252 PUBLIC FINANCE

PUBLIC FINANCE Suppose for the moment that these two assumptions are
satisfied. Does the government have any role to play in the
1. Scope of the Field economy? Only a very small government that protects prop-
erty rights and provides law and order would seem appro-
Public Finance is the branch of economics that studies the priate. However, even if an allocation of resources is
taxing and spending activities of government. The term is Pareto-efficient, it may not be socially desirable. A society
something of a misnomer, because the fundamental issues may be willing to trade some efficiency in return for a fairer
are not financial (that is, relating to money). Rather, the distribution of resources among its members (although
key problems relate to the use of real resources. For this “fairer” may be hard to define). Hence, even if the economy
reason, some practitioners prefer the label public sector is Pareto efficient, government intervention may be neces-
economics or simply public economics. Public finance sary to achieve a fair distribution of real income.
encompasses both positive and normative analysis. Furthermore, real world economies may not satisfy the
Positive analysis deals with issues of cause and effect, for two assumptions required for Pareto efficiency. The first
example, “If the government cuts the tax rate on gasoline, assumption is violated when firms have market power and
what will be the effect on gasoline consumption?” raise their prices above competitive levels. Monopoly is an
Normative analysis deals with ethical issues, for example, extreme example. The issues associated with market
“Is it fairer to tax income or consumption?” power are generally dealt with in the field of Industrial
Modern public finance focuses on the microeconomic Organization, not Public Finance. The second assumption
functions of government, how the government does and is violated when markets for certain commodities do not
should affect the allocation of resources and the distribu- emerge. After all, if a market for a commodity does not
tion of income. For the most part, the macroeconomic exist, then we can hardly expect the market to allocate
functions of government — the use of taxing, spending, it efficiently. For example, there is no market for clean
and monetary policies to affect the overall level of air. In effect, individuals can use up clean air (that is,
unemployment and the price level — are covered in other pollute) at a zero price. That particular resource is not used
fields. efficiently.
Nonexistence of markets occurs in a variety of situa-
2. Methodological Basis tions; each one opens potential opportunities for the
government to intervene and improve welfare. In effect,
Mainstream economic theory provides the framework for then, the list of market failures provides the public finance
public finance. Indeed, it would not be unreasonable to agenda.
view public finance as just an area of applied microeco-
nomics. As is the case in other fields of economics, the 3. Public Expenditure
normative framework of public finance is provided by wel-
fare economics, the branch of economic theory concerned The theory of welfare economics focuses our attention on
with the social desirability of alternative economic states.1 market failure and distributional considerations as reasons
Much of welfare economics focuses on the conditions for considering governmental intervention. This section
under which the allocation of resources in an economy is illustrates these issues.
Pareto-efficient, defined as an allocation such that the only
way to make one person better off is to make another per- 3.1. Public Goods
son worse off. Pareto efficiency seems a reasonable nor-
mative criterion — if the allocation of resources is not A public good has two characteristics. First, once it is
Pareto efficient, it is “wasteful” in the sense that it is pos- provided, the additional cost of another person consuming
sible to make someone better off without hurting anybody the good is zero — consumption is nonrival. Second, pre-
else. A stunning result of welfare economics is that if two venting anyone from consuming the good is either very
assumptions are satisfied, then an economy will achieve a expensive or impossible — consumption is nonexcludable.
Pareto-efficient allocation of resources without any gov- A classic example of a public good is national defense. One
ernment intervention. The assumptions are: 1) All produc- person’s consumption of the services provided by the army
ers and consumers act as perfect competitors; that is, no does nothing to diminish another person’s consumption of
one has any market power. 2) A market exists for each and the same services. Further, excluding any particular person
every commodity. In a way, this result formalizes an old from the benefits of national defense is all but impossible.
insight: When it comes to providing goods and services, In contrast, a private good (such as food) is both rival and
free enterprise systems are amazingly productive. excludable.
 PUBLIC FINANCE 253

To see why the market may not provide public goods in such a market. The government announces it will sell
efficient amounts, note that, for a private good, the market in permits to spew a given quantity of some pollutant into the
effect forces each person to reveal what his true preferences environment. Firms bid for the rights to own these permis-
are. If the value of the commodity to a person is greater than sions to pollute, and the permissions go to the firms with
or equal to the market price, he buys it; otherwise not. There the highest bids. Again, firms are forced to confront a cost
is no incentive to hide one’s true preferences. In contrast, for using up the resource. 3) It can simply order each pol-
people have incentives to hide their true preferences for pub- luter to reduce pollution by a certain amount. A major
lic goods. Each person knows that once national defense is problem with such a command-and-control solution is that
provided, he can enjoy its services, whether he pays for them the reduction in pollution may be greater or less than the
or not. Therefore, he may claim that defense means nothing efficient amount. That is, the reduction that the government
to him, hoping that he can get a “free ride” after other peo- orders may not be the same reduction that would occur if
ple pay for it. Everyone has the same incentive, so that the firm were facing the true price of the resource.
defense may not be funded, even though it is in fact benefi- In general, most countries rely on command-and-control
cial. In short, the market cannot be relied upon to provide a mechanisms for dealing with environmental problems.
public good in efficient amounts; some kind of collective However, in recent years market-oriented approaches have
decision making process may be better (Samuelson, 1954). made some inroads. In the United States, for example,
While important, this finding does not provide a firm there is now an active market in allowances to emit sulfur
set of guidelines for deciding when the government rather dioxide into the air. An important area for future research
than the private sector should provide some commodity. is to see if it is possible to expand the scope of such poli-
The result depends in part on whether the public and cies, and to determine whether the efficiency gains that
private sectors pay different amounts for labor and materi- theory predicts actually occur (Stavins, 2002).
