Toshihiro Ihori. Principles of Public. Finance. Springer

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1 Toshihiro Ihori Principles of Public Finance Springer

2 Contents 1 Public Finance and a Review of Basic Concepts 1 1 The Main Functions of the Public Sector Resource Allocation Redistribution Stabilization Dynamic Optimization The Failure of Government 5 2 A Review of Basic Analytical Concepts Constrained Maximization Pareto Optimality A Dual Approach 7 3 The Public Sector in Japan The Role of Central Government Intergovernmental Finance The Budgetary System The Budgetary Formula in Japan The Budgetary Process The Execution of the Budget and the Settlement of the Account The Content of the General Account in Japan The Category of Budget Government Expenditure Tax Revenue Public Debt 16 4 Organization of the Book Part One PartTwo Appendix 18 Appendix: Japan's Fiscal Management 19 AI The 1950s 21 A2 The 1960s 21 A3 The 1970s 22 A4 The 1980s 22 vii

3 viü Contents A5 The 1990s 22 A6 The 2000s 23 A7 The 2010s 24 References 25 Part I Macroeconomic Aspects of Public Finance 2 The Macroeconomic Theory of Fiscal Policy The Simple Keynesian Model The 45 -degree Model The Fiscal Multiplier The Multiplier with Tax Rate The Built-In Stabilizer The Balanced-Budget Multiplier 33 2 The IS/LM Analysis The Investment/Saving and Liquidity Preference/ Money Supply Equilibrium Model The Size of the Multiplier in the IS/LM Model Extreme Cases of the Zero Crowding-Out Effect Direct Crowding Out The Crowding-In Effect 38 3 The Open Economy Extension to an Open Economy Model The Fixed Exchange System The Flexible Exchange Rate System: The Effect of Fiscal Policy The Flexible Exchange Rate System: The Effect of Monetary Policy Zero Capital Movement 42 4 The Efficacy of Fiscal Policy and the Policymaker Three Viewpoints The Lag of Policy Lag of Monetary Policy Lag of Fiscal Policy Lag and Automatic Stabilizers Rules Versus Discretion 46 Appendix: Public Investment in Japan 47 AI Introduction 47 A2 The Efficacy of Public Investment as a Counter-Cyclical Measure 48 A3 Fiscal Policy and the Optimal Size of Public Investment 49 References 50

4 Contents ix 3 The Macroeconomic Theory of Fiscal Policy II 53 1 The Permanent Level of Fiscal Variables Definition of the Permanent Level of an Economic Variable The Government's Budget Constraint 54 2 Consumption and Saving Behavior Optimization Over Time The Permanent Income Hypothesis 57 3 The Labor Market and Supply Function Labor Supply by Households Labor Demand by Firms Equilibrium in the Labor Market 61 4 Equilibrium in the Goods Market 62 5 The Effect of Fiscal Policy Three Gases of Fiscal Expansion Temporary Expansion Permanent Expansion A Permanent Expansion B 66 6 Evaluation of the Public Sector Substitutability The Multiplier Effect of Government Spending Evaluation of Government Spending 68 Appendix: The Size of Government Spending and the Private Sector's Evaluation 68 AI Introduction 68 A2 Theoretical Considerations 69 A2.1 Evaluation of Government Spending 69 A2.2 Optimal Size of Government Spending 71 A2.3 Optimizing Behavior 71 A2.4 Indirect Test 72 A3 Empirical Results 74 A4 Conclusion 74 References 75 4 Public Debt 77 1 Ricard's Neutrality Theorem A Two-Period Model The Implications of Public Debt Issuance Debt Issuance in an Infinite Horizon Economy 79 2 The Shift of the Bürden to Future Generations A Two-Overlapping-Generations Model The Efficacy of Keynesian Policy The Shift of the Bürden 82 3 Barro's Neutrality The Inclusion of Bequests A Simple Model with Bequests Barro's Neutrality Theorem 84

5 x Contents 4 Policy Implications of the Debt Neutrality Theorem Policy Implications Theoretical Assumptions Perfect Capital Market Lump-Sum Taxes Anticipation of Future Tax Increases Flanning Period and Bequest Motive Empirical Evidence 89 5 The Non-Keynesian Effect What Is the Non-Keynesian Effect? The Non-Keynesian Effect in the Real World Simple Theory of the Non-Keynesian Effect 90 Appendix: Government Debt in an Overlapping-Generations Model 91 AI Introduction 91 AI The Basic Model of Overlapping Generations 92 A2.1 The Consumer Within the Model of Overlapping Generations 92 A2.2 Production Technology and Capital Accumulation 94 A3 Government Debt and Intergenerational Transfer 95 A3.1 The Transfer Program 95 A3.2 Some Remarks 96 A3.3 The Bürden of Debt 97 A4 Debt Neutrality with Altruistic Bequests 98 References Economic Growth and Fiscal Policy A Simple Growth Model Long-Run Growth Rate in the Harrod-Domar Model The Effect of Fiscal Policy The Incorporation of Public Investment Optimal Public Investment The Role of Public Spending Public Investment in the Market Economy Optimal Allocation Between Two Regions Optimal Size of Public Investment The Discount Rate of Public Investment The Solow Model Formulation of the Solow Model Stability of the System The Effect of Fiscal Policy 112

