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Summary: Public Finance, Chapter 1-16

Public Finance (Rijksuniversiteit Groningen)

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Summary Public Finance (Harvey S. Rosen and Ted Gayer)

Chapter 1

Public finance refers to the taxing and spending activities of a government.

A sensible approach to measure the size of government is by the volume of its annual expenditures,
of which there are basically three types:

1. Purchases of goods and services

2. Transfers of income to people, businesses, or other governments
3. Interest payments

The federal government itemizes its expenditures in a document referred to as the unified budget.

A regulatory budget is an annual statement of the costs imposed on the economy by government
regulations.

Entitlement programs are programs whose cost is determined not by fixed dollar amounts but by the
number of people who qualify.

Chapter 2

The substitution effect is the tendency of an individual to consume more of one good and less of
another because of a decrease in the price of the former relative to the latter.

A normal good is a good for which demand increases as income increases and demand decreases as
income decreases, other things being the same.

The income effect is the effect of a price change on the quantity demanded due exclusively to the
fact that the consumer's income has changed.

In order for us to infer that government action X causes societal effect Y, three conditions must hold:

1. The cause X must precede the effect Y.

2. The cause and effect must be correlated.
3. Other explanations for any observed correlation must be eliminated.

Correlation is a measure of the extent to which two events move together.

A biased estimate is one that conflates the true causal impact with the impact of outside factors.

The counterfactual is the outcome for people in the treatment group had they not been treated.

In an experimental (or randomized) study, subjects are randomly assigned to either the treatment
group or the control group.

Observational studies use data obtained by observing and measuring actual behavior outside of an
experimental setting.

Econometrics uses various statistical techniques in order to estimate causal relationships in economic
data.

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Variables that are thought to be causal are referred to as independent variables and variables that is
thought to be an outcome are referred to as the dependent variables.

Regression analysis fits a regression line through the observed data points.

The standard error indicates the reliability of the estimated coefficients.

Data that contain information on individual entities at a given point in time are known as cross-
sectional data.

Time-series data include information on a single entity at different points in time.

Panel data (also called longitudinal data) combine the features of cross-sectional data and time-
series data. A panel data set contains information on individual entities at different points in time.

A quasi-experimental (also known as natural experiment) study is an observational study that relies
on circumstances outside of the researcher's control to mimic random assignment.

Difference-in-difference analysis compares the difference in a treatment group's outcome after

receiving the treatment to the difference in the outcome of the control group over the same period.

Instrumental variables analysis is an analysis that relies on finding some variable that affects entry
into the treatment group, but in itself is not correlated with the outcome variable.

Regression-discontinuity analysis is an analysis that relies on a strict cut-off criterion for eligibility of
the intervention under study in order to approximate an experimental design.

Chapter 3

Welfare economics is the branch of economic theory concerned with the social desirability of
alternative economic states.

The Edgeworth Box is a device used to depict the distribution of goods in a two good-two person
world.

Pareto efficient is an allocation of resources such that no person can be made better off without
making another person worse off.

A Pareto improvement is a reallocation of resources that makes at least one person better off
without making anyone else worse off.

The contract curve is the locus of all Pareto efficient points.

The absolute value of the slope of the indifference curve is called the marginal rate of substitution
(MRS) and indicates the rate at which the individual is willing to trade one good for an additional
amount of another. Pareto efficiency requires that marginal rates of substitution be equal for all
consumers.

The production possibilities curve shows the maximum quantity of one output that can be produced,
given the amount of the other output.

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The marginal rate of transformation is 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.

MRT = MC y-as / MC x-as

Under the assumptions:

1. All producers and consumers are perfect competitors

2. A market exists for each and every commodity.

The so-called First Fundamental Theorem of Welfare Economics states that a Pareto efficient
allocation of resources emerges.

MRS = P y-as / P x-as

MC y-as / MC x-as = P y-as / P x-as

MRT = P y-as / P x-as

The utility possibilities curve is a graph showing the maximum amount of one person's utility given
each level of utility attained by the other person. All points on this curve are Pareto efficient, all
points within the curve are not.

Social welfare function is a function reflecting society's views on how the utilities of its members
affect the well-being of society as a whole. Algebraically, social welfare (W) is some function F() of
each individual's utility.

Even if the economy generates a Pareto efficient allocation of resources, government intervention
may be necessary to achieve a ''fair'' distribution of utility.

