Public Finance and Public Policy

Public Finance and Public Policy s FOURTH EDITION Jonathan Gruber Massachusetts Institute of Technology / WORTH PUBLISHERS A Macmillan Higher Education Company

Contents Contents Preface.. VII XXVll PART I Introduction and Background CHAPTER 1 Why Study Public Finance? 1 1.1 The Four Questions of Public Finance When Should the Government Intervene in the Economy? 3 Application: The Measles Epidemic of 1989-1991 5 How Might the Government Intervene? 7 What Are the Effects of Alternative Interventions? 8 Application: The CBO: Government Scorekeepers 9 Why Do Governments Do What They Do? 9 3 1.2 Why Study Public Finance? Facts on Government in the United States and Around the World 10 The Size and Growth of Government 10 Decentralization 12 Spending, Taxes, Deficits, and Debts 13 Distribution of Spending 16 Distribution of Revenue Sources 17 Regulatory Role of the Government 19 1.3 Why Study Public Finance Now? Policy Debates over Social Security, Health Care, and Education 20 Social Security 20 Health Care 21 Education 21 1.4 Conclusion 22 Highlights > 22 Questions and Problems 23 Advanced Questions 24 vii

CHAPTER 2 Theoretical Tools of Public Finance 25 2.1 Constrained Utility Maximization 26 Preferences and Indifference Curves 27 Utility Mapping of Preferences 29 Budget Constraints 31 Putting It All Together: Constrained Choice 33 The Effects of Price Changes: Substitution and Income Effects 35 2.2 Putting the Tools to Work: TANF and Labor Supply Among Single Mothers 37 Identifying the Budget Constraint 38 The Effect of TANF on the Budget Constraint 39 ( 2.3 Equilibrium and Social Welfare 43 Demand Curves 44.Supply Curves 46 Equilibrium 48 Social Efficiency 49 Competitive Equilibrium Maximizes Social Efficiency 50 From Social Efficiency to Social Welfare: The Role of Equity 52 ( Choosing an Equity Criterion 54 2.4 Welfare Implications of Benefit Reductions: The TANF Example Continued 55 2.5 Conclusion 57 Highlights 57 Questions and Problems 58 Advanced Questions 59 APPENDIX TO CHAPTER 2 The Mathematics of Utility Maximization... 60 CHAPTER 3 Empirical Tools of Public Finance 63 3.1 The Important Distinction Between Correlation and Causality... 64 The Problem 65 3.2 Measuring Causation with Data We'd Like to Have: Randomized Trials Randomized Trials as a Solution 67 The Problem of Bias 67 Randomized Trials of ERT 69 66

Randomized Trials in the TANF Context 69 Why We Need to Go Beyond Randomized Trials 70 3.3 Estimating Causation with Data We Actually Get: Observational Data 71 Time Series Analysis 71 Cross-Sectional Regression Analysis 74 Quasi-Experiments 79 Structural Modeling 82 3.4 Conclusion 84 Highlights 84 Questions and Problems 85 Advanced Questions 86 APPENDIX TO CHAPTER 3 Cross-Sectional Regression Analysis 87 CHAPTER 4 Budget Analysis and Deficit Financing 91 4.1 Government Budgeting 93 The Budget Deficit in Recent Years 93 The Budget Process 94 Application: Efforts to Control the Deficit 96 Budget Policies and Deficits at the State Level 98 4.2 Measuring the Budgetary Position of the Government: Alternative Approaches 98 Real vs. Nominal 98 Economic Conditions 100 Cash vs. Capital Accounting 100 / Static vs. Dynamic Scoring 102 4.3 Do Current Debts and Deficits Mean Anything? A Long-Run Perspective 103 Background: Present Discounted Value 104 Why Current Labels May Be Meaningless 104 Alternative Measures of Long-Run Government Budgets 105 What Does the U.S. Government Do? 109 Application: The Financial Shenanigans of 2001 112 4.4 Why Do We Care About the Government's Fiscal Position? 113 Short-Run vs. Long-Run Effects of the Government on the Macroeconomy 113 Background: Savings and Economic Growth 114

