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    MBA智库文档 管理 财务管理 PUBLIC FINANCE.ppt

    PUBLIC FINANCE.ppt

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    Greenmind1
     |  2011-03-05 11:25 
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    CHAPTER 1 INTRODUCTION Defining the Field of Study Public Finance – the field of economics that analyzes government taxation and spending policies Public Sector Economics-see definition above Public Economics-see definition above What is not part of public finance Public Finance and Ideology Organic view of government Mechanistic view of government The Legal Framework Federal government Federal Constitutional provisions Article 1, Section 8 Article 1, Section 9 16th Amendment 5th Amendment The Legal Framework State governments Federal constitutional provisions 10th amendment The State constitutions Local governments Derive power to tax and spend from the States Fiscal independence of local governments The Size of Government How to measure the size of government Number of workers Annual expenditures Types of government expenditure Purchases of goods and services Transfers of income Interest payments Budget documents Unified budget Regulatory budget State, Local, and Federal Government Expenditures (selected years) *Conversion to 2005 dollars done using the GDP deflator Source: Calculations based on Economic Report of the President, 2006 (Washington, DC: US Government Printing Office, 2006), pp. 280,284,323,379 % 13,066 3,876 3,876 2005 % 11,461 3,237 2,887 2000 % 10,289 2,574 1,873 1990 % 7,679 1,749 843 1980 % 5,858 1,201 295 1970 % 3,627 655 123 1960 Percent of GDP 2005 Dollars per capita 2005 Dollars (billions)* Total Expenditures (billions) 4 3 2 1 Adjusting for Inflation Adjusting for Population Relative to Economy Source: Organization for Economic Cooperation and Development [2006]. Figures are for 2005. United States Source: Economic Report of the President [2006, p. 377]. Note decline in Defense Note increase in Social Security, Medicare and Income Security Source: Economic Report of the President [2006, p. 383]. Decline in highways Increase in public welfare Source: Economic Report of the President [2006, p. 377]. Social insurance and individual income tax have become more important Corporate and other taxes have become less important Source: Economic Report of the President [2006, p. 383]. Individual tax more important Property tax less important Changes in the Real Value of Debt Inflation tax Doing Research in Public Finance Public Finance journals International Tax and Public Finance Journal of Public Economics National Tax Journal Public Finance Public Finance Quarterly General-interest journals American Economic Review Journal of Economic Perspectives Journal of Political Economy Quarterly Journal of Economics Review of Economics and Statistics Doing Research in Public Finance Other sources Journal of Economic Literature Brookings Institution’s Studies of Government Finance Congressional Budget Office reports National Bureau of Economic Research working papers Tax Foundation’s Facts and Figures on Government Finance . Government Printing Office publications Statistical Abstract of the United States Economic Report of the President Budget of the United States . Census of Governments Historical Statistics of the United States from Colonial Times to 1970 Doing Research in Public Finance Public Finance data available on internet Resources for Economists on the Internet . Census Bureau University of Michigan’s Office of Tax Policy Research Urban-Brookings Tax Policy Center CHAPTER 2 Tools of Positive Analysis The Role of Theory Economic models virtue of simplicity judging a model limitations of models Empirical analysis Causation vs. Correlation Statistical analysis Correlation Control group Treatment group Conditions required for government action X to cause societal effect Y X must precede Y X and Y must be correlated Other explanations for any observed correlation must be eliminated Experimental Studies Biased estimates Counterfactual Experimental (or randomized) study Conducting an Experimental Study Random assignment to control and treatment groups Pitfalls of Experimental Studies Ethical issues Technical problems Response bias Impact of limited duration of experiment Generalization of results to other populations, settings, and related treatments Black box aspect of experiments Observational Studies Observational study – empirical study relying on observed data not obtained from experimental study Sources of observational data Surveys Administrative records Governmental data Econometrics Regression analysis Conducting an Observational Study L = α0 + α1wn + α2X1 + … + αnXn + ε Dependent variable Independent variables Parameters Stochastic error term Regression analysis Regression line Standard error wn L α0 Intercept is α0 Slope is α1 Types of Data Cross-sectional data Time-series data Panel data Pitfalls of Observational Studies Data collected in non-experimental setting Specification issues Quasi-Experimental Studies Quasi-experimental study (= natural experiment) – observational study relying on circumstances outside researcher’s control to mimic random assignment Conducting a Quasi-Experimental Study Difference-in-difference quasi-experiments Instrumental Variables quasi-experiments Regression-Discontinuity Quasi-Experiments Pitfalls of Quasi-Experimental Studies Assignment to control and treatment groups may not be random Not applicable to all research questions Generalization of results to other settings and treatments CHAPTER 3 TOOLS OF NORMATIVE ANALYSIS Welfare Economics Welfare Economics – branch of economic theory concerned with the social desirability of alternative economic states Edgeworth Box Edgeworth Box Adam Eve 0 0’ s r Apples per year Fig leaves per year v w u y x Indifference curves in Edgeworth Box Edgeworth Box Adam Eve 0 0’ s r Apples per year Fig leaves per year A1 A2 A3 E1 E3 E2 Making Adam better off without Eve becoming worse off Edgeworth Box Adam Eve 0 0’ s r Apples per year Fig leaves per year Ag Ah Ap Eg g h p A Pareto Efficient Allocation Making Eve better off without Adam becoming worse off Edgeworth Box Adam Eve 0 0’ s r Apples per year Fig leaves per year Ag Eg g p1 p Ep1 A Pareto Efficient Allocation Making both Adam and Even better off Edgeworth Box Adam Eve 0 0’ s r Apples per year Fig leaves per year Ag Eg g p1 p Ep2 Ap2 p2 Pareto efficient Pareto improvement Starting from a different initial point Edgeworth Box Adam Eve 0 0’ s r Apples per year Fig leaves per year Ag Eg g p1 p Ep2 Ap2 p2 p3 p4 k The Contract Curve Edgeworth Box Adam Eve 0 0’ s r Apples per year Fig leaves per year Ag Eg g p1 p Ep2 Ap2 p2 p3 p4 The contract curve Pareto Efficiency in Consumption MRSaf = MRSaf Adam Eve Production Possibilities Curve Apples per year Fig leaves per year C C 0 w y x z │Slope│ = marginal rate of transformation Marginal Rate of Transformation MRTaf = Marginal rate of transformation of apples for fig leaves MRTaf = MCa/MCf Efficiency Conditions with Variable Production MRTaf = MRSaf = MRSaf MCa/MCf = MRSaf = MRSaf Adam Eve Adam Eve The First Fundamental Theorem of Welfare Economics MRSaf = Pa/Pf MRSaf = Pa/Pf MRSaf = MRSaf MCa/MCf = Pa/Pf MRTaf = Pa/Pf Pa/Pf = MCa/MCf Adam Eve Adam Eve Efficiency versus Equity Edgeworth Box Adam Eve 0 0’ s r Apples per year Fig leaves per year q p5 p3 Utility Possibilities Curve Eve’s utility Adam’s utility U U p3 q p5 Social Indifference Curve Eve’s utility Adam’s utility W = F(UAdam, UEve) Increasing social welfare Maximizing Social Welfare Eve’s utility Adam’s utility i ii iii Market Failure Market Power monopoly Nonexistence of Markets asymmetric information externality public good Buying into Welfare Economics Individualistic outlook merit goods Results orientation Coherent framework for analyzing policy Will it have desirable distributional consequences? Will it enhance efficiency? Can it be done at a reasonable cost? CHAPTER 4 Public Goods Characteristics of Goods Excludable v Nonexcludable Excludable – preventing anyone from consuming the good is relatively easy Nonexcludable – preventing anyone from consuming the good is either very expensive or impossible Rival v Nonrival Rival – once provided, the additional resource cost of another person consuming the good is positive Nonrival – once provided, the additional resource cost of another person consuming the good is zero 0 Types of Goods NO YES NO YES RIVAL EXCLUDABLE PRIVATE GOODS PUBLIC GOODS COMMON RESOURCES NATURAL MONOPOLY Noteworthy Aspects of Public Goods Even though everyone consumes the same quantity of the good, it need not be valued equally by all Classification as a public good is not absolute; it depends on market conditions and the state of technology impure public good A commodity can satisfy one part of the definition of a public good but not the other Some things that are not conventionally thought of as commodities have public good characteristics Private goods are not necessarily provided exclusively by the private sector publicly provided private goods Public provision of a good does not necessarily mean that it is also produced by the public sector Some Other Public Goods Basic research Programs to fight poverty Uncongested nontoll roads Fireworks display Efficient Provision of Private Goods 26 11 15 $1 22 9 13 $3 18 7 11 $5 14 5 9 $7 10 3 7 $9 6 1 5 $11 Market (DfA+E) Eve (DfA) Adam (DfA) Price 0 DfA DfE DfA+E 0 Sf $ Quantity of Pizza Pareto Efficiency – Private Goods Case MRSfa = Pf/Pa Set Pa = $1 MRSfa = Pf DfA shows MRSfa for Adam DfE shows MRSfa for Eve Sf shows MRTfa Necessary condition for Pareto efficiency: MRSfaAdam = MRSfaEve = MRTfa Efficient Provision of Public Goods $250 $350 $450 $550 Market (DfA+E) 100 150 200 250 Eve (DfE) $150 $200 $250 $300 Adam (DrA) 4 3 2 1 Units of Fireworks 0 0 DrA DrE DrA+E Sr Quantity of Fireworks $ Pareto Efficiency – Public Goods Case MRSfa = Pf/Pa Set Pa = $1 MRSfa = Pf DfA shows MRSfa for Adam DfE shows MRSfa for Eve Sf shows MRTfa Necessary condition for Pareto efficiency: MRSfaAdam + MRSfaEve = MRTfa Problems Achieving Efficiency The Free-Rider Problem Solutions to the free-rider problem Perfect price discrimination Policy Perspective: Global Positioning System Do people free ride? 0 Laboratory Experiments and Free-Riding How a typical experiment works Typical results People contribute about 50% of resources to provision of public good Contributions fall the more often the game is repeated Cooperation fostered by prior communication Contribution rates decline when opportunity cost of giving goes up “Warm-glow” giving The Privatization Debate Privatization – taking services supplied by government and turning them over to the private sector Public v Private Provision: What is the right mix? Relative wage and materials costs Administrative costs Diversity of tastes Distributional Issues Commodity egalitarianism – notion that some commodities ought to be made available to everyone Public versus Private Production Efficiency of private production Problems in comparing cost differences Incomplete Contracts Competition to supply good or service Reputation building Policy Perspective: Should airport security be produced publicly or privately? Market Environment Preference Revelation Mechanisms ∆TEve = MRTra – (MRSraTotal – MRSraEve) Eve’s choice: ∆TEve = MRSraEve By substitution: MRTra – (MRSraTotal – MRSraEve) = MRSraEve Add (MRSraTotal – MRSraEve) to both sides: MRTra = MRSraTotal CHAPTER 5 Externalities Externalities Externality 外部效应– An activity on one entity that affects the welfare of another entity in a way that is outside the market mechanism Not an Externality – suburban-urban migration example The Nature of Externalities Privately-owned versus commonly-owned resources versus prep. 1.（表示两队或双方对阵）对，诉，对抗 2.