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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 2

Societies cannot rely on voluntary payments for prisoners- dilemma public goods and governments are called upon to levy taxes to finance public goods.

• We cannot rely on the Tiebout mechanism to reveal

information about preferences because people with different preferences reside in the same jurisdiction

• We cannot rely on the Clarke tax
• Governments do not know subjective benefits ∑MB that

public goods provide to the people in a population

• Asymmetric information remains

Hillman, 2009: Public finance for public goods 3

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?

Hillman, 2009: Public finance for public goods 4

The advantage of government: Governments can resolve the free-rider problem by making payment for public goods compulsory through taxes

Hillman, 2009: Public finance for public goods 5

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

Hillman, 2009: Public finance for public goods 6

The excess burden of an incom e tax The excess burden BEC is revealed by asking the individual one

• f 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? The excess burden of taxation

Hours worked O L1 J H L2 Wage w(1 – t) A D E B C SL w Tax revenue Excess burden Pre–tax wage Labor supply with substitution effect only

Hillman, 2009: Public finance for public goods 7

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 SL is linear, the area BEC is a triangle and the excess burden of taxation is

 

2

1 2

SL

wL t 

Measurement of the excess burden of taxation requires knowing the elasticity of labor supply SL

Hillman, 2009: Public finance for public goods 8

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. A labor-supply function with an increasing elasticity of labor supply

Labor supply with substitution effect only Wage Hours worked O SL 1 2

Hillman, 2009: Public finance for public goods 9

The excess burden of taxation increases with the square of the rate of taxation An increase in the tax rate from t1 to t2 increases the excess burden of taxation from B1EC1 to B2EC2. The excess burden and the rate of taxation

Labor supply with substitution effect only D1 D2 H Hours worked Wage E B1 B2 C1 C2 O SL w w(1-t1) w (1-t2) Pre–tax wage A

Hillman, 2009: Public finance for public goods 10

The case of SL = 0 Taxation with no excess burden

Labor supply with substitution effect only Wage Hours L O SL w w(1-t)

Hillman, 2009: Public finance for public goods 11

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.

Hillman, 2009: Public finance for public goods 12

An indirect tax (sales tax) The excess burden of taxation when income is spent εD = the individual’s elasticity of demand The excess burden of the tax BEC is

 

2

1 2

D

pq t 

D C P A P(1+ t) q1 q2 MBi E B Quantity O Price Pre-tax price determined in a competitive market Tax revenue Excess burden

Hillman, 2009: Public finance for public goods 13

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

Hillman, 2009: Public finance for public goods 14

A value-added tax A value-added tax is an indirect tax, like a sales tax The tax base

• For a sales tax, the value of goods sold (and therefore

bought)

• For a value-added tax, value-added at different stages of

production The virtue of the value-added tax compared to a sales tax:

• The value-added tax does not depend on the structure of
• wnership of productive activities
• 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

Hillman, 2009: Public finance for public goods 15

Use of the value-added tax

• A value-added tax is the common indirect tax outside of the

U.S.

• In the U.S. individual state governments levy sales taxes: a

value-added tax would require a complex administrative tracking procedures

• Similar problems arise if governments in a union such as the

European Union levy their own value-added taxes

Hillman, 2009: Public finance for public goods 16

An excise tax

• Excise taxes are higher than general rates for sales and

value-added taxes

• The taxes are usually levied on goods for which demand is

perceived to be quite inelastic, such as alcohol and tobacco

• The low demand elasticities suggest goods that are habit-

forming or addictive

• The low elasticities give rise to low substitution effects and so

there are low excess burdens of taxation

Hillman, 2009: Public finance for public goods 17

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?

