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Summary: book " Public Finance ", Rosen and Gayer, Lecture
(s) Chapters 3 to 6, 8, 12, 14, 15, 16, 18, 20, 22
Public Finance (Rijksuniversiteit Groningen)

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Public finance summary


Chapter 3 Tools of normative analysis
welfare economics: the branch of economic theory concerned with the social desirability of alternative
economic states
basic concepts: 1) efficiency can we improve overall welfare?
2) equity
is it fair?
pareto efficiency: nobody can be made better off without making someone worse off
pareto improvement: a reallocation of resources that makes at least one person better off without
making anyone else worse off
contract curve: the locus of all Pareto efficient points
production possibilities curve: a graph that shows the maximum quantity of one output that can be
produced, given the amount of the other output
marginal rate of transformation (MRT): the rate at which the economy can transform one good into
another good; it is the absolute value of the slope of the production possibilities frontier
marginal cost: the incremental cost of producing one more unit of output
utility possibilities curve: a graph showing the maximum amount of one persons utility given each level
of utility attained by the other person

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Pareto-efficient allocation of resources if:


- perfect competition
- identical prices
- no market power
- existence of markets
- everything can be traded
1st Pareto efficiency condition: MRSadam = MRSeve
2nd Pareto efficiency condition: MRSaf = MRTaf
With well-functioning markets, prices reflect both:
- relative costs of production (MRT), and
- relative attractiveness of goods (MRS)
social welfare function: a function reflecting societys views on how the utilities of its members affect
the well-being of society as a whole
asymmetric information: a situation in which one party engaged in an economic transaction has better
information about the good or service traded than the other party
externality: a cost or benefit that occurs when the activity of one entity directly affects the welfare of
another in a way that is outside the market mechanism
merit good: a commodity that ought to be provided even if people do not demand it (operas, concerts)

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Correct market failures:


- firms have market power
- firms set their own prices (P > MC)
- a market does not exist, because of:
- asymmetric information
- lack of property rights
- public goods

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Chapter 4 Public goods


A pure public good has both these properties:
- consumption is non-rival
> cost of use by additional person is zero
> use by one person does not prohibit use by someone else
- consumption is non-excludable
> everyone consumes it
> everyone consumes the same quantity
> whether you want to or not
is NOT necessarily a good provided by the public sector:
- public sector provides private goods too (education)
- public goods can be provided by private sector (fireworks)
impure public good: a good that is rival and/or excludable to some extent
Public good examples
national security
flood protection
disease eradication
lighthouse

Not public good examples


medical care
highways

A pure private good is both rival and excludable


Public good
same quantity, different prices
MRSadam + MRSeve = MRT
competitive markets do not produce efficient
outcome
people can consume without pay (free rider problem)

Private good
same price, different quantities
MRSadam = MRSeve = MRT
competitive markets ensure efficiency
individuals have no incentive to lie about their
preferences

Free rider problem: the incentive to let other people pay for a public good while you enjoy the benefits
solution: governments provides public goods people pay through taxation
however: government has failures too market failure should be weighed against government
failure
perfect price discrimination: when a producer charges each person the maximum he or she is willing to
pay for the good
horizontal summation: the process of creating a market demand curve by summing the quantities
demanded by each individual at every price (private good)

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vertical summation: the process of creating an aggregate demand curve for a public good by adding the
prices each individual is willing to pay for a given quantity of a good (public good)
privatization: the process of turning services that are supplied by the government over to the private
sector for provision and/or production
commodity egalitarianism: the idea that some commodities ought to be made available to everybody
(education)

Chapter 5 Externalities

An externality is the consequence of the absence of property rights

example:
- Barts factory dumps waste into a river nobody owns
- Lisa makes her living by fishing from the river
~ Barts activities make Lisa worse off in a direct way that is not the result of price changes
not through market mechanism externality
~ Bart pays zero for using the water the costs are not zero
~ If Lisa owns the river, she can make Bart pay to pollute Bart will pollute less in order to save
money
~ If Bart owns the river, he can charge Lisa for fishing Bart will pollute less, Lisa will pay more

If someone owns the river

market mechanism

externality is internalized

Two sets of options to reach efficient output:


- private responses
- market system
- possible because all parties may gain from change
- public responses
- government action
Coase theorem: no matter who is assigned the property rights, an efficient solution will be achieved if:
1) bargaining costs are low
2) the owner can identify all users (polluters, fishers)