According to the Second Fundamental Theorem of Welfare Economics, society can attain any Pareto
efficient allocation of resources by making a suitable assignment of initial endowments and then
letting people freely trade with each other, as in our Edgeworth Box model.

An economy may be inefficient for two general reasons, market power and nonexistence of markets.

Asymmetric information is a situation in which one party engaged in an economic transaction has
better information about the good or service traded than the other party.

An externality is a situation that occurs when the activity of one entity directly affects the welfare of
another in a way that is outside the market mechanism.

A public good is a good that is nonrival and nonexcludable in consumption.

A commodity that ought to be provided even if people do not demand it.

Chapter 4

A pure public good is defined as a commodity that is nonrival and nonexcludable in consumption.

A private good is a commodity that is rival and excludable in consumption.

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An impure public good is a good that is rival and/or excludable to some extent.

Publicly provided private goods are rival and excludable commodities that are provided by
governments.

To find the market demand at any given price, sum the horizontal distance between each of the
private demand curves and the vertical axis at that price. This process is called horizontal summation.

Efficiency requires that provision of a public good be expanded until the point at which the sum of
each person's marginal benefit for the last unit just equals the marginal cost.

Vertical summation is 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 the good.

The equilibrium of a public good is characterized by the condition MRS ab 1 + MRS ab 2 = MRT ab .

A free rider has the incentive to let other people pay for a public good while you enjoy the benefits.

Perfect price discrimination occurs when a producer charges each person the maximum he or she is
willing to pay for a good.

Privatization is the process of turning services that are supplied by the government over to the
private sector for provision and/or production.

Commodity egalitarianism is the idea that some commodities ought to be made available to
everybody.

Chapter 8

Cost-benefit analysis is a set of procedures based on welfare economics for guiding public
expenditure decisions.

The present value is the value today of a given amount of money to be paid or received in the future.

The discount rate is the rate of interest used to compute present value.

The discount factor is the number by which an amount of future income must be divided to compute
its present value. If the interest rate is r and the income is receivable T periods in the future, the
discount factor is (1+r)T.

Nominal amounts are amount of money that are valued according to the price levels that exist in the
years that the amounts are received.

Real amounts are amounts of money adjusted for changes in the general price level.

When inflation is anticipated, both the stream of returns and the discount rate increase. When
expressed in nominal terms, the present value of the income stream is thus:

PV = R 0 + ((1+π)R 1 )/((1+π)(1+r)) + ( (1+π)2R 2 )/((1+π)2(1+r)2) + ....

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If real values are used for the Rs, the discount rate must also be measured in real terms, the market
rate of interest minus the expected inflation rate. Alternatively, if we discount by the market rate of
interest, returns should be measured in nominal terms.

The present value criteria for project evaluation are that:

• A project is admissible only if its present value is positive

• When two projects are mutually exclusive, the preferred project is the one with the higher
present value

The internal rate of return is the discount rate that would make a project's net present value zero.

The benefit-cost ratio is defined as B/C and is the ratio of the present value of a stream of benefits to
the present value of a stream of costs for a project.

The social rate of discount is the rate at which society is willing to trade off present consumption for
future consumption.

Sensitivity analysis is the process of conducting a cost-benefit analysis under a set of alternative
reasonable assumptions and seeing whether the substantive results change.

The shadow price is the underlying social marginal cost of a good.

Consumer surplus is the amount by which consumers' willingness to pay for a commodity exceeds
the sum they actually have to pay.

Cost-effectiveness analysis is comparing the costs of the various alternatives tat attain similar
benefits to determine which one is the cheapest.

The Hicks-Kaldor criterion states that a project should be undertaken if it has a positive net present
value, regardless of the distributional consequences

Certainty equivalent is 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.

Chapter 5

An externality is 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.

MSC = MPC + MD in words: Marginal society cost = marginal private cost + marginal
damage

The marginal damage schedule shows the dollar value of the external costs imposed by each
additional unit of output.

Two important assumptions play a key role with bargaining:

1. The costs to the parties of bargaining are low

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2. The owners of resources can identify the source of damages to their property and legally
prevent damages

Coase Theorem: Provided that transaction costs are negligible, an efficient solution to an externality
problem is achieved as long as someone is assigned property rights, independent of who is assigned
those rights.

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.

An emissions fee is a tax levied on each unit of pollution.

The total cost of emissions reduction is minimized only when the marginal costs are equal across all
polluters. An outcome is called cost effective if it is achieved at the lowest cost possible.

