Course 2.2 AE/IES

'Public Finance and Public Choice'

Code 1316

Faculty of Economics and Business Administration

University of Maastricht

October-December 1998

Fourth/Fifth Lecture, 18/25 November 1998

Dr J.G.A. van Mierlo

Associate Professor of Public Economics

University of Maastricht

1. Taxation Principles and Problems

1. Policy Objectives of Taxation

-Raising government revenues

-Finance of specific public goods

-Changing economic behaviour (Pigovian taxes)

-Controlling the business cycle (functional finance, Keynesianism)

-Redistribution of income

2. Problems of Taxation

-The importance of income and subsitution effects

-remember EV and CV!

-labour market: income versus leisure

-commodity market: commodities versus commodities

-net effects: from partial to general equilibrium analysis!

-The importance of price (in)elasticities

-price (in)elasticies of demand and supply

-Dalton's Law

-tax incidence: who bears the tax burden?

-partial versus general equilibrium analysis

-Direct (income side) versus indirect taxation (spending side)

-The problem of 'income prices for public goods'

3. Solutions

-Lump sum taxes

-Separation of social and economic functions of taxation (Lindahl)

-Distinction between ends and means of economic policy

-The Big Trade-Off between Equity and Efficiency (Okun)

2. Income (Re-)Distribution

1. Policy objectives

-equity versus efficiency: trade-off

-equity versus equality

-absolute versus relative equality

-theory of marginal factor productivity and Contributive Principle

2. Policy instruments

-primary income policies

(policies to income sources/factor endowments; factor reward policies)

-taxes and subsidies (redistribution in cash)

-social security system (redistribution in cash)

-the provision of public goods (redistribution in kind)

3. Various problems

-with policy objectives (target variables)

-with policy instruments (instrument variables)

-with objectives and instruments

3. The Process of Income Formation

Balance Sheet of Income Formation

* Start: FACTOR INCOMES

+ earnings from labour

+ earnings from entrepreneurship

+ interests on capital

= PRIMARY INCOME (the process of income formation on markets!)

- direct taxes (on income)

- social security premiums

+ social security benefits

= SECUNDARY INCOME (income redistribution in cash)

- indirect taxes (on commodities)

+ price subsidies on market goods

+ price subsidies on public goods

- transfers in kind to government (conscription base of military services)

= TERTIARY INCOME (income redistribution in kind)

Improtant Notes:

1. Dynamic perspective of income formation!

2. Positive and negative feedbackmechanisms in the Process!

4. Income Policies

1. Target: Primary income distribution

-working of factor markets: efficiency arguments

-influencing P: factor prices

-influencing Q: factor quantities and qualities (factor endowments)

-factor rewards, education policies, health policies, housing policies

-demand (technology!) and supply of level of schooling (education!)

2. Target: Secundary income distribution

-redistribution in cash

-tax and social security system

-income and subsitution effects on the labour market

-distorsion on the labour market (disincentives, poverty traps!)

-efficiency versus equity arguments

3. Target: Tertiary income distribution

-redistribution in kind (or cash bound to commodities)

-indirect taxes and price subsidies

-income and substition effects on the commodities market

-double distorsion on the commodity market (subsitution, over/under demand!) as well on the labour market (disincentives, poverty traps!)

-distributional effects of public goods/public bads

-the problem of 'income prices' for public goods

OVER ALL PROBLEM: equity versus efficiency!