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Summary Public Finance, Rosen and Gayer, Lecture (s)

Chapters 3 to 6, 8, 12, 14, 15, 16, 18, 20, 22
Public Finance (Rijksuniversiteit Groningen)

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Public finance summary

Chapter 3 – Tools of normative analysis

welfare economics: the branch of economic theory concerned with the social desirability of alternative
economic states
basic concepts: 1) efficiency can we improve overall welfare?
2) equity is it fair?
pareto efficiency: nobody can be made better off without making someone worse off
pareto improvement: a reallocation of resources that makes at least one person better off without
making anyone else worse off
contract curve: the locus of all Pareto efficient points
production possibilities curve: a graph that shows the maximum quantity of one output that can be
produced, given the amount of the other output
marginal rate of transformation (MRT): the rate at which the economy can transform one good into
another good; it is the absolute value of the slope of the production possibilities frontier
marginal cost: the incremental cost of producing one more unit of output
utility possibilities curve: a graph showing the maximum amount of one person’s utility given each level
of utility attained by the other person

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Pareto-efficient allocation of resources if:

- perfect competition
- identical prices
- no market power
- existence of markets
- everything can be traded

1st Pareto efficiency condition: MRSadam = MRSeve

2nd Pareto efficiency condition: MRSaf = MRTaf

With well-functioning markets, prices reflect both:

- relative costs of production (MRT), and
- relative attractiveness of goods (MRS)

social welfare function: a function reflecting society’s views on how the utilities of its members affect
the well-being of society as a whole
asymmetric information: a situation in which one party engaged in an economic transaction has better
information about the good or service traded than the other party
externality: a cost or benefit that occurs when the activity of one entity directly affects the welfare of
another in a way that is outside the market mechanism
merit good: a commodity that ought to be provided even if people do not demand it (operas, concerts)

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Correct market failures:

- firms have market power
- firms set their own prices (P > MC)
- a market does not exist, because of:
- asymmetric information
- lack of property rights
- public goods

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Chapter 4 – Public goods

A pure public good has both these properties:

- consumption is non-rival
> cost of use by additional person is zero
> use by one person does not prohibit use by someone else
- consumption is non-excludable
> everyone consumes it
> everyone consumes the same quantity
> whether you want to or not
is NOT necessarily a good provided by the public sector:
- public sector provides private goods too (education)
- public goods can be provided by private sector (fireworks)

impure public good: a good that is rival and/or excludable to some extent

Public good examples Not public good examples

national security medical care
flood protection highways
disease eradication
lighthouse

A pure private good is both rival and excludable

Public good Private good

same quantity, different prices same price, different quantities
MRSadam + MRSeve = MRT MRSadam = MRSeve = MRT
competitive markets do not produce efficient competitive markets ensure efficiency
outcome
people can consume without pay (free rider problem) individuals have no incentive to lie about their
preferences

Free rider problem: the incentive to let other people pay for a public good while you enjoy the benefits
solution: governments provides public goods people pay through taxation
however: government has failures too market failure should be weighed against government
failure

perfect price discrimination: when a producer charges each person the maximum he or she is willing to
pay for the good
horizontal summation: the process of creating a market demand curve by summing the quantities
demanded by each individual at every price (private good)

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vertical summation: the process of creating an aggregate demand curve for a public good by adding the
prices each individual is willing to pay for a given quantity of a good (public good)
privatization: the process of turning services that are supplied by the government over to the private
sector for provision and/or production
commodity egalitarianism: the idea that some commodities ought to be made available to everybody
(education)

Chapter 5 – Externalities

An externality is the consequence of the absence of property rights

example:
- Bart’s factory dumps waste into a river nobody owns
- Lisa makes her living by fishing from the river

~ Bart’s activities make Lisa worse off in a direct way that is not the result of price changes
not through market mechanism externality
~ Bart pays zero for using the water the costs are not zero
~ If Lisa owns the river, she can make Bart pay to pollute Bart will pollute less in order to save
money
~ If Bart owns the river, he can charge Lisa for fishing Bart will pollute less, Lisa will pay more

If someone owns the river market mechanism externality is internalized

Two sets of options to reach efficient output:

- private responses
- market system
- possible because all parties may gain from change
- public responses
- government action

Coase theorem: no matter who is assigned the property rights, an efficient solution will be achieved if:
1) bargaining costs are low
2) the owner can identify all users (polluters, fishers)

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Private responses characteristics N.B.

