INTERMEDIATE PUBLIC ECONOMICS second edition Jean Hindriks and Gareth D. Myles The MIT Press Cambridge, Massachusetts London, England
Preface to Second Edition Preface to First Edition List of Figures xxi xxiii xxv I PUBLIC ECONOMICS AND ECONOMIC EFFICIENCY 1 1.1 1.2 1.3 1.4 1.5 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 3 3.1 3.2 An to Public Economics Public Economics Methods Analyzing Policy Preview Scope Equilibrium and Efficiency Economic' Models Competitive Economies The Exchange Economy Production and Exchange Efficiency of Competition 2.6.1 Single Consumer 2.6.2 Pareto-Efficiency 2.6.3 Efficiency in an Exchange Economy 2.6:4 Extension to Production Lump-Sum Taxation Discussion of Assumptions Summary Behavioral Economics Behavioral Individuals 3.2.1 Simple Example: How Much to Save? 3.2.2 Present-Bias " 3.2.3 The (0, S) Model of Self-Control 3.2.4 Reference-Dependence Bias 3.2.5 The Gambler's Fallacy 3 3 3 5 6 9 13 13 13 14 15 22 26 27 31 33-. 37 39 41 43 51 51 53 53 54 55 57 58
viii II GOVERNMENT 3.2.6 3.2.7 3.2.8 3.2.9 3.2.10 Confirmation Bias Confidence Bias Framing Bias Conformism Bias Identity and Social Norms 3.3 Behavioral Markets 64 3.3.1 Money Pump 65 3.3.2 Complementary Mistakes 65 3.3.3 Rationality Tug'of-War 67 3.4 Behavioral Policy 67 3.4.1 Internalities versus Externalities 68 3.4.2 Automatic Enrollment 69 3.4.3 The SMarT Plan 69 3.4.4 Complementarity 70 3.5 Behavioral Welfare 71 3.5.1 New Welfare Criterion 71 3.5.2 Choice-Based Welfare Analysis 72 3.5.3 Refinement and Structural Modeling 73 3.5.4 Application: Global Warming \ 74 3.6 Other-Regarding Preferences 76 3.6.1 Ultimatum Game 76 3.6.2 Social Preferences 77 3.6.3 Market Impact 78 3.7 ' 80 4 Public Sector Statistics 89 4.1 89 4.2 Historical Development 89 4.3 Composition of Expenditure 94 4.4 Revenue 97 4.5 Government Debt ' 107 4.6 Measuring the Government 112 4.7 114 59 60 60 62 63
5 5.1 5.2 5.3 5.4 5.5 Theories of the Public Sector Justification for the Public Sector 5.2.1 5.2.2 The Minimal State Market versus Government 5.2.3 Equity» 5.2.4 Efficiency and Equity Public Sector Growth 5.3.1 5.3.2 5.3.3 5,3.4 5.3.5 DevelopmenfModels Wagner's Law Baumol's Law A Political Model Ratchet Effect Excessive Government 5.4.1 5.4.2 5.4.3 5.4.4 ; 5.4.5 5.4.6 Bureaucracy Budget-Setting Monopoly Power ' Corruption Government Agency Cost Diffusion 119 119 119 119 121 122 123 123 123 124 125 126 128 129 130 132 133 134 135 137 138 III DEPARTURES FROM EFFICIENCY 6 Public Goods 147 6.1 147 6.2 Definitions 148 6.3' Private Provision 150 6.4. Efficient Provision 154 6.5 Voting 156 6.6 Personalized Prices.159 6.7 Mechanism Design 163 6.7.1 Examples of Preference Revelation 163 6.7.2 Clarke-Groves Mechanism 166 6.7.3 Clarke Tax 168 6.7.4 Further Comments 169