（比较两种不同想法、选择等）与…相对，与…相比 Externalities can be produced by consumers as well as firms Externalities are reciprocal in nature Externalities can be positive Public goods can be viewed as a special kind of externality The Nature of Externalities-Graphical Analysis Q per year $ MB 0 MD MPC MSC = MPC + MD Q1 Q* Actual output Socially efficient output a b c d f e g h What Pollutants Do Harm? Empirical Evidence: What is the Effect of Pollution on Health? What Activities Produce Pollutants? What is the Value of the Damage Done? Empirical Evidence: The Effect of Air Pollution on Housing Values Bargaining and the Coase Theorem Q per year $ MB 0 MD MPC MSC = MPC + MD Q1 Q* c d g h The Coase Theorem Coase Theorem – Provided that transaction casts are negligible, an efficient solution to an externality problem is achieved as long as someone is assigned property rights, independent of who is assigned those rights Assumptions necessary for Coase Theorem to work The costs to the parties of bargaining are low The owners of resources can identify the source of damages to their property and legally prevent damages Other Private Solutions Mergers 英['mɜ:dʒə] 美['mədʒɚ] n.(两个公司的)合并,（机构或企业的）归并 Social conventions Public Responses to Externalities - Taxes Q per year $ MB 0 MD MPC MSC = MPC + MD Q1 Q* c d (MPC + cd) Pigouvian tax revenues i j Public Responses to Externalities - Subsidies Q per year $ MB 0 MD MPC MSC = MPC + MD Q1 Q* c d (MPC + cd) i j g k h f e Pigouvian subsidy Emissions Fee 0 Pollution reduction MSB MC e* f* $ Uniform Pollution Reductions Bart’s pollution reduction Homer’s pollution reduction 50 75 90 50 75 90 MCB MCH 25 f = $50 f = $50 Bart’s Tax Payment Homer’s Tax Payment Cap-and-Trade Bart’s pollution reduction Homer’s pollution reduction 50 75 90 50 75 90 MCB MCH 25 f = $50 f = $50 10 a b Cap-and-Trade v Emissions Fee 0 Pollution reduction MSB MC* e* f* $ MC’ ef e’ Too much pollution reduction Too little pollution reduction Cap-and-Trade v Emissions Fee 0 Pollution reduction MC* e* f* $ MC’ ef e’ MSB Too much pollution reduction Too little pollution reduction Emissions Fee v Cap-and-Trade Responsiveness to Inflation Responsiveness to Cost Changes Responsiveness to Uncertainty Distributional Effects Emissions fee 排放费 Cap-and-Trade Command-and-Control Regulation Incentive-based regulationsincentive [in'sentiv] 美[ɪn'sɛntɪv] n.激励某人做某事的事物; 刺激; 诱因, 动机,奖励 adj.刺激；鼓励的 Command-and-control regulations technology standard performance standard Is command-and-control ever better? hot spots The . Response Clean Air Act 1970 amendments 英[ə'mendmənt] 美[ə'mɛndmənt] n. 1.（法律、文件的）改动，修正案，修改，修订 2.（美国宪法的）修正案 Command-and-control in the 70s How well did it work? Progress with Incentive-based Approaches Policy Perspective: Cap-and-Trade for Sulfur Dioxide Policy Perspective: Cap-and-Trade to Protect Fisheries and Wildlife individual transferable quotas quota 英['kwəutə] 美['kwotə] n. 1.(正式限定的)定量, 定额, 配额 2.定量；定额；指标 3.（候选 人当选所需的）规定票数，最低票数 Implications for Income Distribution Who Benefits? Who Bears the Cost? Positive Externalities Research per year $ MPB MC MEB MSB = MPB + MEB R* R1 A Cautionary Note Requests for subsidies(补贴, 津贴, 补助金) Resource extracted萃取的，提取 from taxpayers Market does not always fail Policy Perspective: Owner-Occupied Housing adj.自己住的, 不出租的 CHAPTER 6 POLITICAL ECONOMY Direct Democracy-Unanimity Rules r per year 0 0’ Adam’s share (SA) Eve’s share (SE) DrA The Lindahl Model DrE r* S* Feasibility of Unanimity Rules Reaching equilibrium Practical problems Strategic behavior time to reach equilibrium Direct Democracy-Majority Voting Rules Majority voting rule – one more than half of the voters must favor a measure for it to be approved A A C Third C B B Second B C A First Angelina Jen Brad Choice Voter Direct Democracy-Majority Voting Rules Voting Paradox – community preferences can be inconsistent even though individual’s preferences are consistent Agenda Manipulation – process of organizing order of votes to ensure a favorable outcome Cycling – when paired voting on more than two possibilities goes on indefinitely without a conclusion ever being reached A B C Third C A B Second B C A First Angelina Jen Brad Choice Voter Graphing Preferences Missiles Utility A B C Brad Jen Angelina Single-peaked preferences Double-peaked preferences Practical Importance of Double-peaked Preferences Availability of private substitutes Issues ranked along single dimension Direct Democracy - The Median Voter Theorem 700 Louie 160 Dewey 150 Huey 100 Daisy $5 Donald Expenditure Voter Direct Democracy - Logrolling I 220 400 -60 -120 Pool 80 -30 150 -40 Library 95 -55 -50 200 Hospital Total Net Benefits Scarlet Rhett Melanie Project Voter Direct Democracy - Logrolling II -10 400 -140 -270 Pool -10 -120 150 -40 Library -15 -105 -110 200 Hospital Total Net Benefits Scarlet Rhett Melanie Project Voter Direct Democracy - Arrow’s Impossibility Theorem “Reasonable” collective decision-making criteria It can produce a decision whatever the configuration of voters' preferences It must be able to rank all possible outcomes It must be responsive to individuals’ preferences It must be consistent Independence of irrelevant alternatives Dictatorship ruled out Arrow’s Impossibility Theorem All conceivable voting schemes have some potential for being unfair or producing a paradoxical result Meaning of theorem consistent rule not necessarily impossible to find, but cannot be guaranteed Buchanan’s critique Use of social welfare functions Representative Democracy - Elected Politicians Number of Voters Liberal Conservative 0 Implications of the Median Voter Model Two-party systems tend to be stable Replacement of direct referenda by representative system has no effect on outcomes Other Factors Influencing Voting Single-dimensional rankings Ideology Personality Leadership Decision to vote Representative Democracy-Public Employees Function of bureaucrats Goals of bureaucrats Niskanen’s Model of Bureaucracy Q per year $ 0 V C Q* Efficient output Qbc Actual output Representative Democracy – Special Interests What are “Special Interests” Establishment of Special Interest Groups Source of Income: Capital or Labor Size of Income Source of Income: Industry of Employment Region Demographic and Personal Characteristics Representative Democracy – Rent-Seeking tons of peanuts per year $ S=MC D MR Rents Representative Democracy – Other Actors Judiciary Journalists Experts Explaining Government Growth Citizen Preferences G = f(P, I) Marxist View Chance Events Changes in Social Attitudes Income Redistribution Controlling Government Growth Government growth as a non-issue Government growth as a problem Commitments made in the past Basic flaws in the political system Improving the Workings of the Political System Change bureaucratic incentives financial incentives privatization Change Fiscal Institutions Budget Enforcement Act (BEA) – 1990 Balanced budget rules at the state level Institute Constitutional Limitations Balanced budget amendment Provisions of a Typical Balanced Budget Amendment Congress must adopt a budget statement “in which total outlays are no greater than total receipts” Total receipts may not increase “by a rate greater than the rate of increase in national income” “The Congress and President shall…ensure that actual outlays do not exceed the outlays set forth in the budget statement” The provisions can be overridden in times of war Critique of Balanced Budget Amendments Forecasting issues Definitional issues Penalties for violation of the law Economic issues CHAPTER 7 EDUCATION Real Annual Expenditure Per Pupil in Public Elementary and Secondary Schools (selected years) Source: Computed from US Census Bureau, Statistical Abstract of the United States 2006. Washington, DC 2006, p. 155 $8,248 2004 $8,242 2003 $7,574 2000 $6,849 1995 $6,746 1990 $5,687 1985 4,917 1980 Expenditure per pupil (2004 dollars) School Year Justifying Government Intervention in Education Is Education a Public Good? Does Education Generate Positive Externalities? The Conventional Wisdom The Case Against the Conventional Wisdom The Case of Higher Education Is the Education Market Inequitable? Commodity Egalitarianism What Can Government Intervention in Education Accomplish? Should public education be free and compulsory? Should government produce public education? Does Government Intervention Crowd Out Private Education? Quantity of Education Quantity of all other goods A B i e0 ep ii x Private School quantity of education Public schooling “crowds out” education Does Government Intervention Crowd Out Private Education? Quantity of Education Quantity of all other goods A B i e0 ep ii x Public schooling increases quantity of education Does Government Intervention Crowd Out Private Education? Quantity of Education Quantity of all other goods A B i e0 ep ii x Public schooling does not increase quantity of education Does Government Spending Improve Educational Outcomes? SOURCE: Organization for Economic Cooperation and Development [2005, Table ]. Does Government Spending Improve Educational Outcomes? Comparative educational outcomes Empirical Evidence: Does Spending on Education Improve Student Test Scores? Public Spending and the Quality of Education Empirical Evidence: Does Reducing Class Size Improve Student Test Scores? Measuring costs Measuring benefits Project STAR Israel Timings of births Political economy analysis of class size California Does Education Increase Earnings? Link between higher spending on education and earnings Elementary and secondary education outcomes Influence of age and economic status Spending on the margin New Directions for Public Education-Charter Schools Charter Schools- public schools operating under special state charters that permit experimentation and allow independence Empirical evidence Diversity of choice Student outcomes New Directions for Public Education-Vouchers Vouchers – financial grants to families that can be used to pay their children’s tuition at (nearly) any school Argument in favor Vouchers create competition in educational marketplace Arguments opposing Parents might not be well-enough informed to make good choices Moving children to private schools might reduce positive externalities of education If good students escape bad schools, weaker students left behind may received even worse educations Inequitable Empirical evidence on the effect of vouchers New Directions for Public Education-School Accountability School accountability – monitoring student and school performance via standardized tests No Child Left Behind Act (2001) Empirical evidence on the effectiveness of school accountability CHAPTER 8 COST-BENEFIT ANALYSIS Projecting Present Dollars into the Future R0 = $1000 R1 = $1000*(1+.01) = $1010 R2 = $1010*(1+.01) = $ R2 = $1000*(1+.01)2 = $ RT = R0*(1+r)T Projecting Future Dollars into the Present R0 = $1000 R1 = $1000*(1+.01) = $1010 R2 = $1010*(1+.01) = $ R2 = $1000*(1+.01)2 = $ RT = R0*(1+r)T R0 = RT/(1+r)T Present Value discount rate discount factor Present Value of a Stream of Money Inflation Private Sector Project Evaluation -21 10 37 46 1,200 550 3 98 86 0 0 2 165 128 0 600 1 $200 $150 0 -$1,000 $1,000 0 Advertising R&D R = Advertising R&D Year PV Annual Net Return Admissible Preferable Present Value Criteria Internal Rate of Return $20 $4 Profit 8% $1,080 -$1,000 Y 10% $110 -$100 X PV ρ Year 1 Year 0 Project Benefit-Cost Ratio Benefit-cost ratio = B/C Problems with the Benefit-cost Ratio $140 $250 I: Add $40 mistake to C $100 $210 I: Subtract $40 mistake from B $100 $200 II $100 $250 I B/C C B Method Discount Rate for Government Projects Returns in Private Sector Social Discount Rate Concern for Future Generations Paternalism Market Inefficiency Government Discounting in Practice Valuing Public Benefits and Costs Market Prices Adjusted Market Prices shadow price Monopoly Taxes Unemployment Consumer Surplus Pounds of avocados per year Price per pound of avocados Da Sa d A0 Sa’ $ $ b c g A1 e Inferences from Economic Behavior The Value of Time The Value of Life Lost earnings Probability of Death Valuing Intangibles Subverting cost-benefit exercises Reveal limits on intangibles Cost-effectiveness analysis Games Cost-Benefit Analysts Play The Chain-Reaction Game The Labor Game The Double-Counting Game Distributional Considerations