Robert F. Mulligan, Ph.D. WESTERN CAROLINA UNIVERSITY COLLEGE OF BUSINESS Department of Accountancy, Finance, Information Systems, & Economics
chapter seventeen public choice theory and The Economics of taxation
This chapter includes a study of public choice theory, an economic analysis of government decision making, and selected topics related to public expenditures and tax revenues. The theoretical discussion includes an examination of the inefficiency of voting outcomes, interest‑group influence, political logrolling, and the paradox of voting outcomes. The median-voter model is considered. Also examined is public sector failure, or the failure of public decisions to promote the general welfare. Attention is then focused on how public goods are financed. The ability‑to‑pay vs. the benefits‑received principles of taxation are evaluated. Progressive, proportional, and regressive taxes are defined and illustrated with examples. The concepts of tax incidence and efficiency loss are also reviewed. This chapter concludes with a discussion of the structure of the U.S. tax system.
Concept Illustration … Rent Seeking The French economist Frédéric Bastiat (1801-1850) is remembered for his wit and capacity to point out absurdities in the arguments of his opponents. In the following passage, he satirizes appeals to government for special benefits at someone else’s expense, or what today we call "rent-seeking." His message is timeless: When rent-seekers succeed, it is often at the expense of the general interest. When, unfortunately, one has regard to the interest of the producer, and not to that of the consumer, it is impossible to avoid running counter to the general interest, because the demand of the producer, as such, is only for efforts, wants, and obstacles. I find a remarkable illustration of this in a Bordeaux newspaper. M. Simiot proposes this question: Should the proposed railway from Paris to Madrid offer a solution of continuity at Bordeaux? [Mr. Simiot argues that] the railway from Paris to Bayonne should have a break at Bordeaux, for if goods and passengers are forced to stop at that town, profits will accrue to bargemen, pedlars, commissionaires, hotel-keepers, etc. Here we have clearly the interest of labour put before the interest of consumers. But if Bordeaux has a right to profit by a gap in the line of railway, and if such profit is consistent with the public interest, then Angoulême, Poitiers, Tours, Orleans, nay, more, all the intermediate places, Ruffec, Châtellerault, etc., should also demand gaps, as being for the general interest, and, of course, for the interest of national industry; for the more these breaks in the line are multiplied, the greater will be the increase of consignments, commissions, transhipments, etc., along the whole extent of the railway. In this way, we shall succeed in having a line of railway composed of successive gaps, and which may be denominated a Negative Railway. The principle of restriction is the very same as the principle of gaps; the sacrifice of the consumer’s interest to that of the producer, in other words, the sacrifice of the ends to the means.^(1) ^1Frédéric Bastiat, Economic Sophisms (Edinburgh: Oliver & Boyd, Ltd., 1873), pp. 80-81, abridged.
I. Introduction A. Learning objectives – In this chapter, students should learn to: 1. Explain the problems created with majority voting and the median-voter outcome. 2. State four reasons given by public choice theorists for government’s inefficiency in providing public goods and services. 3. Differentiate between the benefits-received and ability-to-pay principles of taxation. 4. Identify which taxes are progressive, proportional, and regressive. 5. Describe how elasticities of demand and supply are related to the incidence of a sales or excise tax. 6. Explain the relationship between the elasticities of demand and supply and the efficiency loss of a particular tax. 7. Describe the probable incidence of the personal income tax, corporate income tax, sales and excise taxes, and property tax. 8. Explain the U.S. structure relative to the progressivity or regressivity of Federal, state, and local taxes. 9. Define and identify the terms and concepts listed at end of the chapter. B. In the last chapter we examined some examples of market failure in the private sector and the government policies designed to remedy them. This chapter examines more closely the public sector and its failures that elicit disenchantment. C. This chapter deals with two main topics: a. “Public choice theory” is the economic analysis of government decision-making that helps us to understand public sector problems. b. The economics of taxation.