Congestion pricing is a tax levied to the marginal congestion costs imposed on other drivers.

Cap-and-trade is a policy of granting permits to pollute. The number of permits is set at the desired
pollution level, and polluters may trade the permits.

An emissions fee limits the cost of reducing pollution but leads to changes in emissions as economic
circumstances change, whereas a cap-and-trade system limits the amount of emissions but leads to
changes in the cost of reducing pollution as the economy changes. Neither system automatically
leads to an efficient outcome when the costs of reducing pollution change.

Safety valve price: Within a cap-and-trade system, a price set by government at which polluters can
purchase additional permits beyond the cap.

We conclude that a cap-and-trade system is preferable to an emissions fee when marginal social
benefits are inelastic and costs are uncertain.

We conclude that if marginal costs are uncertain, an emissions fee is preferable to a cap-and-trade
system when marginal social benefits are elastic.

Incentive-based regulations are policies that provide polluters with financial incentives to reduce
pollution.

Command-and-control regulations are policies that require a given amount of pollution reduction
with limited or no flexibility with respect to how it may be achieved.

A technology standard is a type of command-and-control regulation that requires firms to use a

particular technology to reduce their pollution.

Performance standard is a command-and-control regulation that sets an emissions goal for each
individual polluter and allows some flexibility in meeting the goal.

Hot spots are areas with relatively high concentration of emissions.

When an individual or firm produces positive externalities, the market underprovides the activity or
good, but an appropriate subsidy can remedy the situation.

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Chapter 7

Human capital is the investments that individuals make in their education, training, and health care
that raise their productive capacity.

Crowd out is when public provision of a good substitutes for private provision of the good.

Charter schools are public schools that operate under special state government charters. Within
limits established by their charters, these schools can experiment with a variety of approaches to
education and have some independence in making spending and hiring decisions.

A school voucher is a voucher given to a family to help pay for tuition at any qualified school. The
school redeems the voucher for cash.

School accountability is a system of monitoring the performance of schools through standardized

tests and either issuing ''report cards'' on the schools' test performances or linking financial
incentives to the test outcomes.

Chapter 16 micro book

Private benefit and cost of activity x is the maximum monetary amount a person would be willing to
pay to do activity x and the cost to that person of doing activity x.

Social benefit and cost of activity x is the combined monetary amount people would be willing to pay
for activity x and the combined cost of activity x.

Negative and positive externality if an activity imposes costs on others or creates benefits for others
that are not captured in private costs and benefits.

The Coase Theorem: When the parties affected by externalities can negotiate costlessly with one
another, an efficient outcome results no matter how the law assigns responsibility for damages.

Efficient laws and social institutions are the ones that place the burden of adjustment to externalities
on those who can accomplish it at least cost.

If negotiation is costless, taxing will always lead to an efficient outcome. But so will not taxing If
negotiation is impractical, taxing pollution will still lead to an efficient outcome if the polluter has the
least costly way of reducing pollution damage. Only if negotiation is impractical and the victim has
the least costly means of avoiding damage will taxing pollution lead to an inefficient outcome.

Chapter 9

Social insurance programs are government programs that provide insurance to protect against
adverse events.

Insurance premium is the money paid to an insurance company in exchange for compensation if a
specified adverse event occurs.

Expected value is the average value over all possible uncertain outcomes, with each outcome
weighted by its probability of occurring.

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Actuarially fair insurance premium is an insurance premium for a given time period set equal to the
expected payout for the same time period. It charges just enough to cover the expected
compensation for the expenses.

Expected utility is the average utility over all possible uncertain outcomes, calculated by weighting
the utility for each outcome by its probability of occurring.

Risk smoothing is taking action to obtain a certain level of consumption should an adverse event
occur.

The demand for insurance depends on the curvature of the utility function, also known as the level of
risk aversion. Risk aversion is a preference for paying more than the actuarially fair premium in order
to guarantee compensation if an adverse event occurs.

Risk premium is the amount above the actuarially fair premium that a risk-averse person is willing to
pay to guarantee compensation if an adverse event occurs.

Loading fee is the difference between the premium an insurance company charges and the
actuarially fair premium level. One simple way to measure the loading fee is the ratio of market
insurance premiums divided by benefits paid out.

Asymmetric information is a situation in which one party engaged in an economic transaction has
better information about the good or service traded than the other party.

Adverse selection is the phenomenon under which the uninformed side of a deal gets exactly the
wrong people trading with it (that is, it gets an adverse selection of the informed parties).