Hillman, 2009: Public finance for public goods 18

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:

1 n j j

W B C X



   



Efficient tax-financed public spending requires:

( ) ( )

i G X i

MB MC inputs for the public good MC theexcessburden  



Hillman, 2009: Public finance for public goods 19

MCX is the marginal excess burden of tax-financed public spending

R t( wL )  1

SL

dR wL.( ). dt   

We proceed with εSL < 1 because a government would not knowingly increase the tax rate if more tax revenue were not

• btained

Hillman, 2009: Public finance for public goods 20

View εSL as constant

1 . . 2

SL

X R t  

The average excess burden per dollar of tax revenue is

1 2

SL

X t R  

For any rate of taxation t, the average excess burden increases with the labor-supply elasticity εSL

Hillman, 2009: Public finance for public goods 21

The average excess burden of taxation for two elasticities of labor supply εSL > εSL The average excess burden of taxation (per dollar of tax revenue)

Tax rate Excess burden per dollar of tax revenue O ½εSL ½εSL 1 > εSL > εSL t

Hillman, 2009: Public finance for public goods 22

MCX is the marginal excess burden

1 1 1

X SL SL

t MC where           

With εSL < 1 and constant: The marginal excess burden MCX is linear and is increasing the tax rate t

Hillman, 2009: Public finance for public goods 23

Comparison between tax-financing and voluntary payment GE

TAX = finance by compulsory tax

GE = voluntary payment according to true benefit GE

TAX < GE

Because of the excess burden of taxation, efficient tax- financed spending on public goods is less than efficient voluntary spending

GE

TAX

GE Quantity of the public good MCG=P (cost of inputs only) MCG+MCX (marginal cost of inputs plus marginal excess burden of taxation) ∑MB O Valuation and cost

Hillman, 2009: Public finance for public goods 24

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

Hillman, 2009: Public finance for public goods 25

Are taxes available that have no excess burden? A tax with no substitution response is called a lump-sum tax Taxation of goods with no substitution effects A life-preserving medication has completely inelastic demand A tax on essential goods or services is politically unwise Addiction and taxes  Addiction ensures the tax base  The excess burdens of the taxes are low

Hillman, 2009: Public finance for public goods 26

Tiebout locational choice and taxes  The Tiebout locational choice mechanism is an application of the benefit principle of taxation  There would be no excess burden if the taxes paid to governments through voluntary locational choice were analogues of voluntarily paid market prices  Local public goods are in general not financed according to the benefit principle but through property, income, and sales taxes that have excess burdens  Often the principal tax for financing local public goods is a property tax on improved land: this is a tax on adding to the value of a property through further investment  The substitution response to the tax is that investment is undertaken elsewhere in other lower-tax jurisdictions  Substitution responses also occur through allowances in the tax code for depreciation

Hillman, 2009: Public finance for public goods 27

Taxes on unimproved value of land and Henry George  Taxes on the unimproved value of land have no excess burden  Land is trapped within a tax jurisdiction with no substitution response that allows “escape” from the tax  Henry George (1839 - 1897) proposed that there should be

• nly a single tax levied on the tax base of the unimproved

value of land  George did not make his case on efficiency grounds due to the absence of an excess burden  His case was based on social justice He observed that people who owned land benefited when economic growth increased the value of land, yet landowners had done nothing productive to merit the increase in their wealth

Hillman, 2009: Public finance for public goods 28

A poll tax A poll tax is a payment for the right to vote If all citizens choose to exercise their right to vote, poll taxes are lump-sum taxes Poll taxes impose a cost of voting By determining who votes, a poll tax can affect political decisions about public finance and public policy

Hillman, 2009: Public finance for public goods 29

A personal head tax A personal head-tax is a lump-sum tax with no substitution effect  The head-tax can depend on nothing other an individual’s existence and identity  The head-tax cannot depend on any attribute or behavior that a person can change – income, purchases, wealth, number of dependents, or marital status, personal ability (which people can hide) There is scope for unfairness because different people can arbitrarily be assigned different taxes The only escape from a head tax is to leave the jurisdiction of the government levying the tax Head taxes would not be politically popular In civil societies, taxes are levied on the market-determined value of a person’s income or the market-determined value of property and not according to people’s inalterable identities