1) assign property rights bargaining; it does not matter it does matter who is owner for
who is owner for efficiency income distribution
2) mergers internalize the externality; one not always feasible (many
business; all costs will be taken different parties; hard to
into account manage different activities)
3) social conventions impose social cost hard to create (e.g. media
campaigns against smoking)

Private response does not always work government can intervene; public response

Public response 1):

Pigouvian tax: polluter pays external cost through a tax on output
price now reflects damage; costs taken fully into account efficient output
Pigouvian subsidy: subsidy for output not produced; similar to tax case in reverse

Both Pigouvian tax and subsidy lead to the same efficient production level,
but with different distributional consequences (fairness):
- Tax: polluter pays
- Subsidy: polluter is paid
both cases: MPC polluter is increased to include damage

difficulties Pigouvian tax:

- costly to find out who pollutes and how much
- marginal damage is unclear (= tax rate)
- no incentive to use cleaner technology
> because tax is on output, not on pollution
However: an imperfect Pigouvian tax is often better than none at all

Public response 2):

Create a market: emission fees or cap-and-trade
- creates incentive to innovate
- firms that can reduce pollution cheaply will reduce it cost-effective; Pigouvian tax not cost-effective
- but: measuring pollution may be costly; more than measuring output

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Emission fees cap-and-trade

kind of Pigouvian tax, now on unit of pollution, not government issues permits to pollute (no more
output than socially efficient output) and allows polluters
to trade the permits
firms that can reduce pollution cheaply will reduce permissions to pollute go to the firms with the
it cost effective highest bids cost effective
pollution is reduced as long as fee >MC pollution can be easily reduced by limiting number
set fee at MC at efficient output level of permits
stimulates innovation; produce cleaner government can sell permits, or give away:
- no difference for efficiency
- difference for income distribution

must be adjusted regularly for same pollution no adjustment needed

reduction
if marginal cost of pollution reduction increase: if marginal cost of pollution reduction increase:
same costs; less pollution reduction same pollution reduction; higher costs

If marginal cost is uncertain: If marginal cost is uncertain:

elastic marginal social benefits; emission fees inelastic marginal social benefits; cap-and-trade
better better

NB: for both emission fees and cap-and trade: measuring pollution may be costly;
more than measuring output

congestion pricing: a tax levied on driving equal to the marginal congestion costs imposed on other
drivers (e.g.: a fee for driving in the city during peak hours)
safety valve price: within a cap-and-trade system, a price set by government at which polluters can
purchase additional permits beyond the cap

Public response 3):

Regulation; command and control
incentive-based regulations: policies that provide polluters with financial incentives to reduce pollution
- useful when pollution cannot be measured
- two options:

Option 1) set technology standard 2) performance standard

all firms must use a certain all firms must cut back by equal
technology to reduce pollution amounts
e.g.: ban on nuclear power > incentive to innovate
problems - no incentive to innovate - some firms can reduce
- not cost effective emissions cheaper than others
- not cost effective

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hot spots: localized concentrations of emissions

Chapter 6 – Political economy

Lindahl prices: the tax share an individual must pay per unit of public good

Types of democracy:

i) Direct democracy: people vote themselves on all kinds of issues

- time consuming
- still done in some regions of Switzerland
ii) Representative democracy: people choose representatives to vote for them
- parliament, municipal council
- vote only once every four of five years

i) Direct democracy

Different voting rules:

1) Unanimity: everyone must agree

2) Majority rule
- 50% or more voters must agree
- sometimes qualified majority (e.g. 75% of the vote)

Arrow’s voting paradox: there is not necessarily a stable outcome ( = same result in another vote)
reason multi-peaked preferences
Preferences are single-peaked if utility falls consistently if outcome is further removed from preferred
outcome otherwise: multi-peaked

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Agenda manipulation: organize voting in order to manipulate outcome

- make sure the option that can beat your preferred outcome is defeated in earlier vote
- wait with your proposal until strong alternatives have been defeated

cycling: when paired majority voting on more than two possibilities goes on indefinitely without a
conclusion ever being reached

Median voter theorem: choose outcome of voter whose preferences lie in the middle

The median voter has the decisive vote, if:

- preferences are single-peaked
- no strategic voting

Strategic voting: logrolling or vote trading

Logrolling: you support someone else’s proposal; in return for their support for your proposal

Advantages Disadvantage
reveals intensity of preferences may lead to wasteful public expenditures (e.g.
projects with negative NPV may pass)
compromises help the democratic system to
function

In short: when all preferences are single peaked, majority voting yield a stable result, and the choice
selected reflects the preferences of the median voter. however, when some voters’ preferences are
multipeaked, a voting paradox can emerge.

