Springer Texts in Business and Economics

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Toshihiro Ihori

Principles of Public
Finance
Toshihiro Ihori
National Gradual Institute for Policy Studies
Minato-ku, Tokyo, Japan

ISSN 2192-4333 ISSN 2192-4341 (electronic)

Springer Texts in Business and Economics
ISBN 978-981-10-2388-0 ISBN 978-981-10-2389-7 (eBook)
DOI 10.1007/978-981-10-2389-7

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Preface

This book is a standard, but new-style, textbook on public finance. It provides

instructors and students with an overview of the literature so that students can attain
an overall understanding of macroeconomic and microeconomic public finance.
Conventional textbook offerings are mainly restricted to microeconomic public
finance topics. However, the literature on public finance has grown dramatically,
particularly theoretical studies and empirical analysis, with much of the focus on
the macroeconomic effects of public services. This text intends to fill a gap in such
literature by presenting a theoretically based, comprehensive explanation of public
finance including macroeconomic topics.
Particular emphasis is directed at developing tools that can be applied theoreti-
cally and empirically to clarify essential economic concerns in the current public
sector in advanced countries, including Japan. Such concerns include the macro-
economic effect of fiscal policy, the dependence on bonds to cover government
deficits, and social security reform.
The main text explains the standard concepts of public finance, while the
appendix offers various advanced topics together with case studies of Japan’s
circumstances. The material facilitates an understanding of how to investigate
changes in the public sector, interpret results, and, essentially, undertake research
on fiscal policy. The textbook is of value to a broad range of course offerings,
including those with a general focus on fiscal policy, social security reform, and tax
reform.
The main text is appropriate for undergraduates. The appendix is useful for
graduate students who wish to learn about advanced research in this area and for
practitioners who want to broaden their knowledge outside their own areas of
expertise, especially with regard to Japan. I present the background of each result
and try to give the reader a feel for how a particular area of the literature has
developed. The technical results are provided, and an intuitive explanation for them
is also given.
Each chapter is reasonably self-contained. A variety of models are studied in
each chapter and are fully described so that the reader can open the book to any
chapter and begin reading without missing any of the notations or techniques.
Consequently, emphasis is placed on geometric and economic intuition rather
than on the rigorous development of general results. In fact, I have purposely

v
vi Preface

limited the complexity such that the textbook can easily be read and understood by
anyone with an understanding of basic economics. Although some advanced studies
assume a sound comprehension of modern microeconomics and a good level of
familiarity with basic calculus, I use no sophisticated mathematical analyses;
instead, I use detailed explanations to supplement the understanding of more
technical sections. This strategy is intended to make most sections of interest to a
broader range of readers. I hope you will agree.
During the long gestation period of this book, I have incurred much gracious
assistance, and it is now with pleasure that I acknowledge this. I am indebted to a
number of colleagues and students for helpful conversations along the way. In
particular, I would like to thank Junichi Itaya, Hirofumi Shibata, Tatsuo Hatta,
Takero Doi, Hiroki Kondo, Masumi Kawade, Shun-ichiro Bessho, Ryuta Kato,
Keigo Kameda, C.C. Yang, Martin McGuire, and especially Raymond Batina.
I wish to thank Kosuke Soga for arranging the camera-ready figures. I would like
to thank Editage (www.editage.jp) for the English language editing. I am also
grateful to Juno Kawakami and Misao Taguchi for their editorial assistance in
preparing this book.

Tokyo, Japan Toshihiro Ihori

July 2016
Contents

1 Public Finance and a Review of Basic Concepts . . . . . . . . . . . . . . . 1

1 The Main Functions of the Public Sector . . . . . . . . . . . . . . . . . . 1
1.1 Resource Allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.2 Redistribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.3 Stabilization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.4 Dynamic Optimization . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.5 The Failure of Government . . . . . . . . . . . . . . . . . . . . . . . 5
2 A Review of Basic Analytical Concepts . . . . . . . . . . . . . . . . . . . 5
2.1 Constrained Maximization . . . . . . . . . . . . . . . . . . . . . . . . 5
2.2 Pareto Optimality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
2.3 A Dual Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
3 The Public Sector in Japan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
3.1 The Role of Central Government . . . . . . . . . . . . . . . . . . . 8
3.2 Intergovernmental Finance . . . . . . . . . . . . . . . . . . . . . . . . 9
3.3 The Budgetary System . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
3.3.1 The Budgetary Formula in Japan . . . . . . . . . . . . . . 10
3.3.2 The Budgetary Process . . . . . . . . . . . . . . . . . . . . . 12
3.3.3 The Execution of the Budget and the
Settlement of the Account . . . . . . . . . . . . . . . . . . . 13
3.4 The Content of the General Account in Japan . . . . . . . . . . 14
3.4.1 The Category of Budget . . . . . . . . . . . . . . . . . . . . 14
3.4.2 Government Expenditure . . . . . . . . . . . . . . . . . . . 14
3.4.3 Tax Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
3.4.4 Public Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
4 Organization of the Book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
4.1 Part One . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
4.2 Part Two . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
4.3 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Appendix: Japan’s Fiscal Management . . . . . . . . . . . . . . . . . . . . . . . 19
A1 The 1950s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
A2 The 1960s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
A3 The 1970s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
A4 The 1980s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

vii
viii Contents

A5 The 1990s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
A6 The 2000s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
A7 The 2010s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

