Updated: 02 Oct 2007 Lecture Notes: ECON 635: PUBLIC ECONOMICS Lecture 1

1 Four Functions of Public Finance Allocation Distribution Stabilization Growth

2 Allocation An organized society requires the consumption of public goods and services that would be unprofitable to produce privately Public goods include: –Defense, –Law and order, justice –Infrastructure –Taxation is used to raise funds to pay for production of these goods and services

3 Redistribution Very difficult to do in a short period of time Redistributing wealth does not change individual incomes much. Redistribution is impossible to do via the tax system alone. Redistribution through expenditure system is much more promising. Redistribution should be related to the role of governments in promoting growth.

4 Redistribution (cont’d) Only through growth can people in developing countries be lifted out of economic backwardness Public education, health services Rural roads, rural telephone, electricity and public water supplies all ways that people can change their position in life overtime Important to consider changing income distribution between generations

5 Stabilization A short run objective Outgrowth of the Keynesian revolution in economics. The main objective to keep actual level of income close to its potential. The target is full employment and price stability. Inflation extremely damaging to poor and reduces the efficiency of market system.

6 Growth Probably the most important objective when per capita incomes are low Sources of Per Capita growth –Capital accumulation, Human capital (education, health), and Productivity change Tools of taxation and public expenditure need to be focused on how to promote growth Need policies that encourage investors to reinvest their business surpluses not take them out of country Government budget surplus important for providing savings for private sector to borrow

7 1.Avoid false technicism in economic policymaking. 2.Keep budgets under adequate control. 3.Keep inflationary pressures under reasonable control. 4.Take advantage of international trade. 5.Recognize that some types and patterns of trade restrictions are far worse than others, and work both to liberalize and rationalize them. (For example, uniform tariff rates are not as damaging as import quotas) 6.If import restrictions are excessive, and reducing them is politically impossible, mount an indirect attack on the problem by increasing incentives to export. Twelve Lessons of Economic Policy

8 7.Make tax systems simple, easy to administer, and (as much as possible) neutral and non-distorting with respect to resource allocation. 8.Avoid excessive income tax rates 35 to 40% are representing a plausible marginal rate that should not be exceeded). 9.Avoid excessive use of tax incentives to achieve particular objectives. 10.Use price and wage controls sparingly, if at all. 11.Rarely can an economic justification be found for quotas, licenses, and similar quantitative restrictions on output, imports, exports, etc. Twelve Lessons of Economic Policy (Cont’d)

9 12.The borderline of public-sector and private-sector activity should be clear and well-defined. When the two compete in a given area, the same rules should govern their operations. Twelve Lessons of Economic Policy (Cont’d)

10 Five Important Innovations of Tax Policy a)It is a possible to introduce more progressivity in a value added tax system, but that its benefits have to be weighted against significant extra vulnerability to evasion. b)Significant differentiation among rates of import tariffs can lead to huge economic inefficiencies by giving vastly different degrees of effective protection to different activities. c)Personal income tax rates above 35 to 40 percent are very hard to justify in light of their efficiency and incentive costs.

11 d)Labor is likely to bear the burden of any unilateral rise in the rate of tax on the income of corporations (or businesses in general), once an open-economy setting is put in place. e)It is much easier to index a tax system for inflation than people think. By its nature full indexation promotes both equity and efficiency. Five Important Innovations of Tax Policy (Cont’d)

12 Pattern of Tax Revenue Collection (Approximation) Category of CountriesRatio of Tax Revenue to GNP i)Low Income countries15% (per capita income Less than $400) ii)Low Middle income20% (per capita income $400 to $1,600) iii)Upper Middle income30% iv)High Income Industrialized countries 45% (Source: Wagner's Law – State takes an expanding share of GNP as per capita incomes rise.)

13 Pattern of Tax Revenue Collection CountryGNP/CapitalRev/GDPNon-tax Rev/Rev YEARUS $ Nepal %13.65% Bolivia %11.00% Egypt %33.55% Turkey %12.88% Mexico %14.27% Brazil %14.10% Chile %17.33% Kuwait %95.55% Canada %17.05% Italy %11.02% UK %12.45% Sweden %10.20%

14 Composition of Government Revenues

15 Composition of Government Expenditures

16 Rapid growth in size over the past 50 years Two reasons: a.Desire to increase rate of growth and industrialization -growth in state owned enterprises. -this trend is reversing b.Growth in social program -social security -health expenditure -unemployment insurance -welfare programs Need to think how these objectives and programs can be more effectively delivered. E.g. public-private partnerships. What is the Appropriate Size of the Public Sector?

