Public Finance - lecture notes
Econ 132 3-5:45 code: 23524, 3 units 1/23-5/13 DMH 160
Notes will be on the class web site.
1. Public finance and the pure free market
Public finance is a subset of public economics.
Public economics: the economics of collective action.
Includes the fields of social philosophy, regulation, law and economics, policy studies, governance, federalism, social choice, public choice, public finance, constitutional economics.
“Public” means either people or government.
Public finance is the revenue, spending, and budgeting of governments and clubs.
A club is a voluntary collective organization.
A government is an organization that imposes rules on a domain.
The domain includes territory and people.
The basic framework: the pure free market, and how government changes the outcomes.
Like in physics, the inclined plane.
There is no ideological implication in analyzing the features of a pure free market.
What is freedom?
The absence of legal restrictions or imposed costs on peaceful and honest human action.
In a pure free market, all activity is voluntary for everyone.
Violations of property rights are outside the pure market.
E.g. would there be much or little pollution?
What would be the public finance of a government in a pure free market.
All public revenue would have to be voluntary.
User fees for benefits received. Parking meters, tuition.
Penalties or compensation for inflicting harm to others such as by polluting.
Payments for the use of property that belongs to the public.
What is the moral basis of the ownership of property.
Begin with self-ownership.
Extends to labor and the products of labor.
To the creator belongs the creation.
What about property not created by human action: land?
Two alternative rules:
Homesteading: unclaimed property may be occupied and then owned..
Equal-benefit: the rent of the property belongs to the members of a community in equal shares.
In the egalitarian rule, public revenue from land rent is a voluntary source of public revenue.
It is not a redistribution but the proper initial distribution.
In the homesteading rule, rent belongs to the title holder; its taxation is coercive.
What of government spending?
A pure free market has no subsidies.
But beneficial government services increase land rent and land value if they are not paid for with user fees, and possibly even when user fees pay for it.
Therefore in the pure market, all civic services are either provided by private enterprise,
or if provided by government, paid for by assessments on the site value.
Thus with the homesteading rule, there cannot be any government services.
It has to be individualist anarchism.
With the egalitarian rule, there can be government spending.
There can also be an egalitarian anarchism.
2. Taxation and the social surplus
A surplus is a gain greater than costs.
Costs include all opportunity costs.
If the surplus is in money or goods, then it is the same as an economic profit.
The consumer surplus equals the maximum one would pay minus the actual payment.
The “producer” surplus equals the price minus the marginal costs of production.
The benefit from an economy consists of the totality of the surpluses.
There is also a separate worker surplus from labor, and a taxpayer surplus from government.
The “social surplus” is the sum of the consumer and “producer” surplus.
In atomistic and monopolistic competition, with many small firms. economic profit is zero.
But a producer surplus is an economic profit.
To whom does it go?
Not to the owners of firms, who get zero profit.
It must flow down to the factors which provide the inputs.
But if labor is competitive, the surplus does not go to higher wages.
If capital goods are competitive, the surplus does not go to those producers.
The only factor left is land.
The surplus goes to the owners of land as rent.
Unlike labor and capital goods, there is no entry into the land market to expand land.
But landowners have not produced land.
In that role, they only collect rent due to their legal titles.
They are non-producers.
So the surplus should be called a non-producer surplus.
A sales tax imposed on sellers shifts up the supply curve.
This reduces the quantity sold and produced,
and raises the price.
This also reduces the social surplus.
Some of the surplus pays the tax.
But some is wasted as resources not allocated to their most productive use.
This is called a deadweight loss, or excess burden of taxation.
The effect is the same whether the tax is levied on the seller or buyer.
The effect is the same with a tax on incomes or value added.
Economists have estimated the deadweight loss at about $1.5 trillion,
measured for one year’s loss.
But the economy would have grown faster without the drag of deadweight losses,
so the loss due to lost growth is greater than today’s GDP.
If the consumer surplus equals the producer surplus before the tax,
and if land rent is 20% of GDP, then
60% of the tax is at the expense of rent, and 40% at the expense of wages.
A direct tax on rent would provide the same funds without a deadweight loss.
The economics of taxation
Taxation can be in form and in substance.
Taxation in form is a forced payment of income or wealth from individuals and organizations to the state, or a subtraction of wealth due to government policy, not due to any violations by the payer.
A fine is not a tax.
True users fees are voluntary and not taxes.
A tax in substance is a compulsory payment to a government unrelated to any direct penalty, voluntary service, or debt.
For example, sales and income taxes are taxes in form.
A tax in substance is an arbitrary liability or loss imposed by government.
A tax can be implicit, not necessarily an explicit payment to government.
For example, monetary inflation is a type of tax.
When the monetary authority expands the money supply by a greater amount than the growth in the demand to hold money, this causes price inflation.
It is in effect a tax on money holdings such as currency and checking accounts.