Part I Macroeconomic Aspects of Public Finance

2 The Macroeconomic Theory of Fiscal Policy I . . . . . . . . . . . . . . . . 29
1 The Simple Keynesian Model . . . . . . . . . . . . . . . . . . . . . . . . . . 29
1.1 The 45-degree Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
1.2 The Fiscal Multiplier . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
1.3 The Multiplier with Tax Rate . . . . . . . . . . . . . . . . . . . . . . 31
1.4 The Built-In Stabilizer . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
1.5 The Balanced-Budget Multiplier . . . . . . . . . . . . . . . . . . . 33
2 The IS/LM Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
2.1 The Investment/Saving and Liquidity Preference/
Money Supply Equilibrium Model . . . . . . . . . . . . . . . . . . 34
2.2 The Size of the Multiplier in the IS/LM
Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
2.3 Extreme Cases of the Zero Crowding-Out
Effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
2.4 Direct Crowding Out . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
2.5 The Crowding-In Effect . . . . . . . . . . . . . . . . . . . . . . . . . . 38
3 The Open Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
3.1 Extension to an Open Economy Model . . . . . . . . . . . . . . . 39
3.2 The Fixed Exchange System . . . . . . . . . . . . . . . . . . . . . . 39
3.3 The Flexible Exchange Rate System: The Effect
of Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
3.4 The Flexible Exchange Rate System: The Effect
of Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
3.5 Zero Capital Movement . . . . . . . . . . . . . . . . . . . . . . . . . . 42
4 The Efficacy of Fiscal Policy and the Policymaker . . . . . . . . . . . 43
4.1 Three Viewpoints . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
4.2 The Lag of Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
4.3 Lag of Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . 44
4.4 Lag of Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
4.5 Lag and Automatic Stabilizers . . . . . . . . . . . . . . . . . . . . . 45
4.6 Rules Versus Discretion . . . . . . . . . . . . . . . . . . . . . . . . . . 46
Appendix: Public Investment in Japan . . . . . . . . . . . . . . . . . . . . . . . . 47
A1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
A2 The Efficacy of Public Investment as a Counter-Cyclical
Measure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
A3 Fiscal Policy and the Optimal Size of Public
Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
Contents ix

3 The Macroeconomic Theory of Fiscal Policy II . . . . . . . . . . . . . . . . 53

1 The Permanent Level of Fiscal Variables . . . . . . . . . . . . . . . . . . 53
1.1 Definition of the Permanent Level of an Economic
Variable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
1.2 The Government’s Budget Constraint . . . . . . . . . . . . . . . . 54
2 Consumption and Saving Behavior . . . . . . . . . . . . . . . . . . . . . . . 56
2.1 Optimization Over Time . . . . . . . . . . . . . . . . . . . . . . . . . 56
2.2 The Permanent Income Hypothesis . . . . . . . . . . . . . . . . . . 57
3 The Labor Market and Supply Function . . . . . . . . . . . . . . . . . . . 58
3.1 Labor Supply by Households . . . . . . . . . . . . . . . . . . . . . . 58
3.2 Labor Demand by Firms . . . . . . . . . . . . . . . . . . . . . . . . . 60
3.3 Equilibrium in the Labor Market . . . . . . . . . . . . . . . . . . . 61
4 Equilibrium in the Goods Market . . . . . . . . . . . . . . . . . . . . . . . . 62
5 The Effect of Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
5.1 Three Cases of Fiscal Expansion . . . . . . . . . . . . . . . . . . . 63
5.2 Temporary Expansion . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
5.3 Permanent Expansion A . . . . . . . . . . . . . . . . . . . . . . . . . . 65
5.4 Permanent Expansion B . . . . . . . . . . . . . . . . . . . . . . . . . . 66
6 Evaluation of the Public Sector . . . . . . . . . . . . . . . . . . . . . . . . . 66
6.1 Substitutability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
6.2 The Multiplier Effect of Government Spending . . . . . . . . . 67
6.3 Evaluation of Government Spending . . . . . . . . . . . . . . . . 68
Appendix: The Size of Government Spending and the Private
Sector’s Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
A1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
A2 Theoretical Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . 69
A2.1 Evaluation of Government Spending . . . . . . . . . . . . 69
A2.2 Optimal Size of Government Spending . . . . . . . . . . . 71
A2.3 Optimizing Behavior . . . . . . . . . . . . . . . . . . . . . . . . 71
A2.4 Indirect Test . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72
A3 Empirical Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
A4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
4 Public Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
1 Ricard’s Neutrality Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
1.1 A Two-Period Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
1.2 The Implications of Public Debt Issuance . . . . . . . . . . . . . 79
1.3 Debt Issuance in an Infinite Horizon Economy . . . . . . . . . 79
2 The Shift of the Burden to Future Generations . . . . . . . . . . . . . . 80
2.1 A Two-Overlapping-Generations Model . . . . . . . . . . . . . . 80
2.2 The Efficacy of Keynesian Policy . . . . . . . . . . . . . . . . . . . 81
2.3 The Shift of the Burden . . . . . . . . . . . . . . . . . . . . . . . . . . 82
3 Barro’s Neutrality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82
3.1 The Inclusion of Bequests . . . . . . . . . . . . . . . . . . . . . . . . 82
3.2 A Simple Model with Bequests . . . . . . . . . . . . . . . . . . . . 83
3.3 Barro’s Neutrality Theorem . . . . . . . . . . . . . . . . . . . . . . . 84
x Contents

4 Policy Implications of the Debt Neutrality Theorem . . . . . . . . . . 85

4.1 Policy Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
4.2 Theoretical Assumptions . . . . . . . . . . . . . . . . . . . . . . . . . 86
4.2.1 Perfect Capital Market . . . . . . . . . . . . . . . . . . . . . 86
4.2.2 Lump-Sum Taxes . . . . . . . . . . . . . . . . . . . . . . . . . 86
4.2.3 Anticipation of Future Tax Increases . . . . . . . . . . . 87
4.2.4 Planning Period and Bequest Motive . . . . . . . . . . . 88
4.3 Empirical Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
5 The Non-Keynesian Effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
5.1 What Is the Non-Keynesian Effect? . . . . . . . . . . . . . . . . . 89
5.2 The Non-Keynesian Effect in the Real World . . . . . . . . . . 90
5.3 Simple Theory of the Non-Keynesian Effect . . . . . . . . . . . 90
Appendix: Government Debt in an Overlapping-Generations
Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
A1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
A2 The Basic Model of Overlapping Generations . . . . . . . . . . . . 92
A2.1 The Consumer Within the Model of Overlapping
Generations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92
A2.2 Production Technology and Capital
Accumulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
A3 Government Debt and Intergenerational Transfer . . . . . . . . . . 95
A3.1 The Transfer Program . . . . . . . . . . . . . . . . . . . . . . . 95
A3.2 Some Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
A3.3 The Burden of Debt . . . . . . . . . . . . . . . . . . . . . . . . . 97
A4 Debt Neutrality with Altruistic Bequests . . . . . . . . . . . . . . . . 98
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
5 Economic Growth and Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . 101
1 A Simple Growth Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
1.1 Long-Run Growth Rate in the Harrod-Domar
Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
1.2 The Effect of Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . 102
1.3 The Incorporation of Public Investment . . . . . . . . . . . . . . 103
2 Optimal Public Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
2.1 The Role of Public Spending . . . . . . . . . . . . . . . . . . . . . . 104
2.2 Public Investment in the Market Economy . . . . . . . . . . . . 104
2.3 Optimal Allocation Between Two Regions . . . . . . . . . . . . 106
2.4 Optimal Size of Public Investment . . . . . . . . . . . . . . . . . . 107
2.5 The Discount Rate of Public Investment . . . . . . . . . . . . . . 109
3 The Solow Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110
3.1 Formulation of the Solow Model . . . . . . . . . . . . . . . . . . . 110
3.2 Stability of the System . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
3.3 The Effect of Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . 112
Contents xi

