Wealth Tax (20 points)

Consider the basic standard Solow model we studied in this course. Assume that the economy is initially in a steady state. The government is considering introducing a wealth tax which will decrease the savings rate in the economy.

Question 4.1 [10 points] Discuss the consequences of this tax for capital and output in the short-run and in the long-run. Be sure to use a phase diagram and illustrate the time-path of these variables after the introduction of the wealth tax.

Question 4.2 [5 points] What will happen to consumption in the short-run and in the long-run? Will consumption in the long-run increase or decrease relative to its original value? Be sure to explain what parameters of the model determine the answer to this last question.

Question 4.3 [5 points] Suppose that consumption falls in the long-run relative to its initial value. Does this necessarily imply that the wealth tax is a bad idea? Explain your answer.