als, the extent to which the government can address the
diversity of tastes for the commodity among the citizenry, 3.3. Social Insurance
and whether or not government provision will have a more
favorable (somehow defined) impact on the distribution of One way to obtain some protection against the uncertain-
real income. Whether public or private provision is better ties of life is to purchase insurance. In private insurance
must be decided on a case by case basis. The fact that this markets, people pay premiums to an insurance company,
can be difficult is reflected in the ongoing political debates and receive benefits in the event of certain unlucky
in many countries about the merits or privatization — occurrences. In addition, a number of government
taking services that are supplied by the government and programs also replace income losses that are consequences
turning them over to the private sector. of events at least partly outside personal control. These
programs, collectively referred to as social insurance, are
3.2. Externalities among the largest components in the budgets of western
governments.
When the activity of one entity (a person or firm) directly Is there a rationale within conventional welfare eco-
affects the welfare of another in a way that is outside the nomics for such substantial government involvement in
market mechanism, that effect is called an externality. The insurance markets? There are reasons to believe that private
classic example is a polluter, who imposes losses on other insurance markets will fail to operate efficiently. To see
individuals by degrading the environment. In general, why, note that we can expect an individual who knows he
efficiency requires that individuals pay a price for any com- is especially likely to collect benefits to have an especially
modity that reflects its value in alternative uses. But there is high demand for insurance, a phenomenon known as
no market for (say) clean air. Individuals treat it as if its adverse selection. Due to adverse selection, in order to
price is zero, and hence use it in inefficiently large break even, the insurance company must charge a higher
amounts. premium for individual coverage than it would if a random
There are a number of ways in which government inter- group of people were buying insurance. However, these
vention can potentially enhance efficiency in the presence higher premiums exacerbate the adverse selection problem.
of an externality. 1) It can levy a tax on the externality pro- Only individuals who know they are at great risk will pay
ducing activity. Basically, the tax makes up for the fact that the high prices. This, in turn, requires a further increase in
the price being faced by the polluter is too low. 2) It can premiums, and the pattern continues. The market fails to
create a market for the right to pollute. Recall that the fun- provide an efficient amount of insurance.2 In essence,
damental problem is that there is no market for the resource mandatory social insurance solves this problem by forcing
being polluted. In some cases, the government can create everybody into one big group — the country.
254 PUBLIC FINANCE

Government retirement programs, which, in effect, For example, should it impose ceilings on the prices of com-
provide insurance against the possibility that people will modities consumed by the poor? The answer is no. Roughly
outlive the resources they have accumulated for retirement, speaking, it is a better policy for the government to redis-
are particularly important forms of social insurance. tribute income suitably and then let markets work. Put
Typically, such programs have been funded on a pay-as- another way, the issues of efficiency and distributional fair-
you-go basis, meaning that the benefits paid to current ness can be separated. If society determines that the current
retirees come from payments made by those who are distribution of resources is unfair, it need not interfere with
presently working. The problem is that in most countries, market prices and impair efficiency. Of course, the govern-
the ratio of retirees to workers will be increasing in coming ment needs some way to reallocate resources, and problems
years. Hence, other things being the same, it will be neces- arise if the only available mechanisms for doing so (such as
sary either to increase the tax rate on current workers or taxes) themselves induce inefficiencies. These issues are
reduce the benefits received by retirees. The best way to discussed below.
cope with this problem is a major academic and political This whole area is complicated by the fact that there is
controversy (Feldstein and Liebman, 2001). Considerable no consensus on what a fair income distribution looks like.
attention has been given to privatizing the systems. Under Some believe that the government should engineer com-
privatization, workers’ contributions are earmarked for their plete equality. Others believe that society should move
own accounts. Workers then invest the funds in various toward equality, but take into account the losses in effi-
financial assets, and finance their retirements out of the ciency that are engendered by taxing high-income people
accumulations in the accounts. Major issues in privatization and subsidizing low-income people. Still others believe
schemes include how to pay benefits to the current genera- that attention to the distribution of income at a given point
tion of retirees, and how to provide a socially acceptable liv- in time is misguided; what matters is whether there is social
ing standard to individuals who are unable to accumulate mobility over time. The idea here is that even if people at
enough wealth in their accounts during their working lives. the bottom of the income distribution are quite poor, it may
Other forms of social insurance are unemployment not be a major social problem if the identities of these
insurance and health insurance. Unemployment insurance people change over time (Atkinson, 1983).
provides benefits to workers who lose their jobs. The major In many countries, income distribution programs rely
problem is how to devise systems that provide protection primarily on in-kind transfers — payments from the gov-
but do not at the same time make unemployment too attrac- ernment to individuals in the form of commodities or serv-
tive (Meyer, 1995). One of the main issues in health insur- ices rather than cash. In-kind transfers include medical care,
ance is the extent to which the government should directly food, housing, and energy consumption. A natural question
provide insurance as opposed to providing people with is why governments do not simply give the poor cash and let
incentives to purchase insurance on the private market. them spend the money as they want? One possibility is that
Various nations have come up with quite different solu- policy makers care about the distribution of certain com-
tions. In Canada, for example, health care services are pro- modities rather than income per se. For example, they may
duced by the private sector, with the reimbursements want every family to consume housing of a given quality. In
negotiated by the government. In the United Kingdom, addition, in-kind transfers may help curb welfare fraud. In-
health services are produced by the public sector through kind transfers may discourage ineligible persons from
the National Health Service. In the United States, there is applying because some well-off people may be willing to
publicly provided insurance only for certain groups, basi- lie to receive cash, but be less willing to lie to obtain
cally the elderly (through Medicare) and for the poor some commodity they do not really want (Nichols and
(through Medicaid). A particularly contentious and impor- Zeckhauser, 1982). Finally, in-kind transfers are attractive
tant issue is the effect that the various systems have on politically because they help not only the beneficiary but
people’s health status (Fuchs, 1998). also the producers of the favored commodity. Thus, for