The Federal Budget, Interest Rates, and Economic Growth 115 Intergenerational Equity 118 4.5 Conclusion 118 Highlights 119 Questions and Problems s 119 Advanced Questions 120 PART II Externalities and Public Goods CHAPTER 5 Externalities: Problems and Solutions 121 5.1 Externality Theory 123 Economics of Negative Production Externalities 123 Negative Consumption Externalities 126! Application: The Externality of SUVs 127 Positive Externalities 128 5.2 Private-Sector Solutions to Negative Externalities 130 The Solution 130 The Problems with Coasian Solutions 132 5.3 Public-Sector Remedies for Externalities 134 Corrective Taxation 134 Subsidies 135 Regulation 137 5.4 Distinctions Between Price and Quantity Approaches to Addressing Externalities 137 Basic Model 138 Price Regulation (Taxes) vs. Quantity Regulation in This Model 139 Multiple Plants with Different Reduction Costs 140 Uncertainty About Costs of Reduction 143 5.5 Conclusion 146 \ Highlights 146 Questions and Problems 147 Advanced Questions 148

CHAPTER 6 Externalities in Action: Environmental and Health Externalities 149 6.1 Acid Rain 150 The Damage of Acid Rain 151 Empirical Evidence: Estimating the Adverse Health Effects of Particulates 152 History of Acid Rain Regulation 152 Has the CAA Been a Success? 155 6.2 Global Warming 155 Application: The Montreal Protocol 158 The Kyoto Treaty 158 Can Trading Make Kyoto More Cost-Effective? 159 What Does the Future Hold? 162 Application: Congress Takes on Global Warming 163 6.3 The Economics of Smoking 165 The Externalities of Smoking 167 Should We Care Only About Externalities, or Do "Internalities" Matter Also? 171 6.4 The Economics of Other Addictive Behaviors 174 Drinking 174 Illicit Drugs 175 Empirical Evidence: The Effect of Legal Drinking at Age 21 176 Application: Public Policy Toward Obesity 178 Summary 180 6.5 Conclusion 181 Highlights 181 Questions and Problems 181 / Advanced Questions / 182 CHAPTER 7 Public Goods 183 7.1 Optimal Provision of Public Goods 184 Optimal Provision of Private Goods 185 Optimal Provision of Public Goods 187 i 7.2 Private Provision of Public Goods 189 Private-Sector Underprovision 189 Application: The Free Rider Problem in Practice 191 Can Private Providers Overcome the Free Rider Problem? 192 Application: Business Improvement Districts 192 When Is Private Provision Likely to Overcome the Free Rider Problem? 194

7.3 Public Provision of Public Goods 196 Private Responses to Public Provision: The Problem of Crowd-Out 197 Measuring the Costs and Benefits of Pubjic Goods 199 How Can We Measure Preferences for the Public Good? 199 Empirical Evidence: Measuring Crowd-Out 200 7.4 Conclusion 201 Highlights 202 Questions and Problems 202 Advanced Questions 203 APPENDIX TO CHAPTER 7 The Mathematics of Public Goods Provision 204 CHAPTER 8 Cost-Benefit Analysis 207 8.1 Measuring the Costs of Public Projects 208 The Example 209 Measuring Current Costs 209 j 8.2 Measuring the Benefits of Public Projects 212 Valuing Driving Time Saved 213 Application: The Problems of Contingent Valuation 214 Empirical Evidence: Valuing Time Savings 216 Valuing Saved Lives 216 \ Application: Valuing Life 217 Discounting Future Benefits 222 Cost-Effectiveness Analysis 222 8.3 Putting It All Together 223 Other Issues in Cost-Benefit Analysis 223 8.4 Conclusion 225 Highlights 225 Questions and Problems 226 Advanced Questions 227 CHAPTER 9 Political Economy 229 9.1 Unanimous Consent on Public Goods Levels 231 Lindahl Pricing 231 Problems with Lindahl Pricing 233

