Chaper 12 Fiscal olicy, page 1 of 8 fiscal policy and invesmen: fiscal policy refers o governmen policy regarding revenue and expendiures fiscal policy is under he capial resources secion of he ex because i used o be believed ha governmen was a major saver in he economy; governmen can conribue o saving hrough a surplus in he governmen budge and profi from governmen enerprises governmen and axaion: LDC governmens have less axing capaciy han indusrialized counries; LDCs also earn more from axing rade han income axes, unlike indusrialized counries developed counries have lower axes on profis han on wages, which may increase inequaliy; however, in LDCs, income axes migh increase equaliy because only a small proporion of people (usually hose who work in he formal secor) pay hem he incidence and efficiency of axaion is also an imporan consideraion governmen as a major saver in an economy: i was believed a one ime ha people in poor counries do no save; because capial formaion depends on saving, if his were rue, hen poor counries would be suck in povery; i was argued ha in order for a developing counry economy o save, he governmen should ax as much as possible and reallocae he revenue o invesmen projecs; his idea has gone ou of fashion because here is no evidence ha governmens have a higher propensiy o save han privae individuals he classificaion of expendiures by governmen as invesmen or consumpion can be arbirary for example, he wages of eachers and healhcare workers are considered consumpion, alhough hey could be considered invesmen governmens can sill be effecive a aiding developmen; differences in growh could be due o he governmen s capaciy o be efficien and foser developmen; for example, economiss generally agree ha a governmen should provide public goods because privae firms will no find i profiable o sell hem and people will no pay for hem (because hey are nonrival and nonexcludable) governmen can fund schooling, healhcare, ransporaion, communicaion, infrasrucure, ec. differences in he size of governmen, governmen revenue, and governmen expendiure beween indusrialized and developing counries: page 422, able 12-1 governmen expendiure as a share of GN: governmen expendiure as a share of GN is an indicaor of he governmen s size; governmen expendiure as a share of GN in developing counries is less in poor counries han i is in rich counries i rises from 17% in low-income counries o 32% in high-income counries; his follow s Wagner s law, which saes ha as an economy grows, he relaive size of governmen does also social spending as a proporion of GN is higher in rich counries han in poor counries; i rises from 1% in low-income counries o 11% in high-income counries (abou 1/3 of oal governmen expendiure in rich counries) miliary spending in high-income counries is a greaer proporion of GN han in lowincome counries; however, low-income counries spend a greaer proporion of heir governmen revenue on miliary spending han do high-income counries
Chaper 12 Fiscal olicy, page 2 of 8 page 424, able 12-2 governmen recurren expendiure: ransfers o subnaional governmens refer o paymens o provincial governmens, ec. (no found in uniary saes) page 443, able 12-6 sources of ax revenue: income axes are a larger share of governmen revenue in developed counries han in developing counries (from 28% in developed counries o 18.8% in low-income counries); i is difficul for LDCs o collec income axes because 80+% of he populaion is no in he formal secor and does no repor is earnings, and he cos of enforcing income axes in he informal secor is prohibiively high axes on inernaional rade are a larger share of governmen revenue in developing counries han in developed counries (from 25% in LDCs o 0-1% in OECD counries); alhough axes on inernaional rade are inefficien and policy advisors encourage LDCs o lower hem, developing counries rely on hem as a source of ax revenue; axes on inernaional rade are easier o collec and enforce because he governmen can concenrae is adminisraion a a few pors equiy and efficiency of a ax sysem: here are wo ypes of coss o axaion: 1) adminisraive he cos of imposing, collecing, and enforcing he ax 2) he discouragemen of economic aciviy deadweigh loss o be efficien, a ax should raise revenue in he leas cosly way equiy considers he fairness of a ax by looking a he disribuion of he ulimae burden of a ax if a ax is progressive, people wih higher incomes pay a larger proporion of heir income han do people wih lower incomes; if a ax is regressive, people wih lower incomes pay a larger proporion of heir