example, agricultural interests can be expected to support
3.4. Income Redistribution programs for subsidizing food consumption by the poor.
One of the most contentious issues in this area is how
As noted above, even in the absence of market failures, income maintenance policies affect the behavior of the
government intervention in the economy may be necessary poor. Most attention has been focused on work effort — do
to achieve a “fair” distribution of real income. A key ques- beneficiaries reduce their work effort and if so, by how
tion in this context is whether the government needs to much. In the belief that welfare reduces work effort, several
intervene directly in markets in order to enhance fairness. countries have introduced work requirements — in order to
 PUBLIC FINANCE 255

be eligible for welfare, recipients have to agree to accept income distribution would be to conduct a survey in which
work or job-training programs. The efficacy of such pro- each person is asked how many dollars he or she pays to the
grams is not yet well understood. Another open question is tax collector each year.
whether income maintenance programs lead to the creation Although such an approach is convenient, it is quite
of a “welfare culture” — children brought up in households likely to produce misleading answers. To see why, suppose
receiving welfare come to view it as a way of life and hence that the government levies a tax of one dollar on the sellers
are unlikely to acquire the skills necessary to earn a living. of a certain commodity. Suppose that prior to the tax, the
It is indeed the case that a mother’s participation in welfare price of the commodity is $20, and that after the tax is
increases the probability that her daughter eventually also levied, the price increases to $21. Clearly, the sellers
ends up on welfare. However, it is not clear whether the receive as much per unit sold as they did before. The tax
exposure to welfare “causes” the daughter to go on welfare, has not made them worse off. Consumers pay the entire tax
or if other correlated aspects of the family environment are in the form of higher prices. Suppose that instead, the price
responsible (Blank, 1997). increases to $20.25. In this case, sellers are worse off by
75 cents per unit sold; consumers are worse off by 25 cents
per unit sold. The burden of the tax is shared between the
3.5. A Caveat
two groups. Yet another possibility is that after the tax is
We have discussed a number of situations in which the imposed, the price stays at $20. If so, the consumer is no
government can improve welfare by enhancing efficiency worse off, while the seller bears the full burden of the tax.
and fairness. However, the fact that the market-generated The statutory incidence of a tax indicates who is legally
allocation of resources is imperfect does not mean the gov- responsible for the tax. All three cases above have exactly
ernment is necessarily capable of doing better. For exam- the same statutory incidence. But the situations differ dras-
ple, in certain cases the costs of setting up a government tically with respect to who really bears the burden. The eco-
agency to deal with some market failure could be greater nomic incidence of a tax is the change in the distribution of
than the cost of the market failure itself. Moreover, gov- private real income induced by the tax.
ernments, like people, have only imperfect information, The example above suggests that the economic
and hence can make mistakes. Finally, it is not clear that incidence problem is fundamentally one of determining
government decision-makers will have maximizing social how taxes change prices. In the conventional supply and
welfare as their goal; we return to this theme at the end of demand model of price determination, the economic inci-
this essay. Hence, it is best to think of welfare economics dence of a tax depends on how responsive supply and
as helping us identify situations in which government inter- demand are to prices.3 In general, the more responsive sup-
vention may enhance efficiency and fairness; whether it ply is to price relative to demand, the greater the share of
actually will needs to be evaluated on a case by case basis. the tax that will be shifted to consumers. Intuitively, the
more responsive demand is to price, the easier it is for con-
sumers to turn to other products when the price goes up,
4. The Theory of Taxation and therefore more of the tax must be borne by suppliers.
Conversely, if consumers purchase the same amount
Taxes are the most important source of revenue for modern regardless of price, the whole burden can be shifted to
economies. The theory of taxation explores how taxes them. In cases where the responses of supply and demand
should be levied to enhance economic efficiency and to to price are well understood, then fairly reliable estimates
promote a “fair” distribution of income. Just as in the case of the economic incidence of a tax can be obtained. In
of expenditures discussed in Section 3, welfare economics some areas, the behavioral responses are not well under-
provides the underlying analytical framework. Various stood, and incidence analysis is on less firm ground. For
aspects of the theory are discussed in this section. example, there is still great controversy over the burden of
taxes on corporations — to what extent are they borne by
4.1. Tax Incidence owners of capital, and to what extent by laborers? This is
an important topic for research.
Policy debates about taxation are usually dominated by the
question of whether its burden is distributed fairly. To dis- 4.2. Excess Burden
cuss this normative issue requires some understanding of
the positive question of how taxes affect the distribution of Taxes impose a cost on the taxpayer. It is tempting to view
income. A simple way to determine how taxes change the the cost as simply the amount of money that he or she pays
256 PUBLIC FINANCE

to the government. However, this is only part of the story. ways to characterize the result. One of the most elegant is
A tax distorts economic behavior — in general, consumers the rule that as long as goods are unrelated in consumption
buy fewer taxed goods and more untaxed goods than other- (that is, are neither substitutes nor complements), then the
wise would have been the case. Their decisions are not more responsive demand is to price, the lower should be
based entirely on the merits of the commodities them- the tax rate on that commodity. The intuition behind this
selves. In the same way, business owners make investments rule is straightforward. Efficient taxes should distort deci-
based in part on tax considerations, as opposed to eco- sions as little as possible. The potential for distortion is
nomic fundamentals. Because a tax distorts economic greater the more responsive the demand for the commodity
activity, it creates a loss in welfare that actually exceed the is to its price. Therefore, efficient taxation requires that
revenues collected. This is referred to the excess burden of relatively high rates of taxation be levied on goods whose
the tax. demands are relatively unresponsive to their price.
