Question

8. Felix's preferences can be represented by the following utility function: u(x,k)-(p) s where x, and x2 denote the amounts consumed of goods 1 and 2, respectively. The prices of these goods are pi > 0 and p2 >0, respectively, and his wealth is w> 0. Thegovernment needs to collect a large amount of moneyto financea new Health Care plan, and contemplates two options: (i) Introduce an income tax equivalent to 40% offexswealth; or (ii) Chargea sales tax overthe price ofgood 1 which would imply an increase in theprice of good 1 fromp, top(1+t), collecting the same dollar amount as with the income tax. Use Felix's indirect utility function to evaluate option 1 (income tax) and option 2 (sales tax). which tax produces a smaller utility reduction. Explain