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Public Sector Economics

Public Sector Economics. Optimal Taxation. Optimal Taxation in the Logic of Public Finance. first determine how policy affects the economy (dwl, winners and losers) examples of duality, mechanism design [closely related to I-O optimal pricing questions] a positive theory of government

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Public Sector Economics

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  1. Public Sector Economics Optimal Taxation

  2. Optimal Taxation in the Logic of Public Finance • first determine how policy affects the economy (dwl, winners and losers) • examples of duality, mechanism design [closely related to I-O optimal pricing questions] • a positive theory of government • Optimal tax topics • inverse elasticity principle • tax reform • screening • taxation in-kind

  3. Deadweight Costs • resource and/or efficiency loss from tax evasion and avoidance • derives from the microeconomic involuntary nature of tax payments • taxpayers change their behavior to reduce their tax bill • beneficiaries change their behavior to increase their benefit • the behavioral change is often costly to the taxpayer/beneficiary and to the treasury • like melting ice: $1 in taxes cost taxpayers more than $1, and help beneficiaries less than $1 • there is no close analogue in the private sector • higher tax rates lead to higher deadweight costs, and at an increasing rate

  4. south dwc average dwc south tax rate 0% Narrow tax base north dwc north tax rate 20%

  5. average dwc Broad tax base north dwc south dwc north tax rate south tax rate 10% 10%

  6. south dwc average dwc south tax rate 0% Narrow tax base north dwc north tax rate 20%

  7. A Tax Collection PrincipleMinimize dwc of taxes per dollar of revenue, eg., with low rates and broad base • not a trivial issue in practice. Consider three federal taxes, 1994: • personal income tax: $543b with typical rate of 24% • payroll tax: $484b with rate of 12% • corporate tax: $140b with rate of 35% • basic principle behind “The Flat Tax”

  8. DWCs: Summary • in the corporate sector, creditors are (individually) voluntary participants • government revenues are provided by (individually) involuntary participants  deadweight costs • hence, principles of public and corporate finance are different • deadweight costs may be reduced when government is “widely held” – aka, tax base breadth

  9. Tax Reform Jargon • revenue neutral • CBIT = clean-base income tax • x tax • graduated rates on labor income without deductions • flat tax • single rate (or few rates) • on labor income • without deductions • cash flow tax – a direct consumption tax (can be graduated) • R-base tax: income tax with investment deductions • sales tax • VAT = value-added tax

  10. Optimal Screening Favored group membership is like an occupation e.g., poor, elderly, farmers, persons with American Indian ancestors, etc. free entry into a favored group is inconsistent with policies that raise their utility in the absence of natural entry barriers, lump sum transfers are not optimal in-kind and other distortionary subsidies create deadweight losses, but may raise entry barriers literature Stigler (1971) on occupational licensing Becker (1983) and Gardner (1983) on farm subsidies Nichols and Zeckhauser on “socially optimal screening” some distortionary subsidies lower barriers

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