6.8 More on Private Provision 170 6.8.1 Neutrality and Population Size 170 6.8.2 Experimental Evidence 174 6.8.3 Modifications 176 6.9 Fund-Raising Campaigns ' 178 6.9.1 The Contribution Campaign 179 6.9.2 The Subscription Campaign 181 6.10 '"'"" 182 7 7.1 7.2 7.3 7.4 7.5 7.6 7.7 7.8 8 8.1 8.2 8,3 8.4 8.5 8.6 Club Goods and Local Public Goods Definitions Single-Product Clubs 7.3.1 Fixed Utilization 7.3.2 Variable Utilization 7.3.3 Two-Part Tariff Clubs and the Economy 7.4.1 Small Clubs 7.4.2 Large Clubs 7.4.3 Conclusion Local Public Goods The Tiebout Hypothesis Empirical Tests Externalities, ' Externalities Defined Market Inefficiency Externality Examples 8.4.1 River Pollution 8.4.2 Traffic Jams 8.4.3 Pecuniary Externality 8.4.4 The Rat Race Problem 8.4.5 The Tragedy of the Commons 8.4.6 Bandwagon Effect Pigouvian Taxation Licenses 191 191 192 193 194 196 197 199 200 200 207 208 212 214,' 216 ' 223 223 224 228 228 229 230 232 233 235 236 239
xi 8.7 8.8 8.9 8.10 9 9.1 9.2 9.3 9.4 9.5 9.6 9.7 9.8 9.9 9.10 9.11 Internalization The Coase Theorem Nonconvexity Imperfect Competition Concepts of Competition Market Structure 9.3.1 Defining the Market 9.3.2 Measuring Competition Welfare 9.4.1 Inefficiency 9.4.2 Incomplete Information 9.4.3 Measures of Welfare Loss Tax Incidence Specific and Ad valorem Taxation Regulation of Monopoly Regulation of Oligopoly 9.8.1 Detecting Collusion 9.8.2 Merger Policy Unions and Taxation Monopsony 241 242 247 248 255 255 256 257 257 258 260 260 263 264 268 274 277. 282 \ 282. 283 285 286 288 10 Asymmetric Information 297 10.1 297 10.2 Hidden Knowledge and Hidden Action 300 10.3 Actions or Knowledge? 301 10.4 Market Unraveling 302-10.4.1 Hazard Insurance 302 10.4.2 Government Intervention 305 10.5 Screening 307 10.5.1 Perfect Information Equilibrium 308 10.5.2 Imperfect Information Equilibrium 310 10.5.3 Government Intervention 313 10.6 Signaling 314 10.6.1 Educational Signaling 316 10.6.2 Implications 321
xii 10.7 Moral Hazard (Hidden Action) 323 10.7.1 Moral Hazard in Insurance 323 10.7.2 Effort Observable 325 10.7.3 Effort Unobservable 326 10.7.4 Second-Best Cdhtract 327 10.7.5 Government Intervention 329 10.8 Public Provision of Health Care 330 10.8.1 Efficiency 330 10.8.2 Redistributive Politics 332 10.9 Evidence 334 10.10 336 IV POLITICAL ECONOMY 11 11.1 11.2 11.3 11.4 Voting Stability Impossibility Majority Rule 345 345 345 347 350 11.4.1 11.4.2 11.4.3 11.4.4 11.4.5 May's Theorem Condorcet Winner Median Voter Theorems Multidimensional Voting Agenda Manipulation 350 351 351 356 358 11.5 Alternatives to Majority Rule 361 \ 11.5.1 11.5.2 11.5.3 11.5.4 Borda Voting Plurality Voting Approval Voting Runoff Voting 361 363 363 364 11.6 11.7 11.8 The Paradox of Voting The "Alabama" Paradox Political Competition 365 371 372 11.8.1 11.8.2 11.8.3 11.8.4 11.8.5 Downsian Model Policy Divergence Multidimensional Competition "Swing Voter" Politics Citizen-Candidate Model 372 373 376 377 379 11.9 381
xiii 12 12.1 12.2 12.3 12.4 12.5 12.6 12.7 12.8 12.9 Rent-Seeking Definitions Rent-Seeking Games 12.3.1 Deterministic Game 12.3.2 Probabilistic Game 12.3.3 Free-Entry 12.3.4 Risk Aversion 12.3.5 Social Cost of Monopoly Equilibrium Effects - Government Policy 12.6.1 Lobbying 12.6.2 Rent Creation 12.6.3 Informative Lobbying Controlling Rent-Seeking 387 387 388 390 391 394 396 397 398 398 401 404 404 406 408 408 413 414 V EQUITY AND DISTRIBUTION 13 Optimality and Comparability 423 13.1 423 13.2 Social Optimality *",' 424 13.3 Lump-Sum Taxes 427 13.4 Impossibility of Lump-Sum Taxes 430 13.5 Redistribution In-Kind 434 13.6 Aspects of Pareto-Efficiency 436 1317 Social Welfare Functions 440 13.8 Arrow's Theorem 441 13.9 Interpersonal Comparability 443 13.10 Comparability and Social Welfare 446 13.11 450 14 Inequality and Poverty 457 14.1 457 14.2 Measuring Income 458 14.3 Equivalence Scales 460
