Toshihiro Ihori. Principles of Public. Finance. Springer

Toshihiro Ihori Principles of Public Finance Springer

Contents 1 Public Finance and a Review of Basic Concepts 1 1 The Main Functions of the Public Sector 1 1.1 Resource Allocation 1 1.2 Redistribution 2 1.3 Stabilization 3 1.4 Dynamic Optimization 4 1.5 The Failure of Government 5 2 A Review of Basic Analytical Concepts 5 2.1 Constrained Maximization 5 2.2 Pareto Optimality 6 2.3 A Dual Approach 7 3 The Public Sector in Japan 8 3.1 The Role of Central Government 8 3.2 Intergovernmental Finance 9 3.3 The Budgetary System 10 3.3.1 The Budgetary Formula in Japan 10 3.3.2 The Budgetary Process 12 3.3.3 The Execution of the Budget and the Settlement of the Account 13 3.4 The Content of the General Account in Japan 14 3.4.1 The Category of Budget 14 3.4.2 Government Expenditure 14 3.4.3 Tax Revenue 15 3.4.4 Public Debt 16 4 Organization of the Book 16 4.1 Part One 16 4.2 PartTwo 18 4.3 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

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 1 29 1 The Simple Keynesian Model 29 1.1 The 45 -degree Model 29 1.2 The Fiscal Multiplier 30 1.3 The Multiplier with Tax Rate 31 1.4 The Built-In Stabilizer 32 1.5 The Balanced-Budget Multiplier 33 2 The IS/LM Analysis 34 2.1 The Investment/Saving and Liquidity Preference/ Money Supply Equilibrium Model 34 2.2 The Size of the Multiplier in the IS/LM Model 35 2.3 Extreme Cases of the Zero Crowding-Out Effect 36 2.4 Direct Crowding Out 37 2.5 The Crowding-In Effect 38 3 The Open Economy 39 3.1 Extension to an Open Economy Model 39 3.2 The Fixed Exchange System 39 3.3 The Flexible Exchange Rate System: The Effect of Fiscal Policy 41 3.4 The Flexible Exchange Rate System: The Effect of Monetary Policy 42 3.5 Zero Capital Movement 42 4 The Efficacy of Fiscal Policy and the Policymaker 43 4.1 Three Viewpoints 43 4.2 The Lag of Policy 43 4.3 Lag of Monetary Policy 44 4.4 Lag of Fiscal Policy 44 4.5 Lag and Automatic Stabilizers 45 4.6 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

Contents ix 3 The Macroeconomic Theory of Fiscal Policy II 53 1 The Permanent Level of Fiscal Variables 53 1.1 Definition of the Permanent Level of an Economic Variable 53 1.2 The Government's Budget Constraint 54 2 Consumption and Saving Behavior 56 2.1 Optimization Over Time 56 2.2 The Permanent Income Hypothesis 57 3 The Labor Market and Supply Function 58 3.1 Labor Supply by Households 58 3.2 Labor Demand by Firms 60 3.3 Equilibrium in the Labor Market 61 4 Equilibrium in the Goods Market 62 5 The Effect of Fiscal Policy 63 5.1 Three Gases of Fiscal Expansion 63 5.2 Temporary Expansion 63 5.3 Permanent Expansion A 65 5.4 Permanent Expansion B 66 6 Evaluation of the Public Sector 66 6.1 Substitutability 66 6.2 The Multiplier Effect of Government Spending 67 6.3 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 77 1.1 A Two-Period Model 77 1.2 The Implications of Public Debt Issuance 79 1.3 Debt Issuance in an Infinite Horizon Economy 79 2 The Shift of the Bürden to Future Generations 80 2.1 A Two-Overlapping-Generations Model 80 2.2 The Efficacy of Keynesian Policy 81 2.3 The Shift of the Bürden 82 3 Barro's Neutrality 82 3.1 The Inclusion of Bequests 82 3.2 A Simple Model with Bequests 83 3.3 Barro's Neutrality Theorem 84