6 Contents xi 4 The Endogenous Growth Model The Optimal Growth Model The AK Model Public Investment and Growth Rate Inequality and Economic Growth Income Redistribution and Tax Rate Extemality of Educational Investment 118 Appendix A: Taxes on Capital Accumulation and Economic Growth 118 AI Introduction 118 A2 The Endogenous Growth Model 119 A2.1 Technology 119 A2.2 The Three-Period Overlapping-Generations Model A2.3 The Altruistic Bequest Motive 122 A3 Economic Growth and Efficiency 122 A3.1 The First Best Solution 122 A3.2 Optimizing Behavior in the Market Economy 123 A3.3 The Circumstance in Which Physical Bequests Are Zero 123 A3.4 The Circumstance in Which Physical Bequests Are Operative 125 A4 Taxes and Economic Growth 126 A4.1 The Constrained Economy 126 A4.2 The Unconstrained Circumstance 127 A5 Conclusion 127 Appendix B: The Supply-Side Effect of Public Investment in Japan 128 B1 Earlier Studies 128 B2 Recent Studies 128 B3 Public Investment Management 130 B3.1 Constraints in Japan 130 B3.2 Public Investment Management Reform 131 B3.3 Strengthening Wide-Ranging Coordination 132 B3.4 Cost-Benefit Analysis 133 B4 Public Investment Management Reform 135 References Fiscal Management Understanding Fiscal Management The Problem of Public Debt Issuance Balanced-Budget Policy The Efficacy of Keynesian Policy The Tax-Smoothing Hypothesis Compensation Policy The Long-Run Argument for a Zero-Tax Nation Overall Arguments on Fiscal Deficits 146

7 xii Contents 2 Fiscal Bankruptcy The Possibility of Fiscal Bankruptcy The Government Budget Constraint Primary Balance The Dynamics of Government Budget Constraint Some Special Gases g = t r = n g + rb t = The Rate of Interest and Fiscal Crisis Fiscal Consolidation Desirable Fiscal Consolidation The Optimal Target of Fiscal Consolidation Politically Weak Government The Legal Constraint of Fiscal Consolidation The EU and the Euro 156 Appendix: Fiscal Deßcits in a Growing Economy 158 AI Introduction 158 A2 A Simple Growth Model 158 A2.1 Analytical Framework 158 A2.2 The Government's Objective 160 A3 Optimal Deßcits 161 A3.1 Phase Diagram 161 A3.2 Optimal Deficit Düring Transition 162 A3.3 Macro IS Balance 163 A3.4 Comparative Dynamics 163 A3.5 Optimal Deficit in the Long Run 163 A3.6 Numerical Example 164 A4 Conclusion 165 A4.1 Deßcits and Growth 165 A4.2 Deficit Ceilings and Fiscal Privilege 166 A4.3 Hard Budget and Soft Budget Outcomes 166 References The Public Pension Justification of the Public Pension The Public Pension System Justification Income Redistribution The Failure of Private Pensions Patemalism The Efficiency of a Compulsory Public Pension 172

8 Contents xiii 2 Economic Effect of the Public Pension The Funded System The Pay-AS-You-GO System Public Debt and the Public Pension The Funded System and Public Debt Issuance Within the Same Generation Pay-AS-You-GO System and Public Debt Issuance Among Generations Generational Accounting Public Pension Reform The Aging Population in Japan The DB System The Move front DB to DC A Fully Funded System Intergenerational Conflicts Privatization of the Pay-AS-You-GO System A Simple Model The Gain in Economic Weifare Through Privatization 183 Appendix A: Intergenerational Conflict in an Aging Japan 185 AI Introduction 185 A2 Medical Insurance 185 A2.1 Japan's Health Gare System 185 A2.2 The Retired and Elderly 186 A2.3 Issues of Medical Insurance 187 A3 The Pension System 188 A3.1 Japan's Public Pension System 188 A3.2 Pension Reform in an Aging Japan 189 A3.3 Outline of the 2004 Pension Plan Revision 190 A3.4 Is the 2004 Reform Effective? 191 Appendix B: Simulation Analysis in an Aging Japan 191 B1 Introduction 191 B2 The Model 192 B3 Simulation Analysis in Ihori et al. (2005) 193 B3.1 Demography 193 B3.2 Government Deficits 193 B3.3 The Social Security System 194 B3.4 Taxes 194 B3.5 Technological Progress 196 B3.6 Simulation Results 196 B4 Simulation Analysis in Ihori et al. (2011) 198 B4.1 Assumptions 198 B4.2 Simulation Results 198 B5 Conclusion 200 References 201

