Deze samenvatting is gebaseerd op het studiejaar 2013-2014.

Chapter A: Welfare Economics

Public finance can be described as the public sector economics. Given the enormous diversity of the government’s economic activities, a systematic framework is needed to assess the desirability of various government actions. The framework is called welfare economics. It compares alternative economic states to decide which is socially most desirable.

To explain this theory, we start with a simple pure exchange economy.

• Fixed supply of goods
• 2 individuals: Andy (A) & Britney (B)
• 2 goods: Food (F) & Clothing (C)

All important results from this two good-two person case hold in economies with many people and commodities.

To depict the distribution of food and clothing between Andy and Britney, we use an Edgeworth Box. Any point within the Edgeworth Box represents some allocation of both goods between Andy and Britney.

To represent the preferences of both individuals we use indifference curves, graphs showing combinations of goods for which a consumer is indifferent. Indifference curves with greater numbers represent higher levels of happiness (utility).

Given a set of alternative allocations and a set of individuals, a movement from one allocation to another that can make at least one individual better off, without making any other individual worse off, is called a Pareto improvement. An allocation of resources is Pareto-efficient when it is not possible to make someone better off without making someone else worse off (no further Pareto improvements can be made). Pareto efficiency is the economist's benchmark of efficient performance for an economy.

A whole set of Pareto-efficient points can be found in the Edgeworth Box. The locus of all the Pareto-efficient points is called the contract curve. As you can see, at a Pareto-efficient allocation the indifference curves are tangent – the slopes of the indifference curves are equal.

In economic terms, the absolute slope of the indifference curve equals the willingness to trade one commodity for the another. This is called the marginal rate of substitution (MRS).

We can conclude that Pareto efficiency requires equal MRS for all consumers:

MRS(f,c)_A = MRS(f,c)_B

So far we assumed that the production of the commodities was fixed (exchange economy). Now we will look at the production. The supply of the production factors is limited. The quantity of the two goods can change. More apples and less fig leaves can be produced, or more fig leaves and less apples.

The production possibilities curve shows the maximum quantity of one output that can be produced, given the amount of the other output. The slope of the production possibilities curve at any given point is called the marginal rate of transformation (MRT). It describes numerically the rate at which one good can be transformed into the other. It is useful to express the MRT in terms of marginal cost (MC) – the incremental production cost of one more unit of output.

MRT(f,c) = ^MC(f)/_MC(c)

The new Pareto efficiency condition (with variable production) becomes:

MRT(f,c) = MRS(f,c)_ANDY = MRS(f,c)_BRITNEY

In words: the rate at which food can be transformed into clothing (MRT) must equal the rate at which consumers are willing to trade food for clothing (MRS).

First Fundamental Theorem of Welfare Economics

A Pareto-efficient allocation of resources emerges if:

• All consumers and producers act as perfect competitors (perfect competition). No one has market power.

• There exists a market for each and every commodity (existence of markets).

Under these assumptions, the First Fundamental Theorem of Welfare Economics tells us that a competitive economy automatically allocates resources efficiently, without any need for centralized direction. In a competitive market, all people face the same prices. Consumers and producers are so small relative to the market that they cannot affect the prices.

Utility maximization requires: (1) MRS(f,c) = P(f)/P(c)

Remember the profit maximization condition: P = MC

So MC(f)/MC(c) = P(f)/(P(c)

But MC(f)/MC(c) = MRT(f,c)

Therefore (2) MRT(f,c) = P(a) / P(c)

Combining both formulas yields MRS(f,c) = MRT(f,c)

Because a competitive economy automatically allocates resources efficiently, it is hard to imagine what role the government plays in this economy. Things are really much more complicated than described in the First Theorem. The economic concept of efficiency is not the only thing that a society might care about. In particular, the theorem says nothing about the distributional equity of the outcome. Efficiency isn’t everything; fairness matters to.

Fairness

The utility possibility curve is derived from the contract curve. It shows the maximum amount of one person’s utility given the other individual’s utility level. The points on the curve are Pareto-efficient, but represent very different distributions of real income. All points on or below the utility possibilities curve are attainable by society; all points above are unattainable.

But which point on the utility possibility curve is the best? The solution to this question is to postulate a social welfare function, which embodies society’s views on the relative deservedness of both individuals:

W = F(U_A,U_B).

Society’s welfare depends on the utilities of each of its members. A social welfare function leads to a set of indifference curves between people’s utilities. The function is downward sloping.This indicates that if B’s utility decreases, the only way to maintain a given level of social welfare is to increase A’s utility, and vice versa. An increase in any individual’s utility will increase social welfare.

Social welfare is maximized (a ‘fair’ distribution of utility) when the utility possibilities curve is tangent to the highest attainable utility indifference curve.

If society prefers an equal distribution of income to efficiency, an inefficient situation can be preferred. Government intervention may be necessary to achieve a “fair” distribution of utility. But how should the government intervene? The Second Fundamental Theorem of Welfare Economics states that a society can attain any Pareto-efficient allocation of resources by:

1. Assigning initial endowments fairly

2. Letting people freely trade

If necessary to ensure fairness, the government should redistribute income, but then step out of the way – no interference with prices or allocation.