x Contents 4 Policy Implications of the Debt Neutrality Theorem 85 4.1 Policy Implications 85 4.2 Theoretical Assumptions 86 4.2.1 Perfect Capital Market 86 4.2.2 Lump-Sum Taxes 86 4.2.3 Anticipation of Future Tax Increases 87 4.2.4 Flanning Period and Bequest Motive 88 4.3 Empirical Evidence 89 5 The Non-Keynesian Effect 89 5.1 What Is the Non-Keynesian Effect? 89 5.2 The Non-Keynesian Effect in the Real World 90 5.3 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 100 5 Economic Growth and Fiscal Policy 101 1 A Simple Growth Model 101 1.1 Long-Run Growth Rate in the Harrod-Domar Model 101 1.2 The Effect of Fiscal Policy 102 1.3 The Incorporation of Public Investment 103 2 Optimal Public Investment 104 2.1 The Role of Public Spending 104 2.2 Public Investment in the Market Economy 104 2.3 Optimal Allocation Between Two Regions 106 2.4 Optimal Size of Public Investment 107 2.5 The Discount Rate of Public Investment 109 3 The Solow Model 110 3.1 Formulation of the Solow Model 110 3.2 Stability of the System 111 3.3 The Effect of Fiscal Policy 112

Contents xi 4 The Endogenous Growth Model 113 4.1 The Optimal Growth Model 113 4.2 The AK Model 114 4.3 Public Investment and Growth Rate 115 5 Inequality and Economic Growth 117 5.1 Income Redistribution and Tax Rate 117 5.2 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... 120 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 136 6 Fiscal Management 139 1 Understanding Fiscal Management 139 1.1 The Problem of Public Debt Issuance 139 1.2 Balanced-Budget Policy 140 1.3 The Efficacy of Keynesian Policy 141 1.4 The Tax-Smoothing Hypothesis 142 1.5 Compensation Policy 144 1.6 The Long-Run Argument for a Zero-Tax Nation 146 1.7 Overall Arguments on Fiscal Deficits 146

xii Contents 2 Fiscal Bankruptcy 147 2.1 The Possibility of Fiscal Bankruptcy 147 2.2 The Government Budget Constraint 148 2.3 Primary Balance 149 2.4 The Dynamics of Government Budget Constraint 150 2.5 Some Special Gases 150 2.5.1 g = t 151 2.5.2 r = n 151 2.5.3 g + rb t = 0 152 2.6 The Rate of Interest and Fiscal Crisis 153 3 Fiscal Consolidation 154 3.1 Desirable Fiscal Consolidation 154 3.2 The Optimal Target of Fiscal Consolidation 155 3.3 Politically Weak Government 155 3.4 The Legal Constraint of Fiscal Consolidation 156 3.5 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 167 7 The Public Pension 169 1 Justification of the Public Pension 169 1.1 The Public Pension System 169 1.2 Justification 169 1.2.1 Income Redistribution 170 1.2.2 The Failure of Private Pensions 171 1.2.3 Patemalism 171 1.2.4 The Efficiency of a Compulsory Public Pension 172

Contents xiii 2 Economic Effect of the Public Pension 172 2.1 The Funded System 172 2.2 The Pay-AS-You-GO System 173 3 Public Debt and the Public Pension 176 3.1 The Funded System and Public Debt Issuance Within the Same Generation 176 3.2 Pay-AS-You-GO System and Public Debt Issuance Among Generations 177 3.3 Generational Accounting 178 4 Public Pension Reform 179 4.1 The Aging Population in Japan 179 4.2 The DB System 180 4.3 The Move front DB to DC 180 4.4 A Fully Funded System 181 4.5 Intergenerational Conflicts 182 5 Privatization of the Pay-AS-You-GO System 182 5.1 A Simple Model 182 5.2 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