II. Revealing society’s preferences through majority voting is the way collective decisions are made in a democracy. A. Majority voting can lead to inefficient outcomes; that is, the majority can defeat a proposal that would have provided greater benefits than costs and adopt one that costs more than the benefits it provides (Figure 17.1). 1. Illustration of an inefficient “no” vote result: Suppose there are 3 voters who each will have to pay $300 in tax if a proposal is adopted. It is worth $700 to one, $250 to the second and $200 to the third. The second and third voters will vote “no” and defeat the proposal despite the fact that the total benefits ($1150) exceed the $900 cost. 2. Illustration of an inefficient “yes” vote result: Take the same three voters as above and the same level of taxation. Now the proposal is worth $100 to the first voter and $350 to each of the others. The vote will be 2 to 1 in favor of the proposal even though the total benefit of $800 is less than the $900 cost. 3. Conclusion: The problem is that the one‑person one‑vote rule does not measure intensity of preferences, so the result may not be economically efficient. B. Interest groups may improve the economic efficiency of results by registering intense feelings with elected representatives or by organizing major efforts to get the vote to go their way. C. Logrolling or vote trading may also secure favorable decisions for those who feel strongly about certain issues, but it may also negate an efficient outcome in favor of a special interest group where the value of the benefits received does not justify the cost. The efficiency of the outcome will depend on the circumstances. D. The paradox of voting is that society may not be able to rank its preferences consistently through majority voting. 1. Table 17.1 demonstrates a situation in which three voters have expressed their rankings of three public projects; each has a different ranking. If voting is done on pairs of projects, it can be shown that national defense will win over roads, and roads will win over weather warning systems. But the logical conclusion that the community prefers national defense to weather warning systems is not the case—they would each get the same number of points (if points were awarded for a 1st, 2nd, and 3rd choice). In other words, if one choice must receive a majority of the votes, there will not be a consistent outcome in this case unless somehow the strengths of the rankings can be measured. 2. Government might find it difficult to provide the “correct” public goods by acting in accordance with majority voting. E. The median-voter model suggests that under majority rule the median voter will in a sense determine the outcomes of elections. The median voter is the person holding the middle position on an issue. 1. The textbook example has three voters deciding among three types of weather warning systems. The first is willing to spend $400; the second, $800; the third, $300. The median-voter model suggests that the $400 proposal will win. In a choice between the $400 and $800 proposal, the first and third will vote for the $400 type. In a choice between the $400 and $300, the first and second will vote for the $400 type. In other words, both extreme voters prefer the median choice rather than the other extreme, so the median voter will tend to predominate. 2. Real-world examples occur in political positions where candidates seem to aim their appeal at the median voters within each party to get the nomination and later at the middle of the population in an effort to win the election. 3. Implications of the median-voter model: a. Many people will be dissatisfied by the extent of government involvement in the economy. b. Some people may “vote with their feet” by moving into political jurisdictions where the median voter’s preferences are closer to their own. c. Median preferences can change over time.