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Private responses
1) assign property rights
2) mergers

3) social conventions

characteristics
bargaining; it does not matter
who is owner for efficiency
internalize the externality; one
business; all costs will be taken
into account
impose social cost

Private response does not always work

N.B.
it does matter who is owner for
income distribution
not always feasible (many
different parties; hard to
manage different activities)
hard to create (e.g. media
campaigns against smoking)

government can intervene; public response

Public response 1):


Pigouvian tax: polluter pays external cost through a tax on output
price now reflects damage; costs taken fully into account
Pigouvian subsidy: subsidy for output not produced; similar to tax case in reverse

efficient output

Both Pigouvian tax and subsidy lead to the same efficient production level,
but with different distributional consequences (fairness):
Tax: polluter pays
Subsidy: polluter is paid
both cases: MPC polluter is increased to include damage
difficulties Pigouvian tax:
- costly to find out who pollutes and how much
- marginal damage is unclear (= tax rate)
- no incentive to use cleaner technology
> because tax is on output, not on pollution
However: an imperfect Pigouvian tax is often better than none at all
Public response 2):
Create a market: emission fees or cap-and-trade
- creates incentive to innovate
- firms that can reduce pollution cheaply will reduce it cost-effective; Pigouvian tax not cost-effective
- but: measuring pollution may be costly; more than measuring output

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Emission fees
kind of Pigouvian tax, now on unit of pollution, not
output
firms that can reduce pollution cheaply will reduce
it cost effective
pollution is reduced as long as fee >MC
set fee at MC at efficient output level
stimulates innovation; produce cleaner

cap-and-trade
government issues permits to pollute (no more
than socially efficient output) and allows polluters
to trade the permits
permissions to pollute go to the firms with the
highest bids cost effective
pollution can be easily reduced by limiting number
of permits
government can sell permits, or give away:
- no difference for efficiency
- difference for income distribution

must be adjusted regularly for same pollution


reduction
if marginal cost of pollution reduction increase:
same costs; less pollution reduction

no adjustment needed

If marginal cost is uncertain:


elastic marginal social benefits; emission fees
better

If marginal cost is uncertain:


inelastic marginal social benefits; cap-and-trade
better

if marginal cost of pollution reduction increase:


same pollution reduction; higher costs

NB: for both emission fees and cap-and trade: measuring pollution may be costly;
more than measuring output
congestion pricing: a tax levied on driving equal to the marginal congestion costs imposed on other
drivers (e.g.: a fee for driving in the city during peak hours)
safety valve price: within a cap-and-trade system, a price set by government at which polluters can
purchase additional permits beyond the cap
Public response 3):
Regulation; command and control
incentive-based regulations: policies that provide polluters with financial incentives to reduce pollution
- useful when pollution cannot be measured
- two options:
Option

problems

1) set technology standard


all firms must use a certain
technology to reduce pollution
e.g.: ban on nuclear power
- no incentive to innovate
- not cost effective

2) performance standard
all firms must cut back by equal
amounts
> incentive to innovate
- some firms can reduce
emissions cheaper than others
- not cost effective

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hot spots: localized concentrations of emissions

Chapter 6 Political economy


Lindahl prices: the tax share an individual must pay per unit of public good
Types of democracy:
Direct democracy: people vote themselves on all kinds of issues
- time consuming
- still done in some regions of Switzerland
ii) Representative democracy: people choose representatives to vote for them
- parliament, municipal council
- vote only once every four of five years

i)

i)

Direct democracy

Different voting rules:


1) Unanimity: everyone must agree
2) Majority rule
- 50% or more voters must agree
- sometimes qualified majority (e.g. 75% of the vote)
Arrows voting paradox: there is not necessarily a stable outcome ( = same result in another vote)
reason multi-peaked preferences
Preferences are single-peaked if utility falls consistently if outcome is further removed from preferred
outcome
otherwise: multi-peaked

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Agenda manipulation: organize voting in order to manipulate outcome


- make sure the option that can beat your preferred outcome is defeated in earlier vote
- wait with your proposal until strong alternatives have been defeated
cycling: when paired majority voting on more than two possibilities goes on indefinitely without a
conclusion ever being reached
Median voter theorem: choose outcome of voter whose preferences lie in the middle

The median voter has the decisive vote, if:


- preferences are single-peaked
- no strategic voting
Strategic voting: logrolling or vote trading
Logrolling: you support someone elses proposal; in return for their support for your proposal
Advantages
reveals intensity of preferences

