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ECONOMICS OF THE PUBLIC SECTOR

FOURTH EDITION

ECONOMICS OF THE PUBLIC SECTOR

FOURTH EDITION

JOSEPH E. STIGLITZ | JAY K. ROSENGARD

n W. W. NORTON & COMPANY, INC. NEW YORK • LONDON

W. W. Norton & Company has been independent since its founding in 1923, when William Warder Norton and Mary D. Herter Norton f irst published lectures delivered at the People’s Institute, the adult education division of New York City’s Cooper Union. The f irm soon expanded its program beyond the Institute, publishing books by celebrated academics from America and abroad. By midcentury, the two major pillars of Norton’s publishing program—trade books and college texts— were f irmly established. In the 1950s, the Norton family transferred control of the company to its employees, and today—with a staf f of four hundred and a comparable number of trade, college, and professional titles published each year—W. W. Norton & Company stands as the largest and oldest publishing house owned wholly by its employees.

Copyright © 2015 by W. W. Norton Company, Inc.

Copyright © 2000, 1988, 1986 by Joseph E. Stiglitz, the Trustee of Edward Hannaway Stiglitz Trust, the Trustee of Julia Hannaway Stiglitz Trust, and the Trustee of the Trust for the Benef it of Joseph E. Stiglitz’s Children

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Library of Congress Cataloging-in-Publication Data.

Stiglitz, Joseph E. Economics of the public sector / Joseph E. Stiglitz, Jay K. Rosengard.—Fourth edition. pages cm Includes bibliographical references and index. ISBN 978-0-393-92522-7 (pbk.) 1. Finance, Public—United States. 2. Fiscal policy—United States. I. Rosengard, Jay K. II. Title. HJ257.2.S84 2015 336.73—dc23 2014048383

W. W. Norton & Company, Inc., 500 Fif th Avenue, New York, NY 10110-0017 ww nor ton.com

W. W. Norton & Company Ltd., Castle House, 75/76 Wells Street, London W1T 3QT

1 2 3 4 5 6 7 8 9 0

To our f irst teachers, Nat and Charlotte Jordan and Betty

vii

BRIEF CONTENTS

Preface xxvii

PART 1 ROLE AND SIZE OF THE PUBLIC SECTOR 1

1 DEFINING PUBLIC SECTOR RESPONSIBILITIES 3

2 MEASURING PUBLIC SECTOR SIZE 26

PART 2 FUNDAMENTALS OF WELFARE ECONOMICS 59

3 MARKET EFFICIENCY 61

4 MARKET FAILURE 81

5 PUBLIC GOODS AND PUBLICLY PROVIDED PRIVATE GOODS 101

6 EXTERNALITIES AND THE ENVIRONMENT 129

7 EFFICIENCY AND EQUITY 163

PART 3 PUBLIC EXPENDITURE THEORY 197

8 PUBLIC PRODUCTION OF GOODS AND SERVICES 199

9 PUBLIC CHOICE 230

viii BRIEF CONTENTS

PART 4 PUBLIC EXPENDITURE IN PRACTICE 267

10 FRAMEWORK FOR ANALYSIS OF EXPENDITURE POLICY 269

11 EVALUATING PUBLIC EXPENDITURE 296

12 DEFENSE, RESEARCH, AND TECHNOLOGY 329

13 HEALTH CARE 357

14 EDUCATION 394

15 WELFARE PROGRAMS AND THE REDISTRIBUTION OF INCOME 428

16 SOCIAL INSURANCE 470

PART 5 TAXATION IN THEORY 503

17 INTRODUCTION TO TAXATION 505

18 TAX INCIDENCE 538

19 TAXATION AND ECONOMIC EFFICIENCY 574

20 OPTIMAL TAXATION 606

21 TAXATION OF CAPITAL 636

PART 6 TAXATION IN PRACTICE 665

22 THE PERSONAL INCOME TAX 667

23 THE CORPORATION INCOME TAX 709

24 A STUDENT’S GUIDE TO TAX AVOIDANCE 746

25 REFORM OF THE TAX SYSTEM 762

PART 7 FURTHER ISSUES 799

26 INTER GOVERNMENTAL FISCAL RELATIONS 801

27 SUBNATIONAL TAXES AND EXPENDITURES 832

28 FISCAL DEFICITS AND GOVERNMENT DEBT 851

References 880 Index 893

ix

CONTENTS

Preface xxvii

PART 1 ROLE AND SIZE OF THE PUBLIC SECTOR 1

1 DEFINING PUBLIC SECTOR RESPONSIBILITIES 3

The Economic Role of Government 4

The Mixed Economy of the United States 4 Different Perspectives on the Role of Government 6 An Impetus for Government Action: Market Failures 7 Achieving Balance between the Public and Private Sectors 10 The Emerging Consensus 11

Thinking Like a Public Sector Economist 13

Analyzing the Public Sector 15 Economic Models 17 Case Study Musgrave’s Three Branches 18 Normative versus Positive Economics 19