III. Government failure can occur as well as market or private sector failure. The fact that the latter exist does not mean that the public sector improves efficiency. A. Special interests and “rent seeking” may promote the interests of a small group at the expense of society at large. 1. The special-interest effect refers to the situation where a small number of people will receive large gains at the expense of a much larger number of people who individually suffer small losses. The small group will be well informed and highly vocal on the issue and press politicians for approval. The large numbers who will each suffer small losses will not have the incentive to be informed or feel strongly. The result is that the politician will support the special‑interest program, whose supporters will notice the vote in their favor, and ignore the majority who don’t feel strongly. 2. Pork-barrel politics is an example of the special-interest effect. In this case, the benefit goes to a single political district and to the politician from that political district. The cost of the project is spread out to many individuals who will never receive the benefits. Pork-barrel politics is often combined with logrolling. 3. Rent-seeking behavior occurs when a transfer of wealth at someone else’s or society’s expense occurs through government action. Here the term “rent” means any payment to a resource supplier, business, or other organization above that which would accrue under competitive market conditions. Examples include tax loopholes that benefit only certain groups; public works projects that cost more than the benefits they yield; and occupational licensing that requires more than is necessary to protect consumers. B. Clear benefits, hidden costs (or the reverse, immediate costs and future more vague benefits) are another dilemma for politicians trying to decide on public programs. Where the benefits are recognizable and popular, the politician may vote for the program even if the costs exceed these benefits if the costs are diffuse or hidden. C. Limited and bundled choice is another problem with public goods. The voter must choose between a few candidates who will have the power to select the public goods and services to be financed by the voter’s tax money. The choices are “bundled” in that the limited set of candidates will govern over a variety of issues, and the voter’s preferences may not perfectly align with any candidate. In the private sector, the consumer has a multitude of choices available, and can generally separate out those goods and services not desired. D. Bureaucracy and inefficiency can be another problem in the public sector because there is not the profit motive or competitive pressure to perform efficiently. Ironically, the typical response of government to a program’s failure may be to increase its budget and staff. 1. Government employees, together with the special-interest groups they serve, often have the political clout to block attempts to pare down or eliminate their agencies. 2. There is a tendency for government bureaucracy to justify continued employment by looking for and eventually finding new problems to solve. E. Imperfect institutions exist in both the public and private sectors, which often makes it difficult to decide which institutions would perform best in the production of certain goods and services.
IV. Apportioning the tax burden and deciding how the public sector should be financed is also a complex question. A. Benefits received vs. ability to pay principle of taxation. 1. The benefits‑received principle asserts that households and businesses should be taxed in relationship to the services they receive. For example, gasoline taxes are earmarked for highway construction and maintenance. a. How can the government decide which citizens receive how much benefit from less divisible public goods like national defense? b. Government efforts to redistribute income would be self‑defeating if the benefits‑received principle of taxation were applied universally—welfare recipients would have to pay for their welfare at the extreme version of this. 2. The ability-to-pay principle asserts that the tax burden should rest more heavily on those with greater income and wealth. The rationale is that those people with much income or wealth will value their marginal dollars less than those with low incomes, where each dollar is very meaningful. B. Progressive, proportional, and regressive taxation systems relate to the above issues. (Key Question 7) 1. A tax is progressive if its average rate increases as income increases; the tax grows absolutely with income and also proportionately. 2. A tax is proportional if its average rate remains the same; the tax payment grows absolutely with income but remains the same proportionate to income. 3. A tax is regressive if its average rate declines as income increases; the tax may or may not increase in the absolute amount, but it declines in proportion to income. C. Applications in existing tax structure: 1. The federal personal income tax is mildly progressive, with marginal tax rates ranging from 10 to 35 percent in 2008. Certain deductions that favor high-income groups erode the progressivity of this tax. 2. Sales taxes are not as proportional as they seem if they are on all goods. A general sales tax is regressive because, although everyone pays the same percent on expenditures, the rich tend to spend a much smaller fraction of their incomes, while the poor may spend all of their incomes. Therefore, the rich will pay a smaller overall proportion of their income in sales taxes. 3. The federal corporate income tax is essentially a flat-rate tax with a set rate, but if it is passed on to consumers in the form of higher prices it may actually be regressive in its impact. 4. Payroll taxes are regressive. The Social Security portion of the tax (6.2 percent) is not applied to income above a certain level ($94,200 in 2006). On the other hand, the Medicare tax (1.45 percent) is applied to all wage income. A person making $94,200 pays 7.65 percent ($7206) of his or her wage income; a person making $188,400 pays only 4.55 percent ($8572) of his or her wage income. 5. Property taxes tend to be regressive because landlords pass along this cost to tenants who have lower incomes; housing costs are a larger proportion of income for the poor than for the rich, so economists estimate that the property tax on that housing would end up being a greater proportion of low incomes than of high incomes.
