Public Finance All Lectures

Public Finance
1
Today
• Course introduction
• Chapter 3: Welfare economics
• Chapter 4: Public goods
2
3
Mortgage Debt-To-GDP Ratio
4
Introduction
Government: An important sector

• In many countries, government spends 25% - 50% of GDP
• Netherlands: about 40%
• Big effect on economy as a whole
5
Introduction
Government affects private sector

• Regulation is essential for a well functioning economy
• Markets cannot be left alone
•
• It is important to get it right
• Foolish regulation can stifle the economy
• High tax rates can cripple firms and households
6
Introduction
Course contents
• What role for government?
7
Introduction
Course contents
• How does the government affect the economy?
• How to design
• expenditure programs?
• tax systems?
8
Introduction
Course contents
• How does the government affect the economy?
• How to design
• expenditure programs?
• tax systems?
• Tax or borrow – is debt bad?
• Why won’t politicians always listen to your advice? 9

Introduction
General remarks
• Public Finance = Public Sector Economics = Public Economics
• ≠ Finance
• We apply tools of analysis from:

• Microeconomics
• Macroeconomics
10
Introduction
Student Portal / Nestor:
• Literature
• Course plan
• Tutorial groups
• Tutorial questions
• Excursion program
• Slides
• Forthcoming: previous exam (questions + answers)

• After your exam: questions & answers 11
Introduction
Lectures
 Cover main points from the book


not all of them!
 Cover some issues which are not in the book


example: internalities
12
Introduction
Tutorials
• Tutorials: exercises and questions (see Nestor)
• Here is your chance:

• there is no such thing as a stupid question
• train to solve problems similar to exam questions
• If you come, I expect you to participate
• Answers to tutorial questions will not available on Student

Portal 13
• This would be useless: exam questions will all be different
Introduction
Trip to The Hague
• December 6
• Netherlands Bureau for Economic Policy Analysis (CPB)

• Ministry of Economic Affairs and Climate
• Hear what people who work there do all day – and see
where they do it
• Learn about career opportunities
14
• Registration obligatory!
Introduction
Literature
• Public Finance, by Rosen & Gayer
• 10th edition
• Not much different from 9th
15
Introduction
Exam
• Essay questions, perhaps some multiple choice
• Like the ones discussed during tutorials – but different
• Exam is about book & lectures

• No exam questions about trip to The Hague
16
Introduction
How to get a good grade (1)
• Work efficiently: Read the relevant chapters before

every lecture
• better results without spending more time
17
Introduction
• Don’t underestimate Rosen & Gayer

• it is not as simple as it seems
18
Introduction
• Close the book after every few pages

• see if you can repeat the main points
• especially: if you can draw the graphs
19
Introduction
• Just reading the book won’t do you much good

• exercise, exercise, exercise
• participate in tutorials
• or form a small study group - explain difficult stuff to
each other
20
Chapter 3
Welfare Economics
What role for government?
21
22
Louis XIV
1638-1715
“I am the state”
23
Welfare economics
Welfare economics: basic question

• Governments as we know them now are a recent
phenomenon in history
• Why do we need them?
24
Welfare economics
Welfare economics: basic question

• Market provides many goods & services
• When is government action needed?
• If markets don’t produce desirable results
• So the question is: When will markets produce desirable

results?
• → Welfare economics
25
Welfare economics
Welfare economics: Basic concepts

• Efficiency
• Can we improve overall welfare?
• Equity
• Is it fair?
• Both are important
26
Welfare economics
Two kinds of efficiency
• 1 Technical efficiency (production)

• highest output with given input, or
• lowest input for given output
• This is not what concerns us in welfare economics
27
Welfare economics
• 2 Efficient allocation
• Allocation means: who gets what?
• optimal distribution of goods over persons
• What does “optimal” mean?
28
Welfare economics
• 2 Efficient allocation
• Optimal: nobody can be made better off without
making someone else worse off
• = Pareto efficiency
• Welfare economics:
• what allocation is efficient, and
• how can we get that allocation?
29
Welfare economics: exchange economy
First: exchange economy
2 individuals
• Adam
• Eve
2 goods
• apples (food)
• fig leaves (clothing)
No production - fixed supply of goods (by nature)
Question: How are goods allocated?

30
• who gets what?
Edgeworth Box: allocation

Eve
a
Fig leaves per year
Adam Apples per year
31
Shows all possible allocations; e.g., allocation a
Edgeworth Box: allocation

Eve
Eve’s
a fig leaves
Fig leaves per year
Adam’s
fig
leaves
Adam’s apples Eve’s apples
32
All points/allocations within the box are possible.
Which is best?
Edgeworth Box: indifference curves

Eve
Fig leaves per year
a Adam’s indifference curves
A3
A2
A1

33
Indifference curve shows what you are willing to give up
in order to get more of something else
→ |slope| = marginal rate of substitution (MRS)
Edgeworth Box: indifference curves

Eve
E1
E2
Fig leaves per year
a
E3
b
A3
A2
A1

34
For Adam, allocations a and b are of equal value
Eve prefers b over a
→ move from a to b improves total welfare
Edgeworth Box: Pareto efficiency

Eve
a
Fig leaves per year
c Contract curve
b d
Allocations b, c and d are Pareto efficient: 35

indifference curves are tangent
Contract curve joins all efficient allocations
Pareto Efficiency if MRSAdam = MRSEve


Efficient allocation:
 impossible to make someone better off …
 … without making someone else worse off

Indifference curves are tangent
 same slope → same MRS
36
Pareto Efficiency if MRSAdam = MRSEve


Efficient allocation:
 impossible to make someone better off …
 … without making someone else worse off

Indifference curves are tangent
 same slope → same MRS

Absolute slope of indifference curve
 = willingness to trade one commodity for the other
 = marginal rate of substitution MRS

Pareto-efficiency: MRS is equal for all consumers
37
Welfare economics: production economy
Now: production economy

 Until now: exchange economy
 no production
 fixed supply apples and fig leaves
 Now look at production

Supply of production factors is limited
 more apples and less fig leaves can be produced
 or more fig leaves and less apples
38
Production possibilities curve (PPC)

Fig leaves PPC shows possible combinations
of apples and fig leaves
Depends on production technology

PPC
a, b, and c are possible; d is not
c a
d
b
39
Apples
Production possibilities curve (PPC)

Fig leaves
Absolute slope of PPC = MRTaf
(marginal rate of transformation)
MRTaf = MCa/MCf = y/x
PPC
MC of apples
a
y
b
x
40
Apples
MC of producing fig leaves (measured in apples)
Production possibilities curve

Which point on PPS is best – a or b?
• depends on preferences
• how much do you like
apples and fig leaves?
Fig leaves
PPC
a
b
41
Apples

Which point on PPS is best – a or b?
• compare indifference curves
• b is on higher indifference curve
• b is preferred over a
Fig leaves
PPC • At b, MRT=MRS
a
b
Indifference curves
42
Apples
Pareto efficiency if: MRTaf = MRSafadam = MRSafeve
Fig leaves
Allocation
PPC Production
a
b
Indifference curves
Apples 43
Fig leaves
PPC Point a: MRS  MRT
Point b: MRS = MRT
a
b
Indifference curves
Apples 44
Fig leaves
PPC Point a: MRS  MRT
Point b: MRS = MRT
a |Slope| of PPC
b |Slope| of indifference curve
Indifference curves
Apples 45
The question is: How do we get to point b?

Welfare economics:efficiency
Policy implications
• Pareto efficient allocation has been identified

• Now, the question is: How do we reach that allocation?
• Is government action necessary?
• Answer: No. Not if there is a competitive market
46
First Fundamental Theorem of Welfare

Economics
• Pareto-efficient allocation of resources will arise if:
• All consumers and producers are perfect competitors
• Perfect Competition
• Everyone faces identical prices
• No market power
47

Economics
•Pareto-efficient allocation of resources will arise if:
•All consumers and producers are perfect competitors
•Perfect Competition
•And: there is a market for each and every commodity
•Existence of Markets
•Everything can be traded
•A competitive economy automatically allocates resources efficiently!
48

Economics: Why?
Formal proof not part of this course
What’s the intuition?
Based on two assumptions:

• Consumers maximize their utility
• Producers maximize their profit
49

Economics: Why?
1 Utility maximation:
• indifference curve and budget line have same slope
• MRSaf = Pa / Pf
50

Economics: Why?
• MRSaf = Pa / Pf
2 Perfect competition:
• PaAdam = PfEve
• (Pa/Pf)Adam = (Pa/Pf)Eve
51

Economics: Why?
• MRSaf = Pa / Pf
• PaAdam = PfEve
• MRSAdam = MRSEve
• first efficiency condition met
52

Economics: Why?
• MRSaf = Pa / Pf
• PaAdam = PfEve
3 Profit maximation
• P = MC
• MCa / MCf = Pa / Pf
4 By definition:
• MRTaf = MCa / MCf →
• MRTaf = Pa / Pf
53

Economics: Why?
• MRSaf = Pa / Pf
• PaAdam = PfEve
3 Profit maximation
• P = MC
• MCa / MCf = Pa / Pf
4 By definition:
• MRTaf = MCa / MCf →
• MRTaf = Pa / Pf 54
5 Combining (1) and (4):
• MRSafAdam = MRTafEve
• second efficiency condition met

Economics: What’s the intuition?
• With well-functioning markets, prices reflect both:
• relative costs of production (MRT), and
• relative attractiveness of goods (MRS)
• People will only consume more of a commodity if they
are willing to pay the additional production costs
• They will trade until their utility is maximized
55
Welfare economics: equity versus efficiency

 A competitive economy automatically allocates resources
efficiently

So: what role for government?
 → Make sure markets exist and are competitive

That does not happen automatically
56

 A competitive economy automatically allocates resources
efficiently

So: what role for government?

That does not happen automatically
 Many firms have market power


seems to be getting worse

digital economy; winner-takes-all markets, …
57
58
Source IMF, World Economic Outlook, October 2018


 Is that all?
59

 Is that all?

No! Efficiency isn’t everything
 Fairness matters, too

What income distribution is desirable?
60
Welfare economics:
Welfareequity
economics:efficiency
versus efficiency
Efficiency versus fairness: which allocation

is better? Eve
Fig leaves per year
Contract curve
b

61
Point a is efficient, but Eve is rich and Adam is poor

Welfare economics:
Welfareequity
economics:efficiency
versus efficiency
Efficiency versus fairness: which allocation

is better? Eve
Fig leaves per year
Efficient
a
Fairer (?)

62
Point b is not efficient, but income distribution is more equal

Social welfare function

 What is fair?
 Suppose there is a social welfare function:
 W = f[U(Adam), U(Eve)]

W defines a set of indifference curves between
people’s utilities
63

 What is fair?
 Suppose there is a social welfare function:
 W = f[U(Adam), U(Eve)]

W defines a set of indifference curves between
people’s utilities

W depends on how important the utility of one
person is, compared with the utility of other persons
 Value judgment, not science!

To be decided through political process
64

 Examples:
 W = U(Adam) + U(Eve)
 W = U(Adam) + 2 U(Eve)
65

Adam’s utility
W = f[U(Adam, U(Eve)]
Increasing
social
welfare
Indifference curves
66
Eve’s utility

 What indifference curve can we reach?

Contract curve shows maximum utility Adam can
reach, given Eve’s utility

Move to contract curve along Eve’s indifference curve
67

 What indifference curve can we reach?

Contract curve shows maximum utility Adam can
reach, given Eve’s utility

Move to contract curve along Eve’s indifference curve

From this, derive the utility possibilities curve

How exactly? Not part of this course
 Social welfare is maximized when:
 utility possibilities curve is tangent to the highest
attainable utility indifference curve
68
Maximizing social welfare

Adam’s utility
Utility possibilities curve (efficient points derived from contract curve)
b
c
Indifference curves (derived from
social welfare function)
69
Eve’s utility

Adam’s utility
a: Pareto-efficient (on utility possibilities curve)
b
c
70
Eve’s utility

Adam’s utility
a: Pareto-efficient
b: not efficient, but higher welfare than a (fairer)
b
c
71
Eve’s utility

Adam’s utility
a: Pareto-efficient
b: not efficient, but higher welfare than a (fairer)
c is best: efficient & most fair
b
c
72
Eve’s utility
Equity versus efficiency


If society prefers an equal distribution of income to
efficiency, a non Pareto-optimal situation can be
preferred
a
b is preferred over a
73


preferred
 Government intervention may be necessary to achieve
a “fair” distribution of utility
 Efficient markets ensure efficiency not fairness
74


preferred
 Government intervention may be necessary to achieve
a “fair” distribution of utility
 Efficient markets ensure efficiency not fairness

How should the government intervene?
 Should it allocate commodities?
 Or lower prices for poor people?
 No! 75
Second Fundamental Theorem of

Welfare Economics
• A society can attain any Pareto-efficient allocation of

resources by
1. assigning initial endowments fairly, and
2. then letting people trade freely
76
Second Fundamental Theorem of

Welfare Economics
• A society can attain any Pareto-efficient allocation of

resources by
1. assigning initial endowments fairly, and
2. then letting people trade freely
• So: if necessary to ensure fairness, the government

should redistribute income, but then step out of the way
• no interference with prices or with allocation
77
• this would reduce efficiency
Two roles for government

• 1) Ensure efficiency: make sure markets and perfect
competition exist
• assure property rights (law and order)
• correct market failures
• 2) Ensure equity: redistribute income according to

social welfare function
• Thus, equity and efficiency can be fixed separately,

according to the second theorem of welfare 78
economics
Welfare economics
Efficiency: correct market failures

• Market power
• Firms set inefficiently high prices (P>MC)
• Monopoly, oligopoly, monopolistic competition
• No efficient markets without government intervention
79
Welfare economics

• Market power
• Asymmetric information (e.g. poverty insurance)
• Some know more than others
80
Welfare economics

• Market power
• Public goods
• People can use something without paying
• More users does not result in higher costs
• e.g. national defense, street lights
• Chapter 4
81
Welfare economics

• Market power
• Public goods
• Externalities
• e.g. air pollution: no market for clean air
• Costs and benefits to others not taken into account
• Chapter 5
82
Welfare economics

• Market power
• Public goods
• Externalities
• Costs and benefits to others not taken into account
• Internalities – not in the book
• Costs or benefits to ourselves not accurately weighted
• Standard economic theory is based on strong assumptions
• Perfect information
• Rational behavior, maximizing individual welfare
• These do not hold in practice
• Behavioral economics 83
Welfare economics

• Internalities
• Example: imperfect information or inattention
• Benefits not clear or salient (energy efficient light
bulb)
84
Welfare economics

• Internalities
• Example: present bias
• Stronger weight to present payoff (e.g. leisure) than to
future payoff (education)
• Even if people know what to do, they cannot commit
• “I’ll stop smoking tomorrow”
85
Welfare economics

• Internalities
• Example: present bias
• This may be a reason to provide merit goods

• But there are other options
• More next week
86
Welfare economics
Welfare economics: limitations

• Aims to maximize people’s utilities – but other goals are
possible
• glory of God (e.g., Iran)
• race supremacy (e.g., Nazi Germany)
• national grandeur
87
Welfare economics
Welfare economics: advantage

 Coherent framework for assessing public policy

Next chapters build on it

Asking the right questions about proposed government
activity:
 Will it improve the income distribution / fairness?
 Will it enhance efficiency?
88
Break
89
Ali Maow Maalin
1977
90
Smallpox (Dutch: pokken)
91
Smallpox
Smallpox (Dutch: pokken)
• Made more casualties than all wars, ever, combined

• Survivors were scarred for life
• 1796: first vaccine made
• Twentieth century: cheap vaccine available

• Still, poor countries remained vulnerable
92
Smallpox
Eradication
• 1967: Start of global eradication program
• 10-15 million smallpox cases
• in 31 countries
• mostly in Africa and Asia
• Money problems almost crippled the project
• 1977: smallpox eradicated!
93
Smallpox
Eradication
• Estimated lives saved: 40 million and counting
• Total costs: only $ 300 million
• Cost per life saved < $ 7.50
• This is probably the best investment ever made on earth
94
Smallpox
Eradication
• Estimated lives saved: 40 million and counting
• Total costs: only $ 300 million
• Cost per life saved < $ 7.50
• This is probably the best investment ever made on earth
• So: why was it so hard to do?

• Because eradication is a public good
• A similar campaign to eradicate polio has not yet been

successful
95
Chapter 4
Public Goods
A market failure which often leads to government intervention

96
Public goods
Definition of a Public Good
• A pure public good has both these properties:

• Consumption is non-rival
• Consumption is non-excludable
• A pure private good is both rival and excludable
97
Public goods

• cost of use by additional person is zero
• use by one person does not prohibit use by
someone else
98
Public goods

• Consumption is non-excludable
• everyone consumes it
• everyone consumes the same quantity
• whether you like it or not!
99
Public goods
Public Good – common misunderstandings

• It’s not necessarily a good provided by the public
sector!
• public sector provides private goods too (education)
• public goods can be provided by private sector
(fireworks)
100
Public goods
Public Good – common misunderstandings

• It’s not necessarily a good provided by the public
sector!
• public sector provides private goods too (education)
• public goods can be provided by private sector
(fireworks)
• Public provision does not necessarily imply public

production
• E.g., streetlights & dikes are publicly provided …
• … but made by private contractors
101
Public goods
Public Good
• Classification public – private good depends on

technology and market conditions
• Public good may become private
• invention may make exclusion possible
102
Public goods
Public Good
• Public goods may be impure

• To some extent rival or excludable
• E.g. roads:
• rival if crowded
• excludable if few connections to other roads
• E.g. fire protection:

• Firefighters can only be in one place at a time
103
Public goods
Public Good
• Examples:
• national security
• flood protection
• disease eradication (smallpox)
• lighthouse
• Not public goods:

• medical care
• education
104
Public goods
Public Good
• Reach may differ

• Global public goods
• Biodiversity
• Smallpox eradication
105
Public goods
Public Good

• Biodiversity
• National public goods
• Royal family
• National defense
106
Public goods
Public Good

• Biodiversity
• National public goods
• Royal family
• National defense
• Local public goods
• Street lights
• Lighthouse
107
Public goods
Optimal allocation
• Question: How much of a public good is optimal?
• First, look at private goods

• Perfect competition means: same price for everyone
108
Public goods
Efficient provision of a private good

Same price → horizontal summation of demand
Price
Demand
Adam
1 Quantity
At a price of 8, Adam wants 1 109

Public goods

Price
Price
Demand Demand
Adam Eve
1 Quantity 3 Quantity
At a price of 8, Adam wants 1, Eve wants 3 110

Public goods

Price
Price
Price
Demand Demand Aggregate
Adam Eve demand
10
1 Quantity 3 Quantity 4
Quantity
At a price of 8, Adam wants 1, Eve wants 3 → 111

aggregate
demand = 4
Public goods
Price
Price
Price
Adam Eve demand
Supply
8
7
1 Quantity 3 Quantity 4 5
Quantity
Intersection of supply and (aggregate) demand curves:

Q=5
112
P=7
Public goods
Price
Price
Price
Adam Eve demand
Supply
8
7
1 Quantity 3 Quantity 4 5
Quantity
A competitive market results in Pareto efficient allocation:

MRSAdam = MRSEve = MRT
113
(First fundamental theorem of welfare economics)
Public goods
Efficient provision public good

Same quantity → vertical summation
Price
Demand
At quantity 6:
Adam Adam is willing to pay 2 per
2 unit
6 Quantity
114
Public goods

Price
Demand
At quantity 6:
2 unit
Quantity
Price
Demand
3 Eve
Eve is willing to pay 3 per unit
6 Quantity
115
Public goods

Price
Demand
At quantity 6:
2 unit
Quantity
Price
Demand
3 Eve
Eve is willing to pay 3 per unit
Quantity
Price
5 Aggregate → total willingness to pay = 5 116

demand per unit
6 Quantity
Public goods
Intersection of supply and aggregate demand:

Q=7
P = 4 = total willingness to pay per unit = sum of MRS
Price
Supply
4 Aggregate 117
demand
7 Quantity
Public goods
• Nonrival → everyone consumes the same amount

