Public Finance and Public Policy: Responsibilities and Lim itations of Governm ent Arye L. Hillm an Cam bridge University Press, 2 0 0 9 Second edition Presentation notes, chapter 4 PUBLI C FI NANCE FOR PUBLI C GOODS
Hillman, 2009: Public finance for public goods Societies cannot rely on voluntary payments for prisoners- dilemma public goods and governments are called upon to levy taxes to finance public goods. o We cannot rely on the Tiebout mechanism to reveal information about preferences because people with different preferences reside in the same jurisdiction o We cannot rely on the Clarke tax o Governments do not know subjective benefits ∑ MB that public goods provide to the people in a population o Asymmetric information remains 2
Hillman, 2009: Public finance for public goods We set aside political and bureaucratic principal-agent problems We hope that governments have been successful in using cost- benefit analysis to approximate efficient public spending We shall not now ask normative questions about the desirable structure of taxation The question is positive: What are the consequences of using public finance to provide public goods? 3
Hillman, 2009: Public finance for public goods The advantage of government: Governments can resolve the free-rider problem by making payment for public goods compulsory through taxes 4
Hillman, 2009: Public finance for public goods 4 .1 TAXATI ON A. Efficient tax-financed public spending The excess burden of taxation arises for both direct and indirect taxes: A direct tax is paid when income is earned An indirect tax is paid when income is spent 5
Hillman, 2009: Public finance for public goods The excess burden of an incom e tax The excess burden BEC is revealed by asking the individual one of the following two questions: (1) How much are you prepared to pay the government, in return for the government not levying the tax on you? (2) How much does the government have to give you to compensate you for the tax that has been levied? Wage Labor supply with substitution effect only Tax Excess S L revenue burden A B E Pre–tax wage w w(1 – t) D C J H Hours worked O L 1 L 2 The excess burden of taxation 6
Hillman, 2009: Public finance for public goods When there is only a substitution effect, and no income effect, the answer to the questions is the same: area BEC The tax has imposed a greater cost than the money paid in taxes No sum of money equal to the excess burden of taxation changes hands. The excess burden of taxation is invisible. When the supply-of-labor function S L is linear, the area BEC is a triangle and the excess burden of taxation is 1 2 wL t SL 2 Measurement of the excess burden of taxation requires knowing the elasticity of labor supply SL 7
Hillman, 2009: Public finance for public goods The elasticity of labor supply The previous figure showed a special case where SL = 1 The elasticity of labor supply can be constant or variable, depending on the form of the labor supply function. Wage Labor S L supply with substitution 2 effect only 1 O Hours worked A labor-supply function with an increasing elasticity of labor supply 8
Hillman, 2009: Public finance for public goods The excess burden of taxation increases with the square of the rate of taxation An increase in the tax rate from t 1 to t 2 increases the excess burden of taxation from B 1 EC 1 to B 2 EC 2 . Wage S L Labor supply with A B 2 B 1 substitution w Pre–tax E effect only wage D 1 H w(1-t 1 ) C 1 D 2 w (1-t 2 ) C 2 O Hours worked The excess burden and the rate of taxation 9
Hillman, 2009: Public finance for public goods The case of SL = 0 Wage Labor supply with substitution effect only S L w w(1-t) O Hours L Taxation with no excess burden 10
Hillman, 2009: Public finance for public goods Intrusion into other markets The excess burden of taxation arises because payment for public goods is not taking place in the market for public goods There would be no excess burden if public goods were voluntarily financed in markets for public goods: payment would then be taking place in the same market in which the goods are supplied. 11
Hillman, 2009: Public finance for public goods An indirect tax (sales tax) Price Tax revenue A B P(1+ t) Excess burden Pre-tax price determined in E P D C a competitive market MB i Quantity O q 2 q 1 The excess burden of taxation when income is spent ε D = the individual’s elasticity of demand The excess burden of the tax BEC is 1 2 pq t D 2 12