Disagreements among Economists 21

Differences in Views on How the Economy Behaves 21 Disagreement over Values 23 Case Study Public Sector Economics and

the Global Economic Crisis 23

Review and Practice 24

Summary 24 Key Concepts 24 Questions and Problems 25

x

2 MEASURING PUBLIC SECTOR SIZE 26

What or Who Is the Government? 27

Types of Government Activity 29

Providing a Legal System 30 Government Production 30 Government’s Infl uence on Private Production 33 Government Purchases of Goods and Services 36 Government Redistribution of Income 36 Overview of Government Expenditures 40

Gauging the Size of the Public Sector 42

Growth in Expenditures and Their Changing Composition 42 Case Study Estimating the Full Budgetary and Economic Costs of War 43 Comparison of Expenditures across Countries 45

Government Revenues 47

Taxes and the Constitution 47 Federal Taxation Today 48 State and Local Government Revenues 49 Comparison of Taxation across Countries 50

Defi cit Financing 51

Playing Tricks with the Data on Government Activities 55 Review and Practice 56

Summary 56 Key Concepts 57 Questions and Problems 57

PART 2 FUNDAMENTALS OF WELFARE ECONOMICS 59

3 MARKET EFFICIENCY 61

The Invisible Hand of Competitive Markets 61

Welfare Economics and Pareto Effi ciency 63

Case Study On the Prowl for Pareto Improvements 64 Pareto Effi ciency and Individualism 65 The Fundamental Theorems of Welfare Economics 66 Effi ciency from the Perspective of a Single Market 68

Analyzing Economic Effi ciency 69

The Utility Possibilities Curve 69 Exchange Effi ciency 70 Production Effi ciency 74 Product Mix Effi ciency 78

CONTENTS

xi

Review and Practice 79

Summary 79 Key Concepts 80 Questions and Problems 80

4 MARKET FAILURE 81

Property Rights and Contract Enforcement 82 Case Study Property Rights and Market Failures:

The Tragedy of the Commons Revisited 82

Market Failures and the Role of Government 83

1. Failure of Competition 83 2. Public Goods 86 3. Externalities 86 4. Incomplete Markets 87 Case Study Student Loans: Incomplete Reform of an

Incomplete Market 89 5. Information Failures 91 6. Unemployment, Infl ation, and Disequilibrium 93 Interrelationships of Market Failures 93

Case Study Market Failures: Explanations or Excuses? 94

Redistribution and Merit Goods 95

Two Perspectives on the Role of Government 97

Normative Analysis 97 Positive Analysis 98

Review and Practice 99

Summary 99 Key Concepts 99 Questions and Problems 100

5 PUBLIC GOODS AND PUBLICLY PROVIDED PRIVATE GOODS 101

Public Goods 102

Public Goods and Market Failures 103 Paying for Public Goods 103 The Free Rider Problem 105 Case Study Economists and the Free Rider Problem 106 Pure and Impure Public Goods 107 Case Study Property Rights, Excludability, and

Externalities 110

Publicly Provided Private Goods 111

Rationing Devices for Publicly Provided Private Goods 113

Effi ciency Conditions for Public Goods 116

Demand Curves for Public Goods 117 Pareto Effi ciency and Income Distribution 122

CONTENTS

xii

Limitations on Income Redistribution and the Effi cient Supply of Public Goods 122 Distortionary Taxation and the Effi cient Supply of Public Goods 123

Effi cient Government as a Public Good 124

Review and Practice 125

Summary 125 Key Concepts 125 Questions and Problems 126

APPENDIX: The Leftover Curve 127

6 EXTERNALITIES AND THE ENVIRONMENT 129

The Problem of Externalities 130

Private Solutions to Externalities 132

Internalizing Externalities 132 The Coase Theorem 133 Using the Legal System 134 Case Study The Exxon Valdez Oil Spill 135 Failures of Private Solutions 136

Public Sector Solutions to Externalities 138

Case Study Double Dividend 138 Market-Based Solutions 139 Regulation 145 Innovation 146 Information Disclosure 148 Compensation and Distribution 149

Protecting the Environment: The Role of Government in Practice 150

Air 151 Water 155 Land 156

Concluding Remarks 159

Review and Practice 159

Summary 159 Key Concepts 160 Questions and Problems 160

7 EFFICIENCY AND EQUITY 163

Effi ciency and Distribution Trade-Offs 164

Analyzing Social Choices 164

Determining the Trade-Offs 166 Evaluating the Trade-Offs 169 Two Caveats 173

CONTENTS

xiii

Social Choices in Practice 174

Measuring Benefi ts 175 Ordinary and Compensated Demand Curves 178 Consumer Surplus 179 Measuring Aggregate Social Benefi ts 181 Measuring Ineffi ciency 181 Case Study Drawing a Poverty Line 182 Quantifying Distributional Effects 184 Case Study The Great Gatsby Curve 185

Three Approaches to Social Choices 186

The Compensation Principle 186 Trade-Offs across Measures 186 Weighted Net Benefi ts 187