14.4 14.5 14.6 14.7 14.8 Inequality Measurement 14.4.1 The Setting 14.4.2 Statistical Measures 14.4.3 Inequality and Welfare 14.4.4 An Application Poverty 14.5.1 Poverty and the Poverty Line 14.5.2 Poverty^ Measures 14.5.3 Two Applications Unequal Opportunities 14.6.1 Defining Equality of Opportunity 14.6.2 Measuring Equality of Opportunity 14.6.3 Equal-Opportunity Policy Intergenerational Inequality 14.7.1 Measuring Issues 14.7.2 Causal Mechanisms 466 '467 467 475 480 481 482 483 488 489 490 491 491 492 492 493 496 VI TAXATION 15 15.1 15.2 15.3 15.4 15.5 1 15.6 1 15.7 15.8 15.9 15.10 Commodity Taxation Deadweight Loss Optimal Taxation Production Efficiency Tax Rules, 15.5.1 Inverse Elasticity Rule 15.5.2 Ramsey Rule Equity Considerations Applications. 15.7.1 Reform 15.7.2 Optimality Efficient Taxation Public Sector Pricing 505 505 506.: 509 513 515 516 517 521 523' 524 526 528 530 531 16 Income Taxation 537 16.1 537 16.2 Equity and Efficiency 538
XV 16.3 16.4 16.5 16.6 16.7 16.8 16.9 17 17.1 17.2 17.3 17.4 17.5 17.6 17.7 17.8 17.9 17.10 18 18.1 18.2 18.3 18.4 18.5 18.6 Taxation and Labor Supply Empirical Evidence Optimal Income Taxation Two Specializations 16.6.1 Quasi-Linearity 16.6.2 Rawlsian Taxation Numerical Results Voting over a Flat Tax VII MULTIPLE JURISDICTIONS Tax Evasion The Extent of Evasion The Evasion Decision Auditing and Punishment Evidence on Evasion Effect of Honesty Tax Compliance Game Behavioral Models Compliance and Social Interaction 539 544 547 555 555 559 561 563 565 573 573 574 576 583 586 588 590 593 599 600 Limits to Redistribution 607 607 Revelation Principle 609 The Tax Principle 614 Tax Mix: Separation Principle 620 Capital Income Tax 624 Non-Tax Redistribution 626 628 19 Fiscal Federalism 635 19.1 635 19.2 Arguments for Multi-level Government 636 19.2.1 Costs of Uniformity 637 19.2.2 Tiebout Hypothesis 639 19.2.3 Distributive Arguments 640
xvi 19.3 Optimal Structure: Efficiency versus Stability 640 19.4 Accountability 643 19.5 Risk-Sharing 646 19.5.1 Voluntary Risk-Sharing 646 19.5.2 Insurance versus Redistribution 649 19.6 Hard and Soft Budgets f 650 19.7 Evidence on Decentralization 653 19.7.1 Decentralization around the World 653 19.7.2 Decentralization by Functions 655 19.8 19.7.3 Determinants of Decentralization 656 657 20 20.1 20.2 20.3 20.4 20.5 20.6 \ \ 21 21.1 Fiscal Competition Tax Competition 20.2.1 Competitive Behavior 20.2.2 Strategic Behavior 20.2.3 Size Matters 20.2.4 Public Input Provision 20.2.5 Tax Overlap 20.2.6 Tax Exporting 20.2.7 Efficient Tax Competition Income Distribution 20.3.1 Perfect Mobility 20.3.2 Imperfect Mobility 20.3.3 Race to the Bottom Intergovernmental Transfers 20.4.1 Efficiency 20.4.2 Redistribution 20.4.3 Flypaper Effect Evidence 20.5.1 Race to the Bottom 20.5.2 Race to the Top 20.5.3 Tax Mimicking Issues in International Taxation ; 665 665 665 666 667 673 674 676 677 679 681 681 682 685 686 686 689 690 691 691 693 693 694 703 703
