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Summary Public Finance, whole course

Public Finance (Rijksuniversiteit Groningen)

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WELFARE ECONOMICS + PUBLIC GOODS

1st fundamental theorem:
• Perfect competition
• Exists a market for each and every commodity
nd
2 fundamental theorem:
• Assigning initial endowments fairly (FAIRNESS)
• Letting people trade freely
Market failure:
• Market power (monopolies etc. P>MC)
• Non-existence of markets: due to asymmetric information (one party has more info than the
other)
• Externalities
• Public goods: non-rival (if consumed does not reduce the availability for others) non-excludable
(impossible to prevent anyone from using the good)
o Excludable: If paid for the good, then it is limited to your use only
o Rivalry: If consumed it reduces the availability for others to consume it as well

Utility possibility curve: Any point on the utility possibility curve is efficient. (graph)
Social indifference curve: maximizes utility given two goods (graph)
Pareto efficient: Nobody can be better off without making the other worse off.
The condition for Pareto efficient provision of a public good is (in a two person world) is:
MRS1 +MRS2 = MRT
In a utility graph it is where the social indifference curves = utility possibility curve
Edgeworth box: A device used to depict the distribution of goods in a two good two person world (≠ a
graph with utility possibilities curves for two persons)
Slope = MRS: amount of one good a consumer is willing to give for another.
Contract Curve: Any point on the contract curve is efficient, it joins all the points where the indifference
curves are tangent (pareto-efficient allocations).

Incidence of a Tax
• Income effect: Income is lower hence less is bought of everything
• Substitution effect: relative price of the good taxed is higher, the taxed good is then
substituted by other goods.
• Compensated demand
Pure Public Good: Non-rivalry (street lights) and Non-excludable (national security)
Pure Private Good: Rival (bus ticket) and excludable (chocolate bar)
Publicaly provided private goods: private goods provided by the government (medical service, housing)
Privately provided public goods: fireworks
Impure public good: to some extent rival or excludable roads
Private good horizontal summation to determine demand (MRS = MRS = MRT)

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Public good vertical summation (yet people are not always honest) MRS +MRS=MRT
For standard private goods, everyone sees the same prices and determines how much they want. For
public goods, everyone sees the same quantity and people decide what price they are willing to pay.
Free rider: not being honest with the price one is willing to pay because then it use the good will other
people pay for it.
Privatization: Takign services/goods that are supplied by government and taking them in private sector
for provision/protection.
Education: not necessarily a public good.

PUBLIC RESPONSE TO EXTERNALITIES (Lecture 2)

Externality: Activity directly affects welfare of others, but not through the market mechanism. Due to
absence of property rights. (Gov can; subsidy, tax, make a law, create trade permits)

Private responses: Bargaining, mergers, social conventions.

1. Assigning property rights: Example. Fisher and factory. Factory pollutes river which has a negative
effect on the fisher. This is a problem because no one owns the river. If property rights are assigned to
the river, the problem will be solved but some individual parties will lose. Yet that party can force then
force a settlement.
Coase Theorem: No matter who is assigned the property rights, an efficient solution will be achieved if:
1. Bargaining costs are low
2. Owner can identify all users (polluters, fisher…)

2. Pigouvian tax: A special tax that is often levied on companies that pollute the environment or create
excess social costs, called negative externalities, through business practices. The efficient tax rate is the
amount equal to the marginal damage at the efficient level of output.

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Pigouvian subsidy: subsidy given to an activity given it generates external benefits (difference with
pigouvian tax is that it can also be provided by private philanthropy)
Yet polluters amount hard to identify, subsidy may attract more factories more pollution, ethically
wrong

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3. Emission Fees: tax per unit of pollution (not per unit of output Pigouvian tax)
ADVANTAGE DISADVANTAGE
• Cost effective, businesses that can reduce • Need to be adjusted to inflation in order to
their pollution cheaper than the emission fee have same effect as Cap and Trade
will. • Pollution measure of all polluter must be
• Provide an incentive to innovate measured, costly and time consuming