Market failure

A second reason for government intervention is market failure. Failing to allocate resources efficiently may be caused by:

1. Market power: a firm with market power (monopoly, oligopoly, monopolistic competition) may be able to raise price above marginal cost by supplying less output than a competitor would (P>MC). An insufficient quantity of resources is devoted to the commodity.

2. Non-existence of markets: often a market fails to emerge, because of:

• Asymmetric information: one party in a transaction has information that is not available to the other party.
• Externalities: a situation in which one person’s behavior affects the welfare of another in a way that is outside existing markets. The price system fails to provide correct signals about the opportunity cost of a commodity.
• Public goods : A commodity that is nonrival and nonexcludable in consumption. Means that the fact that one person consumes it does not prevent anyone else from doing so as well. It is too expensive or impossible to prevent anybody from consuming it. The market mechanism may fail to force people to reveal their preferences for public goods, and possibly result in insufficient resources being devoted to them.

The fact that the market does not allocate resources perfectly does not necessarily mean the government can do better. Each case must be evaluated on its own merits.

Although the theory of welfare economics provides a coherent and useful framework for analyzing policy, it is not universally accepted:

• It aims to maximize people’s utilities (other goals are possible).

• Individuals may not know their true preferences.

• It focuses on results and does not pay much attention to the processes used to achieve results.

The framework of welfare economics encourages us to ask three key questions whenever a government activity is proposed:

1. Will it have desirable distributional consequences?

2. Will it enhance efficiency?

3. Can it be done at a reasonable cost?

If the answers to these questions is no, the market should probably be left alone.

Chapter B: Public goods

A pure public good (example = national security) has both these properties:

• Consumption is nonrival: the additional resource cost of another person consuming the good is zero.

• Consumption is nonexcludable: everyone consumes the same amount and it is impossible (or very expensive) to prevent anyone from consuming the good.

A pure private good (example = pizza) is in contrast rival and excludable.

Several aspects of our definition of a public good are worth noting:

• Even though everyone consumes the same quantity, it needs not to be valued equally by all. This depends on the preferences of the consumers. Everyone consumes the same quantity, even those who don’t want it.

• Classification as a public good is not an absolute. It depends on market conditions and the state of technology. Consumption of a public good can be rival or excludable to some extent; this is called an impure public good.

• A commodity can satisfy one part of a public good and not the other. Nonexcludability and nonrivalness do not have to go together.

• Some things that are not thought of as commodities have public good characteristic. An example is honesty. If all people would be honest, business costs would be lower. This cost reduction is nonexcludable and nonrival.

• The terms private and public don’t tell anything about which sector provides the item. Private goods are not necessarily provided exclusively by the private sector. Some private commodities are provided by governments, these are called publicly provided private goods. Examples are medical services and housing. On the other hand public goods can be provided privately, an example is fireworks.

• Public provision of a good does not necessarily mean that it is also produced by the public sector.

Efficient provision of public goods

The equilibrium in the market is found where supply and demand are equal. The demand curve of Andy shows the quantity of Food that he would be willing to consume at each price, other things being the same. To find the market demand curve of Food, we simply add together the units of Food each person demands at every price. This involves summing the horizontal distance between each of the private demand curves and the vertical axes at that price. This process is called horizontal summation. With a private good, there is no reason to expect all consumers to consume the same amounts. This is because of different tastes, incomes and other characteristics. A competitive market results in Pareto efficient allocation (first fundamental theorem of welfare economics):

MRS_A = MRS_B = MRT

However, a public good must be consumed in equal amounts. It makes no sense to derive the market demand by summing up the quantities of a public good that the individuals would consume at a given price. Because the prices can differ, we add the prices that each would be willing to pay for a given quantity.

For a public good, then, the group willingness to pay is found by vertical summation of the individual demand curves. Hence, the market equilibrium requires that the total valuation consumers place on the last unit provided (sum of MRS’s) equal the incremental cost to society of providing it (MRT):

MRS_A + MRS_B = MRT

The difference in equilibrium can be explained by the prices for both private and public good. For standard private goods, everyone sees the same price and then people decide what quantity they want. For public goods, everyone sees the same quantity and people decide what price they are willing to pay.

In case of a private good, individuals will have no incentive to lie about their preferences (competition assures efficiency). However, in case of a public good people may hide their preferences because people who do not pay cannot be excluded. Each individual has the incentive to understate his or her willingness to pay. Hence, the market may fall short of providing the efficient amount of the public good. This problem is called the free rider (someone who lets other people pay while enjoying the benefits himself) problem.

Free ridership is not a given fact. It is an implication of the fact that people maximize utility depending on their own consumption of goods.

Market mechanisms are unlikely to provide nonrival goods efficiently, even if they are excludable. The only possible solution seems to be perfect price discrimination. If:

• The entrepreneur knows each person’s demand curve for the public good.

• It is not possible to transfer the good from one person to another.

Then you can charge each person an individual price based on the willingness to pay.

Privatization Debate

Privatization: Taking services that are supplied by the government and turning them over to the private sector for provision and/or protection.

Sometimes the services provided by publicly provided goods can be obtained privately. The mix between public and private provision has changed substantially over time. But what is the right mix? Publicly and privately provided goods should be seen as inputs into the production of some output that people desire. What ultimately matters to people is the level of output, not the particular inputs used to produce it. In selecting the amount of inputs, there are several considerations:

• Relative wage and material costs

The less expensive sector is to be preferred on efficiency grounds.

