Public Finance (MPA405) Dr. Khurrum S. Mughal

Lecture 25: Taxation, Prices Efficiency, and the Distribution of Income Public Finance

General Equilibrium Analysis and Shifting When one good is taxed and another good is not taxed, the impact of the tax is not confined to the taxed good. Because a tax on one good lowers the profit that can be made to firms producing it, they may shift their productive resources to the other good so as to maximize their after-tax rate-of-return in both markets. This has the effect of equalizing the after-tax rate-of-return.

General Equilibrium Analysis and Shifting Complex inter-related markets –Tax in one markets affects other Tax on electricity consumption –Electrical appliances –Natural Gas –Products whose production needs electricity as an input

Multimarket Analysis of Excess Burden (Minimizing the excess burden) PFPF E2E2 A A DFDF S' S Price Clothing per Year 0QC2QC2 PCPC DCDC S' S P F (1 + t) B E1E1 QCQC P C (1 + t) QC1QC1 E2E2 E1E1 B QFQF Q F1 Q F2 Food per Year

Implication Efficiency loss can be minimized –Goods are taxed at rates that decrease with elasticity of demand More inelastic demand needs higher tax Efficient system of taxes will have to face political opposition

Multimarket Analysis Incidence 0 Q* PGPG Q' P* PNPN A D S' = MC + T S B Price Food per Year 0 P D S S' QFQF Clothing per Year P' F Q' F E2E2 E1E1 E1E1 E2E2

Implication Price of clothing to increase but that of food to decrease Effect on specialized capital and labor of clothing industry The specialized inputs of one industry face a decrease in income when they move to another industry

The Lorenz Curve The Lorenz Curve maps the cumulative percentage of households against their cumulative percentage of income.

A Lorenz Curve Percentage of Real Income Line of Equal Distribution 0 D 100 E y x Percentage of Households Area A B

The Gini Coefficient The Gini Coefficient is the ratio of the area between the Lorenz curve and the perfect equality line (Area A in the previous slide) to the area under the perfect equality line (Areas A and B). Closer to zero represents equality in distribution

Budget Balance and Government Debt Public Finance

Budget Terms A Budget Surplus exists when Tax Revenues are greater than Expenditures and is the difference between the two. A Budget Deficit exists when Expenditures are greater than Tax Revenues and is the difference between the two. The National Debt is the sum of deficits minus the sum of all surpluses

Controversies Over What To Do With the Current Surpluses Options Pay off portions of the national debt Cut taxes Increase spending on programs Set surpluses aside to make Social Security and Medicare more solvent

High-Employment Deficit or Surplus The budget balance is altered significantly by the state of the economy. –Size of budget deficit or surplus varies with business cycles If GDP is rising quickly, then fewer people are drawing on the welfare state and more are paying taxes. Deficits and Surpluses can be attributed to –current year economic activity –Structural imbalances between revenue and expenditure

High-Employment Deficit or Surplus The high-employment deficit or surplus is what the surplus would be if unemployment were low. –usually estimated at 5-6% –Deficits, receipts, and expenditure, if were employed Economists often prefer this measure to the actual level of the deficit or surplus when advocating policy.

Unified Budget The Unified Budget is the sum of the on- and off-budget deficits and surpluses. If this is a net deficit, then the government must borrow new money from the public. If it is a net surplus, then it is a net provider of capital to the private sector.

Real Surpluses and Deficits Real Surpluses and Real Deficits are expressed in inflation-adjusted terms.

Economic Effects of Federal Budget Deficits Deficits can be financed by taxes or issuing bonds –Borrowing rather than taxing can improve votes for a politician –Borrowing postpones the burden of taxation

Government Demand for Loanable Funds and the Market Rate of Interest Interest Rate Loanable Funds per Year 0 L1L1 E' L2L2 i2i2 i1i1 E S D 1 +  D G D1D1

Ricardian Equivalence Ricardian Equivalence is the view that deficits do not alter interest rates because citizens today see that deficits today will be financed with higher taxes tomorrow and citizens save in order to have the funds to pay those higher taxes.

Ricardian Equivalence: Deficits Do Not Affect Interest Rates Interest Rate 0 L1L1 E' L2L2 L3L3 E'' i2i2 i1i1 Loanable Funds per Year LL D 1 +  D G E S D1D1 S'

Economic Effects of Federal Budget Surpluses Unified budget surpluses allow government to provide capital to the loanable funds market.

Impact of a Budget Surplus on Credit Markets Interest Rate Loanable Funds per Year 0 LL D E' E I1I1 I2I2 L1L1 L2L2 S S' = S 1 +  L

Budget Balance, National Saving, and Economic Growth An increase in the deficit contributes to a decrease in national savings while an increase in a surplus contributes to a increase in national savings. Increases in national savings increases the potential for the economy to grow.

Incidence of Deficit Finance Lower growth rates imply lower incomes for future generations. If Ricardian Equivalence holds, then this is not the case. Deficits may also change political equilibrium so that there are increases in government infrastructure that could lean to increased future growth.

Net Federal Debt The Net Federal Debt is the portion of the debt not held by the federal government.

Internal and External Debt The Internal Debt is the portion of the debt owed to our own citizens. The External Debt is the portion of the debt owed to people other than our own citizens.

Burden of the Debt Impact on future generations: –People have to pay increased taxes to pay interest on that debt. –Some may inherit the original bonds. –Growth rates are reduced because of higher interest rates. These impacts can be offset by the increased private savings of the generation that does the borrowing, or by returns that come from programs that were funded by the borrowing.

What Should be Done With Surpluses? Social Security and Medicare solvency Tax Cuts Other Spending Programs Reduce National Debt