Economic Assignment
Read the materials and textbook and answer Chapter1 Question1-3 & Chapter 2 Question 1
What is Public Administration?
Government in Action – what government can do and what government can do efficiently using the least amount of time or money
Public administration is the management of people and materials in the accomplishment of the purposes of the state
The objective of public administration is the most efficient utilization of resources at the disposal of public officials and employees
1
(Scarcity Competition Limited Choice)
= Budgetary Politics
Lewis, Carol W. and W. Bartley Hildreth, 2012. Budgeting: Politics and Power, 2nd ed. New York: Oxford University Press
Lewis, Carol W. and W. Bartley Hildreth, 2012. Budgeting: Politics and Power, 2nd ed. New York: Oxford University Press, figure 1.3.
Accountability
answering to someone
such as legislature, chief executive, taxpayer
for something
such as a decision, a program, or mistake
Democracies hold public officials and employees accountable through elections, public records (such as accounts) and disclosure, and the chain of command in organizations.
Lewis, Carol W. and W. Bartley Hildreth, 2012. Budgeting: Politics and Power, 2nd ed. New York: Oxford University Press
Democracies
hold public officials and employees
accountable through
elections
public records (such as accounts) and disclosure
chain of command in organizations
the courts
Lewis, Carol W. and W. Bartley Hildreth, 2012. Budgeting: Politics and Power, 2nd ed. New York: Oxford University Press
A
B
C
C
B
C
Transparency
information is readily available and understandable or clear and
decision-making processes are regular, known, open, and participatory
Lewis, Carol W. and W. Bartley Hildreth, 2012. Budgeting: Politics and Power, 2nd ed. New York: Oxford University Press
A budget can include
only those things that can be
counted and valued in dollars.
Not everything that can be counted counts,
and not everything that counts can be counted.
Albert Einstein
Reproduced from the original held by the Department of Special Collections of the Hesburgh Libraries of the University of Notre Dame.
Lewis, Carol W. and W. Bartley Hildreth, 2012. Budgeting: Politics and Power, 2nd ed. New York: Oxford University Press
Overall importance of the budget
Budgets serve as a guide for public administrators
Define govts economic & political role in a community
Serve as plans for the future
Mold the future that is planned
Brings about order and cohesion
Political Importance of Budgeting
Property tax
Public perception of taxes
Public education and budgets
Financing public education
Laboratories of democracy
Citizen participation
Budget Process Logic
Wrangling over public servicesbudget is a communication device
Overarching functions of the budget process
Decision plan
Allocation vehicle
Fiscal discipline & control
Response to strategic priorities
Efficient implementation
The Context of Local Government Budgeting
The budget document along with its preparation, implementation and adoption express the basic political values of a government.
Budgets reflect the compromises negotiated in the contentious process of budget adoption.
Summary/
The role of budgeting in local government
Allocation of resources between public & private sectors
Invest in infrastructure
Promote economic growth
Give legitimacy to govt actions
Help manage a complex bureaucracy
Provide social and political functions
Overall, the budget establishes the level of supply for public goods and services delivered to citizens ECONOMICS OF THE PUBLIC SEC TOR
FOUR TH EDITIO N
ECONOMICS
OF THE
PUBLIC SECTOR
FOUR TH EDITION
JOSEPH E. STIGLITZ | JAY K. ROSENGARD
n
W. W. N O R TO N & CO M PA N Y, IN C .
N E W YO R K LO N D O N
W. W. Nor ton & Company has been independent since it s founding in 1923, when W illiam Warder
Nor ton and Mar y D. Her ter Nor ton f ir s t published lec tures delivered at the Peoples Ins titute, the
adult educ ation division of New York Cit y s Cooper Union. The f irm soon ex panded it s program
beyond the Ins titute, publishing book s by celebrated ac ademic s from Americ a and abroad. By
midcentur y, the t wo major pillar s of Nor tons publishing program trade book s and college tex t s
were f irmly es t ablished. In the 1950 s, the Nor ton family trans ferred control of the company to it s
employees, and today with a s t af f of four hundred and a comparable number of trade, college,
and profes sional titles published each year W. W. Nor ton & Company s t ands as the larges t and
oldes t publishing house owned wholly by it s employees.
C o py r i g h t 2 015 by W. W. N o r to n C o m p a ny, I n c .