• Administrative costs

The larger the community, the more one is able to spread these costs.

• Diversity of tastes

When there is diversity of tastes, private provision is more efficient because people can adapt their consumption to their own tastes.

• Distributional issues

When a community is based on fairness, it can decide that some commodities should be available to everybody. This is called commodity egalitarianism. Even in cases where public provision of a good is selected, a choice between public and private production must be made. There a two key factors in determining whether public or private production will be more efficient:

• Market environment

• Incomplete contracts – the extent to which complete contracts can be written with private sector service providers.

Chapter C: Externalities

When the activity of one entity (person or firm) directly affects the welfare of another in a way that is not reflected in the market price, the effect is called an externality. Because one entity directly affects the welfare of another entity that is external to the market. Unlike effects that are transmitted through market prices, externalities affect economic efficiency negatively.

Characteristics of externalities:

• They can be produced by consumers as well as by firms

• Externalities are reciprocal in nature

• Externalities can be positive (example = vaccination)

• Public goods can be viewed as a special kind of externality. When an individual creates a positive externality with full effects felt by every person in the economy, the externality is a pure public good. Although public goods and positive externalities are similar, we have to distinguish between them in practice.

As long as someone owns a resource, its price reflects the value for alternative uses, and the resource is therefore used efficiently. An externality is the consequence of the absence of property rights.

If a person (person 1) wants to maximize profits, he produces each unit of output for which his marginal benefit (MB) exceeds his marginal costs (MPC). Thus he produces then the output level where MB intersects MPC, the actual output.

If we want to maximize profits from society’s point of view, society produces as long as marginal benefit for the society (MB) exceeds society’s marginal costs (MSC). The MSC consists of the MPC of person 1 and the marginal damage done to person 2 (MD). The output that is produced is where MSC and MB intersect and is called the socially efficient output.

By looking at producer and consumer surpluses we can prove that the society gains by reducing production from actual output to socially efficient output.

We can implicate two observations from this analysis:

1. When externalities exist, private markets do not produce the socially efficient output level.

2. The model shows that efficiency would be improved by a move from actual output to socially efficient output and it also provides a way to measure the benefits of doing so.

3. In general zero pollution is not desirable.

It is difficult to identify and to value the effect of an externality like pollution:

• What activities produce pollutants?

The types and quantities of pollution associated with various production processes are hard to identify.

• Which pollutants do harm?

It is difficult to determine which pollutants cause harm and by how much.

• What is the value of the damage done?

It is a hard to calculate the dollar value of the damage. Pollution is generally not bought and sold in explicit markets. The use of a willingness-to-pay measure can be questioned. People may be ignorant about the effects of an externality and underestimate the value of reducing it.

The inefficient allocation caused by an externality can be avoided. An efficient output can be achieved by both private and public responses.

Private responses:

1. Bargaining

When property rights are assigned, individuals may respond to the externality by bargaining with each other. In this way the gain is divided over the involved parties.

The Coase Theorem states that no matter who is assigned the property rights, an efficient solution will be achieved if both:

• The bargaining costs are low;

• The owner can identify the polluter.

This theory implies that once property rights are established, no government intervention is required to deal with externalities.

2. Mergers

Another way to deal with an externality is to internalize it by combining the involved parties. In effect, by failing to act together, companies are often throwing away money. The market, then, provides a strong incentive for the firms to merge.

3. Social conventions

Individuals cannot merge to internalize externalities like firms can. Certain social conventions can be viewed as attempts to force people to take into account the externalities they generate. Often moral regulations cause people to emphasize with others (example = turn of mobile phones in class). These regulations correct for the absence of missing markets.

Public responses

1. Pigouvian tax

A natural solution is to levy a tax on the polluter that makes up for the fact that some of his inputs are prices too low. A Pigouvian tax is a tax levied on each unit of a polluter’s output in an amount just equal to the marginal damage it inflicts at the efficient level of output. Such a tax gives the producer a private incentive to produce the efficient output. Practical problems in implementing a Pigouvian tax:

What is the marginal damage (= tax rate)?

• Who pollutes and how much?

However, an imperfect Pigouvian tax is often better than none at all.

2. Pigouvian subsidy

A subsidy for pollution not produced can induce producers to pollute at the efficient level. This is called a Pigouvian subsidy.

A subsidy also leads to the efficient production level, but it has different distributional consequences compared to a Pigouvian tax (SEE FIGURE).

Practical problems of a Pigouvian subsidy:

• Polluters and the amount of pollution are hard to identify.

• Subsidy may attract more factories, because a subsidy increases the profits. Eventually, total pollution, then, will increase.

• Subsidizing polluters is often ethically undesirable.

3. Creating a market

The government can sell permits with socially efficient output and permissions to pollute go to the firms with the highest bids (example = CO2 emission rights). The price paid for permission to pollute measures the value to producers of being able to pollute. The main advantage of this permit approach is that it reduces uncertainty about the ultimate level of pollution.

4. Regulation

Under regulation, each polluter must reduce pollution by a certain amount or else face legal sanctions. Regulation is likely to be inefficient when there are multiple firms that differ from each other, because the social value of pollution reduction varies across firms, locations and the populace. Regulation that mandates all firms to cut back by equal amounts (either in absolute or proportional terms) leads to some firms producing too much and others too little.