4. Cap and Trade: Government creates a certain number of emission permits. Polluters need an
emission permit per unit of pollutant emitted. Such permits can be traded among polluters.
ADVANTAGE DISADVANTAGE
• Pollution can easily be reduced by reducing • Encourages industries most addicted to carry
the amount of permits. on.
• No correction is needed for inflation
• 2013 permits will be auctioned: government
able to make profit

PROJECT EVALUATION (Lecture 3)

Cost –Benefit analysis tricks:
• Chain Reaction Game: Include all kinds of secondary benefits.
Ex. New road evaluation will include increase in profits of restaurants along the road but exclude
decrease of profits for other restaurants
• Double counting game: count benefits twice
Ex. Benefit of an irrigation project includes increased revenue from farming and increase value
of the land
• Labor game: Include wages of jobs created by a project even though wages is a cost not a
benefit
• Use Benefit/Cost ratio: NPVbenefits/NPVcosts>1, useless to compare projects because a cost can be
classified as a lower benefit no real identification of costs and benefits
• Use internal rate of return: p>r where p=discount rate that would make NPV=0, if projects differ
in size p can be misleading because a big project with small p may be better than a small project
with high p
Ex. NPV= 100 + 105/(1+p)=0 p=0.05 where 100 was what they originally spent and 105 is
what they get next year.
• Net present value: NPV>0 Always use

Discount rate: reflects opportunity cost.

• Tax lowers private sector investment before tax rate of return on capital.
• Tax lowers private sector consumption after tax rate of return on capital.
Present value costs = costs on day one + (maintenance cost)/r – (maintenance cost)/(1+r)
Present value benefits = (n of commuters x days per year x hours saved x wage)/r
Wage: usually two options whether the hour gained is leisure or an extra hour work

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If there is an income tax on wage then: wage - (income tax x wage)

Sensitivity analysis: evaluates the present value of a project over a range of different discount rates and
exams whether or not the present value stays positive fro all reasonable values of r.
Hicks-Kaldor criterion: If the NPV of a project is positive it should be undertaken regardless of who gains
and losses because the gainers will compensate the losers and still enjoy a net increase in utility.

Maximizing efficiency minimizing excess burden.

Hence the government should borrow the money to finance the project. If they were to levy the money
using a one time tax the excess burden would increase because EB=0.5nQPt2. Borrowing money will also
have to be repaid by levying a tax but it would be a yearly tax, so much smaller than a one-time tax. If
the capital supply is elastic we do not have to worry about rising interest rates and crowding out private
investment.

POLITICAL ECONOMY (Lecture 3)

Logrolling: The trading of votes to obtain passage of a package of legislative proposals.

Ex. You support someone else’s proposal…in return for their support of your proposal.
ADVANTAGE DISADVANTAGE
Reveals intensity of preferences compromises May lead to wasteful public exp.
help the democratic system to function
If a project has a positive net benefit then it should be adopted (add all the preferences of the voters)

Voting paradox: community preferences can be inconsistent even though individual preferences are
consistent. Yet if all preferences are single peaked (utility consistently falls when he moves from his
favored outcome in all directions) the voting paradox will not occur.
Agenda manipulation: organising the order of votes to assure a favorable outcome.
Rent-seeking: Group that manipulates the political system to redistribute income towards them.
Ex when company lobbies a subsidy yet it creates no increase in welfare.
Government growth dut to:
• Citizen preferences: growth is due to expression of the preferences of the people
• Marxist view: private sector overproduces (niskanen’s model)
• Chance events: external shocks to economy
• Change in social attitudes: people more confident/aggressive gov in action
• Income redistribution: low income individuals use gov to redistribute income.
Debt isn’t so bad as the figure make them out to be:
1. Gov owns assets as well as debt
2. Inflation automatically decreases the value of debt
3. Captial expenditure is fully included in deficit even thogh purchases of a durable asset doesn’t
increase debt only depreciation does
4. Gov debt held by the CB is counted as debt even though CB is owned by gov.
Unstable finances can be due to: ageing population public expenditure > economic growth. Price of
natural gas.