• The price may differ
• Efficient provision requires: MRSAdam + MRSEve = MRT
• This means: total willingness to pay = MC
• MRS of Adam end Eve need not be equal
118
Public goods
Efficient allocation: summary

• Private good:
• same price, different quantities
• MRSAdam = MRSEve = MRT
119
Public goods
Efficient allocation: summary

• Private good:
• same price, different quantities
• MRSAdam = MRSEve = MRT
• Public good:
• same quantity, different prices
• MRSAdam + MRSEve = MRT
• because of non-rivalness, total willingness to pay
should equal MRT
• the same units Eve consumes are consumed by Adam 120
as well
Public goods
Efficient allocation: conditions
• Private good: competitive markets ensure efficiency
• Public good: competitive markets do not produce

efficient outcome – Why?
121
Public goods
Free rider problem
• Private good: individuals have no incentive to lie about

their preferences
• those who pay, profit - others are excluded
• competition ensures efficiency
122
Public goods
Free rider problem
• Public good: people consume with or without paying

• nobody can be excluded – everybody consumes the
same quantity
• So why pay?
• If asked, individuals have an incentive to lie about their

willingness to pay
• perhaps someone else is stupid enough to pay
• → you get a free ride!
• Example: disease eradication 123

Public goods
Free rider problem
• Market may provide a public good

• e.g., some people give to charities
• But not the efficient amount (too little)
124
Public goods
Free rider problem
• Market may provide a public good

• e.g., some people give to charities
• But not the efficient amount (too little)
• Solution: governments provides public goods

• Why? Government can make people pay: taxation
• No free rides
• But: how much of a public good should the
government provide?
• Chapter 6
125
Public goods
Government failure
• Government intervention may solve market failure
• But: government has failures too

• Chapter 6: limitations of political decision making
• Market failure should be weighed against government

failure
126
That’s it for today
127
Today’s topics:
• Chapter 5: Externalities and internalities

• Chapter 6: Political economy
128
The big picture
• Ch 3. Welfare economics
• Two tasks for government: efficiency and equity
• Efficiency → ensure:
• existence of markets
• perfect competition
• Problem: market failures
• Ch 4. Market failure 1: public goods
Now:
• Ch 5. Market failure 2: externalities 129
The Netherlands The Rhine
Germany
France
130
Switzerland
Pollution of the Rhine
• France: potash (K) mines dump

salt in the Rhine
• Netherlands: drinking water

from the Rhine
• Removing the salt is very

costly 131
Water pollution of the Rhine
• Decades of negotiations
• Then, the Dutch actually paid the French to dump the

salt at a slower rate
• → easier to purify the water in the Netherlands
• French still dump all the salt, but over a longer period
• Annual cost of water purification lower

132
Questions
• Equity
• Do the Dutch have a right to clean water?
• Do the French have a right to pollute?
• Or is this irrelevant from an economist’s point of view?
133
Questions
• Equity
• Efficiency
• How much pollution is optimal?
• Zero?
134
Questions
• Equity
• Efficiency
• How much pollution is optimal?
• Zero?
• How to get to that optimum?
135
• Were the Dutch fools to pay the French?
Chapter 5
Externality:
- activity that directly affects welfare of others

- but not through the market mechanism
136
Externalities
Externalities: Bart-Lisa example
• Bart’s factory dumps waste into a river nobody owns
• Lisa makes her living by fishing from the river
• Bart’s activities:
• make Lisa worse off in a direct way
• but not through the market mechanism
• → externality
137
Externalities
Externalities: Bart-Lisa example
• Bart pays a zero price for using the water
• The costs are not zero (Lisa is harmed)
• → Bart uses the water in inefficiently large quantities

• Scarcity of clean water is not taken into account
• No trade-off of cost versus benefit
• What causes the externality?

138
Externalities
Nature of Externalities
• An externality is the consequence of the absence of

property rights
• If Lisa owns the river, she can make Bart pay to pollute
• → Bart will pollute less, to save money
139
Externalities
• An externality is the consequence of the absence of

property rights
• If Lisa owns the river, she can make Bart pay to pollute
• → Bart will pollute less, to save money
• If Bart owns the river, he can charge Lisa for fishing

• → Bart will pollute less, to get more money from Lisa
140
Externalities
• As long as someone owns the river, the price of

pollution reflects the value for alternative use
• Market mechanism operates → externality is internalized
• Less pollution
141
Externalities
Implications externality problem

 First theorem of welfare theory: Pareto efficiency if
competitive markets exist

Externalities: absence of markets
 Private sector does not produce the socially efficient

output level

negative externality: too much

positive externality: too little
142
Externalities
Three important questions:

1 What is the efficient output level?
 Zero pollution?

2 How much will society gain by getting there?
 Increase in social welfare

3 How can we get to that level?
 Policy instruments
143
Externalities
Bart’s output decision
Euro
Marginal benefit Bart (MB)
Marginal Private Cost Bart (MPC)
144
Quantity
Output
Externalities
Lisa’s costs not taken into account

Euro
Marginal benefit Bart (MB)
Marginal Private Cost Bart (MPC)
Marginal Damage Lisa (MD)
145
Quantity
Output
Externalities
Efficiency: take all costs into account

→ First question solved
Euro
MB Bart Marginal Social Cost (Bart and Lisa)
= MPC + MD
Marginal Private Cost MPC
Marginal Damage MD
146
Quantity
Socially Actual
efficient output output
Externalities
Lisa gains from less factory output
Euro
MB Bart
MSC = MPC + MD
MPC
a MD
Lisa’s gain
b 147
Quantity
Socially Actual
Externalities
Lisa gains from less factory output
Euro
MB Bart
MSC = MPC + MD
Lisa’s gain
MPC
a MD
b 148
Quantity
Socially Actual
Externalities
Bart loses from less factory output
Euro
MB Bart
MSC = MPC + MD
Bart’s loss MPC
MD
149
Quantity
Socially Actual
Externalities
Lisa gains more than Bart loses
Euro
MB Bart
MSC = MPC + MD
Lisa’s gain
Bart’s loss MPC
MD
150
Quantity
Socially Actual
Externalities
Gain from moving to efficient output

→ Second question solved
Euro
MB Bart
MSC = MPC + MD
Efficiency gain = Lisa’s gain – Bart’s

loss
MPC
MD
151
Quantity
Socially Actual
Externalities
How to reach efficient output?
• First two questions are answered

• What is the efficient output level? MB = MSC
• What will society gain by getting there?
• Now for the third question:

• How can we reach the efficient output level?
152
Externalities
How to reach efficient output?
• Two sets of options:
• Private responses
• Market system
• Possible because all parties may gain from change
• Total welfare increases
• Public responses
• Government action
153
Externalities: Private responses
Private responses: Solution 1
• Assign property rights and let them bargain
• Bart and Lisa split the gain
• Who should own the river?

• Doesn’t matter for efficiency!
• Same level of pollution
• But it matters for the income distribution
154
Coase theorem:
• no matter who is assigned the property rights, an
efficient solution will be achieved, if:
1 bargaining costs are low, and
2 owner can identify all users (polluters, fishers, …)
Ronald Coase 155

The Problem of Social Cost
(1960)
Back to Rhine example
• No supranational government exists

• In practice: France owns the river
• Dutch can’t stop them from polluting
• Dutch are better off to pay the French to pollute less
• if marginal price < marginal costs of purifying water
• Income distribution would be different if Dutch had

owned the river
• Then, the French would pay for the right to pollute
• Pollution would still not be zero! 156

 Mergers → internalize the externality
 Bart can take over Lisa’s fishing business, or Lisa
can take over Bart’s factory
 One business → externality is internalized
 All costs/benefits will now be taken into account
 Not always feasible

 e.g., with many different parties involved
 firms with different activities are difficult to
manage
157

Social conventions
 Impose social cost on polluter
 For instance:
 Keep mobile phones turned off during class
 Polluting is “not done”
 Hard to create social convention

 E.g., media campaigns against smoking or
158
dumping garbage in the street
Private responses: summary

Bargaining (after assigning property rights)
 Mergers

Social conventions
 Doesn’t always work → government can intervene
159
Externalities: public responses
Public responses – the government steps

in
• Pigouvian tax
• Polluter pays external cost through a tax on output
• Price now reflects damage
• Costs taken fully into account → efficient output
Arthur Cecil Pigou (1877 – 1959) 160

Public responses
• Alternative: Pigouvian subsidy
• for output not produced
• producing more results in cost: subsidy not received
• similar to tax case: price now reflects damage
161
Public responses
• Pigouvian tax and subsidy lead to the same efficient
production level, but with different distributional
consequences (fairness)
• Tax: polluter pays
• Subsidy: polluter is paid!
• Both cases: MPC polluter is increased to include
damage
162
Externalities: public
Externalities
responses
Pigouvian tax: at what rate?

Euro
MB
MSC = MPC + MD
Problem:
MPC MPC < MSC
MD
163
Quantity
Socially Actual
Externalities
responses
Pigouvian tax rate: cd

= marginal damage at socially efficient output
Euro
MB
MSC = MPC + MD
MPC+cd
d MPC
c MD
164
Quantity
Socially Actual
Externalities
responses
Pigouvian tax: cd per unit of output

Euro
MB
MSC = MPC + MD
MPC+cd
d MPC
Tax revenue
c MD
165
Quantity
Socially Actual
Pigouvian Tax: difficulties
• Need to know who pollutes and how much they

produce
• Often costly to find out
• Need to know marginal damage (= tax rate)
• Often unclear
166
Pigouvian Tax: difficulties
• Need to know who pollutes and how much they

produce
• Often costly to find out
• Need to know marginal damage (= tax rate)
• Often unclear
• No incentive to use cleaner technology
• Because tax is on output, not on pollution
• Polluter doesn’t have the option to produce cleaner,
instead of reducing output
167
• But: An imperfect pigouvian tax is often better than
none at all
Externalities
responses
Pigouvian subsidy cd per unit of output

forgone
Euro
MB
MSC = MPC + MD
MPC+cd
d MPC
c
MD
168
Quantity
Socially Actual
Externalities
responses
Pigouvian subsidy for output forgone
Euro
MB
MSC = MPC + MD
MPC+cd
d MPC
Pink area =
subsidy
c amount
MD
169
Quantity
Socially Actual
Externalities
responses
Pigouvian subsidy: difficulties
• Again, polluters and damage are hard to identify
• Subsidy may attract more factories!
• Equity: Subsidizing polluters is morally dubious
• Subsidy is financed by taxes →

• redistribution of income (Chapter 14) and
• distortion of the market which is taxed (Chapter 15)
• Creates new inefficiency 170
Externalities
responses
Pigouvian subsidy
• Sometimes: subsidy for positive externality
• But: the fact that an activity is beneficial does not

mean that a subsidy is required for efficiency
• only if the market is imperfect!
• E.g., doctors and teachers work for benefit of
society, but they are paid to do so → no externality
171
Externalities
responses
Public responses to externalities: Solution 2
• Create a market: emission fees or cap-and-trade
• Emission fee: kind of Pigouvian tax

• but now on unit of pollution, not output
• Works quite differently
172
Externalities
responses
Emission fees or cap-and-trade

• Make pollution more expensive
• not targeted at output
• Creates incentive to innovate
• Firms that can reduce pollution cheaply will reduce it

more
• cost effective
• Pigouvian tax is not cost effective
• But: measuring pollution may be costly

173
• more costly than measuring output
Externalities
responses
Emission fee
Euro
Marginal cost of pollution reduction
Marginal social benefit of reduction
174
Level Pollution reduction
without Efficient level
intervention !!
Externalities
responses
Emission fee
Pollution is reduced as long as fee > MC
Euro
MC of pollution reduction
fee a
MSB of pollution reduction
175
Pollution reduction
Level with
Efficient level
fee !!
Externalities
responses
Emission fee
Pollution is reduced as long as fee > MC
Euro → set fee at MC at efficient output level
MC of pollution reduction
Efficient
fee
MSB of pollution reduction
176
Level Pollution reduction
without Efficient level
intervention !!
Externalities
responses
Cap and trade

 This creates a market, like emission fees
 Now, government issues permits

 No more than socially efficient output
 Example: European carbon emissions trading
system

Creates incentive to innovate
 Permissions to pollute go to the firms with the highest 177

bids → cost effective
Externalities
responses
Cap and trade

 Pollution can easily be limited by limiting the number
of permits
 Politically, this is not always easy; see EU CO2
emission permits
 Government can sell permits, or give them away
 Makes no difference for efficiency
 Does make a difference for income distribution
 Like fees, this only works if pollution can be measured

 this is costly 178
Public responses to externalities: Solution 3

• Regulation / command and control
• Useful when pollution cannot be measured
• Two options
• Option 1: Set technology standard

• All firms must use a certain technology
• e.g., particle filter for diesel cars
• e.g., ban on nuclear power
• Problems:
• no incentive to innovate
179
• not cost effective
More public responses to externalities
• Regulation / command and control
• Option 2: Performance standard

• All firms must cut back by equal amounts
• but: some firms can reduce emissions cheaper than
others
• → not cost effective
• Incentive to innovate
180
Externalities
Externalities: a summing up
• Welfare of others is affected, not through the market
• Source of the problem: absence of property rights
• assign property rights → bargaining
• merger
• social convention
• tax, subsidy (Pigou)
• create a market (fee, cap-and-trade)
• regulate 181
Internalities
Internalities
• Our own welfare is affected
• Source of the problem: costs or benefits to ourselves not
accurately weighted in decision making
• Theory based on behavioral economics

• The usual assumptions of standard economics do not
always apply in practice (perfect info, rational behavior)
• Based on work of (among others):

• Daniel Kahneman (Nobel prize 2002)
182
• Richard Thaler (Nobel prize 2017)
Internalities
Internalities
• Example 1: present bias

• Stronger weight to present payoff than future payoff
• Result: smoking, eating unhealthy stuff, not exercising…
183
Internalities
Internalities
• Example 1: present bias

• Stronger weight to present payoff than future payoff
• Result: smoking, eating unhealthy stuff, not exercising…
• Example2 : imperfect information or inattention

• People do not know or realize costs / benefits
184
Internalities
Internalities
Costs and benefits of studying
Euro
Marginal cost (now)
Marginal benefit (later)
185
Quantity
Optimal output
Internalities
Internalities
Present bias: too low weight to benefits of studying
Euro
bias
MC
True MB
Biased MB
186
Quantity
Optimal output
Actual output
Internalities
Internalities
Present bias: too low weight to benefits of studying
Euro
bias Welfare loss
MC
True MB
Biased MB
187
Quantity
Optimal output
Actual output
Internalities
Internalities: policy options

• You can use commitment devices (like StickK)
• See self-help literature
• Works only if people realize they have a problem!
188
Internalities

• Should be based on true preferences of people
• No paternalism
189
Internalities

• Merit goods
• Provide services like education cheaply
190
Internalities

• Merit goods
• Information campaigns
• Does not help if present bias is the problem!
191
Internalities

• Merit goods
• “Pigouvian” tax or subsidy
• Analogous to externalities
192
Internalities

• Merit goods
• Regulation
• Ban on smoking or drugs
• Compulsory education
• Compulsory saving for retirement
193
Internalities

• Merit goods
• Regulation
• “Nudges”
• Change the circumstances under which choices are made
• E.g., make the desired option the default, let people take
action if they want something else
• e.g. automatic participation in pension plan, except
when you object 194
Chapter 6
Political economy
(or: Public Choice)
How are political decisions made?
195
The big picture
 In Ch 3 – 5:

What should the government do
 Normative theory

Ch 6
 How is decided what the government actually does?

Positive theory
196
Political economy
Democracies
 Until 1960s: standard economic theory assumed that

the government acts in the interest of society
 Maximizing social welfare
 Political economy / public choice theories assume

that politicians are self-interested
 Maximizing their own welfare
197
Political economy
Dictatorships
 Work not as different from democracy as you might

think
 Dictators need (some) popular support as well
198
Political economy
Democracies
 Is self-interest in politicians a bad thing?

 Is it inefficient?
 Not necessarily
 We also assume consumers and producers are self-
interested
 Still, markets can provide efficiency
 If the market for political decisions works perfectly, we
should see an efficient outcome
 But does it?

199
Political economy
Types of democracy
• (1) Direct democracy:
• People vote themselves on all kinds of issues

• this is still done in some parts of Switzerland
• raise your hand in the market square
• romantic, but very time consuming
200
Political economy
Types of democracy
• (2) Representative democracy:
• People choose representatives to vote for them

• parliament, municipal council
• vote only once every four or five years
201
Political economy
Different voting rules
• Unanimity:
• everyone must agree
• Majority rule:
• > 50% of voters must agree
• sometimes qualified majority
• e.g., 75% of the vote
202
Political economy: direct democracy
Direct democracy (1):
Unanimity
• Public good: free rider problem

• Government must finance it through taxation
• Everyone can be made better off by providing efficient

amount →
• if put to the vote, everyone would approve
203
Unanimity
• How to formulate a proposal that everyone accepts?
• Lindahl’s procedure
• Example: firework (public good)
204
Unanimity
• Example Lindahl’s procedure
• How many rockets?
• Ask everyone how many rockets they want for every

possible share of total costs they pay
• How many rockets if you pay 10%? Or 20%?
• Sum of shares must equal 100% → we can derive the

efficient size 205
Lindahl: how many rockets? (public good)

Adam’s share
Adam’s demand schedule
Number of rockets 206

Lindahl: how many rockets? (2 persons)
Eve’s demand schedule Sum of shares

Eve’s share
equals one
Adam’s share
Adam’s demand schedule

Eve’s demand
Eve’s share
With these shares,

b
Adam’s share
Adam wants more rockets than Eve
Adam’s demand
If b is put to the vote, Eve will vote against it

Eve’s demand
Eve’s share
a Here, Adam wants the same number

of rockets as Eve
b
Adam’s share
Adam’s demand
If a is put to the vote, everyone will agree - unanimity

Eve’s demand
Eve’s share
Each person pays personalized

a price per unit, depending on
tax share.
• Here, Adam pays more
Adam’s share
Adam’s demand

Lindahl’s procedure: is it feasible?
• Free rider problem/strategic behavior

• people hide their true preferences
• demand curves are unknown
• free rider problem not solved by Lindahl
• Decision making costs are high

• especially if many parties are involved
211
Lindahl’s procedure: is it feasible?
• With unanimity, often no decision can be made at all

• One voter can block any decision
• Opportunity for “blackmail”
• Example: European Union

• Voting rules changed some years ago
• Unanimity is now less often required
212

Majority Voting Rules
• More than half of voters must approve
• Most simple case: two options
• Example: what would you like me to do now:

• A Continue this interesting lecture
• B Go away and show movie instead
213
 Problems if there are more than 2 options to choose

from

Voting paradox: there is not necessarily a stable
outcome
 Stable outcome = same result in another vote

Reason: multi-peaked preferences
214

What are multi-peaked preferences?

Preferences are single-peaked if:

utility falls consistently if outcome is further
removed from preferred outcome

Otherwise: multi-peaked
215
(Simple) Majority Voting Rules

Preferred
Utility A outcome
B
C
Kate: ABC - single
peaked preferences
Rockets
10 20 30 216

Preferred
B outcome
Utility
Pete: BCA - single

peaked preferences
C
Rockets
10 20 30 217

Preferred
outcome
Utility
C
Gina: CAB - double
peaked preferences
Rockets
10 20 30 218
Voting paradox
• Example: pairwise voting
• Three options: 10 rockets, 20, or 30
• Preferences:
Kate prefers 10 rockets, then 20, then 30
Pete: 20-30-10,
Gina: 30-10-20
219
Voting paradox
• Preferences:
Pete: 20-30-10,
Gina: 30-10-20 Kate & Gina prefer 10 over 20
• Vote 10-20 first: 10 wins
220
Voting paradox
• Preferences:
Pete: 20-30-10,
Gina: 30-10-20 Kate & Gina prefer 10 over 20
• Vote 10-20 first: 10 wins
Now, 20 is no longer an option
221
Voting paradox
• Preferences:
Pete: 20-30-10,
Gina: 30-10-20
• Vote 10-20 first: 10 wins, then vote 10-30: 30 wins
222
Voting paradox
• Preferences:
Pete: 20-30-10,
Gina: 30-10-20
• Vote 20-30 first: 20 wins; then vote 20-10: 10 wins
223
Voting paradox
• Preferences:
Pete: 20-30-10,
Gina: 30-10-20
224
Voting paradox
• Preferences:
Pete: 20-30-10,
Gina: 30-10-20
• Result depends on the order of voting!