Criteria for voting system:

- must produce decisions
- must be able to rank all outcomes
- must be responsive to individuals’ preferences
- must be consistent
- must be independent of irrelevant alternatives
- dictatorship is ruled out
in short: voting should be fair and not produce paradoxical result

ii) Representative democracy

Three parties involved:

- voters elect politicians
- politicians decisions are carried out by civil servants (bureaucrats)

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Median voter theorem applies here as well

- in theory, voting outcomes are the same as with direct democracy
- candidates have incentive to move towards political middle

Bureaucrats can make all-or nothing proposal

- high output or none at all
- because of informational advantage

Rent seeking: interest groups can manipulate the political system to redistribute income towards them
cartel: an arrangement under which suppliers and together to restrict output and raise price

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Chapter 8 – Cost-benefit analysis

Hicks-Kaldor criterion: potential Pareto improvement if total benefit > total cost

Three measures used to compare different projects:

1) net present value
2) internal rate of return
3) benefit/cost ratio

1) Net present value

- a project is admissible only if NPV > 0
- when two projects are mutually exclusive, choose the one with highest NPV

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2) Internal rate of return (ρ = discount rate that would make NPV zero)
- project admissible if ρ > r (r = actual discount rate)
- ρ cannot be used to choose between projects; if projects differ in size, ρ can be misleading

3) Benefit-cost ratio

However, B/C is useless as a basis for comparing projects

there is no fundamental difference between benefit and cost
- cost can be classified as lower benefit instead, and vice versa
- by manipulating definitions of costs or benefits, any project can be given a high B/C

r plays a key role reflects opportunity cost

social rate of discount: the rate at which society is willing to trade off present consumption for future
consumption

in the private sector, the tax money could have been used for:
i) investment
ii) consumption

Private sector discount rate may not be appropriate:

- benefit for future generations not taken into account
- people underestimate future benefits
- projects may generate positive externalities

Valuing public benefits and costs

1. Use market prices – unless market imperfections are too big

- reflect marginal social costs of production (MRT)
- reflect marginal value to consumers (MRS)
2. Shadow prices: market price adjusted for market imperfections
- often, market price does not equal marginal social costs, if difference is big; use shadow price
- equals opportunity cost; shows what the benefit would have been otherwise
3. Use consumer surplus (if market is so big market prices are affected)
- consumer surplus increase = project benefit
4. Non traded goods
- calculate how valuable the intangibles must be in order to make project admissible
- or; different ways for attaining intangible benefits may be compared

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Pitfalls of cost-benefit analysis:

i) chain-reaction game
- include all kinds of secondary ‘benefits’ until NPV > 0
- often, these are not benefits, but transfers
ii) double-counting game
- count benefits twice
iii) labor game
- count jobs created by project as benefit instead of cost
iv) use B/C ratio of internal rate of return

certainty equivalent: the value of an uncertain project measured in terms of how much certain income
an individual would be willing to give up for the set of uncertain outcomes generated by the project

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Chapter 12 – Income redistribution

Hard to tell how big differences in income are:

- income data are based on annual income measures, but income may fluctuate
> students earn little now but a lot later in life
- people may choose to work part-time
> low income doesn’t necessarily mean low hourly wage
- compare income of individuals of households?
- income before or after
> tax, subsidies, transfers

poverty line: a fixed level of real income considered enough to provide a minimally adequate standard
of living

Additive social welfare function: an equation defining social welfare as the sum of individuals’ utilities
W = U1 + U2 + ... + Un If:
1 Individuals have identical utility functions …
2 … that depend only on their incomes
3 Marginal utility of income diminishes
4 Total income is fixed

Then the optimal solution is: redistribute until complete equality

However: assumptions are not valid:

- utility does not only depend on income
- total amount of income is not fixed

Maximin criterion: social welfare depends on the utility of the individual who has the minimum utility in
the society redistribute income to maximize Upoor

Can redistribution be Pareto efficient?

