PUBLIC FINANCE FOR PUBLIC GOODS

Transcription

1 Public Finance and Public Policy: Responsibilities and Limitations of Government Arye L. Hillman Cambridge University Press, 2009 Second edition Presentation notes, chapter 4 PUBLIC FINANCE FOR PUBLIC GOODS

2 Societies cannot rely on voluntary payments for prisonersdilemma 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

3 We set aside political and bureaucratic principal-agent problems We hope that governments have been successful in using costbenefit 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

4 The advantage of government: Governments can resolve the free-rider problem by making payment for public goods compulsory through taxes 4

5 4.1 TAXATION 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

6 The excess burden of an income 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 w A Tax revenue B Excess burden E S L Labor supply with substitution effect only Pre tax wage w(1 t) D C O L 1 J H Hours worked The excess burden of taxation L 2 6

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 S L is linear, the area BEC is a triangle and the excess burden of taxation is wl SL t Measurement of the excess burden of taxation requires knowing the elasticity of labor supply SL 7

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. Wage 2 S L Labor supply with substitution effect only 1 O Hours worked A labor-supply function with an increasing elasticity of labor supply 8

9 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 w w(1-t 1 ) A D 1 H B 2 B 1 C 1 E S L Pre tax wage Labor supply with substitution effect only w (1-t 2) D 2 C 2 O Hours worked The excess burden and the rate of taxation 9

10 The case of SL = 0 Wage w S L Labor supply with substitution effect only w(1-t) O L Hours Taxation with no excess burden 10

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. 11

12 An indirect tax (sales tax) Price P(1+ t) A B Tax revenue Excess burden P D C E Pre-tax price determined in a competitive market MB i O q 1 q 2 Quantity 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 pq t D 12

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 13

14 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

15 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

16 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 habitforming or addictive o The low elasticities give rise to low substitution effects and so there are low excess burdens of taxation 16

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 rentseeking 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 publiclyfinanced public spending? 17

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: n W B C X j 1 j 0 Efficient tax-financed public spending requires: i MB MC ( inputs for the public good) MC ( theexcess burden) i G X 18

19 MC X is the marginal excess burden of tax-financed public spending R t(wl) dr wl.( 1 ). 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

20 View ε SL as constant 1 X R. SL. t 2 The average excess burden per dollar of tax revenue is X R 1 2 SL t For any rate of taxation t, the average excess burden increases with the labor-supply elasticity ε SL 20

21 The average excess burden of taxation for two elasticities of labor supply ε SL > ε SL Excess burden per dollar of tax revenue 1 > ε SL > ε SL ½ε SL ½ε SL O t Tax rate The average excess burden of taxation (per dollar of tax revenue) 21

22 MC X is the marginal excess burden MC With ε SL <1 and constant: X t 0 where SL SL The marginal excess burden MC X is linear and is increasing the tax rate t 22

23 Valuation and cost MC G +MC X (marginal cost of inputs plus marginal excess burden of taxation) MC G=P (cost of inputs only) O G E TAX G E MB Quantity of the public good Comparison between tax-financing and voluntary payment G TAX E = finance by compulsory tax G E = voluntary payment according to true benefit G E TAX < G E Because of the excess burden of taxation, efficient taxfinanced spending on public goods is less than efficient voluntary spending 23

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 24

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 25

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 26

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 ( ) proposed that there should be only 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 27

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 28

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 29

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 30

31 Measurement 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. 31

32 Wage Price of good 2 Excess burden B 2 E 2 Supply good 2 w B Excess burden E S L Pre tax wage B 1 C 1 E 1 C 2 Demand for good 2 AFTER the tax on good 1 Demand for good 2 BEFORE the tax on good 1 O L 1 Hours worked A tax with an excess burden and no revenue O Quantity of good 2 The change in the excess burden in market 2 when the tax changes in market 1 32

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 33

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 34

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 35

36 B. Tax revenue and the Laffer curve Tax revenue is: R t( wl ) { tax rate }.{ 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 dr wl.( 1 ). SL dt 36

37 Ln wage w S w SL >1 Tax rate t Slope=1, SL = 1 increases, net wage declines SL < 1 Labor supply with substitution effect only Pre tax wage Zero tax rate Zero tax revenue 100% tax rate Zero hours worked Zero tax revenue O Ln hours worked L 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 37

38 Tax revenue R Maximum revenue when ε SL=1 R o ε SL <1 ε SL >1 t = 0% provides zero revenue for the government O t 1 t * t 2 Tax rate t t = 100% provides zero revenue for the government 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. 38

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 of 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. 39

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 40

41 Tax evasion the Laffer curve o Another reason for the Laffer curve is tax evasion where tax rates become too high The political sensitivity of the Laffer curve o Location on the Laffer curve is revealed empirically by changing the rate of taxation and observing the revenue response o 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 o Political sensitivity is compounded by the distinction between the short and long-run Laffer curve 41

42 A leviathan government and the Laffer curve o A leviathan government seeks the maximum point of the Laffer curve o Information about the Laffer curve is not always precise o A leviathan government is prone to straying onto the wrong side of the Laffer curve 42

43 C. Who pays a tax? Normative principles of just taxation are: o Horizontal equity requires that people who are identical in income and other attributes face the same tax obligations. o 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 of individual differences. Principles according to which taxes can be levied: o The benefit principle of taxation: people who benefit from public spending should pay the taxes that finance the spending o 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. 43