• cycling
• inconsistent: no stable outcome 225
Voting paradox

This is the Voting paradox

No stable outcome
 Voting paradox may occur if preferences are multi-

peaked
 Not necessarily!
 E.g., there is no voting paradox if everyone wants
the same thing
226
Agenda manipulation: real-life

example

Group of municipalities has joint fire brigade

Costs are shared – but how?
 Everyone agrees: current cost allocation system unfair
 Proposal for fairer system

Needs 2/3 majority of mayors – seems no problem 227
Voting paradox

Agenda manipulation:

Organize voting order to manipulate outcome
 How? Make sure the option that can beat your

preferred outcome is defeated in an earlier vote
228
Agenda manipulation - example

Agenda
Vote on new, fair system
2/3 majority?
Yes No 229
New system is Current system
applied (fair) stays (unfair)

Agenda
Vote on 50/50 system (half

fair)
2/3 majority?
50/50 system is
Yes No
applied (half
fair)
2/3 majority?
Yes No 230

Agenda

fair)
2/3 majority?
Order
50/50 system is
Yes No changed (by
applied (half simple majority)
fair)
2/3 majority?
Yes No 231

Agenda
2/3 majority?
New system is
Yes No
applied (fair)

fair)
2/3 majority?
Yes No 232
50/50 system is Current system
applied (half stays (unfair)
fair)

Agenda
2/3 majority?
New system is
Yes No
applied (fair)

fair)
2/3 majority?
Yes No 233
fair)

Agenda
2/3 majority?
New system is
Yes No
applied (fair)

fair)
2/3 majority?
Yes No 234
fair)
Majority voting: who wins?
• Choosing an amount. Who’s vote is decisive?
• Median voter = voter whose preferences lie in the

middle (Marvin)
Laura Kim Marvi Gita Zeno

0 2 4 n 5 9 16
• Half the voters want more than the median voter

wants, half want less
235
Majority voting: who wins?
• The median voter has the decisive vote, if

• preferences are single-peaked, and
• no strategic voting
• people vote according to their true preferences
Laura Kim Marvi Gita Zeno

0 2 4 n 5 9 16
236
Logrolling
Originally: assisting new settlers in the American West in
rolling away the logs of their clearing
237
Strategic voting: logrolling or vote trading
• Intensity of preferences may differ
• Logrolling:
• You support someone else’s proposal …
• … in return for their support for your proposal
• Strategic voting: not according to your own

preferences (in this vote)
238
• Package deals: e.g. EU-decision making
Strategic voting: logrolling or vote trading
• Effect on general welfare is unclear
• Advantages:
• reveals intensity of preferences
• compromises help the democratic system to
function
• Disadvantage:
• may lead to wasteful public expenditures 239
• projects with negative net benefit may pass

Arrow’s Impossibility Theorem
• So far: voting systems far from perfect
• Does a perfect system actually exist?
• Kenneth Arrow: No, it doesn’t!
240
• Criteria for voting system:

• must produce decisions
• must be able to rank all outcomes
• must be responsive to individuals’ preferences
• must be consistent
• must be independent of irrelevant alternatives
• dictatorship is ruled out
•…
• Bottom line: voting should be fair and not produce 241

paradoxical result
• Arrow: It’s impossible to find a rule which satisfies all

conditions!
• proof not part of this course
• Sometimes, no consistent and fair decision-making rule

will be found
• Doesn’t mean it can never be found

• there is no guarantee it can be found
• depends on, e.g., preferences 242
• Is this a problem?
• James Buchanan: No.

• democracy is an ongoing process
• there will always be another election
• different policies will be tried and tested
243
• But:
• Does a social welfare function actually exist?

• Welfare theory is built on social welfare function
• W must be chosen collectively, but how?
• W still useful as a theoretical concept
244
Direct democracy: a summing up

 Unanimity voting often problematic
 strategic voting / hidden preferences
 high costs of reaching a decision
245
Direct democracy: a summing up

 Unanimity voting often problematic
 strategic voting / hidden preferences
 high costs of reaching a decision

Majority voting:
 Single peaked preferences: stable result, which
reflects the preferences of the median voter
 Multi-peaked preferences: voting paradox may
emerge
 Even when results are consistent, they are not
necessarily efficient 246
 costs of projects may exceed benefits –
logrolling
Political economy: representative democracy
Representative democracy
• Three parties involved:

• Voters elect politicians
• Politicians’ decisions are carried out by civil servants
(= bureaucrats)
• Median voter theorem applies here as well

• In theory, voting outcomes are the same as with
direct democracy
• Candidates have incentive to move towards political
middle 247
Representative Democracy: median voter

Number of voters
Sure to
Sure to vote for
vote for Maggie
Karl
248
Left-wing Karl Median Maggie Right-wing


Number of voters
Sure to
Sure to vote for
vote for Maggie
Karl
→ 249
Left-wing Karl Median Maggie Right-wing


Number of voters
Two-party system:
candidates tend to
crowd the political
middle ground
250
Left-wing Karl Maggie Right-wing

Median
Civil servants
• Politicians make decisions, but policy is carried out by

bureaucrats / civil servants
• Goals of civil servants will sometimes differ from the

public good:
• reputation, power, patronage, etc.
251
Civil servants
• Niskanen (1971) model: civil servants’ goals are

positively related with the size of their budget
252
Civil servants
• Niskanen (1971) model: civil servants’ goals are

positively related with the size of their budget
• Therefore, bureaucrats want to spend as much as

possible
• How can they get away with it?

• Because they know more than politicians (= their
bosses)
253
Niskanen’s model of bureaucracy
Total cost of project

Price
Total benefit of project
Quantity 254
Total cost
Price
Marginal benefit Total benefit
= slope of total benefit curve
Marginal
cost
Quantity 255
Total cost
Price
Marginal benefit Total benefit
= slope of total benefit curve
Niskanen: politicians
don’t have
this information
Marginal
cost
Quantity 256
Socially efficient
output:

Total cost
Price
Total benefit
Politicians are told

that TB > TC
→ they approve
Quantity 257
Socially Proposal
efficient output where TB>TC
Niskanen’s model
• Bureaucrats can make all-or nothing proposal

• high output or none at all
• because of informational advantage
258
Niskanen’s model

• Therefore, they propose output where total benefit
just exceeds total costs
• MC > MB, but politicians don’t know that
• Bureaucrats also try to increase the perceived benefit

of a program
• Make people think the benefit is higher than it is
259
Niskanen’s model
Not necessarily
true
• Therefore, they propose output where total benefit
just exceeds total costs
• MC > MB, but politicians don’t know that
• Bureaucrats also try to increase the perceived benefit

of a program
• Make people think the benefit is higher than it is
260
Rent seeking
• Rent = a revenue higher than under market conditions

• e.g. monopoly profit
• (not: what you pay your landlord)
• Interest groups can manipulate the political system to

redistribute income towards them
• Rent seeking
261
Rent seeking
• Example: campaign contributions in return for lucrative

contracts
• Example: let government restrict output

• Higher prices → producers gain
• Examples:
• milk quota in the EU (until 2015)
• peanut licenses in the USA
262
Rent seeking by restricting output (1)

Perfect competition
Price
P = MC
Pcompetition A Supply = marginal cost
Demand
263
Quantity
Qcompetition
Rent seeking by restricting output (2)

Cartel: MC=MR
Price
Marginal
revenue Question: what is the
loss in welfare?
Pcartel
Pcompetition B A Supply = marginal cost
Demand
264
Quantity
Qcartel Qcompetition
Political economy: deja-vu
Consumer surplus – what was that

again?
Price At quantity Q*, consumers are willing to pay P*,
B but they only pay P → benefit P*-P
In equilibrium (quantity Q), consumer benefit is
ABC
P*
P C A Supply
Demand
265
Quantity
Q* Q
Rent seeking reduces consumer
surplus
from ACF to DEF
Price F
Consumer surplus
Loss to consumers:
Pcartel E D ACED
Pcomp C B A Supply
MR
Demand
266
Quantity
Qcartel Qcomp
Rent seeking results in lost welfare

Shaded area ACED is not completely lost:
Price F some of it consists of rents
The rest is lost to society
Loss to society
Pcartel E D
Rents
Pcomp C B A Supply
MR
Demand
267
Quantity
Qcartel Qcomp
Political economy
Political economy: lessons
• Public decision making:

• complicated
• not well understood
• Often, government expenditures ≠ preference of

median voter
• The ultimate democratic voting procedure does not

exist
268
Political economy
Political economy: lessons
• Correcting market failure is not as easy as it sounds

• There is also government failure
• Government intervention does not always improve
social welfare
269
Political economy
Democracy is the worst form of government,

except for all those other forms
that have been tried
from time to time
- Winston Churchill
270
Chapter 8
Cost-Benefit Analysis
The practical use of welfare economics to evaluate

271
potential projects
Annual global temperature change,
1850-2017
272
Climate change: immediate action
needed?
• Famous debate
• Nicholas Stern:
• High carbon needed tax now
• Benefits far in the future should weigh heavily
• The longer we wait, the more difficult it gets
273
Climate change: immediate action
needed?
• Famous debate
• Nicholas Stern:
• High carbon needed tax now
• Benefits far in the future should weigh heavily
• The longer we wait, the more difficult it gets
• William Nordhaus:
• Carbon tax, yes, but, with low rate
• Future benefits strongly discounted
• Silly to make high costs now
• Who is right? 274
Cost-benefit analysis
The big picture
• Ch 3. Welfare economics:
• A project should be carried out if it increases social
welfare
275
The big picture
welfare
• Step 1: define social welfare function
• Step 2: get to highest attainable social indifference
curve
• … not very practical
276
The big picture
welfare
• Step 1: define social welfare function
• Step 2: get to highest attainable social indifference
curve
• … not very practical
• Ch 8 How do we know whether a project will increase
welfare?
• A project is proposed (road, welfare program, …)
• Accept or reject? 277
• Choose between competing projects (bridge or
tunnel?)
Project evaluation
• Increase spending on an project as long as:
• marginal social benefits > marginal social costs
278
Project evaluation
• Increase spending on an project as long as:
• marginal social benefits > marginal social costs
• In practice, discrete choices because of indivisibles

• You cannot build half a bridge
• OK, you can, but benefit = 0
• Therefore, you compare entire projects
279
Project evaluation
• Net gain may be used to compensate losers

• income distribution can be fixed separately
• Second fundamental theorem of welfare
economics
• Hicks-Kaldor criterion:
• Potential Pareto improvement if:
• total benefit > total cost
280
Project evaluation

economics
To society, not to the

281
government!
Project evaluation

economics
Remember what
282
Niskanen said about this!
Ch 6
Project evaluation
• Two important questions:
• How to decide if a project should be carried out or not?
• How to choose the best of 2 or more competing projects?
283
Problems
• Cost-benefit analysis is more of an art than a science
• Perfect information is not available
• Use the best you’ve got
• This implies making assumptions

• different assumptions → different outcomes
• therefore, assumptions should be transparent! 284
Problems
• Costs and benefits usually occur in different years
• 1 euro next year < 1 euro now

• discounting needed
• what discount rate?
• Costs and benefits may be difficult to measure

285
Cost-benefit analysis: measures
Present value: discounting future benefits
• How to compare sums of money in different periods?
• 100 euro next year < 100 euro now

• Suppose revenue stream R:
• R0 now,
• R1 next year and
• R2 the year after that
• Discount rate = r
286
Present value: discounting future benefits
• Suppose revenue stream R:

• R0 now,
• R1 next year and years after that (forever)
• Discount rate = r
287
Net present value of project
B1  C1 BT  CT
NPV  B0  C0   ... 
1 r (1  r )T
t0 t1 tT
B = benefit
C = cost
r = discount rate
• Calculate net benefit in each period

• Correct for discount factor 288
• Assumption: no inflation
NPV: what about inflation π?

 100 euro now will buy the same as 100(1+π) next year
289

( B1  C1 )(1   ) ( BT  CT )(1   )T
NPV  ( B0  C0 )   ... 
(1  r ) (1  r )T
t0 t1 tT
290

 Lenders demand 1+π times higher interest payment
( B1  C1 )(1   ) ( BT  CT )(1   )T
NPV  ( B0  C0 )   ... 
(1  r )(1   ) (1  r )T (1   )T
t0 t1 tT
291

 Lenders demand 1+π times higher interest payment
( B1  C1 )(1   ) ( BT  CT )(1   )T
NPV  ( B0  C0 )   ... 
(1  r )(1   ) (1  r )T (1   )T
t0 t1 tT
• Inflation cancels out
292
• Inflation cancels out, so we can use real or nominal

amounts (but don’t mix them up)
• Nominal amounts: valued according to prices that

exist in the year the cost or benefit occurs
• Real amounts: valued according to prices that exist

in one single year
• e.g., everything in euros of t0
293
Private sector project evaluation
Firm can do project X or project Y (or nothing)
Q1: Which projects are admissible?

Admissible means: better than doing nothing
Q2: If both are admissible, which is best?
294
Measures for evaluating projects
• Three measures used to compare different projects:
• 1 Net present value

• 2 Internal rate of return
• 3 Benefit/cost ratio
295
Project evaluation
• Criterion 1: Net present value (NPV)
• A project is admissible only if NPV > 0

• total benefit must exceed total cost
• When two projects are mutually exclusive, choose the

one with the highest NPV
296
Project evaluation
• Example:
• invest 100 now and get 110 next year
• r = 0.05
Now Next year
• → project is admissible
297
Cost-benefit
Cost-benefit
analysis: measures
analysis
Project evaluation
• Criterion 2: Internal rate of return ρ

• ρ = discount rate that would make NPV=0
• Example:
• invest 100 now and get 105 next year
• → ρ = 0.05
• Project admissible if ρ > r

• r = actual discount rate
298
Cost-benefit
Cost-benefit
analysis: measures
analysis
Project evaluation
• Internal rate of return can be used to decide if project

is worth doing
• However, do not use ρ to choose between projects
• If projects differ in size, ρ can be misleading

• big project with low ρ may be better than small
project with high ρ
299
Internal rate of return: example

• Project X Cost now = 100
Benefit next year = 110 → ρ = 0.10
• Project Y Cost now = 1000
• Discount rate r = 0.06 → both are admissible
300

• Should we choose X (highest ρ)? No!

• Profit X = 10 – 6 = 4
• Profit Y = 80 – 60 = 20 → choose Y
301


• Profit X = 10 – 6 = 4
• Profit Y = 80 – 60 = 20 → choose Y
Forgone interest on 302

invested capital


• Profit X = 10 – 6 = 4
• Profit Y = 80 – 60 = 20 → choose Y
• A big project with a low ρ may make more money than a

small one with a high ρ!
• If projects differ in size, ρ can be misleading 303
Compare NPV and internal rate of return

Project Year 0 Year 1 ρ NPV
X -100 110 10% 3.8
Y -1,000 1,080 8% 18.9
NPV criterion always identifies the best project
304
Project evaluation
• Criterion 3: Benefit-cost ratio (B/C)
• B/C
• Project admissible if B/C>1

• → benefits exceed costs
305
Project evaluation
• However, B/C is useless for comparing different

projects
• Reason: there is no fundamental difference between

benefit and cost
• Cost can be classified as lower benefit instead, and
vice versa
• By manipulating definitions of costs or benefits, any
project can be given a high B/C!
306
Benefit-cost ratio: example
• Raw materials: 2
• Production cost: 8
• Sales: 15
• Subsidy: 5
307

• Sales: 15
• Subsidy: 5
• B=20 (of which 5 is subsidy)

• C=10
• B/C = 20/10 = 2
308
• Sales: 15
• Subsidy: 5

• C=10
• B/C = 20/10 = 2
• B=15
• C=5 (after subtraction of subsidy) 309
• B/C = 15/5 = 3
• Sales: 15
• Subsidy: 5

• C=10
• B/C = 20/10 = 2 Benefit cost ratio
increased by 50%!
• B=15
• C=5 (after subtraction of subsidy) 310
• B/C = 15/5 = 3
• Bottom line: always use NPV

• Internal rate of return and B/C ratio may be misleading
• Can only be used to decide if project is worth doing
(meaning: better than doing nothing)
• Cannot be used to compare different projects
• If someone uses ρ or B/C: beware

• they want to mislead you …
• … or they didn’t pay attention in class
311
Practical cost-benefit analysis
• 3 kinds of information needed:

1. What are the benefits, and when do they occur?
2. What are the costs, and when do they occur?
3. What is the discount rate?
• Looks simple. It’s not.
312
Cost-benefit analysis: discount rate
What discount rate r?
• r plays a key role
• With high r, almost no project is worth doing

• With low r, almost any project is worth doing
• Choice of r may be decisive
• No simple matter, however
313
• r plays a key role → reflects opportunity cost
• Project money could have been used for something

else
• Project’s return must be higher than return on best

alternative
314
• r plays a key role → reflects opportunity cost
• Firm:
• r reflects rate of return on alternative investments
• Government:
• r depends on where the money comes from
• usually: tax revenue
315
What discount rate?
• Project financed by tax revenue →

• taxes are paid by private sector
• opportunity cost in private sector determines r
• In the private sector, the tax money could have been

used for:
• investment or
• consumption
316
What discount rate?
• Suppose: tax lowers private sector investment

• Opportunity costs: rate of return in private sector
• Before tax or after tax rate of return?
317
What discount rate?

• Look at the output that the funds would have
generated for society
• Doesn’t matter how this value is split between firm and
government (tax)
318
What discount rate?

• Look at the output that the funds would have
generated for society
• Doesn’t matter how this value is split between firm and
government (tax)
• Taxation is not a cost to society
• it’s a transfer
• r = before-tax rate of return 319
What discount rate?
• Suppose: tax reduces private sector consumption
• Consider the saving decision of a consumer

• cost of consumption now =
• value consumption next year + interest
320
What discount rate?

• Opportunity costs of consumption depend on rate of

return available to consumer
321
What discount rate?

• Opportunity costs of consumption depend on rate of

return available to consumer
• r = after-tax rate
• because this determines individual saving decision 322
What discount rate?

• Often, both investment and consumption are reduced
• Then, r should be weighted average of before and after

tax rate of return in private sector
• This r cannot be determined exactly

• You don’t know how much investment or consumption
is sacrificed
• Solution: make a reasonable assumption

323
Social discount rate is perhaps lower
• Private sector discount rate might not be appropriate:

• “Benefit for future generations not taken into
account”
• → include them in cost-benefit analysis
• “People underestimate future benefits” (present bias)
• e.g. people save too little for old age
• “Projects may generate positive externalities”
• If true, use Pigouvian subsidy, not different r
• The book stops here – but… 324

• Private sector discount rate reflects the weight people

attach to future costs/benefits in daily life
• Short / medium term
• Affects themselves
325
• Private sector discount rate reflects the weight people

attach to future costs/benefits in daily life
• Short / medium term
• Affects themselves
• However: a capital market where people can express

their preferences for the very long term does not exist
• Affects future generations
326
• Such preferences can be only voiced through the
political system
• Example: climate policy
• With conventional r, strongly reducing greenhouse

gas emissions is not worth the cost (Nordhaus)
• But this affects future generations

• Voters have given politicians mandate to make
climate agreements
• → apparently, voters value future more than private
327
sector discount rate suggests
• A positive discount rate for the very long term means:

• “Our generation is more important than future
generations”
• You may think so, but this is not economics
• It’s politics
328
• A positive discount rate for very long term means:

• “Our generation is more important than future
generations”
• You may think so, but this is not economics
• It’s politics
• However: a zero discount rate means that PV of any

cost that goes on forever is enormous
• Discount rate of, e.g., 1% is often used
329
• Discount rate for very long term is a political decision
• If uncertain: do sensitivity analysis

• use range of plausible discount rates
• e.g. 0.5% and 5%
• see how sensitive results are to r
• if project is acceptable throughout this range, you’re
probably OK
330
Practical cost-benefit analysis
• Apart from discount rate, we need to know:
• What are the benefits, and when do they occur?
• What are the costs, and when do they occur?
331
Cost-benefit analysis: benefits and costs
Valuing public benefits and costs (1)
Market prices
• In competitive markets, use market prices
• Market prices reflect:
• marginal social costs of production (MRT), and
• marginal value to consumers (MRS)
332
Market prices
• In competitive markets, use market prices
• Market prices reflect:
• marginal social costs of production (MRT), and
• marginal value to consumers (MRS)
• Of course, many markets imperfections exist
• However, alternative measures are often debatable, and
more expensive to use
• So: use market prices - unless market imperfections are
too big
333
Shadow prices
• Big market imperfections: use shadow price

• market price adjusted for market imperfections
• Shadow price equals opportunity cost
• What would have been the benefit of the resources
if they had not been used in the project?
334
Shadow prices: example
• Determine social cost of project input X

• Monopoly
• P > MC → market price of X not appropriate
335

• Monopoly
• Two options:
• Production of X will expand to compensate for
government purchase
• Project will increase use of resources needed to
produce X
• Use marginal production cost of X
336

• Monopoly
• Two options:
government purchase
produce X
Government pays the (higher) market 337

price, but it is social cost we need here

• Monopoly
• Two options:
government purchase
produce X
• Production of X is fixed
• Use forgone benefit of consumption of X
• Use consumer price 338

Projects that affect prices

If project is so big market prices are affected, which
price should be used?
 Price before or after project?