Disadvantage
may lead to wasteful public expenditures (e.g.
projects with negative NPV may pass)

compromises help the democratic system to


function

In short: when all preferences are single peaked, majority voting yield a stable result, and the choice
selected reflects the preferences of the median voter. however, when some voters preferences are
multipeaked, a voting paradox can emerge.
Criteria for voting system:
- must produce decisions
- must be able to rank all outcomes
- must be responsive to individuals preferences
- must be consistent
- must be independent of irrelevant alternatives
- dictatorship is ruled out
in short: voting should be fair and not produce paradoxical result

ii)

Representative democracy

Three parties involved:


- voters elect politicians
- politicians decisions are carried out by civil servants (bureaucrats)

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Median voter theorem applies here as well


- in theory, voting outcomes are the same as with direct democracy
- candidates have incentive to move towards political middle

Bureaucrats can make all-or nothing proposal


- high output or none at all
- because of informational advantage
Rent seeking: interest groups can manipulate the political system to redistribute income towards them
cartel: an arrangement under which suppliers and together to restrict output and raise price

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Chapter 8 Cost-benefit analysis


Hicks-Kaldor criterion: potential Pareto improvement if

total benefit > total cost

Three measures used to compare different projects:


1) net present value
2) internal rate of return
3) benefit/cost ratio

1) Net present value


- a project is admissible only if NPV > 0
- when two projects are mutually exclusive, choose the one with highest NPV

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2) Internal rate of return ( = discount rate that would make NPV zero)
- project admissible if > r
(r = actual discount rate)
- cannot be used to choose between projects; if projects differ in size, can be misleading
3) Benefit-cost ratio

However, B/C is useless as a basis for comparing projects


there is no fundamental difference between benefit and cost
- cost can be classified as lower benefit instead, and vice versa
- by manipulating definitions of costs or benefits, any project can be given a high B/C
r plays a key role

reflects opportunity cost

social rate of discount: the rate at which society is willing to trade off present consumption for future
consumption
in the private sector, the tax money could have been used for:
i) investment
ii) consumption
Private sector discount rate may not be appropriate:
- benefit for future generations not taken into account
- people underestimate future benefits
- projects may generate positive externalities
Valuing public benefits and costs
1. Use market prices unless market imperfections are too big
- reflect marginal social costs of production (MRT)
- reflect marginal value to consumers (MRS)
2. Shadow prices: market price adjusted for market imperfections
- often, market price does not equal marginal social costs, if difference is big; use shadow price
- equals opportunity cost; shows what the benefit would have been otherwise
3. Use consumer surplus (if market is so big market prices are affected)
- consumer surplus increase = project benefit
4. Non traded goods
- calculate how valuable the intangibles must be in order to make project admissible
- or; different ways for attaining intangible benefits may be compared

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Pitfalls of cost-benefit analysis:


i) chain-reaction game
- include all kinds of secondary benefits until NPV > 0
- often, these are not benefits, but transfers
ii) double-counting game
- count benefits twice
iii) labor game
- count jobs created by project as benefit instead of cost
iv) use B/C ratio of internal rate of return
certainty equivalent: the value of an uncertain project measured in terms of how much certain income
an individual would be willing to give up for the set of uncertain outcomes generated by the project

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Chapter 12 Income redistribution

Hard to tell how big differences in income are:


- income data are based on annual income measures, but income may fluctuate
> students earn little now but a lot later in life
- people may choose to work part-time
> low income doesnt necessarily mean low hourly wage
- compare income of individuals of households?
- income before or after
> tax, subsidies, transfers
poverty line: a fixed level of real income considered enough to provide a minimally adequate standard
of living
Additive social welfare function: an equation defining social welfare as the sum of individuals utilities
W = U1 + U2 + ... + Un If:
1 Individuals have identical utility functions
2 that depend only on their incomes
3 Marginal utility of income diminishes
4 Total income is fixed
Then

the optimal solution is: redistribute until complete equality

However: assumptions are not valid:


- utility does not only depend on income
- total amount of income is not fixed
Maximin criterion: social welfare depends on the utility of the individual who has the minimum utility in
the society redistribute income to maximize Upoor
Can redistribution be Pareto efficient?
The rich can benefit too:
- Altruism: other peoples income may enter your welfare function
> externality problem
> people will help the poor, provided others do the same
> fair income distribution as public good
- Income redistribution as an insurance against future poverty
- If people are very poor, they will be coming for your money anyway fair distribution bus social
peace