Hillman, 2009: Public finance for public goods 30

The unavailability of taxes with no excess burden Other than taxes on unimproved value of property, taxes without an excess burden are not feasible, or not ethically or politically desirable Taxes without an excess burden are generally not used

Hillman, 2009: Public finance for public goods 31

Measurem ent of the excess burden of taxation Invisibility of the excess burden of taxation makes measurement difficult: the excess burden cannot simply be observed and directly measured Surveys are unlikely to yield reliable information Estimation from aggregate market data Two types of problems (1) There are taxes with no tax revenue The excess burden (which is invisible in the first place) may be invisible in a market that no longer exists. (2) Taxes in one market result in excess burdens in other markets. The excess burden of a tax in the market where the tax is levied understates the excess burden of taxation because of responses in other markets.

Hillman, 2009: Public finance for public goods 32

A tax with an excess burden and no revenue The change in the excess burden in market 2 when the tax changes in market 1

E2 O C1 B1 E1 Excess burden Quantity

• f good 2

Price of good 2 Supply good 2 Demand for good 2 BEFORE the tax on good 1 Demand for good 2 AFTER the tax on good 1 B2 C2 Hours worked O Wage B E SL w Excess burden Pre–tax wage L1

Hillman, 2009: Public finance for public goods 33

Measuring the excess burden in labor markets The value of the labor-supply elasticity depends on  Possibilities for marginal adjustments to labor supply  The decision whether to work for a living (when hours worked are not flexible, the choice is between having and not having a job)  Payments provided by governments to people who do not work  Obligations outside the labor market

Hillman, 2009: Public finance for public goods 34

Diversity in empirical estimates of the excess burden Example: In the United States, estimates of the marginal excess burden of taxation have ranged from 7 cents to 39 cents. Tracing effects through other markets suggests higher values. Why is there diversity in estimates? Difficulties of  accurately measuring something that is invisible  tracing through effects in the different markets in an economy  taking into account both adjustments in hours worked and the decision whether or not to have a job  accounting for the effect of income received from the government when not working Scope for discretion and assumptions Flexibility in assumptions can result in estimates that are influenced by predisposition regarding size of government

Hillman, 2009: Public finance for public goods 35

Evidence on the excess burden from social experiments Under communism, people were asked (or compelled to) behave as if their personal elasticity of labor supply were zero The principle was People should contribute according to their ability and not according to personal reward. The natural experiment persisted over decades and over generations The social experiment resulted in significant excess burdens “We pretend to work and they pretend to pay us”

Hillman, 2009: Public finance for public goods 36

• B. Tax revenue and the Laffer curve

Tax revenue is: R

t( wL ) {taxrate}.{taxbase}.  

w= gross market wage, constant for any number of hours worked Based on the substitution effect: The tax base contracts when the rate of taxation increases. Tax revenue increases if the increased tax rate more than compensates for the contraction of the tax base

1

SL

dR wL.( ). dt   

Hillman, 2009: Public finance for public goods 37

The elasticity of labor supply and tax revenue The inverse slope of the labor-supply function measures the value of the elasticity of labor supply SL

O Tax rate t increases, net wage declines SL < 1 Ln hours worked L Ln wage w SL >1 S w Slope=1, SL = 1 Labor supply with substitution effect only 100% tax rate Zero hours worked Zero tax revenue Pre–tax wage Zero tax rate Zero tax revenue

Hillman, 2009: Public finance for public goods 38

The Laffer curve On the wrong side of the Laffer curve, the same revenue can be obtained with a lower rate of taxation and so with a lower excess burden of taxation We previously used SL < 1 on the grounds that governments would never knowingly set a tax rate on the wrong side of the Laffer curve.