4 The Endogenous Growth Model . . . . . . . . . . . . . . . . . . . . . . . . . 113

4.1 The Optimal Growth Model . . . . . . . . . . . . . . . . . . . . . . . 113
4.2 The AK Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114
4.3 Public Investment and Growth Rate . . . . . . . . . . . . . . . . . 115
5 Inequality and Economic Growth . . . . . . . . . . . . . . . . . . . . . . . . 117
5.1 Income Redistribution and Tax Rate . . . . . . . . . . . . . . . . . 117
5.2 Externality of Educational Investment . . . . . . . . . . . . . . . 118
Appendix A: Taxes on Capital Accumulation and Economic
Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118
A1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118
A2 The Endogenous Growth Model . . . . . . . . . . . . . . . . . . . . . . 119
A2.1 Technology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
A2.2 The Three-Period Overlapping-Generations Model . . . 120
A2.3 The Altruistic Bequest Motive . . . . . . . . . . . . . . . . . 122
A3 Economic Growth and Efficiency . . . . . . . . . . . . . . . . . . . . . 122
A3.1 The First Best Solution . . . . . . . . . . . . . . . . . . . . . . 122
A3.2 Optimizing Behavior in the Market Economy . . . . . . 123
A3.3 The Circumstance in Which Physical Bequests
Are Zero . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123
A3.4 The Circumstance in Which Physical Bequests
Are Operative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
A4 Taxes and Economic Growth . . . . . . . . . . . . . . . . . . . . . . . . 126
A4.1 The Constrained Economy . . . . . . . . . . . . . . . . . . . . 126
A4.2 The Unconstrained Circumstance . . . . . . . . . . . . . . . 127
A5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127
Appendix B: The Supply-Side Effect of Public Investment
in Japan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
B1 Earlier Studies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
B2 Recent Studies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
B3 Public Investment Management . . . . . . . . . . . . . . . . . . . . . . 130
B3.1 Constraints in Japan . . . . . . . . . . . . . . . . . . . . . . . . . 130
B3.2 Public Investment Management Reform . . . . . . . . . . 131
B3.3 Strengthening Wide-Ranging Coordination . . . . . . . . 132
B3.4 Cost-Benefit Analysis . . . . . . . . . . . . . . . . . . . . . . . 133
B4 Public Investment Management Reform . . . . . . . . . . . . . . . . 135
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136
6 Fiscal Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139
1 Understanding Fiscal Management . . . . . . . . . . . . . . . . . . . . . . . 139
1.1 The Problem of Public Debt Issuance . . . . . . . . . . . . . . . . 139
1.2 Balanced-Budget Policy . . . . . . . . . . . . . . . . . . . . . . . . . . 140
1.3 The Efficacy of Keynesian Policy . . . . . . . . . . . . . . . . . . . 141
1.4 The Tax-Smoothing Hypothesis . . . . . . . . . . . . . . . . . . . . 142
1.5 Compensation Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144
1.6 The Long-Run Argument for a Zero-Tax Nation . . . . . . . . 146
1.7 Overall Arguments on Fiscal Deficits . . . . . . . . . . . . . . . . 146
xii Contents

2 Fiscal Bankruptcy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147

2.1 The Possibility of Fiscal Bankruptcy . . . . . . . . . . . . . . . . 147
2.2 The Government Budget Constraint . . . . . . . . . . . . . . . . . 148
2.3 Primary Balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149
2.4 The Dynamics of Government Budget
Constraint . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
2.5 Some Special Cases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
2.5.1 g ¼ t . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151
2.5.2 r ¼ n . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151
2.5.3 g + rb  t ¼ 0 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
2.6 The Rate of Interest and Fiscal Crisis . . . . . . . . . . . . . . . . 153
3 Fiscal Consolidation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154
3.1 Desirable Fiscal Consolidation . . . . . . . . . . . . . . . . . . . . . 154
3.2 The Optimal Target of Fiscal Consolidation . . . . . . . . . . . 155
3.3 Politically Weak Government . . . . . . . . . . . . . . . . . . . . . 155
3.4 The Legal Constraint of Fiscal Consolidation . . . . . . . . . . 156
3.5 The EU and the Euro . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156
Appendix: Fiscal Deficits in a Growing Economy . . . . . . . . . . . . . . . . 158
A1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158
A2 A Simple Growth Model . . . . . . . . . . . . . . . . . . . . . . . . . . . 158
A2.1 Analytical Framework . . . . . . . . . . . . . . . . . . . . . . . 158
A2.2 The Government’s Objective . . . . . . . . . . . . . . . . . . 160
A3 Optimal Deficits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161
A3.1 Phase Diagram . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161
A3.2 Optimal Deficit During Transition . . . . . . . . . . . . . . 162
A3.3 Macro IS Balance . . . . . . . . . . . . . . . . . . . . . . . . . . 163
A3.4 Comparative Dynamics . . . . . . . . . . . . . . . . . . . . . . 163
A3.5 Optimal Deficit in the Long Run . . . . . . . . . . . . . . . 163
A3.6 Numerical Example . . . . . . . . . . . . . . . . . . . . . . . . . 164
A4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165
A4.1 Deficits and Growth . . . . . . . . . . . . . . . . . . . . . . . . . 165
A4.2 Deficit Ceilings and Fiscal Privilege . . . . . . . . . . . . . 166
A4.3 Hard Budget and Soft Budget Outcomes . . . . . . . . . . 166
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167
7 The Public Pension . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169
1 Justification of the Public Pension . . . . . . . . . . . . . . . . . . . . . . . 169
1.1 The Public Pension System . . . . . . . . . . . . . . . . . . . . . . . 169
1.2 Justification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169
1.2.1 Income Redistribution . . . . . . . . . . . . . . . . . . . . . . 170
1.2.2 The Failure of Private Pensions . . . . . . . . . . . . . . . 171
1.2.3 Paternalism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
1.2.4 The Efficiency of a Compulsory Public
Pension . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172
Contents xiii