9.2 Mechanisms for Aggregating Individual Preferences 234 Application: Direct Democracy in the United States 234 Majority Voting: When It Works 235 Majority Voting: When It Doesn't Work 237 Arrow's Impossibility Theorem 238 Restricting Preferences to Solve the Impossibility Problem 239 Median Voter Theory 241 The Potential Inefficiency of the Median Voter Outcome 241 Summary 242 9.3 Representative Democracy 242 Vote-Maximizing Politicians Represent the Median Voter 243 Assumptions of the Median Voter Model 244 Lobbying 246 Application: Farm Policy in the United States 247 Evidence on the Median Voter Model for Representative Democracy 249 Empirical Evidence: Testing the Median Voter Model 250 9.4 Public Choice Theory: The Foundations of Government Failure 251 Size-Maximizing Bureaucracy 251 Problems with Privatization 252 Application: Contracting Out with Noncompetitive Bidding 253 Leviathan Theory 255 Corruption 256 Application: Government Corruption 256 The Implications of Government Failure 259 9.S Conclusion 259 Empirical Evidence: Government Failures and Economic Growth 260 Highlights 261 Questions and Problems 261 / Advanced Questions 262 CHAPTER 10 State and Local Government Expenditures 263 10.1 Fiscal Federalism in the United States and Abroad 265 Spending and Revenue of State and Local Governments 266 Fiscal Federalism Abroad 268 10.2 Optimal Fiscal Federalism 269 The Tiebout Model 269 Problems with the Tiebout Model 271

Evidence on the Tiebout Model 273 Optimal Fiscal Federalism 275 Empirical Evidence: Evidence for Capitalization from California's Proposition 13 276 10.3 Redistribution Across Communities 276 Should We Care? 278 Tools of Redistribution: Grants 279 Redistribution in Action: School Finance Equalization 284 Empirical Evidence: The Flypaper Effect 285 Application: School Finance Equalization and Property Tax Limitations in California 287 10.4 Conclusion 287 Highlights 288 Questions and Problems 288 Advanced Questions 289 CHAPTER 11 Education (291 11.1 Why Should the Government Be Involved in Education? 294 Productivity 294 Citizenship 295 Credit Market Failures 295 Failure to Maximize Family Utility 295 Redistribution 296 11.2 How Is the Government Involved in Education? 296 Free Public Education and 7Crowding Out 297 Solving the Crowd-Out problem: Vouchers 299 Problems with Educational Vouchers 301 11.3 Evidence on Competition in Education Markets 306 Direct Experience with Vouchers 306 Experience with Public School Choice 306 Empirical Evidence: Estimating the Effects of Voucher Programs 307 Experience with Public School Incentives 308 Bottom Line on Vouchers and School Choice 308 11.4 Measuring the Returns to Education 309 Effects of Education Levels on Productivity 309 Empirical Evidence: Estimating the Return to Education 311 Effect of Education Levels on Other Outcomes 312 The Impact of School Quality 312 Empirical Evidence: Estimating the Effects of School Quality 313

11.5 The Role of the Government in Higher Education Current Government Role 314 What Is the Market Failure, and How Should It Be Addressed? 316 313 11.6 Conclusion 317 Highlights 317 Questions and Problems 318 Advanced Questions 319 l>flrt_iii Social Insurance and Redistribution S CHAPTER 12 Social Insurance: The New Function of Government 321 12.1 What Is Insurance and Why Do Individuals Value It? 323 What Is Insurance? 323 Why Do Individuals Value Insurance? 324 Formalizing This Intuition: Expected Utility Model 325 12.2 Why Have Social Insurance? Asymmetric Information and Adverse Selection 328 Asymmetric Information 328 Example with Full Information 329 Example with Asymmetric Information 329 The Problem of Adverse Selection 331 Does Asymmetric Information Necessarily Leacl to Market Failure 331 Application: Adverse Selection and Health Insurance "Death Spirals" 333 How Does the Government Address Adverse Selection? 334 12.3 Other Reasons for Government Intervention in Insurance Markets 335 Externalities 335 Administrative Costs 335 Redistribution 335 Paternalism 336 Application: Flood Insurance and the Samaritan's Dilemma 336 12.4 Social Insurance vs. Self-Insurance: How Much Consumption Smoothing? 339 Example: Unemployment Insurance 339 Lessons for Consumption-Smoothing Role of Social Insurance 343