Example: irrigation project lowers cost of avocados
339


If project is so big market prices are affected, which
price should be used?
 Price before or after project?

Example: irrigation project lowers cost of avocados

How should extra avocados be valued:
 at original price, or lower price after the project?
 both are wrong!

Use consumer (producer) surplus
340

 Irrigation projects lowers cost of avocados
P1 S1
D
341
Q1

 Irrigation projects lowers cost of avocados
 Supply curve shifts from S1 to S2
 Quantity increases to Q2, price drops to P2

What’s the benefit?
P1 S1
P2 S2
D
342
Q1 Q2

• Consumer surplus increases from dark area to total
shaded area
Consumer surplus increase = project benefit
P1 S1
P2 S2
D
343
Q1 Q2
Valuing public benefits and costs
(4)
Non-traded goods
 Non-traded goods: no market data available

Example: what’s the value of one life?
 To the person concerned, the sky is the limit

 But available resources are limited
 not every life can be saved; a choice must be made
 save as many lives as possible with available budget
344
(4)
Non-traded goods
 If value of life is considered infinite, any project that
saves at least one life has infinitely high NPV
 → you can’t compare projects
 So, we need to put a monetary value on life

 Non-economists think this is heartless…
345
(4)
Non-traded goods
 Look at economic behavior
 use information from choices people make
 why put higher value on life than people do themselves?
346
(4)
Non-traded goods

1. Different wages for dangerous and safe jobs
 calculate how much extra wage people want to
compensate higher probability of death
347
(4)
Non-traded goods

1. Different wages for dangerous and safe jobs
 calculate how much extra wage people want to
compensate higher probability of death
 2. Prices of safety devices
 how much are people paying to reduce danger?
 Example: smoke detectors
348
(5)
Intangibles
• What is the value of:
• national security?
• preventing (too much) climate change?
• flying to mars?
349
(5)
Intangibles
• flying to mars?
• Two options:
• Calculate how valuable the intangibles must be in
order to make project admissible
• does it make sense?
350
(5)
Intangibles
• flying to mars?
• Two options:
• Calculate how valuable the intangibles must be in
order to make project admissible
• does it make sense?
• Different ways for attaining intangible benefits may
be compared
• choose most cost-effective one 351
Cost-benefit analysis: Pitfalls
Pitfalls of cost-benefit analysis

• Tricks can make a silly project look admissible:
• Chain-reaction game
• include all kinds of secondary ‘benefits’
• often, these are not benefits at all, but transfers
352

• Double-counting game
• count benefits twice
353

• Labor game
• count jobs created as benefit - instead of cost
354

• Labor game
• count jobs created as benefit - instead of cost
• Use benefit/cost ratio or internal rate of return
355
Fundamental problems of cost-benefit

analysis
• Theoretical foundation on welfare economics is rather
loose
• Social welfare function?
356

analysis
loose
• Marginal utility on one euro is different for everybody
• Benefits to different people cannot simply be added
up
357

analysis
loose
• Marginal utility on one euro is different for everybody
• Benefits to different people cannot simply be added
up
• Impossible to identify, let alone quantify, every cost or
benefit
• Important non-monetary items tend to be ignored 358
• Biased outcome
Cost-benefit analysis: Equity
Effects on distribution
• Even if benefits exceed costs, some people benefit more

• some may even lose
• We assume a project is admissible if NPV is positive

• total social welfare increases
• net gainers could compensate net losers and still be
better off
• Hicks-Kaldor criterion
359
• In practice, compensation of losers is often absent
• Behavioral economics: loss counts heavier than gain

• ‘loss aversion’
• For a net welfare gain, benefits should actually exceed
costs by a margin!
360
• Are benefits to every person valued the same?

• Political concerns may dominate cost-benefit
analysis
• Who benefits from government spending is hard to

assess
• Next Chapter (12)
361
Cost-benefit analysis: Use
Practical value of cost-benefit analysis
• Useful way of summarizing information
But
• Limited effect on actual government decisions
• Reasons:
• Practical difficulties → assumptions needed
• Outcome depends heavily on discount rate
• Difficult to understand for non-economists
• Results may be manipulated
• Unfavorable results are often ignored 362
Income redistribution
363
Chapter 12
Income Redistribution
 Why redistribute?
 Who benefits from government programs?
364
Redistribution
The big picture

• Ch 3: Welfare economics:
• a project should be carried out if it increases social
welfare
• Ch 8: Will a project increase welfare?

• Ch 12: Should we fix the income distribution?
365
Redistribution
Global income inequality
• 5% richest people receive 33% of world income
366
Redistribution
• Top 10% receive half of world income
367
Redistribution
• Top 10% receive half of world income
• Bottom 5% get 0.2% of world income 368

Redistribution
Glabalization changed income
distribution
Source: World Bank
369
Redistribution
Wealth distribution is even more unequal
370
Redistribution
Income inequality
• Biggest differences between countries

• GDP per capita differs
• Congo: $ 320
• Luxembourg: $84.000
371
Redistribution
Income inequality
• Biggest differences between countries

• GDP per capita differs
• Congo: $ 320
• Luxembourg: $84.000
• Within countries, inequality is usually smaller
• but still substantial
• Netherlands:
• 4% earns up to 10,000 euro
• 12% earns at least 100,000 euro
372
Redistribution
Why do incomes differ so much?
• Between countries:
• level of development differs tremendously
373
Redistribution
Why do incomes differ so much?
• Between countries:
• level of development differs tremendously
• Within developed countries:
• wage differentials most important
• differences in property income (interest, dividends)
are less important
• Piketty: this will become more important again
• This chapter: income redistribution within countries

• Income redistribution between countries is scarce
374
• Development aid, European regional funds
Redistribution: Income data
How big are differences in income?

Hard to tell

Income data are based on annual income measures but
income may fluctuate (e.g. for businesspeople)
→ students earn little now but a lot later in life
→ lifetime income better indicator, but unknown
375

Hard to tell


People may choose to work parttime
→ low income doesn’t necessarily mean low hourly wage
376

Hard to tell


 Compare income of individuals or of households?
→ how many people must live on one income?
→ how to account for economies of scale in household?
377

Hard to tell


 Compare income of individuals or of households?
→ how many people must live on one income?
→ how to account for economies of scale in household?

Income before or after:
 tax? 378
 subsidies?
 transfers in kind?
Inequality: different income concepts
Primary Gross Disposable Standardized

180 160
Income from
160
labor, business 160
or wealth
160 140 140 140
140 120 120 120
120 100
100 100
100
80 80 80
80
60 60 60
60
40 40 40
40
20 20 20 20
0 0 0 0
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
-20 -20 -20 -20
Distribution of households over income groups, Netherlands 2014 379

Horizontal axis: ten income groups of equal size (deciles)
Vertical axis: 1,000 euro per year

180 160 160
Primary income
160
plus
160 140 140 transfers received
140
140 120 120 120
120 100
100 100
100
80 80 80
80
60 60 60
60
40 40 40
40
20 20 20 20
0 0 0 0
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
-20 -20 -20 -20


Gross income
160
180 160 160
160 140 140
minus tax &
140
140 120 120
transfers paid
120
120 100
100 100
100
80 80 80
80
60 60 60
60
40 40 40
40
20 20 20 20
0 0 0 0
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
-20 -20 -20 -20


Standardized for
single household
180 160 160 160
160 140 140 140
140 120 120 120
120 100
100 100
100
80 80 80
80
60 60 60
60
40 40 40
40
20 20 20 20
0 0 0 0
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
-20 -20 -20 -20
Distribution of households over income groups,

groups Netherlands 2014 382
Redistribution: Reasons to redistribute
Why redistribute?
• Welfare is a function of all individuals’ utilities

• W = F(U1, U2, ..., Un)
• Redistribute income as long as it increases W
• You need to know W
383
Why redistribute?
• Welfare is a function of all individuals’ utilities

• W = F(U1, U2, ..., Un)
• Redistribute income as long as it increases W
• You need to know W
• Redistribution often not a Pareto improvement!

• some people will be worse off
• take from the rich, give to the poor 384
Example: Additive social welfare function
W = U1 + U2 + ... + Un
Utility of every person is equally important
What is the optimal income distribution?
385
W = U1 + U2 + ... + Un
If:
• 1 Individuals have identical utility functions …
• 2 … that depend only on their incomes
• 3 Marginal utility of income diminishes
• 4 Total income is fixed
386
W = U1 + U2 + ... + Un
If:
• 1 Individuals have identical utility functions …
• 2 … that depend only on their incomes
• 3 Marginal utility of income diminishes
• 4 Total income is fixed
Then:
• The optimal solution is: redistribute until complete
equality!
387
Optimal income distribution with W = U1 + U2

Assumptions:
1 identical utility functions …
2 … depending on income only
3 diminishing marginal utility
4 total income fixed
Marginal
utility Paul Peter
388
Paul’s income Peter’s income

Optimal income distribution with W = U1 +

U2
Distribution a?
Marginal
utility Paul Peter
389
Paul’s income a Peter’s income


U2
Distribution a?
utility of last euro is higher for Paul than for Peter
→ W increases if one euro is given from Peter to Paul
Marginal
utility Paul Peter
390
Paul’s income a Peter’s income


U2
Point b: Paul’s income = Peter’s income; MUpaul = MUPeter
Marginal
utility Paul Peter
391
Paul’s income a b Peter’s income


U2
Point b: Paul’s income = Peter’s income; MUpaul = MUPeter
Marginal Welfare W is
utility Paul Peter maximized at b
Shaded area is
welfare gain
from
redistribution
392
Paul’s income a b Peter’s income

Are assumptions valid?

1. Are utility functions identical? We don’t know
Reasonable guess
393

1. Are utility functions identical? We don’t know
Reasonable guess
2. Do they only depend on income?
No! People derive utility from leisure too (see also 4.)
394

1. Are utility functions identical? We don’t know.
Reasonable guess
3. Does marginal utility of income diminish? Probably.
If not, redistribution cannot change social welfare!
395

Reasonable guess
4. Total amount of income is clearly not fixed
• Redistribution:
→ makes work less attractive
→ less income to redistribute
• people choose leisure instead of income
396

Reasonable guess
4. Total amount of income is clearly not fixed
• Redistribution:
→ makes work less attractive
→ less income to redistribute
• people choose leisure instead of income
397
Also: additive social welfare function may be questioned
So: complete equality might not be optimal
Maximin Criterion
• W = Minimum (U1, U2, ..., Un)

• Society’s only concern is the poorest person
• Redistribute income to maximize Upoor
398
Maximin Criterion
• John Rawls: maximin has ethical validity

• Suppose people don’t know their future position in
society
• opinions are impartial and fair
399
Maximin Criterion

society
• Risk-averse people choose maximin as an insurance –
just in case they will be poor
400
Maximin Criterion

society
• Risk-averse people choose maximin as an insurance –
just in case they will be poor
• But:
• Maximin ignores the welfare of all other persons
• Is that reasonable?
• And: are people really totally risk-averse?
401
Can redistribution be Pareto efficient?

• Redistribution: take from the rich, give to the poor
• The rich lose money → do they lose welfare?
402

• The rich can benefit too:
• 1. Altruism: other people’s income may enter your
welfare function
• externality problem
• people will help the poor, provided others do the
same
• fair income distribution as public good
403

welfare function
• 2. Income redistribution as an insurance against future
poverty
404

welfare function
• 2. Income redistribution as an insurance against future
poverty
• 3. If people are very poor, they will be coming for your
money anyway
• If the poor don’t eat, the rich don’t sleep
• safer to give it to them 405
• fair distribution buys social peace
Redistribution: examples
Income distribution: examples

Suppose UAdam and UEve depend only on income
Income
Adam
Utility possibilities curve

(Chapter 3)
Income 406
Which distribution is fair? Eve

Suppose UAdam and UEve depend only on income
Income
Adam
Utility possibilities curve

(Chapter 3)
a b
c
Income 407
Which distribution is fair? Eve

1 Equality
Point a: equality. IAdam = IEve. Both persons are equally well off
IAdam
45º IEve
408

1 Equality
Point a: equality. IAdam = IEve. Both persons are equally well off
IAdam
45º IEve
409
But: Total income is not fixed. We can give both Adam and Eve more!

2 Maximin: W = min(WAdam,WEve)
IAdam
Maximin indifference
curves
a b
45º IEve
410

2 Maximin: W = min(WAdam,WEve)
Move from a to b is Pareto improvement (both gain)
Point b: maximin. Income poorest person (Adam) maximized
IAdam
a b
IEve
411
IEve > IAdam
Eve’s welfare is not taken into account by maximin

3 Maximize U1 + U2
Point c: additive social welfare function W = U1 + U2 maximized
UAdam
Indifference curve (slope -1)
a b
c
IEve
412

3 Maximize U1 + U2
Point c: additive social welfare function W = U1 + U2 maximized
UAdam
Indifference curve (slope -1)
a b
c
IEve
413
Utility of Eve is as important as utility of Adam – but incomes differ!
Outcomes depend on utility possibilities curve
Redistribution: questions
Redistribution: some awkward questions
• Is it fair to redistribute income towards people who are

too lazy to work?
• No? → income cannot be the only criterion
414

too lazy to work?
• Focus on opportunities instead of income?
• opportunities differ – e.g., if your parents are well-
educated, you will probably do better at school
415

too lazy to work?
• Income mobility reduces the need to redistribute
• students may be poor, but get a good job later
416

too lazy to work?
• Income mobility reduces the need to redistribute
• students may be poor, but get a good job later
• Social welfare function hard to find
• different welfare functions, different outcomes
• what is optimal income distribution? 417
Does money actually make you happy?

(1)
 Choice 1:
 you earn 60,000 euro
 people you know 40,000
418

(1)
 Choice 1:
 Choice 2:
 What would you choose?

419

(2)
 Peter earned 30,000 last year, 40,000 this year
 Rose earned 80,000 last year, 50,000 this year
 Who do you think is happier?
420
Redistribution
Income distribution: How?
• After deciding whether the government should

redistribute income, the question is: How?
• 1. Tax the rich more than the poor – Chapter 14
• 2. Expenditures: spend money on the poor
421
Redistribution: Public expenditure incidence
Public expenditure incidence:
who benefits?
• Impact of expenditure policy on income distribution

• Simple view:
• people who get the subsidy gain
• those who pay the tax lose
422
Public expenditure incidence:
who benefits?
• Impact of expenditure policy on income distribution

• Simple view:
• people who get the subsidy gain
• those who pay the tax lose
• But: an expenditure program will affect relative
prices
• This makes it very difficult to predict its effect on
income distribution
423
Example
• Subsidy on low-income housing
424
Example
• Lower price → demand increases
• Price of housing will rise
• Owners benefit
• They are often not poor
425
Example
• Lower price → demand increases
• Price of housing will rise
• Owners benefit
• They are often not poor
• Wages of builders will increase, and prices of
construction materials
• Etc.
• Very hard to trace all price changes
• Chapter 14
426
Public goods and income distribution

• People do not reveal how they value public goods
• Therefore: impact on income distribution unknown
• You can make assumptions, but results are very different
if assumptions change
• Example: who benefits most from police?
427
Public goods and income distribution

• People do not reveal how they value public goods
• Therefore: impact on income distribution unknown
• You can make assumptions, but results are very different
if assumptions change
• Example: who benefits most from police?

• View 1: The rich – they have more to lose
• View 2: The poor – they are more likely to be robbed
428
In kind transfers
• In-kind transfers: give the poor goods or services instead
of money
• public housing
• free education
• medical care
• food or food stamps
429
In kind transfers
• In-kind transfers: give the poor goods or services instead
of money
• public housing
• free education
• medical care
• food or food stamps
• May be inefficient
• A good is at best valued as much as it costs
• often, it is valued less
• also, administrative costs reduce efficiency
430
Cash transfer
Other goods
1: no transfer, budget line AB
A
1
Indifference curve
Budget line
431
B Cheese
Cash transfer
Other goods
C 1: no transfer, budget line AB

2: cash transfer, budget line CE
you can buy more of both goods
2
A
1
432
B E Cheese
In-kind transfer: poor receive cheese

Other goods
3: in-kind transfer, budget line ADE
A D
1 3 In-kind transfer moves
budget line to the right,
but upper part (CD) is
inaccessible – amount of
other goods cannot
exceed A
433
B E Cheese
Comparison in-kind and cash transfer

Other goods

2: cash transfer, budget line CDE
2
A D
1 3
434
B E Cheese

Other goods

2: cash transfer, budget line CDE
2
Here, welfare is lower with in-kind
A D
transfer
1 3 Poor prefer to eat less cheese and
have more of other goods
435
B E Cheese

Other goods
Welfare depends on preferences

A D
With these indifference curves, there
is no difference between a cash
transfer and an in-kind transfer
In-kind: CD is inaccessible, but you

don’t want that anyway (in this case)
436
B E Cheese
Reasons for in-kind transfers
• In-kind benefits are widespread. Why?

• Paternalism
• politicians think they know better what people
need
• cash may be spent on alcohol or drugs
437

• Paternalism
need
• Some services must be equally accessible to
everyone
• e.g. housing, education
• commodity egalitarianism
438

• Paternalism
need
• Some services must be equally accessible to
everyone
• Perhaps less fraud than money transfer
• less attractive → only the needy apply
439

• Paternalism
need
• Some services must be equally accessible to everyone
• Perhaps less fraud than money transfer
• less attractive → only the needy apply
• Political attractiveness / lobbying
• especially from producers, e.g. school milk 440
Redistribution
Redistribution: main points again

• Income redistribution can increase social welfare, but:
what is fair?
• what is the social welfare function?
• additive? maximin? etc.
• Redistribution makes working less attractive

• more redistribution → less income to redistribute?
• Benefits from public services are hard to quantify:

• relative price effects → benefit hard to find out
441
• value of in-kind benefits depends on preferences
Chapter 14
Taxation and Income Distribution
Who bears the burden of a tax?

- tax incidence
Until now: focus largely on expenditures

Chapter 14-18: effects of taxation
442
The big picture
• Taxation has three effects:

• Transfer of money from taxpayer to government
• Taxpayers’ loss = governments gain
• Chapter 14: Who pays the tax?
443
The big picture

• Inefficient allocation of resources
• Because tax changes relative prices
• Loss to taxpayer, gain to no-one → welfare loss
• Chapter 15: Effect on welfare
444
The big picture

• Chapter 15: Effect on welfare
• Transaction costs
• Cost of tax administration
• Compliance cost to taxpayer 445
• Chapter 16
Who pays the tax?
Tax incidence
• Incidence means: who pays the tax
• Statutory incidence: who is legally responsible for

paying the tax
• Economic incidence: who bears the burden

• Whose income is reduced?
• Example: value added tax

• Shopkeeper pays the tax, but bills the customer 446
• Who bears the burden?

