PUBLIC ECONOMICS

PREAMBLE
1
st
Welfare Theorem:
Competitive Equilibrium is Pareto Efficient.
Violated if there is not a competitive market, or there are externalities.
Correct via Pigou taxation (efficiency gains via corrective taxation).
2
nd
Welfare Theorem:
Any Pareto Efficient equilibrium can be obtained by use of ͚lump-sum͛
taxation + transfers.
If this is not possible, we use a ͚second best͛ measure of distortive taxation on
economic activity, which have equity gains but efficiency losses.
Examples: Ramsey Taxation (distortive commodity taxes), Mirrlees Taxation
(distortive labour income taxes).
Problem: How to set taxes to minimise the cost of raising a set level of revenue?
Adopt a SWF to represent state preferences, then maximise with respect to the
revenue constraint
COMMODITY TAXATION:
REPRESENTATIVE HOUSEHOLD
Assumptions of the Ramsey Taxation Model:
Prices:
Pre-tax producer prices: pi=Li.w
Assume pre-tax prices are fixed, wage rate is fixed,
and there are ͚n͛ commodities.
Consumer price is qi = pi + ti
Individual Preferences (see equations):
Single household model.
Utility function is a function of a consumption
vector ͚x͛ and labour supply: u(x,L)
Subject to the budget constraint (with I as lump-
sum income).
When solved, can get an indirect utility function
v(q , w, I). Generally assume I=0.
No redistribution (utility a function of one͛s
consumption only).



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I w q q x x
x q I wL L x U
I wL x q x q x q t s
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COMMODITY TAXATION:
REPRESENTATIVE HOUSEHOLD
Lump-sum taxes aren͛t feasible (2
nd
welfare theorem breaks down).
Constant Returns to Scale, Perfect Competition.
No Pigouvian (corrective) elements to the taxation.
Government observes commodity trades.
Government only needs to raise a fixed revenue.
Labour only input into production.
No labour income taxation.
Government aims to maximise a SWF.
One respective household, we assume that U1=U2=...=Uh=...UH=U.
W=W(U)
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COMMODITY TAXATION:
REPRESENTATIVE HOUSEHOLD
Optimal tax problem (maths on next slide):
Gov. Maximises the utility of the representative individual (thus, the
SWF as well).
Subject to its budget constraint.
Simple Lagrange is used to maximise w.r.t the tax rates on each of the ͚n͛
goods.
Remember that every commodity͛s demand x* is a function of the
post-tax prices of ALL OTHER GOODS. This is why dxi/dtk is not
necessarily 0, and is included in the F.O.C.
The use of Roy͛s Identity is employed at a point:
Roy͛s identity essentially states that the Marshallian Demand Function
can be computed from the Indirect Utility Function.
COMMODITY TAXATION:
REPRESENTATIVE HOUSEHOLD

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Interpretation:
Additional tax revenue per unit of utility
foregone should be the same regardless
of what tax has been changed.
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This isn͛t the end of the problem,
however, our result now depends on the
existence of cross-price effects (dxi/dqk).
COMMODITY TAXATION:
REPRESENTATIVE HOUSEHOLD
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The Inverse Elasticity Rule:
In the absence of cross price effects,
the proportional rate of tax for a good
should be inversely proportional to
the elasticity of demand for that
good.
Results may appear counter-intuitive:
Suggests that necessities (clothes,
food) should have the highest
commodity taxes, but luxuries (yachts,
planes, small islands) should get the
lowest taxes.
However, this result only derives from
consideration of a single household
acting solely in its interests.

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