topic 1 taxation intro

7/25/2019 Topic 1 Taxation Intro

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Topic I: Economics and the Public Sector

Business Administration and Management

Fall 2015-2016

Departament dEconomia Pblica, Economia Poltica i Economia Espanyola


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Bibliography

2

Rosen and Gayer: Chapter 1

Chapter 4 Chapter 5


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1. The Public Sector: Introduction2. Functions of the public sector: Why does the

public sector intervene in a market economy?

i.

Efficiency

ii. Redistribution

iii.Stabilization of the economic cycle

Musgrave, (1959)

Outline


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What is Public Economics or Public Finance?

Part of economics that studies the intervention of the public sector in a market economy,

mainly through financial activity (i.e. public revenues and expenses).

Public Economics: Economic decisions of the public sector and/or the reaction of

private agents to the public sector

Public Finance: Decisions directly related to public revenues and expenditures.

Public

EconomicsEconomics

Introduction: The Public Sector


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Twofold approach:

1. What arethe measureable effects of government programs andinterventions? (positive analysis)

2. What should the government do if we can choose optimal policy?

(normative analysis)

Closely related: Political Economy

Why do governments behave the as they do?

Introduction: The Public Sector


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When we do NOT need a public sector!

First Welfare Theorem

Private markets provide a Pareto efficient outcome under thefollowing conditions:

Private good

No externalities

Perfect competition

Complete and symmetric information

Functions of the Public Sector


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If QQ*, the marginal cost exceed the marginal revenue (over-provision)

p*

Aggregate Supply(Marginal Cost)

P

Q*

Aggregate demand(Marginal Revenue)

Q

Functions of the Public SectorHow it should be

The market maximizes the consumers and

producers surpluses


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! The market is not always in this equilibrium due to the existence ofmarket failures.

Public goods (goods that are non-rivaland non-excludable)

Externalities

Natural Monopolies

Information asymmetry (adverse selection and moral hazard)

Functions of the Public SectorMarket Failures


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Functions of the Public SectorHow it should be Private goods

The aggregate demand for private goods is derived by summing individual

demand horizontally:

Rival: a good taken off the shelf it isnt there for other people to consume.

Excludable: once you buy it, you own it and can consume it as you please.

We sum private goods horizontally, because consumers cannot consume the

same units


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A simple example: Fig Leaves (f)

Source: Rosen and Gayer (Chapter 4)


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A simple example: Fig Leaves (f) EFFICIENT PROVISION



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Characteristics of public goods (e.g. national defense):1. Non-rival consumption: The consumption of a good by an

individual doesnt !the available q for the rest of individuals. The

mg cost of a new individual that starts consuming is equal to 0.

a good cannot be taken off the shelf because individuals

enjoy the same.

2. Non-excludable consumption: It is not possible to prevent the

consumption of a good by someone who is not paying for it.

everybody can enjoy the public good.

The aggregate demand for public goods is derived by summing

individual demand vertical: We sum public goods vertically, becauseconsumers can consume the same units.

Functions of the Public SectorMarket Failures: Public Goods


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A simple example: Fireworks



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A simple example: Fireworks

EFFICIENT PROVISION



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MRSAdam= MRSEve=MCPrivate Good

MRSAdam+ MRSEve= MCPublic Good

SummaryNecessary condition for Pareto efficiency:

MRS= It is the maximum rate at which the consumer would be willing tosubstitute a little more of good x for a little less of good y


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Why are public goods a market failure?

Inefficient market provision - unlike price, quantity is not an

effective market mechanism:

For a given quantity, individuals will not automatically self-select theiroptimal price, but will instead wish to pay the lowest price possible

when they cannot be excluded from consuming the good.

! If the consumption of a good is non-excludable, the market will not

provide it.


The Free Rider Problem

Public Sector Interventions:public provision


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Functions of the Public SectorMarket Failures

rival

excludable

yes no

yes private good

naturalmonopoly

(e.g. cable tv)

no

commonresource

(parkingspaces)

public good(national

defense)

Public goods "goods provided by the public sector

Public sector might or might not provide public goods

Goods Classification:


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If the consumption of a good is non-rival but excludable, there may beprivate provision, but it will be sub-optimum

Functions of the Public SectorMarket Failures: Non-rival and Excludable Goods

Public Sector Interventions:public provision?

