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    Chapter 5 Theories of the Public Sector Exercise 5.1 Can trade occur in a world with no rules? Is it ever possible to have no rules? Solution 5.1 Trade could occur if there is a balance of forces that. prevents unwarranted appropriation by one party. ‘The gains from trade need to exceed the expected benefit of theft (the expectation of the gain less the expectation of suffering from the use of force by the other party). However, it is hard to imagine there | Rules need not be explicit or documented but can be social conventions which are implicitly understood by the trade participants. ing no rule: Exercise 5.2 If it takes four days of labor to produce a week’s food, and one day of labor to steal a week's food, what will be the equilibrium onteome? Solution 5.2 This scenario cau be summarized as a simple game. Let p denote the expected value of being caught stealing and subsequently punished. Assume there is a utility cost to supplying the labor to produce food. The payoffs in the e conditions. The equilibrium of the matrix summarize a game that meets the game depends on the value of p. If p is low, the equilibrium is {Steal, Steal}, but if p is high, the equilibrium is {Produce, Produce}. If there was a state of anarchy with an expected value of punishment of zero, then no production would occur Produce | Steal__] Produce [5.5 0.10—p] eal | 10—p.0. Exercise 5.3 Would a minimal state finance a fire service? sl 82 CHAPTER 5. THEORIES OF THE PUBLIC SECTOR Solution 5.3 The minimal state only engages in economic intervention to en- wre that the most fundamental requiren tivity to take place. ‘The provision of a fire service is not usually seen as one of these requirements. The question can he generalized to whether economic efficiency demands that the state should provide a fire serviee. Putting it differ- ently, are there any reasons why the market would fail to deliver fire services”? Assume that the occurrence of a fire is a random event. The natural solution I then to have a private fire service with the eost covered by insurane his would be efficient unless there is some market failure, such as monopol asymmetric information, or an externality ts are in position for economic ac- Exercise 5.4 Does the data of chapter 4 support the view that governments have expanded beyond the minimal state? Solution 5.4 There can be no doubt that in all developed economies the gov= ernment has expanded far beyond the minimal state. The review of government expenditnre emphasized the current significance of soeial security payments and health care expenditure in the budget. ‘The minimal state would never under- take the transfer payments that are a major feature of current. government expenditure, Exercise 5.5 Discuss whether provision of state education enhances efficiency or equity. What about health care? Solution 5.5 For an expenditure to enhance efficiency, there must be some underlying market failure that it is addressing. To apply this to education to address why individuals would not make socially correct in- vestments in education without government intervention, There may be both it is necessar private returns to education (the increase in expected income that follows from education) and social returns (the benefits that accrue to the wider economy through having a auore educated workforce). If there are only private returns then efficient education decisions will be made provided that there is access to the necessary finance for the investinent. An imperfect capital market will make borrowing to invest more costly than is appropriate given the level of risk, In this ease, if the government intervenes by subsidizing loans, providing seliolar- ships, or directly financing education, it will raise efficiency. Moreover, if the market failure bears disproportionately on those with lower initial wealth, then government intervention will also enhance equity. If there are also social returns to education, these will not be factored into individual decisions. Hence govern- ment intervention ean be efficiency-euhancing if it correets for this deviation of private return from social return, Many sinnilar comments can be made about health care. Inefficiency ean arise through market failure, and government in- tervention can address this. If market imperfections bear disproportionately on the rich and poor then government intervention can also enhance equity bo Exercise 5.6 Would a minimal state: fa, Ensure that wage agreements were enforced? b, Limit maximum working hours? ¢. Prevent involuntary overtime? Solution 5.6 a, Yes, # minimal state would ensure that all contracts, inedluding tho wage agreements between contracting parties, are