Who pays the tax?
Tax incidence
• Statutory incidence tells us nothing about economic

incidence
• Ultimately, everything is owned by people

• So, only people bear taxes. But which people?◦
447
Who pays the tax?
Determinants of tax incidence

Economic
incidence
• Taxes change prices
• Without taxation: price consumer = price producer

• With taxation: price consumer > price producer
• Who pays the burden depends on how prices are

changed
448
Who pays the tax?
Differential tax incidence
• Different types of analysis:

• Balanced-budget incidence: combined effects of taxation
and spending financed by those taxes
• But usually, taxes are not earmarked for particular
expenditures
• Who profits from government expenditures is already
discussed (Chapter 12)
• → here we abstract from spending
449
Who pays the tax?
Differential tax incidence
• Different types of analysis:

• Balanced-budget incidence: combined effects of taxation
and spending financed by those taxes
• But usually, taxes are not earmarked for particular
expenditures
• Who profits from government expenditures is already
discussed (Chapter 12)
• → here we abstract from spending
• Differential tax incidence: who bears the burden if we
use this tax instead of that
450
• → this chapter ◦
Who pays the tax? Progressiveness
Tax progressiveness
• Progressive tax: the rich pay more
• Different definitions exist
• Average tax rate increases with income
average tax = taxes paid / income
→ rich pay more tax as % of their income
451
Tax progressiveness
• Marginal tax rate increases with income
marginal tax = tax paid on last euro
→ rich pay more tax on last euro earned
452
Tax progressiveness
• Marginal tax rate increases with income
marginal tax = tax paid on last euro
→ rich pay more tax on last euro earned
• Netherlands: usually marginal tax rate used
• Book uses average tax rate ◦
453
Tax progressiveness
• How can a tax be progressive?
• Different tax rates for different income levels

• E.g.: 30% on first 30,000 euro
• 50% above 30,000 euro
• Average and marginal tax rate increase with income
454
Tax progressiveness
• How can a tax be progressive?
• Different tax rates for different income levels

• E.g.: 30% on first 30,000 euro
• 50% above 30,000 euro
• Average and marginal tax rate increase with income
• Leave first x euro free of tax

• E.g., tax only income above 10,000 euro
• Average (not marginal) tax rate increases with income 455
Measures of tax progressiveness

• 1. Difference in average tax rate / difference in
income
Average
Average
tax rate
tax rate
with
with
low income
high
V = progressiveness
income Th Tl
 T = tax liability
I h Il I = income
V1  h = high income
Ih  Il Difference l = low income
in income
456
Measures of tax progressiveness


2. Elasticity of tax revenues with respect to income
Th  Tl Relative tax V = progressiveness

increase if income T = tax liability
Tl rises from Il to Ih
I = income
V2 
Ih  Il Relative increase in
h = high income
l = low income
Il income from Il to Ih
457
Different measures, different outcomes

• Example: will a 20% increase of both Tl and Th lead to a
more progressive tax system?
V1 Before: After:
Th Tl 1.2Th 1.2Tl
 
I Il Ih Il
V1  h V1 
Ih  Il I h  Il
Vafter = 1.2 × Vbefore → progressiveness increases by 20% ◦

458
Different measures, different outcomes

 Example: will a 20% increase of both Tl and Th lead to a
more progressive tax system?
1.2 cancels
V2 Before: After: out
Th  Tl 1.2Th  1.2Tl
Tl V2 
1.2Tl
V2  I h  Il
Ih  Il
Il
Il
Vafter = Vbefore → progressiveness unchanged ◦ 459
Who pays the tax? Partial equilibrium model
Models to measure tax incidence

• Two kinds of models:
• Partial Equilibrium Model
• General Equilibrium Model
• First a Partial Equilibrium Model will be used

• Considers only one market
• Assumes effects on other market are negligible
• Use if market is small compared to rest of economy
• First, assume perfect competition ◦

460
Commodity taxation: two types:
• Unit tax:
Fixed amount (e.g., € 5) per unit of a commodity
• Ad valorem tax:
Percentage (e.g., 21%) of commodity price, like VAT
• Key: when something is taxed, the price paid by

consumers differs from the price received by
producers
• Pc > Pp ◦
461
Commodity taxation: unit consumer tax u

P S
• Tax reduces demand as
u
Pconsumers perceived by producers
u p0 • For every quantity,
Pproducers
producers receive a lower
price
• Demand curve shifts down
D1 D0 • Pproducers < Pconsumers◦
Q1 Q0 Q 462
Commodity taxation: unit consumer tax u

P S
u
Yellow area: consumers’
Pconsumers burden (Pc-P0)×Q1
p0
Pproducers Blue area: producers’
burden (P0-Pp) ×Q1
Shaded area (yellow and

blue): tax revenue u×Q1
D1 D0
Q1 Q0 Q 463
Consumers pay biggest share – why? ◦

Commodity taxation: unit producer tax u

S1
P
S0
u • Tax reduces supply as
Pconsumers perceived by
p0 consumers
Pproducers
• For every quantity,
consumers pay a
higher price
• Supply curve shifts up

D
Q1 Q0 Q • Pconsumers > Pproducers ◦
464
Commodity taxation: unit producer tax u

S1
P
S0
u Incidence is the same as
Pconsumers
that of consumer tax!
p0
Pproducers
Here, consumers pay more
than producers – depends
on elasticities
Here, supply is more elastic

D than demand ◦
Q1 Q0 Q 465
Incidence with inelastic demand; unit tax

S1
P S0
Pconsumers
u
P0 = Pproducers Demand inelastic: D vertical

- quantity demanded
independent of price
- consumers bear full burden
Supply inelastic:
producers bear the full burden ◦
D
Q0 Q 466
Commodity taxation: ad valorem
producer tax (x% of price)
S1
P S0
Pconsumers X%
• Analysis same as for unit tax
p0
Pproducers • Only difference: slope of
supply curve changes (no
parallel shift)
• Again: same result if demand

curve is shifted ◦
D
467
Q1 Q0 Q
Partial equilibrium analysis -

extentions
 So far, we looked at commodity taxation
 Similar analysis for factors of production
 Labor, capital

So far, we assumed perfect competition
 Similar analysis for monopoly – see tutorial exercise
 Not for oligopoly
 price changes unknown
 we do not know how to analyze tax incidence ◦
468
Tax on profits
• Economic profit = return in excess of opportunity costs

of factors of production used
• Under competition: economic profit exists only in
short run
• Competition reduces economic profit to zero
• Profit maximization: marginal cost = marginal revenue

• Neither marginal cost nor marginal revenue are
affected by profit tax
469
• Therefore: output and price remains the same
• Profits tax is fully borne by the firm’s owners!
Special case: tax on land
• Land is durable and fixed in supply

• No tax: price of land = present value (PV) of future returns
• Because supply is fixed, tax is borne by owner

• Price of land = PV future returns – PV future tax
• Land price drops as soon as tax is introduced
• So: owner at that time pays burden of tax forever!

• Future owners do pay tax, but are compensated
because they bought the land cheaper → no net burden
• The tax is capitalized into the price of land ◦ 470
Main points partial equilibrium model
• Incidence is independent of who hands over

the tax to the government (statutory incidence)
• Moving S or D curve gives same result
• Incidence depends on elasticities of supply and
demand
• Elasticity reflects ability to escape tax burden
• Supply perfectly elastic: consumers bear entire
burden
• Demand perfectly elastic: producers bear entire
burden ◦
471
Who pays the tax? General equilibrium model
General Equilibrium Model
• So far, we examined one market at a time
• However, other markets may be affected
• When a tax is imposed on a sector that is large, we use

general equilibrium analysis
• General equilibrium analysis takes into account how

various markets are interrelated
472
General Equilibrium Model

 2-sectors: manufacturing (M), food (F)
 2-factors: capital (K), labor (L)
 No savings
 Then there are 9 possible ad valorem taxes:
 capital tax for either sector M or sector F 2
 labor tax for either sector M or sector F 2
 consumption tax on either good M or good F 2
 tax on either labor or capital (in both sectors) 2
 general income tax (= general consumption tax) 1
9
 Some taxes are combinations of others 473
 Tax on F and M = tax on income = tax on consumption ◦
Tax equivalence relations

tKF + tLF = tF Example: first row
If we know incidence of tKF and
+ + + tLF, we know incidence of tF
If you analyze the incidence of

tKM + tLM = tM four taxes, you know the
incidence of all nine
= = =
Most important questions are:
• do relative prices change?
tK + tL = t • can you escape a tax? ◦
474
Harberger model
• Method for analizing tax incidence

• General equilibrium
• Main assumptions
• Perfect competition, profit maximization
• Constant returns to scale
• One sector capital intensive, other labor intensive
• Mobile production factors, total supply fixed
• No savings
• Differential tax incidence
• study the effect of substituting one tax for another
• Assumptions very strong – not exactly realistic! 475

• Needed to keep it simple
Commodity tax: for instance on Food
(tF)
• Relative price of food increases: PF↑ and PM↓
• Quantity of food sold goes down: QF↓ and QM↑
• Less food, more manufactures are produced
• Capital and labor move to manufacturing sector
• If food is more capital-intensive than manufactures:
• More capital than labor will be moved to the
manufacturing sector – which is labor-intensive
• Relative demand for capital falls
• Relative price capital falls economy-wide
• Capital owners are hurt by tax on food
• Tax on the output of a sector lowers the relative price 476

of the input used intensively in that sector ◦
Tax on production factor:

for instance on labor (tL)
• Labor is taxed in both sectors
• food and manufactures
• impossible to escape the tax by migration to the
other sector
• Total supply of production factor is fixed
• assumption Harberger model
• although not very realistic …
• → Production factor labor bears the entire burden ◦
477
Income tax (t)

• Equivalent to a set of taxes on capital and labor
t = tL + tK
• As factor supply is fixed by assumption (perfectly
inelastic supply), these taxes cannot be shifted
• tL is borne by labor-suppliers
• tK is borne by capital-owners
• Thus, income tax cannot be shifted either
• It is borne in proportion to people’s initial income (from
both labor or capital)
• Tax burden depends on income ◦
478
Partial factor tax, e.g. tKM
• Tax on capital in manufacturing, not food

• Two effects Relative
• Output effect to food
• Price manufactures rises →
• Output manufacturing falls
• Factor substitution effect
• In manufacturing, capital becomes more expensive →
• less capital and more labor is used in manufacturing
• What are the results of both effects together? ◦
479
Incidence of a partial factor tax (tKM)

tKM increases cost of capital in manufacturing (M)
Output effect Factor substitution effect
PM rises; consumers Less capital, more labor

buy less manufactures used in manufacturing
If M labor-intensive: If M capital-intensive:
PK rises (PL falls) PK falls PK falls
PK falls
480
PK may
fall or rise
Who pays the tax?
Main points again
• Statutory (legal) incidence tells us nothing about who

bears the burden of a tax
• → depends on the elasticities of supply and demand
• Tax on small sector → use partial equilibrium analysis

• Tax on large sector → use general equilibrium analysis
• If a tax affects many markets, incidence depends on

many demand and supply curves
• Incidence is hard to trace ◦ 481
Chapter 15
Taxation and Efficiency
Taxpayer loses more than government gains

Excess burden
= deadweight loss
= loss of welfare above tax revenues collected
482
The big picture

• Today: Chapter 15
• Transaction costs
• Cost of tax administration
• Compliance cost to taxpayer 483
• Today: Chapter 16 ◦
Excess burden: definition
Taxation distorts prices

• Efficiency condition:
MRS = MRT
willingness to pay = marginal production cost
price consumer = price producer
• Taxation: price consumer > price producer
• MRS  MRT
• Prices no longer reflect relative scarcities
• Economic behavior affected
• Result: inefficiency
• Exception: lump sum taxes ◦
484
Excess burden: lump sum tax
Lump sum tax: no excess burden


Lump sum: you pay the same amount no matter what
you do
 So, lump sum taxes don’t change relative prices
 E.g. poll tax: fixed amount per person
 Therefore, no excess burden
 No change in behavior
 If they are so efficient, why not use them more often?
 Often not considered fair
 Let everyone pay the same amount – not fair
 Let, e.g., people with blue eyes pay tax – not fair either

Income-based tax is not a lump sum tax, because it 485
reduces the price of leisure ◦
Excess burden: lump sum tax
A tax on talent instead of income?

• Tax on income may reduce labor supply
• Reduces price of leisure
• Nobel-laureate Tinbergen: tax talent instead
• Talent: ability to make money
• Talent is determined at birth
• Lump sum tax
• No excess burden
• Problems:
• Talent is difficult to measure
• People are not free to choose their profession
• you must earn enough money to pay the tax 486
• You may be forced to take a job you don’t want ◦

Excess burden: measurement
Excess burden of tax on good A (1)

Budget
Other constraint Tax payment
goods before tax in terms of
other goods
Budget But: utility loss > tax payment ◦

constraint
after tax
E2
E1
ii
i
487
Good A
Equivalent variation
• Tax lowers income and changes prices
• Lower income is inevitable with taxation
• intended effect
• Price change creates excess burden
• unintended effect
• Utility loss taxpayer = tax + excess burden
Unknown
Known
• If you know utility loss, you know excess burden ◦
488
Equivalent variation
• Utility loss taxpayer = tax + excess burden
• Lump-sum tax: excess burden = 0
• → utility loss = tax
• Compare tax with lump-sum tax that has the same
utility loss
Tax payment Excess Utility loss
burden
Distortive tax 100 x 100+x
Lump sum tax 100+x 0 100+x
• Excess burden = payment lump sum tax – payment

distortive tax ◦
489
Excess burden of a commodity tax

Tax: move from E1 to E2
Other How big is utility loss?
goods Shift the budget line downward until it is tangent
to the lower indifference curve ii
AB = Equivalent variation
= difference between parallel
A budget lines
Parallel to = revenue of lump sum tax
original E2 with same welfare loss ◦
budget line E1
B
ii i
490
Good A
Excess burden
Other Excess burden = equivalent variation - tax revenue
goods
Revenue tax on A
Equivalent
variation
Excess
burden i
ii
Good A 491
Equivalent variation: income reduction leading to the move from i to ii
= tax payment lump sum tax with the same utility loss
Tax has income and substitution effect
AC: uncompensated response (total effect)
AB: income effect (parallel budget line shift)
Other BC: substitution effect
compensated response (constant utility)
goods movement along indifference curve
slope indif curve = MRS
→ MRS changes: it no longer equals MRT
→ welfare loss ◦
C
A
B
i
ii 492
Good A
Measuring excess burdens:
use compensated demand curve
• Ordinary demand curve: uncompensated change in
demand as price changes
• Reflects income effect and substitution effect
• Compensated demand curve: Income effect removed
• Consumer remains on same indifference curve
• Only substitution effect
• effect from product A being more expensive relative
to other products
• Why use compensated demand curve? Only

compensated response affects MRS
• So, excess burden depends on movement along
compensated demand curve ◦ 493
Compensated demand curve is steeper
• Tax on commodity X → lower demand for X for two

reasons:
• Because of tax, income is lower
• Less it bought of everything
• Income effect
• Because of tax, relative price of X is higher
• Less of X is bought
• X is substituted by other goods
• Substitution effect
• Compensated demand curve: no income effect
• Only substitution effect
• Demand falls by less than on ordinary demand curve 494
• Compensated demand is less elastic → steeper ◦
Using the compensated demand curve

Price Compensated demand curve
Supply curve shifts up after tax
p1 S1
Tax
S0
p0
Excess burden:
reduction in consumer
surplus, minus tax
495
Q1 Q0 Quantity
Excess burden measurement

EB = ½ Q p
Price p = (1+t)p-p = p+tp-p = tp
EB = ½ Q tp
Elasticity η = (Q/Q0) / (p/p)
→ Q =  Q0 p /p =  Q0 t
(1+t)p EB = ½  Q0 p t2
Δp
p
ΔQ
496
Q1 Q0 Quantity
Determinants of excess burden


Excess burden = ½  Q p t2
 Depends on:
  Compensated price elasticity of demand
 Q Quantity before tax was imposed
 p Price before tax was imposed
 t2 Square of tax rate → tax rate has big impact ◦
497
Determinants of excess burden


Excess burden = ½  Q p t2

Suppose t raised from 30% to 40% (increase of 25%)
 EB0 = ½    Q  p  Does
0.32 not
change!
 EB1 = ½    Q  p  0.4
2
 EB1 is 0.42/0.32 times EB0 → EB increases by 78%!

High tax rate has big impact ◦
498
Excess burden with upward sloping

supply curve
• Until now: supply curve horizontal
• Assumption: supply completely elastic
• Usually: price elasticity of supply is limited
• producer surplus decreases as well
• So: ½  Q p t2 is approximation
• only consumer surplus
499
Excess burden with upward sloping

supply curve
• Until now: supply curve horizontal
• Assumption: supply completely elastic
• Usually: price elasticity of supply is limited
• producer surplus decreases as well
• So: ½  Q p t2 is approximation
• only consumer surplus
• Upward sloping supply curve → excess burden also
depends on the elasticity of supply:
• ε is compensated price elasticity of supply ◦

500
Excess burden
Remarks (1)
 If compensated elasticities zero → no excess burden
 no reaction to price change
 behavior not affected by tax
 If market distortions exist → new tax can lower the

overall excess burden
 Example: if consumption is too high as a result of
negative externalities, a tax can improve welfare
 Pigouvian tax, Chapter 5 ◦
501
Excess burden
Remarks (2)
 Lump-sum tax:
 efficient: no excess burden
 Unfair(?): rich and poor pay the same
 trade-off: efficiency versus equity

Income redistribution requires non-lump-sum tax
 Book: lump-sum tax usually not available, and excess

burden is a problem

But: society chooses non-lump-sum tax
 Apparently, the excess burden is compensated by 502
the welfare increase of income redistribution ◦
Excess burden
Excess burden of a subsidy s
Supply curve shifts down

Q increases
Consumer surplus up by aecd
Subsidy is abcd
Subsidy > consumer gain a e b S0

Difference is excess burden ebd P
EB
Tax used to finance this subsidy (1-s)P c d S1

creates excess burden as well!
Dcomp
Q 503
→ Subsidy reduces efficiency
→ Will only increase welfare if equity gain is big enough to compensate
(or reduction of externality)
Excess burden
Excess burden of a tax on labor t

Wage surplus reduced by tax
• shaded area: loss to worker
Tax revenue: no loss to society
Excess burden: wage surplus reduction – tax revenue
Compensated supply curve
w
Tax EB
Assumption: demand elastic
(1-t)w
504
L2 L1
Excess burden
Differential taxation of inputs

Example: Tax on labor in labor market, not labor used at home
Euros Euros
← Hours worked 505

Hours worked
at home → in market
Excess burden

Euros Euros
VMP
= value of marginal product
= value of additional output
with one more hour of work
w1
VMPmarket
Equilibrium:
VMPhome
VMPhome = VMPmarket
Hours worked at H* ← Hours worked in 506

home → market
Excess burden

After tax
Euros Euros
Tax reduces VMPmarket

to (1-t)VMPmarket
w2
Equilibrium shifts to Ht
VMPmarket (1-t)w2
More work at home
VMPhome
Less work in market
(1-t)VMPmarket Difference is excess
burden (orange) ◦
Hours worked in
H* Ht ← Hours worked 507
home → in market
Excess burden
Main points again

• Tax causes excess burden if relative prices are affected
• No excess burden if:
• lump sum tax, or
• compensated elasticities are zero
• Excess burden may be measured using:
• indifference curves, or
• compensated demand curves
• Size of excess burden is proportional to
• compensated elasticities of demand and supply
• original P and Q
• square of tax rate ◦ 508
Efficient & equitable taxation
Chapter 16
509
The big picture
• Chapter 14: Taxation and equity

• Who pays the tax?
• Chapter 15: Taxation and efficiency
• Excess burden
• Chapter 16
• How to design an optimal tax system?
• Apply what we learned in Chapter 14 & 15 510
Overview
Different criteria for evaluating tax
system
• Optimal taxation theory:
• Efficiency: low excess burden (EB)
• Equity: fair distribution, conform social welfare function
• Politically feasibility
• e.g., time inconsistency problem Very
different
equity
• Horizontal equity
concepts!
• equals treated equally
• Operating costs of taxation 511
• Tax evasion ◦
Optimal commodity taxation
Optimal Taxation
Efficient commodity taxation
• Problem: minimize excess burden

• for given amount of tax
• lump-sum tax usually not chosen (not fair)
512
Optimal Taxation

• Excess burdens result from changes in quantities
caused by relative price changes
• No excess burden if relative prices unchanged
• This happens if all goods are taxed at the same rate
513
Optimal Taxation

• Impossible: leisure cannot be taxed
514
Optimal Taxation

• Impossible: leisure cannot be taxed
•  Excess burden cannot be avoided

• But it can be minimized 515
• Question is: how? ◦
How to achieve efficiency?