xiv Contents Part II Microeconomic Aspects of Public Finance 8 The Theory of Taxation 205 1 Taxation and Labor Supply 205 1.1 A Model of Labor Supply 205 1.2 Substitution Effect and Income Effect 207 1.3 The Cobb-Douglas Utility Function 207 2 The Efßciency of Taxation 208 2.1 A Comparison with Lump Sum Tax 208 2.2 The Size of the Excess Bürden 210 2.3 The Excess Bürden and the Substitution Effect 210 3 Interest Income Tax and Saving 211 3.1 The Life Cycle Saving Hypothesis 211 3.2 The Effect of Interest Income Tax: The Substitution Effect and the Income Effect 213 3.3 The Cobb-Douglas Utility Function 214 3.4 The Human Capital Effect 215 3.5 The Cobb-Douglas Utility Function Revisited 215 4 Investment and Tax 216 4.1 The Classical View 216 4.2 Corporate Tax and Borrowing Funds 217 4.3 Corporate Tax and Retained Ramings 218 4.4 The Cost of Capital 219 4.5 Depreciation 219 4.6 The Incidence of Corporate Income Tax in Japan 220 5 Consumption Tax 221 5.1 Shift of the Tax Bürden and Price Determination 221 5.2 The Consumer as the Legal Taxpayer 222 5.3 The Bürden of Tax and Incidence 222 Appendix: The Savings Elasticity Controversy 224 AI Boskin (1978) 224 A2 Summers (1981) 225 References 227 9 Tax Reform 229 1 Labor Income Tax and Interest Income Tax 229 1.1 Exogenous Labor Supply 229 1.2 Comprehensive Income Tax 231 1.3 Expenditure Tax 232 1.4 Endogenous Labor Supply 232 1.5 The Negative Incentive Effect and Optimal Taxation 233

Contents xv 2 The Theory of Optimal Taxation 234 2.1 Theoretical Framework 234 2.2 The Ramsey Rule 234 2.2.1 The Inverse Elasticity Proposition 235 2.2.2 The Uniform Tax Rate Proposition 236 2.3 Mathematical Formulation 236 2.4 Heterogeneous Households 239 3 The Theory of Tax Reform 240 3.1 Optimal Taxation and the Theory of Tax Reform 240 3.2 The Fundamental Rule of Tax Reform 240 3.3 Application to Some Examples 242 3.3.1 Enlarging the Tax Base 242 3.3.2 Unifying Tax Rates 242 4 General Consumption Tax and Labor Income Tax 242 4.1 The Equivalence Theorem 242 4.2 A One-Period Model 243 4.3 Some Remarks 244 5 The Timing Effect of Taxation 245 5.1 The Overlapping-Generations Model 245 5.2 The Incidence of Tax Reform 246 5.3 Transitional Generations 246 5.4 The Effect on Saving and Economic Growth 247 6 Simulation Analysis of Tax Reform 247 6.1 Multi-Period Overlapping-Generations Growth Model 247 6.2 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

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 265 10 Income Redistribution 267 1 Progressive Income Tax 267 1.1 Income Redistribution Policy 267 1.2 A Two-Person Model with Income Inequality 267 1.3 The Social Weifare Function 268 1.4 The Socially Optimal Point 269 1.5 The Optimal Income Tax Schedule 270 1.6 Perfect Equality When Income Is Uncertain 270 2 Endogenous Labor Supply 271 2.1 The Detrimental Outcome of Perfect Equality 271 2.2 Endogenous Labor Supply 272 2.3 A Linear Income Tax Schedule 273 2.4 The Tax Possibility Curve 274 3 The Optimal Income Tax 275 3.1 The Rawls Judgment 275 3.2 The Bentham Criterion 276 3.3 Optimal Redistribution 277 4 Nonlinear Income Tax 278 4.1 The First Best 278 4.2 Self-Selection Constraint 279 4.3 The Optimal Marginal Tax Rate 279 4.4 A Differentiated Linear Tax Schedule 281 4.5 The Recent Approach to the Optimal Marginal Tax Rate 282 5 Economic Constraint and Redistribution 282 5.1 Credibility 283 5.2 The Crowding-Out Effect 283 5.3 Expectation 283 5.4 Asymmetrie Information 284 5.5 Stigma 284 5.6 Commitment 284