enforced. However, a minimal state would not enforee a minimum wage agreement. A minima wage agreement places a limit on the actions of contracting parties. It can therefore impair economic efficiency by preventing mutually advantageous trades. b, No, If the number of working hours was determined by agreement between ‘firm and its workers the minimal state would not interven c. Yes. ‘The word involuntary implies that the worker has not willingly so in breach of contracted to work overtime. The firm imposing overtime does ‘contract, so the minimal state will prevent the overtime. Exercise 5.7 Will elliciency be achieved if ‘0 agent knows what the profit level of a firm will be next year? D. One agent does know what the profit level will be? Solution 5.7 Economic efficiency is attained if trading takes place on equal terms. If one economic agent has an informational advantage over others, then this condition is not satisfied. The agent with better information will be able tosecure unfair gains from trade (and consequently impose a loss on others) by exploiting the information, When applied to financial markets, this is referred tos trading on “inside information a. If all agents are equally uni However, even if no agent knows what the profit level will be, itis still possible for some agents to have better (imperfect) information than others. In this latter case there is an asymmetry of information that can lead to market failure. b. If one agent does know, and the rest do not, then the onteome will be inefficient if the informed agent uses the information to secure an advantage in trade. formed, then efficiency will be achieved Exercise 5.8 Can insider trading occur in the idealized competitive economy’? Solution 5.8 In the idealized competitive economy all economic agents are small (relative to the economy) and view prices as parametric when they trade. It is also assumed that there are no market failures (imperfect competition, externalities, asymmetric information). Insider trading occurs when ox holds finaneial information that others do not and trades using this infor 81 CHAPTER 5. THEOR( OF THE PUBLIC SECTOR This is a clear case of asymmetric information and so will not be present in the idealized competitive economy. Exercise 5.9 All our sulphur emissions are blown into a neighboring country. y be efficient? Can our eeonon Solution 5.9 In taking what happens in the outside world as “given,” our economy can be in an efficient position. The fact that the emissions are blown into a neighboring country means that the social cost of out actions falls upon that country. Within our country, private costs would still be equated to private benefits for efficieney. However, what happens in the rest of the world is not, given but is affected by our discharge of sulphur emissions. If the entire world economy is considered, there will not be efficiency. We will ignore the social cost of the emissions and hence have produced excessive pollution, Exercise 5.10 Are the following policies conducted for efficieney or equity mo- tives: a, Provision of unemployment benetits? 1b, Provision of primary education? ¢, Provision of higher education? 4, Provision of retirement pensions? c, Prohibiting smoking in public places? {, Imposing higher marginal income tax rates on people with higher incomes? In the case of efficiency motives, disenss the type of market failure involved. Solution 5.10 a. ‘The provision of unemployment benefit is usually seen as, undertaken for equity motives. Thos unlucky to find themselves unemployed reevive the benefit as an insurance payment. ‘This is redistribution from the lucky (the employed) to the unlucky (unemployed). Tt is often argued that un employment benefits are a source of inefficieney since they make work relatively less attractive and distort the choice between work and leisure. b, Education cau be provided for reasons of both efficiency and equity. The provision of primary education has more of an efficieney aspect than later levels of education since it equips the population with the basic skills without which the economy would struggle. ‘There is also an equity element since it allows low-income groups to become edueated. In the groups inay not be able to afford education. sion these absence of stich prov ¢, Ifhigher education is provided free, there is a significant element of equity. Higher education is costly, which is a significant disincentive to the participation of low-income groups. Providing higher education for free should allocate places lity to pay. The market failure at work here on academie merit. and not on al is asymmetric information preventing the capital market from being perfect 85, If there are social returns to