The Trade-Off between Effi ciency and Fairness Revisited 188

Review and Practice 189

Summary 189 Key Concepts 190 Questions and Problems 190

APPENDIX: Alternative Measures of Inequality 192

The Lorenz Curve 192 The Dalton–Atkinson Measure 194

PART 3 PUBLIC EXPENDITURE THEORY 197

8 PUBLIC PRODUCTION OF GOODS AND SERVICES 199

Natural Monopoly: Public Production of Private Goods 201

The Basic Economics of Natural Monopoly 202 Regulation and Taxation (Subsidies) 206 No Government Intervention 209 Government Failures 210 Case Study Rent Control and Agricultural Price Supports:

Case Studies in Government Failure 211

Comparison of Effi ciency in the Public and Private Sectors 213

Case Study National Performance Review 214

Sources of Ineffi ciency in the Public Sector 216

Organizational Differences 216 Individual Differences 217 Bureaucratic Procedures and Risk Aversion 220

Corporatization 221

Case Study Privatizing Prisons 224

CONTENTS

xiv

A Growing Consensus on Government’s Role in Production 225

Review and Practice 227

Summary 227 Key Concepts 228 Questions and Problems 228

9 PUBLIC CHOICE 230

Public Mechanisms for Allocating Resources 230

The Problem of Preference Revelation 231 Individual Preferences for Public Goods 232 The Problem of Aggregating Preferences 236 Majority Voting and the Voting Paradox 237 Arrow’s Impossibility Theorem 238 Single-Peaked Preferences and the Existence of a

Majority Voting Equilibrium 240 The Median Voter 243 The Ineffi ciency of the Majority Voting Equilibrium 243 The Two-Party System and the Median Voter 246 Case Study Social Choice Theory 248

Alternatives for Determining Public Goods Expenditures 249

Lindahl Equilibrium 249

Politics and Economics 252

Why Do Individuals Vote? 252 Elections and Special Interest Groups 253 The Power of Special Interest Groups 254 Other Aspects of the Political Process 255 Case Study Campaign Finance Reform 256 The Altruistic Politician? 257 The Persistence of Ineffi cient Equilibrium 258

Review and Practice 259

Summary 259 Key Concepts 260 Questions and Problems 260

APPENDIX: New Preference-Revelation Mechanisms 262

PART 4 PUBLIC EXPENDITURE IN PRACTICE 267 10 FRAMEWORK FOR ANALYSIS OF

EXPENDITURE POLICY 269

Need for a Program 270

Market Failures 271

Case Study Higher Education in the United States 272

Alternative Forms of Government Intervention 272

CONTENTS

xv

The Importance of Particular Design Features 274

Private Sector Responses to Government Programs 275

Effi ciency Consequences 277

Income and Substitution Effects and Induced Ineffi ciency 277

Distributional Consequences 281

Evaluating the Distributional Consequences 284 Case Study Incidence of Education Tax Credits 284 Fairness and Distribution 286

Equity–Efficiency Trade-Offs 287

Public Policy Objectives 290

Political Process 291

Review and Practice 294

Summary 294 Key Concepts 294 Questions and Problems 294

11 EVALUATING PUBLIC EXPENDITURE 296

Private Cost–Benefi t Analysis 297

Present Discounted Value 297

Social Cost–Benefi t Analysis 299

Consumer Surplus and the Decision to Undertake a Project 300

Measuring Nonmonetized Costs and Benefi ts 303

Valuing Time 304 Valuing Life 304 Case Study Children, Car Safety, and the Value of Life 305

Valuing Natural Resources 307

Shadow Prices and Market Prices 308

Discount Rate for Social Cost–Benefi t Analysis 309

Case Study Climate Change and Discount Rates 312

The Evaluation of Risk 314

Risk Assessment 317

Distributional Considerations 318

Cost Effectiveness 319

Post-Expenditure Evaluation: Assessing and Improving Government Performance 323

Case Study Taking a Bite Out of Crime in the Big Apple 324

Review and Practice 326

Summary 326 Key Concepts 327 Questions and Problems 327

CONTENTS

xvi

12 DEFENSE, RESEARCH, AND TECHNOLOGY 329

Defense Expenditures 330

The Value of Marginal Analysis 333 Defense Strategy 334 Case Study Game Theory, the Arms Race, and

the Theory of Deterrence 336 Case Study Converting Swords into Plowshares 338

Increasing the Effi ciency of the Defense Department 339

Defense Procurement 339

Defense Conversion 343

Accounting and the Defense Department 344

Research and Technology 345

Market Failures 348 Case Study The Scope of the Patent: Can the

Human Body Be Patented? 350 Government Direct Support 353

Review and Practice 354

Summary 354 Key Concepts 355 Questions and Problems 355

13 HEALTH CARE 357

The Health Care System in the United States 360

The Private Sector 364 The Role of Government 364 Other Expenditure Programs 365 Tax Expenditures 366