Hicks-Kaldor Criterion – a project should be undertaken if it has positive net present value, regardless of distributional consequences Government costlessly corrects any undesirable distributional aspects Weighted benefits Uncertainty $2,000 $1,000 0 Y $1,000 $1,000 X EV Probability Benefit Project Certainty Equivalent Are Reductions in Class Size Worth It? Discount rate Costs Benefits The Bottom Line and Evaluation Use (and Nonuse) by Government Using Cost-Benefit Analysis Not Using Cost-Benefit Analysis Clean Air Act Endangered Species Act Food, Drug and Cosmetic Act Calculating the Certainty Equivalent Value Income per year Utility C E I* E + y U(E) U* U(E + y) U Expected income Certainty Equivalent CHAPTER 9 The Health Care Market SOURCE: US Census Bureau [2006, pp. 98, 443], and National Income and Product Accounts ( Social Insurance Social insurance - government programs that provide insurance to protect against adverse events Examples Medicaid Medicare Social Security Unemployment Compensation How Health Insurance Works Insurance premium Expected Value Expected value (EV) = probability of outcome 1) * (Payout in outcome 1) + probability of outcome 2)*(Payout in outcome 2) + … + (probability of outcome n)*(Payout in outcome n) Expected Value Computation Draw cards from deck of cards Draw heart and receive $12 Draw spade, diamond or club and lose $4 Probability of drawing heart = 13/52 = ¼ Probability of drawing spade, diamond or club = 39/52 = ¾ EV = (1/4)($12) + (3/4)(-$4) = $0 Why Buy Insurance? $47,000 $47,000 $47,000 $30,000 1 in 10 9 in 10 $50,000 Option 2: Full Insurance ($3,000 premium to cover $30,000 in losses $47,000 $20,000 $50,000 $30,000 1 in 10 9 in 10 $50,000 Option 1: No Insurance Expected Value Income if She Gets Sick Income if She Stays Healthy Lost Income if She Gets Sick Probability of Getting Sick Probability of Staying Healthy Income Insurance Options (C) (B) (A) Actuarially Fair Insurance Policy Why People Buy Insurance Income Utility 20,000 47,000 50,000 UA UC UD UB D C B A Expected Utility Risk Smoothing Do People Buy Insurance with Loading Fees? Risk Aversion Risk Premium Loading Fee The Role of Risk Pooling Insurance in a small population Insurance in a large population Law of large numbers Adverse Selection in the Health Insurance Market Asymmetric information Asymmetric Information and Adverse Selection $0 -$15,000 $0       Insurer's Net Profits -$1,500 $0 $0 $3,000 $30,000 1 in 10 (Low Risk) Ethan -$1,500 $0 $0 $3,000 $30,000 1 in 10 (Low Risk) Hannah -$1,500 $0 $0 $3,000 $30,000 1 in 10 (Low Risk) Matthew -$1,500 $0 $0 $3,000 $30,000 1 in 10 (Low Risk) Olivia -$1,500 $0 $0 $3,000 $30,000 1 in 10 (Low Risk) Joshua $1,500 $3,000 $0 $6,000 $30,000 1 in 5 (High Risk) Madison $1,500 $3,000 $0 $6,000 $30,000 1 in 5 (High Risk) Michael $1,500 $3,000 $0 $6,000 $30,000 1 in 5 (High Risk) Emma $1,500 $3,000 $0 $6,000 $30,000 1 in 5 (High Risk) Jacob $1,500 $3,000 $0 $6,000 $30,000 1 in 5 (High Risk) Emily (Premium = $4,500) (Premium = $3,000) (Differential Premiums) Lost Income if Sick Getting Sick Insurance Buyer Minus Premium Minus Premium Minus Premium Expected Lost Income Probability of   Expected Benefit Expected Benefit Expected Benefit (F) (E) (D) (C) (B) (A)     Does Adverse Selection Justify Government Intervention? Experience rating Experience rating and equity Community rating Insurance and Moral Hazard Moral hazard Deductible Co-payment Co-insurance Moral Hazard Medical services per year Price per unit Dm Sm M1 M0 0 P0 .2P0 a b h deadweight loss Flat-of-the-curve medicine Health Care Expenditures and Health Outcomes Additional Considerations The Elasticity of Demand for Medical Services Does Moral Hazard Justify Government Intervention? Third Party Payment Other Market Failures in the Health Care Market Information Problems Externalities Do We Want Efficient Provision of Health Care? Paternalism The Problem of the Uninsured Who are the uninsured? Does health insurance improve health High Health Care Costs Causes of Health Care Cost Inflation The Graying of America Income Growth Improvements in Quality Commodity Egalitarianism CHAPTER 10 GOVERNMENT AND THE MARKET FOR HEALTH CARE SOURCE: Centers for Medicare and Medicaid Services [2005a]. SOURCE: Centers for Medicare and Medicaid Services [2005a]. Private Health Insurance The Implicit Subsidy for Employer-Provided Insurance World War II era price controls Federal tax subsidy The Advantages of Employer-Provided Health Insurance Increase the risk pool Reduce adverse selection Lower administrative costs Employer-Provided Health Insurance and Job Lock Job lock Health Insurance Policy Portability and Accountability Act of 1996 (Kennedy-Kassenbaum Act) Cost Control and Private Insurance Cost-based reimbursement (fee-for-service) Managed care Capitation-based reimbursement Health Maintenance Organizations (HMOs) Preferred Provider Organizations (PPOs) Point-of-service (POS) Medicare: Overview SOURCE: Centers for Medicare and Medicaid Services [2005a]. Real expenditures on Medicare Expenditures on Medicare as a Share of GDP How Medicare Works Benefits Part A – Hospital insurance (HI) Part B – Supplementary medical insurance (SMI) Financing Payroll tax funds HI General revenues fund SMI Prescription Drug Benefit Part C – Medicare Advantage Part D – Prescription Drug Benefit Monthly premium Low deductible Donut hole Generous coverage for high costs Cost Control Under Medicare Medicare’s retrospective payment system Medicare’s prospective payment system Diagnosis related groups Resource-based relative value scale system Medicare Managed Care Medicare: Impacts on Spending and Health Expenditures on health care for the elderly Health outcomes Medicaid: Overview Medicaid State Children’s Health Insurance Program SOURCE: Centers for Medicare and Medicaid Services [2005a]. Financing and Administration Joint Federal-State financing State administration Benefits States obligated to offer minimum package of benefits States may offer more generous benefits State administrative flexibility Medicaid: Impacts on Health Take-up rate Crowding out Empirical evidence: Are Medicaid expansions effective? Crowding out and taking up Health Care Reform Individual mandates Health savings accounts Catastrophic insurance policy Single payer Final Thoughts Security v efficiency No free lunch Connection between health care expenditures and health Does Public Insurance Crowd Out Private Insurance? Health insurance Health insurance Health insurance Quantity of all other goods Quantity of all other goods Quantity of all other goods A A A F F F B B B M M M 0 0 0 Amount of publicly provided insurance Amount of publicly provided insurance Amount of publicly provided insurance C C C CHAPTER 11 SOCIAL SECURITY GDP data from Department of Commerce's Bureau of Economic Analysis. Sources: Expenditure data from Social Security Trustees [2006]. CPI data from Department of Labor's Bureau of Labor Statistics. Why Have Social Security? Consumption Smoothing and the Annuity Market How Social Security works Annuity Consumption smoothing Adverse Selection and the Annuity Market Asymmetric information Adverse selection Other Justifications Lack of foresight and paternalism Moral hazard Economize on decision-making and administrative costs Income Redistribution Improve the Economic Status of the Aged Fully Funded Plan Period 4 Period 3 Period 2 Period 1 contribute benefits contribute benefits contribute benefits The Greatest Generation The Baby Boom Generation Generation X Work Retire Dead Unborn Work Work Retire Still Dead Dead Childhood Childhood Retire Each generation’s benefits based on deposits it made during working life plus accumulated interest Pay As You Go (or Unfunded) System Period 4 Period 3 Period 2 Period 1 The Greatest Generation The Baby Boom Generation Generation X Work Retire Dead Unborn Work Work Retire Still Dead Dead Childhood Childhood Retire contribute benefits contribute benefits contribute benefits benefits 0 Each generation’s benefits come from tax payments made by current workers Today’s Partially Funded System Period 4 Period 3 Period 2 Period 1 The Greatest Generation The Baby Boom Generation Generation X Work Retire Dead Unborn Work Work Retire Still Dead Dead Childhood Childhood Retire contribute benefits contribute benefits contribute benefits benefits 0 Baby Boomers and Gen X are also contributing to their own retirement Explicit Transfers Benefits for dependents and survivors (1939) Supplemental Security Income Benefits How to calculate benefits AIME (Average Indexed Monthly Earnings) – average monthly earnings in 35 highest paid years Wages indexed for inflation Ceiling on AIME – up to tax ceiling 0 Benefit Structure If AIME < $656  PIA = .90*AIME If $656< AIME <$3955  PIA = .90*$656 + .32*(AIME - $656) If AIME > $3955  PIA = .90*$656 + .32*($3955-$656) + .15*(AIME - $3955) First Bend Point Second Bend Point 0 Adjustments Annual inflation adjustment Age at which benefit is drawn Normal retirement age Early retirement – benefit reduced 5/9th of one percent a month for first 36 months preceding normal retirement age Late retirement – benefit increased 15/24th of one percent a month 0 Adjustments Family Status +50% for spouse or dependent child If covered worker dies spouse receives 100% of worker’s benefit or spouse’s benefit Divorced spouse married at least 10 years gets spouse benefit if not remarried while covered worker alive Earnings test and taxing benefits Benefits reduced $1 for every $2 earned above $12,480 Individuals losing benefits may have later benefits increased Up to 85% of benefits taxed for recipients with income above a base amount ($25,000 for single and $32,000 for married taxpayers.) Financing FICA (Federal Insurance Contribution Act) 2006 Social Security Tax rates Employee % (OASI - %, DI - .6%) of first $94,200 of earnings on both employee and employer Self-employed % 2006 Medicare Tax rates % on both employer and employee with no earnings ceiling Why not fund Social Security through general tax revenues? 0 Distributional Issues Actuarially fair return Intergenerational redistribution Total benefits = Nb * B Total taxes = t * Nw * w If total benefits = total taxes: Nb * B = t * Nw * w or B = t * (Nw/Nb) * w Ida Mae Fuller Social Security Wealth for Representative Individuals All values expressed in 2006 dollars. See C. Eugene Stueuerle and Jon M. Bakija [1994] for original tables and methodology. Source: Updated tables, furnished by C. Eugene Steuerle and Adam Carasso, 2006. Other Distributional Issues Redistribution within a generation Differences by earnings Differences by lifespan Differences by living arrangements Differences by number of earners in the family Normative evaluation The Social Security Trust Fund Social Security and National Saving Budget Treatment of Social Security Off budget Unified budget Worker Retiree Trust Fund 0 Social Security and Savings Behavior Life-cycle theory of savings Wealth Substitution Effect Retirement Effect Bequest Effect Empirical Evidence Martin Feldstein’s work CONS = f(DI, W, SSW, X) MPCssw = .028 60% reduction in personal saving Others Rosen: Social security has had a negative effect on saving, but magnitude of effect is unclear Effects on Retirement and Labor Supply 1930 LFPR 65+ was 54% 2001 LFPR 65+ was 18% Effect of Social Security Income Effect – SS raises retirement income Substitution Effect – SS reduces the cost of retiring Earnings test Impact on Younger Workers? 