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Tr u s t , t h e Tr u s te e o f J u lia H a n n a w ay St i g li t z Tr u s t , a n d t h e Tr u s te e o f t h e Tr u s t f o r t h e B e n e f i t
o fJ o s e p h E . St i g li t z s C h il d re n
A ll r i g h t s re s e r ve d
Pr i n te d i n t h e U n i te d St a te s o f A m e r i c a
Ed i to r : J a c k Re p c h e c k
Ed i to r ia l A s s i s t a n t : Th e re s ia Ko wa ra
Pro j e c t Ed i to r : S u j i n H o n g
M a n a g i n g Ed i to r, C o ll e g e D i g i t a l M e d ia: Ki m Yi
Pro d u c t i o n M a n a g e r : Va n e s s a N u t tr y
M a r ke t i n g M a n a g e r, Ec o n o m i c s: J a n i s e Tu r s o
D e s i g n D i re c to r : J i l l i a n B u rr
Pe r m i s s i o n s M a n a g e r : M e g a n Ja c ks o n
C o m p o s i t i o n: Ce nve o Pu b l i s h e r S e r vi ce s
M a n u f a c t u r i n g: Q u a d/G ra p h i c s Ta u nto n
L i b r a r y o f C o n g re s s C a t a l o g i n g – i n – Pu b li c a t i o n D a t a.
St i g li t z, J o s e p h E .
Eco n o m i c s o f t h e p u b li c s e c to r / J o s e p h E . St i g li t z, Jay K . Ro s e n g a rd. Fo u r t h e d i t i o n.
p a g e s c m
I n c l u d e s b i b li o g r a p h i c a l re f e re n c e s a n d i n d ex .
ISBN 978 – 0 -393 -92522-7 (p b k .)
1. Finance, Public United States. 2. Fiscal polic y United States. I. Rosengard, Jay K. II. Title.
H J257. 2. S 8 4 2 015
3 3 6 .73 d c 23 2 014 0 4 8 3 8 3
W. W. N o r to n & C o m p a ny, I n c ., 5 0 0 F i f t h Ave n u e, N ew Yo r k , N Y 10110 – 0 017
w w n o r to n.c o m
W. W. N o r to n & C o m p a ny Ltd., C a s t l e H o u s e, 75/ 76 We ll s St re e t , L o n d o n W1T 3QT
1 2 3 4 5 6 7 8 9 0
To ou r f ir s t teac her s,
Nat a nd Cha rlot te
Jord an and Bet t y
vii
BRIEF C O N T E N T S
Preface x x vi i
PART 1 ROLE AND SIZE OF THE
PUBLIC SEC TOR 1
1 DEFINING PUBLIC SECTOR
RESPONSIBILITIES 3
2 ME ASURING PUBLIC SECTOR SIZE 26
PART 2 FUNDAMENTAL S OF WELFARE
ECONOMIC S 59
3 MARKET EFFICIENCY 61
4 MARKET FAILURE 81
5 PUBLIC GOODS AND PUBLICLY PROVIDED
PRIVATE GOODS 101
6 E X TERNALITIES AND THE ENVIRONMENT 129
7 EFFICIENCY AND EQUIT Y 163
PART 3 PUBLIC EXPENDITURE THEORY 197
8 PUBLIC PRODUCTION OF GOODS
AND SERVICES 199
9 PUBLIC CHOICE 230
viii B R I E F C O N T E N T S
PART 4 PUBLIC EXPENDITURE INPR AC TICE 267
10 FR AMEWORK FOR ANALYSIS OF
E XPENDITURE POLICY 269
11 EVALUATING PUBLIC E XPENDITURE 296
12 DEFENSE, RESE ARCH, AND TECHNOLOGY 329
13 HE ALTH CARE 357
14 EDUCATION 394
15 WELFARE PROGR AMS AND THE
REDISTRIBUTION OF INCOME 428
16 SOCIAL INSUR ANCE 470
PART 5 TA X ATION IN THEORY 503
17 INTRODUCTION TO TA X ATION 505
18 TA X INCIDENCE 538
19 TA X ATION AND ECONOMIC EFFICIENCY 574
20 OPTIMAL TA X ATION 606
21 TA X ATION OF CAPITAL 636
PART 6 TA X ATION IN PR AC TICE 665
22 THE PERSONAL INCOME TA X 667
23 THE CORPOR ATION INCOME TA X 709
24 A STUDENTS GUIDE TO TA X AVOIDANCE 746
25 REFORM OF THE TA X SYSTEM 762
PART 7 FURTHER ISSUES 799
26 INTER GOVERNMENTAL FISCAL
REL ATIONS 801
27 SUBNATIONAL TA XES AND
E XPENDITURES 832
28 FISCAL DEFICITS AND GOVERNMENT
DEBT 851
References 880
Index 893
ix
C O N T E N T S
Preface x x vi i
PART 1 ROLE AND SIZE OF THE
PUBLIC SEC TOR 1
1 DEFINING PUBLIC SEC TOR
RESPONSIB ILITIES 3
The Economic Role of Government 4
The Mixed Economy of the United States 4
Different Perspectives on the Role of Government 6
An Impetus for Government Action: Market Failures 7
Achieving Balance between the Public and Private Sectors 10
The Emerging Consensus 11
Thinking Like a Public Sector Economist 13
Analyzing the Public Sector 15
Economic Models 17
Case Study Musgraves Three Branches 18
Normative versus Positive Economics 19