Ro Maximum revenue when εSL=1 t = 0% provides zero revenue for the government εSL>1 εSL<1 t* Tax revenue R Tax rate t t2 t = 100% provides zero revenue for the government

O

t1

Hillman, 2009: Public finance for public goods 39

Individual behavior and the aggregate Laffer curve The aggregate Laffer curve reveals the tax rate that maximizes total tax revenue Individuals have their own personal labor-supply functions and labor-supply elasticities Values of the tax rate that drive individuals onto the wrong side

• f their personal Laffer curve differ for different people

Tax rates that are sufficiently high drive some people onto the wrong side of their personal Laffer curves.

Hillman, 2009: Public finance for public goods 40

Investment and the Laffer curve There is a Laffer curve for taxation of capital Taxes on returns from investment result in substitution effects: investment declines or capital moves elsewhere to other tax jurisdictions When capital leaves a tax jurisdiction, the marginal product of labor declines and the tax base for labor income contracts There is negative reinforcement on tax revenue: a tax on one factor of production reduces the tax base of the other factor

Hillman, 2009: Public finance for public goods 41

Tax evasion the Laffer curve

• Another reason for the Laffer curve is tax evasion where tax

rates become too high The political sensitivity of the Laffer curve

• Location on the Laffer curve is revealed empirically by

changing the rate of taxation and observing the revenue response

• The Laffer curve is politically sensitive for people who prefer

high government spending because of the possibility that decreasing tax rates can increase government revenue

• Political sensitivity is compounded by the distinction between

the short and long-run Laffer curve

Hillman, 2009: Public finance for public goods 42

A leviathan government and the Laffer curve

• A leviathan government seeks the maximum point of the

Laffer curve

• Information about the Laffer curve is not always precise
• A leviathan government is prone to straying onto the wrong

side of the Laffer curve

Hillman, 2009: Public finance for public goods 43

• C. W ho pays a tax?

Normative principles of just taxation are:

• Horizontal equity requires that people who are identical in

income and

• ther

attributes face the same tax

• bligations.
• Vertical equity requires that people who are not identical

in income and other attributes face tax liabilities that are just in accounting for the sources

• f

individual differences. Principles according to which taxes can be levied:

• The benefit principle of taxation: people who benefit from

public spending should pay the taxes that finance the spending

• Ability-to-pay principle of taxation: people who can most

afford to pay should pay taxes, without regard for personal benefit obtained from the taxes paid.

Hillman, 2009: Public finance for public goods 44

Governments need to be able to verify that taxes are paid by intended taxpayers The effective incidence of a tax does not necessarily correspond to the legal incidence Payment of a tax depends on substitution possibilities, not on legal incidence

P’S PB = PS = PE P’B F A J D’ O Q1 QE V G H E S + TAX S= ∑MC Quantity D Price Tax

Hillman, 2009: Public finance for public goods 45

The sharing of the excess burden Demand and supply elasticities determine  Effective tax incidence (who pay a tax)  The sharing of the excess burden

Hillman, 2009: Public finance for public goods 46

Effective tax incidence when taxes have no excess burden Substitution effects only A tax paid by sellers A tax paid by buyers The side of a market (buyers or sellers) with no substitution responses pays the entire tax. When one side of the market pays the entire tax, there is no excess burden of taxation.

P’S P=P′B D’ O D S Quantity Price D O Quantity S’ S P = P’S P’B Price

Hillman, 2009: Public finance for public goods 47

Political pronouncements and taxation

Substitution effects determine who pays a tax and the sharing of the excess burden of taxation

Public policy pronouncements that imply effective tax incidence is determined by legal tax incidence indicate  Misinformation (the political decision maker does not know economic principles), or  Disinformation (the political decision maker hopes that

• thers do not know economic principles)

L1 O Demand for labor LE wE wB wS Tax Hours worked Supply of labor Wage

Hillman, 2009: Public finance for public goods 48

Fiscal illusion and tax incidence Fiscal illusion occurs when taxpayers are not aware they are paying taxes The excess burden of taxation and fiscal illusion

• When there is fiscal illusion, people do not know that they are

paying taxes but the excess burden of taxation is present

• The substitution response is a response to change in a

relative price and not a response to the reason for the change Political decisions

