1. Theory of Public Expenditure and Taxation
Second Best Analysis

2. 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

3. 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”

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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