Disagreements among Economists 21
Differences in Views on How the Economy Behaves 21
Disagreement over Values 23
Case Study Public Sector Economics and
the Global Economic Crisis 23
Review and Practice 24
Summary 24
Key Concepts 24
Questions and Problems 25
x
2 ME A SURING PUB LIC SEC TOR SIZE 26
What or Who Is the Government? 27
Types of Government Activity 29
Providing a Legal System 30
Government Production 30
Governments Infl uence on Private Production 33
Government Purchases of Goods and Services 36
Government Redistribution of Income 36
Overview of Government Expenditures 40
Gauging the Size of the Public Sector 42
Growth in Expenditures and Their Changing
Composition 42
Case Study Estimating the Full Budgetary and
Economic Costs of War 43
Comparison of Expenditures across Countries 45
Government Revenues 47
Taxes and the Constitution 47
Federal Taxation Today 48
State and Local Government Revenues 49
Comparison of Taxation across Countries 50
Defi cit Financing 51
Playing Tricks with the Data on Government
Activities 55
Review and Practice 56
Summary 56
Key Concepts 57
Questions and Problems 57
PART 2 FUNDAMENTAL S OF WELFARE
ECONOMIC S 59
3 MARKET EFFICIENC Y 61
The Invisible Hand of Competitive Markets 61
Welfare Economics and Pareto Effi ciency 63
Case Study On the Prowl for Pareto
Improvements 64
Pareto Effi ciency and Individualism 65
The Fundamental Theorems of Welfare Economics 66
Effi ciency from the Perspective of a Single Market 68
Analyzing Economic Effi ciency 69
The Utility Possibilities Curve 69
Exchange Effi ciency 70
Production Effi ciency 74
Product Mix Effi ciency 78
C O N T E N T S
xi
Review and Practice 79
Summary 79
Key Concepts 80
Questions and Problems 80
4 MARK ET FAILURE 81
Property Rights and Contract Enforcement 82
Case Study Property Rights and Market Failures:
The Tragedy of the Commons Revisited 82
Market Failures and the Role of Government 83
1.Failure of Competition 83
2. Public Goods 86
3. Externalities 86
4. Incomplete Markets 87
Case Study Student Loans: Incomplete Reform of an
Incomplete Market 89
5. Information Failures 91
6. Unemployment, Infl ation, and Disequilibrium 93
Interrelationships of Market Failures 93
Case Study Market Failures: Explanations or Excuses? 94
Redistribution and Merit Goods 95
Two Perspectives on the Role of Government 97
Normative Analysis 97
Positive Analysis 98
Review and Practice 99
Summary 99
Key Concepts 99
Questions and Problems 100
5 PUB LIC GOODS AND PUB LICLY PROVIDED
PRIVATE GOODS 101
Public Goods 102
Public Goods and Market Failures 103
Paying for Public Goods 103
The Free Rider Problem 105
Case Study Economists and the Free Rider Problem 106
Pure and Impure Public Goods 107
Case Study Property Rights, Excludability, and
Externalities 110
Publicly Provided Private Goods 111
Rationing Devices for Publicly Provided Private Goods 113
Effi ciency Conditions for Public Goods 116
Demand Curves for Public Goods 117
Pareto Effi ciency and Income Distribution 122
C O N T E N T S
xii
Limitations on Income Redistribution and the Effi cient
Supply of Public Goods 122
Distortionary Taxation and the Effi cient Supply of
Public Goods 123
Effi cient Government as a Public Good 124
Review and Practice 125
Summary 125
Key Concepts 125
Questions and Problems 126
APPENDIX: The Leftover Curve 127
6 E X TERNALITIES AND THE ENVIRONMENT 129
The Problem of Externalities 130
Private Solutions to Externalities 132
Internalizing Externalities 132
The Coase Theorem 133
Using the Legal System 134
Case Study The Exxon Valdez Oil Spill 135
Failures of Private Solutions 136
Public Sector Solutions to Externalities 138
Case Study Double Dividend 138
Market-Based Solutions 139
Regulation 145