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 293 11 The Theory of Public Goods 295 1 Public Goods 295 1.1 Public Goods and Private Goods 295 1.2 Formulation of Public Goods 296 1.3 Public Goods and Actual Government Spending 297 2 Optimal Provision of Public Goods: The Samuelson Rule 298 2.1 The Samuelson Rule: Diagramed Derivation 298 2.2 The Samuelson Rule: Mathematical Derivation 299 2.3 The Samuelson Rule: Simple Derivation 300 2.4 Numerical Example: A Two-Person Model of Public Goods 301 3 The Theory of Public Good Provision: The Nash Equilibrium Approach 302 3.1 The Nash Equilibrium Approach of Private Provision 302 3.2 A Two-Person Model 303 3.3 Efficiency of the Nash Equilibrium 305 3.4 Examples: Comparison 306 3.5 Criticism of the Nash Equilibrium Approach 307 4 The Theoretical Analysis of Public Goods: The Lindahl Equilibrium 308 4.1 The Lindahl Equilibrium 308 4.2 Efficiency of the Lindahl Equilibrium 309 5 The Free Rider Problem 310 5.1 Public Goods and the Free Rider Problem 310 5.2 Possibility of the Free Ride Problem 311 5.3 Game Theory Approach to the Free Rider Problem 312 5.4 The Clarke Tax 314 5.5 The Clarke Tax and a Balanced Budget 315 6 The Neutrality Theorem of Public Goods 316 6.1 The Neutrality Theorem 316 6.2 The Model of Neutrality Result 316

xvjü Contents 6.3 Perfect Crowding Out 318 6.4 Plausibility of the Neutrality Theorem 318 6.5 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 327 12 Public Spending and the Political Processi 329 1 The Failure of Government 329 1.1 Government Intervention 329 1.2 The Theory of Public Choice 329 1.3 Small Government 330 2 The Voting Model 331 2.1 Inequality and the Demand for Public Goods 331 2.2 Analytical Framework 331 2.3 The Median Voter Theorem 333 3 The Voting Model and Reality 334 3.1 The Paradox of Voting 334 3.2 Problems with the Median Voter Hypothesis 335 3.3 Interest Groups 336 4 Political Parties and Fiscal Policy 337 4.1 The Objective of Parties 337 4.2 The Convergence Theorem 338 4.3 Further Analysis of the Convergence Theorem 339 4.4 Extensions and Voting 340 4.5 The Political Business Cycle 340 4.6 The Partisan Business Cycle 341 5 Theoretical Model of the Partisan Business Cycle 342 5.1 The Macroeconomic Model 342 5.2 The Behavior of Two Parties 343 5.3 The Effect of the Election 344 5.4 The Probability of Winning the Election 346 6 Further Comments 346 6.1 Change of Government 346 6.2 The Evaluation of Public Spending 348 Appendix A: Fiscal Privileges, Consolidation Attempts, and Pigouvian Taxes 349 AI Introduction 349 A2 The Basic Model 350

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 361 13 Local Public Finance 363 1 Intergovernmental Finance 363 1.1 Decentralization and Local Finance 363 1.2 The Decision System of Intergovernmental Finance 363 1.3 The Centralized System 364 1.4 The Decentralized System 365 1.5 Intergovernmental Finance 367 2 The Supply of Local Public Goods 367 2.1 Local Public Goods 367 2.2 The Optimal Provision of Local Public Goods 367 2.3 Voting with Their Feet: The Tiebout Hypothesis 369 2.4 Plausibility of the Tiebout Hypothesis 370 3 Tax Competition 371 3.1 The Competition for a Mobile Tax Base 371 3.2 Taxing Mobile Capital 373 4 The Time Consistency of a Tax Policy 375 4.1 The Time Consistency Problem 375 4.2 A Simple Model 375 5 The Principle of Local Tax 377 5.1 The Overlapping Tax Base 377 5.2 The Soft Budget Problem 377 5.3 The Benefit-to-Pay Principle 378 5.4 The Fixed Asset Tax 379 5.5 The Inhabitant Tax 379 5.6 The Consumption Tax 380 5.7 Basic Principles of a Local Tax System 380

xx Contents 6 Redistribution among Local Governments 381 6.1 Regional Diversity of Local Tax 381 6.2 The Three-Person Model of Regional Redistribution 381 6.3 Efficiency 383 7 Further Issues on Intergovernmental Finance 383 7.1 Local Public Debt 383 7.2 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