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Lindahl prices: A concept that proposes that individuals pay for the provision of Public goods. Efficient
provision = sum of each individuals marginal benefit. Each individual faces a personalized price per unit
of public good, which depends on his or her tax share. The tax shares are referred to as Lindahjl prices.

Niskanen’s model: bureaucrats want to maximize their budget (spend as much as possible). This is
because bureaucrat’s goals are positively related with the size of their budget. This is possible because
they have more information than the politicians (their bosses). Bureaucrats can make all or nothing
proposals which concerns a project which has benefits exceeding costs (TB>TC) but the optimal size of
the project is much smaller (MC=MB). But politicans do not have that information all they know is what
the bureaucrats tell them TB>TC, hence likely to approve.

Total Benefits = Sum of marginal benefits to society

Total costs = Sum of marginal costs
INCOME DISTRIBUTION (Lecture 4)
Income redistribution: (taking money from the rich to help the poor) can be Pareto-efficient if the rich
are not worse off, in other words do not lose utility. This is possible because rich can benefit from other
things:
1.Altruism: poor people’s income may enter the rich’s welfare function (W=U1+U2+…+Un)
2.Insurance against poverty. Rich people may become poor hence it is an insurance it won’t
happen.
3.Social peace less poverty usually leads to less crime.
In-Kind transfer: give the poor goods or services instead of money (public housing, free education,
medical care…)
In-kind benefits: (not cash benefits) Less valuable to recipients, yet still used because:

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• Paternalism: prevents people from using the benefit on alcohol, drug etc…
• Commodity egalitarianism: the feeling that some services like education should be available for
everyone
• May reduce fraud
• May be politically attractive (lobbying: seek to influence (a legislator: a person who makes laws)
on an issue).

Maximin criterion: Social welfare depends on the utility of the individual who has the minimum utility in
the society. The social objective is to maximize the utility of the person with the minimum utility.

TAXATION AND EFFICIENCY (Lecture 5)

Optimal taxation states that the tax must minimize EB and be fair. EB occurs as a result from changes in
quantities caused by the change in relative prices. This can be minimized if we tax all commodities at the
same time so that relative prices don’t change Impossible because can’t tax leisure.
• Corlett-Hague rule: The fact that leisure cannot be taxed creates an excess burden. Corlett and
Hague say that you should tax goods that are complementary to leisure (ex. Films, games…).This
makes leisure less attractive and reduces the excess burden.
• Ramsey Rule: tax rates should be set so that the proportional reduction in the quantity
demanded of each good is the same.
ΔX/X1 = ΔY/Y1 X1 and Y1 are the quantity of the commodity taxed.
minimized when the percentage reduction of demand for each commodity is the same
If X and Y are not related:
• Inverse elasticity rule: EB minimized when tx/ty=ny/nx, where t are the tax rate and n is the
compensated demand elasticity n = compensated elasticities of demand and t=tax rate.
• Efficent taxation: Relative high tax rates should be applied on relatively inelastic goods. Small
EB. But also fairness etc.

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GOVERNMENT INTERNVENTION (Lecture 5)

Taxes drive a wedge between consumer price and the price received by producers.
Equivalent Variation: the change in income (shift of the original budget line) that is needed to
cause a shift from an indifference curve to a lower indifference curve.
EB: equivalent variation – tax revenue.

Tax systems may be evaluated by standards other than those of optimal tax theory (small EB):
• Horizontal equity: People in equal positions should be treated equally. Hard to
measure. Wage rate not useful because rate per hour often hard to measure and
investment in human capital can influence wage.
o Utility definition of horizontal equity: same level of equity before tax same
after impossible because different tastes in leisure etc.
• Cost of administration: If a tax regime is found with small EB would have cost to find it.
Any reduction in EB must be compared to incremental administrative costs.
• Incentives of tax evasion:
o Tax avoidance: move to Monaco Legal
o Tax evasion: don’t pay illegal
Problems with tax evasion theory:
• Guilt feeling of cheating
• Risk aversion doesn’t necessarily bother people
• Underground economy

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• Audit probabilities depend on occupation and the size of the

reported income.
Underground economy: can raise social welfare leaving the underground economy intact
may be desirable for the government who is busy with income redistribution. The goal is to
eliminate cheating at lowest administrative costs. Money comes from penalties.