Innovation 146
Information Disclosure 148
Compensation and Distribution 149
Protec t ing t he Environment: The Role of
Government inPractice 150
Air 151
Water 155
Land 156
Concluding Remarks 159
Review and Practice 159
Summary 159
Key Concepts 160
Questions and Problems 160
7 EFFICIENC Y AND EQUIT Y 163
Effi ciency and Distribution Trade-Offs 164
Analyzing Social Choices 164
Determining the Trade-Offs 166
Evaluating the Trade-Offs 169
Two Caveats 173
C O N T E N T S
xiii
Social Choices in Practice 174
Measuring Benefi ts 175
Ordinary and Compensated Demand Curves 178
Consumer Surplus 179
Measuring Aggregate Social Benefi ts 181
Measuring Ineffi ciency 181
Case Study Drawing a Poverty Line 182
Quantifying Distributional Effects 184
Case Study The Great Gatsby Curve 185
Three Approaches to Social Choices 186
The Compensation Principle 186
Trade-Offs across Measures 186
Weighted Net Benefi ts 187
The Trade-Off between Effi ciency and
Fairness Revisited 188
Review and Practice 189
Summary 189
Key Concepts 190
Questions and Problems 190
APPENDIX: Alternative Measures of Inequality 192
The Lorenz Curve 192
The DaltonAtkinson Measure 194
PART 3 PUBLIC EXPENDITURE THEORY 197
8 PUBLIC PRODUC TION OF GOODS
AND SERVICES 199
Natural Monopoly: Public Production of
Private Goods 201
The Basic Economics of Natural Monopoly 202
Regulation and Taxation (Subsidies) 206
No Government Intervention 209
Government Failures 210
Case Study Rent Control and Agricultural Price Supports:
Case Studies in Government Failure 211
Comparison of Effi ciency in the Public and
Private Sectors 213
Case Study National Performance Review 214
Sources of Ineffi ciency in the Public Sector 216
Organizational Differences 216
Individual Differences 217
Bureaucratic Procedures and Risk Aversion 220
Corporatization 221
Case Study Privatizing Prisons 224
C O N T E N T S
xiv
A Growing Consensus on Governments Role
in Production 225
Review and Practice 227
Summary 227
Key Concepts 228
Questions and Problems 228
9 PUB LIC CHOICE 230
Public Mechanisms for Allocating Resources 230
The Problem of Preference Revelation 231
Individual Preferences for Public Goods 232
The Problem of Aggregating Preferences 236
Majority Voting and the Voting Paradox 237
Arrows Impossibility Theorem 238
Single-Peaked Preferences and the Existence of a
Majority Voting Equilibrium 240
The Median Voter 243
The Ineffi ciency of the Majority Voting Equilibrium 243
The Two-Party System and the Median Voter 246
Case Study Social Choice Theory 248
Alternatives for Determining Public Goods
Expenditures 249
Lindahl Equilibrium 249
Politics and Economics 252
Why Do Individuals Vote? 252
Elections and Special Interest Groups 253
The Power of Special Interest Groups 254
Other Aspects of the Political Process 255
Case Study Campaign Finance Reform 256
The Altruistic Politician? 257
The Persistence of Ineffi cient Equilibrium 258
Review and Practice 259
Summary 259
Key Concepts 260
Questions and Problems 260
APPENDIX: New Preference-Revelation Mechanisms 262
PART 4 PUBLIC EXPENDITURE INPR AC TICE 267
10 FR AMEWORK FOR ANALYSIS OF
E XPENDITURE POLIC Y 269
Need for a Program 270
Market Failures 271
Case Study Higher Education in the United States 272
Alternative Forms of Government Intervention 272
C O N T E N T S
xv
The Importance of Particular Design Features 274
Private Sector Responses to Government Programs 275
Effi ciency Consequences 277
Income and Substitution Effects and Induced
Ineffi ciency 277
Distributional Consequences 281
Evaluating the Distributional Consequences 284
Case Study Incidence of Education Tax Credits 284
Fairness and Distribution 286
Equit y Ef f icienc y Trade – Offs 287
Public Policy Objectives 290