income han do people wih higher incomes a poll ax (a head ax), which requires all people o pay he same amoun, is regressive because poorer people pay a larger fracion of heir income (alhough everybody pays he same absolue amoun) an excise ax (a sales ax), which is levied on he purchase of a basic consumpion good, is regressive because poorer people pay a larger fracion of heir income for he ax on a good (alhough all people mus pay he same ax for a given good); according o he Keynesian model of saving, richer people spend a smaller proporion of heir income on consumpion han poorer people if boh have o pay an excise ax equal o a cerain fracion of heir consumpion, hen he poorer people will pay a larger fracion of heir oal income as a ax, and he ax is regressive governmen expendiure and equiy: governmen expendiure could be regressive, if i funds urban hospials, higher educaion, ec.; however, governmen could use is expendiure o reduce inequaliy hrough progressive spending, such as by subsidizing necessiies, funding primary educaion, ec. governmens migh no have much abiliy o conrol he progressiviy of he ax sysem because i is consrained in is abiliy o earn ax revenue, bu i can achieve equiy goals
Chaper 12 Fiscal olicy, page 3 of 8 on he expendiure side; hus, he ex suggess he governmen ax neurally and use expendiures o reduce inequaliy excess burden (deadweigh loss) of axaion: an excise ax is a common source of ax revenue when assessing a ax, he governmen will gain revenue bu somebody loses income, revenue, or wealh; he excess burden is he difference beween wha he governmen gains and wha people lose an elasic demand curve is shown: b Supply ( b = MC = AC) Q b Q he consumer surplus is he difference beween wha consumers as a whole are willing o pay and how much hey acually pay; in his graph, he consumer surplus is given by he area beween he demand curve and he supply curve up o Q b: b consumer surplus Supply ( b = MC = AC) Q b Q
Chaper 12 Fiscal olicy, page 4 of 8 when he ax is levied, he price rises from b o b and he quaniy demanded drops from Q b o Q b: b b ax Supply ( b = MC = AC) Q b Q b Q when he ax is levied, he consumer surplus is reduced in size (compare shaded area o previous graph) and consumers lose bfh b, bu he governmen gains revenue bfg b: consumer surplus b f gov revenue b g h Supply ( b = MC = AC) Q b Q b Q
Chaper 12 Fiscal olicy, page 5 of 8 however, as a resul of he ax here is an excess burden (also known as a deadweigh loss), which is he consumer surplus los and no gained by he governmen; he excess burden is he riangle fgh as shown: b f b g h Supply ( b = MC = AC) Q b Q b Q if he supply curve is oally inelasic, hen he excess burden is deermined by he elasiciy of he demand curve; for an inelasic good he excess burden is smaller han for an elasic good; an inelasic demand curve is shown (compare he deadweigh losses of he elasic and inelasic demand curves): b b Supply ( b = MC = AC) Q b Q b Q hus, in order o maximize he efficiency (minimize he excess burden) of a ax, he governmen should ax inelasic goods, for which he demand is less responsive o price; however, inelasic goods end o be less responsive o price because hey are necessiies in his case, efficiency objecives run couner o equiy objecives; for example, axes on saple foods would be more efficien han axes on a luxury iem bu would hur he poor more increasing governmen saving: governmen saving is he difference beween ax revenue and he expendiures labeled governmen consumpion ; governmen saving can be increased by increasing ax revenue or decreasing governmen consumpion
Chaper 12 Fiscal olicy, page 6 of 8 high governmen consumpion can lead o harmful deficis if expendiure is greaer han revenue; deficis are ofen financed by prining money, which increases inflaion; hus, organizaions like he IMF ake measures o reduce governmen expendiure in developing counries; however, i can be difficul o reduce governmen expendiure in a developing counry because i is already low reducing expendiure: o reduce expendiure, governmens in he pas have reduced expendiure on mainenance, which has caused expensive projecs o have o be rebuil afer a few years because of disrepair; hus, reducing funds for mainenance is no a good way o reduce governmen expendiure reducing governmen employee salaries is no desirable because i leads o greaer corrupion or lower efficiency (because employees spend ime on privae secor aciviies o earn addiional income); reducing he number of governmen employees could be a beer way o reduce governmen expendiure han reducing