9 xiv Contents Part II Microeconomic Aspects of Public Finance 8 The Theory of Taxation Taxation and Labor Supply A Model of Labor Supply Substitution Effect and Income Effect The Cobb-Douglas Utility Function The Efßciency of Taxation A Comparison with Lump Sum Tax The Size of the Excess Bürden The Excess Bürden and the Substitution Effect Interest Income Tax and Saving The Life Cycle Saving Hypothesis The Effect of Interest Income Tax: The Substitution Effect and the Income Effect The Cobb-Douglas Utility Function The Human Capital Effect The Cobb-Douglas Utility Function Revisited Investment and Tax The Classical View Corporate Tax and Borrowing Funds Corporate Tax and Retained Ramings The Cost of Capital Depreciation The Incidence of Corporate Income Tax in Japan Consumption Tax Shift of the Tax Bürden and Price Determination The Consumer as the Legal Taxpayer The Bürden of Tax and Incidence 222 Appendix: The Savings Elasticity Controversy 224 AI Boskin (1978) 224 A2 Summers (1981) 225 References Tax Reform Labor Income Tax and Interest Income Tax Exogenous Labor Supply Comprehensive Income Tax Expenditure Tax Endogenous Labor Supply The Negative Incentive Effect and Optimal Taxation 233

10 Contents xv 2 The Theory of Optimal Taxation Theoretical Framework The Ramsey Rule The Inverse Elasticity Proposition The Uniform Tax Rate Proposition Mathematical Formulation Heterogeneous Households The Theory of Tax Reform Optimal Taxation and the Theory of Tax Reform The Fundamental Rule of Tax Reform Application to Some Examples Enlarging the Tax Base Unifying Tax Rates General Consumption Tax and Labor Income Tax The Equivalence Theorem A One-Period Model Some Remarks The Timing Effect of Taxation The Overlapping-Generations Model The Incidence of Tax Reform Transitional Generations The Effect on Saving and Economic Growth Simulation Analysis of Tax Reform Multi-Period Overlapping-Generations Growth Model Comments by Evans (1983) 248 Appendix A: Optimal Taxation in an Overlapping-Generations Economy 250 AI The Optimal Tax Rule 250 Al.l Overlapping-Generations Growth Model 250 AI.2 Dual Approach 252 A2 The First Best Solution 253 A3 Second Best Solution 254 A4 Optimal Taxation in the Second Best Gase 256 A4.1 The Modified Ramsey Rule 256 A4.2 The Elasticity Term 256 A4.3 The Implied Separability Condition 257 A4.4 Two Objectives and Intertemporal Efficiency 257 A4.5 The Lagrange Multiplier 257 A5 Heterogeneous Individuais and Distributional Objectives 258

11 xvj Contents Appendix B: Tax Reform Within Lump Sum Taxes 258 B1 Introduction 258 B2 Analytical Framework 259 B3 Lump Sum Tax Reform 260 B3.1 The Tax Postponement Effect 260 B3.2 The Effect on Savings 261 B3.3 The Weifare Effect of Tax Reform 262 B4 The Tax Timing Effect 262 B4.1 The Weifare Implication of the Tax Timing Effect 262 B4.2 Summary 263 B5 Some Remarks 264 References Income Redistribution Progressive Income Tax Income Redistribution Policy A Two-Person Model with Income Inequality The Social Weifare Function The Socially Optimal Point The Optimal Income Tax Schedule Perfect Equality When Income Is Uncertain Endogenous Labor Supply The Detrimental Outcome of Perfect Equality Endogenous Labor Supply A Linear Income Tax Schedule The Tax Possibility Curve The Optimal Income Tax The Rawls Judgment The Bentham Criterion Optimal Redistribution Nonlinear Income Tax The First Best Self-Selection Constraint The Optimal Marginal Tax Rate A Differentiated Linear Tax Schedule The Recent Approach to the Optimal Marginal Tax Rate Economic Constraint and Redistribution Credibility The Crowding-Out Effect Expectation Asymmetrie Information Stigma Commitment 284