Political Process 291
Review and Practice 294
Summary 294
Key Concepts 294
Questions and Problems 294
11 EVALUATING PUB LIC E XPENDITURE 296
Private CostBenefi t Analysis 297
Present Discounted Value 297
Social CostBenefi t Analysis 299
Consumer Surplus and the Decision to Undertake
a Project 300
Measuring Nonmonetized Costs and Benefi ts 303
Valuing Time 304
Valuing Life 304
Case Study Children, Car Safety, and the Value of Life 305
Valuing Natural Resources 307
Shadow Prices and Market Prices 308
Discount Rate for Social CostBenefi t Analysis 309
Case Study Climate Change and Discount Rates 312
The Evaluation of Risk 314
Risk Assessment 317
Distributional Considerations 318
Cost Effectiveness 319
Post-Expenditure Evaluation: Assessing and
Improving Government Performance 323
Case Study Taking a Bite Out of Crime in
the Big Apple 324
Review and Practice 326
Summary 326
Key Concepts 327
Questions and Problems 327
C O N T E N T S
xvi
12 DEFENSE , RESE ARCH, AND TECHNOLOGY 329
Defense Expenditures 330
The Value of Marginal Analysis 333
Defense Strategy 334
Case Study Game Theory, the Arms Race, and
the Theory of Deterrence 336
Case Study Converting Swords into Plowshares 338
Increasing the Effi ciency of the Defense
Department 339
Defense Procurement 339
Defense Conversion 343
Accounting and the Defense Department 344
Research and Technology 345
Market Failures 348
Case Study The Scope of the Patent: Can the
Human Body Be Patented? 350
Government Direct Support 353
Review and Practice 354
Summary 354
Key Concepts 355
Questions and Problems 355
13 HE ALTH C ARE 357
The Health Care System in the United States 360
The Private Sector 364
The Role of Government 364
Other Expenditure Programs 365
Tax Expenditures 366
Rationale for a Role of Government in
the Health Care Sector 367
Imperfect Information 368
Limited Competition 369
Absence of Profi t Motive 370
Special Characteristics of the U.S. Market 371
The Role of the Health Insurance Industry 372
Case Study Medical Malpractice 372
Insurance and Excessive Expenditures on Health Care 374
Consequences of Ineffi ciencies in Health Care Markets 379
Poverty, Incomplete Coverage, and the Role of
Government 381
Reforming Health Care 382
Cost Containment 383
Case Study Comprehensive Health Care Reform 384
Extending Insurance Coverage 385
C O N T E N T S
xvii
Medicare Reform: Easing Long-Term Fiscal Strains 387
Reforming Medicaid 390
Review and Practice 391
Summary 391
Key Concepts 392
Questions and Problems 392
14 EDUC ATION 394
The Structure of Education in the United States 397
Federal Tax Subsidies to Private and Public Schools 399
Why Is Education Publicly Provided and
Publicly Financed? 401
Is There a Market Failure? 401
The Federal Role 403
Issues and Controversies inEducational Policy 403
Education Outcomes 404
Do Expenditures Matter? 405
School Vouchers: Choice and Competition 407
Case Study Vouchers: The San Jose and Milwaukee
Experiments 412
School Decentralization 413
Performance Standards: No Child Left Behind and
Race to the Top 414
Inequality 416
Aid to Higher Education 418
Review and Practice 422
Summary 422
Key Concepts 423
Questions and Problems 423
APPENDIX: How Should Public Educational Funds
Be Allocated? 425
15 WELFARE PROGRAMS AND THE REDISTRIBUTION
OF INCOME 428
A Brief Description of Major U.S. Welfare Programs 430
AFDC and TANF 430
Earned Income Tax Credit 431
Food Stamps/SNAP 432
Medicaid 434
Housing 435
Other Programs 436
Rationale for Government Welfare Programs 437
Dimensions of the Problem 438
C O N T E N T S
xviii
Analytic Issues 440
Labor Supply 440
Cash versus In-Kind Redistribution 444
Ineffi ciencies from In-Kind Benefi ts 445
Are In-Kind Benefi ts Paternalistic? 450
