Public Finance, 2nd Edition

10

THE FIRST-BEST THEORY

OF TAXATION

PUBLIC CHOICE AND PARETO-OPTIMAL REDISTRIBUTION

Pareto-Optimality and the Overall Distribution of Income

Pareto-Optimal Redistribution and the Poor

What Motivates Charity: Should Aid Be In-Kind or Cash?

Are Pareto-Optimal Redistributions Enough?

ALTRUISM, FREE RIDING, AND CROWDING OUT OF

PRIVATE CHARITY

Do People Free Ride?

Does Public Assistance Crowd Out Private Giving?

OTHER MOTIVATIONS FOR REDISTRIBUTIVE TRANSFERS

Public Insurance

Social Status

Equal Access

Having covered the mainstream normative theory of public expenditures

in Chapters 2 through 9, the mainstream Wrst-best theory of taxation is easy

to describe. We saw that Wrst-best public expenditure theory addresses two

fundamental questions:

1. In what area of economic activity can the government legitimately

became involved?

2. What decision rules should the government follow in each area?

In answering these questions, public expenditure theory provides both a

complete prescription for government expenditures and a complete norma-

tive theory of taxation. There is no Wrst-best theory of taxation distinct from

the Wrst-best theory of public expenditures. All we need do is review the main

results from the previous chapters.

The Wrst point to recall is that taxes can only enhance social welfare in a

Wrst-best environment. They are not at all the necessary evil that the public

sometimes makes them out to be. To the contrary, Wrst-best taxes promote

307

the public interest in eYciency and equity as they support society's quest for a

social welfare maximum at the bliss point. They have no other purpose in the

mainstream Wrst-best theory.

Regarding eYciency, either public expenditure theory describes some

particular tax necessary to achieve a pareto-optimal allocation of resources

or it does not. If not, then taxes have no further role to play in promoting

economic eYciency. For example, we found that exclusive goods that gener-

ate either consumption or production externalities can be allocated correctly

with a set of Pigovian taxes (subsidies) equal to the aggregate marginal

damage (beneWt) resulting from the externality. Similarly, decreasing cost

services require marginal-cost pricing for pareto optimality. Whether one

refers to these publicly set prices as admission ``fees,'', highway and bridge

``tolls,'' or transit ``fares'' hardly matters. The marginal cost charges for these

services can always be thought of as taxes set according to the competitive

interpretation of the beneWts-received principle of taxation, the only inter-

pretation consistent with economic eYciency.

One can analyze the eYciency costs of distorting taxation, of course. In

fact, the analysis of distorting taxation dates from the very beginnings of

modern public Wnance when taxes received far more attention than expend-

itures. But distorting taxation is inherently part of second-best theory.

At times Wrst-best public expenditure theory requires certain government

expenditures without specifying exactly how to collect the revenues to Wnance

these expenditures. Leading examples are Samuelsonian nonexclusive public

goods and subsidies to cover the deWcits of decreasing cost services when

prices (taxes) are set equal to marginal costs. The only eYciency criterion in

these instances is that the taxes be lump sum to avoid generating distortions

that would prevent the Wrst-best pareto-optimal conditions from holding.

Any pattern of lump-sum taxation preserves the eYcient allocation of these

goods.

As we have also seen, Wrst-best theory solves the problem of how to

collect the lump-sum taxes to Wnance these expenditures. The required taxes

(transfers) simply become part of the pattern of lump-sum taxes and transfers

that satisfy the interpersonal equity conditions of social welfare maximiza-

tion of the form

qW

q U

h

qU

h

qI

h

 all h  1, ...,H

where I

h

can loosely be thought of as lump-sum income.

1

Whether the

requirement of equalizing the social marginal utilities of income is viewed

as part of Wrst-best expenditure theory or Wrst-best tax theory is a matter of

semantics. Either way, the interpersonal equity conditions are the only equity

1

More precisely, it is a good or factor (presumably the numeraire) singled out for taxation

and transfer.

308 THE FIRST-BEST THEORY OF TAXATION