Public responses to externalities:

1. Emissions fee

An emissions fee works the same as a pigouvian tax. The only difference is that with an emissions fee a tax is levied on each unit of pollutions rather than on each unit of the polluter’s output. The total cost of emissions reduction is minimized when the marginal costs are equal across all polluters. The outcome is called cost effective if it is achieved at the lowest cost possible.

2. Cap-and-Trade

An alternative policy to an emissions fee is that the government can require person 1 and person 2 to submit one government-issued permit for each unit of pollution they emit. A system of tradable pollution permits is called cap-and-trade.

Emissions fees and cap-and-trade systems are called incentive-based regulations because they provide polluters with market incentives to reduce pollution.

The traditional approach to environmental regulation has relied on command-and-control regulations instead of incentive-based regulations. Command-and-control regulations are more flexible than incentive-based ones and take a variety of forms. Two types:

1. Technology standard. Requires polluters to install a certain technology to clean up their emissions. The law does not allow this so technology standards are unlikely to be cost effective.

2. Performance standard. It sets an emissions goal for each polluter. Polluter frequently has the flexibility to meet this standard in any way it chooses. Therefore it is more cost effective than a technology standard.

Positive externalities

The analysis of positive externalities is similar to that of negative externalities. Efficiency requires the marginal cost to equal the social marginal benefit. When an entity produces positive externalities, the market underprovides the good. This can be corrected by an appropriate Pigouvian subsidy.

However, requests for such subsidies must be viewed cautiously:

• Subsidy has to be financed by taxes. This means a redistribution of income and a distortion of the market which is taxed.

• The fact that an activity is beneficial does not always mean that a subsidy is required for efficiency – only if the market is imperfect.

Chapter D: Public choice

Till now, we questioned ourselves what kind of actions the government should take. In this chapter we will look at who decides what the government actually does. This chapter applies economic principles to the analysis of political decision making, a field known as political economy. Most economic theories assume that the government acts in the interest of society, but political economy theories assume that politicians are self-interested.

• Selfishness does not necessarily lead to inefficient outcomes. If the market for political decisions works perfect, we should see an efficient outcome.

• While the maximization assumption may not be totally accurate, it provides a good starting point for analysis.

We will examine how political decisions are being made in both a direct and a representative democracy.

Democratic societies use various different voting procedures to decide on public expenditures. Some direct democracy voting procedures:

1. Unanimity rules

Lindahl stated that if a vote was taken on whether to provide an efficient quantity of the good, consent would be unanimous as long there was a suitable tax system to finance it. In this Lindahl procedure, each individual faces a personalized price per unit of public good, which depends on his or her tax share. The tax shares are referred to as Lindahl prices. Lindahl’s procedure has two main problems:

• Free rider problem: People hide their true preferences.

• Getting everyone’s consent involves enormous decision-making costs.

2. Majority voting rules

With a majority voting rule, more than half of the voters must favor a measure to gain approval. But if there are more than 2 options to choose from, majority decision rules do not always yield such clear-cut results. Although each individual voter’s preferences are consistent, the community’s could be not. This is called the voting paradox.

It depends on the question if a voter has single-peaked or double-peaked preferences. A peak in an individual’s preferences is a point at which all the neighboring points are lower. A voter had single-peaked preferences if his utility consistently falls when he moves from his favored outcome in all directions. He has multi-peaked preferences if, as he moves away from his favored outcome, the utility goes down, but then goes up again. If all voters’ preferences are single peaked, no voting paradox occurs.

With more voting options, the ultimate outcome depends on the order in which the votes are taken. This opens the opportunity of agenda manipulation: organizing the order of votes to assure a favorable outcome. A related problem is that paired voting can go on forever without reaching a decision. This process of cycling can continue indefinitely.

The median voter theorem states that as long as all preferences are single peaked; the outcome of majority voting reflects the preferences of the median voter. The median voter is the voter whose preferences lie in the middle of all voters’ preferences. Half the voters want more than the median voter wants, half want less.

3. Logrolling

Logrolling systems allow people to trade votes and hence register how strongly they feel about various issues. The effect on general welfare is unclear. The main disadvantage is that it leads to wasteful public expenditures. Logrolling is likely to result in special-interest gains not sufficient to outweigh general losses. The main advantage is that it allows voters express the intensity of their preferences by trading votes.

Arrow’s impossibility theorem

In a democratic society, a collective decision-making rule should satisfy the following ethical criteria:

• It must produce decisions, whatever the configuration of votes’ preferences.

• It must be able to rank all outcomes

• It must be responsive to individuals’ preferences

• It must be consistent

• It must be independent of irrelevant alternatives

• Dictatorship is ruled out

Arrow’s impossibility theorem states that it is impossible to find a rule which satisfies all of these criteria. This means that democracies are inherently prone to make inconsistent decisions.

Representative democracy

Explanations of government behaviour in a representative democracy require studying the interaction of elected politicians, public employees, and special-interest groups.

1. Elected politicians

Often, citizens elect politicians who make decisions on their behalf. The median voter theorem helps explain how these representatives set their positions. It pays candidates to place themselves as close as possible to the position of the median voter. Still several issues require careful examination:

• Single-dimensional rankings: it should be possible to rank political beliefs along a single spectrum.

