In the final Topic of in this Lesson we address the problem of how governments
should spend tax payers' money and how they should acquire that tax revenue.
There are three broad reasons why governments need to raise and spend tax
revenue. First, a legislative process has to be paid for through appropriate
compensation for the work of elected politicians and the employed workers that
are needed to help them determine and carry out decisions that represent, as
best as can be established, the will of the community. These decisions are
necessary to ensure that an appropriate institutional framework is constructed
and maintained within which private sector activities can efficiently function.
An essential component of this expenditure pays for a legal structure which
ensures that individual citizens, and organizations they create, adhere to
rules necessary for proper functioning of these institutions. The second
broad reason is the existence of externalities that arise because individuals,
in many areas, do not receive and pay some of the social benefits and costs of
their actions. Funds have to be raised and spent to bring, as far as possible,
these individual costs and benefits into line with their social counterparts.
A third reason is that, even if social institutions function perfectly, the
community as a whole may be unhappy with the distribution of wealth and income
among its citizens and may want to redistribute income from one part of the
community to another.
An obvious requirement for government taxes and expenditure is the
maintenance of a police force. While private police forces can ensure that
the individual rights of the people that hire them are maintained, their focus
is entirely on the interests of those individuals and only indirectly on, and
possibly even against, the interests of the community at large.
Another classic role for government is the provision of fire protection of
property---were fire protection provided by a private market, individuals
whose property must automatically be protected by fire fighters as part of
their protection of a neighboring property will have an incentive to free ride
off their neighbor's fire-protection expenditure. But the best example of
a complete externality is the provision of national defence. Everyone in the
community benefits from the protection provided by the national armed forces,
completely independently of the amount any particular individual spends on the
provision of those services. And the armed services must be entirely controlled
by a representative government to avoid any possibility of a military
dictatorship.
While government-imposed regulations can eliminate some externalities, the best
practice in a free market economy is for the government to impose a tax or
subsidy on the provision of the services to which the externality is attached.
The standard example is toxic chemicals emitted in the process of producing
an otherwise valuable commodity. The authorities can simply impose a tax on
the output of that commodity sufficient to reduce that output to the point where
the marginal social benefit from another unit of production---normally the market
price---just equals the marginal social cost of that unit, where the marginal
social cost is the sum of the marginal private cost to the producers plus the
social cost of the damage resulting from its production.
Another externality arises with respect to the provision of roads. For the
private sector to produce and manage a road system, the firms constructing and
managing roads would have to obtain ownership of the land on which the roads
are to be constructed and then, once a road is built, be able to impose tolls to
earn revenues sufficient to cover its cost. It turns out that only in the case
of major roads can the revenues from such tolls sufficiently exceed the costs
of collecting them. And the acquisition of rights to build roads requires, in
many cases, the legal powers that can only be invested in government. It is
thus not surprising that almost all roads are built and owned by the community
at large through the actions of government.
Since all members of the community benefit by having the people they have to
interact with able to read and write and in possession of some minimum degree of
knowledge about a wide range of issues, the acquisition of education by every
individual yields external benefits to other people. Were the provision
elementary and secondary education arranged and paid for entirely by the
individuals acquiring it, those individuals would have no incentive to take into
account these benefits to others beyond themselves. The common way of dealing
with these externalities is for the government to provide elementary and secondary
schools and force all young people to attend them. An alternative is for the
government to provide every school-age individual with a voucher that must be
spent to obtain attendance at a privately owned and operated school. This has
the advantage that the private schools' survival will depend upon them offering
the education that the students' parents want, forcing the school teachers and
administrators to maximize the parents' utility rather than simply their own.
Of course, since not all parents will have the understanding and ability to impose
the necessary conditions on the private educators, the government most surely will
have to impose regulations which would most likely include independently set and
marked common examinations which all students would be required to take. There
are a number of problems with this alternative approach. First, it may allow
religious and ethnic groups to induce the incorporation of socially divisive
elements into the education of certain groups of children. Second, it may
lead to a hierarchical ordering of schools by student ability so that students
of poor ability may have no opportunity to be educated along with those of
greater ability---this would follow from the fact that many parents will
try to get their children into the most educationally rigorous environment
possible. Nevertheless, of course, it may be viewed by some educational experts
as more effective to educate students in conjunction with others of similar rather
than differing levels of academic ability. Finally, it might be argued that
any efficiency and motivational gains that could be attained by a system of
government-voucher-financed private schools could also be obtained within a
purely public school system by simply imposing independently set and graded
common examinations within that system---being forced to get one's students to
a level where they do better on a common exam may be a more appropriate
motivational tool than the profit motive.