In general, the more responsive behavior is to the tax, This result strikes many people as ethically unappeal-
the greater the excess burden, other things being the same. ing. For example, the demand for food is relatively unre-
Intuitively, because excess burdens arise because of distor- sponsive to changes in its price. Is it really desirable to tax
tions in behavior, the more that behavior is capable of being food at relatively high rates? Most people would argue that
distorted, the greater the excess burden. Another important it is not desirable, because their ethical views indicate that
result is that the excess burden of a tax increases with the a tax system should have vertical equity: It should distrib-
square of the tax rate — doubling a tax quadruples its ute burdens fairly across people with different abilities to
excess burden, other things being the same. This means pay. Public finance economists have shown how to modify
that, in general, it makes sense to spread taxes over as large the efficiency rule to account for the distributional conse-
a group of commodities as possible — a small tax on a quences of taxation. Suppose, for example, that the poor
number of commodities has a smaller excess burden than a spend a greater proportion of their income on commodity
very large tax on one commodity.4 X than do the rich, and vice versa for commodity Y. Then
This discussion suggests that, just like the incidence even if the demand for X is less responsive to price than the
problem discussed above, the excess burden of a tax demand for Y, optimal taxation may require a higher rate of
depends on the behavioral response to the tax. Estimating tax on Y than X. True, a high tax rate on Y creates a rela-
such behavioral responses and computing excess burdens tively large excess burden, but it also tends to redistribute
is an important role for public finance economists. Some income toward the poor. As in other areas of public
estimates suggest that the excess burdens for real-world tax finance, the optimal policy depends on the extent to which
systems are quite high. One recent survey suggested that in society is willing to tradeoff efficiency for fairness
the United States, the average excess burden per dollar (Auerbach and Hines, 2002).
of tax revenue is 18 cents. While any particular figure must With its focus on efficiency and fairness issues, the the-
be taken with a grain of salt, virtually all estimates suggest ory of optimal taxation falls directly within the framework
that the tax system is highly inefficient in the sense of gen- of conventional welfare economics. There are other criteria
erating large excess burdens (Jorgenson and Yun, 2001). for tax design that are not reconciled so easily with welfare
The fact that a tax generates an excess burden does not economics. The main one is horizontal equity, the notion
mean that the tax is bad. One hopes, after all, that it will be that people in equal positions should pay equal amounts of
used to obtain something beneficial for society either in taxes. One problem with implementing this principle is
terms of enhanced efficiency or fairness. But to determine defining equal positions. The most common criterion is
whether or not the supposed benefits are large enough to income, but wealth and consumption are also possible.
justify the costs, sensible policy requires that excess burden A problem with all three measures, however, is that they
be included in the calculation as a cost to society. are the outcomes of people’s decisions. Two individuals
may have exactly the same wage rate, but one chooses to
4.3. Optimal Taxation work 1000 hours per year while another chooses to work
2000 hours per year. Despite the fact that they have differ-
Public finance economists have devoted a great deal of ent incomes, in a meaningful sense they are in “equal posi-
attention to the problem of the design of optimal taxes. Of tions” because their potential to earn income is the same.
course, this is a normative issue, and it cannot be answered Things are complicated further by the fact that adjust-
without a statement of ethical goals. To begin, suppose that ments in market prices may render some horizontal
the goal is to raise a given amount of money with the small- inequities more apparent than real. Suppose, for example,
est amount of excess burden possible. There are a variety of that in one type of job a large part of compensation consists
 PUBLIC FINANCE 257

of amenities that are not taxable — pleasant offices, access in other contexts, implementing the Haig-Simons criterion
to a swimming pool, and so forth. In another occupation, can lead to major problems. 5 Some examples follow:
compensation is exclusively monetary, all of which is sub-
● Only income net of business expenses increases poten-
ject to income taxation. This would appear to be a violation
tial consumption power. But distinguishing between
of horizontal equity, because the person in the job with a lot
consumption and costs of obtaining income can be
of amenities has too small a tax burden. But, if both
difficult. To what extent is a desk bought for an office
arrangements coexist and individuals are free to chose,
at home just furniture, and to what extent is it a
then the net after-tax rewards (including amenities) must be
business expense?
the same in both jobs. Otherwise, people would leave the
job with the lower net after-tax rewards. In short, the fact ● A capital gain is the increase in the value of an asset —
that amenities are not taxed is not unfair, because the say, a share of stock — during a period of time. From
before- tax monetary compensation falls by just enough to a Haig-Simons point of view, a capital gain is income
offset this advantage. Put another way, introducing taxation whether or not the stock is actually sold, because the
for such amenities would create horizontal inequities capital gain represents an increase in potential to con-
(Feldstein, 1976). sume. However, captial gains and losses may be very
We conclude that horizontal equity is a rather amor- difficult o measure, particularly when the assets are not
phous concept. Yet it has enormous appeal as a principle of sold. Indeed, in general, no attempts are made to tax
tax design. Notions of fairness among equals, regardless of capital gains of assets that have not actually been sold.
their vagueness, will continue to play an important role in ● In-kind services are not easy to value. One important
the development of tax policy. example is the income produced by people who do
housework rather than participate in the market.