• Ideology: they ideology of the politicians also plays an important role

• Personality: voters not only base their vote on the issues

• Leadership: voters’ preferences can be influenced by the politicians themselves.

• Decision to vote: not every eligible citizen chooses to exercise his or her franchise.

2. Public employees

The decisions of politicians are carried out by civil servants, bureaucrats. Public employees have an important impact on the development and implementation of economic policy. The goals from the bureaucrats will sometimes differ from the public good. They often focus on reputation, power, patronage, etc.

The Niskanen model suggests that these goals are positively related with the size of the bureaucrat’s budget. Bureaucrats attempt to maximize the size of their agencies' budgets, resulting in oversupply of the service. They have the power to influence this output decision, because of their informational advantage.

3. Special interests

People with common interests can exercise disproportionate power by acting together. Special interest groups can form on the basis of income source( capital/labor, industry/employment), income size, region, or demographic and personal characteristics. These groups can manipulate the political system to redistribute income towards them. This is called rent-seeking.

There are also other groups that affect government fiscal decisions:

• Judiciary – through court decisions.

• Journalists – by bringing certain issues to public attention.

• Experts – information is potentially an important source of power.

Government growth

The concern about political economy issues has been stimulated by the growth of the government. There are different explanations for the growth of the government. The most prominent theories follow:

• Citizen preferences: Growth in government expenditure is an expression of the preferences of the citizenry.

• Marxist view: Growth in government expenditure depends to the political economic system. In the Marxist model, the private sector tends to overproduce, so the capitalist-controlled government must expand its expenditures in order to absorb this production.

• Chance events: External shocks to the economic and social systems require higher level of government expenditure.

• Change in social attitudes: Social trends encouraging personal self-assertiveness lead people to make extravagant demands on the political system.

• Income redistribution: Government grows because low-income individuals use the political system to redistribute income towards themselves.

Many people want to control the growth in government. Proposals include encouraging private sector competition, reforming the budget process, and constitutional amendments.

Chapter E: Cost benefit analysis

Social welfare functions are generally not much help for the day-to-day problems of project evaluation. However, welfare economics does provide the basis for cost-benefit analysis: a set of practical procedures for evaluating potential projects. In this way resources can be allocated to a project as long as the marginal social benefit exceeds the marginal social cost.

To compare costs and benefits in different time periods, their present value must be computed. The present value is the value today of a given amount of money to be paid or received in the future. To find the value of money today one year in the future, you multiply by one plus the interest rate. To find the value of money one year in the future today, you divide plus one plus the interest rate.

R = investment

r = interest rate (discount factor)

T = time (in years)

The dollar values R can both be nominal or real amounts. With nominal amounts, the market interest rate increases by an amount approximately equal to the expected rate of inflation from r percent to (r+ π) percent.

The moral of the story is that you obtain the same answer whether real of nominal magnitudes are used. It is crucial, however, to use both consistently. Then inflation cancels out.

A project is admissible only if its net return is positive, benefits exceed costs. In project evaluation, the calculation of the net present value of a project can be useful.

B = benefits, C = costs, r = discount rate, T = time (years)

The net present value criteria for project evaluation are that:

• A project is admissible only if NPV > 0

• When two projects are mutually exclusive, choose the one with the higher NPV

Several criteria other than the present value are often used for project evaluation:

• Internal rate of return (p)

The internal rate of return (p) is the discount rate that makes the NPV=0. The project is admissible if the internal rate of return exceeds the actual discount rate (p > r). When two projects are mutually exclusive, choose the one with the higher value of p. However, if projects differ in size, the internal rate of return can be misleading. A big project with a low p may make more money than a small one with a high p.

• Benefit-cost ratio = B/C (NPVBENEFITS/NPVCOSTS)

A project is admissible if the benefit-cost ratio exceeds one. However, the ratio is useless in comparing different projects. By manipulating definitions of costs or benefits, any project can be given a high B/C (e.g. a benefit is a cost reduction)

Choosing the discount rate is critical in cost-benefit analyses. The discount rate reflects opportunity costs, so it depends on where the money for the project comes from. In public sector analyses, there are three possible measures for the discount rate:

• Before-tax private rate of return

Money is extracted from private sector investment. The opportunity cost of the government project equals the rate of return in the private sector.

• After-tax private rate of return

Money is extracted from consumption. Because the after-tax rate of return measures what an individual loses when consumption is reduced, dollars that come at the expense of consumption should be discounted by the after-tax rate of return.

Because funds for the public sector reduce both private sector consumption and investment, a natural solution is to use a weighted average of both.

• Social discount rate

Measure the valuation that society places on consumption that is sacrificed in the present. The social discount rate may be lower than the market rates of return for several reasons:

• Concern for future generations

The public sector should care about the future generations as well. The private sector ignores future generations and is only concerned with its own welfare.

• Paternalism

People may not know their own best interests. The government forces them to consume less in the present en, in return, they have more in the future (and they will be thankful afterwards).

• Market inefficiency

Investments can create positive externalities and will be underprovided by private markets.

It appears that it is hard to pick the right discount rate for the public sector. The best procedure is a sensitivity analysis. It evaluates the present value of a project over a range of different discount rates and examines whether or not the present value stays positive for all reasonable values of r.