Rationale for a Role of Government in the Health Care Sector 367

Imperfect Information 368 Limited Competition 369 Absence of Profi t Motive 370 Special Characteristics of the U.S. Market 371 The Role of the Health Insurance Industry 372 Case Study Medical Malpractice 372 Insurance and Excessive Expenditures on Health Care 374 Consequences of Ineffi ciencies in Health Care Markets 379

Poverty, Incomplete Coverage, and the Role of Government 381

Reforming Health Care 382

Cost Containment 383 Case Study Comprehensive Health Care Reform 384 Extending Insurance Coverage 385

CONTENTS

xvii

Medicare Reform: Easing Long-Term Fiscal Strains 387 Reforming Medicaid 390

Review and Practice 391

Summary 391 Key Concepts 392 Questions and Problems 392

14 EDUCATION 394

The Structure of Education in the United States 397

Federal Tax Subsidies to Private and Public Schools 399

Why Is Education Publicly Provided and Publicly Financed? 401

Is There a Market Failure? 401 The Federal Role 403

Issues and Controversies in Educational Policy 403

Education Outcomes 404 Do Expenditures Matter? 405 School Vouchers: Choice and Competition 407 Case Study Vouchers: The San Jose and Milwaukee

Experiments 412 School Decentralization 413 Performance Standards: No Child Left Behind and Race to the Top 414 Inequality 416

Aid to Higher Education 418

Review and Practice 422

Summary 422 Key Concepts 423 Questions and Problems 423

APPENDIX: How Should Public Educational Funds Be Allocated? 425

15 WELFARE PROGRAMS AND THE REDISTRIBUTION OF INCOME 428

A Brief Description of Major U.S. Welfare Programs 430

AFDC and TANF 430 Earned Income Tax Credit 431 Food Stamps/SNAP 432 Medicaid 434 Housing 435 Other Programs 436

Rationale for Government Welfare Programs 437

Dimensions of the Problem 438

CONTENTS

xviii

Analytic Issues 440

Labor Supply 440 Cash versus In-Kind Redistribution 444 Ineffi ciencies from In-Kind Benefi ts 445 Are In-Kind Benefi ts Paternalistic? 450 Categorical versus Broad-Based Aid 451 Is Means Testing Objectionable in Its Own Right? 453 Other Distortions 453 Case Study Conditional Cash Transfer Programs 454

Welfare Reform: Integration of Programs 456

The Welfare Reform Bill of 1996 458

Block Granting 458 Analytics of State Responses to Block Grants 459 Time Limits 461 Mandatory Work 461 The Welfare Reform Debate of 1996 462 Case Study The Person or the Place? 464

Concluding Remarks 466

Review and Practice 466

Summary 466 Key Concepts 467 Questions and Problems 468

16 SOCIAL INSURANCE 470

The Social Security System 472

Social Security, Private Insurance, and Market Failures 475

High Transactions Costs 476 Risk Mitigation 477 Lack of Indexing: The Inability of Private Markets to

Insure Social Risks 477 Adverse Selection, Differential Risks, and the Cost of Insurance 478 Moral Hazard and Social Security 480 Retirement Insurance as a Merit Good 481 Social Security, Forced Savings, and Individual Choice 481

Is There a Need to Reform Social Security? 482

The Nature of the Fiscal Crisis 484 Savings 487 Labor Supply 488 The Rate of Return 490 Inequities 491

Reforming Social Security 492

Reducing Expenditures 492 Increasing Revenues 494

CONTENTS

xix

Structural Reforms 495 Case Study Social Security Abroad 496

Review and Practice 500

Summary 500 Key Concepts 501 Questions and Problems 501

PART 5 TAXATION IN THEORY 503

17 INTRODUCTION TO TAXATION 505

Background 506

Forms of Taxation 507 Changing Patterns of Taxation in the United States 508 Comparisons with Other Countries 509

The Five Desirable Characteristics of Any Tax System 511

Economic Effi ciency 512 Administrative Costs 517 Case Study Corrective Taxes and the Double Dividend 518 Flexibility 520 Transparent Political Responsibility 521 Fairness 523 Case Study Corruption-Resistant Tax Systems 531

General Framework for Choosing among Tax Systems 532

Utilitarianism 533 Rawlsian Social Welfare Function 534

Review and Practice 536

Summary 536 Key Concepts 537 Questions and Problems 537

18 TAX INCIDENCE 538

Tax Incidence in Competitive Markets 540

Effect of Tax at the Level of a Firm 540 Impact on Market Equilibrium 542 Does It Matter Whether the Tax Is Levied on Consumers

or on Producers? 543 Case Study The Incidence of Government Benefi ts 544 Ad Valorem versus Specifi c Taxes 545 The Effect of Elasticity 546 Taxation of Factors 548 Case Study The Philadelphia Wage Tax 549

CONTENTS

xx

Tax Incidence in Environments without Perfect Competition 552

Relationship between the Change in the Price and the Tax 554 Ad Valorem versus Specifi c Taxes 556 Tax Incidence in Oligopolies 556 Equivalent Taxes 557 Income Tax and Value-Added Tax 557 Equivalence of Consumption and Wage Taxes 558 Equivalence of Lifetime Consumption and Lifetime Income Taxes 559 A Caveat on Equivalence 560