12.5 The Problem with Insurance: Moral Hazard Application: The Problems with Assessing Workers' Compensation Injuries 345 What Determines Moral Hazard? 346 Moral Hazard Is Multidimensional 346 The Consequences of Moral Hazard 347 12.6 Putting It All Together: Optimal Social Insurance 12.7 Conclusion Highlights Questions and Problems Advanced Questions APPENDIX TO CHAPTER 12 Mathematical Models of Expected Utility... CHAPTER 13 Social Security 13.1 What Is Social Security, and How Does It Work? Program Details 357 Application: Why Choose 35 Years? 358 How Does Social Security Work Over Time? 361 Application: Ida May Fuller 363 How Does Social Security Redistribute in Practice? 364 13.2 Consumption-Smoothing Benefits of Social Security Rationales for Social Security 367 Does Social Security Smooth Consumption? 368 Social Security and Private Savings 368 Living Standards of the Elderly 369 Empirical Evidence:'Measuring the Crowd-Out Effect of Social Security on Savings 370 13.3 Social Security and Retirement Theory 371 Evidence 371 Application: Implicit Social Security Taxes and Retirement Behavior 375 Implications 376 13.4 Social Security Reform \Reform Round I: The Greenspan Commission 378 Application: The Social Security Trust Fund and National Savings 378 Incremental Reforms 379 Fundamental Reforms 382 Application: Company Stock in 401(k) Plans 385 Application: Mixed Proposals for Social Security Reform 386

13.5 Conclusion 387 Highlights 388 Questions and Problems 388 Advanced Questions 389 CHAPTER 14 Unemployment Insurance, Disability Insurance, and Workers' Compensation 391 14.1 Institutional Features of Unemployment Insurance, Disability Insurance, and Workers' Compensation 393 Institutional Features of Unemployment Insurance 393 Institutional Features of Disability Insurance 395 Institutional Features of Workers' Compensation 396 Comparison of the Features of Ul, Dl, and WC 397 Application: The Duration of Social Insurance Benefits Around the World 398 14.2 Consumption-Smoothing Benefits of Social Insurance Programs... 399 14.3 Moral Hazard Effects of Social Insurance Programs 400 Moral Hazard Effects of Unemployment Insurance 400 Empirical Evidence: Moral Hazard Effects of Unemployment Insurance 402 Evidence for Moral Hazard in Dl 404 Evidence for Moral Hazard in WC 405 Empirical Evidence: Moral Hazard Effects of Disability Insurance 406 Empirical Evidence: Moral Hazard Effects of Workers' Compensation 407 14.4 The Costs and Benefits of Social Insurance to Firms 408 The Effects of Partial Experience Rating in Ul on Layoffs 408 The "Benefits" of Partial Experience Rating 410 Application: The "Cash Cow" of Partial Experience Rating 410 Workers'Compensation and Firms 411 / / 14.5 Implications for Program Reform 412 Benefits Generosity 412 Targeting 412 Experience Rating 413 Worker Self-Insurance? 413 Application: Reforming Ul 413 14.6 Conclusion 414 Highlights 415 Questions and Problems 415 Advanced Questions 416 APPENDIX TO CHAPTER 14 Advanced Quasi-Experimental Analysis... 417

CHAPTER 15 Health Insurance I: Health Economics and Private Health Insurance 419 15.1 An Overview of Health Care in the United States 421 How Health Insurance Works: The Basics 422 Private Insurance 423 Medicare 427 Medicaid 427 TRICARE/CHAMPVA 428 The Uninsured 428 Empirical Evidence: Health Insurance and Mobility 431 15.2 How Generous Should Insurance Be to Patients? 432 Consumption-Smoothing Benefits of Health Insurance for Patients 432 Moral Hazard Costs of Health Insurance for Patients 433 Application: The Problem with McAllen, Texas 436 'How Elastic Is the Demand for Medical Care? The RAND Health Insurance Experiment 438 Empirical Evidence: Estimating the Elasticity of Demand for Medical Care 440 Optimal Health Insurance 440 Why Is Insurance So Generous in the United States? 441 Application: Health Savings Accounts 443 15.3 How Generous Should Insurance Be to Medical Providers? 445 Managed Care and Prospective Reimbursement 446 The Impacts of Managed Care 448 How Should Providers Be Reimbursed? 449 i 15.4 Conclusion 449 / / Highlights 449 Questions and Problems 450 Advanced Questions 451 453 454