17 1.Current expenditures on personnel explode ? 2.Investment expenditures have huge cost over runs ? 3.Crop failures ? 4.Exchange rate fluctuations ? 5.Rapid increase in military expenditures ? 6.A contingent liability comes due -e.g. Guarantee of bank deposits -Guarantee of exchange rate -Guarantee of state enterprise loans What are the most frequent causes of Government Budget Crisis ?

18 Principles to Evaluate a Good Tax System Revenue Adequacy The taxes introduced should be sufficient to finance and fund the government expenditure requirements over time. Tax revenues should increase at a rate equal to or greater than the growth of GNP. The entire tax system should evolve as the economy changes. Inadequate revenues will force the government to resort to borrowing, selling state assets or printing money (inflation). Deficit financing by domestic borrowing leads to the crowding out of private sector credit given by commercial banks. Deficit financing by foreign borrowing is limited and economically expensive. Deficit financing by Central Bank borrowing leads to inflation. High inflation usually leads to financial crises.

19 Principles to Evaluate a Good Tax System (Cont’d) Stability The stability of tax revenues is important for good government. Revenue instability will cause new programs to be poorly implemented. Stability in the tax rules and rates over time allows the private sector to make long term plans more efficiently. For the stability of a tax system, it is necessary that: a.the legislation be well written to eliminate unintended tax exemptions or deductions (loopholes) b.the statutory rates of tax for each of the taxes are not so high as to create powerful incentives to promote tax avoidance schemes or to stimulate tax evasion activity c.the tax revenue is adequate and grows in a consistent fashion d.the tax system is simple and the combined cost of administration and compliance is low

20 Principles to Evaluate a Good Tax System (Cont’d) Simplicity A Tax system should be simple so that it is easy to comply with by taxpayers. Simplicity must apply to the administration of the law as well as its legal structure. A complex tax system imposes high level of compliance costs on tax payers and a high cost of administration on the government. Tax neutrality needed for growth. Growth comes about primarily through the expansion of savings and expansion of investment into high return activities. The tax system should not create major distortions in consumption and production behavior. A tax should not change the investment decisions by favoring one set of investments over the others. The tax system should not create a disincentive to work. Well-designed tax systems should encourage competitive growth in all sectors of the economy.

21 Principles to Evaluate a Good Tax System (Cont’d) Economic Efficiency A tax is efficient if the dead weight loss or efficiency cost is small. High differential tax rates create larger economic efficiency costs. The economic efficiency of a tax is an important consideration when designing a tax system. Estimates of efficiency cost range from 5 to 150 percent of additional tax revenues. Low Administration and Compliance Costs A good tax system has low administration and compliance costs. These costs are part of the economic cost of having a tax system.

22 Tax Systems Before and After Reforms Design of a tax reform depends on the existing elements of the tax system Considerable differences in the existing tax policies and economic systems of various countries The legislative and administrative set-up also vary from country to country For the former Socialist economies of Eastern Europe and the former Union of Soviet Socialist Republics a completely new tax system has had to be created PRINCIPLES OF TAX REFORM

23 Tax Systems Before and After Reforms (Cont’d) In many developing countries tax reforms need to concentrate only on redesigning the existing tax system. Where reforms are extensive, their implementation could spread over a number of years. Appropriate tax rules for the implementation is an important component required for the success of a tax reform. A general understanding or consensus must be reached among concerned economists, lawyers, and legislators for successful legislation and implementation of these rules.

24 Implementation of Reforms The actual implementation of a tax reform depends on the will of the political leaders and the capabilities of the tax administration of the country Political leadership has a major role in legislation of acts and rules Difficult to produce an integrated tax reform which has the support of all the interest groups. Political leadership often seeks to influence the tax administration in order to favor special interest groups, and this destroys tax systems The tax administration in a particular country may be slack and inactive For effective implementation of tax reforms, a prime requisite is that reforms in the administrative setup keep pace with the changes in the tax system and in the way the tax clients operates.

25 Design of tax reform will also depend on the type of tax which is the object of reform Main categories of taxes: a) Direct Taxes *personal income tax *business or corporate tax b) Indirect Taxes *sales taxes (Value Added Tax) *excise taxes trade taxes c) Property Taxes *wealth tax *estate and gift tax *asset tax d) User Charges *users charges *environmental taxes

26 Direct Taxes A) Income Tax: Before ReformAfter Reform High top rates (40%-75%) (Statutory Tax) Top rates falling (20%-35%) Many ratesVery few rates Many exemptionsMost exemptions eliminated

27 Direct Taxes (Cont’d) B) Corporate Income Tax: Before ReformAfter Reform High marginal tax ratesConvergence of top statutory tax rates for personal and corporate tax systems Incentives with tax holidays Elimination of special incentives Double taxationIntegration of corporate and personal taxes