education in addition to private gains, then free provision will also have an efficiency aspect. This is market failure through an external effet d, The answer is dependent on the strneture of the retirement pension. [Fit is a fixed sum regardless of contribution, then there is a distinct equity element the pension redistributes to those who would not otherwise have been able to save for retirement. The provision of a pension can also involve efficiency ifinadequate private saving has been undertaken for reasons of market failure, A source of such market failure is imperfection in the market for investment products, This can result from imperfect competition and from asymmetric information. ¢. The fundamental issue with smoking in public places is that there is no well-defined property right, The smokers may believe that they have the right to pollute and the nonsmokers may believe that they have the right to clean air. A prohibition on smoking in public places is the establishment of a property right. Hence the intervention is for reasons of efficiency. [t may not be the perfect solution: supporters of the Coase theorem would argue that the property right needs to be tradable for an efficient outcome to be realized. £ The impesition of higher marginal tax rates on higher income groups raises the proportional contribution they make to government revenue relative come groups. This is an instance of equity, to low Exercise 5.11 Should the government intervene with a redistributive policy if income inequality is due to: a, Differences in work effort? b. Differ sees in ability? Solution 5.11 a. Assume there are two workers with identical ability levels Ifone chooses to work hard and the other to slack, there is no reason why the government should intervene to redistribute. The two workers are faced with the same opportunities but make different decisions, ‘The high-income worker should not be taxed for preferring work to leisure, b. The situation is changed when two workers have different innate ability lewls, We can think of ability levels as being assigned randomly to workers (perhaps prior to birth). Some are lucky in this random allocation process and others are unlucky. A redistributive policy does nothing mor: than transfer from the lucky to the unlucky. Viewed from a point prior to the allocation of ability, the redistribution policy is a form of insurance against bad hick in the allocation of ability. Exercise 5.12 Consider two consumers who each have a total of T hours to allocate between production and theft. Assume that produetion produces out put yp =log(ty) for fy units of time in production, If time ty is devoted to 86 CHAPTER 5. THEORIES OF THE PUBLIC SECTOR theft, then a proportion aty/T of the other consumer's output ean be stolen. Assuming that it of output has price p and both consumers atten to maximize their wealth, what is the equilibrium? How does the equilibrium depend on the value of a? What is the equilibrium if there is no theft? What is the maximum that would be paid to prevent theft? Solution 5.12 The value of output of consumer 1 is py} = plosi(t). (6.1) After the act of theft of consumer 2 this is reduced to ( - “) plog(t}). ‘The value stolen from consumer 2 by consumer 1 is 2) (5) Putting these together the total wealth of consumer Lis at} at r= (1-97) plog(th) + 7 ptog(ee (5. Ww (: 7 ) met + op Ploslts) (5.4) A similar expression can be derived for consumer 2. ‘The use of time is constrained by the total stock available so pathy th, haA2 (65.5) Substituting for ¢#, the decision problems of the two consumers can then be described by _ ate max W! = (- ale Ye + (Pot plog(t2) (5.6) {ay r and pat ( =" ~ ”) plog(t2) + @- © ptow(t) (6.7) Each takes the choice of the other as given when maximizing. We next s for the Nash equilibrium of the game, For consumer 1 the necessary condition is p i> plots) =0 (5.8) 87 The consumers are identical, so there will be a symmetric equilibrinm with 1) =12 = ty. Employing symmetry, we write (5.8) as (1a) P+ ats (I~ logttn)) = 0. (65.9) This expression implicitly characte tion, ‘Totally differentiating (5.9) with respect to fy and ce shows that es the equilibrium value of time in produc- ty T ~ty (1 — log(tn)) do alog(tn) Using (5.9) to substitute for [1 —log(t,,)] gives dy dey ~~ 0 log(ty)’ Provided that the initial solution has t, > 1 (so log(ta) > 0), this implies dln /dex < 0) 50 time in production is reduced as a, the suceess of theft, increases If there is no theft, then t = 7. The maximum, V,, that would be paid to awid theft is equal to the payoff without theft less the payoff with theft. This 7 (f-t) plog(T) — (: a) = pllog(T) — log(tn)) ) plog(tn) —° plogttn) lost.) (Note: These calculations have assuaned that