The rich can benefit too:
- Altruism: other people’s income may enter your welfare function
> externality problem
> people will help the poor, provided others do the same
> fair income distribution as public good
- Income redistribution as an insurance against future poverty
- If people are very poor, they will be coming for your money anyway fair distribution bus social
peace

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Research shows not absolute but relative income matters

- not income levels but income changes determine happiness
> Preference drift: discover new desires
> Reference drift: compare yourself with the rich

In kind-transfers: give the poor goods or services instead of money

- public housing
- free education
- medical care
may be inefficient:
> a good is at best valued as much as it costs
> often, it is valued less
> also, administrative costs reduce efficiency

Reasons for in-kind transfers explanation

paternalism - politicians think they know better what people
need
- cash may be spent on alcohol/drugs etcetera
some services must be equally accessible to - housing, education
everyone - commodity egalitarianism
less fraud than money transfer - less attractive only the needy apply
political attractiveness, lobbying - especially from producers, e.g. school milk

Redistribution makes working less attractive more distribution less income to redistribute

expenditure incidence: the impact of government expenditures on the distribution of real income

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Chapter 14 – Taxation and income distribution

Taxation has 3 effects:

- transfer of money from taxpayer to government
- inefficient allocation of resources
> because tax changes relative prices
> loss to taxpayer, gain to no-one
- transaction costs
> cost of tax administration
> compliance cost to taxpayer

Statutory incidence: who is legally responsible for paying the tax

Economic incidence: who bears the burden
Tax shifting: the difference between statutory incidence and economic incidence
functional distribution of income: the way income is distributed among people when they are classified
according to the inputs they supply to the production process (e.g.: landlords, capitalists)
size distribution of income: the way that total income is distributed across income classes
lump sum tax: a tax whose value is independent of the individuals’ behavior
tax wedge: the tax-induced difference between the price paid by consumers and the price received by
producers

different types of analysis:

- balanced-budget incidence: combined effects of taxation and spending financed by those taxes
- differential tax incidence: who bears the burden if we use this tax instead of that

Progressive tax: the rich pay more

- different definitions
> Average tax rate increases with income rich pay more tax as % of their income
> Marginal tax rate increases with income rich also pay more tax on last euro earned

Partial Equilibrium model:

- one market

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- effects on other market are negligible

- use if market is small compared to rest of economy

unit tax: fixed amount (e.g. €5) per unit of a commodity

ad valorem tax: percentage (e.g. 17%) of commodity price

When something is taxed Priceconsumers > Priceproducers

Tax on profits

Economic profit: return in excess of opportunity costs of factors of production used

- under competition: economic profit exists only in short run
- competition reduces economic profit to zero

Profit maximization: MR = MC
- neither MC nor MR are affected by profit tax output and price remain the same
profit tax is fully born by the firm’s owners

Partial Equilibrium model General Equilibrium model

one market, effects on other markets are 2 sectors (M, F), takes into account how various
negligible markets are interrelated
use if market is small compared to rest of use if market is large
economy
incidence is independent statutory incidence;
moving S or D gives same result
incidence depends on supply and demand 9 possible ad valorem taxes:
elasticities; - capital tax for either M of F
- supply perfectly elastic: consumers bear entire - labor tax for either M or F
burden - consumption tax on either good M or F
- demand perfectly elastic: producers bear entire - tax on either labor or capital
burden - general income tax
(Tax on F & M = tax on income = tax on
consumption)
NB: nothing about the incidence of a tax can be known without information on the relevant behavioral
elasticities

capitalization: the process by which a stream of tax liabilities becomes incorporated into the price of an
asset

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Harberger model: method for analyzing tax incidence

- perfect competition, profit maximization
- constant returns to scale
- one sector capital intensive, another labor intensive
- mobile production factors, total supply fixed
- no savings
- differential tax incidence

Example commodity tax on Food

Relative PF goes up, PM goes down QF goes down more manufactures produced If food is more
capital-intensive than manufactures more capital than labor will be moved to the manufacturing
sector demand capital falls price capital falls capital owners are hurt by tax on food

Tax on the output of a sector lowers the relative price of the input used intensively in that sector

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Chapter 15 – Taxation and efficiency

excess burden: a loss of welfare above and beyond taxes collected. also called welfare cost or
deadweight loss
equivalent variation: a change in income that has the same effect on utility as a change in the price of a
commodity
tax interaction effect: the increase in excess burden in the labor market stemming from the reduction in
real wages caused by Pigouvian tax
double-dividend effect: using the proceeds from a Pigouvian tax to reduce inefficient tax rates