5. Revenue Raising Instruments Such difficulties in implementing a Haig-Simons con-
cept of income are of great practical significance. To the
Public finance economists have used the theoretical frame-
extent that income that comes in certain forms cannot be
work discussed in Section 4 above to analyze the various
taxed, individuals’ decisions are biased in the direction of
revenue sources used by modern governments. This section
taking their income in those forms. Thus, for example,
discusses briefly some of the key issues associated with
there is a bias in favor of capital gains (which are taxed
each kind of tax.
only when the asset is sold) as opposed to dividend income
(which is taxed as it is earned). Such biases create
5.1. Income Tax efficiency losses to the economy. Further, complicated
rules are often needed to determine whether a certain type
Taxes on income play a major role in the fiscal systems of
of income falls in a category that is favored by the tax sys-
all western countries. A starting point for the analysis and
tem. Capital gains again provides a good example; it is not
evaluation of real world income tax systems is a definition
always obvious whether the return that an individual
of income. Traditionally, public finance economists use the
receives from a company is a dividend or a capital gain.
so-called Haig-Simons definition: Income is the money
Such complexity leads to substantial compliance costs.
value of the net increase in an individual’s power to con-
In additions, several forms of income that would be
sumer during a period. This is equal to the amount actually
administratively relatively easy to tax are partially or alto-
during the period plus net additions to wealth. Net addi-
gether excluded from the income tax bases of most coun-
tions to wealth — saving — must be included in income
tries. An important example is the return on saving that is
because they represent an increase in potential consump-
deposited in retirement accounts. Indeed, given the extent
tion. Importantly, the Haig-Simons criterion requires the
to which income that is saved in various forms is excluded
inclusion of all sources of potential increases in consump-
from taxation, it is a misnomer to characterize these sys-
tion, regardless of whether the actual consumption takes
tems as income taxes. They are more a hybrid between
place, and regardless of the form in which the consumption
income and consumption taxes.
occurs. While not uncontroversial, the Haig-Simons defini-
tion provides a useful guide.
The Haig-Simons definition encompasses those items 5.2. Corporation Income Tax
ordinarily thought of an income: wages and salaries, business
profits, rents, royalties, dividends, and interest. These forms Corporations are independent legal entities and as such are
of income are relatively easy to measure and to tax. However, subject to taxes on their incomes. Most public finance
258 PUBLIC FINANCE

economists believe that it makes little sense to levy a 5.3. Consumption Taxes
special tax on corporations. Only real people can pay a
tax; hence, it would make more sense to tax the incomes of The base of a consumption tax is the value (or quantity) of
corporation owners via the personal income tax. Again, commodities sold to a person for actual consumption, as
this distinction is of more than academic importance. opposed to an income tax, whose base is the change in
Treating the corporation as a freestanding entity for tax potential consumption. Consumption taxes take a variety
purposes leads to important distortions in economic activity. of forms. A retail sales tax is levied on the purchase of a
To see why, note that when a corporation earns income it is commodity. In the United States, retail sales taxes are not a
taxed once at the corporate level, and then again when it is significant component of revenue at the national level, but
paid out to shareholders in the form of dividends. In effect, they are at the state level. Even there, though, the rates
then, corporate income that is paid out in the form of generally do not exceed 7 percent or so.
dividends is double taxed. This biases businesses against In Europe, the most important type of consumption tax
organizing in corporate form. Moreover, double taxation of is a value-added tax (VAT). The value-added at each stage
corporate income effectively increases the tax rate on of production of a commodity is the difference between the
the return to corporate investments. This reduces the vol- firm’s sales and the purchased material inputs used in pro-
ume of investment undertaken by corporations, although duction. If a firm pays $100 for its material inputs and sells
there is substantial disagreement about the magnitude of its output for $150, then its value added is $50. A VAT is a
this effect. percentage tax on value-added at each stage of production.
The incidence of the corporation tax is highly contro- For example, if the VAT rate were 10 percent, then the
versial. In one highly influential model due to Harberger firm’s tax liability would be $5. Note that the total value of
(1962), the tax on corporate capital leads to a migration of a commodity when it is finally sold is equal to the sum of
capital from the corporate sector until after-tax rates of the value-added at each stage of production. Hence, a VAT
return are equal throughout the economy. In the process, of 10 percent applied to each stage is equivalent to a
the rate of return to capital in the noncorporate sector is 10 percent tax on the final product. In Europe, VAT rates
depressed so that ultimately all owners of capital, not just are as high as 25 percent. With rates at such levels, evasion
those in the corporate sector, are affected. The reallocation is likely to be a problem for retail sales taxes; VATs are
of capital between the two sectors also affects the return to easier to administer, which accounts for their popularity.6
labor. Most public finance economists believe that the A distinguishing feature of both VATs and retail sales
burden of the corporation tax is split between labor and taxes is that the tax liability does not depend on the char-
capital, although there is significant disagreement about acteristics of the buyer. Whether one is rich or poor, the rate
the exact division. is the same. This prompts concerns over equity, which have
If corporate income was untaxed, individuals could been dealt with by applying lower rates to commodities
avoid personal income taxes by accumulating income with such as food and medicine. But this may not be an effective
corporations. Evidently, this would lead to serious way to deal with equity concerns. For example, even if it is
equity and efficiency problems. The question is whether true that food expenditures on average play an especially
there is a way to integrate personal and corporate income important role in the budgets of the poor, there are still
taxes into a single system so as to avoid the distortions many upper-income families whose food consumption is
associated with double taxation. The most radical solution proportionately very high. In recent years, public finance
to this problem is called full integration. Under this economists have given a great deal of attention to the
approach, all earnings of the corporation during a given problem of designing personal consumption taxes. Such
year, whether they are distributed or not, are attributed to taxes require individuals to file tax returns and write
stockholders just as if the corporation were a partnership. checks to the government, allowing tax liabilities to depend
The corporation tax as a separate entity is eliminated. This on personal circumstances.