the parameter values are such that fa symmetric interior equilibrium exists, A more detailed analysis would take account of Lhe possibility of corner solutions and asymmetric equilibria.) Exercise 5.13 Describe the expenditures at eadh stage of the development process in terms of efficiency and equity. Solution 5.13 The carly stage of development is the period of industrializa- tion during whieh the population moves from the countryside to urban areas. To meet the needs of the urban population, there is a requirement for infrastrue- tural expenditure. ‘The typically rapid growth experienced at this stage of de~ velopment results in a significant increase in expenditure, and the need for in frastrueture determines the nature of expenditure. This is primarily expenditure {or efficiency reasons. In the middle stages of development, the infrastructural expenditure of the public sector becomes increasingly complementary with expenditure by the pri- vate sector. For example, factory construction will be supported by the build- ing of connecting roads. As urbanization proceeds, population density increases 88 CHAPTE 5. THEORIES OF THE PUBLIC. “TOR Private good Gy G, Public good Figure 5.1: Income elasticity in excess of one which produces a range of externalities such as pollution and erime, An in- creasing proportion of public expenditure is then diverted toward the control of these externalities. ‘This expenditure is again diteeted to the reduetion of market failure so is for efficiency reasons. In the developed phase of the economy expenditure is driven hy the desire to react to equity issues. As a result transfer payments, such as social security, health, and education, become the main items of expenditan Exercise 5.14 a, Provide a graphical two-commodity (one private good and one public good) example of a preference relation generating an income elasticity of the demand for public good that is greater than one. b. Show that in this case the fraction of the budget spent on the public good inereases as income increases, Explain why the indifference eurve in this two-commodity space is negatively sloped and convex (preferences are convex if, for any two points on the same indifference curve, the line segment between them is in the “weakly preferred” set, which is defined as the set of commodity bundles [weakly] preferred to any bundle that lies on the indifference curve.) Solution 5.14 a. The implication of an income elasticity greater than one is, that public good demand will snore than double when income doubles. Figure 5.1 show a doubling of income and the demand for the publie good increasing, from Gy to Gy with Gi > 2Go. 89 b. Assume the public good has a unit price of 1. ‘The proportion of the budget, M, spent on the public good is defined by G/M. ‘The effect of an inerease in income on this is aGin aM (5.13) ) where cf isthe income elasticity of demand, Ife, > 1, theshare of the budget increases as income increases TThe negative slope means that an increase in the public good will compen- sate the cousumer for a reduction in the private good, Convexity means that Exercise 5. 5 Isa theory of any value if it makes no predictions? Discuss the development model of public sector expenditure growth from this perspective. Solution 5.15 The development model provides an explanation for the major aspects of public expenditure growth over the past century. It would be a sur prise if it did not do this, since the model was constructed after the event to describe a set of historical observations. As a historical narrative it has some value. To be valuable, economie theory should enable us to derive predictions from the model. It is not clear what predictions the development model makes, ifany. At best, it provides the truism that publi sector expenditure will be de- termined by the stage of development of the economy. A harsh judgment would be that the model cannot explain what has happened to publie expenditure since its publication (the apparent cessation of growth in public expenditure in many developed countries), never mind predict what will happen. The very best of economic models have predictive power outside of the existing range of observations. Exercise 5.16 In the same two-commodity economy as in exereise 5.14, keep- ing constant the price of the private good: a. Give a graphical illustration of a preference relation generating a price elasticity of demand for a public good that is less than one in absolute value . Show that in this case the fraction of the budget spent on the publie good increases as the (relative) price of public good increases, Solution 5.16 a. ‘The consequence of a price elasticity of demand that is less than one is that if the price, pq, of the