12 Contents xvii Appendix: Optimal Linear Income Tax 284 AI Introduction 284 A2 The Model 285 A3 Shift of the Social Weifare Function 288 A4 Shift of the Tax Possibility Frontier 289 A4.1 The Maximin Gase 290 A4.2 The Utilitarian Gase 291 A5 Conclusion 292 References The Theory of Public Goods Public Goods Public Goods and Private Goods Formulation of Public Goods Public Goods and Actual Government Spending Optimal Provision of Public Goods: The Samuelson Rule The Samuelson Rule: Diagramed Derivation The Samuelson Rule: Mathematical Derivation The Samuelson Rule: Simple Derivation Numerical Example: A Two-Person Model of Public Goods The Theory of Public Good Provision: The Nash Equilibrium Approach The Nash Equilibrium Approach of Private Provision A Two-Person Model Efficiency of the Nash Equilibrium Examples: Comparison Criticism of the Nash Equilibrium Approach The Theoretical Analysis of Public Goods: The Lindahl Equilibrium The Lindahl Equilibrium Efficiency of the Lindahl Equilibrium The Free Rider Problem Public Goods and the Free Rider Problem Possibility of the Free Ride Problem Game Theory Approach to the Free Rider Problem The Clarke Tax The Clarke Tax and a Balanced Budget The Neutrality Theorem of Public Goods The Neutrality Theorem The Model of Neutrality Result 316

13 xvjü Contents 6.3 Perfect Crowding Out Plausibility of the Neutrality Theorem Concluding Remarks 319 Appendix: Public Bads, Growth, and Weifare 320 AI Introduction 320 A2 Analytical Framework 320 A3 Wealth Differentials 322 A3.1 The Neutrality Result 322 A3.2 Analytical Result 323 A4 Immiserizing Growth 325 A5 Conclusion 326 References Public Spending and the Political Processi The Failure of Government Government Intervention The Theory of Public Choice Small Government The Voting Model Inequality and the Demand for Public Goods Analytical Framework The Median Voter Theorem The Voting Model and Reality The Paradox of Voting Problems with the Median Voter Hypothesis Interest Groups Political Parties and Fiscal Policy The Objective of Parties The Convergence Theorem Further Analysis of the Convergence Theorem Extensions and Voting The Political Business Cycle The Partisan Business Cycle Theoretical Model of the Partisan Business Cycle The Macroeconomic Model The Behavior of Two Parties The Effect of the Election The Probability of Winning the Election Further Comments Change of Government The Evaluation of Public Spending 348 Appendix A: Fiscal Privileges, Consolidation Attempts, and Pigouvian Taxes 349 AI Introduction 349 A2 The Basic Model 350

14 Contents xix A3 The Model Without Consolidation Attempts 351 A3.1 The Competitive Solution 351 A3.2 Pigouvian Tax 352 A4 The Model with Consolidation Attempts 354 A4.1 The Competitive Solution 354 A4.2 Pigouvian Tax 355 A4.3 The Consumption Tax 356 A5 Conclusion 357 Appendix B: Political Factors and Public Investment Policy in Japan 358 B1 Political Pressures front Local Internst Croups 358 B2 Intergovernmental Transfers in Japan 359 B3 The Impact of Interregional Transfers 359 B4 Efficient and Effective Public Investment Management 360 References Local Public Finance Intergovernmental Finance Decentralization and Local Finance The Decision System of Intergovernmental Finance The Centralized System The Decentralized System Intergovernmental Finance The Supply of Local Public Goods Local Public Goods The Optimal Provision of Local Public Goods Voting with Their Feet: The Tiebout Hypothesis Plausibility of the Tiebout Hypothesis Tax Competition The Competition for a Mobile Tax Base Taxing Mobile Capital The Time Consistency of a Tax Policy The Time Consistency Problem A Simple Model The Principle of Local Tax The Overlapping Tax Base The Soft Budget Problem The Benefit-to-Pay Principle The Fixed Asset Tax The Inhabitant Tax The Consumption Tax Basic Principles of a Local Tax System 380

15 xx Contents 6 Redistribution among Local Governments Regional Diversity of Local Tax The Three-Person Model of Regional Redistribution Efficiency Further Issues on Intergovernmental Finance Local Public Debt A Decentralized Fiscal System 384 Appendix: An Analytical Model of Central and Local Governments in Japan 384 AI The Local Allocation Tax in Japan 384 A2 An Analytical Model of Central and Local Governments 386 A2.1 The Soft Budget Constraint 386 A2.2 An Analytical Framework 387 A2.3 The Pareto Efficient Solution 389 A3 The Hard Budget Game 390 A3.1 The Second Stage 391 A3.2 The First Stage 391 A3.3 Outcome 392 A4 The Soft-Budget Game 393 A4.1 CG's Ex Post Transfer: The Second Stage 393 A4.2 LG's Behavior: The First Stage 395 A5 Weifare Implications 397 References 398 Index 399

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