What Health Services Does Medicaid Cover? 456 How Do Providers Get Paid? 456 16.2 What Are the Effects of the Medicaid Program? 457 How Does Medicaid Affect Health? A Framework 457 How Does Medicaid Affect Health? Evidence 458 Empirical Evidence: Using State Medicaid Expansions to Estimate Program Effects 460 16.3 The Medicare Program 461 How Medicare Works 462 Application: The Medicare Prescription Drug Debate 463 16.4 What Are the Effects of the Medicare Program? 466 The Prospective Payment System 466 Empirical Evidence: On the Move to the PPS 467 Problems with PPS 467 Lesson: The Difficulty of Partial Reform 469 Medicare Managed Care 469 Should Medicare Move to a Full Choice Plan? Premium Support 472 Application: A Premium Support System for Medicare 472 Gaps in Medicare Coverage 474 16.5 Long-term Care 475 Financing Long-term Care 475 16.6 Health Care Reform in the United States 476 The Historical Impasse 476 The Massachusetts Experiment with Incremental Universalism 478 The Affordable Care Act 480 Application: Rising Health Care Costs and Cost Control Efforts in the ACA 481 16.7 Conclusion /. 485 Highlights 485 Questions and Problems 486 Advanced Questions 486 CHAPTER 17 Income Distribution and Welfare Programs 489 17.1 Facts on Income Distribution in the United States 491 Relative Income Inequality 491 Absolute Deprivation and Poverty Rates 494 Application: Problems in Poverty Line Measurement 495 What Matters Relative or Absolute Deprivation? 496

17.2 Welfare Policy in the United States 497 Cash Welfare Programs 497 In-Kind Programs 499 17.3 The Moral Hazard Costs of Welfare Policy 500 Moral Hazard Effects of a Means-Tested Transfer System 501 Solving Moral Hazard by Lowering the Benefit Reduction Rate 504 The "Iron Triangle" of Redistributive Programs 505 17.4 Reducing the Moral Hazard of Welfare 506 Moving to Categorical Welfare Payments 506 Using "Ordeal Mechanisms" 509 Application: An Example of Ordeal Mechanisms 510 Increasing Outside Options 511 Empirical Evidence: The Canadian Self-Sufficiency Project 514 17.5 Welfare Reform 517 Changes Due to Welfare Reform 517 Empirical Evidence: Estimating the Impact of Welfare Reform 518 Effects of the 1996 Welfare Reform 518 17.6 Conclusion 520 i Highlights!. 520 Questions and Problems 520 Advanced Questions 521 P-flRT I-V i I 1 Taxation in Theory and Practice CHAPTER 18 Taxation in the United States and Around the World 523 18.1 Types of Taxation 524 J Taxes on Earnings 524 Taxes on Individual Income 525 I Taxes on Corporate Income 525 i ; Taxes on Wealth 525 i \ Taxes on Consumption 525 Taxation Around the World 525 18.2 Structure of the Individual Income Tax in the United States Computing the Tax Base 527 527

Tax Rates and Taxes Paid 529 Application: The Coming AMT Timebomb 530 18.3 Measuring the Fairness of Tax Systems 532 Average and Marginal Tax Rates 532 Vertical and Horizontal Equity 533 Measuring Vertical Equity 534 Application: The Political Process of Measuring Tax Fairness 534 18.4 Defining the Income Tax Base 536 The Haig-Simons Comprehensive Income Definition 536 Deviations Due to Ability-to-Pay Considerations 537 Deviations Due to Costs of Earning Income 538 Application: What Are Appropriate Business Deductions? 538 18.5 Externality/Public Goods Rationales for Deviating from Haig-Simons 540 Charitable Giving 54'0 Spending Crowd-Out Versus Tax Subsidy Crowd-In 541 Consumer Sovereignty Versus Imperfect Information 543 Housing 543 Empirical Evidence: The Social Benefits of Homeownership 545 Tax Deductions Versus Tax Credits 546 Application: The Refundability Debate 547 Bottom Line: Tax Expenditures 549 18.6 The Appropriate Unit of Taxation 550 The Problem of the "Marriage Tax" 550 Marriage Taxes in Practice 552 18.7 Conclusion 554 Highlights /. 554 / Questions and Problems 555 Advanced Questions 556 CHAPTER 19 The Equity, Implications of Taxation: Tax Incidence 557 19.1 The Three Rules of Tax Incidence 559 The Statutory Burden of a Tax Does Not Describe Who Really Bears the Tax 559 The Side of the Market on Which the Tax Is Imposed Is Irrelevant to the Distribution of the Tax Burdens 561 Parties with Inelastic Supply or Demand Bear Taxes; Parties with Elastic Supply or Demand Avoid Them 564 Reminder: Tax Incidence Is about Prices, Not Quantities 567