Partial equilibrium analysis (one market)

Partial equilibrium model only looks at the market in which the tax is imposed and ignores the
ramifications in other markets.
Compensated demand curve: shows how quantity demanded varies with price, holding "real income" or
utility constant. It removes income effect.
Uncompensated demand curve: shows how quantity demanded varies with price, holding money
income constant.
Compensated demand curve is steeper. So excess burden is smaller when using compensated
demand curve.

Statutory tax incidence: (legal) describes who should hand over how much money to the tax revenue. It
determines nothing about economic tax incidence because that depends on the elasticity of demand
and supply.
Economic tax incidence: reflects the actual burden.

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Economics incidence of a tax on economic profit: Borne by the owners of the firm . Tax on profits does
not change marginal costs or revenues. Output does not change neither does the price paid by
consumers hence owners suffer.

Horizontal supply curve

Subsidy: CS increases by ABCD. Subsidy cost AECD. Hence EB because costs>gain. Loss to society.

Tax: Tax revenue increases by ABED. But BEC deadweight loss hence EB.

Non-horizontal supply curve

Pconsumers=Pproducers + tax

Tax burden (economic incidence): Consumer + producer tax burden: elasticity reflects ability to escape
the tax burden. Supply perfectly elastic, consumers bear entire burden. Demand perfectly elastic,
producers bear entire burden.
• Tax burden on producer (P0-Pt)xQt
• Tax burden on consumer (Pt-P0)xQt

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Excess tax burden: Loss of consumer surplus + loss of producer surplus – tax revenue. It arises because
the price for consumers no longer equals the price for producers. Consequently MRS ≠ MRT. Prices no
longer represent relative scarcities. This may effect economic behavior inefficient allocation.
• 0.5 ΔQ ΔP ΔP=tax
• Can be calculated if the demand curve is compensated.
• Tax can result in welfare gain instead of excess burden if the consumption of a good is too
high as a result of negative externalities.

Lump sum tax: Does not create excess burden. Onetime payment. Tax payment cannot be influenced by
changes in behavior of the taxpayers. Because behavior not influenced, efficient allocation is not
disturbed. For example, a 10% income tax is not a lump sum tax because it depends on how much the
individual earns. But a head tax of $500 independent of earnings is a lump sum tax. A tax whose value is
independent of the individual’s behavior. It is a shift in the budget line hence tax revenue = equivalent
variation.

Excess Burden: Equivalent Variation – Tax Revenue (equivalent variation is an income reduction due to
the shift to the left of the indifference curve)
• EB=0.5ΔQtP
• Where elasticity n=ΔQ/Q x P/ΔP ΔQ=nQt
• EB=0.5(1/((1/n)+(1/e)))pQt2
• EB=0.5nQPt2 Excess burden grows with the square of the tax rate
o n= (absolute value) compensated elasticity of demand
o e= (absolute value) compensated elasticity of supply

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o p=price before taxation

o q=quantity before taxation
o t=tax rate

Commodities such as land are durable and fixed in supply. The value of land is the net present value of
all future revenues and taxes. Hence a tax on land will immediately reduce the value of the land. The tax
will be “capitalized” into the land price. Owner bears the full burden of the tax. Selling the land will not
help because the value of the land is already reduced.

General equilibrium Model

NATURAL MONOPOLY
A situation in which factors of inherent to the production process lead to a single firm supplying the
entire industry output. A natural monopoly’s average cost curve is continuously downward sloping. This
means that the marginal cost always lies below the AC curve.

Solutions:
1. Average Cost pricing: According to theory of welfare economics: P=MC. But Qa<Q*, less
output than socially efficient output.
2. Marginal cost pricing with lump sum tax: P=MC, yet does not conform with benefits
received principle. Everyone pays for a product/service not everyone uses.

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3. Ramsey solution: Suppose that the government has several enterprises and as a whole they
cannot lose money. The government would then set high prices for relatively inelastic
government products and to set low (possibly lower than average costs as in the graph
above) for elastic government products. The profit from the inelastic products will
compensate for the losses on elastic goods.