Hillman, 2009: Public finance for public goods Substitution effects and the excess burden of taxation In the labor market, the individual is a seller (or supplier of labor services) and the substitution response to a tax is expressed through the supply elasticity In the case of a sales tax, the individual is the buyer and the substitution response is expressed through the demand elasticity 13
Hillman, 2009: Public finance for public goods A value-added tax A value-added tax is an indirect tax, like a sales tax The tax base o For a sales tax, the value of goods sold (and therefore bought) o For a value-added tax, value-added at different stages of production The virtue of the value-added tax compared to a sales tax: o The value-added tax does not depend on the structure of ownership of productive activities o A value-added tax makes income tax evasion difficult International trade: the value-added tax can be levied on imports so that foreign intermediate goods have no advantage over domestic output and can be rebated for exports 14
Hillman, 2009: Public finance for public goods Use of the value-added tax o A value-added tax is the common indirect tax outside of the U.S. o In the U.S. individual state governments levy sales taxes: a value-added tax would require a complex administrative tracking procedures o Similar problems arise if governments in a union such as the European Union levy their own value-added taxes 15
Hillman, 2009: Public finance for public goods An excise tax o Excise taxes are higher than general rates for sales and value-added taxes o The taxes are usually levied on goods for which demand is perceived to be quite inelastic, such as alcohol and tobacco o The low demand elasticities suggest goods that are habit- forming or addictive o The low elasticities give rise to low substitution effects and so there are low excess burdens of taxation 16
Hillman, 2009: Public finance for public goods Other costs of taxation The excess burden is accompanied by other costs of taxation Compliance costs Administrative costs Emotional costs of taxation Rent seeking The administrative costs associated with taxation reflect rent- seeking behavior – or behavior intended to change or prevent change to distribution We proceed by focusing on the excess burden of taxation How does the excess burden of taxation affect efficient publicly- financed public spending? 17
Hillman, 2009: Public finance for public goods Cost-benefit analysis and the excess burden of taxation How does the excess burden of taxation affect cost-benefit analysis? X is the total excess burden incurred in collecting tax revenue. The cost-benefit rule for justifying public spending is: n W B C X 0 j j 1 Efficient tax-financed public spending requires: MB MC ( inputs for the public good ) MC ( theexcessburden ) i G X i 18
Hillman, 2009: Public finance for public goods MC X is the marginal excess burden of tax-financed public spending R t( wL ) dR 1 wL.( ). SL dt We proceed with ε SL < 1 because a government would not knowingly increase the tax rate if more tax revenue were not obtained 19
Hillman, 2009: Public finance for public goods View ε SL as constant 1 X R . . t SL 2 The average excess burden per dollar of tax revenue is X 1 t SL R 2 For any rate of taxation t , the average excess burden increases with the labor-supply elasticity ε SL 20
Hillman, 2009: Public finance for public goods The average excess burden of taxation for two elasticities of labor supply ε SL > ε SL Excess burden per dollar of 1 > ε SL > ε SL tax revenue ½ ε SL ½ ε SL Tax rate O t The average excess burden of taxation (per dollar of tax revenue) 21
Hillman, 2009: Public finance for public goods MC X is the marginal excess burden t where MC 0 1 X SL 1 1 SL With ε SL < 1 and constant: The marginal excess burden MC X is linear and is increasing the tax rate t 22
Hillman, 2009: Public finance for public goods Valuation and cost MC G +MC X (marginal cost of inputs plus marginal excess burden of taxation) MC G =P (cost of inputs only) ∑ MB Quantity of the O public good TAX G E G E Comparison between tax-financing and voluntary payment TAX = finance by compulsory tax G E G E = voluntary payment according to true benefit TAX < G E G E Because of the excess burden of taxation, efficient tax- financed spending on public goods is less than efficient voluntary spending 23
Hillman, 2009: Public finance for public goods Accountability and transparency of public spending Accountability and transparency require the government budget to include the excess burden of the taxes that finance public spending 24
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