2 Economic Effect of the Public Pension . . . . . . . . . . . . . . . . . . . . 172

2.1 The Funded System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172
2.2 The Pay-AS-You-GO System . . . . . . . . . . . . . . . . . . . . . . 173
3 Public Debt and the Public Pension . . . . . . . . . . . . . . . . . . . . . . 176
3.1 The Funded System and Public Debt Issuance Within
the Same Generation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
3.2 Pay-AS-You-GO System and Public Debt Issuance
Among Generations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177
3.3 Generational Accounting . . . . . . . . . . . . . . . . . . . . . . . . . 178
4 Public Pension Reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179
4.1 The Aging Population in Japan . . . . . . . . . . . . . . . . . . . . . 179
4.2 The DB System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180
4.3 The Move from DB to DC . . . . . . . . . . . . . . . . . . . . . . . . 180
4.4 A Fully Funded System . . . . . . . . . . . . . . . . . . . . . . . . . . 181
4.5 Intergenerational Conflicts . . . . . . . . . . . . . . . . . . . . . . . . 182
5 Privatization of the Pay-AS-You-GO System . . . . . . . . . . . . . . . 182
5.1 A Simple Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182
5.2 The Gain in Economic Welfare Through
Privatization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183
Appendix A: Intergenerational Conflict in an Aging Japan . . . . . . . . . 185
A1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185
A2 Medical Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185
A2.1 Japan’s Health Care System . . . . . . . . . . . . . . . . . . . 185
A2.2 The Retired and Elderly . . . . . . . . . . . . . . . . . . . . . . 186
A2.3 Issues of Medical Insurance . . . . . . . . . . . . . . . . . . . 187
A3 The Pension System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188
A3.1 Japan’s Public Pension System . . . . . . . . . . . . . . . . . 188
A3.2 Pension Reform in an Aging Japan . . . . . . . . . . . . . . 189
A3.3 Outline of the 2004 Pension Plan Revision . . . . . . . . 190
A3.4 Is the 2004 Reform Effective? . . . . . . . . . . . . . . . . . 191
Appendix B: Simulation Analysis in an Aging Japan . . . . . . . . . . . . . 191
B1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191
B2 The Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192
B3 Simulation Analysis in Ihori et al. (2005) . . . . . . . . . . . . . . . 193
B3.1 Demography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193
B3.2 Government Deficits . . . . . . . . . . . . . . . . . . . . . . . . 193
B3.3 The Social Security System . . . . . . . . . . . . . . . . . . . 194
B3.4 Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
B3.5 Technological Progress . . . . . . . . . . . . . . . . . . . . . . 196
B3.6 Simulation Results . . . . . . . . . . . . . . . . . . . . . . . . . . 196
B4 Simulation Analysis in Ihori et al. (2011) . . . . . . . . . . . . . . . 198
B4.1 Assumptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198
B4.2 Simulation Results . . . . . . . . . . . . . . . . . . . . . . . . . . 198
B5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201
xiv Contents

Part II Microeconomic Aspects of Public Finance

8 The Theory of Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205
1 Taxation and Labor Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205
1.1 A Model of Labor Supply . . . . . . . . . . . . . . . . . . . . . . . . 205
1.2 Substitution Effect and Income Effect . . . . . . . . . . . . . . . . 207
1.3 The Cobb-Douglas Utility Function . . . . . . . . . . . . . . . . . 207
2 The Efficiency of Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208
2.1 A Comparison with Lump Sum Tax . . . . . . . . . . . . . . . . . 208
2.2 The Size of the Excess Burden . . . . . . . . . . . . . . . . . . . . . 210
2.3 The Excess Burden and the Substitution
Effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210
3 Interest Income Tax and Saving . . . . . . . . . . . . . . . . . . . . . . . . . 211
3.1 The Life Cycle Saving Hypothesis . . . . . . . . . . . . . . . . . . 211
3.2 The Effect of Interest Income Tax: The Substitution
Effect and the Income Effect . . . . . . . . . . . . . . . . . . . . . . 213
3.3 The Cobb-Douglas Utility Function . . . . . . . . . . . . . . . . . 214
3.4 The Human Capital Effect . . . . . . . . . . . . . . . . . . . . . . . . 215
3.5 The Cobb-Douglas Utility Function Revisited . . . . . . . . . . 215
4 Investment and Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216
4.1 The Classical View . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216
4.2 Corporate Tax and Borrowing Funds . . . . . . . . . . . . . . . . 217
4.3 Corporate Tax and Retained Earnings . . . . . . . . . . . . . . . . 218
4.4 The Cost of Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219
4.5 Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219
4.6 The Incidence of Corporate Income Tax
in Japan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220
5 Consumption Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221
5.1 Shift of the Tax Burden and Price
Determination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221
5.2 The Consumer as the Legal Taxpayer . . . . . . . . . . . . . . . . 222
5.3 The Burden of Tax and Incidence . . . . . . . . . . . . . . . . . . . 222
Appendix: The Savings Elasticity Controversy . . . . . . . . . . . . . . . . . . 224
A1 Boskin (1978) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224
A2 Summers (1981) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227
9 Tax Reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229
1 Labor Income Tax and Interest Income Tax . . . . . . . . . . . . . . . . 229
1.1 Exogenous Labor Supply . . . . . . . . . . . . . . . . . . . . . . . . . 229
1.2 Comprehensive Income Tax . . . . . . . . . . . . . . . . . . . . . . . 231
1.3 Expenditure Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232
1.4 Endogenous Labor Supply . . . . . . . . . . . . . . . . . . . . . . . . 232
1.5 The Negative Incentive Effect and Optimal Taxation . . . . . 233
Contents xv

