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-What goods should or should not be publicly provided?
-What effect does changing the regulatory environment change
economic activity?
-How should we go about collecting revenue?
-Does changing any of these things effect overall welfare, both
individually and socially? How so?
-What are the tradeoffs?
-We're trying to assess what government should do.
-Positive analysis=What is?
-Normative analysis=What ought to be/should be?
-Tradeoff between equity (i.e. fariness) and economic efficiency
(MB>=MC)
-Excess burden (in public finance) and deadweight loss (in
economics)
-Impose high taxes on more relatively inelastic goods to
generate revenue (lack of substitutes, think about gas)
-Ramsey Rule (will end up with a fairly efficient tax, not
necessarily equitable)
-Equality and efficiency are generally opposed to each other
-Broad questions
1.) Is it possible to draw normative conclusions from positive
analysis?
2.) Can we evaluate normative conclusions and try to predict
outcomes through positive analysis?
3.) How can we go about measuring the expected or actual
impact of a policy proposal?
4.) How do these issues impact individual or societal welfare
(can we measure them and what is societal welfare)?
5.) What is the difference between blackboard economics and
real world policy?
-We need to have a way to analyze the effects of policy on
overall welfare
-At least in the US, all regulatory agencies are required to
conduct cost-benefit analysis before implementing a regulation;
needs to conclude whether or not to impose the regulation
-Obviously, if no policy can survive cost-benefit analysis, then
you're in a Pareto Optimal situation; if it can, then it is at least
Kaldor-Hicks efficient
-We are not measuring goodness or badness
-What we are trying to do is evaluate whether a policy will be
worth the costs; we're going to get at this through social
welfare
-Marginal cost is less than or equal to marginal benefit (stop at
MC=MB)
-Example: Cutting off your head for stealing from grandma;
people will only steal when no one else is around, hence the
only witness is grandma; the criminal is incentivized to murder
grandma as well
-Optimal level of crime is greater than 0
-Caveats with Cost-Benefit Analysis
1.) CBA is not about money.
2.) Not about inputs and outputs.
3.) CBA is about welfare.
4.) Requires a common denominator in order to express
heterogeneous items into homogenous flows. This is where
money comes into CBA. It allows us to compare these different
measures that we have.
-We need to think in terms of outputs and the effects that these
outputs have on welfare. These are going to become a means to
increase welfare.
-Utlimately, we need to think terms of the social value that is
achieved through the outputs that we obtain relative to the
opportunity costs of the project.
-Minor League Baseball Stadium Example: Troy evaluates the
success of the stadium based on attendance. Could just set the
ticket price to 0 and subsidize the owner of the stadium to
incentive him to do so.
-Social welfare will decline; personally beneficial, but socially
wasteful
-We're hoping to measure this change in welfare (going to try to
figure out people's willingness to pay WTP)
-You can apply CBA whether you assume a benevolent dictator
or a policy driven completely by special interests
-Assumptions
1.) We assume the benevolent dictator model.
-What does it mean to act in the general interest of society?
Public agents are going to consider all relevant costs and
benefits regardless of who the beneficiaries and the losers are.
If society improves, then we are going to undertake the project.
-In order to do this, we have to analyze counterfactuals.
-2 Major Problems
1.) We need to build a counterfactual world where the project
did not exist and then forecast what would have happened.
2.) We need to create a counterfactual with the policy and then
forecast how that would happen.
-There are problems with CBA. However, if you believe that
this is all garbage, ask yourself, "Do we believe it is the case
that firms are profit maximizers?" If so, well, firms use CBA
for determining whether or not a project should be taken on.
Given this, it provides evidence for the efficacy of CBA.
-Things to Spell Out in CBA
1.) Objective
-Examining relevant alternatives
-Are we actually maximizing net benefits, not just increasing
them?
2.) Identification of Costs and Benefits
-If a project already has only direct effects, then this is pretty
easy and straightforward
-Tons of indirect effects; this will be the problem
3.) How do we measure the costs and benefits?
-With market goods, we'll evaluate willingness to pay (WTP)
-Evaluate and consider someone's stated preference (what would
you pay)
-Shadow prices: These are going to approximate the social
opportunity costs of whatever input we're looking at.
4.) Aggregate Costs and Benefits
-Will accrue across different time periods and affect different
people
-Need homogenous way to analyze this heterogeneous effect
-Discount factor (How do we discount future costs and
benefits?)
5.) Interpret Everything
-How do we interpret our results and decision criteria (assumed
discount rate, cost benefits, etc.)?
-How sensitive are your results?
-Your job is just to present
6.) Comparison with Your Relevant Base Case
-Counterfactual with status quo
7.) Consider both Economic and Financial Feasibility
-Economic Return: Social costs and social benefits
-Financial Return: Revenues relative to costs (i.e. accounting)
-Park in the City of Troy example (budget constraint)
-All of this needs to be couched in economics
-What is a benefit?
-What is a cost?
-How do you calculate them?