Experience rating is the practice of charging different insurance premiums based on the existing risk
of the insurance buyers.

Community rating is the practice of charging uniform insurance premiums for people in different risk
categories within a community, thus resulting in low-risk people subsidizing high-risk people.

Moral hazard occurs when obtaining insurance against an adverse outcome leads to changes in
behavior that increase the likelihood of the outcome.

The more that an insurance plan smoothes risk by covering health care costs, the more it leads to
inefficient overuse of health care through an increase in risky behavior.

Deductible is the fixed amount of expenditures that must be incurred within a year before the
insured is eligible to receive insurance benefits.

Copayment is a fixed amount paid by the insured for a medical service.

Coinsurance is a percentage of the cost of a medical service that the insured must pay.

Deadweight loss is the pure waste created when the marginal benefit of a commodity differs from its
marginal cost.

Flat-of-the-curve medicine is the notion that at a certain point, the additional health gains of greater
spending on health care are relatively limited.

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Third-party payment is a payment for services by someone other than the consumer.

Paternalistic arguments would suggest that such people either have the 'wrong' tastes (they should
be more risk averse) or they have 'wrong' expectations (they should put a higher weight on the
probability of a bad outcome).

Commodity egalitarianism is the idea that some commodities ought to be made available to
everybody.

Chapter 10

Job lock is the tendency for workers to remain in their job in order to keep their employer-provided
health insurance coverage.

Cost-based reimbursement or fee-for-service is a system under which health care providers receive
payment for all services required.

Managed care is any of a variety of health care arrangements in which prices are kept down by
supply-side control of services offered and prices charged.

Capitation-based reimbursement is a system in which health care providers receive annual payments
for each patient in their care, regardless of services actually used by the patient.

Health Maintenance Organization (HMO) is an organization that offers comprehensive health care
from an established network of providers, often using capitation-based reimbursement.

Preferred Provider Organization (PPO) is an organization that gives incentives to enrollees to obtain
health care services from within a specified network of providers.

Point-of-service (POS) plans are similar to PPO, but also assigns each enrollee a primary care provider
to serve as a gatekeeper.

Medicare is a federally funded government program that provides health insurance to people aged
65 and over and to the disabled.

Hospital insurance (HI) is part A component of Medicare that covers inpatient medical care and is
funded through a payroll tax.

Supplementary medical insurance is part B component of Medicare that covers physician services
and medical services rendered outside the hospital and is funded by a monthly premium and by
general revenues.

Retrospective payment system is a payment system, previously used by the Medicare Hospital
Insurance program, in which compensation is paid after the care is completed and thus provides little
incentive to economize the costs.

Prospective payment system is a payment system, currently used by the Medicare Hospital Insurance
program, in which the compensation level is set prior to the time that care is given.

Diagnosis related groups (DRG) is a classification system used to determine prospective

compensation payments in the Medicare Hospital Insurance program.

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Resource-based relative value scale system is a set of values based on time and effort of physician
labor used to determine physicians' fees in the supplementary medical insurance component of
Medicare.

Medicaid is a federal- and state-financed health insurance program for the poor.

State Children's Health Insurance Program (SCHIP) is a program that expanded Medicaid eligibility to
some children with family incomes above Medicaid limits.

Crowd out refers to when public provision of a good leads to a reduction in private provision of the
good.

The single-payer approach would scrap the current health insurance market and replace it with a
single provider of health insurance. It would be funded by taxes and provide all citizens, regardless of
income or health status, with a specified set of health care services, at no (or low) direct cost to the
insured.

The market-oriented approach reforms health care by lowering costs and increasing access by
harnessing the power of competition.

Chapter 11

An annuity is an insurance plan that charges a premium and then pays a sum of money at some
regular interval for as long as the policyholder lives.

Consumption smoothing is reducing consumption in high-earning years in order to increase

consumption in low-earning years.

Asymmetric information is a situation in which one party engaged in an economic transaction has
better information about the good or service traded than the other party.

Adverse selection is the phenomenon under which the uninformed side of a deal gets exactly the
wrong people trading with it (that is, it gets an adverse selection of the informed parties).

Moral hazard occurs when obtaining insurance against an adverse outcome leads to changes in
behavior that increase the likelihood of the outcome.

Fully funded is a pension system in which an individual's benefits are paid out of deposits that have
been made during his or her working life, plus accumulated interest.

Pay-as-you-go (unfunded) is a pension system in which benefits paid to current retirees come from
payments made by current workers.