19.2 Tax Incidence Extensions 568 Tax Incidence in Factor Markets 568 Tax Incidence in Imperfectly Competitive Markets 571 Balanced Budget Tax Incidence 573 19.3 General Equilibrium Tax Incidence 574 Effects of a Restaurant Tax: A General Equilibrium Example 574 Issues to Consider in General Equilibrium Incidence Analysis 577 19.4 The Incidence of Taxation in the United States 579 Empirical Evidence: The Incidence of Excise Taxation 580 CBO/IPC Incidence Assumptions 580 Results of CBO/TPC Incidence Analysis 581 Current Versus Lifetime Income Incidence 583 19.5 Conclusion 584 Highlights 584 Questions and Problems 585 Advanced Questions ). 585 APPENDIX TO CHAPTER 19 The Mathematics of Tax Incidence 587 CHAPTER 20 Tax Inefficiencies and Their Implications for Optimal Taxation. 589 20.1 Taxation and Economic Efficiency 590 Graphical Approach 590 Elasticities Determine Tax'lnefficiency 592 Application: Tax Avoidance in Practice 593 Determinants of Deadweight Loss 594 Deadweight Loss and the Design of Efficient Tax Systems 596 Application: The Deadweight Loss of Taxing Wireless Communications 600 20.2 Optimal Commodity Taxation 601 Ramsey Taxation: The Theory of Optimal Commodity Taxation 601 Inverse Elasticity Rule 602 Equity Implications of the Ramsey Model 603 \ Application: Price Reform in Pakistan 604 20.3 Optimal Income Taxes 607 A Simple Example 607 General Model with Behavioral Effects 608 An Example 610

20.4 Tax-Benefit Linkages and the Financing of Social Insurance Programs 612 The Model 612 Issues Raised by Tax-Benefit Linkage Analysis 614 Empirical Evidence: A Group-Specific Employer Mandate 616 20.5 Conclusion 616 Highlights 617 Questions and Problems 617 Advanced Questions 618 APPENDIX TO CHAPTER 20 The Mathematics of Optimal Taxation... 619 CHAPTER 21 Taxes on Labor Supply 623 21.1 Taxation and Labor Supply Theory 625 Basic Theory 625 Limitations of the Theory. Constraints on Hours Worked and Overtime Pay Rules 627 21.2 Taxation and Labor Supply Evidence 628 Empirical Evidence: Estimating the Elasticity of Labor Supply 629 Limitations of Existing Studies 630 21.3 Tax Policy to Promote Labor Supply: The Earned Income Tax Credit 631 Background on the EITC 631 Impact of EITC on Labor Supply: Theory 633 Impact of EITC on Labor Supply: Evidence 634 Empirical Evidence: The Effect of the EITC on Single-Mother Labor Supply 636 Summary of the Evidence 637 Application: EITC Reform 637 21.4 The Tax Treatment of Child Care and Its Impact on Labor Supply 639 The Tax Treatment of Child Care 639 Empirical Evidence: The Effect of Child Care Costs on Maternal Labor Supply 640 Options for Resolving Tax Wedges 641 Comparing the Options 642 21.5 Conclusion 643 Highlights 644 Questions and Problems 644 Advanced Questions 645