• Political

benefit from effective tax incidence requires asymmetric information about who pays a tax

• Because of fiscal illusion, political decision makers may prefer

indirect taxes Fiscal illusion arises with bond financing (to be considered presently)

Hillman, 2009: Public finance for public goods 49

Economy-wide effects on who pays taxes Economy-wide (or general-equilibrium effects) of taxes affect how the excess burden is shared and who pays a tax Examples

• Factor prices and incomes
• A sales tax on toothbrushes and incomes of dentists

To know who in the final analysis pays a tax and who bears the excess burden of taxation, governments need to be able to trace the effect of the tax throughout all markets.

Hillman, 2009: Public finance for public goods 50

• D. Taxes on international trade

Import duties or tariffs are a form of indirect taxation Import duties provide governments with revenue but in high- income countries the tax revenue is the incidental consequence

• f protectionist policies

The excess burden of an import tariff

J I G A ∑MC Domestic supply P* (1 + t) N D C B ∑MB Domestic demand O Price Quantity P* Q1 Q2 Q4 Q3

Hillman, 2009: Public finance for public goods 51

A sales tax and a tariff A sales tax provides the same tax revenue as an import tariff with a lower rate of taxation and a lower excess burden of taxation. Costs of collection of revenue Costs of collecting revenue from taxes on imports are low compared to a sales tax

Hillman, 2009: Public finance for public goods 52

Where tax administration allows domestic taxes to be collected, the purpose of a tax on imports cannot be to provide tax revenue – since a sales tax is a better revenue instrument. The purpose of a tax on imports is not revenue but to provide protectionist rents to domestic industry interests.

Hillman, 2009: Public finance for public goods 53

Why use an import tariff? If the objective is government revenue, a sales tax is preferable to an import tariff If the objective is protection, a subsidy to domestic producers provides the same rents to domestic producers as an import tax but with a smaller efficiency loss. Why would governments choose to use import tariffs as means of providing protectionist rents to a domestic industry?

• Visibility

in the government budget

• pens

production subsidies to scrutiny and debate.

• An import tax provides protectionist rents that do not appear

in the government budget

• Buyers provide the rents directly to the domestic industry,

through the higher domestic price directly paid to domestic producers

Hillman, 2009: Public finance for public goods 54

Import quotas The choice between tariffs and import quotas For a competitive domestic industry, the two policy instruments are equivalent – except for who obtains revenue The quota creates rents for private individuals at the expense

• f government revenue.

The private profits from being assigned quota rents set in place a rent-seeking contest Why would a government forego tariff revenue to create private rents through an import quota?

Hillman, 2009: Public finance for public goods 55

4 .2 TAX EVASI ON AND THE SHADOW ECONOMY

• A. Tax evasion as free riding

Tax evasion is illegal free riding in contributions to public goods.

• Tax evasion and tax incidence
• Public policy

The expected penalty for being found to have evaded taxes is: {probability of detection}.{penalty if detected}.

• Why do people evade taxes?
• Tax evasion and social norms
• Risk-averse behavior

Hillman, 2009: Public finance for public goods 56

Opportunities for tax evasion Opportunities for tax evasion are not uniform  A property tax  Employees and employers  Sellers who deal directly with final purchasers  Self-employed persons and employers or owners of small businesses have opportunities for evading taxes by finding ways to understate revenues and overstate expenses Estimates of underreporting for the United States

• One percent of incomes from wages and salaries
• 4 percent of income from taxable interest and dividends
• 57 percent of non-farm self-employed business income
• 74 percent for farm income, under-reporting increases to 74

percent

Hillman, 2009: Public finance for public goods 57

 Tax evasion and exchanges of services  Indirect taxes (sales taxes, excise taxes, and import tariffs) - complicity of corrupt cooperating customs inspectors.  Multinational firms and transfer prices  Illegal immigrants  Tax avoidance and tax evasion There is injustice when some people can engage in tax avoidance and others only in tax evasion Tax evasion does not incur the expenses of tax avoidance but is illegal and subject to penalties and stigma if detected.