0 Distribution of Wealth Bequeathable v Annuitized Wealth Effect of Social Security on Bequeathable Wealth Effect on Wealth Mobility Budget Constraint for Present and Future Consumption Present consumption (c0) Future consumption (c1) N M I0 I1 D I0 - S I1 + (1+r) S S (1+r)S I1 - (1+r) B F B (1+r)B At endowment point consumer neither saves nor borrows Utility-maximizing Choice of Present and Future Consumption Present consumption (c0) Future consumption (c1) N M I0 I1 E1 c1* A c0* Saving Crowding out of private saving due to Social Security Present consumption (c0) Future consumption (c1) N M I0 I1 E1 c1* A c0* R T I0T (1+r)T Saving before Social Security Saving after Social Security Other ways Social Security Affects Saving Retirement effect Bequest effect Empirical evidence Retirement Decisions Social security wealth and the retirement decision Empirical evidence Diamond and Gruber [199] Gruber and Wise [2004] Long-Term Stresses on Social Security Projected revenues and projected costs of Social Security as share of Gross Domestic Product Source: Social Security Trustees [2006] Long-Term Stresses on Social Security Since: B = t * (Nw/Nb) * w Rearrange: t = (Nw/Nb) * (B/w) Dependency Ratio Replacement Ratio Social Security Reform Time horizon for solvency Sustainable solvency Maintain the Current System Raise the payroll tax Raise the Maximum Taxable Earnings Level Raise the Retirement Age Reducing the Cost-of-Living Adjustment Change the Benefit Formula Comparing the Options Privatize the System Personal Accounts Pros and cons of personal accounts Effect on Solvency Effect on Saving Carve-out accounts Add-on accounts Risk Administration Distribution Policy Perspective: President Bush’s Social Security Reform Proposal Voluntary personal accounts Carve-outs Government management Portfolio limitations Benefit offsets Inheritability Achieving sustainable solvency Progressive indexing Empirical Evidence: Does Social Security Reduce Saving? Time-series evidence Martin Feldstein (1974, 1996) v Leimer and Lesnoy (1982) Cross-section evidence Evidence from other countries Attanasio and Brugiavini (2003) and Italy Ida Mae Fuller 0 CHAPTER 12 INCOME REDISTRIBUTION: CONCEPTUAL ISSUES The Distribution of Income Among Households These figures do not include the value of in-kind transfers. URL: Source: . Census Bureau, Current Population Survey, Annual Social and Economic Supplements 2004 2002 1997 1992 1987 1982 1977 1967 Top 5 Percent Highest Fifth Fourth Fifth Middle Fifth Second Fifth Lowest Fifth Year Percentage Share Who is Poor? Figures are for 2004. [WWW Document] URL: Source: US Bureau of the Census, “Historical Poverty Tables.” Hispanic origin Female households, no husband present Black 65 years and older White % Under 18 years % All persons Poverty Rate Group Poverty Rate Group Poverty Rate (1960-2004) Source: US Bureau of the Census, “Historical Poverty Tables.” [WWW Document] URL: Measuring Poverty Poverty line Interpreting the Distributional Data Census income consists only of family’s cash receipts in-kind transfers Official figures ignore taxes Income measured annually Consumption data may provide better assessment of well-being Problems defining unit of observation Simple Utilitarianism Utilitarian Social Welfare Function: W = F(U1, U2, ,,,, Un) “Promote Greatest Good for Greatest Number” Additive Social Welfare Function W = U1 + U2 + … + Un Assume Individuals have identical utility functions that depend only on their incomes Utility functions exhibit diminishing marginal utility of income Total amount of income is fixed 0 Implications for Income Inequality Paul’s marginal utility 0 Peter’s marginal utility Paul’s income Peter’s income 0 0’ MUPaul MUPeter a e c d f I* b Paul’s income Peter’s income Take ab from Peter and give to Paul Paul gains this much utility Peter loses this much utility This is the net gain to society Social welfare maximized Evaluating the Assumptions Assumption 1 Assumption 2 Assumption 3 The Maximin Criterion Social Welfare Function W = Minimum(U1, U2, …, Un) Maximin criterion - No inequality acceptable unless it works to the advantage of the least well off Original position – “behind the veil of ignorance” Critique of Rawls Pareto Efficient Income Redistribution Will redistribution always make someone worse off? Utility Function Ui = F(X1, X2, …, Xn, U1, U2, …, Ui-1, Ui+1, …, Um) Redistribution if gain in utility from charity exceeds loss from reduced consumption Government reduces cost of redistribution Income distribution as a Public Good Social safety net Social stability Nonindividualistic Views Fundamental principles specifying income distribution derived independent of tastes Incomes distributed equally as matter of principle Plato’s 4:1 ratio of highest to lowest income Commodity Egalitarianism Other Considerations Processes versus Outcomes Fairness of distribution of income judged by fairness of process that generated it Robert Nozick Society cannot redistribute income because society has no income to redistribute Mobility Corruption Expenditure Incidence Relative price effects Public goods Valuing in-kind transfers In-kind Transfers Pounds of cheese per month Other goods per month 300 260 20 150 B A D 210 60 F E1 U E3 420 340 H In-kind Transfers Pounds of cheese per month Other goods per month 300 136 82 150 B A D 210 F E4 E5 420 H 168 126 Reasons for In-Kind Transfers Commodity egalitarianism Reduce welfare fraud Political factors CHAPTER 13 EXPENDITURE PROGRAMS FOR THE POOR A Quick Look at Welfare Spending Means-tested Cash versus in-kind assistance Anti-poverty impact of non-means-tested programs Source: Burke [2003, p. 3]. Figures are for 2002. Energy aid Jobs/training Services Education Housing benefits Food benefits Cash aid $ $ Medical care State and Local Federal Program TANF Aid to Families with Dependent Children (1935-96) TANF-Temporary Assistance for Needy Families (1996- ) No entitlement Time limits Work requirement Block grants to states Benefit reduction rates Work Incentives B = G – tE B = 0 if E = G/t 0 The Basic Trade-offs G – basic grant if not working t – rate at which grant reduced when recipient earns money B – benefit received Analysis of Work Incentives w* Hours of leisure per month Income per month 0 T a Time Endowment D |Slope| = w b c 2w Analysis of Work Incentives Hours of leisure per month Income per month 0 T D |Slope| = w i ii iii E1 F G Leisure Work Income Analysis of Work Incentives Hours of leisure per month Income per month (= earnings + transfers) 0 T D |Slope| = w Q F G S $100 V |Slope| = 3/4w K Hours before TANF Hours after TANF Analysis of Work Incentives Hours of leisure per month Income per month (= earnings + transfers) 0 T D P F G $338 R P1 Budget constraint with t = 100% S 0 hours of work selected Analysis of Work Incentives Hours of leisure per month Income per month (= earnings + transfers) 0 T D P M G R E2 Hours worked Work Requirements Workfare TANF Mandated work Time Limits Lifetime Per spell of welfare Family Structure Marriage Childbearing National versus State Administration Race to the Bottom State experimentation Earned Income Tax Credit Empirical Evidence: The Effect of the Earned Income Tax Credit on Labor Supply Labor force participation Work hours Supplemental Security Income SSI versus conventional welfare Uniform minimum federal guarantee Benefit levels Work incentives Medicaid How Medicaid works Crowding Out The Medicaid Notch Medicaid and Health The Medicaid Notch Hours of leisure per year Income per year 0 T D M N R S X Z $1,000 Unemployment Insurance Why does government insure against unemployment? Adverse selection Moral hazard Benefits Gross replacement rate Financing Experience rated Effects on Unemployment Food Stamps and Child Nutrition How food stamps work Foods stamps as an in-kind transfer Participation rates Housing Assistance How housing assistance works Housing subsidies Section 8 certificates Voucher programs Impact on stock of housing Public housing and economic self-sufficiency of inhabitants Programs to Enhance Earnings Education Head Start Employment and Training Overview Source: Holt [2005, Part D, Figure 1]. Figure : Estimated effective marginal tax rates for a one-parent, two-child household residing in Wisconsin (2000) New Ideas Replace current hodgepodge with single cash assistance program Benefit levels Faith-based social services CHAPTER 14 TAXATION AND INCOME DISTRIBUTION Vocabulary Statutory Incidence Economic Incidence Tax Shifting Partial Equilibrium Models 0 Tax Incidence: General Remarks Only people can bear taxes Functional distribution of income Size distribution of income Both sources and uses of income should be considered Incidence depends on how prices are determined Incidence depends on the disposition of tax revenues Balanced-budget tax incidence Differential tax incidence Lump-sum tax Absolute tax incidence Tax Progressiveness Can Be Measured in Several Ways Average tax rate versus marginal tax rate Proportional tax system Progressive tax system Regressive tax system 5,400 30,000 1,400 10,000 400 5,000 0 0 3,000 -$200 $2,000 Marginal Tax Rate Average Tax Rate Tax Liability Income Tax Liabilities under a hypothetical tax system Measuring How Progressive a Tax System is Measuring How Progressive a Tax System is – A Numerical Example Suppliers Receive Consumers Pay After Tax Before Tax $ $ $ $ 0 D0 S0 D1 S1 Partial Equilibrium Models Quantity $ 0 DX S SX DX’ Perfectly Inelastic Supply Quantity $ 0 DX S SX DX’ Perfectly Elastic Supply Quantity $ Ad Valorem Taxes Pounds of food per year Price per Pound of food Df Sf Q0 Qm Qr P0 Pm Pr Df’ Taxes on Factors The Payroll Tax Capital Taxation in a Global Economy Commodity Taxation without Competition Monopoly Oligopoly Profits Taxes Economic profit Perfect competition Monopoly Measuring economic profit Tax Incidence and Capitalization PR = $R0 + $R1/(1 + r) + $R2/(1 + r)2 + … + $RT/(1 + r)T PR’ = $(R0 – u0) + $(R1 – u1)/(1 + r) + $(R2 – u2)/(1 + r)2 + … + $(RT – uT)/(1 + r) u0 + u1/(1 + r) + u2/(1 + r)2 + … + uT/(1 + r)T Capitalization General Equilibrium Models Partial equilibrium General equilibrium Tax Equivalence Relations tKF = a tax on capital used in the production of food tKM = a tax on capital used in the production of manufactures tLF = a tax on labor used in the production of food tLM = a tax on labor used in the production of manufactures tF = a tax on the consumption of food tM = a tax on consumption of manufactures tK = a tax on capital in both sectors tL = a tax on labor in both sectors t = a general income tax Tax Equivalence Relations Partial factor taxes Source: McLure [1971]. t are equivalent to tL and tK to to to equivalent equivalent equivalent are are are tM are equivalent to tLM and tKM and and and tF are equivalent to tLF and tKF The Harberger Model Assumptions Technology Elasticity of substitution Capital intensive Labor intensive Behavior of factor suppliers Market structure Total factor supplies Consumer preferences Tax incidence framework Analysis of Various Taxes Commodity tax (tF) Income tax (t) General tax on labor (tL) Partial factor tax (tKM) Output effect Factor substitution effect Some Qualifications Differences in individuals’ tastes Immobile factors Variable factor supplies An Applied Incidence Study Source: Congressional Budget Office [2004]. These figures are based on projections that rely on assumptions about inflation and income growth. They include all tax law as of 2001. Top 1% All Quintiles Highest Quintile Fourth Quintile Third Quintile Second Quintile % % Lowest Quintile Share of Federal Taxes Average Federal Tax Rate Income Category Table Average federal tax rates and share of federal taxes by income quintile (2006) The Payroll Tax Hours per year Wage rate per hour DL SL L0 = L1 wg = w0 Pr DL’ wn Monopoly X per year $ DX MRX ATCX MXX X0 P0 ATC0 a b c d Economic Profits DX’ MRX’ Pn i g f h X1 Economic Profits after unit tax CHAPTER 15 TAXATION AND EFFICIENCY Excess Burden Defined Pounds of corn per year Pounds of barley per year E1 B1 C1 D F A Cb Ca B0 Government levies tax on barley i Effect of Tax on Consumption Bundle Pounds of corn per year Pounds of barley per year E1 B1 C1 D F A Cb Ca B0 E2 i ii G Excess Burden of the Barley Tax Pounds of corn per year Pounds of barley per year E1 B1 C1 D F A Cb Ca B0 E2 i ii G H B3 M I Tax Revenues Equivalent variation Questions and Answers If lump sum taxes are so efficient, why aren’t they widely used? Are there any results from welfare economics that would help us understand why excess burdens arise? Questions and Answers Does an income tax entail an excess burden? Questions and Answers Pounds of corn