publie good doubles, the quantity 90) CHAPTER 5. THEORIES OF THE PUBLIC Private good GG Public good Figure 5.2: Price elasticity less than one demanded will be reduced by less than a half. Tn figure 5.2 this implies that Gy <2) b. The proportion of the budget, M, spent on the public good is defined by paG/M. The effect of an increase wconie on this is AlpeG/M) Opa (5.14) where ef is the price elasticity of demand. Ife < 1, the share of the budget increases as the price of the public good increases. Exercise 5.17 Assume that the demand for public output at time t, Gy, is given by the demand function G, = [¥i]", where ¥; is national income at time t a, What is the income elasticity of demand? b, For what values of a does Wagner's law hold? Show that expenditure on publie output rises as a fraction of income for these values. ¢. Assume that national income growth is determined by Yier = 6¥, + [G — G,}. Will an increase in G, raise ¥;, in the cases for which Wagner's law applies? Explain your answer mn Solution 5.17 a. The income elasticity of demand is given by ¥ VY! =a. (5.15) b, Wagner's law require This oceurs when a> 1. P the demand for public output to be income elastic. plic output as a fraction of income is given by 7 (5.16) Therefore (5.17) c, Substituting for ¥; obtains Yau = AGU" + (@- Gr) (5.18) The derivative of ¥;,1 with respect to Gy is Bis “1 (5.19) Even with the restriction «> 1, this expression is not signed, One interpretation is that there is a Keynesian story linking output to expenditure but there is an ontput cost to financing the expenditure. Exercise 5.18 Obtain data on public sector expenditure as a proportion of gross domestic product since 1970. Is expenditure still growing? Assess the an- swer relative to the arguments of the development model. Do the data deseribe a relation of demand to income that supports Wagner's law? Solution 5.18 Figure 5.3 graphs US government expenditure as a proportion of income from 1970 to 2012 (the data source is the US Bureau of Economic Analysis). ‘The trend line indicates that this proportion has fallen over the period. ‘The development model argues that expenditnre for equity reasons ‘ocomes inereasingly important for a developed economy. One sueh expenditure is unemployment benefit, whieh increases during an economie downturn. ‘This is observed in the figure where expenditure rises during the downturn of the late 1980s and falls during the boom of the 1990s. Waguer’s law is based on the demand for government expenditure being income elastic. A simple way to test this law is to regress the logarithm of government expenditure on the logarithm of GDP. The fitted coefficient on GDP is tho income elasticity of demand. ‘The result of this regression for the US data is lou(G) = — 1.853, + 1.004 Jox(¥’), (5.20) 92 CHAPTER 5. THEORIES OF THE PUBLIC SECTOR SE EFL EOE ELS ure 5, of GDP Government consumption expenditure and investement as a percent whore the standard errors are in parentheses. ‘The regression equation shows that there is a positive income elasticity of demand that is just above 1 but is not significantly different than 1. Wagner's law requires the coefficient on log(Y) > 1. The data are inconclusive. (Note: The econometrics is intentionally simple here. Since we are dealing with time series, we would clearly need to take stationarity issues into account.) Exercise 5.19 Sketch a story of learning about preferences that supports the ratchet effect Solution 5.19 The ratchet effect relates to the observation that the level of government expenditure does not fall back to its original level after a period of upheaval. Prior to an increase in expenditure there may be goods and services that consumers have not tried. For example, until the founding of the National Health Service, not one resident in the United Kingdom had previously experi- enced universal health care that was frve at the point of delivery. Consequently no one would be in a position to evaluate personally the benefit the National Health Service availed to them. Once such a good is experienced consumers may find they have a previously unrealized preference for the good. The demand for the good is then sustained. Exercise 5.20 Assume the rental rate for capital is fixed at r. Tf the private sector has a production function y = K'/? [¢Z]'/? and sells output at price p, what happens to the wage rate as technical progress increases 1? What would happen if r were not fixed? Relate your answer to Baumol’s law 93, Solution 5.20 The profit-ma: mize profit ing firm chooses capital and labor to maxi- max m= py — rk — wh = pK"? (th)'? — rk — wh. 5. Ray t= py PB — wh = pi? (tL) K wh (5.21) ‘The first-order conditions are 1 Kean? shy (5.22) and Ave? A