Categorical versus Broad-Based Aid 451
Is Means Testing Objectionable in Its Own Right? 453
Other Distortions 453
Case Study Conditional Cash Transfer Programs 454
Welfare Reform: Integration of Programs 456
The Welfare Reform Bill of 1996 458
Block Granting 458
Analytics of State Responses to Block Grants 459
Time Limits 461
Mandatory Work 461
The Welfare Reform Debate of 1996 462
Case Study The Person or the Place? 464
Concluding Remarks 466
Review and Practice 466
Summary 466
Key Concepts 467
Questions and Problems 468
16 SOCIAL INSUR ANCE 470
The Social Security System 472
Social Security, Private Insurance, and
Market Failures 475
High Transactions Costs 476
Risk Mitigation 477
Lack of Indexing: The Inability of Private Markets to
Insure Social Risks 477
Adverse Selection, Differential Risks, and
the Cost of Insurance 478
Moral Hazard and Social Security 480
Retirement Insurance as a Merit Good 481
Social Security, Forced Savings, and Individual Choice 481
Is There a Need to Reform Social Security? 482
The Nature of the Fiscal Crisis 484
Savings 487
Labor Supply 488
The Rate of Return 490
Inequities 491
Reforming Social Security 492
Reducing Expenditures 492
Increasing Revenues 494
C O N T E N T S
xix
Structural Reforms 495
Case Study Social Security Abroad 496
Review and Practice 500
Summary 500
Key Concepts 501
Questions and Problems 501
PART 5 TA X ATION IN THEORY 503
17 INTRODUC TION TO TA X ATION 505
Background 506
Forms of Taxation 507
Changing Patterns of Taxation in the United States 508
Comparisons with Other Countries 509
The Five Desirable Characteristics of Any
Tax System 511
Economic Effi ciency 512
Administrative Costs 517
Case Study Corrective Taxes and the
Double Dividend 518
Flexibility 520
Transparent Political Responsibility 521
Fairness 523
Case Study Corruption-Resistant Tax Systems 531
General Framework for Choosing among
Tax Systems 532
Utilitarianism 533
Rawlsian Social Welfare Function 534
Review and Practice 536
Summary 536
Key Concepts 537
Questions and Problems 537
18 TA X INCIDENCE 538
Tax Incidence in Competitive Markets 540
Effect of Tax at the Level of a Firm 540
Impact on Market Equilibrium 542
Does It Matter Whether the Tax Is Levied on Consumers
or on Producers? 543
Case Study The Incidence of Government Benefi ts 544
Ad Valorem versus Specifi c Taxes 545
The Effect of Elasticity 546
Taxation of Factors 548
Case Study The Philadelphia Wage Tax 549
C O N T E N T S
xx
Tax Incidence in Environments without Perfect
Competition 552
Relationship between the Change in the Price and the Tax 554
Ad Valorem versus Specifi c Taxes 556
Tax Incidence in Oligopolies 556
Equivalent Taxes 557
Income Tax and Value-Added Tax 557
Equivalence of Consumption and Wage Taxes 558
Equivalence of Lifetime Consumption and
Lifetime Income Taxes 559
A Caveat on Equivalence 560
Other Factors Affecting Tax Incidence 560
Tax Incidence under Partial and General Equilibrium 560
Case Study Behavioral Economics, Managerial Capitalism,
and Tax Incidence 561
Short-Run versus Long-Run Effects 564
Open versus Closed Economy 564
Associated Policy Changes 565
Case Study Tax Incidence of Specifi c Tax Provisions 566
Incidence of Taxes in the United States 566
Review and Practice 570
Summary 570
Key Concepts 570
Questions and Problems 571
APPENDIX: Comparison of the Effects of an Ad Valorem
and Specifi c Commodity Tax on a Monopolist 572
19 TA X ATION AND ECONOMIC EFFICIENC Y 574
Effect of Taxes Borne by Consumers 575
Substitution and Income Effects 576
Quantifying the Distortions 577
Measuring Deadweight Loss Using Indifference Curves 578
Measuring Deadweight Loss Using Compensated
Demand Curves 580
Calculating the Deadweight Loss 582