DEFICIT FINANCE (Lecture 6)

Crowding out effect: concept where increased public sector spending will decrease private sector
spending. If the government lends a large amount of money to finance a project the interest rate might
increase. A higher interest rate will discourage individuals and businesses from borrowing money, hence
reducing spending and investment.
Lerner’s view: It is not bad to leave government debt for the future generation if debt is held by own
citizens (not foreigners). Future generation has debt but also bonds so they cancel out.
IF debt held by foreigners:
• If loan used for consumption consumption of FG decreases
• If loan used for investment only burden if Marginal rate of return on public investment is
bigger than marginal costs of funds.
• Problem “generation” means everyone alive at given time (ignore immigrant, emmigrants, ppl
who die..)
Overlapping generations model: define a generation as everyone born at the same time. So several
generation coexist simultaneously. By comparing net taxes paid by different generations, one can get a
sense of how the government distributes the taxes or income.

Who bears the burden of financing?

Neoclassical model: (money used for consumption)
• Crowding out effect
o Except if small country borrowing on international capital market
• Private capital stock deacreases
• Future generation income decreases they bear the burden
• If money used for investment then the rate of return compared to the rate of return in private
sector determines who bears the burden.
Ricardian model:
• Assumptions: people are completely rational and have full information
• People know gov. Debt must be paid hence they save more in anticipation
• Tax financing: ppl pay tax decrease private consumption
• Debt financing ppl save decrease private consumption

Intergenerational equity: Future generation be as well of as we are

Debt vs Tax Financing: Debt financing you borrow money do the ‘future generation pays’, and tax
financing the ‘present generation’ pays. If the government believes the future generation to be richer

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then it will finance a project with debt financing and if it believe the future generation to be poorer it
will finance the project with tax financing.

Benefits received principle: A theory of income tax fairness that says the people should pay taxes based
on the benefits they receive from them. In other words people that will benefit from a project/service
should pay for it.

PERSONAL TAXATION AND BEHAVIOR (Lecture 6)

Large sector, takes into account how various markets are interrelated.
Manufacturing + Food and Capital + Labor
Incidence of a tax in the manufactoring (labor intensive) sector:
1. Output effect: FOP of manufacture increases. Hence supply decreases, price increases,
production decreases. This means that the FOPs will move towards the agriculture sector.
Agriculture sector is capital intensive, hence in order for the extra labor to be absorbed the price
of labor must decreases relative to capital.
2. Substitution effect: Manufacturers will start using more labor than capital hence the relative
price of capital reduces.
3. Net effect: Uncertain, since we do not know which effect dominates.
Effect of income tax on labor supply?
1. Income effect: people can spend less. So they will consume less of everything including
leisure income effect increases labor supply.
2. Substitution effect: opportunity cost of leisure go down which creates a tendency to
substitute leisure for work labor supply decreases.
3. Net effect: Depends on which effect dominates.
Laffer curve: Tax collected per hour can be very high but the number of hours can drop dramatically
that the product of tax rate and hours is lower than before. The laffer curve is determined by the
elasticity of labor with respect to the net wage.

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Portfolio composition:
If a tax is levied on return of capital assets then the (1) net expected return will decrease which will
discourage an investors to take risks. YET (2) tax also reduces losses which DOES encourage an investor
to take risk hence the net effect of a tax on return of capital asset is not clear.

Intertemporal budget contraints: trade off between consumption across times. Problem assumes
people are forward looking yet critics believe people are more myopic.