Other Factors Affecting Tax Incidence 560

Tax Incidence under Partial and General Equilibrium 560 Case Study Behavioral Economics, Managerial Capitalism,

and Tax Incidence 561 Short-Run versus Long-Run Effects 564 Open versus Closed Economy 564 Associated Policy Changes 565 Case Study Tax Incidence of Specifi c Tax Provisions 566

Incidence of Taxes in the United States 566

Review and Practice 570

Summary 570 Key Concepts 570 Questions and Problems 571

APPENDIX: Comparison of the Effects of an Ad Valorem and Specifi c Commodity Tax on a Monopolist 572

19 TAXATION AND ECONOMIC EFFICIENCY 574

Effect of Taxes Borne by Consumers 575

Substitution and Income Effects 576

Quantifying the Distortions 577

Measuring Deadweight Loss Using Indifference Curves 578 Measuring Deadweight Loss Using Compensated

Demand Curves 580 Calculating the Deadweight Loss 582

Effect of Taxes Borne by Producers 584

Effects of Taxes Borne Partly by Consumers, Partly by Producers 587

Taxation of Savings 588

Quantifying the Effects of an Interest Income Tax 591

Taxation of Labor Income 591

Effects of Progressive Taxation 593 Case Study The 1993, 2001, and 2003 Tax Reforms 596 Secondary Labor Force Participants 597

CONTENTS

xxi

Measuring the Effects of Taxes on Labor Supplied 597

Statistical Techniques Using Market Data 598 Experiments 600 Review and Practice 603

Summary 603 Key Concepts 604 Questions and Problems 604

APPENDIX: Measuring the Welfare Cost of User Fees 605

20 OPTIMAL TAXATION 606

Two Fallacies of Optimal Taxation 607

The Fallacy of Counting Distortions 607 Misinterpretations of the Theory of the Second Best 607

Optimal and Pareto Effi cient Taxation 608

Lump-Sum Taxes 609 Why Impose Distortionary Taxes? 609 Case Study Estimating the Optimal Tax Rate 610 Case Study Rent Seeking, Inequality, and

Optimal Taxation 611 Designing an Income Tax System 611 Why Does More Progressivity Imply More Deadweight Loss? 612 A Diagrammatic Analysis of the Deadweight Loss of Progressive Taxation 614 Choosing among Flat-Rate Tax Schedules 615 Case Study The 1993 Tax Increase on Upper-Income Individuals: A Pareto Ineffi cient Tax? 616 General Equilibrium Effects 617 Case Study Flat-Rate Taxes Arrive on the Political Scene 618

Differential Taxation 621

Ramsey Taxes 621 Differential Commodity Taxes in Advanced Countries

with Progressive Income Taxes 625 Interest Income Taxation and Commodity Taxation 626

Taxes on Producers 627

The Dependence of Optimal Tax Structure on the Set of Available Taxes 629

Review and Practice 630

Summary 630 Key Concepts 631 Questions and Problems 631

APPENDIX A: Deriving Ramsey Taxes on Commodities 632 APPENDIX B: Derivation of Ramsey Formula for Linear Demand Schedule 634

CONTENTS

xxii

21 TAXATION OF CAPITAL 636

Should Capital Be Taxed? 638

Relationship among Consumption Taxes, a Wage Tax, and Exempting Capital Income from Taxation 638 Equity Issues 638 Effi ciency Arguments 639 Administrative Problems 640

Effects on Savings and Investment 641

Effects of Reduced Savings in a Closed Economy 641 The Distinction between Savings and Investment 642 National Savings and Budget Neutrality 644 Effects of Reduced Savings in an Open Economy 646

Impact on Risk Taking 648

Why Capital Taxation with Full Loss Deductibility May Increase Risk Taking 649 Case Study Tax Incentives for Risk Taking 650 Why Capital Taxation May Reduce Risk Taking 651

Measuring Changes in Asset Values 652

Capital Gains 653 Case Study Equity and the Reduction in

Capital Gains Taxes 654 Depreciation 657 Case Study Distortions from Depreciation 657 Neutral Taxation 659 Infl ation 659

Review and Practice 662

Summary 662 Key Concepts 663 Questions and Problems 663

PART 6 TAXATION IN PRACTICE 665

22 THE PERSONAL INCOME TAX 667

Outline of the U.S. Income Tax 667

Legislated versus Actual Tax Rates 672 Case Study A Loophole in the Earned Income

Tax Credit? 673 Other Taxes 673

Principles Behind the U.S. Income Tax 677

The Income-Based Principle and the Haig–Simons Defi nition 677 The Progressivity Principle 679 The Family-Based Principle 680 The Annual Measure of Income Principle 683

CONTENTS

xxiii

Practical Problems in Implementing an Income Tax System 684

Determining Income 684 Timing 690 Personal Deductions 690 Deductions versus Credits 698 Case Study Temporary Tax Changes 699