Effect of Taxes Borne by Producers 584
Effects of Taxes Borne Partly by Consumers,
Partly by Producers 587
Taxation of Savings 588
Quantifying the Effects of an Interest Income Tax 591
Taxation of Labor Income 591
Effects of Progressive Taxation 593
Case Study The 1993, 2001, and 2003 Tax Reforms 596
Secondary Labor Force Participants 597
C O N T E N T S
xxi
Measuring the Effects of Taxes on Labor Supplied 597
Statistical Techniques Using Market Data 598
Experiments 600
Review and Practice 603
Summary 603
Key Concepts 604
Questions and Problems 604
APPENDIX: Measuring the Welfare Cost of User Fees 605
20 OP TIMAL TA X ATION 606
Two Fallacies of Optimal Taxation 607
The Fallacy of Counting Distortions 607
Misinterpretations of the Theory of the Second Best 607
Optimal and Pareto Effi cient Taxation 608
Lump-Sum Taxes 609
Why Impose Distortionary Taxes? 609
Case Study Estimating the Optimal Tax Rate 610
Case Study Rent Seeking, Inequality, and
Optimal Taxation 611
Designing an Income Tax System 611
Why Does More Progressivity Imply More
Deadweight Loss? 612
A Diagrammatic Analysis of the Deadweight Loss
of Progressive Taxation 614
Choosing among Flat-Rate Tax Schedules 615
Case Study The 1993 Tax Increase on Upper-Income
Individuals: A Pareto Ineffi cient Tax? 616
General Equilibrium Effects 617
Case Study Flat-Rate Taxes Arrive on the Political Scene 618
Differential Taxation 621
Ramsey Taxes 621
Differential Commodity Taxes in Advanced Countries
with ProgressiveIncome Taxes 625
Interest Income Taxation and Commodity Taxation 626
Taxes on Producers 627
The Dependence of Optimal Tax Structure on the
Set of Available Taxes 629
Review and Practice 630
Summary 630
Key Concepts 631
Questions and Problems 631
APPENDIX A: Deriving Ramsey Taxes on Commodities 632
APPENDIX B: Derivation of Ramsey Formula for
Linear Demand Schedule 634
C O N T E N T S
xxii
21 TA X ATION OF C APITAL 636
Should Capital Be Taxed? 638
Relationship among Consumption Taxes, a Wage Tax, and
Exempting Capital Income from Taxation 638
Equity Issues 638
Effi ciency Arguments 639
Administrative Problems 640
Effects on Savings and Investment 641
Effects of Reduced Savings in a Closed Economy 641
The Distinction between Savings and Investment 642
National Savings and Budget Neutrality 644
Effects of Reduced Savings in an Open Economy 646
Impact on Risk Taking 648
Why Capital Taxation with Full Loss Deductibility May
Increase Risk Taking 649
Case Study Tax Incentives for Risk Taking 650
Why Capital Taxation May Reduce Risk Taking 651
Measuring Changes in Asset Values 652
Capital Gains 653
Case Study Equity and the Reduction in
Capital Gains Taxes 654
Depreciation 657
Case Study Distortions from Depreciation 657
Neutral Taxation 659
Infl ation 659
Review and Practice 662
Summary 662
Key Concepts 663
Questions and Problems 663
PART 6 TA X ATION IN PR AC TICE 665
22 THE PER SONAL INCOME TA X 667
Outline of the U.S. Income Tax 667
Legislated versus Actual Tax Rates 672
Case Study A Loophole in the Earned Income
Tax Credit? 673
Other Taxes 673
Principles Behind the U.S. Income Tax 677
The Income-Based Principle and the HaigSimons
Defi nition 677
The Progressivity Principle 679
The Family-Based Principle 680
The Annual Measure of Income Principle 683
C O N T E N T S
xxiii
Practical Problems in Implementing an
Income Tax System 684
Determining Income 684
Timing 690
Personal Deductions 690
Deductions versus Credits 698
Case Study Temporary Tax Changes 699
Special Treatment of Capital Income 699
Housing 700
Savings for Retirement 701
Interest on State and Municipal Bonds 703
Capital Gains 704
Concluding Remarks 706
Review and Practice 707
Summary 707
Key Concepts 707