Valuing public benefits and costs

In private firms, benefits are the revenues received and costs are they payments for inputs. This is more complicated for the government because market prices may not reflect social benefits and costs. There are several possibilities for measuring the benefits and costs in the public sector:

1. Market prices

If the government uses inputs/produces outputs that are traded in competitive private markets, market prices should be used. Market prices reflect the marginal costs of production and the marginal value to consumers.

2. Shadow prices

However, often market imperfections exist and the prices for the commodities don’t reflect its marginal costs anymore. The shadow price of such a commodity is its underlying social marginal cost. It is the price adjusted for market imperfections (like a monopoly, taxes or unemployment) and it depends on how the economy responds to the government intervention.

3. Consumer surplus

If large government projects change equilibrium prices, the consumer surplus can be used to measure the benefits. The consumer surplus reflects the amount by which the sum that individuals would have been willing to pay exceeds the sum they actually have to pay.

4. Inferences from economic behaviour

For non-traded commodities, there is no market data available. The value can sometimes be inferred by observing people’s behaviour. In this way people’s willingness to pay for such commodities can be estimated.

• Value of time

A common way of to estimate the value of time is to take advantage of the theory of leisure-income choice. People work up to the point where the subjective value of leisure is equal to the income they gain from one hour of work. However, often people can’t choose their hours of work and not all uses of time from a job are equivalent.

• Value of life

The value of life can be estimated for instance by examining the difference in wages for dangerous and safe jobs or the market prices for safety devices – how much people are willing to pay to reduce the probability of death.

Often, (future) costs and benefits are uncertain and risky. In such a case it is best to convert them into certainty equivalents – the amount of certain income the individual would be willing to trade for the set of uncertain outcomes generated by the project.

Certain intangible benefits and costs simply cannot be measured. It is hard to attain these benefits, but the best possibilities seem to be:

• Exclude them in a cost-benefit analysis and then calculate how large they must be to reverse the decision.

• Cost-effectiveness analysis: a systematic study of the costs of the various alternatives to find the cheapest way possible.

Tresh (2002) has noted some other common errors in cost-benefit analysis:

• Chain-reaction game

Secondary benefits are included to make a proposal appear more favourable, without including the corresponding secondary costs. It counts as benefits changes that are merely transfers.

• Labor game

Wages are viewed as benefits rather than costs of the project, because the project ‘creates’ employment.

• Double-counting game

Some benefits are incorrectly counted twice.

Distributional considerations

There is a discussion about giving consideration to the question of who receives the benefits and bears the costs of a public sector project.

• Some argue that if the net present value of a project is positive, it should be undertaken regardless of who gains and who loses. This is because as long as the NPV is positive, the gainers could compensate the losers and still enjoy a net increase in utility (potential Pareto improvement). This notion is called the Hicks-Kaldor criterion.

• Others oppose that because the goal of the government is to maximize social welfare, the distributional implications of a project should be taken into account.

Chapter F: Income redistribution

This chapter presents a framework for thinking about the normative and positive aspects of government income redistribution policy.

A way to distribute income is to compute the number of people below the poverty line; a fixed level of real income considered enough to provide a minimally adequate standard of living.

First, it is important to see why there are large disparities in income. Within the developed countries, wage differentials are the most important reason. Differences in property income (interest, dividends) account for only a small portion of income inequality. A key factor driving the increase in inequality is an increase in the financial returns to education.

Measuring the extent of poverty is hard to do. It is therefore very important to know the conventions use to construct the income data:

• The income is based on cash-receipts and in-kind transfers – payments in commodities or services as opposed to cash.

• The official figures ignore taxes. Tax redistribution is not reflected in the numbers.

• Income is measured annually. However, even annual measures may not reflect an individual’s true economic position. Income can fluctuate.

• There are problems in defining the unit of observation. The figures ignore changes in household composition. It is hard to account for economies of scale. The data may provide a better assessment of well-being than it is in practice.

Welfare economics posits that society’s welfare depends on the well-being of its members. This means welfare is a function of all individuals’ utilities (utilitarianism):

Utilitarian social welfare function: W = F(U1,U2, … , Un)

A change that makes someone better off without making anyone else worse off increases social welfare. Income should be redistributed as long as it increases W.

Additive social welfare function: W = U1 + U2 + … + Un

If: (1) Individuals have identical utility functions only depending on income

(2) Marginal utility of income diminishes

(3) Total income is fixed

Then the government should redistribute income so as to obtain complete equality.

However, these are strong assumptions and weakening them gives radically different results. Obviously, you can question the assumptions:

• It is a reasonable guess that utility functions are identical, but they do not only depend on income (often also on for instance leisure). So it is impossible to know whether utility functions are identical.

• It is probably that marginal utility of income diminishes. If it does not, the redistribution cannot change social welfare.

• Total amount of income is not fixed. If an individual’s utility depends on leisure, redistribution makes working less attractive, so there is less income to redistribute.

The additive social welfare function assumed that society is indifferent to the distribution of utilities. Not every utilitarian social welfare function carries this implication:

Maximin criterion: W = Minimum (U1,U2, … , Un)

In this equation, social welfare depends only on the utility of the person who has the lowest utility. The best income distribution maximizes the utility of the person who has the lowest utility. This means society’s only concern is the poorest person.