 EB minimized if:
 marginal excess burden of the last euro of revenue
raised from each commodity is the same
516
How to achieve efficiency?

 EB minimized if:
 marginal excess burden of the last euro of revenue
raised from each commodity is the same
 Otherwise, you can reduce excess burden by:
 raising tax rate on commodity with lowest marginal
excess burden, and
 lowering rate on commodity with highest marginal
excess burden
 Need to know:
 marginal excess burden
 marginal tax revenue ◦
517
Marginal excess burden of tax ux

Assume horizontal supply curve
Price Compensated demand curve
Marginal excess burden

P0+ux+1 ≈ X0 – X1 = ΔX (see book) ◦
P0+ux Excess burden of tax ux:

reduction in consumer
surplus, minus tax revenue
P0
ΔX 518
X2 X1 X0 Quantity
Marginal revenue of tax ux

Price
Revenue of tax ux+1

P0+ux+1 a
P0+ux Revenue of tax ux
b
P Marginal revenue: area a – area b
0 ≈ X1 – ΔX (see book) ◦
ΔX
519
X2X1 X0 Quantity
Excess burden minimized:

Marginal excess burden divided by marginal revenue is the
same for each commodity X, Y, etc:
Marginal excess
burden X Y
  ...
X 1  X Y1  Y
Marginal tax
revenue
This implies:
Relative
X Y reduction in
 demand Y
X1 Y1 520
Ramsey rule
 Marginal excess burden of last euro of tax revenue is
the same for each commodity:
X Y
• 
X1 Y1
• Set tax rates so that the

percentage reduction in demand
is the same for each commodity
Frank Ramsey 521

Ramsey rule: what does it mean?

• EB not minimized with same tax rate on each
commodity!
522

• EB not minimized with same tax rate on each
commodity!
• Suppose X and Y are unrelated commodities
• If price of X or Y changes, it affects only its own
demand, not the demand for the other good
• → no substitutes or complements
523

• EB not minimized with same tax rate on each commodity!
• Suppose X and Y are unrelated commodities
• If price of X or Y changes, it affects only its own
demand, not the demand for the other good
• → no substitutes or complements
• Then, inverse elasticity rule applies:
t X Y
 η is compensated
t Y X elasticity of demand
• If elasticity is high, tax causes a big EB → low t is best
524
•  tax commodities with low elasticity most ◦
Ramsey rule isn’t sacred
• Equity considerations may lead to departure from

Ramsey rule
• Efficiency isn’t everything
• Taxation must be fair as well
525
Ramsey rule isn’t sacred
• Equity considerations may lead to departure from

Ramsey rule
• Efficiency isn’t everything
• Taxation must be fair as well
• Example: essential drugs

• Very low elasticity of demand
• sick people have no choice
• Efficient but unfair to tax heavily ◦ 526
Corlett-Hague rule
• Efficient taxation: tax goods which are complementary

to leisure
• Remember: excess burden could be avoided if leisure

could be taxed
• Leisure itself cannot be taxed, but its complements can
• E.g., games, films
• Leisure becomes less attractive this way
• Second-best solution to taxing leisure
527
Optimal user fees
Efficiency for governmental monopolies
• If average costs decrease with output, economies of

scale may lead to a natural monopoly
• high fixed costs & very low marginal costs
• e.g., electricity, water supply, railway
528
Optimal user fees
Efficiency for governmental monopolies
• If average costs decrease with output, economies of scale

may lead to a natural monopoly
• high fixed costs & very low marginal costs
• e.g., electricity, water supply, railway
• No competitive market  government may provide

• or regulate a private monopoly
• What price (user fee) should the government charge?

529
• Application of Ramsey Rule
Optimal user fees
Natural monopoly
$ 
AC and MC decrease; MC < AC

What would a monopolist do?
AC
MC
530
MR D
Z per year
Optimal user fees
Natural monopoly
$ 
AC and MC decrease; MC < AC

What would a monopolist do?
 Set MC = MR
 Price P and quantity Z

Monopoly profit: red rectangle

Not efficient : P > MC
P
AC
AC
MC
531
MR D
Z Z per year
Optimal user fees
Natural monopoly
$  Option 1: Marginal Cost Pricing

 P = MC

Price P*

Optimal quantity Z*
 P* < AC → loss (red rectangle)
AC
P* MC
532
MR D
Z* Z per year
Optimal user fees
Natural monopoly
$ 
Option 2: Marginal cost pricing with
lump sum tax to cover loss
 Lump sum tax usually not fair
 + violation of Benefits received
principle
 Non-users must pay as well
 Is that fair?
AC
P* MC
533
MR D
Z* Z per year
Optimal user fees
Natural monopoly
$ 
Option 3: Marginal cost pricing with
distortive tax to cover loss
 Excess burden tax may exceed
efficiency gain in market for Z
 + violation of Benefits received
principle
AC
P* MC
534
MR D
Z* Z per year
Optimal user fees
Natural monopoly
$  Option 4: Average Cost Pricing

 P = AC
 Price PA
 No profit, no loss
 Quantity ZA
 Not efficient: ZA < Z*
PA
AC
P* MC
535
MR D
ZA Z* Z per year
Optimal user fees
Natural monopoly
 Suppose government runs several enterprises
 Losses are compensated by profits elsewhere
 User fee may be considered tax
 → use Ramsey rule:
 set user fees so that demand for each commodity is
reduced proportionately
 i.e., by same %
536
Optimal user fees
Natural monopoly
 Suppose government runs several enterprises
 Losses are compensated by profits elsewhere
 User fee may be considered tax
 → use Ramsey rule:
 set user fees so that demand for each commodity is
reduced proportionately
 i.e., by same %
 In practice: often average cost pricing

 Easy; no loss
 Complies with benefits-received principle 537
 Output lower than optimal
Optimal income tax
Optimal income taxation
• So far, we looked at commodity taxation

• Now, consider tax on income
• Edgeworth’s model
• Assume:
• W = U1 + U2 + … + Un
• People have identical downward-sloping utility
functions depending only on income
• Total income is fixed
538
Optimal income tax
• So far, we looked at commodity taxation

• Now, consider tax on income
• Edgeworth’s model
• Assume:
• W = U1 + U2 + … + Un
• People have identical downward-sloping utility
functions depending only on income
• Total income is fixed
• Then: after-tax income should be the same for
everyone (compare Ch. 12)
• Marginal tax rate on high income 100% ◦ 539
Optimal income tax
• Edgeworth’s assumptions are problematic

• Total income is not fixed
• Utility depends not only on income but also on
leisure
• → Tax reduces total amount of income available for

redistribution
• Welfare loss must be weighted against equity gain

540
Optimal income tax

• Consider simple income tax:
• Revenue = -α + t × Income
• People choose between income and leisure
Tax revenue
Slope = t (= marginal tax rate)  Marginal tax rate t is constant
 Still, tax is progressive: rich pay
higher % of their income
 … because of -α
Income  → Average tax rate increases
-α with income
541
Optimal income tax

 Stern: optimal t = 0.19

<< 100% (Edgeworth)

Assumptions:
 W = U1 + U2 + … + Un
Tax revenue  required tax revenue

Slope = t (= marginal tax 20% of income
rate)  low substitution
between income and
leisure (elasticity)
Income →
-α
542
Optimal income tax


<< 100% (Edgeworth)

Assumptions:
 W = U1 + U2 + … + Un

between income and
leisure
Income → 
Optimal t depends heavily
-α
on elasticity of labor supply
 Higher elasticity, lower t
543
Optimal income tax


<< 100% (Edgeworth)

Assumptions:
 W = U1 + U2 + … + Un

between income and
leisure
Income → 
-α

One single marginal tax rate 544
 In practice: several
Optimal income tax


<< 100% (Edgeworth)

Assumptions:
 W = U1 + U2 + … + Un

between income and
leisure
Income → 
-α

One single marginal tax rate 545
 In practice: several
 Maximin: t = 0.80! ◦
Optimal income tax
So far: Optimal taxation theory

Efficiency: low excess burden (EB)
Equity: fair distribution, conform to social welfare
function
Now: look at different criteria for a good tax system
546
Other criteria for tax design
Politics: protection against revenue

maximizing
• Optimal tax theory is normative
• Institutional and political setting ignored
• Assumes politicians act in the common interest
547
Politics: protection against revenue

maximizing
• Optimal tax theory is normative
• Institutional and political setting ignored
• Assumes politicians act in the common interest
• Political economy: politicians serve own interests

• What if politicians maximize tax revenue?
• Then it might be optimal to exclude certain goods from
taxation
• e.g., in the constitution
• even if optimal taxation theory prescribes differently ◦ 548
Politics: time inconsistency problem

• Tax policy is impossible if it conflicts with government’s
long-term incentives
549
Politics: time inconsistency problem

• Tax policy is impossible if it conflicts with government’s
long-term incentives
• E.g., a one-time tax

• no effect on behavior → efficient
• … if it really is a one-time tax
• but, government has incentive to repeat
• if taxpayers know this → effect on behavior →
welfare loss
• Political credibility is important factor ◦ 550

A different notion of fairness
• Optimal taxation theory: tax burden distributed

according to social welfare function
551
• Optimal taxation theory: tax burden distributed

according to social welfare function
• Alternative: horizontal equity
• People in equal positions treated equally
• Social welfare not used
• Outcome will usually differ from optimal taxation
• To non-economists, horizontal equity often sounds more
logical ◦
552
• Problem: what is equal position??
553
• E.g., equal position = same income?
• Different income may reflect different behavior
• Higher income ≠ higher wage
• high income may result form working more hours
• part-time workers: less tax but more leisure
554
• E.g., equal position = same income?
• Different income may reflect different behavior
• Higher income ≠ higher wage
• high income may result form working more hours
• part-time workers: less tax but more leisure
• Higher wage may result of more schooling
• no income in college years
• tax may discourage education ◦ 555
Administrative and compliance costs of

taxation (1)
• Optimal taxation theory: efficient tax has small excess
burden
• Alternative criterion: low operating costs
556

taxation (1)
burden
• Administrative costs: costs incurred by tax authority
• Compliance costs: costs incurred by tax payers
• individuals and firms
• e.g., filling out forms, administering VAT
557

taxation (1)
burden
• Administrative costs: costs incurred by tax authority
• Compliance costs: costs incurred by tax payers
• individuals and firms
• e.g., filling out forms, administering VAT
• Empirical research: operating costs Dutch taxes 5% of
revenue
• Some taxes are very expensive 558
• Costs up to 26% of revenue! ◦
Administrative and compliance costs:

Netherlands
Compliance costs Compliance costs

0.7% 4.0%
Subsidies Taxes
Benefits
Administrative costs Administrative costs

559
2.0% 1.1%
Allers (1994)
Administrative and compliance costs

• Empirical research: compliance costs relatively high for
small firms
• Competitive advantage for large firms
• Firms will grow inefficiently large
560

small firms
• More complicated tax → higher operating costs

• Trade-off between equity and operating costs
561

small firms
• More complicated tax → higher operating costs

• Trade-off between equity and operating costs
• More different taxes → higher operating costs

• Trade-off between excess burden reduction and operating 562
costs ◦
Tax evasion versus tax avoidance

• Tax avoidance: Altering behavior in such a way as to
reduce your tax liability
• Legal
• E.g., take your bike, not your car, and escape fuel tax
• Creates excess burden
563
Tax evasion versus tax avoidance

• Tax avoidance: Altering behavior in such a way as to
reduce your tax liability
• Legal
• E.g., take your bike, not your car, and escape fuel tax
• Creates excess burden
• Tax evasion: Not paying taxes legally due

• Illegal
• E.g., hide your savings in Switzerland / Panama / …
• Evasion is possible because monitoring everyone all the
time is impossible ◦ 564
Tax evasion
• Tax evasion depends on marginal costs and marginal
benefits of cheating
MB = tax rate
Evasion (euros not reported)

565
Tax evasion
• Tax evasion depends on marginal costs and marginal
benefits of cheating
Here: rising with evasion
MC = risk×marginal penalty + psychological costs of cheating
MB = tax rate
R* Evasion (euros not reported)

566

R* increases with tax rate and decreases with penalty and risk
(chance of getting caught)
Tax evasion
• For tax payer, tax evasion seems optimal when MB = MC

• Net income is maximized on average
• But:
• Chance of being audited is not random
• Once caught, you will be monitored more closely
• Now, optimal cheating level lies lower
567
Tax evasion
• For tax payer, tax evasion seems optimal when MB = MC

• Net income is maximized on average
• But:
• Chance of being audited is not random
• Once caught, you will be monitored more closely
• Now, optimal cheating level lies lower
• For honest people, psychic costs will be so high they do
not cheat
• People are risk-averse
• They do not like the risk of being caught 568
A clever way to avoid tax evasion
Denmark controlled
both sides of the
important seaway to
the Baltic area
Baltic area
Trade route
Tax on shipping from
Denmark Sound 1429 to 1857
You are here
569
Cash chest used for
Sound tax revenues
570
Sound tax
• Suppose you are king or queen of Denmark
• You want to tax shipping through the Sound
• Option 1: Fixed amount per ship →
• For cheap cargo, the tax rate is (too?) high
• For expensive cargo, the tax rate is low
572
Sound tax
• Suppose you are king or queen of Denmark
• You want to tax shipping through the Sound
• Option 1: Fixed amount per ship →
• For cheap cargo, the tax rate is (too?) high
• For expensive cargo, the tax rate is low
• Option 2: Percentage of cargo value →
• Captain has incentive to lie
• Assessing true value of every cargo is costly
• 15,000-20,000 ships every year; 50 per day
• What would you do?

573
Sound tax
• Solution:
• Ask captain for value of cargo
574
Sound tax
• Solution:
• Ask captain for value of cargo
• Then, either
• tax imposed on self-declared value
• or, cargo bought at that value
• → incentive for captain to give true value
• Disadvantage: it is costly to buy cargo and sell it again

575
Chapter 18
Effect of personal taxation on
behavior:
1 Labor supply
2 Saving 576
3 Risk taking
The big picture
• Ch 14-15: Equity and efficiency of taxation

• Ch 16: How to design optimal tax system
Now:
• Ch 18: How will people and businesses react?
577
Effects of tax on labor supply
1 Taxation and labor supply
• Most people seem to think an income tax lowers labor

supply
• Lower (after tax) wage makes work less attractive
• But is that true?
578
• A tax on labor lowers the relative price of leisure

• → more leisure is consumed
579

• For any number of hours worked, a tax lowers income
• Budget line moves down → less consumption
• → less leisure will be consumed
• Income effect
580

• For any number of hours worked, a tax lowers income
• Budget line moves down → less consumption
• → less leisure will be consumed
• Income effect
• → net effect is ambiguous

• depends on:
• the size of the substitution effect
• the size of the income effect ◦ 581
Effects
Effects of
of tax
tax on
on labor
labor income
supply
Choice of work and leisure


Without taxation
 T = time endowment
Income  T is split between work and leisure
D  Depends on:
• wage w (slope budget line)
• indifference curves
Budget line:│slope│ = w 582

Leisure (hours) T
Effects
Effects of
of tax
tax on
on labor
labor income
supply


Without taxation
D  Depends on:
Indifference curves

F T
Effects
Effects of
of tax
tax on
on labor
labor income
supply


Without taxation
D  Depends on:
Indifference curves
Income
F T
Effects
Effects of
of tax
tax on
on labor
labor income
supply


Proportional income tax
 Net wage rate = (1-t)w
Income 
New budget constraint HT
D 
Slope (1-t)w

Work reduced by FI

Substitution effect > income effect
H
G
585
F I T
Effects
Effects of
of tax
tax on
on labor
labor income
supply


Same tax
 Other indifference curve
Income 
Work increased by JF
D 
Income effect > substitution effect
H
G
586
J F T
Effects
Effects of
of tax
tax on
on labor
labor income
supply


Same tax
 Other indifference curve
Income 
Work increased by JF
D 
Income effect > substitution effect

Effect of income tax on labor
H supply depends on preferences ◦
G
587
J F T
Effects
Effects of
of tax
tax on
on labor
labor income
supply


Dotted red line: parallel to
original budget line DT
Income 
Income effect: F→K
D • K: Dotted red line tangent
to indifference curve
• Effect of income reduction;
price of leisure unaffected
H
• Move to other indifference
G
curve
KJ F T 588
Income effect FK
Effects
Effects of
of tax
tax on
on labor
labor income
supply


Income effect: F→K

Substitution effect: K→J
Income • J: Indifference curve
D tangent to new budget line
HT
• Effect of price change
H
• Move along indifference
curve
G
• Leisure cheaper → more
leisure

Net effect: F→J ◦
KJ F T 589
Income effect FK
Substitution effect KJ
Effects
Effects of
of tax
tax on
on labor
labor income
supply
• According to theory, the effect of income tax on labor

supply is ambiguous
• Depends on which effect is stronger

• Income effect, or
• Empirical evidence needed

• Difficult to study – can’t use laboratory
• Effect may be different in different countries 590
Effects
Effects of
of tax
tax on
on labor
labor income
supply
Empirical evidence
• Primary earners:
• often males
• effect of net wage changes on hours of work very small
• elasticity of supply about 0.05
• income effect ≈ substitution effect
591
Effects
Effects of
of tax
tax on
on labor
labor income
supply
Empirical evidence
• often males
• Secondary earners:
• often females
• elastic labor supply: supply decreases with tax rate
• substitution effect > income effect
592
Effects
Effects of
of tax
tax on
on labor
labor income
supply
Empirical evidence
• often males
• Secondary earners:
• often females
• elastic labor supply: supply decreases with tax rate
• Income tax discourages female labor supply
• more women work part-time, or not at all ◦ 593
Effects
Effects of
of tax
tax on
on labor
labor income
supply
Income tax and human capital
• Until now: effect on hours worked

• Quantity of labor supply
• Human capital is also important for labor supply
• Quality of labor supply
• Better educated → more productive → higher wage
594
Effects
Effects of
of tax
tax on
on labor
labor income
supply
• Before tax: invest in education if B – C > 0

• NPV > 0
• Tax lowers benefits to (1-t)B

• …but tax also lowers costs to (1-t)C
• cost of education = foregone wages
• we abstract from tuition fees
595
Effects
Effects of
of tax
tax on
on labor
labor income
supply
• After tax:
• Invest in education if (1-t)B – (1-t)C > 0
• or B-C > 0
• Equivalent to criterion without tax! → no effect
596
Effects
Effects of
of tax
tax on
on labor
labor income
supply
• After tax:
• Invest in education if (1-t)B – (1-t)C > 0
• or B-C > 0
• Equivalent to criterion without tax! → no effect
• But: this assumes uniform tax rates

• Usually: higher tax rate if income is high
• progressive tax
• Then: education will be discouraged ◦
597
Effects
Effects of
of tax
tax on
on labor
labor income
supply
Effect of tax rate on tax revenue
• Simple view: high tax rate → high tax revenue

• But: high tax rate may reduce labor supply
• Consequently, revenues may decline
Tax revenue
Laffer curve
598
t* Tax rate
Effects
Effects of
of tax
tax on
on labor
labor income
supply

• At t>t*, reducing tax rate will yield higher tax revenue
• But, usually, t<t*
Tax revenue
Laffer curve
599
t* Tax rate
Effects
Effects of
of tax
tax on
on labor
labor income
supply