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Research shows not absolute but relative income matters


- not income levels but income changes determine happiness
> Preference drift: discover new desires
> Reference drift: compare yourself with the rich
In kind-transfers: give the poor goods or services instead of money
- public housing
- free education
- medical care
may be inefficient:
> a good is at best valued as much as it costs
> often, it is valued less
> also, administrative costs reduce efficiency

Reasons for in-kind transfers


paternalism

some services must be equally accessible to


everyone
less fraud than money transfer
political attractiveness, lobbying
Redistribution makes working less attractive

explanation
- politicians think they know better what people
need
- cash may be spent on alcohol/drugs etcetera
- housing, education
- commodity egalitarianism
- less attractive only the needy apply
- especially from producers, e.g. school milk
more distribution

less income to redistribute

expenditure incidence: the impact of government expenditures on the distribution of real income

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Chapter 14 Taxation and income distribution


Taxation has 3 effects:
- transfer of money from taxpayer to government
- inefficient allocation of resources
> because tax changes relative prices
> loss to taxpayer, gain to no-one
- transaction costs
> cost of tax administration
> compliance cost to taxpayer
Statutory incidence: who is legally responsible for paying the tax
Economic incidence: who bears the burden
Tax shifting: the difference between statutory incidence and economic incidence
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 (e.g.: landlords, capitalists)
size distribution of income: the way that total income is distributed across income classes
lump sum tax: a tax whose value is independent of the individuals behavior
tax wedge: the tax-induced difference between the price paid by consumers and the price received by
producers
different types of analysis:
- balanced-budget incidence: combined effects of taxation and spending financed by those taxes
- differential tax incidence: who bears the burden if we use this tax instead of that
Progressive tax: the rich pay more
- different definitions
> Average tax rate increases with income
> Marginal tax rate increases with income

rich pay more tax as % of their income


rich also pay more tax on last euro earned

Partial Equilibrium model:


- one market

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- effects on other market are negligible


- use if market is small compared to rest of economy
unit tax: fixed amount (e.g. 5) per unit of a commodity
ad valorem tax: percentage (e.g. 17%) of commodity price
When something is taxed

Priceconsumers > Priceproducers

Tax on profits
Economic profit: return in excess of opportunity costs of factors of production used
- under competition: economic profit exists only in short run
- competition reduces economic profit to zero
Profit maximization: MR = MC
- neither MC nor MR are affected by profit tax

Partial Equilibrium model


one market, effects on other markets are
negligible
use if market is small compared to rest of
economy
incidence is independent statutory incidence;
moving S or D gives same result
incidence depends on supply and demand
elasticities;
- supply perfectly elastic: consumers bear entire
burden
- demand perfectly elastic: producers bear entire
burden

output and price remain the same


profit tax is fully born by the firms owners
General Equilibrium model
2 sectors (M, F), takes into account how various
markets are interrelated
use if market is large

9 possible ad valorem taxes:


- capital tax for either M of F
- labor tax for either M or F
- consumption tax on either good M or F
- tax on either labor or capital
- general income tax
(Tax on F & M = tax on income = tax on
consumption)
NB: nothing about the incidence of a tax can be known without information on the relevant behavioral
elasticities
capitalization: the process by which a stream of tax liabilities becomes incorporated into the price of an
asset

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Harberger model: method for analyzing tax incidence


- perfect competition, profit maximization
- constant returns to scale
- one sector capital intensive, another labor intensive
- mobile production factors, total supply fixed
- no savings
- differential tax incidence
Example commodity tax on Food
Relative PF goes up, PM goes down QF goes down more manufactures produced If food is more
capital-intensive than manufactures more capital than labor will be moved to the manufacturing
sector demand capital falls price capital falls capital owners are hurt by tax on food
Tax on the output of a sector lowers the relative price of the input used intensively in that sector

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Chapter 15 Taxation and efficiency


excess burden: a loss of welfare above and beyond taxes collected. also called welfare cost or
deadweight loss
equivalent variation: a change in income that has the same effect on utility as a change in the price of a
commodity
tax interaction effect: the increase in excess burden in the labor market stemming from the reduction in
real wages caused by Pigouvian tax
double-dividend effect: using the proceeds from a Pigouvian tax to reduce inefficient tax rates
Efficiency condition:
- MRS = MRT
- willingness to pay = marginal production cost; price consumer = price producer
Taxation: Priceconsumer > Priceproducer
- MRS =\= MRT
- prices no longer reflect relative scarcities
- economic behavior affected
- result: inefficiency
Exception: lump sum taxes you pay the same amount no matter what you do
Lump sum taxes dont change relative prices no excess burden
- however: often not considered fair; everyone same amount