Supplemental Security Income (SSI) is a welfare program that provides a minimum income guarantee
for the aged and disabled.

Average indexed monthly earnings (AIME) is the top 35 years of wages in covered employment,
indexed each year for average wage growth. The AIME is used to compute an individual's Social
Security benefit.

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Primary insurance amount (PIA) is the basic Social Security benefit payable to a worker who retires at
the normal retirement age or becomes disabled.

Normal retirement age is the age at which an individual qualifies for full Social Security retirement
benefits.

Actuarially fair return is an insurance plan that on average pays out the same amount that it receives
in contributions.

Social Security wealth is the present value of one's expected Social Security benefits minus expected
payroll taxes paid.

Social Security Trust Fund is a fund in which Social Security surpluses are accumulated for the
purpose of paying out benefits in the future.

Off-budget items are federal expenditures and revenues that are excluded by law from budget totals.

Unified budget is the document that includes all the federal government's revenues and
expenditures.

Life-cycle model is the theory that individuals' consumption and savings decisions during a given year
are based on a planning process that considers lifetime circumstances.

The introduction of a Social Security system can substantially alter the amount of lifetime saving.
Such changes are the consequences of three effects:

1. the wealth substitution effect

2. the retirement effect
3. the bequest effect

Wealth substitution effect is the crowding out of private savings due to the existence of Social
Security.

Endowment point is the consumption bundle that is available if an individual neither borrows nor
saves.

Intertemporal budget constraint is the set of feasible consumption levels across time.

The retirement effect to the extent that Social Security induces people to retire earlier, people may
save more in order to finance a longer retirement.

Bequest effect is the theory that people may save more in order to finance a larger bequest to
children in order to offset the intergenerational redistribution of income caused by Social Security.

Dependency ration is the ratio of Social Security beneficiaries to covered workers.

Replacement ratio is the ratio of average Social Security benefits to average covered wages.

t = (N b / N w ) * (B / w)

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Sustainable solvency is that the expected present values of revenues and expenditures are equal into
the indefinite future.

Personal accounts are retirement savings accounts managed by individuals as part of a Social Security
privatization plan. They are also known as individual accounts or personal savings accounts.

Carve-out accounts are personal accounts that are funded by diverting payroll tax revenues away
from the traditional Social Security system.

Add-on accounts are personal accounts that are funded from workers' resources rather than by
diverting money from the payroll tax.

Chapter 12

Poverty line is a fixed level of real income considered enough to provide a minimally adequate
standard of living.

In-kind transfers are payments from the government to individuals in the form of commodities or
services rather than cash.

Utilitarian social welfare function is an equation stating that social welfare depends on individuals'
utilities: W = F(U 1 , U 2 , ..... , U N ).

Additive social welfare function is an equation defining social welfare as the sum of individuals'
utilities. Together with the following assumptions, the government should redistribute income so as
to obtain complete equality:

1. Individuals have identical utility functions that depend only on their incomes.
2. These utility functions exhibit diminishing marginal utility of income.
3. The total amount of income available is fixed.

W = Minimum(U 1 , U 2 , ...., U N ) According to this equation, social welfare depends only on

the utility of the person who has the lowest utility. This social objective is often called the maximin
criterion because the objective is to maximize the utility of the person with the minimum utility.

Original position is an imaginary situation in which people have no knowledge of what their
economic status in society will be.

Commodity egalitarianism is the idea that some commodities ought to be made available to
everybody.

Expenditure incidence is the impact of government expenditures on the distribution of real income.

Chapter 13

Means-tested is a spending program whose benefits flow only to those whose financial resources fall
below a certain level.

The benefit received is related to the basic grant, the tax rate, and level of earnings by:

B = G - tE

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It follows that the benefit is zero when:

E=G/t or any higher level of E.

Time endowment is the maximum number of hours an individual can work during a given period.

At the budget constraint for leisure-income choice the slope is the absolute value of the wage rate.

Workfare is able-bodied individuals who qualify for income support receive it only if they agree to
participate in a work-related activity.

Earned income tax credit (EITC) is a tax credit for low-income individuals.

Experience rated is the practice of charging different insurance premiums based on the existing risk
of the insurance buyers.

Chapter 14

Statutory incidence indicates who is legally responsible for a tax.

Economic incidence is the change in the distribution of real income induced by a tax.

Tax shifting is the difference between statutory incidence and economic incidence.