Health care is a government regulatory nightmare. Setting aside issues involved
in disease prevention, it turns out that in a free-market health care system in
which government is not involved there are virtually no externalities. Those
paying for medical advice and treatment from doctors and for hospital care
impose no significant external costs on other individuals or provide them with
significant external benefits. A free-market system will thus work wonderfully
except for one problem: Really poor
people will have insufficient income to afford treatment for even minor medical
problems and, on frequent occasions, middle and even some upper income individuals
faced with serious medical conditions will exhaust their wealth before death
claims them. These problems for middle and upper individuals can often be avoided
by purchasing medical insurance although, in an unregulated market, this would be
impossible when specific future medical conditions can be identified in advance.
And, of course, the really poor may not be able to afford medical insurance. As
countries became richer and medical care became more effective, and costly, people
became unwilling to watch others die for loss of treatment---especially given an
inability to suppress the thought that it could happen to them. An attempt by
the government to require that everyone buy medial insurance encounters the
problem that very poor people and rich people with known or highly probable medical
conditions will not be able to afford it, and private insurance companies cannot
provide insurance at less than its cost. It is thus inevitable that governments
are required to pay for the provision of some minimal level of medical care to
anyone who cannot afford to pay their own way. In some countries, the government
deals with these problems by financing medical care for everyone in the community,
with the costs being paid out of taxes. Immediately, externalities arise.
The authorities have to regulate the fees charged by doctors and hospitals because
those individuals and institutions have every incentive to set those fees as high
as possible. Then what is to stop doctors from scheduling unnecessary future
appointments for their patients in order to increase their income? And what is
to stop patients from arranging unnecessary visits to doctors? (The British system
of making every person have a doctor and then paying doctors a salary for
each patient on their list suffers from the fact that it weakens the incentive
for doctors to provide really good service.) Then there is
the willingness of many families to spend millions of dollars of public money to
keep grandma alive for another week---the decision to pull the plug can no longer
be an entirely private decision, raising ethical issues that have to be agreed
upon by the community as a whole. Since there are no natural limits on monetary
costs, the rationing mechanism for such medical care systems is increased waiting
times which, it always turns out, will be surmounted by those having important
personal within-system contacts or political influence. Important pressures
thereby arise to permit individuals to purchase medical care directly or by taking
out private insurance, thereby creating a two-tier system. Given the pressure on
politicians to finance additional programs elsewhere in the economy, they have a
political incentive to scrimp on the provision of public medical care, thereby
further increasing waiting times and expanding private-tier provision and reducing
the quantity and quality of service to the poorer members of the community. How
should these issues be best dealt with? No one really knows!
We now turn to the question as to the appropriate ways governments can raise the
tax revenue to finance their expenditures. Policies of taxing the outputs of
particular products to appropriately reduce associated negative externalities will
raise revenue for subsequent expenditure. An obvious use of this revenue would be to
appropriately subsidize any products whose outputs generate positive externalities.
Any balance of such revenues can go to finance other government activities.
In general it would seem reasonable to impose the taxes required to finance government
policies on the individuals who benefit from such policies. For example, taxes on
gasoline and diesel fuel can essentially charge users of roads for the costs of their
construction and maintenance. Property taxes can also be used to charge beneficiaries
of sidewalks that service those properties and lawns and trees that beautify the
roadsides. Property taxes might also be a good way to finance government expenditures
on fire protection. While police protection also benefits property owners, it also
services the community more generally and would seem to be best paid for by more
general widely applied tax policies. The same applies to financing the public
school system. Medicare could be reasonably financed by flat premiums charged to
all individuals covered, although adjustments would have to be made, or other methods
used to enable the very poor segment of the community to cope with these costs.