Tax lowers income and changes prices


- intended effect lower income is inevitable with taxation
- unintended effect price change creates excess burden
Utility loss taxpayer = tax {known} + excess burden {unknown}
Lump sum tax excess burden = 0 utility loss equals tax

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measuring excess burdens: use compensated demand curve


- ordinary demand curve reflects income effect & substitution effect
- compensated demand curve removed income effect only compensated response affects MRS
> consumer remains on same indifference curve
> only substitution effect (effect from product A being more expensive relative to other products)
- excess burden depends on movement along compensated demand curve
Tax on commodity X

lower demand for 2 reasons:

income effect
because of tax, income is lower
every commodity, also less of X

less is bought of

substitution effect
because of tax, price X is higher less of X is
bought, X is substituted by other goods

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Upward sloping supply curve excess burden also depends on the elasticity of supply:
=

- is compensated price elasticity of supply


NB:
- if compensated elasticities zero no excess burden
> no reaction to price change
> behavior not affected by tax
- if market distortions exist new tax can lower the overall excess burden
> e.g. if consumption is too high as a result of negative externalities, a tax can improve welfare

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Chapter 16 Efficient & equitable taxation

criteria for evaluating tax system


system:
(1) optimal taxation theory
> efficiency (low excess burden)
> equity (fairr distribution)
(2) political feasibility
(3) horizontal equity
uity (equals treated equally)
(4) operating costs of taxation
(5) tax evasion
(1)
Excess burden minimized if:
- marginal excess burden of the last euro of revenue raised from each commodity is th
the same, or;
- raising tax rate on commodity with lowest marginal excess burden
& lowering rate on commodity with highest marginal excess burden

= Ramsey rule: set tax rates so that the percentage reduction in demand is the same for
each commodity

If X and Y are unrelated commodities:


commodities
- If price of X or Y changes, it affects only its own demand, not the demand for the other good
no subsStutes or complements
Then, inverse elasticity rule applies:
A tax system should have vertical equity: distributing tax burdens fairly across people with different
abilities to pay
If elasticity is high, tax causes a big EB low t tax commodities with low elasticity most
most.
However: essential drugs have low elasticity of demand; sick
sick people have no choice; unfair to tax heavily

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(2)
Efficient taxation: tax goods which are complementary to leisure
natural monopoly: a situation in which factors inherent to the production process lead to a single firm
supplying the entire industrys output
If average costs decrease with output, economies of scale may lead to a natural monopoly
- no competitive market government may provide what price should the government charge?

Option 1) Marginal cost


pricing
P = MC

Option 2) Marginal cost pricing with


lump sum tax to cover loss
lump sum tax usually not fair

Option 3) Marginal cost pricing


with distortive tax to cover loss
excess burden tax may exceed
efficiency gain in market for Z

P* < AC

violation of benefits received


principle (= consumers of a publicly
provided service should be the ones
who pay for it)

violation of benefits received


principle

loss

Option 4) Average
cost pricing
P = AC
No profit, no loss
used often
Not efficient:
quantity < quantity
marginal cost pricing

Edgeworths model
- identical downward-sloping utility functions depending only on income
- total income is fixed
- after-tax income should be the same for everyone
- marginal tax rate on high-income people 100%
NB: assumptions are problematic (e.g. income is not fixed, utility depends on more than income)

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Politics time inconsistency problem


- tax policy is impossible if it conflicts with a governments long-term incentives
> e.g. a one-time tax has no effect on behavior
> If it really is a one-time tax; but government has incentive to repeat
> if tax-payers know this effect on behavior welfare loss
- Important: political credibility
(3)
Horizontal equity what is equal position?
- higher income =\= higher wage (e.g. more working hours; part-time workers get less tax, more leisure)
- higher wage may result of more schooling (e.g. tax may discourage education)
transitional equity: fairness in changing tax regimes
(4)
low operating costs
- administrative costs: incurred by tax authority
- compliance costs: incurred by tax payers
Empirical research: compliance costs relatively
high for small firms
- competitive advantage for large firms
- firms will grow inefficiently large