Functional distribution of income is 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 is the way that total income is distributed across income classes.

Balanced-budget incidence computes the combined effects of levying taxes and government
spending financed by those taxes.

Differential tax incidence is the idea to examine how incidence differs when one tax is replaced with
another, holding the government budget constant.

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

Lump sum tax is a tax whose value is independent of the individual's behavior.

Proportional is a tax system under which an individual's average tax rate is the same at each level of
income.

Average tax rate is the ratio of taxes paid to income.

Progressive is a tax system under which an individual's average tax rate increases with income.

Regressive is a tax system under which an individual's average tax rate decreases with income.

Marginal tax rate is the proportion of the last dollar of income taxed by the government.

The measurement of progressiveness, v 1 , is:

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𝑇1 𝑇0
−
𝐼1 𝐼0
v1 =
𝐼1 −𝐼0

or:
𝑇1 −𝑇0 𝐼1 − 𝐼0
v2 = /
𝑇0 𝐼0

Partial equilibrium models are models that study only one market and ignore possible spillover
effects in other markets.

Unit tax is a tax levied as a fixed amount per unit of commodity purchased.

Tax wedge is the tax-induced difference between the price paid by consumers and the price received
by producers.

In general, the more elastic the demand curve, the less the tax borne by consumer, other things
being the same. The more elastic the supply curve, the less the tax borne by producers, other things
being the same.

Tax salience is the extent to which a tax rate is made prominent or conspicuous to a taxpayer.

Ad valorem tax is a tax computed as a percentage of the purchase value.

Economic profit is the return to owners of a firm above the opportunity costs of all the factors used
in production Also called supranormal or excess profit.

Capitalization is the process by which a stream of tax liabilities becomes incorporated into the price
of an asset.

General equilibrium analysis is the study of how various markets are interrelated.

Partial factor tax is a tax levied on an input in only some of its uses.

Principal assumptions of the Harberger Model:

1. Technology
2. Behavior of factor suppliers
3. Market structure
4. Total factor supplies
5. Consumer preferences
6. Tax incidence framework

Elasticity of substitution is a measure of the ease with which one factor of production can be
substituted for another.

Capital intensive is an industry in which the ratio of capital to labor inputs is relatively high.

Labor intensive is an industry in which the ratio of capital to labor inputs is relatively low.

A tax on the output of a particular sector induces a decline in the relative price of the input used
intensively in that sector.

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Chapter 15

Excess burden is a loss of welfare above and beyond taxes collected. Also called welfare cost or
deadweight loss.

Equivalent variation is a change in income that has the same effect on utility as a change in the price
of a commodity.

Because the revenue yield of a lump sum tax equals its equivalent variation, a lump sum tax has no
excess burden.

If income were fixed, an income tax would be a lump sum tax. However, when people's choices affect
their incomes, an income tax is not generally equivalent to a lump sum tax.

There is no presumption that income taxation is more efficient than a system of commodity taxes at
different rates, which is referred to as differential commodity taxation.

Income effect is the effect of a price change on the quantity demanded due exclusively to the fact
that the consumer's income has changed.

Substitution effect is the tendency of an individual to consume more of one good and less of another
because of a decrease in the price of the former relative to the latter.

An ordinary demand curve depicts the uncompensated change in the quantity of a commodity
demanded when price changes. A compensated demand curve shows how the quantity demanded
changes when price changes and simultaneously income is compensated so that the individual's
commodity bundle stays on the same indifference curve.

The excess burden of the tax can be given algebraically by:

0,5ƞP b q 1 t b 2 where ƞ is the absolute value of the compensated price elasticity of demand
for b.

Because excess burden increases with the square of the tax rate, the marginal excess burden from
raising one more dollar of revenue exceeds the average excess burden. That is, the incremental
excess burden of raising one more dollar of revenue exceeds the ratio of total excess burden to total
revenues.

Theory of the second best is in the presence of existing distortions, policies that in isolation would
increase efficiency can decrease it and vice versa.

Tax-interaction effect is the increase in excess burden in the labor market stemming from the
reduction in real wages caused by a Pigouvian tax.

Double-dividend effect is using the proceeds from a Pigouvian tax to reduce inefficient tax rates.

The excess burden due to the tax-induced distortion of work choice is given by:

0,5ԑωL 1 t2 where ԑ is the compensated elasticity of hours of work with respect to the wage.

The excess burden due to a tax on market work is given by:

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0,5(delta H)tw 2

Chapter 16

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