-Just a means to assess whether decisions and choices promote
efficiency and the efficient allocation of scarce resources
-Need a second assumption; first assumption was that we just
assume a benevolent dictator
-Economic Rationality: Utility maximization subject to a budget
constraint and individual choice
-We also assume that the government's goal/utility comes from
maximizing social welfare (intention)
-Might be able to bake in a political feasibility component, but
your job is really just to present the costs and benefits of a
policy
-CBA will be focused on efficiency
-We do not generally worry about equity; sometime s, but we're
just going to focus on the efficiency aspect in this class
-Each individual is treated equally
-Social bads for some can be outweighed by the social goods to
others
-How do we actually view future generations?
-The costs to the few in the current period is likely to be greatly
outweighed by the benefit that accrues to many in the future
(when there are likely more people)
-Have to figure out how to discount the future
-Can still apply CBA in deontological environments (i.e. with
those ethics)
-Will think in terms of cost-effectiveness
-State a goal
-Example: Marijuana is a social bad. We're going to end
marijuana use.
-How can we get to this goal in a cost-effective way? What are
the relevant alternatives? There's not just one way to get there.
-How do we value non-human rights?
-Include or exclude; If you exclude, you need to explain why if
it has an impact.
-How do we actually go about deriving social costs and
benefits?
-Necessary to look at individual market transactions and those
valuations that we hold
-Ultimately, we will need to consider consumer and producer
surplus (can derive WTP from this)
-Can also think about this in terms of individual preference and
citizen preference (for example, voting)
-Assume for now that we can look at market transactions
-Derive consumer/producer surplus
-We also have to evaluate how people do or might behave in
markets (from this, we can estimate social costs and social
benefits)
-Will couch this into WTP and consumer sovereignty
-This means that individuals within society and the behavior of
those individuals will inform us about whether or not to pursue
a policy
-Won't worry about problems around WTP and income
distributions for now (taking this as given)
-Consumer surplus
-How much surplus value will be generated for society? Can
address this now.
-Can break this down into 2 questions
1.) How much do different members of society value the
policy?
-How much would each member be willing to pay for the
policy? This tells me social benefit.
2.) What does society actually pay for the policy?
-This tells me social costs.
*From these two questions, we can figure out our net benefit.
-Total benefit minus total cost (NB=TB-TC)
-Once we have net social benefit and consumer surplus, now we
can understand economic value, with which we can measure
WTP
2.) Social Costs: Opportunity Costs of the Resources Used
-Determined by an individual's WTP for the foregone use of the
resource
*Example: Commercial Fishing and Fish Population Policy
-We're going to increase commercial fishing
-Think in terms of net benefit calculation (society's WTP for an
increased fish catch relative to the opportunity costs of the
resources used to increase the catch)
-We don't care about increased employment or increased
income; WTP is only meant to reflect consumer demand for
additional fish
-WTP is what's important in evaluating both benefits and costs
-Figuring out TR: See how much expenditures increase by
-Consumer surplus is tougher (can't figure this out directly)
Sunstein: The Cost-Benefit State
-If we're going to have regulation, it should typically be tied to
CBA
-Makes the argument on both economic and democratic grounds
-Without CBA, there is a strong incentive attracting regulatory
capture or interest-group pressures; also such regulation tends
to be tied to anecdotal evidence, which is highly unreliable
-Administrative state as we know it evolved out of the New
Deal
-Used to be that state and local governments handled their own
crises; during the Great Depression, state and local governments
went broke
-What starts to happen is that very rapidly we task many of
these responsibilities to the Federal government
-Agencies governed by very open-ended statutes and laws, and
hence, they are granted lots of discretion
-Ended up throwing checks and balances out the window
-Have a situation in which there is uncertainty regarding the
justification of any given regulation; no criteria to evaluate this
-Regulation ultimately is a cost; if it's overly so, then this
comes at the expense of economic activity
-Many court decisions that have found against regulations based
on their costliness; outside the question of the constitutionality
of the regulation
-CBA tends to reduce special-interest influences
-Nominally, it increases transparency
-Three Qualifications
1.) Should not require CBA simply to impose undue procedural
requirements on agencies
2.) CBA should have the presumption that economic incentives
and market solutions can fix the problem
3.) Really hard to value social goods; CBA has a serious
methodological problem here
-Need to balance variables
-Which of these actually need to be balanced, and how should
they be valued
-5 Features to Consensus Regarding the Problems in Existing
Government Regulation
1.) Real consensus that government needs to be better at priority
setting.
-Regulatory costs are really poorly allocated
-Real lack of consistency across agencies
2.) Government should have a presumption for flexible market-
based incentives, rather than rigid commands.