2 The Theory of Optimal Taxation . . . . . . . . . . . . . . . . . . . . . . . . 234

2.1 Theoretical Framework . . . . . . . . . . . . . . . . . . . . . . . . . . 234
2.2 The Ramsey Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234
2.2.1 The Inverse Elasticity Proposition . . . . . . . . . . . . . 235
2.2.2 The Uniform Tax Rate Proposition . . . . . . . . . . . . 236
2.3 Mathematical Formulation . . . . . . . . . . . . . . . . . . . . . . . . 236
2.4 Heterogeneous Households . . . . . . . . . . . . . . . . . . . . . . . 239
3 The Theory of Tax Reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240
3.1 Optimal Taxation and the Theory of Tax
Reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240
3.2 The Fundamental Rule of Tax Reform . . . . . . . . . . . . . . . 240
3.3 Application to Some Examples . . . . . . . . . . . . . . . . . . . . 242
3.3.1 Enlarging the Tax Base . . . . . . . . . . . . . . . . . . . . . 242
3.3.2 Unifying Tax Rates . . . . . . . . . . . . . . . . . . . . . . . 242
4 General Consumption Tax and Labor Income Tax . . . . . . . . . . . . 242
4.1 The Equivalence Theorem . . . . . . . . . . . . . . . . . . . . . . . . 242
4.2 A One-Period Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243
4.3 Some Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244
5 The Timing Effect of Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . 245
5.1 The Overlapping-Generations Model . . . . . . . . . . . . . . . . 245
5.2 The Incidence of Tax Reform . . . . . . . . . . . . . . . . . . . . . 246
5.3 Transitional Generations . . . . . . . . . . . . . . . . . . . . . . . . . 246
5.4 The Effect on Saving and Economic Growth . . . . . . . . . . . 247
6 Simulation Analysis of Tax Reform . . . . . . . . . . . . . . . . . . . . . . 247
6.1 Multi-Period Overlapping-Generations Growth
Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247
6.2 Comments by Evans (1983) . . . . . . . . . . . . . . . . . . . . . . . 248
Appendix A: Optimal Taxation in an Overlapping-Generations
Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250
A1 The Optimal Tax Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250
A1.1 Overlapping-Generations Growth Model . . . . . . . . . . 250
A1.2 Dual Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . 252
A2 The First Best Solution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253
A3 Second Best Solution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 254
A4 Optimal Taxation in the Second Best Case . . . . . . . . . . . . . . 256
A4.1 The Modified Ramsey Rule . . . . . . . . . . . . . . . . . . . 256
A4.2 The Elasticity Term . . . . . . . . . . . . . . . . . . . . . . . . . 256
A4.3 The Implicit Separability Condition . . . . . . . . . . . . . 257
A4.4 Two Objectives and Intertemporal
Efficiency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 257
A4.5 The Lagrange Multiplier . . . . . . . . . . . . . . . . . . . . . 257
A5 Heterogeneous Individuals and Distributional
Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 258
xvi Contents

Appendix B: Tax Reform Within Lump Sum Taxes . . . . . . . . . . . . . . 258

B1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 258
B2 Analytical Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259
B3 Lump Sum Tax Reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260
B3.1 The Tax Postponement Effect . . . . . . . . . . . . . . . . . . . 260
B3.2 The Effect on Savings . . . . . . . . . . . . . . . . . . . . . . . . . 261
B3.3 The Welfare Effect of Tax Reform . . . . . . . . . . . . . . . . 262
B4 The Tax Timing Effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
B4.1 The Welfare Implication of the Tax Timing
Effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
B4.2 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263
B5 Some Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 265
10 Income Redistribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267
1 Progressive Income Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267
1.1 Income Redistribution Policy . . . . . . . . . . . . . . . . . . . . . . . . 267
1.2 A Two-Person Model with Income Inequality . . . . . . . . . . . . 267
1.3 The Social Welfare Function . . . . . . . . . . . . . . . . . . . . . . . . 268
1.4 The Socially Optimal Point . . . . . . . . . . . . . . . . . . . . . . . . . 269
1.5 The Optimal Income Tax Schedule . . . . . . . . . . . . . . . . . . . 270
1.6 Perfect Equality When Income Is Uncertain . . . . . . . . . . . . . 270
2 Endogenous Labor Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271
2.1 The Detrimental Outcome of Perfect Equality . . . . . . . . . . . . 271
2.2 Endogenous Labor Supply . . . . . . . . . . . . . . . . . . . . . . . . . . 272
2.3 A Linear Income Tax Schedule . . . . . . . . . . . . . . . . . . . . . . 273
2.4 The Tax Possibility Curve . . . . . . . . . . . . . . . . . . . . . . . . . . 274
3 The Optimal Income Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275
3.1 The Rawls Judgment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275
3.2 The Bentham Criterion . . . . . . . . . . . . . . . . . . . . . . . . . . . . 276
3.3 Optimal Redistribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277
4 Nonlinear Income Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278
4.1 The First Best . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278
4.2 Self-Selection Constraint . . . . . . . . . . . . . . . . . . . . . . . . . . . 279
4.3 The Optimal Marginal Tax Rate . . . . . . . . . . . . . . . . . . . . . 279
4.4 A Differentiated Linear Tax Schedule . . . . . . . . . . . . . . . . . 281
4.5 The Recent Approach to the Optimal Marginal
Tax Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282
5 Economic Constraint and Redistribution . . . . . . . . . . . . . . . . . . . . 282
5.1 Credibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283
5.2 The Crowding-Out Effect . . . . . . . . . . . . . . . . . . . . . . . . . . 283
5.3 Expectation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283
5.4 Asymmetric Information . . . . . . . . . . . . . . . . . . . . . . . . . . . 284
5.5 Stigma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284
5.6 Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284
Contents xvii

Appendix: Optimal Linear Income Tax . . . . . . . . . . . . . . . . . . . . . . . 284

A1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284
A2 The Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285
A3 Shift of the Social Welfare Function . . . . . . . . . . . . . . . . . . . . 288
A4 Shift of the Tax Possibility Frontier . . . . . . . . . . . . . . . . . . . . 289
A4.1 The Maximin Case . . . . . . . . . . . . . . . . . . . . . . . . . . . 290
A4.2 The Utilitarian Case . . . . . . . . . . . . . . . . . . . . . . . . . . 291
A5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293
11 The Theory of Public Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295
1 Public Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295
1.1 Public Goods and Private Goods . . . . . . . . . . . . . . . . . . . . . 295
1.2 Formulation of Public Goods . . . . . . . . . . . . . . . . . . . . . . . . 296
1.3 Public Goods and Actual Government
Spending . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297
2 Optimal Provision of Public Goods: The Samuelson
Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 298
2.1 The Samuelson Rule: Diagramed Derivation . . . . . . . . . . . . 298
2.2 The Samuelson Rule: Mathematical Derivation . . . . . . . . . . . 299
2.3 The Samuelson Rule: Simple Derivation . . . . . . . . . . . . . . . 300
2.4 Numerical Example: A Two-Person Model of
Public Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301
3 The Theory of Public Good Provision: The Nash Equilibrium
Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302
3.1 The Nash Equilibrium Approach of Private
Provision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302
3.2 A Two-Person Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303
3.3 Efficiency of the Nash Equilibrium . . . . . . . . . . . . . . . . . . . 305
3.4 Examples: Comparison . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306
3.5 Criticism of the Nash Equilibrium Approach . . . . . . . . . . . . 307
4 The Theoretical Analysis of Public Goods: The Lindahl
Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308
4.1 The Lindahl Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . 308
4.2 Efficiency of the Lindahl Equilibrium . . . . . . . . . . . . . . . . . 309
5 The Free Rider Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310
5.1 Public Goods and the Free Rider Problem . . . . . . . . . . . . . . 310
5.2 Possibility of the Free Ride Problem . . . . . . . . . . . . . . . . . . 311
5.3 Game Theory Approach to the Free Rider
Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 312
5.4 The Clarke Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314
5.5 The Clarke Tax and a Balanced Budget . . . . . . . . . . . . . . . . 315
6 The Neutrality Theorem of Public Goods . . . . . . . . . . . . . . . . . . . 316
6.1 The Neutrality Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . 316
6.2 The Model of Neutrality Result . . . . . . . . . . . . . . . . . . . . . . 316
xviii Contents