John Rawls claimed that the maximin criterion has a claim to ethical validity. If people are risk-averse and do not know their future position in society (original position), they will choose maximin as an insurance against disastrous outcomes. However, the analysis is controversial, because the welfare of other persons also matters and people are not always totally risk-averse.

Because of the assumption that each individual’s utility depends only on income, redistribution was never a Pareto improvement. Redistribution can actually be a Pareto improvement:

• If high income individuals are altruistic, their utilities depend not only on their incomes but those of the poor as well. Income redistribution can be seen as a public good – everyone derives utility from the redistribution, but government coercion is needed to accomplish redistribution.

• There is always some chance that you will become poor. An income distribution policy is a bit like an insurance against future poverty.

• Income distribution creates social stability. If poor people become too poor, the may engage in antisocial activities such as crime.

After deciding whether the government should redistribute income, the next question is how to do it. The government influences income redistribution through its taxation as well as its expenditure policies. The impact of expenditure policy on the redistribution of real income is referred to as expenditure incidence. This is difficult to determine, because of:

• Relative price effects

An expenditure programme sets off a chain of price changes that affects the income of people both in their role as consumers of goods and as suppliers of inputs. The problem is that it is very hard to trace all the price changes. Economists generally focus on the prices in the markets that are directly affected.

• Public goods

For public goods, the impact on the income distribution is unknown, because people do not reveal how they value public goods.

• In-kind transfers

Many government programs provide goods and services instead of cash. If recipients would prefer to consume less, the value of the in-kind transfer is less than the market price. We cannot know for certain if an in-kind transfer is valued less than a direct income transfer.

The answer has to be found by empirical analysis. Another problem is that in-kind transfers often entail substantial administrative costs, which reduces efficiency.

Reasons for in-kind transfers:

• Paternalism

Politicians seem to know better what is good for people.

• Commodity egalitarianism

Only special commodities must be equally accessible to everyone.

• Administrative feasibility

An in-kind transfer leads to less fraud than with a money transfer. In-kind transfers may discourage ineligible persons from applying because they are less willing to lie to obtain a commodity they do not really want.

• Political attractiveness

In-kind transfers help not only the beneficiary but also the producers of the favoured commodity.

Chapter G: Taxation and equity

The statutory incidence of a tax indicates who is legally responsible for the tax. However, this tells us nothing about who really pays the tax, because prices may change in response to the tax. The economic incidence of a tax is the change in the distribution of private real income induced by a tax. It tells us who really bears the burden. The extent to which statutory and economic incidence differ is called the amount of tax shifting.

General remarks about tax incidence:

1. Only people can bear taxes

From an economist’s point of view only people can bear taxes. For the purpose of incidence analysis, there are different classifications:

• Functional distribution of income – the way income is distributed among people when they are classified according to the inputs they supply to the production process.

• Size distribution of income – the way that income is distributed across different income classes.

2. Both sources and uses of income should be considered

Economists often ignore effects on the sources side when considering a tax on a commodity and ignore the uses side when analyzing a tax on an input.

3. Incidence depends on how prices are determined

Different models of price determination may give quite different answers to the question of who really bears a tax. The question how taxes change prices is closely related to the time dimension of the analysis. It takes time for prices to change. This means that the short- and long-run incidence of a tax may differ.

4. Incidence depends on the disposition of tax revenues

Depending on the policy being considered, one of the following incidences can be examined:

• Balanced-budget incidence

It computes the combined effects of levying taxes and government spending financed by those taxes. However, taxes are usually not marked for particular expenditures. Some studies assume that the government spends the tax revenue exactly the same as the consumers would if they had received the money.

• Differential tax incidence

It abstracts from how the government will spend the money. The idea is to examine how incidence differs when one tax is replaced with another, holding the government budget constant. The basis of the comparison (‘the other tax’) is often assumed to be a lump sum tax – a tax for which the individual’s liability does not depend upon behaviour.

• Absolute tax incidence

It examines the effects of a tax when there is no change in either other taxes or government expenditure.

5. Tax progressiveness can be measured in several ways

Often a tax is characterized as proportional, progressive, or regressive.

• Proportional: the ratio of taxes paid to income (average tax rate) is constant regardless of income level.

• Progressive: an individual’s average tax rate increases with income.

• Regressive: an individual’s average tax rate decreases with income.

Confusion arises because some people think of progressiveness in terms of the marginal tax rate – the change in taxes paid with respect to a change in income. It equals the tax paid on the last euro.

Measuring the tax progressiveness is a hard task. We consider two simple options:

• Progressiveness = (difference in average tax rate) / (difference in income)

The greater the increase in average tax rates as income increases, the more progressive the system.

• Progressiveness = (% change in tax revenues) / (% change in income)

One tax system is more progressive than another if its elasticity of tax revenues with respect to income is higher.

Knowing how prices are determined is critical to the analysis of how taxes change the income distribution. We can apply two models: partial equilibrium models and general equilibrium models.

Partial equilibrium models of price determination are models that only look at the market in which the tax is imposed and ignore the ramifications in other markets. We first assume that the market is perfect competitive. We study both the incidences of a unit tax (fixed amount per unit of a commodity) and an ad valorem tax (percentage of the commodity price).

In the presence of a unit tax, the price paid by consumers (price gross of tax) and the price received by suppliers (price net of tax) differ. The conclusion of the model is the tax makes both producers and consumers worse off.