Questions and Problems 708
23 THE CORPOR ATION INCOME TA X 709
The Basic Features of the Corporation Income Tax 711
The Incidence of the Corporation Income Tax and
Its Effect on Effi ciency 713
The Corporation Income Tax as a Tax on Income from
Capital in the Corporate Sector 713
Shifting of the Corporate Tax in the Long Run 715
The Corporation Tax for a Firm without Borrowing
Constraints 717
Incidence of the Corporation Income Tax with
Credit-Constrained Firms 718
The Corporation Tax as a Tax on Monopoly Profi ts 720
Managerial Firms: An Alternative Perspective 721
Depreciation 726
Combined Effects of Individual and Corporate
Income Tax 728
Distributing Funds: The Basic Principles 728
The Dividend Paradox 730
Mergers, Acquisitions, and Share Repurchases 731
Does the Corporate Tax Bias Firms toward Debt Finance? 732
Distortions in Organizational Form Arising because Some
Firms Do Not Have Taxable Income 734
Are Corporations Tax Preferred? 735
Calculating Effective Tax Rates 736
The Corporation Tax as Economic Policy 737
Case Study The Proposed Incremental Investment Tax Credit
of 1993: An Idea before Its Time? 738
C O N T E N T S
xxiv
Taxation of Multinationals 739
Case Study Foreign Income and the Corporation
Income Tax 741
Should There Be a Corporation Income Tax? 742
Why Is There a Corporate Income Tax at All? 743
Review and Practice 744
Summary 744
Key Concepts 744
Questions and Problems 745
24 A S TUDENTS GUIDE TO TA X AVOIDANCE 74 6
Principles of Tax Avoidance 747
Postponement of Taxes 747
Shifting and Tax Arbitrage 749
Case Study Shorting against the Box 751
Tax Shelters 752
Case Study The Economics of Tax Avoidance 753
Who Gains from Tax Shelters 753
Middle-Class Tax Shelters 755
Tax Reform and Tax Avoidance 756
The 1986 Tax Reform 756
Minimum Tax on Individuals 757
Subsequent Tax Acts 758
Equity, Effi ciency, and Tax Reform 758
Review and Practice 760
Summary 760
Key Concepts 760
Questions and Problems 760
25 REFORM OF THE TA X S YS TEM 762
Fairness 764
Horizontal Equity Issues 764
Vertical Equity 766
Effi ciency 769
Case Study Marginal Tax Rates and the 1986 Tax Reform 772
Base Broadening 773
Interaction of Fairness and Effi ciency Concerns 777
Simplifying the Tax Code 778
Assessing Complexity 778
Increasing Compliance 779
Reducing Tax Avoidance 781
Reducing Administrative and Compliance Costs 781
Sources of Complexity 782
The 1986 Tax Reform 784
C O N T E N T S
xxv
Transition Issues and the Politics of Tax Reform 785
Tax Reforms for the Twenty-First Century 787
Reforms within the Current Framework 787
Major New Reforms 788
Case Study Ordinary Income versus Capital Gains 794
Case Study IRAs and National Savings 796
Review and Practice 797
Summary 797
Key Concepts 797
Questions and Problems 797
PART 7 FURTHER ISSUES 799
26 INTERGOVERNMENTAL FISCAL REL ATIONS 801
The Division of Responsibilities 802
Other Interaction between the FederalGovernment
and the State and Local Governments 805
The Size of Financial Transfers 806
Case Study Unfunded Mandates 807
Principles of Fiscal Federalism 808
National Public Goods versus Local Public Goods 808
Case Study International Public Goods 809
Do Local Communities Provide Local Public Goods
Effi ciently? 810
Tiebout Hypothesis 810
Market Failures 812
Redistribution 814
Other Arguments for Local Provision 818
Production versus Finance 819
Effectiveness of Federal Categorical Aid to
Local Communities 821
The Federal Tax System and Local Expenditures 825
Concluding Remarks 827
Review and Practice 830
Summary 830
Key Concepts 830
Questions and Problems 830
27 SUBNATIONAL TA XES AND EXPENDITURES 832
Tax Incidence Applied to Local Public Finance 832
Local Capital Taxes 833
Property Tax 834
Case Study The U