There are essentially two main types of broad-based taxes that can be used to finance
the wide range of government expenditures that benefit large and diverse segments of
the community. These are income taxes and either generalized sales or value-added
taxes. Income taxes generally tax away some fraction of each persons income. They
can be designed to garner the same fraction of everyone's income or, alternatively, to
take a fraction of the income that increases with the person's income level.
Generalized sales taxes or equivalent value-added taxes, normally denoted by the
respective terms GST and VAT, tax the values of the outputs of a wide range of goods
produced and sold in the economy. Generalized sales taxes are imposed on the selling
prices of final products, with all intermediate products entering into their production
being exempt, while value-added taxes are imposed on the value added at each stage of
the final good's production process with each firm involved in that process being
taxed according to the value it contributes to the final selling price. These two
taxes differ primarily in the method by which they are collected with the total tax
taken as a percentage of the final selling price charged consumers being essentially
the same.
To analyse the effects on the economy of these alternative types of broad-based taxes,
it is necessary to think in terms of the underlying process of economic growth. The
full-employment level of output can be expressed in terms of the following proportional
relationship between output and the economy's capital stock, broadly defined to include
human capital, technology, and knowledge as well as the usual forms of physical
capital.
1. X = (m − δ) K
where X is the level of output, m is the output flow per unit
of aggregate capital stock, δ is the rate of depreciation of
capital and K is the aggregate capital stock. The level of m
will depend on how efficiently aggregate capital holdings are divided into the
various types of capital and on how efficiently those capital resources are used
to produce output---it will achieve its maximum value under conditions of perfect
efficiency. One condition of efficiency will be the extent to which the governmental
process establishes an appropriate legal structure, correctly regulates the private
sector and produces publicly those goods and services which government can produce more
effectively than can the private sector. Suppose that a resulting level
of m becomes established. Given the rate of depreciation, this implies
a specific level of aggregate output. Aggregate income will typically differ from
aggregate output to some degree as a result of the fact that some of the domestically
employed capital stock may be owned by foreigners and domestic residents may own
some capital stock employed in the rest of the world.
It is reasonable to assume that domestic residents will take the future into account
when making each period's aggregate consumption, saving and investment conditions,
maximizing a utility function that can be represented in the following inter-temporally
additive form
2. U = U(Ct ) +
[1/(1 + ρ)] U(Ct+1) +
[1/(1 + ρ)] 2 U(Ct+2) +
[1/(1 + ρ)] 3 U(Ct+3) +
[1/(1 + ρ)] 4 U(Ct+4) +
...............................
where U is the level of utility in the beginning period,
U(Ct+i ) is the utility received in year t+i
and ρ is the rate of time preference. Equation 2 gives the present
value of all future years' utility from consumption. While this particular
form of the inter-temporal utility function is adopted for simplicity, it
nevertheless contains all the necessary attributes for the discussion that follows.
Given the interest rate determined in the world at large, individuals will
allocate consumption through time so that there is zero gain from shifting a unit
of consumption between any two adjacent periods. This implies that the marginal
utility of the last unit of consumption in any period be equal to the present
value of the utility that would be received by shifting that unit of consumption
to the next period.
3. U′(Ct ) dCt =
[1/(1 + ρ)] U′(Ct+1) (1 + r) dCt
where U′(Ct ) is the increase in utility that would
result from increasing consumption in that year by dCt. The
term on the left side of the equality thus gives the change in current utility
associated with a tiny change in consumption in that year. The
term (1 + r) dCt gives the increase
in next-period consumption that could be obtained by investing the
amount dCt for one year at the interest rate r and
then consuming the result. The collection of terms
U′(Ct+1) (1 + r) dCt gives
the amount of utility that will thereby be obtained next year, and the term
1/(1 + ρ) discounts that future utility back to the current year.
Equation 3 can be expanded by multiplying the (1 + r) term by
(1 - τ) where τ is an implicit tax, which could be
positive or negative, on savings---that is, on future consumption---imposed indirectly
by government policy. This tax reduces (or if negative, increases) the amount of
next-period consumption that can be obtained from foregoing dCt
units of current consumption.