6.3 Perfect Crowding Out . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318

6.4 Plausibility of the Neutrality Theorem . . . . . . . . . . . . . . . . . 318
6.5 Concluding Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319
Appendix: Public Bads, Growth, and Welfare . . . . . . . . . . . . . . . . . . . 320
A1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320
A2 Analytical Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320
A3 Wealth Differentials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322
A3.1 The Neutrality Result . . . . . . . . . . . . . . . . . . . . . . . . . 322
A3.2 Analytical Result . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323
A4 Immiserizing Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325
A5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 327
12 Public Spending and the Political Process . . . . . . . . . . . . . . . . . . . . 329
1 The Failure of Government . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329
1.1 Government Intervention . . . . . . . . . . . . . . . . . . . . . . . . . . . 329
1.2 The Theory of Public Choice . . . . . . . . . . . . . . . . . . . . . . . . 329
1.3 Small Government . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330
2 The Voting Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331
2.1 Inequality and the Demand for Public Goods . . . . . . . . . . . . 331
2.2 Analytical Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331
2.3 The Median Voter Theorem . . . . . . . . . . . . . . . . . . . . . . . . . 333
3 The Voting Model and Reality . . . . . . . . . . . . . . . . . . . . . . . . . . . 334
3.1 The Paradox of Voting . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334
3.2 Problems with the Median Voter Hypothesis . . . . . . . . . . . . 335
3.3 Interest Groups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 336
4 Political Parties and Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . . 337
4.1 The Objective of Parties . . . . . . . . . . . . . . . . . . . . . . . . . . . 337
4.2 The Convergence Theorem . . . . . . . . . . . . . . . . . . . . . . . . . 338
4.3 Further Analysis of the Convergence Theorem . . . . . . . . . . . 339
4.4 Extensions and Voting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340
4.5 The Political Business Cycle . . . . . . . . . . . . . . . . . . . . . . . . 340
4.6 The Partisan Business Cycle . . . . . . . . . . . . . . . . . . . . . . . . 341
5 Theoretical Model of the Partisan Business Cycle . . . . . . . . . . . . . 342
5.1 The Macroeconomic Model . . . . . . . . . . . . . . . . . . . . . . . . . 342
5.2 The Behavior of Two Parties . . . . . . . . . . . . . . . . . . . . . . . . 343
5.3 The Effect of the Election . . . . . . . . . . . . . . . . . . . . . . . . . . 344
5.4 The Probability of Winning the Election . . . . . . . . . . . . . . . 346
6 Further Comments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 346
6.1 Change of Government . . . . . . . . . . . . . . . . . . . . . . . . . . . . 346
6.2 The Evaluation of Public Spending . . . . . . . . . . . . . . . . . . . 348
Appendix A: Fiscal Privileges, Consolidation Attempts, and Pigouvian
Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 349
A1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 349
A2 The Basic Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350
Contents xix

A3 The Model Without Consolidation

Attempts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351
A3.1 The Competitive Solution . . . . . . . . . . . . . . . . . . . . . . 351
A3.2 Pigouvian Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352
A4 The Model with Consolidation Attempts . . . . . . . . . . . . . . . . . 354
A4.1 The Competitive Solution . . . . . . . . . . . . . . . . . . . . . . 354
A4.2 Pigouvian Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 355
A4.3 The Consumption Tax . . . . . . . . . . . . . . . . . . . . . . . . . 356
A5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357
Appendix B: Political Factors and Public Investment Policy
in Japan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 358
B1 Political Pressures from Local Interest
Groups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 358
B2 Intergovernmental Transfers in Japan . . . . . . . . . . . . . . . . . . . 359
B3 The Impact of Interregional Transfers . . . . . . . . . . . . . . . . . . . 359
B4 Efficient and Effective Public Investment Management . . . . . . 360
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 361
13 Local Public Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 363
1 Intergovernmental Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 363
1.1 Decentralization and Local Finance . . . . . . . . . . . . . . . . . . . 363
1.2 The Decision System of Intergovernmental
Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 363
1.3 The Centralized System . . . . . . . . . . . . . . . . . . . . . . . . . . . . 364
1.4 The Decentralized System . . . . . . . . . . . . . . . . . . . . . . . . . . 365
1.5 Intergovernmental Finance . . . . . . . . . . . . . . . . . . . . . . . . . 367
2 The Supply of Local Public Goods . . . . . . . . . . . . . . . . . . . . . . . . 367
2.1 Local Public Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367
2.2 The Optimal Provision of Local Public Goods . . . . . . . . . . . 367
2.3 Voting with Their Feet: The Tiebout
Hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 369
2.4 Plausibility of the Tiebout Hypothesis . . . . . . . . . . . . . . . . . 370
3 Tax Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371
3.1 The Competition for a Mobile Tax Base . . . . . . . . . . . . . . . . 371
3.2 Taxing Mobile Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . 373
4 The Time Consistency of a Tax Policy . . . . . . . . . . . . . . . . . . . . . 375
4.1 The Time Consistency Problem . . . . . . . . . . . . . . . . . . . . . . 375
4.2 A Simple Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375
5 The Principle of Local Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377
5.1 The Overlapping Tax Base . . . . . . . . . . . . . . . . . . . . . . . . . 377
5.2 The Soft Budget Problem . . . . . . . . . . . . . . . . . . . . . . . . . . 377
5.3 The Benefit-to-Pay Principle . . . . . . . . . . . . . . . . . . . . . . . . 378
5.4 The Fixed Asset Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 379
5.5 The Inhabitant Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 379
5.6 The Consumption Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380
5.7 Basic Principles of a Local Tax System . . . . . . . . . . . . . . . . 380
xx Contents

