Public Sector Economics

1. Public Sector Economics Tax Incidence

2. Private Sector Response to Public Redistribution • price changes • partial equilibrium • general equilibrium • migration • altruism • insurance markets

3. Outline of Topics • partial equilibrium • excise tax theory • elastic agents bear less • principle of comprehensive cost • cigarette tax incidence • general equilibrium theory • capital tax incidence • incidence of taxes and spending by • income group • cohort  social security • paternalism

4. industry cost curve A B+D = borne by demanders C+E = borne by suppliers B D no-tax price E C industry demand F Tax on Demanders after-tax price B+C = government revenue D+E = dwc pre-tax price B/C = depends only on dp/dt

5. Partial Equilibrium Model • general results • “elastic agents bear less” • doesn’t matter whether the tax is levied on the buyer or seller • special results • only supply and demand elasticities matter • only suppliers and demanders in the taxed market are affected • both suppliers and demanders are harmed by the tax

6. Incidence in the “Long Run” • “long run” = capital can adjust • if capital is elastically supplied in the long run, than capital will not bear the burden of taxes • theories of the supply of capital • international trade • economic growth theories

7. Descriptions of Policy Incidence • dimensions of government redistribution • income classes • age/year of birth • factor ownership • occupation • instruments of redistribution • taxes • spending • regulation

8. Pechman’s Study of Tax Incidence • people distinguished only by their annual income • statutory incidence only • savings and work are fixed • consumption patterns are fixed, and do not vary by income class • variety of assumptions regarding incidence of corporate income, property, and payroll taxes • IIT: 100% on payer • sales and excise: 100% on consumers • payroll tax: 75-100% on workers • property tax: 100% on landholders and/or capital owners • corporate income: variety • MERGE files • start with CPS • for filing population, use Form 1040 income information for “similar” families in the IRS database • CPS necessary because it is a random sample • benchmark: proportional income tax

9. Pechman’s Study of Tax Incidence: Results • no significant difference from flat tax, except at very top and bottom • results for top and bottom are mild, and vary across incidence models • transfers • appear very progressive in Pechman • but Social Security is a big part of transfers, and is not so progressive w.r.t. lifetime income

10. Regressive Taxes in Western Europe • Western European countries • known for their generous welfare states • Sometimes known for progressive income taxes • However, income tax is not the only tax especially in Western Europe • Other taxes • payroll taxes, sales taxes, excise taxes, property taxes • often are regressive • Western European taxes are more regressive because they are less income-tax intensive

12. Calculating the Income Incidence of Social Security • annual cross-sections show the “poor” receive most of the SS expenditures, but do not pay much of taxes • eg., Musgrave et al (1974, Table 6) • generational accounting = focus on age-dimension rather than income dimension • stratify by both income and year of birth • what is the lifetime relation between income and years spent in school? • payroll tax caps • some portion of benefits may be paid from general revenue. Is the general tax system progressive? • payroll tax rates across occupations

13. Calculating the Income Incidence of Social Security (cont’d) • special treatment of government employees • do they tend to be rich or poor? • is the supply of government employees competitive? • benefit receipt often requires knowledge of eligibility and/or infrastructure • not the same with tax payments • is knowledge correlated with lifetime income? • differential valuation of benefits • legislative exclusions • minorities. eg., Jamaica, Rhodesia, South Africa • nonunion members • agriculture • trend is toward eliminating exclusions

14. Calculating the Income Incidence of Social Security (cont’d) • progressivity of the annual benefit formula • SS OASDI paid as a life annuity • more life –> more benefits received • what is the relation between lifetime income and mortality? • health benefits paid as reimbursement for medical procedures, etc. • more life –> more benefits received • when alive, more visits to doctor/hospital –> more benefits received • what is the relation between visits and lifetime income? • years-of-participation rules for eligibility; SI incidence • SS crowds out other (more progressive?) public programs

15. Generational Accounting • date of birth accounts • each cohort’s NPV of taxes - transfers, forward from birth • for a self-financed transfer program with negligible admin costs, sum to PV zero across cohorts (including unborn and deceased cohorts in the sum) • more generally • cohort sum to PV of (past & present) gov. purchases • what is the incidence of these purchases? • can be expressed as: • $ per cohort member • $ per NPV of taxes (Kotlikoff critique) • IRR • remaining lifetime accounts (Kotlikoff) • each cohort’s NPV of taxes & benefits, forward from today • sum across cohorts to debt value + PV of future purchases • based entirely on estimates of future tax & transfer rules

16. IRR as a measure of Generational Incidence

17. Generational Accounts Feature Present Values

18. Generational Accounting – Some Results • large redistribution in the age dimension • from postwar generations to prewar generations (eg., Leimer) • from unborn generations to current generations (Kotlikoff) • old age public pensions are the main mechanism • education spending hardly reverses this • current laws in most, but not all, countries (among those studied) imply redistribution from unborn generations • other (obvious) results • cutting OASDI benefits hurts older generations • raising the sales tax to finance constant OASDI benefits hurts younger generations less than raising the payroll tax • unavoidable legacy

19. Social Security Reforms • unavoidable legacy: since older cohorts, younger cohorts must do poorly • unless • NPV’s do not sum to zero • ie, combine Social Security with a profitable government enterprise • viable government enterprises? • buying stocks and selling bonds • reducing tax distortions has positive NPV • charging for immigration • what is the connection between the government enterprise and SS? Would the enterprise be profitable without SS? • example: letting SS earn the pretax return = reducing capital taxes

20. Distortions and Redistribution • are distortions a necessary but unintended byproduct of redistribution? • standard public finance view • but why are “strings attached” to the transfers? • can this apply to “universal” participation programs? • is redistribution a necessary but unintended byproduct of distortion? • paternalism • correcting market failures • producer interests • tax incidence is very different • distinguishing these models • compare magnitude of distortions with magnitude of redistribution • look at take-up rates • are distortions in the direction of luxury or inferior goods? • is the statutory incidence against the poor? • what determines the markets for intervention?

21. Three Versions of Paternalism • consumption-based paternalism • literal consumption externality/merit good/impure altruism • information-based paternalism • arises from pure altruism • disagreement about the probability of various contingencies • but is force necessary? Why not communicate the information? • strategically-induced paternalism • arises from pure altruism, and the timing of decisions • e.g., Samaritan’s Dilemma, parents relying on their children for elderly support • unfunded mandate enhances efficiency, while helping the Samaritan at the expense of the beneficiary

22. Strategically-Induced Paternalism • consumption over time: c1 and c2 • superscripts r, p still indicate rich poor • second stage • rich make voluntary transfer to the poor • poor consume the sum of their savings and this transfer • no government at this stage • savings from previous period denoted mr and mp • second stage decision rules are: • assume: the rich are altruistic enough, and/or poor are poor enough –> positive and equal partial derivatives of c2p(mp,mr) in the interval (0,1)

23. Strategically-Induced Paternalism (cont’d) • first stage • rich and poor separately choose their savings, looking ahead to the effect of their savings on future consumption • government may be regulating, or taxing, at this stage • without government, rich have objective • compare with

24. Differential Valuation • if paternalism is operative, differential valuation is necessarily an exercise in extrapolation • “structural” approach • build a numerical model of demand • choose utility parameters (or demand elasticities) • calculate compensating variation or consumer surplus • prices from secondary markets • resale of in-kind transfers. but is the existence of a resale market consistent with paternalism? • hedonics. also applicable when differential valuation derives from the public production function (eg., public housing) • contingent valuation