V. Tax Incidence and Efficiency Loss A. Tax incidence refers to who actually bears the economic burden of a tax (Figure 17.2). 1. The division of the burden is not obvious. Figure 17.2 shows the impact of a $2 per-bottle tax on wine that was priced at $8 per bottle before the tax. 2. S is the no-tax supply situation and St is the after-tax supply curve. The new equilibrium price rises to $9, not $10 as one might expect with the $2 tax. a. Consumers pay $1 more per bottle. b. Producers receive $1 less per bottle. 3. In this example, consumers and producers share the burden of the tax equally. The incidence is not completely on either one. B. Elasticities of demand and supply explain the incidence of an excise or sales tax. 1. Given supply, the more inelastic the demand for the product, the larger the portion of the tax is shifted forward to consumers (Figure 17.3b). Figure 17.3a shows the situation if demand is more elastic. 2. Given demand, the more inelastic the supply (Figure 17.4b), the larger the portion of the tax borne by producers or sellers. Figure 17.4a shows the situation if supply is more elastic. C. Efficiency loss is one result of an excise or sales tax. 1. Figure 17.5 illustrates the concept of efficiency loss, which occurs as a result of an excise tax or sales tax. The efficiency loss is the reduction of well‑being that occurs because there will be less produced at the higher price caused by the tax. It is the sacrifice of net benefit accruing to society because consumption and production of the taxed product are reduced below their allocatively efficient levels. 2. Elasticities play a role in determining the extent of the efficiency loss. Other things being equal, the greater the elasticities of supply and demand, the greater the efficiency loss of a particular tax. 3. Qualifications to the analysis relate to the idea that the goals of tax policy may be more important than the goal of minimizing efficiency losses from taxes. Two examples are given. a. Redistributive goals—Excise taxes placed on luxury items in 1990 resulted in efficiency losses, but the benefits from redistributing income from the wealthier consumers who buy luxury items may have been worth the loss in efficiency. However, these luxury taxes were unpopular and have been repealed. b. Reducing negative externalities—If there is less alcohol and tobacco consumption as a result of excise taxes, the taxes may have socially desirable consequences. D. Probable incidence of U.S. taxes is estimated for various taxes. 1. The personal income tax generally falls on the individual except for those who can control the price of their labor services and pass on the cost of the tax through higher fees. 2. The incidence of the corporate income tax is uncertain. Some corporations may be able to shift the burden by charging higher prices; others may find there is decreased profitability and the burden is then borne by stockholders. 3. Excise taxes can be shifted to the consumer where demand is inelastic. This is true generally with the small range of products on which excise taxes are levied (gasoline, cigarettes, and alcoholic beverages). However, because sales taxes cover such a wide range of products, the incidence of sales taxes is just as likely to fall on the seller—it depends on the respective elasticities of demand and supply for the product. 4. The incidence of property taxes may fall on the property owner, or in the case of rental and business property, the tax would be largely shifted onto the tenant or the customer. 5. Global Perspective 17.1 indicates that the U.S. is less dependent upon sales and excise taxes than many other industrialized nations. E. Table 17.2 summarizes the discussion of the shifting and incidence of taxes.
VI. The U.S. Tax Structure A. It is difficult to determine the overall progressivity or regressivity of the American tax structure. Disagreement among economists persists. B. The Federal tax system: The system is progressive. 1. In 2005, the average Federal tax rate for the 20 percent of taxpayers with the lowest incomes was only 4.3 percent. The tax rate for the 20 percent of the taxpayers with the highest income was 25.5 percent. The tax rate was 27.4 percent for the top 10 percent of tax payers and 31.2 percent for the top 1 percent. 2. This progressivity is offset by the Social Security tax, which is regressive. Because of the cap of $94,200, taxpayers who earn more, pay a lower percent of their income as tax than do lower and middle income earners. C. The state and local tax system: State and local tax structures are largely regressive as a percentage of income. Both sales and property taxes fall as a proportion of income when income rises. D. Combined Tax Structure: Overall, the American tax structure is slightly progressive. The American system of taxes and transfer payments does reduce income inequality and is estimated to quadruple the incomes of the poorest one-fifth, which makes the tax-transfer system more progressive than the tax system alone.