Special Treatment of Capital Income 699

Housing 700 Savings for Retirement 701 Interest on State and Municipal Bonds 703 Capital Gains 704

Concluding Remarks 706

Review and Practice 707

Summary 707 Key Concepts 707 Questions and Problems 708

23 THE CORPORATION INCOME TAX 709 The Basic Features of the Corporation Income Tax 711

The Incidence of the Corporation Income Tax and Its Effect on Effi ciency 713

The Corporation Income Tax as a Tax on Income from Capital in the Corporate Sector 713 Shifting of the Corporate Tax in the Long Run 715 The Corporation Tax for a Firm without Borrowing Constraints 717 Incidence of the Corporation Income Tax with Credit-Constrained Firms 718 The Corporation Tax as a Tax on Monopoly Profi ts 720 Managerial Firms: An Alternative Perspective 721

Depreciation 726

Combined Effects of Individual and Corporate Income Tax 728

Distributing Funds: The Basic Principles 728 The Dividend Paradox 730 Mergers, Acquisitions, and Share Repurchases 731 Does the Corporate Tax Bias Firms toward Debt Finance? 732

Distortions in Organizational Form Arising because Some Firms Do Not Have Taxable Income 734 Are Corporations Tax Preferred? 735 Calculating Effective Tax Rates 736

The Corporation Tax as Economic Policy 737

Case Study The Proposed Incremental Investment Tax Credit of 1993: An Idea before Its Time? 738

CONTENTS

xxiv

Taxation of Multinationals 739

Case Study Foreign Income and the Corporation Income Tax 741

Should There Be a Corporation Income Tax? 742

Why Is There a Corporate Income Tax at All? 743

Review and Practice 744

Summary 744 Key Concepts 744 Questions and Problems 745

24 A STUDENT’S GUIDE TO TAX AVOIDANCE 746

Principles of Tax Avoidance 747

Postponement of Taxes 747 Shifting and Tax Arbitrage 749 Case Study Shorting against the Box 751

Tax Shelters 752

Case Study The Economics of Tax Avoidance 753 Who Gains from Tax Shelters 753 Middle-Class Tax Shelters 755

Tax Reform and Tax Avoidance 756

The 1986 Tax Reform 756 Minimum Tax on Individuals 757 Subsequent Tax Acts 758

Equity, Effi ciency, and Tax Reform 758

Review and Practice 760

Summary 760 Key Concepts 760 Questions and Problems 760

25 REFORM OF THE TAX SYSTEM 762

Fairness 764

Horizontal Equity Issues 764 Vertical Equity 766

Effi ciency 769

Case Study Marginal Tax Rates and the 1986 Tax Reform 772 Base Broadening 773 Interaction of Fairness and Effi ciency Concerns 777

Simplifying the Tax Code 778

Assessing Complexity 778 Increasing Compliance 779 Reducing Tax Avoidance 781 Reducing Administrative and Compliance Costs 781 Sources of Complexity 782 The 1986 Tax Reform 784

CONTENTS

xxv

Transition Issues and the Politics of Tax Reform 785

Tax Reforms for the Twenty-First Century 787

Reforms within the Current Framework 787 Major New Reforms 788 Case Study Ordinary Income versus Capital Gains 794 Case Study IRAs and National Savings 796

Review and Practice 797

Summary 797 Key Concepts 797 Questions and Problems 797

PART 7 FURTHER ISSUES 799

26 INTERGOVERNMENTAL FISCAL RELATIONS 801

The Division of Responsibilities 802

Other Interaction between the Federal Government and the State and Local Governments 805 The Size of Financial Transfers 806 Case Study Unfunded Mandates 807

Principles of Fiscal Federalism 808

National Public Goods versus Local Public Goods 808 Case Study International Public Goods 809 Do Local Communities Provide Local Public Goods

Effi ciently? 810 Tiebout Hypothesis 810 Market Failures 812 Redistribution 814 Other Arguments for Local Provision 818

Production versus Finance 819

Effectiveness of Federal Categorical Aid to Local Communities 821 The Federal Tax System and Local Expenditures 825

Concluding Remarks 827

Review and Practice 830

Summary 830 Key Concepts 830 Questions and Problems 830

27 SUBNATIONAL TAXES AND EXPENDITURES 832

Tax Incidence Applied to Local Public Finance 832

Local Capital Taxes 833 Property Tax 834 Case Study The U.S. Property Tax Revolt 834 Income, Wage, and Sales Taxes 836 Distortions 837

CONTENTS

xxvi

Limitations on the Ability to Redistribute Income 837 Rent Control 838

Capitalization 839

Incentives for Pension Schemes 840 Choice of Debt versus Tax Financing 840 Short-Run versus Long-Run Capitalization 841 Who Benefi ts From Local Public Goods? The Capitalization

Hypothesis 841 Absolute versus Relative Capitalization 843 The Use of Changes in Land Rents to Measure Benefi ts 843 Testing the Capitalization Hypothesis 844