They split the tax in a sense that the increase in the consumer price (Pconumers – P0) and the decrease in producer price (P0 – Pproducers) just add up to .

The analysis has two important implications:

• The incidence of a unit tax is independent of whether it is levied on consumers or producers. What matters is the size of the disparity the tax introduces between the price paid by consumers and the price received by producers. The tax-induced difference between the price paid by consumers and the price received by producers is referred to as the tax wedge.

• The incidence of a unit tax depends on the elasticities of supply and demand. The more elastic the demand curve, the less the tax borne by consumers. Similarly, the more elastic the supply curve, the less the tax borne by producers. There are two extreme cases:

  • Inelastic demand: consumer bears the full burden
  • Inelastic supply: producers bear the full burden

The analysis of an ad valorem tax, a tax with a rate given as a proportion of the price, is very similar to that of unit taxes. Instead of moving the curve down by the same absolute amount for each quantity, the ad valorem tax lowers it by the same proportion.

Until now, we assumed that markets were competitive. There are other possibilities:

• Monopoly

The analysis for a monopoly is similar. Despite its market power, a monopolist is generally made worse off by a unit tax on the product it sells. As before, the precise share of the burden borne by the consumers depends on the elasticity of the demand schedule.

• Oligopoly

There is no well-developed theory of tax incidence in an oligopoly, because relative price changes are unknown. We can only say that the ideal situation for firms is a cartel solution – firms jointly produce the output that maximizes the profits of the entire industry. However, each firm has an incentive to cheat that agreement. So the output in an oligopolistic market is often higher that the cartel solution.

The analysis of taxes on the factors of productions is similar to that of a commodity tax. A tax on economic profits cannot be shifted; it is borne only by the owners of a firm. In the short-run, a proportional tax affects neither marginal cost nor marginal revenues. There, the output and the price stay the same. Because the price paid by consumers doesn’t change, the tax is completely absorbed by the firms. In the long-run, a tax on economic profits has no yield, because economics profits are zero.

One special case is examined: the tax on land. We can say that land is durable and fixed in supply. The price of land equals the net present value of future returns. At the time the tax is imposed, the price of land falls by the present value of all future tax payments. This process by which a stream of taxes becomes incorporated into the price of an asset in referred to as capitalization. It implies that the present owner pays the burden of the tax forever.

When a tax is imposed on a sector that is large relative to the economy, looking only at that particular market may not be enough. General equilibrium analysis takes into account the ways in which various markets are interrelated. These analyses often employ a two-sector (Manufacturing [M] +Food [F]), two-factor model (Capital [K] + Labor [L]). This framework allows for nine possible taxes:

• Capital tax for either sector M or sector F (1+2)

• Labor tax for either sector M or sector F (3+4)

• Consumption tax on either good M or good F (5+6)

• Tax on either labor or capital (in both sectors) (7+8)

• General income tax (9)

The first 4 taxes are called partial factor taxes – levied on a factor is only one of its uses.

Any two sets of taxes that generate the same changes in relative prices have equivalent incidence effects:

The Harberger model is a prominent method for analysing tax incidence with general equilibrium models. The main assumptions of this model are:

• Perfect competition, profit maximization and prices are perfectly flexible.

• Constant returns to scale

• One sector capital intensive, another labor intensive

• Production technologies differ with respect to the ease with which capital can be substituted for labor (elasticity of substitution) and the ratio’s in which capital and labor are employed.

• Mobile production factors and the total supply of capital and labor are fixed.

• No savings

• All consumers have identical preferences

• Differential tax incidence: study the effect of substituting one tax for another

We will use the Harberger model to analyse several different taxes:

• Commodity tax (on food) – the relative price of food increases. This leads to less food and more manufactures that are produced. If food is more capital-intensive than manufactures, the relative demand for capital decreases. This will decrease the relative price of capital. In other words, a tax on the output of a sector causes a decline in the relative price of the input used intensively in that sector.

• Income tax - equivalent to a set of taxes on capital and labor. Because factor supply is fixed the tax cannot be shifted and it is borne in proportion to people’s initial incomes.

• General tax on labor - taxed in both sectors, so there are no possibilities to escape the tax by migration to the other sector. Because the total supply of factor supply is fixed, labor bears the entire burden.

• Partial factor tax

When capital used in the manufacturing sector only is taxed, there are two effects:

• Output effect

Price of manufactures rises, which decreases the quantity demanded.

• Factor substitution effect

Capital becomes more expensive in the manufacturing sector, producers will use less capital and more labor.

The output effect is ambiguous with respect to the final effect on the relative prices of capital and labor. As long as factors are mobile between uses, a tax on a given factor in one sector ultimately affects the return to both factors in both sectors.

Changing some assumptions has important implications for the tax incidence:

• Differences in individual’s tastes: When consumers don’t have the same preferences, tax-induced changes in the distribution of income change aggregate spending decisions and hence relative prices and incomes.

• Immobile factors

If a factor is immobile the taxed factor bears the whole burden, because the factor cannot escape taxation by migrating to another sector.

• Variable factor supplies

Supplies to both capital and labor are variable in the long run. A general tax on capital decreases the capital-labor ratio, and the return to labor will fall (labor has less capital to work with). In this way, a general tax on capital can hurt labor.