Tax avoidance
altering behavior in such a way as to reduce your
tax liability
legal
e.g. take your bike, not your car, escape fuel tax

Tax evasion
not paying taxes legally due
illegal
e.g. hide your savings in Switzerland
possible because monitoring everyone all the time
is impossible
depends on marginal costs and marginal benefits
of cheating

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Chapter 18 Personal taxation and behavior


A tax on labor lowers the relative price of leisure
- substitution effect more leisure is consumed
For any number of hours worked, a tax lowers income
- income effect less leisure will be consumed
> net effect is ambiguous, depends on which effect is stronger
human capital: the investment that individuals make in education, training, and health care that raise
their productive capacity
primary earners
usually males
effect of net wage changes on hours of work very
small
elasticity about 0.05
income effect substitution effect

secondary earners
usually females
effect is considerable
elasticity about 0.4
substitution effect > income effect
income tax discourages female labor supply; more
women work part-time

Laffer curve: a graph of the tax rate-tax revenue relationship


Relative price of consumption now: reflected in net interest rate, depends on:
- real interest rate
- tax on interest income
- extent to which interest costs are tax-deductible
life-cycle model: the theory that individuals consumption and savings decisions during a given year are
based on a planning process that considers lifetime circumstances

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Taxation reduces saving if:


- substitution effect > income effect
Taxation increases saving if:
- income effect > substitution effect
iii) taxation and risk taking
Tax reduces net return of risky asset less risk taking;
tax reduces risk (loss is tax deductible) more risk taking
theory: effect is ambiguous

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iv) taxation and housing


- Haig-Simons definition:
> income = net increase in power to consume
> income = consumption + saving
- all income should be taxed
- expenses incurred to earn income should be subtracted from taxable income
- income = rental value interest + value
The effects of taxation on labor supply, saving and risk taking are ambiguous;
- income effect versus substitution effect
Empirical evidence exists, but open to debate
- taxing income probably reduces labor supply, especially among secondary earners
Dutch income tax results in excessive mortgage-financed home ownership

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Chapter 20 Deficit finance


Fiscal deficit: government expenditures minus revenues
- flow variable
Government debt: the total amount owed at a given point in time = sum of all past deficits
- stock variable
surplus: the excess of revenues over spending during a period of time
internal debt: the amount that a government owes to its own citizens
external debt: the amount a government owes to foreigners
Rules of the European Monetary Union:
- deficit 3% GDP
- debt 60% GDP
- medium term objective 0.5% GDP (for NL)
Domar: debt sustainable if debt ratio is constant
- debt ratio: debt as % of GDP
Lerners view if debt is held by own citizens
It creates no burden for future generation as a
whole
Future generation has debt, but also bonds
cancels out

Lerners view if debt is held by foreigners, it


depends:
If loan is used for consumption: consumption of
future generation is reduced
If loan is used for investment, there is only a
burden on future generation if:
marginal rate of return on public investment <
marginal costs of funds

We owe it to ourselves
But: one group of citizens pays the other
effect on income distribution
NB: problems with Lerners view:
- ignores that people die
- you may not be around when debt is repaid
- people born later may not have profited from debt spending
- generation means here: everyone alive at a given time generation means everyone born in the
same period
generational accounting: method for measuring the consequences of government fiscal policy that
takes into account the present value of all taxes and benefits received by members of each generation
crowding out: government borrowing interest rate increases private investment decreases

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Who bears the Overlapping generations model


burden
characteristics - three generations
young, middle aged, old
- every generation is 20 years
long
-government borrows money
from young and middle-aged to
finance consumption
- financed through tax
- no interest, no inflation
burden
limitations

in case of
investment

the old of now benefit, young of


future bear the burden
assumes government debt policy
does not affect economic
decision
If NPV>0 no group is burdened

Neoclassical model

Ricardian model

- government borrowing
may increase interest rate
- crowding out: interest up
private investment down
- private capital stock lower
because of government
borrowing