salaries reducing miliary spending is ofen a favored way o reduce governmen expendiure, even hough miliary spending is no a large proporion of expendiure, because here is a percepion of wase in he miliary subsidies o governmen enerprises, which ofen run a a loss, can be reduced, or he enerprises can be privaized increasing ax revenue: raising ax raes o increase ax revenue is ofen no desirable because higher axes creae disorions in he economy (people swich o differen aciviies, a black marke develops, ec.) insead of raising ax raes, he governmen should increase he effeciveness of ax collecion o increase ax revenue axaion in developing counries: when implemening a ax, he governmen should consider boh he efficiency and he ulimae incidence of he ax a progressive ax axes people wih higher incomes a higher proporion of heir income han people wih lower incomes; a proporionae ax axes all people he same proporion of heir income; and a regressive ax axes people wih lower incomes a greaer proporion of heir income han people wih higher incomes income axes: income axes end in poor counries o be paid by he formal secor employees (who earn high wages) and hey herefore end o be progressive; hus, an income ax migh be desirable for equiy reasons value-added axes (VAT s):
Chaper 12 Fiscal olicy, page 7 of 8 value-added axes have become popular among economiss; a VAT is levied on he value-added a each sae of producion and is paid by he producers of he good or service differen VAT s for consumer and producer goods could be used o encourage invesmen problems of axaion in developing counries: one of he main problems of developing counry governmens is operaing is ax sysem effecively axaion can be par of he insiuional infrasrucure developing counries need o consider alhough equiy and efficiency are imporan o consider in a ax sysem, ofen one mus be raded-off for he oher; he exbook advocaes a broad and neural sysem of axaion: under his sysem, all ciizens would pay he same proporion of heir income; equiy goals would be achieved by he governmen by disproporionaely spending on he poor (such as by supporing primary schools over universiies, prevenaive healhcare over curaive care, ec.) cos-benefi analysis: page 434, equaion 12-2 he ne presen value is he discouned sream of benefis and cos: n ( B C ) NV = = 0 (1 i) NV = ne presen value B = he benefis in year C = he cos in year i = he discoun rae he NV can be used o evaluae how beneficial a projec is page 434, equaion 12-3 he benefi-cos raio: n B BCR = 0 = n (1 i) C = 0 (1 i) BCR = benefi-cos raio B = he benefis in year C = he cos in year i = he discoun rae for a projec o be worhwhile, i s BCR mus be greaer han 1
Chaper 12 Fiscal olicy, page 8 of 8 he inernal rae of reurn is he bes crierion o use when choosing a projec; he inernal rae of reurn is defined by: n n B C = 0 (1 r) = 0 (1 r) B = he benefis in year C = he cos in year r = he inernal rae of reurn In words, he IRR is ha rae ha causes discouned benefis o exacly equal discouned coss. I is a sor of break even ineres rae for he projec. shadow prices: shadow prices are prices ha reflec rue scarciy; in heory, shadow prices would prevail in a perfecly compeiive economy he acual price does no always equal he shadow price; for example, in he wo-secor labor-surplus model, he opporuniy cos of he surplus labor in agriculure equals zero because he marginal produc of his labor equals zero; hus, he shadow price of his labor equals zero; however, hese workers receive he subsisence wage plus he wage premium o move o he indusrial secor; hus, he shadow price of he surplus rural labor is no equal o he acual price of he surplus rural labor if prices are disored in an economy (such as by capped ineres raes, overvalued exchange raes, minimum wages, ec.) hen shadow prices insead of acual prices should be used in a social cos-benefi analysis; when appraising projecs, he rae of reurn is likely o differ in a social cos-benefi analysis if he shadow price is used insead of he acual price (for example, if he cos of labor is among he coss of a projec and if he shadow wage is below he marke wage, he IRR of he projec is higher when he shadow wage is used in calculaing he projec s cos raher han he marke wage) naional goals and projec appraisal: shadow prices (insead of acual prices) can be used o consider naional goals in a social cos-benefi analysis alernaely, he governmen could aach a moneary value o a naional goal in he social cos-benefi accouning mehod (for example, adding a cerain amoun of money on he benefis side for each addiional job creaed)