Efficiency condition:
- MRS = MRT
- willingness to pay = marginal production cost; price consumer = price producer
Taxation: Priceconsumer > Priceproducer
- MRS =\= MRT
- prices no longer reflect relative scarcities
- economic behavior affected
- result: inefficiency
Exception: lump sum taxes you pay the same amount no matter what you do

Lump sum taxes don’t change relative prices no excess burden

- however: often not considered fair; everyone same amount

Tax lowers income and changes prices

- intended effect lower income is inevitable with taxation
- unintended effect price change creates excess burden

Utility loss taxpayer = tax {known} + excess burden {unknown}

Lump sum tax excess burden = 0 utility loss equals tax

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measuring excess burdens: use compensated demand curve

- ordinary demand curve reflects income effect & substitution effect
- compensated demand curve removed income effect only compensated response affects MRS
> consumer remains on same indifference curve
> only substitution effect (effect from product A being more expensive relative to other products)
- excess burden depends on movement along compensated demand curve

Tax on commodity X lower demand for 2 reasons:

income effect substitution effect

because of tax, income is lower less is bought of because of tax, price X is higher less of X is
every commodity, also less of X bought, X is substituted by other goods

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Upward sloping supply curve → excess burden also depends on the elasticity of supply:

=
+

- ε is compensated price elasticity of supply

NB:
- if compensated elasticities zero no excess burden
> no reaction to price change
> behavior not affected by tax
- if market distortions exist new tax can lower the overall excess burden
> e.g. if consumption is too high as a result of negative externalities, a tax can improve welfare

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Ch
hapter 16 – Efficient & equitable taxation

criteria for evaluating tax system m:

(1) optimal taxation theory
> efficiency (low excess burden)
> equity (fair distribution
n)
(2) political feasibility
(3) horizontal equity (equals treaated equally)
(4) operating costs of taxation
(5) tax evasion

(1)
Excess burden minimized if:
- marginal excess burden of the last euro of revenue raised from each commoditty is the same, or;
- raising tax rate on commodity with
w lowest marginal excess burden
& lowering rate on commodity with
w highest marginal excess burden

= Ramsey rule: set tax rates so that the percentage reduction in

n demand is the same for
each commodity

If X and Y are unrelated commod dities:

- If price of X or Y changes, it affe
ects only its own demand, not the demand for th
he other good
→ no subsStutes or complemen nts
Then, inverse elasticity rule app plies:

A tax system should have vertica

al equity: distributing tax burdens fairly across peeople with different
abilities to pay

big EB → low t tax commodities with low elastticity most.

If elasticity is high, tax causes a b
However: essential drugs have lo ow elasticity of demand; sick people have no cho
oice; unfair to tax heavily

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(2)
Efficient taxation: tax goods which are complementary to leisure
natural monopoly: a situation in which factors inherent to the production process lead to a single firm
supplying the entire industry’s output

If average costs decrease with output, economies of scale may lead to a natural monopoly
- no competitive market government may provide what price should the government charge?

Option 1) Marginal cost Option 2) Marginal cost pricing with Option 3) Marginal cost pricing Option 4) Average
pricing lump sum tax to cover loss with distortive tax to cover loss cost pricing
P = MC lump sum tax usually not fair excess burden tax may exceed P = AC
efficiency gain in market for Z No profit, no loss
used often
P* < AC loss violation of benefits received violation of benefits received Not efficient:
principle (= consumers of a publicly principle quantity < quantity
provided service should be the ones marginal cost pricing
who pay for it)

Edgeworth’s model
- identical downward-sloping utility functions depending only on income
- total income is fixed
- after-tax income should be the same for everyone
- marginal tax rate on high-income people 100%
NB: assumptions are problematic (e.g. income is not fixed, utility depends on more than income)

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Politics time inconsistency problem

- tax policy is impossible if it conflicts with a government’s long-term incentives
> e.g. a one-time tax has no effect on behavior
> If it really is a one-time tax; but government has incentive to repeat
> if tax-payers know this effect on behavior welfare loss
- Important: political credibility

(3)
Horizontal equity what is equal position?
- higher income =\= higher wage (e.g. more working hours; part-time workers get less tax, more leisure)
- higher wage may result of more schooling (e.g. tax may discourage education)

transitional equity: fairness in changing tax regimes

(4)
low operating costs
- administrative costs: incurred by tax authority
- compliance costs: incurred by tax payers

