with respect to environmental issues or to be held accountable for any negative results.
Incentives have several advantages, including allowing the source to play a role in determining the most cost-effective way to reduce their emissions and, thereby, in meeting their marginal costs. All three types of incentives attempt to maintain the ?equimarginal principle,? which is when the marginal control costs will be equal across all sources. This creates an efficient or least cost overall solution. Also, when compared to command and control mechanisms, the regulator requires less information under an incentive program since there is greater motivation for ‘polluters’ to devise their own innovative solutions. Therefore, the regulator does not need to know how cost-effective various control options will be, or what the cost is at any particular installation, because the source will be held accountable for all of their actions and will pay both pollution control costs and damage costs.
Market failure :- http://www.economicsdiscussion.net/pareto-optimality/market-failure-of-pareto-optimality-and-measures-to-correct-it/18969
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