6 Redistribution among Local Governments . . . . . . . . . . . . . . . . . . 381

6.1 Regional Diversity of Local Tax . . . . . . . . . . . . . . . . . . . . . 381
6.2 The Three-Person Model of Regional
Redistribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 381
6.3 Efficiency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 383
7 Further Issues on Intergovernmental Finance . . . . . . . . . . . . . . . . 383
7.1 Local Public Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 383
7.2 A Decentralized Fiscal System . . . . . . . . . . . . . . . . . . . . . . . 384
Appendix: An Analytical Model of Central and Local Governments
in Japan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 384
A1 The Local Allocation Tax in Japan . . . . . . . . . . . . . . . . . . . . . 384
A2 An Analytical Model of Central and Local
Governments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 386
A2.1 The Soft Budget Constraint . . . . . . . . . . . . . . . . . . . . . 386
A2.2 An Analytical Framework . . . . . . . . . . . . . . . . . . . . . . 387
A2.3 The Pareto Efficient Solution . . . . . . . . . . . . . . . . . . . . 389
A3 The Hard Budget Game . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 390
A3.1 The Second Stage . . . . . . . . . . . . . . . . . . . . . . . . . . . . 391
A3.2 The First Stage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 391
A3.3 Outcome . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 392
A4 The Soft-Budget Game . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 393
A4.1 CG’s Ex Post Transfer: The Second Stage . . . . . . . . . . 393
A4.2 LG’s Behavior: The First Stage . . . . . . . . . . . . . . . . . . 395
A5 Welfare Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 397
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 398

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 399
About the Author

Toshihiro Ihori is a professor of economics at the National Gradual Institute for Policy
Studies and a professor emeritus of the University of Tokyo. He has a B.A. and an M.A. from
the University of Tokyo and a Ph.D. in economics from Johns Hopkins University. His major field
of research is public economics. Details are at the website of the National Gradual Institute for
Policy Studies.

xxi
List of Figures

Fig. 1.1 Share of expenditure in the system of Japanese

government . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Fig. 1.2 A representation of Japan’s budgetary system . . . . . . . . . . . . . . . . . . . 11
Fig. 1.3 General government public spending in developed
countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Fig. 1.4 General government fiscal balances and gross debt,
1990–2014 . . . . . . . .. . . . . . . . . . . . . .. . . . . . . . . . . . . .. . . . . . . . . . . . . .. . . . . . . . . 17
Fig. 1.A1 Trends in general account tax, revenues, total expenditures
and government bond issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Fig. 1.A2 Government bond issues and the bond dependency
ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Fig. 1.A3 Transition of major expenditure items in the general
account . . .. . . . . .. . . . . . .. . . . . .. . . . . .. . . . . .. . . . . . .. . . . . .. . . . . .. . . . . .. . . . 20
Fig. 2.1 The 45-degree line model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Fig. 2.2 IS and LM curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Fig. 2.3 The interest elasticity of money demand is infinite . . . . . . . . . . . . . 36
Fig. 2.4 The interest elasticity of investment is zero . . . . . . . . . . . . . . . . . . . . . . 37
Fig. 2.5 The effect of fiscal policy in the fixed exchange regime . . . . . . . . 40
Fig. 2.6 The effect of fiscal policy in the flexible exchange rate
regime . . . .. . . . .. . . .. . . . .. . . . .. . . . .. . . .. . . . .. . . . .. . . . .. . . . .. . . .. . . . .. . . 41
Fig. 2.7 The lag of economic policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
Fig. 3.1 The permanent level of variables and actual level of
variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
Fig. 3.2 The government’s budget constraint . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
Fig. 3.3 Consumption and saving . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
Fig. 3.4 Labor supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
Fig. 3.5 Labor demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
Fig. 3.6 Equilibrium in the labor market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
Fig. 3.7 Equilibrium in the goods market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
Fig. 3.8 The effect of fiscal policy (i) (a), and (ii) (b) . . . . . . . . . . . . . . . . . . . . 64

xxiii
xxiv List of Figures

Fig. 4.1 Overlapping generations model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80

Fig. 4.2 Barro’s neutrality theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
Fig. 4.3 The non-Keynesian effect . . . . . . . . . . . .. . . . . . . . . . . . . . . . . .. . . . . . . . . . . . 91
Fig. 5.1a Optimal allocation between public and private
investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
Fig. 5.1b Non-optimal allocation between public and private
investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
Fig. 5.2 Optimal allocation over time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
Fig. 5.3 The macroeconomic production function .. . .. .. .. . .. .. . .. .. . .. .. . 111
Fig. 5.4 Stability of the model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112
Fig. 5.5 Growth rate and tax rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
Fig. 5.6 Kuznets hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118
Fig. 6.1 Tax smoothing and temporal debt issue . . . . . . . . . . . . . . . . . . . . . . . . . . 142
Fig. 6.2a The excess burden curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
Fig. 6.2b Tax-smoothing hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144
Fig. 6.3a Public debt in relation to per capita GDP: sustainable
case . . . .. . . . .. . . . . .. . . . .. . . . . .. . . . .. . . . .. . . . . .. . . . .. . . . . .. . . . .. . . . .. . . . 147
Fig. 6.3b Public debt in relation to per capita GDP: unsustainable
case . . . .. . . . .. . . . . .. . . . .. . . . . .. . . . .. . . . .. . . . . .. . . . .. . . . . .. . . . .. . . . .. . . . 148
Fig. 6.4a The dynamics of the Domar condition. r > n . . . . . . . . . . . . . . . . . . . . 151
Fig. 6.4b The dynamics of the Domar condition. r < n . . . . . . . . . . . . . . . . . . . . 151
Fig. 6.5 The Bohn condition . . .. . .. . . .. . .. . .. . . .. . .. . .. . . .. . .. . .. . . .. . .. . .. . . 152
Fig. 6.A1 Optimal growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161
Fig. 6.A2 Comparative dynamics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162
Fig. 7.1 The pay-as-you-go system . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
Fig. 7.2 Consumption decisions. In the case of (a) n ¼ r,
(b) n > r, (c) n < r .. .. . .. . .. .. . .. . .. .. . .. . .. . .. .. . .. . .. .. . .. . .. .. . .. . 175
Fig. 7.3 Public debt policy .. . . . .. . . .. . . .. . . .. . . . .. . . .. . . .. . . . .. . . .. . . .. . . .. . . 177
Fig. 7.A1 Structure of the pension system . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188
Fig. 7.B1 Aging rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193
Fig. 8.1 Tax and labor supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206
Fig. 8.2 Lump sum tax and labor income tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209
Fig. 8.3 The excess burden . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211
Fig. 8.4 Optimal saving . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212
Fig. 8.5 The effect of interest income tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214
Fig. 8.6 The effect of corporate income tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218
Fig. 8.7 The firm as the legal taxpayer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221
Fig. 8.8 The consumer as the legal taxpayer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222
Fig. 8.9 Extreme cases of incidence. (a) Supply curve: infinite
elasticity, (b) Demand curve: zero elasticity, (c) Supply
curve: zero elasticity, (d) Demand curve: infinite
elasticity q denotes quantity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223
List of Figures xxv