w=0. Rearranging and dividing the first by t one equation obtains, (5.24) ‘The fact that the output price is viewed as fixed implies that the private sector is competitive, so profit is zero. Henee ph? AL)? —rK —wk = pK? rk — wh wl? = wen (2) wt wh = 0. (5.25) Therefore er ( w= This shows that an increase in £ raises w. If r were not fixed, part of the increase in ¢ would be absorbed in an increase in r rather than w, so the increase in w would be reduced. In this example Baumol’s law applies and an inerease in labor productivity raises the wage rate, Exercise 5.21 Suppose that the production function is y = log(K’) + log(t If demand is constant and labor productivity doubles, what happens to labor demand? What will happen to the wage rate if the economy has many firms in this position? Does this analysis support Bauimol’s law’? Solution 5.21 The firm will minimize costs for any given lewl of output. Heuce the firm will solve pin wh +r sit. y=log( kt) + logl(tL). (5.28) 4 CHAPTER 5. THEORIES O1 ‘HE PUBLI ECLOR With \ denoting the Lagrange multiplier on the constraint, the necessary con- ditions are 1 5.29 w-dz =0. (5.29) and 1 83 roa =O. (5.30) These imply that w_iK . T=L (5.81) Substitution into the constraint gives y= tog ("') + tog (te) 2log(L) + log(t) + log(w) — log(r). It can be seen that if labor productivity doubles (¢ — 2¢), the demand for labor falls, Totally differentiating (5.32) gives al 1 Bi 0-2, dL + jal, (5.33) so dbo “8 nat w Exercise 5.25 Do in expanding their bureaus ilar eh nent assist or hinder bureaucrats ges in gove Solution 5.25 Regular changes in government, or at least the politicians hold- ing government posts, probably assist bureaucrats in expanding their bure An explanation for this claim is that it takes time for politicians to understand how the bureau functions, Until such a point is reached the politician relies upon the bureaucrats for guidance. The bureaucrat can exploit this lack of in- formation to expand the bureat because the benefits and costs are hidden the decision maker Exercise 5.26 Why might it be better to tolerate bureaus of excessive size rather than permit bureanerats to seek rewards in cash? Solution 5.26 Allowing rewards in cash opens the path for corruption of the political process. Bureaucratic positions will be sought for the cash rewards that, they can offer. Individuals seeking, the positions will be willing to pay bribes to obtain them, so both the appointments process and the operation of governmer is corrupted. This affects private individuals who find that bribes must be paid to secure the undertaking of standard bureaucratic tasks. (‘This collection of activities is termed rent-seeking.) The cost of living with an excessive bureau size may therefore be small relative to the cost of institutionalizing rent-seeking, Exercise 5.27 a. In the model of bureaucracy, let B (y) = y'/? and C (y) = y? Calculate the value y* that maximizes B(y) ~ C(y). For what values of y does B(y) = C(y)? Use this to find y!. Show that y! > y*. b, Now let the bureaucrat’s income be given by M = a+ by, and let his utility be given by U = B(y) +1. Does this alter the chosen value of y!? c. Is there any pay scale relating y to M that can lead the bureaucrat to choose y"? 98 CHAPTER 5. THEORIES OF THE PUBLIC SECTOR Solution 5.27 a, Using the finetional forms Bly) — Cy) =y'? — y?. (5.46) ‘The maximizing value of y solves 1 ipo, wn BY 2y = 0, (5.47) on 1 Pras (5.48) Therefore y* = 0.39685. When B (y) = C (y), it must be the case that y!/? = ‘This has solution y! = 1. Hence y’ = 1 > y° = 0.39685, b. The value of y is now chosen to solve max U — Cly) = B(y) + M — Cly) =y!!? +04 by — (5.49) t4+b—2y=0. (5.50) The chosen value y is increased if b is positive. ¢. The easiest way to show this is to set y Doing this gives 1 in (5.50) and solve for b. 1 3th Any incentive seheme with 3 Maa+3y will ensure that the bureaucrat chooses y = 1 Exercise 5.28 How can right-wing and left-wing governnents be modeled us- ing the budget-setting framework? Solution 5.28 The role of a model is to allow the contrast between different scenarios to be achieved by altering a small number of parameters. The relevant parameters for modeling right-wing and left-wing governments in the budget- setting model are a (the rate of inerease in budget claims by departments) and 7 (the rate at which claims are deflated). A right-wing government would be represented by a low value of « and a high value of 7. Conversely, a left-wing government would have a high a and a low 7, 99 Exercise 5.29 Cousider a profession with n members and revenue determined by r= bn — [3] 92, What value of x maximizes total revenue? What value ma imizes revenue per member of the profession? If the benefit from