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 Price S + TAX P B V H S= MC Tax P B = P S = P E F G E P S A J D D O Payment of a tax depends on substitution possibilities, not on legal incidence Q 1 Q E Quantity 44

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 45

46 Effective tax incidence when taxes have no excess burden Substitution effects only Price S Price D S P B P=P B S P = P S P S D D O Quantity A tax paid by sellers O Quantity 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. 46

47 Political pronouncements and taxation Wage Supply of labor w B w E Tax Demand for labor w S O L 1 L E Hours worked 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 others do not know economic principles) 47

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 o When there is fiscal illusion, people do not know that they are paying taxes but the excess burden of taxation is present o The substitution response is a response to change in a relative price and not a response to the reason for the change Political decisions o Political benefit from effective tax incidence requires asymmetric information about who pays a tax o Because of fiscal illusion, political decision makers may prefer indirect taxes Fiscal illusion arises with bond financing (to be considered presently) 48

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 o Factor prices and incomes o 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. 49

50 D. Taxes on international trade Import duties or tariffs are a form of indirect taxation Import duties provide governments with revenue but in highincome countries the tax revenue is the incidental consequence of protectionist policies Price MC Domestic supply P* (1 + t) P * O G A B N I D C Q 1 Q 2 Q 3 Q 4 The excess burden of an import tariff J MB Domestic demand Quantity 50

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 51

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. 52

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? o Visibility in the government budget opens production subsidies to scrutiny and debate. o An import tax provides protectionist rents that do not appear in the government budget o Buyers provide the rents directly to the domestic industry, through the higher domestic price directly paid to domestic producers 53

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 of 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? 54

55 4.2 TAX EVASION AND THE SHADOW ECONOMY A. Tax evasion as free riding Tax evasion is illegal free riding in contributions to public goods. o Tax evasion and tax incidence o Public policy The expected penalty for being found to have evaded taxes is: {probability of detection}.{penalty if detected}. o Why do people evade taxes? o Tax evasion and social norms o Risk-averse behavior 55

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 o One percent of incomes from wages and salaries o 4 percent of income from taxable interest and dividends o 57 percent of non-farm self-employed business income o 74 percent for farm income, under-reporting increases to 74 percent 56

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. 57

58 Unequal opportunities to evade taxes are a source of social injustice because of arbitrary sharing of the tax burden and of the excess burden of taxation 58

59 B. The behavior of the tax authorities How do the tax authorities behave toward taxpayers? Presumptive taxation Corruption in low-income countries 59

60 C. The shadow economy 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 official economy. Welfare fraud o People employed in the shadow economy declare themselves to be officially unemployed and receive unemployment benefits or welfare payments o 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. 60

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 61

62 The size of the shadow economy as a proportion of reported official gross national product Georgia Ukraine Russia Turkey Greece India Italy Israel Belgium Portugal Spain Czech Republic China Norway Denmark Hong-Kong SAR 62

63 Sweden Germany Canada Ireland Australia France Netherlands New Zealand U.K Austria Japan Switzerland U.S.A Source: Schneider (2005, 2007). Numbers are rounded up. Corruption and the shadow economy 63

64 Reliability of the estimates The incentive to claim exaggeration o A large shadow economy can be attributed to high taxation and high public spending o Ideology can affect willingness to accept estimates that reveal large shadow economies o Governments with large shadow economies may be politically sensitive and object that estimates overstate the true size of their shadow economies 64

65 D. Inefficiency and illegality in a shadow economy 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 o Limited scope for personal success o No recourse to courts for enforcement of contracts and to settle disputes o The shadow economy invites corruption 65

66 Conspicuous consumption and visible spending Money laundering The Laffer curve and tax evasion 66

67 4.3 GOVERNMENT BORROWING 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. 67

68 Bond financing for public spending Period 1 Period 2 Period 3 T X =40 0 B X =80 0 D 1 = T Y =400 B Y =400 B X =800 =T Y +B Y D 2 =- 400 T Z =40 0 B Y =40 0=T Z D 3 =0 Total cost: C=1200=T X +T Y +T Z Zero interest rate 68

69 Default on government bonds o Generation Z could gain by reneging and refusing to transfer its share of the cost of the project to generation Y. o The public project would continue to provide benefits o The project was completed in period 1 and the only change if a government reneges on honoring bond redemption obligations is in intergenerational income distribution. Sale of government bonds to foreigners o Bonds can be sold to foreigners o The taxes to repay the bonds (and to pay interest on the bonds) continue to levied on the different generations of domestic taxpayers 69

70 B. Intergenerational 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 70

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 o Defense spending provides a public good for the immediately threatened generation o Future generations also benefit o It therefore seems reasonable that future generations should pay part of the cost of ending the threat, through future taxes of bond financing 71

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 72

73 D. Constitutional restraint on government borrowing We have identified reasons why bond financing can be socially undesirable o A government might favor contemporary taxpayers through bond financing o 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 73

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 74

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 75

76 Income (spending on all other goods) Z ICC 2 or income consumption curve (or line) showing changes in consumption as income increases at the post-tax relative price Y H 3 5 ICC 1 or income consumption curve (or line) showing changes in consumption as income increases at the pre-tax relative price D Pre tax relative price U 2 O B A Quantity of X Post tax relative price The excess burden of a tax with income effects 76