4. U′(Ct ) dCt =
[1/(1 + ρ)] U′(Ct+1) (1 + r) (1
− τ) dCt .
Dividing both sides of the above equation by dCt and
rearranging the terms yields
5. U′(Ct ) / U′(Ct+1 )
= (1 + r) (1 − τ) / (1 + ρ) .
If there is diminishing marginal utility in each period, the ratio of marginal
utilities to the left of the equality is directly related to the rate of growth
of consumption---if consumption increases between this year and next, the marginal
utility of consumption will be lower next year that it is this year. The marginal
utility of consumption this year divided by the marginal utility of consumption
next year will thus be positively related to the rate of income growth. Moreover,
if r , τ and ρ are constant through time,
the growth rate of income will be constant through time.
Suppose now that the government finances a broad range of expenditures by the
imposition of a tax that takes a fixed percentage of everyone's income independently
of the level of that income. Since income is taxed independently of whether it
is spent on consumption or saved, this tax will not distort the communities choice
between present and future consumption---apart from other possible distortions,
τ will be zero and the rate of growth of income in the economy will
be unaffected. Of course, the tax will affect peoples' choices between work and
leisure but the equivalent free provision of goods and services by the government
will tend to offset this effect. Alternatively, suppose that the government taxes
away a percentage of income that increases with the level of the person's income.
This will mean that future income will be taxed more heavily than current income and
people will have less incentive to save--- τ will become positive,
reducing the growth rate of the economy. Everyone in the bottom half of the income
distribution will have an incentive to vote for this progressive income tax and, if
the rich care about the suffering of the poor, at least some people in the top half
of the income distribution will also vote for it.
An alternative approach is to impose a flat-rate GST or VAT on all goods sold in the
economy. This is equivalent to a tax on income except for the fact that savings
channeled into government bonds will not be taxed and savings channeled into into
shares in private corporations may not be taxed unless the tax is imposed on the
production of all capital goods and services purchased by corporations. To the
extent that savings are not taxed, there will be an increased incentive to accumulate
capital, resulting in a reduction in τ and an increase in the economy's
growth rate. It would be possible, though a very difficult undertaking, to combine
this tax with an income tax that is just sufficient progressive to offset any
positive effect of this tax on economic growth.
In this respect, one might argue that the main reason to vary income tax rates with
income is to avoid taxing away the incomes of the very poor members of the community,
rather than to tax the very rich relative to the middle class or the richer individuals
in both of these groups relative to those who are less rich. A way to accomplish
this would be to levy a proportional income tax but allow the very poor to claim
a negative tax---that is a topping up of their income. While this would give the
poorest in the community some incentive to work less, this negative work-incentive
would be no bigger than would result from giving poor people welfare benefits,
in excess of any income earned, sufficient to bring their incomes to some minimal
level. And a negative income tax would probably also be cheaper to administer than
a social welfare system.
Now what about corporate income taxes? To the extent that these taxes fall on
income that is paid out in dividends, they involve double taxation when combined
with taxes falling on income. This will create an incentive to consume rather than
save, increasing τ and reducing the growth rate. Taxation of
dividends, or of people's income in general, will also create an incentive for
corporations to reinvest earnings rather than pay them out in dividends, thereby
channeling the income into future capital gains. Under these conditions, social
efficiency requires that capital gains be taxed appropriately. One way around this
problem would be to tax any income of corporations that is not paid out in
dividends---this will avoid double-taxation of dividend income while at the same time
taxing any income channeled into capital investment that will yield capital gains,
making a separate a capital gains tax unnecessary. Another way would be to
appropriately tax corporations on all their income while allowing people paying
income tax to deduct from their income any dividends that have been received.
More generally, what is needed is an appropriate blend of goods and service or
value added taxes, personal income taxes and possibly corporate income taxes as
well, to produce an efficient overall tax structure, taking into account the
community's income distribution objectives, that creates minimal distortion of
people's choices between consumption and saving and, of course, also leads to
the efficient mix of goods being produced.
Finally, it is time for our last test. Please think up your own answers before
looking at the ones provided.
Government Expenditure Policy
Tax Policy