approach has not been implemented in any country, in part One example is a cash-flow tax. Each household files a
because of administrative problems. The dividend relief return reporting its annual consumption expenditures
approach is less extreme. With it, the corporation can during the year. Just as under the personal income tax, var-
deduct dividends paid to stockholders. Although this ious exemptions and deductions can be taken to allow for
approach eliminates the double taxation of dividends, it special circumstances, and a progressive marginal rate
still maintains the corporation tax as a separate entity. schedule applied to taxable consumption. From an admin-
Variants on this approach are used in a number of European istrative viewpoint, the major question is how to compute
nations. annual consumption. Taxpayers would report their
 PUBLIC FINANCE 259

incomes, and then subtract all saving. To keep track of is currently very little in the way of empirical evidence on
saving, qualified accounts would be established at various these incentive issues.
financial institutions. Whether a cash-flow tax is adminis- To the extent that an estate tax reduces saving, it may
tratively feasible is very controversial.7 Many analysts actually increase inequality. If there is less saving, then
believe that its record-keeping requirements would make it there is less capital investment. With less capital with
very difficult or impossible administratively. which to work, the real wages of workers decrease and
under certain circumstances, the share of income going to
5.4. Wealth Taxes labor falls. To the extent that capital income is more
unequally distributed than labor income, the effect is to
Wealth is the value of the assets an individual has accumu- increase inequality. This scenario is hypothetical. It simply
lated as of a given time. Wealth taxes do not play a major emphasizes a point made above in a variety of different
role in the fiscal systems of any western countries. One contexts — to understand the impact of a tax, one must
justification of taxing wealth is that it is a good measure of take into account how taxpayers respond to it.
an individual’s ability to pay taxes. This is a controversial
issue. Suppose that a miser has accumulated a huge hoard 5.5. Deficit Finance
of gold that yields no income. Should she be taxed on the
value of the hoard? Some believe that as long as the miser In addition to taxation, the government’s other major
was subject to the income tax while the hoard was accu- source of revenue is borrowing. The deficit during a time
mulating, it should not be taxed again. Others would argue period is the excess of spending over revenues. The
that the gold per se generates satisfaction and power for the national debt at a given time is the sum of all past budget
individual, and should therefore be subject to tax. Perhaps deficits. That is, the debt is the cumulative excess of past
the major problem with this argument is that many rich spending over past receipts. Future generations either have
people have a substantial component of their wealth in to retire the debt or else refinance it. It would appear, then,
human capital — their stock of education, skills, and so on. that future generations must bear the burden of the debt.
However, there is no way to value human capital except by But the theory of incidence tells us that this line of reason-
reference to the income it yields. This logic points back to ing is questionable. Merely because the legal burden in on
income as the appropriate base. future generations does not mean that they bear a real
Some nations levy taxes on wealth only when it is trans- burden. Just as in the case of tax incidence, the answer
ferred at the time of the death of the owner. These are depends on economic behavior.
referred to as estate taxes. Estate tax proponents argue that Assume that the government borrows from its own
it is a valuable tool for creating a more equal distribution of citizens. One view is that such an internal debt creates no
income. Further, many believe that ultimately, all property burden for the future generation. Members of the future gen-
belongs to society as a whole. During an individual’s life, eration simply owe it to each other. There is a transfer of
society permits her to dispose of the property she has income from those who do not hold bonds to the bondhold-
managed to accumulate as she wishes. But at death, the ers, but the generation as a whole is no worse off in the sense
property reverts to society, which can dispose of it at will. that its consumption level is the same as it would have been.
Opponents argue that it is fundamentally wrong to argue This story ignores the fact that economic decisions can
that a person holds wealth only at the pleasure of “society,” be affected by government debt policy. According to the
or that “society” ever has any valid claim on personal neoclassical model of the debt, when the government bor-
wealth.8 rows, it competes for funds with individuals and firms who
A controversial issue is the incentives created by an want the money for their own investment projects. Hence,
estate tax. Suppose that an individual is motivated to work debt finance leaves the future generation with a smaller
hard during his lifetime to leave a large estate for his chil- capital stock, other things being the same. Its members
dren. The presence of an estate tax might discourage his therefore are less productive and have smaller real incomes
work effort. On the other hand, with an estate tax, a greater than otherwise would have been the case. Thus, the debt
amount of wealth has to be accumulated to leave a given imposes a burden on future generations, through its impact
after-tax bequest, so the tax might induce the individual to on capital formation. The key assumption in this argument
work harder to maintain the net value of his estate. is that public spending crowds out private investment.
Consequently, the effect of an estate tax on a donor’s work Whether crowding out actually occurs is a controversial
effort is logically indeterminate. Similarly, one cannot issue; the empirical evidence is mixed (Elmendorf and
predict how the tax will affect the amount of saving. There Mankiw, 1999).