per year Pounds of barley per year C1 D F A Cb Ca B1 = B2 E2 i ii E1 J B3 R K If the demand for a commodity does not change when it is taxed, does this mean that there is no excess burden? S Uncompensated response Income effect Substitution effect -compensated effect Compensated demand curve Excess Burden Measurement with Demand Curves Pounds of barley per year Price per pound of barley a Db Sb q1 q2 i h S’b Pb (1 + tb)Pb g f d Tax revenues Excess burden of tax Excess burden = ½ ηPbq1tb2 Preexisting Distortions Theory of the Second Best Double-dividend hypothesis Excess Burden of a Subsidy Housing services per year Price per unit of housing services m Dh Sh’ h2 h1 u q Sh (1 – s)Ph Ph n o r Excess burden v Excess Burden of Income Taxation Hours per year Wage rate per hour SL L1 L2 a g (1 – t)w w f i h Excess burden d Excess burden = ½ εωL1t2 The Allocation of Time Between Housework and Market Work $ $ 0 0’ Hours worked in home per year Hours worked in market per year H* w1 w1 VMPhome VMPmkt (1 – t)VMPmkt H1 a b e c d w2 (1 – t)w2 Excess burden = ½ (ΔH)tw2 Does Efficient Taxation Matter? Why no excess burden budget? Is efficiency the primary objective of government policy? Does excess burden mean a tax is bad? Appendix A – Formula for Excess Burden A = ½ * base * height = ½ * (di) * (fd) fd = ∆Pb = (1 + tb) * Pb – Pb = tb * Pb di = ∆q η = (∆q/∆Pb)(Pb/q) ∆q = η(q/Pb)∆Pb since ∆Pb = tb * Pb ∆q = η(q/Pb)*(tbPb) = η * q * tb since di = ∆q A = ½(di)(fd) = ½(ηqtb)*(tbPb) = ½ * η * Pb * q * (tb)2 Appendix B – Multiple Taxes and the Theory of the Second Best Gallons of gin per year Gallons of rum per year Price per gallon of gin Price per gallon of rum Dg Dr g1 Pg Dr’ Pr (1 + tr)Pr r1 r2 r3 a b c g h d g2 e f (1 + tg)Pg CHAPTER 16 EFFICIENT AND EQUITABLE TAXATION Optimal Commodity Taxation w(T – l) = PXX + PYY wT = PXX + PYY + wl wT = (1 + t)PXX + (1 + t)PYY + (1 + t)wl 1 wT = PXX + PYY + wl 1 + t The Ramsey Rule X per year PX DX P0 X0 c P0 + uX b X1 ∆X a Excess Burden P0 + (uX + 1) f X2 i ∆x e j h g Marginal Excess Burden marginal excess burden = area fbae = 1/2∆x[uX + (uX + 1)] = ∆X The Ramsey Rule continued change in tax revenues = area gfih – area ibae = X2 – (X1 – X2)uX marginal tax revenue = X1 ∆X marginal tax revenue per additional dollar of tax revenue = ∆X/(X1 - ∆X) marginal tax revenue per additional dollar of tax revenue for good Y = ∆Y/(Y1 - ∆Y) To minimize overall excess burden = ∆X/(X1 - ∆X) = ∆Y/(Y1 - ∆Y) therefore A Reinterpretation of the Ramsey Rule inverse elasticity rule The Corlett-Hague Rule In the case of two commodities, efficient taxation requires taxing commodity complementary to leisure at a relatively high rate Equity Considerations Equity implications of inverse elasticity rule Vertical equity Optimal departure from Ramsey Rule Application: Taxation of the Family Under federal income tax law, fundamental unit of income taxation is family Is excess burden minimized by taxing each spouse’s income at same rate? Should husbands face higher marginal tax rates than wives? Optimal User Fees Z per year $ A Natural Monopoly DZ MRZ ACZ MCZ ZM PM ACM Z* P* ZA Marginal Cost Pricing with Lump Sum Taxes Benefits received principle Average Cost Pricing A Ramsey Solution Optimal Income Taxation-Edgeworth’s Model W = U1 + U2 + … + Un Individuals have identical utility functions that depend only on their incomes Total amount of income fixed Implications of model for income tax Optimal Income Taxation-Modern Studies Supply-side responses to taxation Linear income tax model (flat income tax) Revenues = -α + t * Income Stern [1987] Gruber and Saez [2002] Income Tax Revenue α = lump sum grant t = marginal tax rate Politics and the Time Inconsistency Problem Public choice analysis of tax policy Time inconsistency of optimal policy Other Criteria for Tax Design Horizontal equity Utility definition of horizontal equity Transitional equity Rule definition of horizontal equity Costs of Running the Tax System Costs of administering the income tax in the . Types of costs Compliance Administration Tax Evasion Evasion versus Avoidance Policy Perspective: Architectural Tax Avoidance Methods of tax evasion Keeping two sets of books Moonlight for cash Barter Deal in cash Positive Analysis of Tax Evasion (Dollars of underreporting) (Dollars of underreporting) $ $ MC = p * marginal penalty MC = p * marginal penalty MB = t MB = t R* R* = 0 Costs of Cheating Psychic costs of cheating Risk aversion Work choices underground economy Changing Probabilities of Audit Normative Analysis of Tax Evasion Tax evaders given weight in the social welfare function Tax evaders given no weight in the social welfare function Expected marginal cost of cheating = penalty rate * probability of detection probability of detection = f(resources devoted to tax administration draconian v just retribution penalties CHAPTER 17 THE PERSONAL INCOME TAX Computation of Federal Personal Income Tax Liability Tax Base “Above-the-line” deductions Adjusted Gross Income - Exemptions Larger of standard deduction or itemized deductions Taxable Income tax rate Tax liability before credits Tax credits Regular tax liability Wages and compensation, interest, dividends, capital gain (or loss), business income (or loss), pensions, farm income (or loss), rents, royalties, Social Security benefits, etc. Trade or business expenses, moving expenses, educator expenses, self-employed health insurance premium payments, student loan payments, tuition and fees, alimony paid, etc. Phase-out with income Charitable contributions, home mortgage interest, state and local taxes, medical expenses in excess of % of AGI, casualty and theft losses, non-reimbursed employee expenses; Phase out with income; Differs by filing status Six ordinary rates (10%, 15%, 25%, 28%, 33%, 35%); differs by filing status; special rates for dividends and capital gains Child tax, additional child tax, EITC, HOPE and Lifetime Learning, electric vehicles, health coverage tax, adoption, mortgage interest, retirement savings contribution, child and dependent care credit, credit for the elderly or the disabled, . First-Time homebuyer’s credit, etc.; Phase-out with income Start over to determine AMT tax liability using AMT base. Pay tentative AMT liability in excess of regular tax liability Pay tax or claim refund Haig-Simons Income (Comprehensive Income) Income = Consumption + DNet Worth Maximum consumption taxpayers can enjoy without spending down their wealth Anything received that can be used, either now or later, to purchase goods and services Subtract costs of earning income Items Included in H-S Income Employer pension contributions and insurance purchase Transfer payments, including Social Security benefits, unemployment compensation, and welfare Capital gains Realized versus unrealized Income in kind Imputed rent Some Practical and Conceptual Problems Computing income net of business expenses Computing capital gains and losses Computing imputed income from durables Valuing in-kind services Evaluating the H-S Criterion Equity – treats likes alike Efficiency – treats all forms of income the same; decisions made on the basis of economic value not tax consequences Excludable Forms of Money Income Interest on State & Local Bonds Some dividends Capital gains Employer contributions to benefit plans Some types of saving Individual retirement account (IRA) Roth IRA 401(k) plan Keogh plan Education savings account Gifts and Inheritances Personal Exemptions Allowable Exemptions Taxpayer and spouse Children under 19 (or 24 if in school) Children and other relatives who pass certain tests (depend on taxpayer for support) Phase out Why are there exemptions? Adjust ability to pay for presence of children Provide tax relief for low-income families Deductions Standard versus Itemized Deductibility and Relative Prices PZ  (1-t)PZ Important Itemized Deductions Unreimbursed medical expenses > % AGI State and Local Income and Property Taxes Certain Interest Expenses Interest on consumer debt Interest on qualified education loans Interest on debt incurred to purchase financial assets Interest on home mortgages Interest rules in terms of H-S criterion Tax Arbitrage Charitable Contributions More Deduction Issues Deductions and complexity Deductions versus credits Itemized deduction phaseout Standard deduction Impact on the Tax Base Tax Expenditures What are tax expenditures? Annual tax expenditure budget Technical problems with measuring tax expenditures Incentive effects Defining income Philosophical objections The Simplicity Issue Tax Reform Act of 1986 (TRA86) Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) Rate Structure 35 $336,550 and over 35 $336,550 and over 33 $188,450-$336,550 33 $154,800-$336,550 28 $123,700-$188,450 28 $74,200-$154,800 25 $61,300-$123,700 25 $30,650-$74,200 15 $15,100-$61,300 15 $7,550-$30,650 10% $0-$15,100 10% $0-$7,550 Marginal Tax Rate Taxable Income Marginal Tax Rate Taxable Income Joint Returns Single Returns Official Statutory Tax Rate Schedule (2006) Effective versus Statutory Rates Statutory rates differ from effective rates Tax system treats some forms of income preferentially Tax shifting Excess burden and administrative costs Flat Income Tax Features of Flat income tax Applies same tax rate to everyone and each component of income Limited deductions Arguments in favor Reduces excess burden Reduces incentive to cheat Greater simplicity Equity Arguments against Shifts burden from rich to middle class Simplicity an illusion Altig et. Al. [2001] Taxes and Inflation Tax Indexing How inflation can affect taxes Bracket creep Deductions and exemptions set in nominal terms Taxation of nominal capital gains Taxation of nominal interest Coping with the Tax/Inflation Problem Ad hoc reductions in tax rates Indexing of parts of tax code [1981] Should indexing be maintained? No – ad hoc adjustments force legislature to reexamine the entire tax code Yes – desirable to have a stable and predictable tax code and fewer opportunities for legislative mischief; repeal would have a larger impact on low-income families The Alternative Minimum Tax Brief history of the AMT Computing the tax base under AMT Add AMT tax preferences to regular taxable income Subtract AMT exemption Alternative minimum tax income (AMTI) Computing Tentative AMT Apply AMT tax rate schedule to AMTI Taxpayer pays higher of tentative AMT or regular income tax liability AMT as a Mass Tax Why has AMT become more important? AMT not adjusted for inflation Cuts in regular tax Problems with AMT Fairness Efficiency Simplicity Choice of Unit and the Marriage Tax Three principles The income tax should embody increasing marginal tax rates Families with equal income should, other things being the same, pay equal taxes Two individuals’ tax burdens should not change when they marry; the tax system should be marriage neutral No tax system can adhere to all three simultaneously Tax Liabilities Under a Hypothetical System 5,100 15,000 Fred 12,600 30,000 10,200 5,100 15,000 Ethel 12,100 29,000 Ricky $12,600 $30,000 $12,200 $ 100 $1,000 Lucy Joint Tax Joint Income Family Tax with Individual Filing Individual Tax Individual Income Brief History of Marriage Tax in the United States Pre-1948 taxable unit was individual 1948 family became taxable unit Income splitting 1969 New tax rate schedule for unmarried people created 1981 New deduction for two-earner married couples added 1986 Two-earner deduction eliminated 2001 law reduces (but does not eliminate) marriage penalty and adds “tax dowry” Analyzing the Marriage Tax Advantages to using the family as taxable unit Fairer treatment of nonlabor income (bedchamber transfers of property) Family a bedrock institution of society Disadvantages of using the family as taxable unit Given high divorce rates, bedchamber transfers of property may not be significant Defining the family Efficiency issues Does tax system affect marriage and divorce rates? Labor supply Treatment of International Income Global versus territorial systems Equity Efficiency Production decisions Residential decisions State