28 Reduction of top marginal income rates since 1984 (Number in parentheses indicates the number of tax brackets) CountryIndividualsCorporations BeforeAfter BeforeAfter Australia60% (5)49%(4) 46% 39% Canada34%(10)29%(3) 28% 23% Finland 50% 43% 52% 40% Germany 56% 53% 56% 50% Portugal41/48% 37%60/68 45% Barbados 60% 50% 45% 35% Colombia 49% 31% 40% 30% El Salvador 60% 35% 30% 35% Guatemala 42% 34% 48% 34% Jamaica 58% 33% 45% 33% New Zealand66% (5)33%(3) 45% 28%

29 Reduction of top marginal income rates since 1984 (Number in parentheses indicates the number of tax brackets) CountryIndividualsCorporations BeforeAfter BeforeAfter Zambia 80% 35% 50%35/45 Denmark 73% 68% 40% 50% U.S.A.50%28% 46% 34% Indonesia 45% 35% 45% 35% Singapore 45% 33% 40% 33% Botswana 75% 50% 35% 40% Mauritius 70% 35% 66% 35% U.K. 60% 40% 52% 35%

30 Indirect Taxes A) Sales Tax: Before ReformAfter Reform Many ratesValue Added Tax (one positive rate and zero rate) Many exemptionsSmall number of exemptions Narrow baseBroad base plus a selective number of excise taxes (cigarettes and liquor etc.)

31 Indirect Taxes (Cont’d) B) Trade Taxes (Import Duties): Before ReformAfter Reform High tariff ratesTop rates lowered Target around the world for a single rate. In free trade areas the target rate is zero. Wide dispersal among rates (in India 90 different tax rates on steel alone) Fewer rates Quantitative controlsNo quotas While in 1950 no country had a Value Added Tax, by 1993 more than 80 countries had adopted some form of VAT Tax By 2001, over 120 countries have introduced VAT

32 Evolution of the tax system of South Cyprus after it began preparations to enter into the European Union. South Cyprus had a history of a very old fashion tax system that was badly in need of reform. Tax system was full of exemptions and incentives Tax Reform Process in South Cyprus

33 South Cyprus Fiscal Issues in 1990: Public sector deficit – 5.3% of GDP Individual Income tax – 3.9% of GDP Corporation Income tax – 1.4% of GDP Import duties – 3.4% of GDP Selective excises – 0.0% of GDP VAT – 0.0% of GDP Other Indirect Taxes – 8.1% of GDP

34 South Cyprus 1991 began reform process with changes to income tax to reduce burden. –Introduced VAT in 1992 at a rate of 5%. –1993 raised VAT rate to 8% –Income tax changes in 1996 –2000 raised VAT rate to 10% –2002 raised VAT rate to 13% –Major reform of Income Tax System –2003 will raise VAT rate to 15%

35 Direct and Indirect Taxes as Share of GDP.

36 Direct Taxes as Share of Total Tax Revenues.

37 Composition of Indirect Taxes as Share of GDP.

38 South Cyprus Fiscal Situation 2001: Public sector deficit – 2.8% of GDP Less distortionary tax system Individual income tax –4.4% of GDP Corporate income tax – 3.9% of GDP Import duties– 1.3% of GDP Selective Excises – 3.0% of GDP Value Added Taxes– 5.9% of GDP Other indirect taxes – 2.1% of GDP

39 Revenue Buoyancies of South Cyprus Taxes, Total Taxes1.59 Total Direct Taxes1.77 Total Indirect Taxes1.46 Individual Income Tax1.07 Corporation Income Tax3.46 Other Direct Taxes1.32 Total Indirect Taxes1.46 Import Duties-1.56 Selective Excises1.25 Value Added Tax3.72 Other Indirect Taxes-.93

40 South Cyprus 2001: Per capita income – US$ 13,500 Real growth rate –4.2% Tourism makes up – 20% of GDP Imports –41.1% of GDP Exports –11.9 of GDP Domestic Savings – 14.0% of GDP Domestic Investment – 18.5% of GDP Rate of inflation – 2.0 % Unemployment rate – 3.0%

41 The Challenge Facing North Cyprus Total Tax Revenues - 35 % of GDP Total Expenditure - 63% of GDP Deficit - 28% of GDP Substantial Public Sector Budget Deficit

42 Tax Collections 2003 as Percentages of GDP. South Cyprus North Cyprus

43 Public Sector Expenditures, Excluding Social Security and public pensions, 2004 as percentages of GDP SOUTH CYPRUS NORTH CYPRUS Wages & salaries 10.96%17.19% Capital Expenditure 3.77%7.87% Debt Service 4.96%5.09% Others (excluding social security and public pensions) 14.96%16.46% Total Expenditures 34.65%46.62% Total Revenue (Excluding SSC) 31.10%30.58% Cash Deficit -3.55%-16.04%

44 Cash Deficits of Social Security and Public Pension Systems of North and South Cyprus