Public Finance, 2nd Edition

PART II

THE THEORY OF PUBLIC

EXPENDITURES AND

TAXATIONÐ

FIRST-BEST ANALYSIS

Part II presents the Wrst-best analysis of public expenditure and tax

theory in the context of a market economy. Recall from the discussion in

Chapter 3 that a Wrst-best policy environment exists if the market economy is

perfectly competitive and the government can use whatever policy tools are

necessary to achieve full pareto optimality and the interpersonal equity

conditions of a social welfare maximum. In other words, the government

can bring the economy to the bliss point on its Wrst-best utility-possibilities

frontier.

The Wrst-best policy environment may seem unduly restrictive, but Wrst-

best analysis is the appropriate way to begin the study of the public sector. It

serves as the baseline for all public sector analysis by indicating the maximum

possible increase in social welfare that public policies can achieve. The social

welfare implications of second-best policy prescriptions are almost always

compared with their Wrst-best counterparts. In addition, the single set of Wrst-

best assumptions permits an exploration of the essence of a technical market

failure such as an externality, along with the policy required to correct it. All

formal Wrst-best analysis uses variations of the general equilibrium model of

social welfare maximization developed in Chapter 2, suitably modiWed to

highlight the problem under consideration. In contrast, the restrictions

added to the basic model to make the policy second best contaminate the

analysis of the market failure and its solutions, with additional factors that

have to do with the second-best restrictions. Finally, Wrst-best analysis Wgures

prominently in the history of the discipline and in much of the conventional

wisdom on government policy. Virtually all public expenditure analysis

before 1970 employed the Wrst-best assumptions, as did much of the huge

body of literature concerned with issues of equity in the theory of taxation.

Second-best analysis in these two areas has been commonplace since then, but

much of the received doctrine on public expenditures and income distribution

that appears in the current undergraduate public sector texts comes from Wrst-

best analysis. Only the allocational theory of taxation has consistently

employed second-best assumptions from the very beginning of public sector

economics, simply because the welfare cost of taxation is inherently a second-

best topic. As we shall discover in Part II, all interesting Wrst-best eYciency

issues relating to taxation are eVectively subsumed within the optimal public

expenditure decision rules.

The eight chapters in Part II are structured as follows.

Chapter 4 begins with the distribution question, one of the fundamental

market failures requiring social decisions. The chapter describes how econo-

mists use the social welfare function in applied research to determine the

eVects of inequality and social mobility on social welfare. Examples are

drawn from the U.S. economy.

Chapters 5±9 then turn to the two most important allocational market

failures in a Wrst-best environment: externalities and decreasing cost produc-

tion. Chapters 5±8 consider the theory of externalities, with applications to

U.S. policy, and Chapter 9 presents the theory of decreasing cost production,

also with U.S. policy applications.

Chapters 10 and 11 conclude Part II with a discussion of taxes and

transfers from a Wrst-best perspective. Chapter 10 brieXy reviews the Wrst-

best optimal tax and transfer rules developed to that point, stressing their

limitations as guidelines for actual tax policy. The rest of the chapter is

100 PART II THE THEORY OF PUBLIC EXPENDITURES AND TAXATIONÐFIRST-BEST ANALYSIS

devoted to the theory of pareto-optimal redistribution, which derives norma-

tive rules for optimal redistribution without resorting to a social welfare

function. Pareto optimal redistribution is the normative distribution theory

favored by public choice economists, who reject the concept of a social welfare

function. Chapter 11 introduces still another distributional norm, the ability-

to-pay principle of taxation and transfer, which dates to Adam Smith and

John Stuart Mill. The ability-to-pay principle has always been the primary

guideline for tax design and tax reform in the United States and other

developed market economies. The chapter begins by comparing the policy

implications of the ability-to-pay principles and the interpersonal equity

conditions of social welfare maximization. It then presents two applications

of the ability-to-pay principle that have been featured in the public sector

literature. One is how closely the U.S. federal personal income tax adheres to

the principle. The other is whether the ability-to-pay principle favors the

taxation of income or consumption. The chapter concludes with two practical

issues relating to the taxation of income from capital under an income tax,

how to adjust for inXation, and the appropriate taxation of capital gains.

PART II THE THEORY OF PUBLIC EXPENDITURES AND TAXATIONÐFIRST-BEST ANALYSIS 101

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