Empirical research: compliance costs relatively

high for small firms
- competitive advantage for large firms
- firms will grow inefficiently large

Tax avoidance Tax evasion

altering behavior in such a way as to reduce your not paying taxes legally due
tax liability
legal illegal
e.g. take your bike, not your car, escape fuel tax e.g. hide your savings in Switzerland
possible because monitoring everyone all the time
is impossible
depends on marginal costs and marginal benefits
of cheating

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Chapter 18 – Personal taxation and behavior

A tax on labor lowers the relative price of leisure

- substitution effect more leisure is consumed
For any number of hours worked, a tax lowers income
- income effect less leisure will be consumed
> net effect is ambiguous, depends on which effect is stronger

human capital: the investment that individuals make in education, training, and health care that raise
their productive capacity

primary earners secondary earners

usually males usually females
effect of net wage changes on hours of work very effect is considerable
small
elasticity about 0.05 elasticity about 0.4
income effect ≈ substitution effect substitution effect > income effect
income tax discourages female labor supply; more
women work part-time

Laffer curve: a graph of the tax rate-tax revenue relationship

Relative price of consumption now: reflected in net interest rate, depends on:
- real interest rate
- tax on interest income
- extent to which interest costs are tax-deductible

life-cycle model: the theory that individuals’ consumption and saving’s decisions during a given year are
based on a planning process that considers lifetime circumstances

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Taxation reduces saving if:

- substitution effect > income effect
Taxation increases saving if:
- income effect > substitution effect

iii) taxation and risk taking

Tax reduces net return of risky asset less risk taking;
tax reduces risk (loss is tax deductible) more risk taking
theory: effect is ambiguous

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iv) taxation and housing

- Haig-Simons definition:
> income = net increase in power to consume
> income = consumption + saving
- all income should be taxed
- expenses incurred to earn income should be subtracted from taxable income
- income = rental value – interest + Δvalue

The effects of taxation on labor supply, saving and risk taking are ambiguous;
- income effect versus substitution effect
Empirical evidence exists, but open to debate
- taxing income probably reduces labor supply, especially among secondary earners
Dutch income tax results in excessive mortgage-financed home ownership

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Chapter 20 – Deficit finance

Fiscal deficit: government expenditures minus revenues

- flow variable
Government debt: the total amount owed at a given point in time = sum of all past deficits
- stock variable
surplus: the excess of revenues over spending during a period of time
internal debt: the amount that a government owes to its own citizens
external debt: the amount a government owes to foreigners

Rules of the European Monetary Union:

- deficit ≤ 3% GDP
- debt ≤ 60% GDP
- medium term objective 0.5% GDP (for NL)

Domar: debt sustainable if debt ratio is constant

- debt ratio: debt as % of GDP

Lerner’s view if debt is held by own citizens Lerner’s view if debt is held by foreigners, it
depends:
It creates no burden for future generation as a If loan is used for consumption: consumption of
whole future generation is reduced
Future generation has debt, but also bonds If loan is used for investment, there is only a
cancels out burden on future generation if:
marginal rate of return on public investment <
marginal costs of funds
We owe it to ourselves
But: one group of citizens pays the other
effect on income distribution

NB: problems with Lerner’s view:

- ignores that people die
- you may not be around when debt is repaid
- people born later may not have profited from debt spending
- ‘generation’ means here: everyone alive at a given time ‘generation’ means everyone born in the
same period

generational accounting: method for measuring the consequences of government fiscal policy that
takes into account the present value of all taxes and benefits received by members of each generation
crowding out: government borrowing interest rate increases private investment decreases

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Who bears the Overlapping generations model Neoclassical model Ricardian model
burden
characteristics - three generations - government borrowing - people are completely rational &
young, middle aged, old may increase interest rate have full information
- every generation is 20 years - crowding out: interest up - government debt must be repaid
long private investment down people save more in anticipation
-government borrows money - private capital stock lower borrowing has same effect on
from young and middle-aged to because of government consumption as taxation
finance consumption borrowing tax financing>pay tax>lower private
- financed through tax consumption
- no interest, no inflation debt financing>saving>lower private
consumption
burden the old of now benefit, young of future generations have people with lower private
future bear the burden lower incomes consumption
limitations assumes government debt policy - no perfect information
does not affect economic - no rational behavior
decision
in case of If NPV>0 no group is burdened burden depends on rate of
investment return

debt creation:
- may cause some crowding out
- result: lower private capital stock
- if money is used for consumption, future generations are worse off
- if money is used for government investment, trade off against benefit of private investment

debt existence:
- results in higher taxes to pay interest
- trade off excess burden against benefit of government spending
- also: redistribution
> from taxpayer to bondholder
> between generations