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Deductible interest payments and taxable interest receipts saving decreases hence more present
consumption and less future consumption

Non deductible interest payments and taxable interest receipts

MULTIGOVERNMENT PUBLIC FINANCE (lecture 7)

Federal system: consists of different levels of government that provide public goods and services.
Field of fiscal federalism: examines the roles of different levels of government and how they interact
with eachother.
Tieabout Model: Different communities produces a market like solution to the local public good
problem. Individuals move to the community which for them offers the best bundle of public
services/goods and taxes. Proportional tax on property is the price and the package of public
services/goods is the quantity.
Assumptions:
• Government activities do not cause externalities
• Individuals are completely mobile
• Have full information on taxes and public goods/services offered
• Enough different communities
• Cost per unit fo public service is constant
• Public goods/services financed with proportional property tax
Advantages of decentralization Disadvantages
The government can tailor outputs to local tastes. Communities impose externalities on each other.
Individuals with similar tastes live together. Local Not efficient on expenditure side.
gov has a greater democratic responsiveness and
can better fit to citizens preferences than the
central gov.
Fostering intergovernmental competition. Taxes levied by decentralized communities are
Individuals can vote with their feet. If one unlikely to be efficient from a national point of

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community is not producing a satisifacotyr amount view. Not efficient on taxation side.
of public services one can move to another
community. Hence gives bureaucrats incentive to
produce more efficiently.
Experimentation and innovation in locally provided People chose communities based on tax-welfare
goods and services package. There is unstable income distribution.
Some communities will spiral downwards will
others upwards. Rich together poor together.

GRANTS
Intergovernmental conditional non matching grant: community indifference curve, budget constraint
(AB to AHM where AH represents the grant and is the reason why it is non-matching). The grant
increases money spent on earmarked good (education) and the other goods. The net increase of
spending on education may be lower than the amount of the grant because before the grant the local
government was probably already spending on education but due to the grant they decrease the
amount they payout of their own pocket. They do spend the grant on education but the grant given
does equal the increase in government spending on education because the local government will spend
less money on education but on other goods.

Three views of incidence (who bears the burden?) of property tax (tax rate x property’s assessed value)
1. Traditional view: property tax as an excise tax on land and structures
Incidence of the tax is determined by the elasticity of the relevant supply and demand
schedules.
Land inelastic supply owner bears the full burden
Structures elastic supply because the construction industry can obtain all capital at market
price tenants bears the full burden.
2. New View Property tax as a capital tax with different rates
• General tax effect: tax progressive?

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• Excise effect: The differentials in tax rates create an excise effect, which tends to hurt
immobile factors in highly taxed juridictions. This is because capital tends to migrate
from high tax rate to low tax rate communities.
• Long-run effect: Capital is not fixed and depends on tax rate. If property tax rate falls
supply of capital, productivity of labor and the real wage will fall.
• OVERALL impact of the property tax is progressive (increases with income)

Unconditional grant: shift of the budget line to the right. According to standard economic theory, both
public and private consumption goes up. Hence local taxation is reduced.
Flypaper effect: money sticks where it hits. Public spending increases relatively more than local
income (private consumption).

Types of intergovernmental grants:

• Conditional: earmarked
o Non-matching: independent of own spending
o Matching: % of own spending
Open ended: not limited
Closed-ended: maximum amount
Unconditional: often equalizing grant

Central government provide grants to subnational/lower level governments:

• Vertical fiscal imbalance: most tax revenue is generated/collected at the central level. Hence in
order for subnational government to provide activities grants must be given.
• Spillovers: If a subnational government pays for public transport within their city this can also be
used by other cities. Hence central government provides grants for services such as public
transport.
• Paternalism: Central government can want all subnational governments to provide a certain
public service it deems essential, hence it finances it.
• Fiscal equalization: Equalizing grants may enable subnational governments to supply basic
services at moderate tax rates. Equity.

3 tasks of the government:

• Income redistribution (central gov)
• Macroeconomic stabilization (central gov)
• Allocation of goods and services (subnational gov)

Why decentralize
• Tailoring services to local tastes: Oates theorem’ preferences differ between communites,
uniform within. Hence minimize spillovers
• Efficiency of production

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• Let governments compete: Yardstick competition can see performance of every government,
vote for another if it isn’t doing well. If performance can be compared politicians will try harder
• More innovation and experiment
• Empowerment: people have more power over local government than over central government
happy people

Corporation tax affects the way corporation are financed because interest payments are deductible
from taxable profits and dividend payments are not, hence debt financing is cheaper than equity. This
results in more debt financing than is efficient.

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