Public Choice at the Local Level 845

Problems of Multi jurisdictional Taxation 847

Review and Practice 849

Summary 849 Key Concepts 849 Questions and Problems 849

28 FISCAL DEFICITS AND GOVERNMENT DEBT 851

The U.S. Defi cit Problem since the 1980s 853

Sources of the Defi cit Problem 853 Factors Not Contributing to the Defi cit Problem 857 Success in Taming the Defi cit: The Experience of the 1990s 858

Case Study Measuring Budget Defi cits: What’s Large, What’s Real, and What’s Right? 858

Consequences of Government Defi cits 866

How Defi cits Affect Future Generations When the Economy Is at Full Employment 869 Alternative Perspectives on the Burden of the Debt 870 Case Study Austerity in a Recession: Expansionary or Contractionary? 871

Improving the Budgetary Process 873

Budget Enforcement Act and Scoring 873 Capital Budgets 874 Other Strategies 874

The Long-Term Problem: Entitlements and the Aged 875

Review and Practice 877

Summary 877 Key Concepts 878 Questions and Problems 878

References 880

Index 893

CONTENTS

xxvii

PREFACE

It has been more than a decade since the last revision of this textbook, and much has happened in the intervening years—two recessions, one from which we have yet to fully recover, two wars, a major health care reform, numerous tax reforms, and budget battles, one of which actually led to a government shutdown. Much has happened also in the development of the economics of the public sector. This edition incorporates this chang- ing economic and intellectual landscape. I have been fortunate enough to be joined by Jay Rosengard, a long-term practitioner of the subject and teacher at Harvard’s Kennedy School of Government, in writing this edition.

When the last edition published, I commented that I had been lucky to have been an active participant in many of these changes, as member and chairman of the President’s Council of Economic Advisers. That edition was written from the unique perspective of a public sector economist who had the chance to be involved in the decision-making process not only in the United States, but also in many other countries. Following my stint at the White House, I worked as chief economist and senior vice president of the World Bank, which is involved in advising developing countries concerning their public sector policies. Since then, I have continued with my passionate involvement in debates about public sector policies, as an adviser to many governments and as member or chair of several interna- tional commissions. I have been able to participate in debates around the world on the central questions with which this book is concerned: What should be the role of government? How should it design its programs in areas ranging from health and education, to Social Security and welfare? How should tax systems be designed to promote economic effi ciency and be consistent with basic views of fairness?

xxviii

In one sense, my experiences confi rmed many of the views and approaches I had developed in previous editions. Indeed, it gave me great pleasure to see the extent to which the ideas and perspectives, many of which seemed so new when they were presented in the fi rst edition of this book, were being integrated into thinking about policy, not only in the United States, but throughout the world. I have become increasingly convinced that the kind of analysis presented in this book can—and has— signifi cantly improve the formation of policies in the public sector.

The economics of the public sector is a subject that is always in fl ux. While there are some general principles that are as applicable today as they were two decades ago, new issues have risen to the top of the pol- icy agenda and old issues have waned in importance. Debates today often hinge on diff erent questions than they did even a decade ago. Even the language in which some of the debates are couched has changed. We have tried in this edition not only to incorporate the many changes in expen- diture policies and tax laws, but also to refl ect some of these changing approaches and themes. There is, for instance, an increased emphasis on understanding why government is often ineffi cient, and on improving the effi ciency of government—to use the phrase popularized by the Clinton administration—to “reinvent government.” Growing inequality, espe- cially in the United States, but also in most other countries around the world, has rightly become a subject of concern, and this book refl ects these concerns, with special attention given to the distributive consequences of diff erent policies.

Our major aim in writing this edition remains the same as when I wrote the fi rst: the belief that an understanding of the issues addressed in this book is central to any democratic society. Among the most import- ant of these are the appropriate balance between the public and private sectors, the ways in which the public and private sectors can comple- ment each other, and how governments can more eff ectively meet their objectives. Issues in public sector economics often become highly charged politically, but we tried to present the analysis in an impartial manner, with a clear delineation between the analysis of the consequences of any policy and the value judgments associated with assessing the desirabil- ity of the policy. We have tried to be clear about what economic theory and empirical research had to say on all sides of the debate, identifying where—and why—there is frequent uncertainty about the outcomes of certain policies, and clarifying why disagreements about the desirability of diff erent policies persist. In this edition, we continue with the commit- ment to present to the student a balanced account of these often heated debates. The favorable reception of the previous editions by instructors of a wide variety of political persuasions suggests that we have succeeded

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in doing so. And the publication of many foreign editions of the book, in countries ranging from Russia, China, Japan, Germany, Italy, and Spain, to Latvia, Turkey, and the Czech Republic has shown that the approach has met with favor not just in the United States, but in countries facing quite diff erent circumstances and problems.