Some governments use high inflation as a deliberate tax. E.g. Zimbabwe today.
The expansion of the money supply cannot make a country richer.
Its effect is to raise prices relative to the case if the money supply were not expanded.
When inflation is expected, the nominal interest rate can make up for the inflation,
but income taxes on nominal gains can eliminate the gain and create a loss.
Unexpectedly higher inflation taxes lenders and benefits borrowers,
as the rates were set before inflation changed.
If prices rise more than wages, employers gain at the expense of employees.
Inflation also imposes costs on the economy, such as for changing prices,
and the distortion of relative prices as prices rise first where money is loaned out.
The burden of taxation is called the “incidence”.
Those who ultimately bear the burden of a tax are often not those who pay the government.
Incidence depends on the size of the tax and on the elasticity.
If the firm is a global price taker, the tax increases cost and cuts into profit.
No DWL if the tax is a property payment,
compensation for damage, or income that belongs to others, or payment for use.
What is the ultimate incidence of government borrowing?
If the borrowing is domestic, the economy has no increase in assets or spending power.
The purchase of government bonds transfers wealth from individuals to government.
Wealth is transferred from some of the people to those who benefit from government spending.
The greater government spending is offset by less private spending, just as with taxation.
The incidence of government borrowing depends on what the funds are used for,
and where the funds come from.
Suppose government borrows from domestic lenders to finance a war.
Resources spent for war diminish resources for civilian goods at the present time.
Government borrowing competes with private borrowing and bids up the interest rate.
If the borrowing is at the expense of consumption, there is no future burden.
But those who buy bonds are usually those who would have bought corporate bonds or stocks.
With more government borrowing, there is less investment in capital goods.
There is less future economic growth.
Future generation are less wealthy, but that could be offset by their not having been invaded.
The incidence on future generations is not the interest they pay but the sacrifice of not having invested in capital goods and human capital instead.
If the government sells bonds to foreigners, then in the future,
they will receive interest from the government.
Future generations will have less income and wealth,
although they may be better of from not being invaded.
If the bonds have to be paid back by a particular date,
then the reduction in future income will be limited to that time.
There is therefore less economic damage if a war is financed from taxation than from domestic borrowing.
The taxes reduce present-day consumption more than it reduces investment.
Taxation is less damaging to economic growth.
Borrowing from abroad will diminish present-day civilian goods just as much as taxation,
by bidding up prices, or the reduction in productivity if resources are drafted.
It is less damaging for the economy for the state to finance a war from taxation rather than price controls and drafts.
Most of the tax would be at the expense of rent, by reducing the profitability of land, and from taxing some of the rent.
What is the incidence of taxes on commodities?
Taxes on commodities go back to ancient times.
The British taxes the commodities bought in the American colonies.
The U.S. federal government has levied excise taxes since the adoption of the Constitution.
Federal excise taxes are included in the price of goods and not noticed by most buyers.
Examples: tires, gasoline and other fuels, alcohol, tobacco, and airline tickets.
There is a federal excise tax of 7.5 percent of the airline ticket, plus fees.
Airline passengers pay the federal government $3.20 for every flight, called a "segment fee." Passengers also pay a federal security fee of $2.50 for every flight, up to $10 for a round-trip. Airports charge per-passenger fees up to $4.50 per boarding to pay for terminals and runways.
There is a combined average of 47 percent federal/state/local taxes on the average pack of cigarettes, and 55 percent in combined taxes on a 750 ml bottle of liquor, and an average 38.37 percent in combined taxes on a gallon of gasoline!
The Current Federal Cigarette Tax Rate is 39c per pack. California’s tax per pack is 87c.
The Federal excise tax on beer amounts to about a nickel per drink, a bit less than seven percent of the average price of a six-pack. California adds 20c per gallon. Plus sales tax.
Over 40 percent of the cost of a bottle of beer is for taxes, including excise taxes.
There is a 18.4 cents-a-gallon federal gasoline tax, and an 18 cent California tax.
Why tax commodities?
The tax is hidden, and taxing many different goods spreads out the total burden and makes it more difficult to compute.
What is the incidence of taxes on commodities competitively produced?
Consider first goods with a constant cost, a completely elastic supply.
The price is raised by the amount of the tax.
Such a tax is shifted entirely to the buyers, the consumers.
There is no producer surplus or non-producer surplus.
The deadweight loss is entirely at the expense of the consumer surplus.
The factor incidence depends on the distribution of income among the factors.
Commodity taxation and the general price level.
Taxes do not affect the general price level.
The price level is determined by the totality of goods and the amount of money.
The price level is such that enables people to buy all the goods.
The rise in price of some goods implies a fall in price of other goods.
If the after-tax price of taxed goods rises, then the prices of non-taxed items falls.
If there is a uniform tax rate on all goods and services, then
people have that much less after-tax income by which to demand goods.