260 PUBLIC FINANCE

A further complication is introduced when we consider of the children eventually emigrate to other jurisdictions,
individuals’ transfers across generations. Suppose that the other communities benefit from having a higher quality
when the government borrows, people realize that their work force. But in deciding how much education to provide,
heirs will be made worse off. Suppose further that people the jurisdiction only considers its own welfare. Therefore, it
care about the welfare of their descendants and do not want may provide an inefficiently low amount of education.
their descendants’ consumption levels reduced. What can More generally, if each community cares only about its own
they do about this? They can save more to increase their members, then any positive or negative externalities it cre-
bequests by an amount sufficient to pay the extra taxes that ates for other communities are overlooked. According to the
will be due in the future. The result is that nothing really standard arguments made above, resources are allocated
changes. Each generation consumes exactly the same inefficiently.
amount as before the government borrowed. Another disadvantage of a decentralized system relates
The striking conclusion is that private individuals undo to the fact that for certain public services, the cost per
the intergenerational effects of government debt policy so person falls as the number of users increases. Suppose that
that tax and debt finance are essentially equivalent. This the more people who use a public library, the lower the cost
view is sometimes referred to as the Ricardian model per user. If each community sets up its own library, costs per
because its antecedents appeared in the work of the user are higher than necessary. A central government, on the
19th century economist David Ricardo. (However, Ricardo other hand, could build one library for the region, allowing
was skeptical about the theory that now bears his name.) people to benefit from scale economies. Of course, various
Some public finance economists have challenged the plau- activities are subject to different scale economies. The
sibility of the Ricardian model. They believe that informa- optimal scale for library services might differ from that for
tion on the implications of current deficits for future tax fire protection, and both surely differ from the optimal scale
burdens is not easy to obtain. Another criticism is that peo- for national defense. This observation helps rationalize a
ple are not as farsighted and not as altruistic as supposed in system of overlapping jurisdictions — each jurisdiction can
the model. A number of statistical studies have examined handle those services with scale economies that are
the relationship between budget deficits and private saving. appropriate for the jurisdiction’s size.
The evidence is rather mixed, and the Ricardian model has Decentralized systems can also lead to inefficiencies
both critics and adherents among professional economists. with respect to raising revenues. Taxes levied by decentral-
From time to time, events such as natural disaster and ized communities are unlikely to be efficient from a
wars lead to temporary increases in federal government national standpoint. Instead, communities are likely to
expenditures. An old question in public finance is whether select taxes on the basis of whether they can be exported to
such expenditures should be financed with taxes or outsiders. For example, jurisdictions that have a near-
borrowing. monopoly on certain natural resources such as coal may
impose large taxes on these commodities, figuring that they
6. Fiscal Federalism will be shifted largely to coal users outside the community.
A major advantage to a decentralized system is that it
The analysis so far has assumed that a nation has one allows communities to tailor their public services to the
government that sets tax and expenditure policies. In con- tastes of their residents. Tastes for public services, just like
trast, many countries have a federal system, which consists the tastes for all other commodities, vary across people.
of different levels of government that provide public goods A centralized government tends to provide the same level of
and services and have some scope for making decisions. public services throughout the country, regardless of the fact
The subject of fiscal federalism concerns the activities of that people’s tastes differ. It is inefficient to provide individ-
the various levels of government and how they relate to each uals with more or less of a public good than they desire if the
other. A key question is the optimal allocation of responsi- quantity they receive can be more closely tailored t their
bilities among different levels of government. Posed within preferences. Under a decentralized system, individuals with
the framework of welfare economics, the question is similar tastes for public goods group together, so communi-
whether a centralized or decentralized system is more likely ties are more likely to provide the types and quantities of
to enhance efficiency and equity (Oates, 1999). public goods desired by their inhabitants.
Among the disadvantages of a decentralized system is Another advantage is that decentralized systems foster
that individual communities may ignore the externalities intergovernmental competition. If citizens can choose among
they create. Suppose, for example, that some jurisdiction communities, then substantial government mismanagement
provides excellent public education for its children. If some may cause citizens to chose to live elsewhere. This threat may
 PUBLIC FINANCE 261

create incentives to government managers to produce more “You are running an inefficient tax system. You could elim-
efficiently and be more responsive to their residents. inate excess burden if you taxed X and Y at equal rates —
Finally, a decentralized system may enhance experimen- an income tax. I recommend that you lower the tax on X
tation and innovation in locally provided goods and and impose a tax at the same rate on Y. Set the rates so that
services. For many policy questions, no one is certain what the same amount of revenue is collected as before.”
the right answer is, or even whether there is a single solu- Suppose, however, that the citizens suspect that if they
tion that is best in all situations. One way to find out is to allow taxation of Y, their politicians will not lower the tax
let each community choose its own way, and then compare rate on X. Rather, they will simply take advantage of the
the results. For example, some jurisdictions might choose opportunity to tax something new to make tax revenues as
to provide innovative job-training programs for individuals large as possible. Therefore, by constitutionally precluding
who lose their jobs. If the innovations are successful, other the taxation of Y, the citizens may be rationally protecting
jurisdictions can imitate them. If not, the costs to the themselves against an inefficiently large public sector. In
country as a whole are small. other words, if government does not necessarily act in the
This discussion makes it clear that a purely decentral- interest of its citizens, then what looks inefficient from the
ized system cannot be expected to maximize social point of view of optimal tax theory may be efficient in a
welfare. Efficiency requires that those services that affect public choice setting.9
the entire country, such as national defense, be provided at In recent years, public choice has had substantial
the national level. On the other hand, it seems appropriate influence on the field of public finance. In both theoretical
for goods that affect only the members of a particular and empirical work, public finance economists study the
jurisdiction to be provided locally. This leaves us with the incentives facing government decision-makers, and how
in-between case of community activities that create exter- these incentives affect policy outcomes. In making their
nalities that are not national in scope. While one solution own policy recommendations, there is a heightened aware-
would be to create a single regional government, a larger ness that a policy that emerges from the legislative process
jurisdiction carries the cost of less responsiveness to local may look quite different from the original proposal, and
differences in tastes. An alternative method is a system of one should take this into effect in formulating recommen-
taxes and subsidies. The central government can subsidize dations. In the future, one can expect both Public Finance
activities that create positive externalities. In some and Public Choice to continue to enjoy the benefits of
countries, central governments give grants to communities intellectual cross-fertilization.
that roughly follow this model.