• At t>t*, reducing tax rate will yield higher tax revenue
• But, usually, t<t*
Tax revenue
Laffer curve
600
t* Tax rate
Effects of tax on saving
2 Effect of taxation on saving
• Life cycle model: saving depends not only on present

income, but also on past and future income
• Simple model: 2 periods
• Present
• Future
• Problem: how much to consume in each period
601
2 Effect of taxation on saving
• Life cycle model: saving depends not only on present

income, but also on past and future income
• Simple model: 2 periods
• Present
• Future
• Problem: how much to consume in each period
• Relative price of consumption now:
• reflected in net interest rate
• depends on:
• real interest rate 602
• tax on interest income
• extent to which interest costs are tax-deductible
Saving in the life cycle model (1)
Future Endowment point: no saving, no

consumption borrowing
(c1) • consumption = income
• co = I o
• c1 = I1
I1 Endowment point
603
I0 Present consumption (c0)

Future
consumption N
(c1)
Saving or borrowing possible
→ budget line NM
I1 Endowment point
|Slope| = 1 + r
604
M

• Possible departure from
Future endowment point depends
consumption N on interest rate r
(c1) • Movement along budget line
• In this case: to E1
c1* E1 • c0 < I0 → saving
I1 Endowment point
|Slope| = 1 + r
Saving
605
M
c0* I0 Present consumption (c0)
Future • Now with different

consumption N indifference curve
(c1) • c0 > I0 → borrowing
Endowment point
• Until now: no
taxation
I1
E2
c1 *
ii
Borrowing 606
M

• Tax on interest
Future • → for saving and borrowing
consumption N • Interest paid is deductible from
(c1) taxable income
• New budget line PQ through
E1
endowment point A
c1 *
P
I1
A
After-tax budget line
|slope| = 1 + (1-t)r
607
Q
M
c0* I0 Present consumption (c0)
• Here, saving is reduced by tax,

Future but with other indifferent curve,
consumption N it could increase
(c1) • Depends on income and
substitution effect
c1 * E1
P
c1 t
I1
A
Saving |Slope| = 1 + (1-t)r
after
tax 608
Q
M
c0* c0t I0
Saving before tax Present consumption (c0)

 Tax on interest receipts
Future
 Interest paid not deductible
consumption N  Budget line is now kinked
(c1)  To left of endowment point A:
|slope| = 1 + (1-t)r as before
 To right of A: |slope| = 1 + r (as
without tax)
 Tax only changes saving, not
borrowing
I1
A
609
Q
M
Taxation and saving: empirical evidence

• Taxation reduces saving if:
• If income effect dominates, tax increases saving
• example: saving to buy a 200,000 euro house? More
saving necessary with tax
610
Taxation and saving: empirical evidence

• Taxation reduces saving if:
• If income effect dominates, tax increases saving
• example: saving to buy a 200,000 euro house? More
saving necessary with tax
• Which effect is stronger?
• Difficult to find out
• Empirical results suggest:
• So, interest taxation does not seem to affect saving ◦ 611
Effects of tax on risk taking
3 Taxation and risk taking

• Suppose return to capital assets is taxed
• Losses are deductible
• Suppose people can choose:

• risky assets (average return > 0), or
• safe assets (rate of return = 0)
612
• Tax reduces net return of risky asset

• → less risk taking
• But: tax also reduces risk (loss is tax deductible)
• → more risk taking
• Theory: effect tax is ambiguous
613
• Tax reduces net return of risky asset

• → less risk taking
• But: tax also reduces risk (loss is tax deductible)
• → more risk taking
• Theory: effect tax is ambiguous
• Empirical evidence is inconclusive
• → net effect of tax on risk taking is uncertain ◦
614
Effects of tax on housing
4 Taxation and housing
• Tax on income: what income should be included?

• Haig-Simons definition:
• Income = net increase in power to consume
• = consumption + saving
615
4 Taxation and housing
• Tax on income: what income should be included?

• Haig-Simons definition:
• Income = net increase in power to consume
• = consumption + saving
• All income sources should be taxed
• If not, people will shift part of income to non-taxed sources
• Expenses incurred to earn income should be subtracted
from taxable income ◦
616
Taxation and housing
• Owning a house creates income

• you rent it out, or
• you live in it → you don’t have to pay rent
• rental value = market rent for house
• House value increase is income too
• Both should be taxed ◦
617
• But: house must be financed

• either you borrow money (mortgage), or you use
your own money
• either you pay interest, or you forgo interest
• makes no difference economically
• Interest is negative return
618
• Housing income = rental value + Δvalue – interest
On total value,
not just mortgage
• Should be taxed according to Haig-Simons
619
Taxation and housing in the Netherlands

• Netherlands: tax on rental value (eigenwoningforfait)
• % of market value is added to taxable income
• usually 0.60%
• Income tax rate: 37.35% for most people
• So, tax on rental value unrealistically low
• 0.60 x 0.3735 = 0.224% of house value
620

• usually 0.60%
• 0.60 x 0.3735 = 0.224% of house value
• Interest payments are fully tax deductible
• But only on mortgage – if you finance your house
yourself, there is no deduction
• Goes against Haig-Simons criterion
621

• usually 0.60%
• 0.60 x 0.3735 = 0.224% of house value
• Interest payments are fully tax deductible
• But only on mortgage – if you finance your house
yourself, there is no deduction
• Goes against Haig-Simons criterion
• No tax at all on Δvalue! ◦ 622

Results:
• Only part of income from owner-occupied housing is
taxed
• no tax on Δvalue
• tax on rental value is too low
• → owning the house you live in is fiscally stimulated
• → houses have become very expensive
623

Results:
• Only part of income from owner-occupied housing is
taxed
• no tax on Δvalue
• tax on rental value is too low
• → owning the house you live in is fiscally stimulated
• → houses have become very expensive
• Financing a house by mortgage is very attractive

• Use as little of your own money as possible
624
• Nobody wants to repay mortgage ◦
625
Effects of tax on behavior
Taxation and housing in the Netherlands:

Economic effect
• IMF (2018): Dutch economy very sensitive to economic

shocks
• If house values decrease, many households have
negative net assets
• Demand will fall, unemployment rise
• When mortgage debt > house value, moving is difficult
• Makes labor market inflexible
• Government is now slowly changing tax deductibility 626

Summing up
• Theoretically, the effects of taxation on labor supply,

saving, and risk taking are ambiguous
• Income effect versus substitution effect
627
Summing up

• Empirical evidence exists, but it is open to debate

• Taxing income probably reduces labor supply,
especially among secondary earners
• Effect of tax on saving is probably small
• Effect on risk taking uncertain
628
Summing up

• Empirical evidence exists, but it is open to debate

• Taxing income probably reduces labor supply, especially
among secondary earners
• Effect of tax on saving is probably small
• Effect on risk taking uncertain
• Dutch income tax design results in excessive mortgage- 629

financed home ownership ◦
Chapter 20
Deficit finance
• Tax or borrow?
• Is debt a burden for future generations?
• Budgetary policy
630
Definitions
Debt and deficit
• Fiscal deficit:
• government expenditures - revenues
• during a period of time
• flow variable
631
Definitions
Debt and deficit
• Fiscal deficit:
• government expenditures - revenues
• during a period of time
• flow variable
• Government debt:
• the total amount owed at a given point in time
• = the sum of all past deficits
• stock variable
632
Size
Netherlands
4
-2
-4
-6
-8
-10
633
Budget balance (deficit if negative; % of GDP)
Source: CPB
Size
Netherlands
4 80
2 70
60
0
50
-2
40
-4
30
-6
20
-8 10
-10 0
634
Debt (% of GDP)
Source: CPB
Size
Netherlands (CPB forecast 2020)

Government debt:396 billion euro (48% GDP)
 Government surplus: 2 billion euro (0.3% GDP)
 Interest rate is presently extremely low (≈0%)


Negative for countries like the Netherlands and
Germany

Problem if interest rate goes up
 Danger: crowding out of other expenditures
635
Size
Rules of the European Monetary Union

Deficit ≤ 3% GDP
 Medium term objective: 0.5% GDP (for NL)
 Debt ≤ 60% GDP

Since 1992

Presently, some European countries exceed these limits
 Temporarily (?)
 Sometimes allowed to combat crisis / terrorism / …
636
Size

Deficit ≤ 3% GDP

Debt ≤ 60% GDP
 Why these percentages?


Not every combination is sustainable
637
Size

Deficit ≤ 3% GDP

Debt ≤ 60% GDP
 Domar (1944): debt sustainable if debt ratio is constant

 debt ratio = debt as % of gdp
 → debt ratio goes to
638
Size

Deficit ≤ 3% GDP

Debt ≤ 60% GDP
 Domar (1944): debt sustainable if debt ratio is constant

 debt ratio = debt as % of gdp
 → debt ratio goes to
 So, EMU rules assume 5% growth (nominal)
 0.60 = 0.03 / 0.05
639
 lower growth → debt stabilizes at higher level
Size
Debt measurement
• (1) It’s not as bad as it seems:
• Includes government debt held by Central bank

• But: Central bank is owned by the government
640
Size
Debt measurement

• Inflation reduces value of outstanding debt
• This “inflation tax” is not included in the deficit
641
Size
Debt measurement

• Government owns assets, not just debt
• E.g., part of debt increase because of support for
banks
• NL: 80 billion euro; 14% of GDP (2008 & 2009)
642
Size
Debt measurement

• Government owns assets, not just debt
• E.g., part of debt increase because of support for
banks
• NL: 80 billion euro; 14% of GDP (2008 & 2009)
• Capital expenditures are fully included in deficit 643
• Purchase of durable assets not really a cost
• only depreciation and interest are true costs
Size
Debt measurement
• (2) It’s worse than it seems:
• Provinces and local governments also have debt

• High in countries like Spain
• Netherlands: local government mostly borrow for
capital expenditures
• Debt normally offset by assets → no big problem
644
Size
Debt measurement
• (2) It’s worse than it seems:
• Provinces and local governments also have debt

• High in countries like Spain
• Netherlands: local government mostly borrow for
capital expenditures
• Debt normally offset by assets → no big problem
• Implicit obligations are not included
• E.g., welfare programs
• Should present value be included in debt? 645
• Not quite the same as debt, because these
programs can be changed
Burden
Who bears the burden of debt?
 Burden on future generations?

Different views
646
Burden
Who bears the burden of debt (1)
• Lerner’s view
• If debt is held by own citizens (not foreigners), it
creates no burden for future generation as a whole
647
Burden
• Lerner’s view
• Future generation has debt, but owns the bonds, too

• it cancels out
• “We owe it to ourselves”
648
Burden
• Lerner’s view
• Future generation has debt, but owns the bonds, too

• it cancels out
• “We owe it to ourselves”
• But: not everybody owns bonds

• one group of citizens pays the other 649
• → effect on income distribution
Burden
• Lerner’s view
• If debt is held by foreigners, it depends:
• If loan is used for consumption, consumption of
future generation is reduced
• If loan is used for investment, there is only a
burden on future generation if:
• marginal rate of return on public investment <
marginal costs of funds
650
Burden

• Problem with Lerner’s view:
• Ignores that people die
• You may not be around when debt is repaid
• People born later may not have profited from debt
spending
• “Generation” here means: everyone alive at given
time
651
Burden

• Problem with Lerner’s view:
• Ignores that people die
• You may not be around when debt is repaid
• People born later may not have profited from debt
spending
• “Generation” here means: everyone alive at given
time
• It is better to look at lifetime consequences

• “Generation” then means: everyone born in the
652
same period
• Use overlapping generations model
Burden
Who bears the burden (2)

• Overlapping generations model
• Suppose there are three generations
• Young, middle-aged and old
• Every generation is 20 years long
• After 20 years, the young are middle aged, the old
are dead
653
Burden

• Overlapping generations model
• Suppose there are three generations
• Young, middle-aged and old
• Every generation is 20 years long
• After 20 years, the young are middle aged, the old
are dead
• Government borrows money from young and middle-
aged to finance consumption
• Money is paid back after 20 years
• financed through tax (after 20 years)
654
• no interest, no inflation (keep it simple)
Burden
Overlapping generations model (1)

Borrowing 12,000 to finance consumption
Year t
Young Middle-aged Old
Borrowing -6,000 -6,000 0
Consumption 4,000 4,000 4,000
655
Burden

Year t
Borrowing -6,000 -6,000 0
Consumption 4,000 4,000 4,000
Year t + 20
Middle-aged
Taxes -4,000
Repayment 6,000 656

Sum 0
Burden

Year t
Borrowing -6,000 -6,000 0
Consumption 4,000 4,000 4,000
Year t + 20
Middle-aged Old (dead)
Taxes -4,000 -4,000
Repayment 6,000 6,000 657

Sum 0 0 4,000
Burden

Year t
Borrowing -6,000 -6,000 0
Consumption 4,000 4,000 4,000
Year t + 20
Young Middle-aged Old (dead)
Taxes -4,000 -4,000 -4,000
Repayment 6,000 6,000 658

Sum -4,000 0 0 4,000
Burden
Borrowing to finance consumption
• Conclusion:
• the old of year t profit
• the future young bear the burden
• Whether foreigners finance the debt (Lerner) is
completely irrelevant in this model
659
Burden
Borrowing to finance consumption
• Conclusion:
• the old of year t profit
• the future young bear the burden
• Whether foreigners finance the debt (Lerner) is
completely irrelevant in this model
• Note, however, that the borrowed money is used

entirely for consumption
• If money is used for investment, burden depends on 660

return on investment
Burden
Borrowing to finance investment
• Same as before, but money is used for investment
• Assume investment pays off after 20 years

• Now, young in t + 20 profit from investment in t
• If NPV ≥ 0, no group is burdened

• because benefit occurs in same period as tax
payment
• and benefit ≥ tax payment 661
Burden

Borrowing 12,000 to finance investment
Assumption: NPV = 0 Year t
(cost = benefit)
Borrowing -6,000 -6,000 0
662
Burden

(cost = benefit)
Borrowing -6,000 -6,000 0
Year t + 20
Young Middle- Old (dead)

aged
Return on +4,000 +4,000 +4,000
investment
663
Burden

(cost = benefit)
Borrowing -6,000 -6,000 0
Year t + 20

aged
Return on +4,000 +4,000 +4,000
investment
Taxes -4,000 -4,000 -4,000
664
Burden

(cost = benefit)
Borrowing -6,000 -6,000 0
Year t + 20

aged
Return on +4,000 +4,000 +4,000
investment
Taxes -4,000 -4,000 -4,000
Repayment 6,000 6,000 665
Sum 0 0 0 0
Burden

(cost = benefit)
Borrowing -6,000 -6,000 0
Year t + 20

aged
Return on +4,000 +4,000 +4,000
investment
Taxes -4,000 -4,000 -4,000
Repayment 6,000 6,000 666
Sum 0 0 0 0
Burden
• If borrowed money is invested with NPV > 0 ..

• .. then debt leaves future generation better off
• Debt does not need to be a burden!

• If money is invested profitably
667
Burden
Overlapping generations model:
limitations
• It assumes debt policy does not affect economic

decisions
• But: taxes levied to repay debt may affect working
and saving decisions
• Income effect & substitution effect
• And: government borrowing affects the interest rate
• Higher demand drives up price
• → Neoclassical model
668
Burden

• Neoclassical model
• Government borrowing may increase interest rate
• For small country borrowing on international capital
market, this effect is negligible (e.g., Netherlands)
669
Burden

• Interest up → private investment down
• This is called crowding out
670
Burden

• Private capital stock lower because of government
borrowing
• Future generations have lower incomes → burden
671
Burden

• Private capital stock lower because of government
borrowing
• Future generations have lower incomes → burden
• But: if government uses money to invest, 672
• burden depends on rate of return …
• … compared with rate of return in private sector
Burden

• Problem with this model:

• it ignores people’s reactions to fiscal policy
• People may anticipate future tax rise
673
Burden

• Ricardian model (developed by Robert Barro, 1974)
• Assumptions:
• people are completely rational
• people have full information
674
Burden

• Ricardian model
• Assumptions:
• people are completely rational
• people have full information
• → people know government debt must be repaid
• They save more in anticipation
675
Burden

• Ricardian model
• Result: borrowing has same effect on consumption as

taxation!
• Tax financing: people pay tax → lower private
consumption
• Debt financing: people save → lower private
consumption
676
Burden

• Ricardian model
• Result: borrowing has same effect on consumption as

taxation!
• Tax financing: people pay tax → lower private
consumption
• Debt financing: people save → lower private
consumption
Same amount!
• Ricandian model: Tax and debt finance are equivalent 677

• “Ricardian equivalence”
Burden

• Ricardian model: what about death?
• Barro: the old realize their descendants must pay
• Therefore, they save to leave money to their children
• So children can pay the future tax
• People undo intergenerational effect of government

debt policy
• No difference between debt and tax financing
678
Burden
Ricardian model: limitations
• Probably:
• No perfect information
• People may not know the size of the debt
• Allers, de Haan & de Kam (1998): they don’t have
a clue
679
Burden
• Probably:
• People do not behave rationally
• People don’t look forward so much, they live in
the present
680
Burden
• Probably:
• People do not care that much about their
descendants
• Do your parents save to leave you money to pay
future taxes?
681
Burden
• Probably:
• People do not care that much about their
descendants
• Still, the model shows how the effect of debt finance
may be partly offset by taxpayers’ reactions
• Worries about future tax rises may discourage
consumption
• People may not be completely rational and informed…
• … but they are not stupid
682
Burden
Practical policy (1)
• For any budget year, two decisions to make:

• create/increase debt or not
• repay existing debt or not
683
Burden

• Debt creation:
• May cause crowding out
• Result: lower private capital stock
• Negligible for small country borrowing on
international capital market
• If money is used for consumption, future
generations are worse off
• If money is used for government investment, trade
off the benefit against the benefit of private
investment
684
Burden

• Debt existence:
• Results in higher taxes to pay interest
• Trade off tax excess burden against benefit of
government spending
• Also: debt redistributes income
• from taxpayer to bondholder (from poor to rich)
• between generations
685
Tax or borrow?
Tax versus debt finance

• Suppose the government wants to spend 1 billion
• Choice:
• tax 1 billion now, or
• borrow 1 billion, and tax smaller amounts in future years
• Present value of tax is the same in both cases
686
Tax or borrow?
Tax versus debt finance

• Suppose the government wants to spend 1 billion
• Choice:
• tax 1 billion now, or
• borrow 1 billion, and tax smaller amounts in future years
• Present value of tax is the same in both cases
• What is the optimal way to finance government

expenditures?
• That depends on how you look at it: 4 perspectives
687
Tax or borrow?
1 Benefits received principle

• Those who benefit from spending should pay
• Fair
• Efficient: cost are traded off against benefits
• If you benefit, but you don’t pay (all of) the bill,
you spend too much
688
Tax or borrow?

• Fair
you spend too much
• Expenditures aimed at present generation should be
financed through taxes
• “pay while you profit”
689
Tax or borrow?