Income Taxes State income taxes similar to federal tax Lower marginal tax rates Including state tax rates when assessing overall marginal tax rates Politics and Tax Reform Disagreements among experts Any change will hurt someone Tax system with low rates and broad base is not stable politically Interest on State and Local Bonds ip = 15% t = 30% ig = % ig = (1-t)ip ip = 15% t1 = 30% ig = % t2 = 20% ig = 12% If person 2 lends $1,000 Treasury loses $1,000*.15*.20 = $30 and State saves $1,000*.03 = $30 If person 1 lends $1,000 Treasury loses $1,000*.15*.30 = $45 and State saves $1,000*.03 = $30 Capital Gains P = $100,000 g = 10% $100,000*(1+.1)^20 = $672,750 Capital Gain = $672,750 - $100,000 = $572,750 Tax $572,750 * .2 = 114,550 Net Gain = $458,200 P = $100,000 g = 10% net g = 10%() = 8% $100,000*(1+.08)^20 = $466,096 Capital Gain = $466,096 - $100,000 = $366,096 Taxes deferred are taxes saved Lock-in Effect Gains Not Realized at Death Evaluation of Capital Gains Rules No justification under optimal tax literature for preferential treatment of capital gains under H-S criterion Other justifications Capital gains are unexpected windfalls Require sacrifice of abstaining from consumption Needed to stimulate capital accumulation and risk taking Counterbalance to effect of inflation Tax Arbitrage Assume Caesar pays taxes at a 35% rate and can borrow all he wants at a 15% interest rate Let Cesar borrow $1,000. Each year he pays $150 in interest (= .15*1,000) Interest payment reduces taxable income $150 and saves $ in taxes (= .35*150) His net payment of interest is $150 - $ = $ for an effective interest rate of $ = %. If he can invest in state & local bonds at 11%, the tax system has created a “money machine.” Taxation of Nominal Interest Real after-tax rate of return: r = (1 – t)i – π Let t = 25%, i = 16%, π = 10% r = (1 - .25)(.16) - .10 = .02 = 2% Now assume expected rate of inflation and nominal interest rate both increase by 4 percentage points r = (1 - .25)(.20) - .14 = .01 = 1% CHAPTER 18 PERSONAL TAXATION AND BEHAVIOR Labor Supply Hours of leisure per week Income per week 0 T time endowment D |Slope| = w F G Leisure Work i ii iii E1 Income Effects of Taxation Hours of leisure per week Income per week 0 T D |Slope| = w F G ii iii E1 i I E2 |Slope| = (1-t)w H G’ Hours of work before tax Hours of work after tax Effects of Taxation Hours of leisure per week Income per week 0 T D F G ii iii E1 i J E3 H K Hours of work before tax Hours of work after tax Effects of Taxation Hours of leisure per week Income per week 0 T D F N E1 P E4 Hours of work before tax |Slope| = w |Slope| = (1-t1)w |Slope| = (1-t2)w |Slope| = (1-t2)w (1-t1)$5,000 (1-t1)$5,000 + (1-t2$5,000 Empirical Findings Eissa [2001] Males Females Some Caveats Demand-side considerations Individual versus group effects Other dimensions of labor supply The compensation package The expenditure side Labor Supply and Tax Revenues Hours per week Wage rate per hour SL w L0 (1-t1)w L1 d b a c (1-t2)w e f L2 k (1-t3)w h i L3 j (1-tA)w LA Tax Rates versus tax revenue – Laffer Curve Tax rate Tax revenue t1 t2 tA t3 Debate Over the Laffer Curve The Laffer curve and the elasticity of labor supply Where on the Laffer curve is the economy operating? Empirical estimates of the elasticity of labor supply Other ways tax rates can affect tax revenues Determining the optimal tax rate Saving Present consumption (c0) Future consumption c1 Endowment point I0 I1 M N ІSlopeІ = 1 + r E1 c0* c1* i ii iii Saving Deductible Interest Payments and Taxable Interest Receipts Present consumption (c0) Future consumption c1 I0 I1 M N After-tax budget line ІSlopeІ = 1 + (1-t)r E1 c0* c1* Saving before tax Q P A c0t c1t Saving after tax Deductible Interest Payments and Taxable Interest Receipts Present consumption (c0) Future consumption c1 I0 I1 M N After-tax budget line ІSlopeІ = 1 + (1-t)r E1 c0* c1* Saving before tax Q P A c0t c1t Saving after tax Nondeductible Interest Payments and Taxable Interest Receipts Present consumption (c0) Future consumption c1 I0 I1 M N After-tax budget line ІSlopeІ = 1 + (1-t)r c1* Q P A c1t Some Additional Considerations Real net rate of return Many assets Private saving versus social saving Validity of life-cycle model Empirical evidence: the effect of taxation on saving Tax-Preferred Savings Accounts Types of tax-preferred savings accounts and how they work Are contributions to these accounts new saving? Administrative details and effect on saving Taxes and the Capital Shortage Taxes and investment Taxes and excess burden Closed versus open economy Empirical evidence Housing Decisions Effects of the income tax on housing decisions Rnet = R – I + ΔV Implicit rent not taxed Deductibility of mortgage interest and property tax payments The decision to rent or buy Proposals for Change Critique of subsidy for owner-occupied housing Are there significant positive externalities? Impact on distribution of income Political feasibility of taxing imputed rent Reform proposals Elimination of deduction for property tax and mortgage interest Placing an upper-limit on deductions An efficient solution Portfolio Composition Tobin’s model of portfolio composition Impact of proportional tax with full loss offset Impact on return Impact on risk Empirical evidence A Note on Politics and Elasticities Ambiguity about effect of taxation on behavior Importance of elasticities “Convenient” beliefs about elasticities Taxes and Human Capital Accumulation Human capital Investing in human capital B – C > 0 (1 – t)B – (1 – t)C = (1 – t)(B – C) > 0 Income versus substitution effects Shortcomings of model Returns uncertain Explicit costs Other taxes Progressive taxes Effect of Taxation on Saving Problems using the regression approach Specification issues Measurement issues Bernheim [2002] CHAPTER 19 THE CORPORATION TAX I’ll probably kick myself for having said this, but when are we going to have the courage to point out that in our tax structure, the corporation tax is very hard to justify? President Ronald W. Reagan Corporations Corporation – A state-chartered form of business organization, usually with limited liability for shareholders (owners) and an independent legal status Limited liability Corporations are “artificial legal persons” Why Tax Corporations? Only real people can pay a tax Justifications Corporations are distinct entities Corporations receive special privileges from society Protects integrity of personal income tax Structure Revenue - Expenses incurred earning revenues Taxable Income * Tax rate (15% - 35%) Tax - Credits Total Tax Alternative Minimum Tax Treatment of Losses Treatment of Dividends versus Retained Earnings Double taxation Effective Tax Rate on Corporate Capital Statutory rate versus effective rate Interest deductibility Depreciation allowances Inflation Double taxation Gravelle [2004] Effective corporate rate = 32%; noncorporate rate = 18% Sensitivity of estimate Incidence and Excess Burden A tax on corporate capital Incidence in a general equilibrium model Excess burden on a general equilibrium model A tax on economic profits Incidence and excess burden of a tax on economic profits Actual corporate profits versus economic profits Stiglitz [1973] model Effects on Behavior – Total Physical Investment Accelerator Model Neoclassical Model Cash Flow Model Effects on Behavior-Type of Asset Tax system encourages purchase of assets that receive relatively generous depreciation allowances Effects on Behavior-Corporate Finance Why do firms pay dividends? Dividends as a signal of firm’s financial strength Clientele effect Effect of taxes on dividend policy Empirical evidence – Chetty and Saez [2004] Effect on savings Debt versus Equity Finance Did the tax system cause the corporate accounting scandals? State Corporation Taxes State taxes have similar incidence and efficiency problems as federal taxes Variation of tax rates across state lines Taxation of Multinational Corporations Structure U. S. corporations pay tax at standard rate on global taxable income Credit for foreign taxes paid Subsidiary status Deferral of taxes on income from foreign enterprise Repatriation Income allocation Arm’s length system Transfer-pricing problem Evaluation of Tax Treatment of Multinational Firms Maximization of world income Maximization of national income Corporation Tax Reform Full Integration (Partnership Method) Issues Nature of the corporation Administrative feasibility Effects on efficiency Effects on saving Effect on distribution of income Dividend Relief Allow corporation to deduct dividends Exclude dividends from individual taxation 2003 legislation – 15% maximal tax rate on dividends Allowable Expenses Employee Compensation except compensation in excess of $1,000,000 Options do not have to be included Cost of Material Inputs Taxes including employer contributions to Social Security Repairs and advertising Interest but not dividends Depreciation No investment tax credit Depreciation What is depreciation? Tax life of an asset 3, 5, 7, 10, 15, 20, , and 39 years Most 5 years Calculating the Value of Depreciation Allowances – Straight-Line Depreciation, 10 year tax life $35, $3, $3, $3, $3, $3, $3, $3, $3, $3, $3, Tax Savings $21, $100, Total $1, $10, 10 $1, $10, 9 $1, $10, 8 $1, $10, 7 $1, $10, 6 $2, $10, 5 $2, $10, 4 $2, $10, 3 $2, $10, 2 $3, $10, 1 Present Value of Tax Savings Write-off Year Calculating the Value of Depreciation Allowances – Straight-Line Depreciation, 5 year tax life $35, $7, $7, $7, $7, $7, Tax Savings $26,535,51 $100, Total $4, $20, 5 $4, $20, 4 $5, $20, 3 $5, $20, 2 $6,363,64 $20, 1 Present Value of Tax Savings Write-off Year Calculating the Value of Depreciation Allowances – Double Declining Balance Depreciation, 10 year tax life $ $2, $6, 10 $1, $2, $6, 9 $1, $2, $6, 8 $1, $2, $6, 7 $1, $2, $6, 6 $23, $35, $100, Total $1, $2, $6, 5 $2, $3, $10, 4 $3, $ $12, 3 $4, $5, $16, 2 $6, $7, $20, 1 Present Value of Tax Savings Tax Savings Write-off Year General Analysis of Depreciation Tax Savings T = tax life D(n) = proportion of asset that can be written off against taxable income in nth year θ = corporate tax rate Present value of tax savings: ψ = θ * D(1) + θ * D(2) + … + θ * D(T) 1 + r (1 + r)2 (1 + r)T More on Depreciation Accelerated depreciation Expensing Intangible Assets Investment Tax Credit k = investment tax credit q = acquisition price of asset (1 – k)q = effective price of asset Stiglitz Model G = before-tax value of output produced by machine r = interest rate Firm buys machine if: G – r > 0 Assume corporate tax (1) net income taxed at rate θ (2) net income = G – r (1 – θ)(G – r) > 0 Neoclassical Model User cost of capital = (r + δ) After tax rate of return = (1 – θ) * (1 – t) (1 – θ) * (1 – t) * C = (r + δ) C = (r + δ) (1 – θ) * (1 – t) C = (r + δ) * (1 – ψ –k) (1 – θ) * (1 – t) Effect of User Cost on Investment Econometric problems Role of expectations Elasticity of supply curve of capital goods Open economy problems Cash Flow Model What is cash flow? Irrelevancy of cash flow in neoclassical model Cost of internal versus external funds Empirical results Maximization of World Income rf = rUS (1 – tf)rf = (1 – tUS)rUS Full credit versus limited credit Maximization of National Income (1 – tf)rf = rUS rf = rUS/(1 – tf) if tf < 1, then rUS < rUS/(1 – tf) Deduction of foreign tax payments from domestic income: rf(1 – tf)(1 – tUS) = rUS(1 – tUS) Note: this equation equivalent to … this one Effects on Efficiency of Full Integration Misallocation of resources between corporate and noncorporate sectors eliminated Tax-induced distortions in savings decisions reduced Remove incentive for “excessive” retained earnings Reduce bias toward debt financing CHAPTER 20 DEFICIT FINANCE How Big is the Deficit? Deficit Surplus On-budget deficit Off-budget deficit How Big is the Deficit? How Big is the Debt? National (Public) Debt Stocks v Flows How Big is the Debt? Interpreting Deficit, Surplus, and Debt Numbers Government Debt held by the Federal Reserve Bank State and Local Government Effects of Inflation inflation tax Capital versus Current