Theory of Public Expenditure and Taxation Second Best Analysis

Second-best analysis An attempt to move toward a more realistic policy environment Adds both government and market restrictions Common government restrictions Infeasible lump-sum taxes, transfers Taxes that introduce deadweight losses Legislated budget constraints Some resources drafted or goods given away

Second-best analysis Common market restrictions Monopoly or monopsony power in some markets Private or asymmetric information Fig 12.1 Restrictions reduce the feasible outcomes Attainable outcomes Might include part of the first-best utility possibilities frontier. (point A in the figure) Excludse the first-best social welfare optimum B, the “bliss poin”

Two Seminal Papers Lipsey-Lancaster Theory of the Second Best(1956) Failure of one first-best conditions Implies other first-best conditions may not hold for constrained social optimal Spawned a large literature on second-best policy reform Different constraints are added to the first-best model Diamond-Mirrlees Optimal taxation and public production (1971) One restriction: Raise revenue using distorting taxes Free to manipulate all other price-cost margins Spawned a large literature on optimal second-best public policy

Partial Equilibrium Analysis Partial equilibrium analysis of distorting taxes Dates back to the very beginnings of public sector economics in the late 1700s. Lipsey-Lancaster added General equilibrium framework Taxation in many person economies Analysis of second-best public expenditure theory Dates from the 1960s Profound effect on the theory

Profound Effects Overturned standard first-best policy prescriptions Samuelson's ∑ MRS = MRT rule for consumption externalities Marginal cost pricing with subsidy for decreasing cost firms Failure of two dichotomies Cannot separate out efficiency and equity policies Efficiency and equity concerns are intertwined Uncomfortable, since appropriate social welfare function is so problematic Cannot separate out target markets to implement policy and leave the others alone Second-best policies extend to the entire economy

Private or Asymmetric Information Central focus over the past 35 years Different from other constraints Primarily behavioral People exploit private information for their own ends Threatens the idea of good citizenship Government should act as in behalf of the people To achieve equilibrium Governments have to ensure the incentive to be truthful Policies must honor evelation principle or be incentive compatible

Private or Asymmetric Information Incentive compatibility constraints Important and often highly restrictive requirement Private information about personal incomes Impossible to use lump-sum taxes and transfers Failure of first-best interpersonal equity conditions High-income people have an incentive to hide income Policies subject to incentive compatibility constraints Difficult to be both (reasonably) efficient and equitable

Private or Asymmetric Information Private information Drive markets underground e.g. escape taxation Market system becomes the villain rather than the hero that should be left alone Underground markets sharply constrain the set of feasible public policies Schneider, et. al. Underground economy is an important component of economic activity in all nations, even ignoring illegal and barter activity

Private or Asymmetric Information Citizens Often have limited information about opportunity sets How will they react to given public policies? Important to have an answer the question for normative analysis Policy makers Limited information about how markets prices will respond to public policies in a general equilibrium setting

Philosophy and Methodology for Second Best Theory No different from first-best theory Government's goal Maximization of Bergson-Samuelson individualistic social welfare function Analysis remains closely tied to competitive market Analytical constructs specified in terms of prices are often used for second best analysis Indirect utility functions Expenditure functions Production price frontiers Constructs implicitly assume competitive market behavior

Philosophy and Methodology for Second Best Theory These constructs are common because the assumed distortion is often distorting taxes which affect price-cost margins, and these distortions are most easily analyzed with general equilibrium models specified in terms of prices Public sector theory with private information requires an analogous assumption to price-taking behavior: the design of truth-telling mechanisms requires the assumption that people have no control over their opportunity sets

Preview of part III Begins with taxation Chapters 13-17 Distorting taxation is often the constraint used in the analysis of second-best public expenditure theory Simplest way to introduce general equilibrium analysis in terms of prices Chapters 13-17 Comprehensive analysis of second-best tax theory

Preview of part III Chapters 18–24 Chapter 25 Rework selected public expenditure problems from Part II Transfer payments to the poor, aggregate externalities, nonexclusive goods, decreasing costs Use the constraints most commonly employed in the literature e.g. distorting taxation, private information. Include the provision of public insurance Directly motivated by private information. Chapter 25 Concludes Part III with a discussion of behavioral economics Studies behavior of individuals that is anomalous or irrational clearly not utility maximizing Analyzes the anomalies most directly related to public sector economics