• Fair
you spend too much
• Expenditures aimed at present generation should be
financed through taxes
• “pay while you profit”
• Expenditures that benefit future generations should
be financed through debt
• Future generation can repay debt while profiting 690
• Like in business, where interest and depreciation
are financed during the useful life of an asset
Tax or borrow?
2 Intergenerational equity
• Suppose we want future generations to be as well off
as we are
691
Tax or borrow?
2 Intergenerational equity
• Suppose we want future generations to be as well off
as we are
• If we expect them to be richer than us, why not
redistribute income towards our generation?
• → Borrow
• If we expect them to be poorer, do the reverse
• → Save
• If we don’t know, choose a neutral policy
• → Don’t borrow, don’t save
692
Tax or borrow?
3 Efficiency considerations
 Minimize excess burden

 Excess burden of taxation increases with square of
the tax rate

Many small taxes are better than on big tax
 Debt finance superior for big expenditure
693
Tax or borrow?
3 Efficiency considerations
 Minimize excess burden

 Excess burden of taxation increases with square of
the tax rate

Many small taxes are better than on big tax
 Debt finance superior for big expenditure

But: debt finance may reduce capital stock in the
private sector (crowding out)
 Inefficient allocation
 → additional welfare loss, depending on extent of
crowding out 694

Trade off both effects
Budgetary
Tax or borrow?
policy
4 Macroeconomic
considerations
• Up to now, we have assumed that the economy runs at
full capacity
• no unemployment, productive capacity fully used
• Taxes and deficits may be used to dampen the business
cycle (Keynes)
695
Budgetary
Tax or borrow?
policy
4 Macroeconomic
considerations
full capacity
cycle (Keynes)
• When unemployment is high, run a deficit
• increase spending, or lower taxes
• higher demand → less unemployment
696
Budgetary
Tax or borrow?
policy
4 Macroeconomic
considerations
full capacity
cycle (Keynes)
• When unemployment is high, run a deficit
• increase spending, or lower taxes
• higher demand → less unemployment
• When unemployment is low, reduce deficit
• deficit finance may now create inflation 697
• cut back government spending, or increase taxation
Budgetary
Tax or borrow?
policy
4 Macroeconomic
considerations
• Problems with Keynesian policy:
• It is very hard to get the timing right
• Economic data become available slowly
• It takes time to implement policy
• If the timing is wrong, the problem gets even
worse
698
Budgetary
Tax or borrow?
policy
4 Macroeconomic
considerations
• Spending and saving leaks:
• Extra spending may be abroad, not at home
• e.g., in China, if Dutch people buy new
television sets
• Lower taxation may result in extra saving, not
spending
699
Budgetary
Tax or borrow?
policy
4 Macroeconomic
considerations
• Spending and saving leaks
• Politicians will be happy to increase spending in
economic downturn, but reluctant to cut back later
• Asymmetry
• Debt has tendency to keep growing
• Interest payments tend to crowd out other
expenditures
700
Budgetary
Tax or borrow?
policy
4 Macroeconomic
considerations
• Keynesian “automatic pilot”
• Economic downturn:
• tax revenue falls automatically (less profits, wage)
• spending rises automatically (social security,
interest)
• Economic upturn: the reverse happens
701
Budgetary
Tax or borrow?
policy
4 Macroeconomic
considerations
• Keynesian “automatic pilot”
• Economic downturn:
• tax revenue falls automatically (less profits, wage)
• spending rises automatically (social security,
interest)
• Economic upturn: the reverse happens
• Automatic stabilizers:
• Don’t react to business cycle!
• Let deficit go up automatically in recession 702
• Let it go down automatically in upturn
Budgetary
Tax or borrow?
policy
4 Macroeconomic
considerations
• Automatic stabilizers
• Example: Dutch budget for 2010:
• Spending was not cut back, despite huge deficit
• If spending was reduced, crisis would only get worse
• Problem: debt increases rapidly; interest payments
explode
• How to get the genie back into the bottle?
703
Budgetary policy
Size
Budgetary policy in the Netherlands

“Keynesian” policy Deficit reduction Expenditure framework
4 80
2 70
60
0
50
-2
40
-4
30
-6
20
-8 10
-10 0
704

Debt (% of GDP)
Budgetary policy
 1950s-1970s
 Keynesian policy to stabilize business cycle
 Use automatic stabilizers
 If necessary: stimulate demand by running a
deficit
 Oil crises (1973; 1979) → structural crisis, not
cyclical
 Result: debt exploded
705
Budgetary policy
 1983-1994
 Deficit reduction at all cost
 Necessary because debt got out of hand
 interest payments exploded
 No matter if recession gets worse

 Massive unemployment
 But, finally: debt stabilized, deficit under control
706
Budgetary policy
Size
 Policy 1994-
 Each new government sets ceiling for expenditures
 Depends on expected revenues (according to CPB)
 For 4 years, not to be altered
 If revenues fall → deficit
 If revenues rise → surplus
 Deficits and surpluses should cancel out over time
707
Budgetary policy
Size
 Policy 1994-
 Each new government sets ceiling for expenditures
 Depends on expected revenues (according to CPB)
 For 4 years, not to be altered
 If revenues fall → deficit
 If revenues rise → surplus
 Deficits and surpluses should cancel out over time
 Exception: if deficit nears 3% GDP, cut back spending

 European Monetary Union requires deficit ≤ 3%
 Deficit 2012: deficit 4% > 3% 708
 → cutbacks
Budgetary policy
Size
Political economy
 Milton Friedman: higher taxes will not reduce debt

 Because they result in higher spending
 Government spends as much as possible
 Only limit = tolerable deficit
 Friedman: reduce taxes, to limit government growth

 “starve the beast”
 Example: US tax bill of December, 2017
709
Chapter 22
Multilevel government:
Why have different levels of government?
Who should do what?
How to finance lower levels of government?
710
Netherlands
• 1 central government
• 12 provinces
• 355 municipalities
• 21 water boards
711
Theory of community formation:
club model
• Formation of communities/jurisdictions
• 1 Aim
• 2 Optimal size
• 3 Optimal public good provision
712
Community formation: club model
• 1 Aim of a community:
• provide local ‘public’ goods to maximize citizens’
welfare
• often impure public goods or even private goods
• e.g., roads, police, schools
• it’s like a club
• after you join, you share in the costs and you
benefit from the services provided
713
• 2 Optimal community size

• More people:
• lower costs per citizen
• more congestion (impure public goods)
714
• 2 Optimal community size

• More people:
• lower costs per citizen
• more congestion (impure public goods)
• Increase community size until:
• marginal cost saving per citizen =
• marginal increase of congestion costs per citizen
715

• More public goods:
• more utility per citizen
• higher costs per citizen
716

• Increase public good provision until:
• marginal revenue per citizen =
• marginal cost per citizen
717

• Increase public good provision until:
• marginal revenue per citizen =
• marginal cost per citizen
• Problem: benefit of public good hard to find out

718
• Free rider problem
• No incentive to reveal true preferences
Tiebout model
• Public good: optimal level of provision unknown

• How to choose service level?
• Tiebout: market-like solution for public good problem

• Makes people reveal their true preferences
719
Tiebout model
• Many different communities

• Each offering its own package of public goods and taxes
• High service levels and high taxes
• or moderate, or low, or …
• Also different kinds of services
• Local public goods fully financed from local taxes
• You pay for what you get
• → no free riding possible!
720
Tiebout model
• People move to community that satisfies their

preferences
• They ‘vote with their feet’
• and form homogeneous communities
• same demand for public services
• similar income & preferences
• Therefore, the equilibrium is Pareto efficient
• People trade off costs versus benefits
• Central government intervention is not needed
• “market-like” solution to public good problem 721
Tiebout model: strong assumptions (1)
• No spillovers (public services are only for residents)

• Perfect mobility
• Perfect information
• Enough communities, catering to every taste
• Constant returns to scale
722
Tiebout model: strong assumptions (2)
• Tax payment = benefit from public services

• → public services financed by local taxation
• In practice, subnational governments usually get
grants from central government
723
Tiebout model and reality
• Assumptions clearly do not hold

• Tiebout never claimed they do!
• he wanted to show theoretical solution for public
good problem
724
Tiebout model and reality
• Assumptions clearly do not hold

• Tiebout never claimed they do!
• he wanted to show theoretical solution for public
good problem
• But: people do sort by income sometimes
• Dissatisfied? → two choices:
• Voice (vote)
• Exit (leave – Tiebout effect)
• Local government must take this into account
• At national level, exit is less of an option 725
Which government level should do what?
• Task assignment
• Three tasks of government:

• Income redistribution
• Macroeconomic stabilization
• Allocation of goods and services
726
Decentralization

• Task 1
• Income redistribution
• Mainly task of central government
• Otherwise, rich people will leave communities that
redistribute more than others
• Effect: not redistribution, but migration!
• Local government can run some modest anti-
poverty programs – no more
727
• Task 2
• Macroeconomic stabilization
• Dampen the business cycle
• Manage employment, inflation
• Central government’s task
• Subnational governments don’t have the instruments
728
• Task 3
• Allocation of goods and services
• Those that the market does not provide sufficiently
(public goods, merit goods)
• Mainly task for subnational governments

• Exception: national public goods like defense
• Why subnational provision? Five reasons for

decentralization 729
Why decentralize?
• 1 Tailoring services to local tastes

• Oates’ theorem
• Preferences differ across regions
• e.g., in religious communities, people don’t want
shops to open on Sundays
• city dwellers usually like to shop on Sundays
• Same policies/services everywhere → welfare not
maximized → decentralization
730
Why decentralize?
• Oates’ theorem
• More decentralization is optimal
• If preferences vary a lot between communities
• If preferences are relatively uniform within
communities
• If there are few spillovers
731
Why decentralize?
• 2 Efficiency of production
• Local government is closer to the people
• Knowledge of problems and possible solutions
• No need to send all that information to central
government..
• … and wait till they act
732
Why decentralize?
• Problem if there are economies of scale in some
services
• Decentralization → smaller scale
733
Why decentralize?
• Problem if there are economies of scale in some
services
• Decentralization → smaller scale
• Solution: separate provision and production
• Local government decides about service levels, and …
• … lets private firms take care of production
• contracting out
• firms work for many governments
• → large scale 734
Why decentralize?
• 3 Let governments compete (yardstick competition)

• Democracy: voter decides if government is re-elected
or not
• But if there is one government only (national):
• how can you know if they perform well?
• If things go bad, they may claim it was due to the
crisis or something
• Comparison with other countries is problematic
• Circumstances differ too much
735
Why decentralize?
• 3 Yardstick competition
• Many local governments:
• You can compare performance in same period
• Crisis affects all of them
• If you see better services / lower taxes elsewhere →
• → your local government may not perform well
• You can vote for a different party next time
736
Why decentralize?
• 3 Yardstick competition
• Politicians want to be re-elected
• If performance can be compared, politicians try harder
• If they don’t, you vote them away
• Empirical evidence → yardstick competition exists
• also in the Netherlands (Allers & Elhorst 2005)
737
Why decentralize?
• 4 More innovation and experimentation

• Local governments: policy laboratories
• If you don’t know if something will work, try it locally
• If it is a disaster, it is only a local disaster
• If it works, other localities can copy it
• yardstick competition makes sure they will
738
Why decentralize?
• 4 More innovation and experimentation

• Example: welfare in Netherlands
• Since 2004, local responsibility to help welfare
recipients find work
• Many different programs were tried
• Successful methods are copied
• Welfare dependency dropped significantly
739
Why decentralize?
• 5 Empowerment
• People have more influence on local government than
on central government
• Influence increases happiness
• Swiss study:
• people are happier in localities that have more
autonomy
• Frey and Stutzer (2000)
740
Spillovers
• Problem with decentralization

• Some public services affect nonresidents
• They use your roads, etc., but don’t pay tax
• Pollution may harm other localities
741
Spillovers
• Problem with decentralization

• Some public services affect nonresidents
• They use your roads, etc., but don’t pay tax
• Pollution may harm other localities
• Efficient allocation requires:
• All costs traded of against all benefits
• With spillovers, costs / benefits to nonresidents not
taken into account
• Service provision may be inefficiently low
742
Spillovers
• Ideal:
• Jurisdiction = area covered by public services
• But: different area for every service
• Separate jurisdiction for every service impossible
743
Spillovers
• Ideal:
• Jurisdiction = area covered by public services
• But: different area for every service
• Separate jurisdiction for every service impossible
• Solution: pigouvian subsidy (or tax)
• Central government gives municipality subsidy
• … for services with positive spillovers
• Hard to do in practice – spillovers difficult to
measure
744
Financing decentralized governments
Theory (1)
• Optimal allocation:
• marginal benefit of service = marginal cost (tax)
• Decision should be made by the same people who
benefit and who pay
• Like in the market sector
• If you decide and benefit, while others pay …
• … service levels will be too high
• “No shopping with someone else’s wallet”
745
Theory (2)
• Local governments should be financed by local taxes

• Exception: tasks performed for the central government
• Local government acts as agent of central
government
• Central governments decides → should also pay
• Finance through intergovernmental grants
746
Theory (3)
• But: scope for local taxation is limited
• Tax competition
• Local income redistribution difficult
• Central government needs taxation for fiscal policy
• Central tax administration is more efficient
747
Theory (3)
• But: scope for local taxation is limited
• Tax competition
• Local income redistribution difficult
• Central government needs taxation for fiscal policy
• Central tax administration is more efficient
• → central government levies most tax
• ‘fiscal imbalance’
• Solution: grants from central to local governments
748
Practice
• Local governments in The Netherlands:
• Own taxes 9%
• User charges 7%
• Unconditional grants 48%
• Conditional grants 11%
• Other 25%
• Tax share very low - contrary to theory’s prescription
• Share of grants very high
749
Intergovernmental grants
• Why grants?
• Taxation is mostly at central level
• Grants needed to transfer money
• Addressing spillovers (at least, in theory)
• Paternalism
• Fiscal equalization
• equity
• enable all subnational governments to supply
basic services at moderate tax rates
750
Fiscal equalization
• Some local governments need more money than

others
• Production costs may be higher
• Some have more “clients” of government services
• more children → more schools needed
• Some local governments can raise more tax than
others
• Large tax base →
• high revenue with moderate tax rate
751
Fiscal equalization
• Goal Netherlands:
• All subnational governments can supply equivalent
service level at average tax rates
• Equivalent, not identical
• Want more services? Raise more tax revenue!
• Method:
• equalization grant
• Allocation formula containing about 60 (!) variables
752
Types of intergovernmental grants
• Conditional grants
• Cannot be spent freely
• earmarked for, e.g., schools, welfare, …
• Unconditional grants
• Decentralized government is free to spend
753
Types of intergovernmental grants
• Conditional grants
• Nonmatching grant
• amount independent of own spending
• Matching grant
• percentage of own spending
• Open-ended: available amount is not limited
• Closed-ended: maximum amount
754
Framework for grant analysis
• Median voter decides

• Available money spent on:
• public goods
• private consumption
755
• Median voter decides

• Available money spent on:
• public goods
• private consumption
• Grants →
• increase expenditures of local governments, or
• increase private consumption
• through lower local taxation
• Different grants, different effects 756
Private No grant
consumption
(c)
c1 E1
757
G1 B
Units of public good (G)
Private Grant changes budget line

consumption • matching grant: different slope
(c)
• because relative price change
A
c1 E1
758
G1 B
Private Grant changes budget line

consumption • matching grant: different slope
(c)
• nonmatching grant: parallel shift
A • relative price unchanged
c1 E1
759
G1 B
Conditional grants (1)
Matching grant (open-ended)
• Grant lowers price of public good

Private
consumption • Income effect and substitution effect
(c) • Here: more public goods and more
private consumption!
A
• even though it is a conditional grant,
• part of grant used for lowering taxes!
E2
c2
c1 E1
760
G1 G2 B R
Matching grant (closed-ended)
• Maximum to grant
Private
consumption • New budget line kinked: ADF
(c) • In this case: more public goods, but
less than with open-ended grant
A • Depends on indifference curves
E3
c3 D
c1
E1
761
G1 G3 B F R
Units of public good
Nonmatching grant
• Lump-sum grant
Private • Same slope budget line
consumption • JH not part of budget line
(c) J • New budget line kinked: AHM
A H • Here: more public goods and more
private consumption
• Depends on indifference curves
c4 E4
c1 E1
Similar to in-kind
transfers! (Ch. 12)
762
G1 G2 B M
Unconditional grants
• Lump-sum grant
• JH now part of budget line
Private • New budget line: JM
consumption • Here: same effect as nonmatching conditional
(c) J grant
• JH-part not chosen
A H • Depends on indifference curves
c4 E4
c1 E1
763
G1 G2 B M
The flypaper effect
764
The flypaper effect
• Unconditional grant →
Private outward shift of budget line
consumption • Same as increase in private
(c)
income
• Effect should be the same,
according to median voter
theory
E4
E1
765
Flypaper Units of public good

The flypaper effect
• Empirical studies (e.g., Allers & Vermeulen 2016):

• grant up → government spending increases a lot
• private income up → only some more
government spending
• “Money sticks where it hits”
766
Flypaper
The flypaper effect
• Empirical studies (e.g., Allers & Vermeulen 2016):

• grant up → government spending increases a lot
• private income up → only some more government
spending
• “Money sticks where it hits”
• Why? Uncertain.
• Bureaucrats may hide the grants from voters
• Allers & Vermeulen: this cannot explain flypaper
effect in Netherlands
• “Mental accounting”
767
• some kinds of money are spent easier then
Flypaperothers
Property tax: incidence
• Local governments often use property tax

• % of value of real estate (houses, favctories, …)
• Who pays the property tax? Different views

• (1) Traditional view: tax on land and tax on buildings
• Partial equilibrium analysis as in Ch 14
• Tax on land falls on landowner at the time the tax
was introduced
• Tax on buildings: incidence depends on elasticity of
supply and demand 768
Property tax: (2) New view
• New view: other markets cannot be ignored
• General equilibrium analysis
• Make distinction between
• average tax rate
• existence of property tax
• local differences
• fact that tax rate differs
769
• Average tax rate: like a national tax

• General factor tax on capital
• Short run:
• capital supply fixed
• → capital owners bear full burden
• property tax is progressive
• Long run:
• supply of capital may decrease
• → labor will be less productive
• → wages will fall 770
• Regional differences from average tax rate

• After-tax rate of return falls most in high-tax area’s
• Capital will move to low-tax area’s
• Until after-tax rate of return is the same everywhere
• → Net rate of return on capital falls everywhere
771
Property tax: view 3
• (3) Property tax as user fee

• Tax revenue is not lost to taxpayer
• It is used for public services
• It is not really a tax
• but a user fee for services
• Benefit view
772
Property tax: view 3
• Property tax as user fee

• House value will:
• Go down because of property tax
• by present value of future tax payments
• Go up because of services financed by tax
• by present value of future services
• even if you don’t value public services yourself!
• because you can sell your house to people who do
• Net effect may be positive or negative
• good government → positive effect 773
• When does which view apply?

• Tax change in one community:
• Effect on rest of economy is small
• → traditional view
774

• Change in all communities
• E.g., eliminating the property tax altogether
• General equilibrium is needed
• → new view
775

• Change in all communities
• E.g., eliminating the property tax altogether
• General equilibrium is needed
• → new view
• Joint change in property tax and service levels
• → user fee view 776
Last lecture: on demand
January 6
All remaining questions will be answered
About book, lectures, and tutorials
Email me your questions, so I can organize them

• Friday, January 3 at the latest
• No questions, no lecture….
Tutorials end this week

• No tutorials in January 777

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Public Finance

• Chapter 3: Welfare economics

• Chapter 4: Public goods

Government: An important sector

Government affects private sector

• How does the government affect the economy?

• How does the government affect the economy?

• Tax or borrow – is debt bad?

• Why won’t politicians always listen to your advice? 9

• We apply tools of analysis from:

Student Portal / Nestor:

• Forthcoming: previous exam (questions + answers)

 Cover main points from the book

 Cover some issues which are not in the book

• Tutorials: exercises and questions (see Nestor)

• Here is your chance:

• If you come, I expect you to participate

• Answers to tutorial questions will not available on Student

Trip to The Hague

• Netherlands Bureau for Economic Policy Analysis (CPB)

• Exam is about book & lectures

How to get a good grade (1)

• Work efficiently: Read the relevant chapters before

How to get a good grade (2)

• Don’t underestimate Rosen & Gayer

How to get a good grade (3)

• Close the book after every few pages

How to get a good grade (4)

• Just reading the book won’t do you much good

What role for government?

Welfare economics: basic question

• Why do we need them?

Welfare economics: basic question

• So the question is: When will markets produce desirable

Welfare economics: Basic concepts

• Both are important

Two kinds of efficiency

• 1 Technical efficiency (production)

• This is not what concerns us in welfare economics

Two kinds of efficiency

• What does “optimal” mean?

Two kinds of efficiency

First: exchange economy

No production - fixed supply of goods (by nature)

Question: How are goods allocated?

Edgeworth Box: allocation

Adam Apples per year

Edgeworth Box: allocation

Adam Apples per year

Edgeworth Box: indifference curves

a Adam’s indifference curves

Adam Apples per year

Edgeworth Box: indifference curves

Adam Apples per year

Edgeworth Box: Pareto efficiency

Adam Apples per year

Allocations b, c and d are Pareto efficient: 35

Pareto Efficiency if MRSAdam = MRSEve

Pareto Efficiency if MRSAdam = MRSEve

Now: production economy

 Now look at production

Production possibilities curve (PPC)

Depends on production technology