Accounting Tangible Assets Implicit Obligations Summing Up The Burden of the Debt Statutory versus Economic Incidence Lerner’s View Internal Debt External Debt Overlapping Generations Model +6,000 +6,000 (5) Government pays back debt -4,000 -4,000 -4,000 (4) Government raises taxes to pay back debt Old Middle-Aged Young The Year 2027 4,000 4,000 4,000 (3) Government- provided consumption -6,000 -6,000 (2) Government Borrowing 12,000 $12,000 $12,000 (1) Income Old Middle-Aged Young The Period 2007-2027 Generational Accounting Computation of Net Tax PV of transfers received – PV of taxes paid Neoclassical Model Crowding Out Hypothesis Empirical testing of the hypothesis The Ricardian Model Intergenerational transfers Form of Finance is irrelevant Empirical evidence To Tax or to Borrow Benefits-Received Principle Intergenerational Equity Efficiency Considerations χ = ½εLt2 Macroeconomic Considerations Functional finance Moral and Political Considerations Present Value of Tax Payments Under Alternative Taxing/Borrowing Decisions 100 10 10 0 Deficit Finance II: borrow 100 in year 1 and pay interest on debt in all subsequent years always rolling over debt principle 100 0 110 0 Deficit Finance I: borrow 100 in year 1 and pay back debt plus interest in year 2 by raising taxes 100 0 0 100 Balanced budget: raise 100 in taxes in year 1 Financing Options 100 0 0 100 Spend an additional $100 in year 1 PV @ 10% interest rate All Future Years Year 2 Year 1 Policy To Tax or To Borrow Tax rate Excess Burden t 2t χ2 χ1 CHAPTER 21 FUNDAMENTAL TAX REFORM: TAXES ON CONSUMPTION AND WEALTH Efficiency and Equity of Personal Consumption Taxes Efficiency issues An income tax and saving and labor supply decisions A consumption tax and saving and labor supply decisions Efficiency and Equity of Personal Consumption Taxes Equity issues Progressiveness Ability to pay Annual versus Lifetime Equity A numerical example A formal model Retail Sales Tax General sales tax Selective sales tax (excise tax or differential commodity tax) Forms of a sales tax Unit tax Ad valorem tax State and Local Sales Tax Revenues by Source ($billions) Source: US Bureau of the Census [2006]. Figures are for 2003-2004. % % Percent of own-source revenue from sales taxes Public utilities Tobacco Alcoholic beverages Motor fuel $ $ General sales tax Local State Source Rationalizations Ease of administration Defining the tax base Tax evasion Efficiency and Distributional Implications of States Sales Taxes Differential versus uniform tax rates How to set rates Efficiency goal only Equity goal Externalities Sales taxes as substitutes for user fees “Sin” taxes Information requirements for differential tax rates A National Retail Sales Tax Arguments in favor Simplicity Ease of compliance Arguments Against Value-Added Tax How a value-added tax works VAT as an alternative method for collecting retail sales tax Implementation Issues Treatment of investment assets Consumption-type VAT Collection procedure Invoice method Rate structure A VAT for the United States? Desirability of VAT depends on… What tax (or taxes) it will replace How revenues will be spent Political implications of VAT’s revenue raising prowess International implications Hall-Rabushka Flat Tax Business tax tax base = Sales – purchases from other firms – payments to workers Pay flat tax rate on final amount Individual Compensation tax tax base = payments received by individual for their labor services No additional deductions Apply selected tax schedule Why is H&R tax a consumption tax? Cash-Flow Tax How a cash-flow tax works How to compute annual consumption Cash-flow basis Qualified accounts Income versus Consumption Taxation No need to measure capital gains and depreciation Fewer problems with inflation No need for separate corporation tax Administrative problems Transitional issues Gifts and bequests Advantages Disadvantages Problems with Both Systems Defining consumption Choosing the unit of taxation Choosing the rate structure Valuing fringe benefits Determining method for averaging over time Taxing home production Discouraging incentive to participate in underground economy Real world versus ideal tax systems Policy Perspective: President’s Advisory Panel on Federal Tax Reform Wealth Taxes Justifications for taxing wealth Large accumulations of wealth should be taxed Correct problems with administration of income tax Higher wealth implies higher ability to pay Reduces the concentration of wealth Payment for benefits received from government Estate and Gift Taxes Rationales Payment for services Reversion of property to society Incentives Recipient versus donor behavior Work Saving Form of bequest Relation to personal income tax Income distribution Provisions of the Unified Transfer Tax Gross Estate Charitable Contributions Funeral Expenses Costs of Settling Estate (lawyer’s fees) Outstanding Debts Lifetime Exemption Qualified Transfers to Spouse Annual Gift Exclusion Taxable Estate * tax rate Tax 0 Special Problems Policy Perspective: Death of the Death Tax? Jointly held property Closely-held businesses Avoidance strategies Insurance trust Gifts of stock Reforming Estate and Gift Taxes Integrate with personal income tax Accessions tax Prospects for Fundamental Tax Reform Broad versus piecemeal changes Gross Estate All decedent’s assets at time of death, including real property, stocks, bonds and insurance policies, plus gifts made during decedent’s lifetime Typically valued at market value at date of death; valuation may be set 6 months later if value of estate declines Closely held businesses and farms are valued at “use value;” this can reduce estate value by up to $770,000 Annual versus Lifetime Equity – A Numerical Example $500 $523 $500 $500 Present Value of taxes paid Consumption tax Income tax Consumption tax Income tax $25 $525 $50 $500 $0 $1,000 $0 $0 $0 $500 $500 $1,000 Taxes period 1 Consumption period 1 Income period 1 Taxes period 0 Consumption period 0 Income period 0 Parameters Income tax rate = 50% Consumption tax rate = 50% Interest rate = 10% $550 $0 $550 $0 $100 $0 $0 $500 $0 $500 $1,000 $1,000 Ms. Ant Mr. Grasshopper Annual versus Lifetime Equity – A Formal Model Ms. Ant Mr. Grasshopper tr(I0 – c0A) r(I0 – c0A) tI0 c0A I0 Taxes period 1 Income period 1 Taxes period 0 Consumption period 0 Income period 0 Parameters Income tax rate = t Consumption tax rate = tc Interest rate = r tr(I0 – c0G) r(I0 – c0G) tI0 c0G I0 Income Tax Annual versus Lifetime Equity – A Formal Model Ms. Ant Mr. Grasshopper RcA = tcc0A + tcc1A/(1 + r) = tcI0 I0 = c0A + c1A/(1 + r) Present Value of Lifetime Tax Liability Present Value of Lifetime Income Parameters Income tax rate = t Consumption tax rate = tc Interest rate = r RcG = tcc0G + tcc1G/(1 + r) = tcI0 I0 = c0G + c1G/(1 + r) Consumption Tax How a Value-Added Tax Works $200 $1,000 $3,050 $2,050   Total 10 50 1,000 950 Grocer 50 250 950 700 Baker 60 300 700 400 Miller $ 80 $  400 $400 $    0 Farmer VAT at 20 Percent Rate Value Added Sales Purchases Producer Policy Perspective: President’s Advisory Panel on Federal Tax Reform Simplified Income Tax (SIT) Growth and Investment Tax (GIT) Policy Perspective: President’s Advisory Panel on Federal Tax Reform Common features Eliminate individual and corporate alternative minimum tax Replace standard deduction, personal exemption, earned income tax credit, and child tax credit with “Family Credit” and “Work Credit” Replace mortgage interest deduction with mortgage tax credit Reduce tax preference for employer-sponsored health insurance eliminate deductibility of state and local taxes Reduce number of tax brackets Reduce maximum tax rate to 33% under SIT and 30% under GIT Create savings plans (Save at Work, Save for Retirement, Save for Family) GIT allows business to expense investments, lowers tax rates on business, and imposes single, low tax rate on dividends, interest and capital gains CHAPTER 22 PUBLIC FINANCE IN A FEDERAL SYSTEM Background Federal system Fiscal federalism Centralization Centralization ratio = Central government expenditures Total government expenditures Community Formation Club – voluntary association of people who band together to finance and share some benefit Optimal Club (or community) The Tiebout Model Voting with your feet Tiebout’s assumptions Government activities generate no externalities Individuals are completely mobile People have perfect information with respect to each community’s public services and taxes There are enough different communities so that each individual can find one with public services meeting her demands The cost per unit of public services is constant so that if the quantity of public services doubles, the total cost also doubles Public services are financed by a proportional property tax Communities can enact exclusionary zoning laws—statutes that prohibit certain uses of land Tiebout and the Real World Critique of Tiebout Empirical tests Optimal Federalism Macroeconomic functions Microeconomic functions Disadvantages of a Decentralized System Efficiency issues Externalities local public good Scale economies in provision of public goods Inefficient tax systems Scale economies in tax collection Equity issues Advantages of a Decentralized System Tailoring outputs to local taxes Fostering intergovernmental competition Experimentation and information in locally provided goods and services Implications Purely decentralized systems cannot maximize social welfare Dealing with community activities that create spillover effects that are not national in scope Combine communities under a single regional government Pigouvian taxes and subsidies Division of responsibility in public good provision Distributional goals and mobility Public Education in a Federal System Local control of schools Financing education through property taxation Federal role in education Property Tax How the property tax works Assessed value Assessment ratio Source: US Bureau of the Census [2006, p. 301] *Figures are for 2003. Los Angeles New York Charlotte Chicago New Orleans Atlanta Detroit % Newark Effective Tax Rate* City Residential Property Tax Rates (selected cities) Incidence and Efficiency Effects – The Traditional View - Tax on Land Acres of land Rent per acre of land SL DL P0L DL’ PnL PsL = P0L Price received by landowners falls by amount of the tax Incidence and Efficiency Effects – The Traditional View - Tax on Land Tax capitalized into price of land Land not fixed in supply Incidence and Efficiency Effects – The Traditional View - Tax on Structures Number of structures per year Price per structure SB DB P0B DB’ PnL PnB = P0B B0 B1 PgB Price paid by tenants increases by full amount of the tax Summary and Implications of the Traditional View Progressivity Land tax Structures tax Empirical evidence Measuring income The New View: Property Tax as a Capital Tax Partial equilibrium versus general equilibrium General Tax effect Excise Tax effects Long-run effects Property Tax as a User Fee The notion of the incidence of the property tax is meaningless The property tax creates no excess burden Federal income tax subsidizes consumption of local public services for individuals who itemize Oates [1969] Reconciling the Three Views New view: Eliminating all property taxes and replacing them with a national sales tax Traditional view: Lowering property tax rate and making up revenue from local sales tax User fee view: Taxes and benefits jointly changed and people are sufficiently mobile Why Do People Hate the Property Tax So Much? Property tax levied on estimated value Property tax highly visible Property tax perceived as being regressive Circuit breakers Property tax easier to attack Ideas for Improving the Property Tax Improve assessment procedures Personal net worth tax Intergovernmental Grants Relation of federal grants-in-aid to federal and state-local expenditures (selected fiscal years) Why Have Intergovernmental Grants Grown So Much? Mismatch theory Conditional (Categorical) Grants G1 c1 E1 Units of public good (G) per year Consumption (c) per year A B Matching Grants R G2 c2 E2 