the profession: is un, what is the efficient membership? Contrast these three membership level. Solution 5.29 The value of » that maximizes total revenue is defined by (5.54) The necessary condition is (5.55) so the massimizing value is n=b. (5.56) Revenue per member of the profession is given by bn r 1/9) n This is maximized at n = 0, so the pro! possible. The efficient membership can be defined as maximizing the difference be- tween benefit and revenue. This difference is given by ween —ins fo bas The efficient level of n satisfies the necessary condition = —bt+n, 5.59 i ob (5.59) n=v-b. 60) Provided that » > b, the revenne-maximizing and the efficient levels of mem- bership will both exceed the membership that maximizes revenue per member The revenne-maxinizing membership will exceed the efficient membership if v and y is indeterminate with profit at zero. (5.75) Exercise 5.31 Consider an economy with two goods (consumption and labor) in which individuals differ only in their income-generating ability @,. Suppose that the distribution of abilities in the population is such that the median ability level, ay is strictly less than the average ability level, 7. Suppose that the income level of each individual i is y, = [1 ~ t] aj, where ¢ > 0 is the proportional income tax rate. Suppose further that all tax revenues are redistributed! rough a uniform lump-sum grant 9, ‘a, What is the tax rate that maximizes the lump-sum grant? , Using the fact that individual i's after-tax income is equal to g+[L ~ 4], show that income equality requires t = L and that the poorest (a, = 0 and s0 1y; = 0) can be better off with a lower tax rate (and thus more inequality), ¢. If every individual i's preference over (t,g) is i = g + 4{1 —f) ai, then what will be the tax rate chosen by majority voting? (Hint: The median ability individual is the decisive voter in this model.] 4. Show that the majority voting tax rate is increasing with the difference between the average and the auedian ability levels, 7 — dj, > 0. Does that mean that inereasing inequality raises the relative size of the public sector (as measured by the tax rate)? Solution 5.31 a. The income level of an individual with ability a; is given by u = (1 ta; with proportional income tax t € (0, 1]. The budget balance for the government implies g (5.76) where mean income is given by D= E(w) =(.—t) Bla) = —da. (3.77) 102 CHAPTER 5. THEORIES OF THE PUBLIC SECTOR Hence the lump-sum grant g as a funetion of tax rate fis g=t(— a. (5.78) which is an increasing and concave function. Maximizing the lump sum grant with respect to tax rate gives the necessary and sufficient first-order condition (1 = 26a = 0, (5.79) which implies ¢= 4 b. The after-tax income of an individual with ability ay is equal to 2; = 9+ (1 —1yj. After substituting for budget constraint = 7 we get H=T+ (1-H -D) (5.80) hus equalizing after-tax incomes requires = 1 so that sry =. However with, = 1 we get T= Ely) =(1-Ha=0 (5.81) so the poorest individual with y = 0 receives after-tax income 2; = 0. The individual would be better off with a lower tax rate t < 1, which gives income 2) = T+ (1-1-7) =G=t(1 Ha >0. (5.82) In fact the after-tax income of the poorest individual is maximized with t cc. A sufficient condition for the median voter theorem to apply is the single crossing of indifference curves in the tax policy space (t,g). That is, the mar- ginal rates of substitution between £ and g among individuals can be ranked independently of the tax policy adopted. Let. si(t,9) denote the marginal rate of substitution of individual i, By totally differentiating preferences over tax policy vj =g + $(1— t)?ai, we obtain siltsg) =i = (1 tai. (5.83) Clearly, the marginal rate of substitution is monotonically increasing ina; for any tax poliey (1,9). Therefore the single crossing property is satisfied, and there exists a mnajority-winning tax rate characterized by the median voter the- orem, So the majority winner maximizes the utility funetion of the median type. Substituting the government budget constraint into the utility function of the median voter a; = ay, we get =t(1-)a+5(1—1)%a 5.84) tm = 4045 (1 1)?a (5.84) Maximizing the median voter's utility with respect to ¢, the solution obtains £2 € (0,1), (5.85) tm = Clearly, the preferred tax rate of the median voter is increasing in the difference between mean and median ability levels, So increasing inequality increases the majority-chosen tax rate and hence government size 103 Exercise 5.32 The government orders that all consumers must cat at least units of vegetables per day. Let a consumer have the utility function U = v220%, where v denotes units of vegetables per day and

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