The incidence would be on all incomes and consumers.
Now consider goods with increasing marginal costs.
A tax on commodities is partly shifted to consumers, and partly shifted to the factors.
In the long run, labor and capital goods in any particular industry have constant costs.
So in the long run, increasing costs imply decreasing productivity,
due to differences in locational advantages.
If labor and capital goods are competitive, then the factor part falls on land rent.
If the industry has decreasing marginal costs, or economies of scale, then
The tax reduces the quantity, and raises the average cost.
The price would rise by more than the tax.
Now consider taxes on commodities monopolistically produced.
The marginal cost is shifted up by the amount of the tax,
reducing the quantity and increasing the price,
creating a greater deadweight loss.
A lump-sum tax is a fixed payment regardless of income, wealth, or spending.
Clubs often have lump-sum dues.
A lump-sum tax on the net economic profits of a monopoly
does not affect its marginal costs or demand,
so it does not change output or the price.
The incidence is entirely on the monopolist.
The incidence of taxes on wages.
If one type of labor is taxed, after-tax wages would equalize in the long run.
The wages of other industries would fall as the gross wage of taxed labor rises.
Labor would shift out of the taxed industry to the untaxed industry.
So the tax would be distributed among labor in general.
What is the incidence of compulsory insurance of labor?
The incidence is on wages, as the tax is in effect a tax on wages.
If all wages are taxed, this makes goods more expensive and leisure less expensive.
If workers prefer more leisure,
his shifts up the cost of labor.
Less labor is employed, the cost of hiring labor being higher,
while after-tax wages fall,
and there is a deadweight loss of less output and employment.
The incidence is partly on wages and partly on consumers
with both higher prices and fewer goods.
If workers instead reduce leisure and work the same hours,
the incidence is all on wages.
The incidence of taxes on capital goods.
The incidence of a tax on particular capital goods is distributed to the owners of all capital goods. Capital goods would be driven out of the taxed industry and increase the supply in other industries. The productivity of capital goods in the taxed industry would rise, and in other industries, fall, given diminishing marginal productivity.
For example, a tax on buildings makes them more expensive,
and houses would be smaller and fewer and more densely used.
Capital goods would be shifted to untaxed types, reducing those returns.
If all capital goods are taxed the same, or if interest income is taxed,
the incidence depends on the effect on supply, which depends on savings.
If interest is taxed, some people would save less, since the reward is lower,
and some would save more, if they seek to have a particular amount of wealth later.
If the effect is greater on those who save less, then there is less savings, higher interest rates, and less investment in capital goods, and less future growth.
If the effect is greater on those who save more, then the tax is at the expense of interest income.
Most likely, a tax on interest income or capital goods would diminish savings and reduce investment and reduce future growth.
The incidence of a tax on “excess profits.”
This tax would retard the distribution of capital into more profitable industries.
It would discriminate against riskier industries with higher returns.
It would reduce investment in general.
The incidence is on future growth, and on present-day wages and rent.
However, if the tax falls on the economic profits of a monopoly, there would be no shifting.
The incidence of a tax on inherited wealth.
Some savings and investment is done with the aim of leaving it to heirs.
A tax on estates would diminish such savings and investment.
This raises interest rates and diminishes economic growth, similar to taxing capital.
The incidence of taxes on land value or land rent.
A tax on particular types of land can be shifted.
Suppose there is a tax only on land used to grow grapes.
Land would be converted from grapes to other crops.
The price of grapes would rise, as would the rent of grape land.
But the price of other goods would fall as supply increased, and other rents would fall.
But the tax would not be shifted overall to consumers.
A tax on land values and land rents in general is fully borne by the owner at the time the tax is increased, in keeping less rent and in the lower selling price of land.
The tax cannot be shifted to tenants.
A new buyer has no burden, because the tax is offset by a lower price of land,
and so lower mortgage payments.
Capitalization of taxes
Capitalization means giving a present value to expected future incomes and expenses.
A tax as an expense lowers the present value of an asset such as a bond or land.
If all variables are constant, then
p = r / i without taxes, and p = r / (i+t) with a tax rate t on p.
A tax on wages is not capitalized, because human beings are not bought and sold.
A tax on capital goods in current production is not capitalized, because they do not normally sell below their costs of productions.
To be capitalized, the cost of production has to be lower than the market price.
In the case of land, the cost of production is zero.
After the transition, are lower prices for land beneficial or harmful to society and the economy?
There is less need to borrow. Lower cost of obtaining real estate.
Funds used to buy land could be invested in capital goods and human capital.
Even during a transition, most homeowners would have a net gain.
The incidence of a local land-value tax
The burden is on those landowners.
If there is a tax shift to land-value taxes from income and sales taxes,
the benefit is spread to the whole community as greater income.
There would be immigration, whose effects can very.