PUBLIC ECONOMICS

PREAMBLE

 1st Welfare Theorem:

 Competitive Equilibrium is Pareto Efficient.

 Violated if there is not a competitive market, or there are externalities.

 Correct via Pigou taxation (efficiency gains via corrective taxation).

 2nd Welfare Theorem:

 Any Pareto Efficient equilibrium can be obtained by use of ‘lump-sum’ taxation

+ transfers.

 If this is not possible, we use a ‘second best’ measure of distortive taxation on

economic activity, which have equity gains but efficiency losses.

 Examples: Ramsey Taxation (distortive commodity taxes), Mirrlees Taxation

(distortive labour income taxes).

 Problem: How to set taxes to minimise the cost of raising a set level of revenue?

 Adopt a SWF to represent state preferences, then maximise with respect to the
revenue constraint
 COMMODITY TAXATION:
REPRESENTATIVE
HOUSEHOLD
 Assumptions of the Ramsey Taxation Model:

 Prices:
pi  w  Li
 Pre-tax producer prices: pi=Li.w

qi  pi  ti
 Assume pre-tax prices are fixed, wage rate is fixed,
and there are ‘n’ commodities.

 Consumer price is qi = pi + ti

 Individual Preferences (see equations):

 Single household model. max : U  x, L   U  x1 ,  , xi , xn , L 

x, L
n
s.t : q1 x1    qn xn   qi xi  wL  I
 Utility function is a function of a consumption
vector ‘x’ and labour supply: u(x,L)
i 1
 Subject to the budget constraint (with I as lump-  n

sum income). max :   U  x, L     wL  I   qi xi 
x , L ,
 i 1 
 xi*  xi  q1 ,..., qn , w, I 
 When solved, can get an indirect utility function
v(q , w, I). Generally assume I=0.

 No redistribution (utility a function of one’s

 
V  U x1* ,  , xn*  V  q1 , qn , w, I 
consumption only).
 COMMODITY TAXATION:
REPRESENTATIVE
HOUSEHOLD
 Lump-sum taxes aren’t feasible (2nd welfare theorem breaks down).

 Constant Returns to Scale, Perfect Competition.

 No Pigouvian (corrective) elements to the taxation.

 Government observes commodity trades.

 Government only needs to raise a fixed revenue.

n  n n 
R   ti xi     qi  pi  xi   wL  I    pi xi 
i 1  i 1 i 1 
 Labour only input into production.
 No labour income taxation.

 Government aims to maximise a SWF.

 One respective household, we assume that U1=U2=...=Uh=...UH=U.

 W=W(U)
 COMMODITY TAXATION:
REPRESENTATIVE
HOUSEHOLD
 Optimal tax problem (maths on next slide):

 Gov. Maximises the utility of the representative individual (thus, the

SWF as well).
 Subject to its budget constraint.

 Simple Lagrange is used to maximise w.r.t the tax rates on each of the
‘n’ goods.
 Remember that every commodity’s demand x* is a function of the
post-tax prices of ALL OTHER GOODS. This is why dxi/dtk is not
necessarily 0, and is included in the F.O.C.

 The use of Roy’s Identity is employed at a point:

 Roy’s identity essentially states that the Marshallian Demand Function
can be computed from the Indirect Utility Function.
 COMMODITY TAXATION:
REPRESENTATIVE
HOUSEHOLD
START :
 n  V V
max :   V  q1 ,..., qn , w, I      ti xi  R  Roy' s Identity    xk  xk
t1 ,...,t n ,
 i 1  qk qk
 V    n
xi  Substituting in :
F.O.C :     xk   t i
   0
t k t k  t k 
i 1
 n
xi 
V   V   xi xi  xk    xk   ti 
It Is True That :  ,   i 1 qk 
t k qk t k qk
 n
x 
V    n
xi  xk    xk   ti i 
     xk   t i
  qk 
qk  i 1 qk   i 1

Interpretation:
Additional tax revenue per unit of utility This isn’t the end of the problem,
foregone should be the same regardless however, our result now depends on the
of what tax has been changed. existence of cross-price effects (dxi/dqk).
 COMMODITY TAXATION:
REPRESENTATIVE
HOUSEHOLD
No Cross Price Effects : The Inverse Elasticity Rule:
In the absence of cross price effects,
xi the proportional rate of tax for a good
 0, i  k
qk should be inversely proportional to
the elasticity of demand for that
 xk  good.

  xk    x k  t k 
 qk  Results may appear counter-intuitive:
Suggests that necessities (clothes,
Rearrange and divide through by qk : food) should have the highest
commodity taxes, but luxuries (yachts,
tk tk       xk qk  planes, small islands) should get the
  
qk pk  t k     qk xk  lowest taxes.

   1
However, this result only derives from
tk
   consideration of a single household
pk  t k     d acting solely in its interests.