Example: Natural Monopoly


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In some industries, there are very high fixed costs associated with thestarting of the activity (natural barriers to entry)

Railways

EnergyGas

Telephony

Decreasing average costs (due to the high fixed costs)

Efficient solution:A single producer, public or private?

(Read: Water privatisation: a worldwide failure? (TheGuardian, 30/01/2015))

Functions of the Public SectorMarket Failures: Natural monopolies


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!

Externality: Utility or production of an agent depends directly onthe actions of another agent

! This effect is NOT included in the price

! Defined in 2 dimensions:

! Positives vs. Negatives

!

Production vs. Consumption

Positives / consumption

Vaccine, Education

Negatives / consumption

Tobacco, Alcohol,

Hydrocarbon

Positives / production

R&D, on-the-job training

Negatives / production

Contamination of a river,

Noise pollution

Functions of the Public SectorMarket Failures: Externalities


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Qm=Sub-optimal demand for the good

MC (S)

MR private (D)

Ext

MR social=D+ext

Qm Q*

"

e.g. Vaccines (positive)


PS Intervention : Increase theconsumption of the good

(subsidize vaccine)


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e.g. contamination of a river (negative)

Qm=Over-provision of the good

MC private (S)

MR private (D)

Ext

MC social=S+ext

QmQ*

"


PS Intervention:

Decrease the production of the good (tax

on the dumping of waste, regulation,#)


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Taxes (or subventions) are instruments that can bring the level of

provision of a good closer to the social optimum (Pigouviantaxes)

private MC (S)

private MR (D)Ext = t

private MC + t = S+ ext

QmQ*

"


If the tax matches up with the value of the externality, the taxinternalizes the externality and the level of production isoptimum (Q*)


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1. Adverse selection (example: insurance) In the insurance market, there are high-risk (cost Ph, share $), and

low-risk (cost Pl, share (1-$)) individuals

If the company cant distinguish the 2 types of individuals,

p = !*Ph + (1-!)*Pl

Low-risk individuals wont contract the insurance (too costly for them!) High-risk individuals will contract the insurance (but then profit


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2. Moral Hazard:the insurance modifies the behavior of individuals, reducing

the effort on preventing the risk from realizing.

If individuals can affect the probability of the risk (losing a job), no one will

provide insurance for it (unemployment insurance)

Is this a problem when consider banks bailouts or a bailout to Greece?

Functions of the Public SectorMarket Failures: Incomplete markets and information asymmetries

Public Sector Intervention:Public provision: e.g., public

unemployment insurance


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The market distributes the income of individuals according to theproductivity of their production factors (no production, no payment)

If large inequalities among individuals are not desired from a social point of view:

The Public Sector can improve the income distribution through by

! Public expenditure:

Transfers of income (subsidies, unemployment benefits, social

assistance)

Provision goods and services free of charge or below the market price

(e.g. healthcare) Free or subsidized education improves the redistribution of a very

important factor of production (Human Capital)

! Taxes:

Based on the ability to pay (progressive income tax)

Functions of the Public SectorRedistribution


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GINI coefficient: Index measures the degree of inequality in the distribution of

family income in a country Calculated from the Lorenz curve

Lorenz Curve

A curve showing the proportion of national income earned by

a given percentage of the population.

E.g. what proportion of national income is earned by the top

10% of the population?



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% of National Income

Percentage of Population

This line represents thesituation if income was

distributed equally

The poorest 10% would earn10% of national income, thepoorest 30% would earn 30%

of national income

10%

10%

30%

30%

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L C


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% of National Income

Percentage of Population30%

20%

7%

Here, the Lorenz curvelies further below the

line of equality

Now, the poorest 30%only earn 7% of thenational income (brown

line)

Lorenz Curve

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%of

NationalIncome

Percentage of Population

Gini Coefficient= A / (A + B)

A

B

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The Gini index measures the areabetween the Lorenz curve and a

hypothetical line of absolute

equality

A Gini index of 0 represents

perfect equality, while an index of

100 implies perfect inequality.


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Objective:

Stabilizing the economics fluctuations by fiscal policy:

! Expansive during recessions: Increase the disposable income

(increase expenditure and/or decrease taxes)! Restrictive during expansions: Decrease the disposable income

(decrease expenditure and/or increase taxes)

Automatic stabilizers:

government budget policies, particularly income taxes and welfare spending,

automatically act to dampen fluctuations in real GDP

! during recessions: unemployment benefits automatically increase

! during expansions: income and corporate tax revenues increase

Functions of the Public SectorStabilization

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