When unemployment is high run a deficit

- increase government spending, or lower taxes
- higher demand less unemployment
When unemployment is low reduce deficit
- deficit finance may now create inflation
- cut back government spending, or increase taxation

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Chapter 22 – Public Finance in a Federal System

federal system: consist of different levels of government that provide public goods and services and
have some scope for making decisions
club: a voluntary association of people who bang together to finance and share some kind of benefit
personal net worth tax: a tax based on the difference between the market value of all the taxpayer’s
assets and liabilities

formation of communities/jurisdictions
1) aim
2) optimal size
3) optimal public good provision

1) aim of a community:
- provide local public goods to maximize citizens’ welfare
- often impure public goods or even private goods (roads, schools)

2) optimal community size

- more people lower cost per citizen / more congestion (impure public goods)
- increase community size until
> marginal cost saving per citizen = marginal increase of congestion costs per citizen

3) optimal public good provision

- more public goods more utility per citizen / higher costs per citizen

Tiebout model
- public good: optimal level of provision unknown
- Tiebout: market-like solution to public good problem makes people reveal their preferences
- many different communities; each offering its own package of public goods and taxes
> High service & high taxes
> or low service & low taxes, or .. etc.
no free riding possible equilibrium is Pareto efficient; central government intervention not needed

assumptions Tiebout model:

- no spillovers
- perfect mobility
- perfect information
- enough communities
- constant returns to scale
do not hold, but: theoretical solution for public good problem

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Three tasks of government:

1) income redistribution
2) macroeconomic stabilization
3) allocation of goods and services

1) income redistribution 2) macroeconomic stabilization 3) allocation of goods and services

central government’s task central government’s task subnational governments’ task
- otherwise, rich people will leave - dampen the business cycle - those that the market does not
communities that redistribute more - manage employment, inflation provide sufficiently (public goods)
than others
- effect: not redistribution, but
migration
local government can run some subnational governments don’t exception: national public goods
modest anti-poverty programs have the instruments like defense task for central
government

5 reasons for decentralization

1) tailoring services to local tastes
2) efficiency of production
3) let governments compete (Yardstick competition)
4) more innovation and experimentation
5) empowerment

1) tailoring services to local tastes

- Oates’ theorem: preferences differ across regions
- same policies/services everywhere welfare not maximized
but: spillovers; welfare of non-residents is affected
- more decentralization is optimal if
> preferences vary a lot between communities
> preferences are relatively uniform within communities

2) efficiency of production
- local government is closer to the people
> knowledge of problems and possible solutions
but: economies of scale in some services
separate provision and production;
local government decides about service levels; private firms produce

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3) let governments compete (Yardstick competition)

- democracy: voter decides if government is reelected or not
- many local governments
- compare performance in same period
> crisis affects all
> if better services/lower taxes elsewhere your local government may not perform well
> vote for different party next time
> if performance can be compared, politicians try harder

4) more innovation and experimentation

- local governments: policy laboratories
- try something new locally; if it fails only local disaster
if it works other localities can copy

5) empowerment
- people have more influence on local government than on central government
- influence increases happiness

Financing decentralized governments

- optimal allocation:
> marginal benefit of service = marginal cost
- decision should be made by the same people who benefit and who pay
- local governments financed by local taxes
but: scope for local taxation limited
- tax competition
- local income redistribution difficult
grants from central to local governments

flypaper effect: a dollar received by the community in the form of a grant to its government results in
greater public spending than a dollar increase in community income

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intergovernmental grants because:

- taxation is mostly at central level
- addressing spillovers
- paternalism
- fiscal equalization

types of intergovernmental grants:

- conditional grants cannot be spent freely; for schools, welfare
nonmatching grant: amount independent of own spending
matching grant: percentage of own spending
- unconditional grants decentralized government is free to spend
equalizing grant: grant is higher if spending need is high/tax capacity is low

the corporation tax in many countries causes inefficiently high corporate debt levels because:

Usually, interest is deductible from taxable profit, but dividends are not. This makes debt financing
cheaper than it would be without taxation, and equity more expensive. As a result, corporations
borrow more than they would without corporation tax.

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