Hillman, 2009: Public finance for public goods 58

Unequal opportunities to evade taxes are a source of social injustice because of arbitrary sharing of the tax burden and

• f the excess burden of taxation

Hillman, 2009: Public finance for public goods 59

• B. The behavior of the tax authorities

 How do the tax authorities behave toward taxpayers?  Presumptive taxation  Corruption in low-income countries

Hillman, 2009: Public finance for public goods 60

• C. The shadow econom y

In the shadow economy, incomes are entirely outside of the domain of taxation Tax evasion takes place in the shadow economy but also in the

• fficial economy.

Welfare fraud

• People employed in the shadow economy declare themselves

to be officially unemployed and receive unemployment benefits or welfare payments

• They fraudulently take money from the government (i.e.,

from taxpayers) while at the same time evading taxes on their incomes in the shadow economy.

Hillman, 2009: Public finance for public goods 61

The size of the shadow economy The size of the shadow economy cannot be directly observed and therefore has to be inferred or estimated Researchers look for observed variables that are correlated with the size of the shadow economy – or that are correlated with the true size of national income including the shadow economy  Money supply  Extent of cash payments  Use of electricity  Differences between total income and total spending  Differences between population size and people employed indicated by official statistics. More complex approaches: A variety of indicators and causes are used to estimate the size of the shadow economy as an unknown variable

Hillman, 2009: Public finance for public goods 62

The size of the shadow economy as a proportion of reported official gross national product 1990 1995 2000 2005 Georgia 58 62 67 66 Ukraine 43 47 52 55 Russia 38 41 46 47 Turkey 26 29 32 33 Greece 23 29 29 26 India 23 25 Italy 23 26 27 23 Israel 16 19 22 23 Belgium 19 22 22 20 Portugal 16 22 23 20 Spain 16 22 23 20 Czech Republic 16 17 19 18 China 13 17 Norway 15 18 19 17 Denmark 11 18 18 16 Hong-Kong SAR 12 13 17 16

Hillman, 2009: Public finance for public goods 63

Sweden 16 20 19 16 Germany 12 14 16 15 Canada 13 15 16 14 Ireland 11 16 16 14 Australia 10 13 13 13 France 9 15 15 13 Netherlands 12 14 13 13 New Zealand 9 11 13 11 U.K. 10 13 13 10 Austria 7 9 10 9 Japan 9 11 11 9 Switzerland 7 8 9 9 U.S.A. 7 9 9 8 Source: Schneider (2005, 2007). Numbers are rounded up. Corruption and the shadow economy

Hillman, 2009: Public finance for public goods 64

Reliability of the estimates The incentive to claim exaggeration

• A large shadow economy can be attributed to high taxation

and high public spending

• Ideology can affect willingness to accept estimates that

reveal large shadow economies

• Governments with large shadow economies may be politically

sensitive and object that estimates overstate the true size of their shadow economies

Hillman, 2009: Public finance for public goods 65

• D. I nefficiency and illegality in a shadow econom y

Injustice There is injustice when unequal opportunities for tax evasion result in discriminatory tax burdens Honesty is penalized: Activity in the shadow economy provides a cost advantage for producers who do not pay taxes Inefficiency in the shadow economy The excess burden of taxation is reduced However, tax evasion is a source of inefficiency

• Limited scope for personal success
• No recourse to courts for enforcement of contracts and to

settle disputes

• The shadow economy invites corruption

Hillman, 2009: Public finance for public goods 66

 Conspicuous consumption and visible spending  Money laundering  The Laffer curve and tax evasion

Hillman, 2009: Public finance for public goods 67

4 .3 GOVERNMENT BORROW I NG

Bond financing of public spending is deferred taxation, including a deferred excess burden of taxation

• A. Bond financing and the benefit principle of taxation

The normative rule based on the benefit principle of taxation is: Current taxes should be used to finance current benefits from public spending Bond financing should be used to match future benefits with future tax payments.