- people are completely rational &


have full information
- government debt must be repaid
people save more in anticipation
borrowing has same effect on
consumption as taxation

future generations have


lower incomes

people with lower private


consumption
- no perfect information
- no rational behavior

tax financing>pay tax>lower private


consumption
debt financing>saving>lower private
consumption

burden depends on rate of


return

debt creation:
- may cause some crowding out
- result: lower private capital stock
- if money is used for consumption, future generations are worse off
- if money is used for government investment, trade off against benefit of private investment
debt existence:
- results in higher taxes to pay interest
- trade off excess burden against benefit of government spending
- also: redistribution
> from taxpayer to bondholder
> between generations
When unemployment is high run a deficit
- increase government spending, or lower taxes
- higher demand less unemployment
When unemployment is low reduce deficit
- deficit finance may now create inflation
- cut back government spending, or increase taxation

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Chapter 22 Public Finance in a Federal System


federal system: consist of different levels of government that provide public goods and services and
have some scope for making decisions
club: a voluntary association of people who bang together to finance and share some kind of benefit
personal net worth tax: a tax based on the difference between the market value of all the taxpayers
assets and liabilities
formation of communities/jurisdictions
1) aim
2) optimal size
3) optimal public good provision
1) aim of a community:
- provide local public goods to maximize citizens welfare
- often impure public goods or even private goods (roads, schools)
2) optimal community size
- more people lower cost per citizen / more congestion (impure public goods)
- increase community size until
> marginal cost saving per citizen = marginal increase of congestion costs per citizen
3) optimal public good provision
- more public goods more utility per citizen / higher costs per citizen
Tiebout model
- public good: optimal level of provision unknown
- Tiebout: market-like solution to public good problem makes people reveal their preferences
- many different communities; each offering its own package of public goods and taxes
> High service & high taxes
> or low service & low taxes, or .. etc.
no free riding possible equilibrium is Pareto efficient; central government intervention not needed
assumptions Tiebout model:
- no spillovers
- perfect mobility
- perfect information
- enough communities
- constant returns to scale
do not hold, but: theoretical solution for public good problem

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Three tasks of government:


1) income redistribution
2) macroeconomic stabilization
3) allocation of goods and services
1) income redistribution
central governments task
- otherwise, rich people will leave
communities that redistribute more
than others
- effect: not redistribution, but
migration
local government can run some
modest anti-poverty programs

2) macroeconomic stabilization
central governments task
- dampen the business cycle
- manage employment, inflation

3) allocation of goods and services


subnational governments task
- those that the market does not
provide sufficiently (public goods)

subnational governments dont


have the instruments

exception: national public goods


like defense task for central
government

5 reasons for decentralization


1) tailoring services to local tastes
2) efficiency of production
3) let governments compete (Yardstick competition)
4) more innovation and experimentation
5) empowerment
1) tailoring services to local tastes
- Oates theorem: preferences differ across regions
- same policies/services everywhere welfare not maximized
but: spillovers; welfare of non-residents is affected
- more decentralization is optimal if
> preferences vary a lot between communities
> preferences are relatively uniform within communities
2) efficiency of production
- local government is closer to the people
> knowledge of problems and possible solutions
but: economies of scale in some services
separate provision and production;
local government decides about service levels; private firms produce

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3) let governments compete (Yardstick competition)


- democracy: voter decides if government is reelected or not
- many local governments
- compare performance in same period
> crisis affects all
> if better services/lower taxes elsewhere your local government may not perform well
> vote for different party next time
> if performance can be compared, politicians try harder
4) more innovation and experimentation
- local governments: policy laboratories
- try something new locally; if it fails only local disaster
if it works other localities can copy
5) empowerment
- people have more influence on local government than on central government
- influence increases happiness
Financing decentralized governments
- optimal allocation:
> marginal benefit of service = marginal cost
- decision should be made by the same people who benefit and who pay
- local governments financed by local taxes
but: scope for local taxation limited
- tax competition
- local income redistribution difficult
grants from central to local governments
flypaper effect: a dollar received by the community in the form of a grant to its government results in
greater public spending than a dollar increase in community income

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intergovernmental grants because:


- taxation is mostly at central level
- addressing spillovers
- paternalism
- fiscal equalization
types of intergovernmental grants:
- conditional grants cannot be spent freely; for schools, welfare
nonmatching grant: amount independent of own spending
matching grant: percentage of own spending
- unconditional grants decentralized government is free to spend
equalizing grant: grant is higher if spending need is high/tax capacity is low
the corporation tax in many countries causes inefficiently high corporate debt levels because:
Usually, interest is deductible from taxable profit, but dividends are not. This makes debt financing
cheaper than it would be without taxation, and equity more expensive. As a result, corporations
borrow more than they would without corporation tax.

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