Conditional (Categorical) Grants G1 c1 E1 Units of public good (G) per year Consumption (c) per year A B Matching Closed-Ended Grants R G3 c3 E3 D Conditional (Categorical) Grants G1 c1 E1 Units of public good (G) per year Consumption (c) per year A B Nonmatching Grants R G2 c4 E4 H J Unconditional Grants Revenue sharing Measuring Need Tax effort The Flypaper Effect Whose indifference curves? Median voter theorem Flypaper effect Intergovernmental Grants for Education Serrano v Priest [1971] Foundation aid District power equalization grants Issues Educational outcomes Impact of centralized financing on voters’ support for public education Callouts highlight real, per capital and relative values Bar representing US slides along graph from left to right Callouts showing decline in national defense and increase in social security, Medicare and income security Callouts showing decline in highway spending and increase in public welfare spending Brackets showing social insurance and individual taxes more important; corporate and other taxes less important Brackets showing individual tax more important and property tax less important First callout identifies intercept term. Second callout identifies slope term. Box and dimensions initially set 1st click – place point v 2nd click – draw horizontal line uw 3rd click – draw vertical line xy Box and dimensions initially set 1st click – Adam’s indifference curves 2nd click – Eve’s indifference curves Box and dimensions initially set 1st click – “A Pareto efficient allocation” and arrow Box and dimensions initially set 1st click – “A Pareto efficient allocation” and arrow Box and dimensions initially set 1st click – Box with Pareto efficient and improvement within Box and dimensions initially set 1st click – Box and dimensions initially set 1st click – contract curve drawn from lower left to upper right and “The contract curve” and arrow appear Axes and labels 1st click – PPC and labels 2nd click – lines x and w 3rd click – lines z and y Each line wipes right after click Box and dimensions initially set 1st click – contract curve drawn from lower left to upper right and “The contract curve” and arrow appear Axes and labels 1st click – Utility possibilities curve, p3 and p5 2nd click - q Axes and labels 1st click – the arrow (speed: medium) and “Increasing social welfare” Axes, labels, and social indifference curves 1st click – utility possibilities curve and points 4 1st click – Excludable v Nonexcludable and all sub paragraphs 2nd click – Rival v Nonrival and all sub paragraphs 1st click - “Private goods” 2nd click - “Public goods” 3rd click - “Common resources” 4th click - “Natural monopoly” 1st click – Adam’s D curve 2nd click – Eve’s D curve 3rd click – sum of Adam and Eve at P = 11 4th click – sum of Adam and Eve at P = 9 5t click – sum of Adam and Eve at P = 7 6th click – sum of Adam and Eve at P = 5 7th click – sum of Adam and Eve at P = 3 8th clck – sum of Adam and Eve at P = 1 9th click - Market Demand curve and dashed horizontal lines disappear 10th click – Market Supply curve 1st click – Adam’s D curve 2nd click – Eve’s D curve 3rd click – sum of Adam and Eve at Q = 1 4th click – sum of Adam and Eve at Q = 2 5t click – sum of Adam and Eve at Q = 3 6th click – sum of Adam and Eve at Q = 4 7th click - Market Demand curve and dashed horizontal lines disappear 8th click – Market Supply curve Axes and labels 1st click – MB 2nd click – MPC, Q1 3rd click – MD 4t click – MSC, Q* Axes and labels 1st click – MB 2nd click – MPC, Q1 3rd click – MD 4t click – MSC, Q* Axes and labels 1st click – MP shifts up to MPC + cd 2nd click – Pigouvian tax revenues box Axes and labels 1st click – MP shifts up to MPC + cd 2nd click – dashed lines fi, hj, and hf 3rd click = Pigouvian subsidy Axes and labels 1st click – MSB 2nd click – MC 3rd click – dashed line and e* 4th click – f* and brown horizontal line axes and labels for both graphs 1st click – MCB and dashed vertical lines, MCH and dashed vertical black line 2nd click – horizontal dashed brown line and vertical dashed brown line 3rd click – dashed brown line and Bart’s dashed black line at 50 disappear 4th click – line at f = $50 wipes right 5th click – Bart’s tax payment 6th click – Homer’s tax payment axes and labels for both graphs 1st click – MCB and dashed vertical lines, MCH and dashed vertical black line; horizontal dashed brown line and vertical dashed brown line 2nd click – 3rd click – dashed brown line and Bart’s dashed black line at 50 disappear 4th click – line at f = $50 wipes right 5th click – Bart’s tax payment 6th click – Homer’s tax payment Axes and labels 1st click – MSB 2nd click – MC* 3rd click – MC’ 4th click – f* Axes and labels 1st click – MSB 2nd click – MC* 3rd click – MC’ 4th click – f* Axes and labels 1st click – MPB 2nd click – MC and R* 3rd click – MEB 4th click MSB and R1 box and labels 1st click – Adam’s D 2nd click – Eve’s D 3rh click – equilibrium r and S axes and labels 1st click – Brad 2nd click – Jen 3rd click – Angelina 4th click – “Single-peaked preferences” and two arrows 5th click – “Double-peaked preferences” and curved arrow Melanie votes for library if Rhett votes for hospital; and Rhett and Scarlet trade votes for the pool and library Left box by 2nd level paragraphs Right box by 2nd level paragraphs Distribution and labels 1st click - Female politician locates on right 2nd click - Male politician locates directly to left of female 3rd click - female moves to left of male (but still to right of mean) 4th click - male politician moves just left of mean Axes and labels 1st click – V schedule 2nd click – C schedule 3rd click – two tangents, dashed line, Q* and “Efficient Output” tag 4th click – dashed line, Qbc, “Actual output” Axes, labels, D, MR, and S=MC 1st click - rents Callout enters after click and pauses 2 seconds at e0, ep and x one click per line 5 lines visible 1st click – 6th line 7th click – “Present Value” 8th click – “discount rate” 9th click ‘ discount rate arrow disappears, bracket appears, “discount factor” 1st click – left-hand side text line-by-line 2nd click - axes and labels, D, S, A, d, and g 3rd click – S’, A1 Axes and labels 1st click – Dm 2nd click – Sm, 3rd click - brown rectangle 4th click - .2P0 5th click - gray rectangle 6th click – deadweight loss triangle 7th click – “Flat-of-the-curve medicine” $1741 maximum benefit SSW = $16,000 billion $16,000 * = $448 billion $296 actually saved 60% reduction Payroll tax reduces everyone’s incentive to acquire bequeathable wealth, but it has a disproportionate effect on low-earners Conclusions based on simulated results so they are not especially strong conclusions Photo of Ida Mae Fuller is from the Social Security web site Ida Mae Fuller – first recipient of monthly Social Security Benefits; retired Nov. 4, 1939 and lived to 99. Collected $20,897 on a tax of $ Review General Concept of Social Welfare Function Utilitarianism simply means W a function of people’s utility Conventional Welfare Economics posits W = F(U1, U2, …, Un), but this so general it doesn’t tell us much Utilitarians believed in additive welfare function, although W = F( ) is called a utilitarian welfare function Only important consideration is the utility of the least well-off member. Society’s objective is to maximize the utility of the person with the least utility. This implies there should be complete equality except to the extent that departures from equality increase the welfare of the worst-off person. No inequality acceptable unless it works to the advantage of everyone. Original position – “behind the veil of ignorance” – people will adopt maximin because of the insurance it gives against disastrous outcomes Criticisms Should decision made in original position have any special claim to ethical validity Are people really that risk adverse? It can lead to some weird outcome. “A new opportunity arises to raise the welfare of the least disadvantaged by a slight amount, but almost everyone else must be made substantially worse off, except for a few individuals who would become extremely wealthy.” Because all that is relevant is the welfare of the worst-off person, the maximin criterion indicates that society should take advantage of the opportunity Assumption that utility depends on your income only implies that al redistribution must hurt at least one person so redistribution can never be a Pareto improvement. If we assume that utilities depend not only on their own income, but those of others, then redistribution can be a Pareto improvement. Some argue specification of income distribution should be derived from a set of principles that are independent of people’s tastes. Nonutilitarian approach Commodity Egalitarianism – James Tobin – certain types of commodities are so important that they should be distributed equally (less unequally than ability to pay for them) – basic necessities of life, health citizenship the higher G, the higher t higher G or lower t leads to a higher breakeven E which raises the costs of the system and includes more people Tax Analysis – use of economic theory to analyze impact of taxes Equity and Efficiency – how do taxes affect the distribution of income, how do taxes affect economic efficiency Statutory Incidence - who is legally responsible for tax (who writes the check) Economic Incidence – whose purchasing power is reduced by the tax Tax Shifting – extent that statutory and economic incidence differ Partial Equilibrium Models- look at a single market, appropriate when market for commodity is small relative to economy Tax scheme depicted – Tax = *(Income - $3,000) Unit Tax on Commodities Consumer Pays $ Producer receives $ Tax on Consumers of $.40 per gallon D curve shifts down – D curve perceived by supplier-amount of money the supplier will receive Tax wedge – tax induced spread between price paid by consumer and price received by producer Tax on Producers of $.40/gal Draw new supply curve Consumer Pays $ Producer receives $ Economic incidence independent of statutory incidence 1st box - shows that tax break reduces the interest rate S&L governments have to pay 2nd box – shows that cost of break to Treasury exceeds gain to S&L government Each line enters separately with a mouse click. Notes: clicking on the “Other dimensions …” link goes to a custom show on “Taxes and Human Capital Accumulation.” Finishing show automatically returns to this slide. $100,000 investment 35% corporate tax rate 10 year tax life straight-line depreciation 10% discount rate $100,000 investment 35% corporate tax rate 5 year tax life straight-line depreciation 10% discount rate $100,000 investment 35% corporate tax rate 10 year tax life double declining balance depreciation 10% discount rate Lerner – generation is everyone alive at same time Alternative – generation is everyone born at the same time Each generation has equal number of people Each lives 20 years Each has fixed income of $12,000/year Internal debt creates burden for future generations OG model  using generational accounting to evaluate impact of Government fiscal policies Clicking on “Efficiency Considerations” goes to custom show showing PV of spending and taxing under alternative taxing/borrowing decisions Clicking on “χ = ½εLt2” goes to custom show of graph of relationship between tax rate and excess burden Table shows 3 ways to finance an extra 100 in spending in year 1. Balanced budget – finance spending by raising 100 in taxes in year 1. PV of tax payments is 100 Deficit Finance I – finance by borrowing the 100 in year 1 and paying it back plus interest in year 2. In year 2 110 must be raised in taxes. PV of 110 in one year at 10% interest rate is 100 Deficit Finance II – finance by borrowing 100 in year 1 and never paying back the debt. In all subsequent years the interest on the debt must be paid so taxes must be raised 10 each year to do that. PV of 10 per year until the end of time is 100. Axes and labels 1st click – curved solid line and dashed lines Click returns to “To tax or borrow” slide

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