Hillman, 2009: Public finance for public goods 68

Bond financing for public spending Period 1 Period 2 Period 3 TX= 40 BX= 80 TY= 400 BY= 400 TZ= 40 BX= 800 = TY+ BY BY= 40 0= TZ D1= - 800 D2= - 400 D3= 0 Total cost: C=1200=TX+TY+TZ

Zero interest rate

Hillman, 2009: Public finance for public goods 69

Default on government bonds

• Generation Z could gain by reneging and refusing to transfer

its share of the cost of the project to generation Y.

• The public project would continue to provide benefits
• The project was completed in period 1 and the only change if

a government reneges

• n

honoring bond redemption

• bligations is in intergenerational income distribution.

Sale of government bonds to foreigners

• Bonds can be sold to foreigners
• The taxes to repay the bonds (and to pay interest on the

bonds) continue to levied on the different generations of domestic taxpayers

Hillman, 2009: Public finance for public goods 70

• B. I ntergenerational tax sharing

Bond financing can be manipulated to redistribute income among different generations Ricardian equivalence When the taxes of different people repay the bond, the choice between taxes and bond financing has distributional effects Whether taxes or bond financing is used does not matter for an individual, if the same individual pays the taxes that finance interest and repayment of the government loan Intergenerational altruism makes taxation and bond financing equivalent When governments tax gifts or bequests, the intergenerational altruism that restores Ricardian equivalence is taxed

Hillman, 2009: Public finance for public goods 71

Future taxpayers Is present bond-financed public spending consistent with the preferences of future taxpayers? Asymmetric information: Only a future generation knows its own preferences for public spending In practice, present generations have no choice but to make decisions on behalf of future generations Example of defense

• Defense spending provides a public good for the immediately

threatened generation

• Future generations also benefit
• It therefore seems reasonable that future generations should

pay part of the cost of ending the threat, through future taxes of bond financing

Hillman, 2009: Public finance for public goods 72

• C. Fiscal illusion in bond financing

 Do taxpayers know that bond financing implies future taxes?  If so, do taxpayers accurately perceive the values of their future tax liabilities due to bond financing? The compensating transfers required for Ricardian equivalence require positive answers to both questions Asymmetric information because of fiscal illusion A political principal-agent problem allows government spending to exceed the spending that informed tax payers would want

Hillman, 2009: Public finance for public goods 73

• D. Constitutional restraint on governm ent borrow ing

We have identified reasons why bond financing can be socially undesirable

• A government might favor contemporary taxpayers through

bond financing

• If there is fiscal illusion, present taxpayers will find

themselves with higher tax payments (and excess burdens) in the future than they would have agreed to A legal constitutional restraint can limit financing through government borrowing to benefits that each future generation receives from past public investment

Hillman, 2009: Public finance for public goods 74

A budgetary surplus We have been considering a government that requires revenue to finance spending Surplus revenue can be used: (1) to reduce present taxes (benefits present taxpayers) (2) to repay past government borrowing by buying back previously issued government bonds (benefits future taxpayers) (3) in ways that benefit particular groups rather than to take advantage of the surplus to reduce present or future taxes The decision about how to use a government budget surplus is distributional and political Constitutional restraint can also apply to government policies when there are budgetary surpluses

Hillman, 2009: Public finance for public goods 75

SUPPLEMENT The excess burden with substitution and income effects The analysis of the excess burden of taxation has been based on the substitution effects alone Taxes also have an income effect The excess burden as payment to avoid a tax and compensation for a tax differ because of the income effect

Hillman, 2009: Public finance for public goods 76

The excess burden of a tax with income effects

1 5 H D 2 3 4 A O B Y Z U2 Pre–tax relative price ICC1 or income consumption curve (or line) showing changes in consumption as income increases at the pre-tax relative price Quantity of X ICC2 or income consumption curve (or line) showing changes in consumption as income increases at the post-tax relative price Income (spending on all other goods) Post–tax relative price