xvii 21.2 International Efficiency 704 21.2.1 Efficient Allocations 705 21.2.2 Markets and Efficiency 706 21.2.3 Taxation and Efficiency 708 21.3 Capital and Corporations 709 21.3.1 Capital Taxes ' 709 21.3.2 Corporate Taxation 711 21.3.3 Formula Apportionment 715 21.3.4 Summary 717 21.4 Transfer Pricing 717 21.5 Location 720 21.5.1 Locational Choice 721 21.5.2 Agglomeration Rents 722 21.5.3 Evidence 723 21.6 Harmonization of Taxes 725 21.7 Tax Principles 729 21.8 Tariff Policy 732 21.8.1" Welfare Cost of Tariffs ', 733 21.9 Trade Agreements " 736 21.10 741 VIII ISSUES OF TIME 22 Intertemporal Efficiency, 751 22.1 751 22.2 Overlapping Generations 753 ' 22.2.1 Time and Generations 753 22.2.2 Consumers 754 22.2.3 Production 755 22.3 Equilibrium 758 22.3.1 Intertemporal Equilibrium 759 22.3.2 Steady State 759 22.4 Optimality and Efficiency 762 22.4.1 The Golden Rule 762 22.4.2 Pareto-Efficiency 765 22.5 Testing Efficiency 769 22.6 770
xviii 23 23.1 23.2 23.3 23.4 23.5 23.6 23.7 23.8 23.9 23.10 24 24.1 24.2 24.3 24.4 24.5 24.6 Social Security Types of System The Pensions Crisis The Simplest Program Social Security and Production Population Growth Sustaining a Program Ricardian Equivalence Social Security Reform Economic Growth Exogenous Growth 24.2.1 Constant Savings Rate 24.2.2 Optimal Taxation Endogenous Growth 24.3.1 Models of Endogenous Growth 24.3.2 Government Expenditure Policy Reform Empirical Evidence 775 775 776 778 781 783 787 790 794 797 802 809 809 810 810 817 823 824 826 829 833 837 IX APPLICATIONS 25 Cost-Benefit Analysis 847 25.1 847 25.2; What Is Cost-Benefit Analysis? 848 25.2.1 Simple Example 849 25.2.2 Broader Approach 850 25.3 The Process of CBA 851 25.3.1 Discounting Future Values, 853 25.4 Principles of CBA 856 25.4.1 Common Unit of Measurement 856 25.4.2 Revealed Preferences 857 25.4.3 Valuing Market Goods: Marshallian Surplus 858
xix 25.5 25.6 25.7 25.8 26 26.1 26.2 26.3 26.4 26.5 26.6 26.7 26.8 25.4.4 25.4.5 25.4.6 25.4.7 Valuing Valuing Non-market Goods: Hedonic Prices Impact Assessment Decision Criteria Difficulties for CBA Life Valuing the Future 25.6.1 Intertemporal Arbitrage 25.6.2 The UK Green Book 25.6.3 Adjustment for Risk Theoretical Foundations of CBA 25.7.1 25.7.2 25.7.3 Social Welfare Evaluation Distributive Weights Market Prices and Shadow Prices Economics of Climate Policy Special Features The Science of Global Warming 26.3.1 26.3.2 26.3.3 Greenhouse Gases and Temperatures Controversies Predictions Integrating Economics and Climate 26.4.1 Sources of Damage 26.4.2 Modeling Economic Damage. 26.4.3 Effects of Policy Competing Generations Ecological Discounting Climate Policy in Practice 26.7.1 Pricing and Policies 26.7.2 The EU Emissions Trading Scheme 26.7.3 International Agreements 26.7.4 Prices or Quantities 26.7.5 Further Policies 859 860 861 862 865 869 870 873 875 876 877 882 883 889 895 895 897 900 900 904 907 910 911 9.12 915 917 924 929 929 931 934-937 939 940 Index 947