Fig. 9.1 Labor income tax and interest income tax . .. . .. .. . .. .. . .. .. . .. .. . 230
Fig. 9.2 The optimizing behavior of a household . . . . . . . . . . . . . . . . . . . . . . . . . 233
Fig. 9.3 (a) An inelastic good, (b) An elastic good . . . . . . . . . . . . . . . . . . . . . . . 235
Fig. 9.4 The theory of tax reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241
Fig. 10.1 Socially optimal point . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269
Fig. 10.2 Extremely progressive income tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270
Fig. 10.3 Perfect equality when income is uncertain . . . . . . . . . . . . . . . . . . . . . . . 271
Fig. 10.4 A linear progressive income tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273
Fig. 10.5 A linear regressive income tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273
Fig. 10.6 The tax possibility curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 274
Fig. 10.7 Optimal income tax: the Rawls criterion . . . . . . . . . . . . . . . . . . . . . . . . . 275
Fig. 10.8 Optimal income tax: the Bentham criterion . . . . . . . . . . . . . . . . . . . . . . 277
Fig. 10.9 The optimal tax schedule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278
Fig. 10.10 Optimal nonlinear income tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280
Fig. 10.A1 The tax possibility frontier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 286
Fig. 10.A2 Shift of the social welfare function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
Fig. 10.A3 The maximin case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 290
Fig. 10.A4 The utilitarian case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 291
Fig. 11.1 The consumption possibility curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297
Fig. 11.2 Optimal provision of public goods. (a) person 1,
(b) person 2 . . .. .. . .. . .. . .. . .. .. . .. . .. . .. . .. . .. .. . .. . .. . .. . .. .. . .. . .. . 299
Fig. 11.3 The Samuelson rule . . .. . .. . . .. . .. . .. . . .. . .. . .. . . .. . .. . .. . . .. . .. . .. . . 302
Fig. 11.4 The Nash reaction function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304
Fig. 11.5 The Nash equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305
Fig. 11.6 The optimizing behavior . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 309
Fig. 11.7 The Lindahl equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310
Fig. 11.8 The Lindahl equilibrium and free riding . . . . . . . . . . . . . . . . . . . . . . . . . 311
Fig. 12.1 Preferences for small or big government . . . . . . . . . . . . . . . . . . . . . . . . . 332
Fig. 12.2 The median voter theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333
Fig. 12.3 Preference for public education . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334
Fig. 12.4 The paradox of voting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335
Fig. 12.5 Multi-dimensional voting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 336
Fig. 12.6 Generalizing the median voter hypothesis . . .. . .. . . .. . . .. . . .. . . .. . 336
Fig. 12.7 The convergence of policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 338
Fig. 12.8 The effect of the election . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345
Fig. 12.9 Change of government . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 347
Fig. 12.10 The evaluation of public spending . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 348
Fig. 12.A1 The competitive solution without consolidation
attempts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352
Fig. 12.A2 The competitive solution with consolidation attempts . . . . . . . . . . 355
Fig. 13.1 Fiscal decentralization . . . . .. . . . .. . . . . .. . . . .. . . . . .. . . . .. . . . .. . . . . .. . . 366
Fig. 13.2 The optimal level of population . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 369
Fig. 13.A1 Intergovernmental finance in Japan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 385
List of Tables

Table 4.1 The non-Keynesian effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90

Table 5.B1 Studies on the productivity effect of transportation-related
public investment . . .. . . . . . .. . . . . . .. . . . . . .. . . . . . .. . . . . . .. . . . . . .. . . . . 129
Table 6.1 The fiscal consolidation targets in developed countries . . . . . . . 157
Table 6.A1 Optimal deficit/GDP ratio in the long run . . . . . . . . . . . . . . . . . . . . . . 164
Table 7.1 The balance of the government budget (i) . . . . . . . . . . . . . . . . . . . . . . 176
Table 7.2 The balance of the government budget (ii) . . . . . . . . . . . . . . . . . . . . . 177
Table 7.3 Useful indicators of fiscal policy . . .. . .. . .. . .. . .. . .. . .. . . .. . .. . .. . 178
Table 7.4 Net payoff for each generation in relation to the
pay-as-you-go (defined benefit) system . . . . . . . . . . . . . . . . . . . . . . . . . 180
Table 7.5 The transition to a defined system in period 3 . . . . . . . . . . . . . . . . . . 180
Table 7.6 The transition to a funded system . . . .. . .. . . .. . . .. . .. . . .. . . .. . .. . . 181
Table 7.7 Costs and benefits of each generation . . . . . . . . . . . . . . . . . . . . . . . . . . . 184
Table 7.A1 Trends and projections for social security benefits
(percentage of GDP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185
Table 7.A2 Trends and projections for social security benefits
(in trillion Yen) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186
Table 7.B1 Base simulation results . .. . .. .. . .. . .. .. . .. . .. .. . .. . .. .. . .. . .. .. . .. . 195
Table 7.B2 Base simulation results . .. . .. .. . .. . .. .. . .. . .. .. . .. . .. .. . .. . .. .. . .. . 199
Table 9.1 Tax collection from young and old generations . . . . . . . . . . . . . . . . 246
Table 9.B1 Tax reform and intergenerational incidence . . . . . . . . . . . . . . . . . . . . 263
Table 11.1 Public goods and private goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296
Table 11.2 The streetlight game . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313
Table 11.3 The Clarke tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315
Table 13.1a Outcome before move . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 382
Table 13.1b Outcome after move .. . .. . .. .. . .. . .. . .. .. . .. . .. .. . .. . .. . .. .. . .. . .. . 382

xxvii