My experiences, at the White House, in the World Bank, and in dialogues around the world have made me even more convinced of the importance of this endeavor. Democracies can only succeed if there are meaningful public debates on the central public policy issues of the day. Too often, in too many countries, good policies fl ounder because of a lack of widespread understanding of basic economic issues. Writing an under- graduate textbook such as this thus present both a great challenge and a great opportunity: the challenge to present complex and complicated ideas in simple enough terms that they can be understood by someone with a relatively limited background in economics (at the most, a single year of a principles course); and the opportunity, if one succeeds in doing so, to infl uence the ways in which public policy debates are approached.

Public sector issues are some of the most exciting in all of economics. Health, defense, education, Social Security, welfare programs, and tax reform all receive steady attention in the news media, and economic anal- ysis brings special insights to the debates. Should education be publicly provided? What is the long-term outlook for our Social Security program? How do current proposals for tax reform match our knowledge of who really bears the tax burden? What determines the effi ciency and equity consequences of various taxes? These kinds of questions breathe life into the course, which is why we give them careful attention.

Examining specifi c tax and expenditure programs off ers an additional benefi t: it underscores the importance of design features. One of the les- sons we learned in the past decade is that good intentions are not enough. There are numerous examples where legislation has not been successful in achieving its objectives, and in which there are often unintended con- sequences. For instance, the 2001 and 2003 tax reforms, counter to their intentions, may have actually led to less investment. We use examples like these not only to enliven the course, but also to instill in students the important habit of testing theories against the complex environment in which public sector decisions are enacted and implemented.

The organization of this book is based on the principle of fl exibility. The sequence we follow is to introduce in Parts 1 and 2, the fundamental questions, institutional details, and a review of the microeconomic the- ory underlying the role of the public sector. Part 3 develops the theory of public expenditures, including public goods, public choice, and bureau- cracy, while Part 4 applies the theory of the fi ve largest areas of public

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expenditure in the United States: health, defense, education, Social Secu- rity, and welfare programs. Parts 5 and 6 repeat this pattern, presenting the theory of taxation and its analysis, respectively. Part 7 takes up two additional topics: issues concerning state and local taxation and expen- diture and fi scal federalism; and issues concerning fi scal policy, with particular emphasis on the relation between microeconomic analysis and macroeconomic performance. The ups and downs of the defi cit are among the major changes we confront in this book. In the fi rst two edi- tions, defi cits were at the center of attention, but then, in the third edition, the defi cits changed to surpluses. As I noted then, there was a risk that this change would be temporary, and so it was, and defi cits are once again part of the economic debate. In this edition, we try to come to an under- standing of these marked fl uctuations in the U.S. defi cits.

A perfectly workable alternative to this sequence would be to cover taxation before expenditures. Parts 5 and 6 have been carefully developed so that instructors wishing to go straight to taxation after Part 1 can do so without losing continuity. Further tips on how courses can be orga- nized, as well as lecture notes, test questions, and coverage of advanced topics that instructors may wish to include in their lectures are in the Instructor’s Manual.

The list of those to whom I am indebted is a long one. My teachers at Amherst College, James Nelson and Arnold Collery, not only stimulated my interest in economics and in the particular subject of this course, but also laid the foundations for my later studies. They also showed me, by exam- ple, what good teaching meant. I hope that some of what I learned from them is refl ected in this book. At M.I.T., Dan Holland and E. Cary Brown introduced me to the formal study of public economics. Again, I hope some of the blend of policy, theory, and institutional detail that marked their work is refl ected here. The insights of my colleagues and collaborators at the institutions at which I have worked (M.I.T., Yale University, Stanford University, Princeton University, Oxford University, Cambridge Univer- sity, and the National Bureau of Economic Research) and the government agencies (Council of Economic Advisers, Treasury, Labor, Interior, Energy, Agency for International Development, State of Louisiana, State of Texas) and international organizations (World Bank, Interamerican Develop- ment Bank, Organization of Economic Cooperation and Development) for which I have worked and consulted have also proved invaluable. I should mention Henry Aaron (Brookings Institution), Alan J. Auerbach (Berkeley), Greg Ballantine (former Assistant Secretary of the Treasury for Tax Policy), William Baumol (Princeton University), Charles T. Clotfelter (Duke University), Partha Dasgupta (Cambridge University), Peter A. Diamond (M.I.T.), Avinash Dixit (Princeton University), Martin Feldstein

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(Harvard University), Harvey Galper (Brookings Institution), Robert E. Hall (Stanford University), Jon Hamilton (University of Florida), Arnold G. Harberger (University of Chicago and University of California, Los Angeles), Charles E. McClure (Hoover Institution; former Deputy Assis- tant Secretary of the Treasury), James A. Mirrlees (Cambridge University), Alvin Rabushka (Stanford University), Michael Rothschild (Princeton), Agnar Sandmo (Norges Handelshøgskole, Norway), Eytan Sheshinski (Hebrew University), Nick Stern (London School of Economics), Lawrence Summers (Harvard University), and in particular Anthony B. Atkinson (Oxford University), Peter Mieskowski (Rice University), Kumar Sah (Uni- versity of Chicago), and Steven L. Slutsky (University of Florida).