HARVEY S. ROSEN

7. Public Finance and Public Choice

NOTES
Traditionally, the field of public finance has tended to
1. Bator (1957) provides a classic exposition of welfare economics.
convey a rather rosy view of government. With a tax here, 2. For a more general treatment of this phenomenon, see Akerlof
an expenditure there, the state readily corrects all market (1970).
imperfections, meanwhile seeing to it that incomes are 3. For a treatment of tax incidence in other models of price
distributed in an ethically desirable way. The implicit determination, see Fullerton and Metcalf (forthcoming).
assumption is that the government is a neutral and benign 4. For a proof, see Auerbach and Hines (forthcoming).
5. Bradford (1986) provides a careful discussion of issues
force. In contrast, the field of public choice assumes that relating to the implementation of an income tax.
individuals view government as a mechanism for maximiz- 6. See Cnossen (1998) for a discussion of issues relating to the
ing their self interest. Such a viewpoint can lead to rather implementation of VATs.
different conclusions from those of conventional public 7. The difficulties and advantages of this system are discussed in
finance. Pechman (1980).
8. See Gale and Slemrod (2000) for further details.
A good example is provided by optimal tax theory.
9. Holcombe (1998) provides further comparisons between
Suppose that in a certain society, there are three commodi- optimal tax theory and a public choice approach.
ties, X, Y, and leisure. Labor is totally fixed in supply, and
therefore, income is fixed. Note that a proportional tax at
REFERENCES
the same rate on X and Y is equivalent to a tax on income.
Now, suppose that currently, this society levies a tax on X, Akerlof, George (1970). “The market for lemons: quality
but its constitution forbids taxing Y. Viewing this situation, uncertainty and the market mechanism.” Quarterly Journal of
a student of optimal tax theory might say something like, Economics, 84: 488–500.
262 PUBLIC FINANCE

Atkinson, Anthony B. (1983). The Economics of Inequality. Gale, Willaim G. and Joel B. Slemrod (2000) “A matter of life and
Oxford: Oxford University Press. death: reassesing the estate and gift tax.” Tax Notes, August 14,
Auerbach, Alan and James R. Hines, Jr., (2002). “Taxation and 927–932.
economic efficiency,” in Alan Auerbach and Martin Feldstein Hargberber, Arnold C. (1962). “The incidence of the
(eds.) Handbook of Public Economics. corporation income tax.” Journal of Political Economy, LXX:
Bator, F.M. (1957). “The simple analytics of welfare maximiza- 215–240.
tion.” American Economic Review, 47: 22–59. Holcombe, Randall (1998). “Tax policy from a public choice
Blank, Rebecca (1997). It Takes a Nation — A New Agenda for perspective.” National Tax Journal, LI: 359–371.
Fighting Poverty. New York: Russell Sage Foundation. Jorgenson, Dale W. and Kun_Young Yun (2001). Investment
Bradford, David (1986). Untangling the Income Tax. Cambridge, Volume 3: Lifting the Burden. Cambridge: The MIT Press.
MA: Harvard University Press. Meyer, Bruce D. (1995). “Lessons from the US unemployment
Cnossen, Sijbren (1998). “Global trends and issues in value-added insurance experiments.” Journal of Economic Literature, 33:
taxation.” International Tax and Public Finance. 5: 399–428. 91–131.
Elmendorf, Douglas W. and Gregory Mankiw, N. (1999). Nichols, Albert L and Richard J. Zeckhauser (1982). “Targeting
“Government debt,” in John B. Taylor and Michael Woodford transfers through restrictions on recipients.” American
(eds.) Handbook of Macroeconomics. Amsterdam: North- Economic Review Papers and Proceedings, 72: 372–377.
Holland. Oates, Wallace E. (1999). “An essay on fiscal federalism.”
Feldstein, Martin (1976). “On the theory of tax reform.” Journal Journal of Economic Literature, 37: 1120–1149.
of Public Economics, 6: 77–104. Pechman, Joseph A. (ed.) (1980). What Should Be Taxed:
Feldstein, Martin and Jeffrey B. Liebman (2001). “Social secu- Income or Expenditure? Washington: The Brookings
rity.” Working Paper No. 8541, National Bureau of Economic Institution.
Research, September. Samuelson, Paul A. (1954). “The pure theory of public
Fullerton, Don and Gilbert Metcalf. (2002). “Tax incidence,” in expenditure.” Review of Economics and Statistics, 36:
Alan Auerbach and Martin Feldstein (eds.) Handbook of 387–389.
Public Economics. Stavins, Robert N. (2002). “Experience with market-based envi-
Fuchs, Victor (1998). “Health, government, and Irving Fisher.” ronmental policy instruments,” in Karl-Goran Maler and
Working Paper No. 8490, National Bureau of Economic Jeffrey Vincent (eds.) The Handbook of Environmental
Research, August. Economics. Amsterdam: North-Holland/Elsevier Science.