CHAPTER 22 Taxes on Savings 647 22.1 Taxation and Savings Theory and Evidence 649 Traditional Theory 649 Evidence: How Does the After-Tax Interest Rate Affect Savings? 653 Inflation and the Taxation of Savings 654 22.2 Alternative Models of Savings 656 Precautionary Savings Models 656 Self-Control Models 657 Empirical Evidence: Social Insurance and Personal Savings 658 22.3 Tax Incentives for Retirement Savings 659 Available Tax Subsidies for Retirement Savings 659 Why Do Tax Subsidies Raise the Return to Savings? 661 Theoretical Effects of Tax-Subsidized Retirement Savings 662 Application: The Roth IRA 666.Implications of Alternative Models 668 Private vs. National Savings 669 Empirical Evidence: Estimating the Impact of Tax Incentives for Savings on Savings Behavior 670 Evidence on Tax Incentives and Savings 671 22.4 Conclusion 672 Highlights 673 Questions and Problems 673 Advanced Questions \.. 674 i i CHAPTER 23 Taxes on Risk Taking and Wealth 675 23.1 Taxation and Risk Taking 677 Basic Financial Investment Model 677 Real-World Complications 678 Evidence on Taxation and Risk Taking 680 Labor Investment Applications 680 23.2 Capital Gains Taxation 681 Current Tax Treatment of Capital Gains 681 What Are the Arguments for Tax Preferences for Capital Gains? 683 ' v What Are the Arguments Against Tax Preferences for Capital Gains? 688 Application: Capital Gains Taxation of "Carried Interest" 688 23.3 Transfer Taxation -Why Tax Wealth? Arguments for the Estate Tax 691 Arguments Against the Estate Tax 692 690

23.4 Property Taxation Who Bears the Property Tax? 696 Types of Property Taxation 697 Application: Property Tax Breaks to Businesses 698 695 23.5 Conclusion 700 Highlights 700 Questions and Problems 701 Advanced Questions 701 CHAPTER 24 Corporate Taxation 24.1 What Are Corporations and Why Do We Tax Them?.. Ownership versus Control 706 Application: Executive Compensation and the Agency Problem 707 Firm Financing 709, Why Do We Have a Corporate Tax? 710 703 705 24.2 The Structure of the Corporate Tax 711 Revenues 712 Expenses 712 Application: What Is Economic Depreciation? The Case of Personal Computers 713 Corporate Tax Rate 714 Tax Credits 715 24.3 The Incidence of the Corporate Tax 715 24.4 The Consequences of the Corporate Tax for Investment 716 Theoretical Analysis of Corporate Tax and Investment Decisions 716 Negative Effective Tax Rates 721 Policy Implications of the Impact of the Corporate Tax on Investment 722 Application: The Impact of the 1981 and 1986 Tax Reforms on Investment Incentives 722 Evidence on Taxes and Investment 724 24.5 The Consequences of the Corporate Tax for Financing 724 The Impact of Taxes on Financing 724 Why Not All Debt? 726 The Dividend Paradox 728 How Should Dividends Be Taxed? 729 Application: The 2003 Dividend Tax Cut 730 Corporate Tax Integration 731 24.6 Treatment of International Corporate Income 732 How to Tax International Income 732 Application: A Tax Holiday for Foreign Profits 733

24.7 Conclusion 736 Highlights 737 Questions and Problems 737 Advanced Questions 738 CHAPTER 25 Fundamental Tax Reform 739 25.1 Why Fundamental Tax Reform? 741 Improving Tax Compliance 741 Application: Tax Evasion 741 Application: The 1997 IRS Hearings and Their Fallout for Tax Collection 744 Making the Tax Code Simpler 746 Improving Tax Efficiency 747 Summary: The Benefits of Fundamental Tax Reform 750 25.2 The Politics and Economics of Tax Reform 750 Political Pressures for a Complicated Tax Code 751 Economic Pressures Against Broadening the Tax Base 751 Application: Grandfathering in Virginia 754 The Conundrum 755 Application: TRA 86 and Tax Shelters 755 25.3 Consumption Taxation 756 Why Might Consumption Make a Better Tax Base? 757 Why Might Consumption Be a Worse Tax Base? 759 Designing a Consumption Tax 762 Backing into Consumption Taxation: Cash-Flow Taxation 765 25.4 The Flat Tax.. 765 ; Advantages of a Flat Tax 766! Problems with the Flat Tax 767! Application: The 2005 Panel on Tax Reform 768 j- 25.5 Conclusion 769 j'. \ Highlights 769 I Questions and Problems 770 j ( Advanced Questions 770 j 1 Glossary G-l References R-l Index I-l