-4 Problems in Markets
1.) Information Asymmetries
2.) Externalities (Positive and Negative) ----->Emphasis is Here
(for purposes of this class)
-Where a negative externality exists, I am not fully internalizing
the cost; I will overproduce
3.) Monopolies
4.) Public Goods (Can't Price It)
-Nonrivalrous
-Nonexcludable
-Taxing away the externality generally better than regulating it
1.) Tax creates revenue for government; we can theoretically
use this revenue to create some other social benefit
2.) Tax avoidance (will incentivize you to minimize tax burden
by producing less of the externality through innovation; a
regulation prevents this innovation by specifying what a firm
has to do)
-As long as you are not a marginal firm, you will support the
tax as it will get rid of some of your competition
-Producers of substitute goods will also support the tax
Private
Public
-Need to think in terms of a spectrum
-Providing it privately will lead to a misallocation of resources
-The limit moves us along this spectrum
-Movie example
-Only person in movie theater; the price should be 0
-At a price of 0, eventually the theater fills up
-Suddenly you have congestion and, hence, rivalry
-Whatever might be non-rivalrous becomes rivalrous
-Producing goods in a private sphere incentivize individuals to
produce efficiently and innovate (improve quality, etc.)
-Markets are more efficient, but they are not necessarily more
equitable
-No profit and loss signals in governmental efforts to improve
equity (chronic over and underproduction)
-Tradeoff between efficiency and equity
Starting back on CBA (Sunstein Article)
1.) Government should engage in better priority setting
2.) Government should have a presumption in favor of flexible
market-based incentives rather than rigid commands
-Means and ends thing
-If we're going to have a regulation, then we need to be focused
on the ends of that regulation (for example, lowering pollution;
just establish this as the end instead of directing the means to
getting there)
3.) Government should be aware of and attempt to counteract
harmful unintended consequences
-Always and everywhere avoid unintended consequences
-Health tradeoffs
-Inhaler example
4.) Government needs more information and it should create
better incentives to compile and provide accurate information.
-Scientific uncertainty can make measuring the harms of
something difficult
5.) Technocratic, economic, and democratic judgments all have
their appropriate place.
-Government needs to respond to reasonable judgments about
risk
-At the end of the day, people are really bad at assessing risk
-You don't want voter demand driving regulation
-Nothing undemocratic about refusing to go along with factual
ignorance; point of having representative democracy
6.) Government should concentrate on basic ends rather than
means.
-Need to avoid the special interest effect
Picking up on Sunstein 6th Point:
6.) Government should concentrate on basic ends rather than
means.
-Incentives on industry from regulation
-Maximize your gains by manipulating the regulation to benefit
you
-Minimize your costs from the regulation
-Regulatory capture
-Industry typically comes up with the regulations
-Focus on performance standards rather than design standards
-Best approach is generally some broad-based tax scheme across
all industries
-If you go to regulatory means, you creating a real incentive for
special interests
-Market forces should be the means to achieve the ends
Benefits to CBA:
-Helps us overcome regulation by anecdote
-Any time you have a regulatory environment/administrative
state, it creates an automatic incentive for special interest
effects
-CBA can make their influence more transparent
Turning Back to CBA in General:
-How do we calculate willingness-to-pay?
Net benefits
NB=Total Benefits-Total Costs
Social Benefits
Social Costs
-What do we do when market prices don't exist?
-When we have market prices:
-What is our willingness to pay for increased commercial
fishing?
*If you do CBA for everything, then this creates strong status
quo bias
-Also creates strong incentives to litigate every single thing
-Issues with consumer surplus
-Options
1.) Ignore it.
2.) Estimate elasticity of demand.
-Statistical regression
Quantity= alpha1 + beta1Price + error term
-Beta1 should be negative
-Look at data over time
-Time series (one observation over many periods of time) as
opposed to cross-sectional or panel
Qt= alpha1 + beta1Pricet + error termt
-Want as many observations as possible
-Daily price observation
-Weekly
-Monthly
-Quarterly (would only have 4 observations per year; need lots
and lots of years)
-Log everything to estimate elasticity
-This is really close to percent change
-There's probably other things affecting quantity other than
price
-To isolate the effect of price, we need to include control
variables
-Want to get as close to a natural experiment as possible, so that
we can tease out causation
-Need economic theory and intuition (really common sense) to
determine controls
-Will never be perfect, as it is practically impossible to control
for everything you need to control for
-What happens when we're faced with a situation of non-market
goods (no market price)?
-Example: Environmental Quality
-Options
1.) Consider surrogate markets.
-For example, in regards to finding WTP for school quality, you
can look at the housing market.
-Home prices are generally a pretty good market to turn to for
most stuff like this
-Look at the effect of distance to good school in home prices
-Have to control for everything else affecting home prices
2.) Create hypothetical markets.
-Try to simulate a market and calculate WTP.
-Shadow prices
-Think in terms of black markets
3.) Survey
-Lots of complications and issues here
-Who is society?
-Who needs to be included in our analysis?
-To properly conduct CBA, we need to know the relevant agents
(those whom the costs and benefits are being imposed on)
-You can get different answers based on whom you include or
how many people you include
-How do we treat socially unacceptable behaviors?
-For example, crime is a benefit to criminals
-This kind of stuff practically isn't going to get counted, but it
raises an ethical or philosophical question?
-How do we count future generations?
-Future generations should be included if something has an
effect over multiple time periods
-You have calculate net benefits for which you have to calculate
WTP
-Someone not born yet doesn't have a WTP
-To get around this, you assume preferences today are the same
as preferences tomorrow
-Sunset clause?
-What do we do with non-human nature (i.e. animals)?
-CBA only anthropocentric society
-Non human entities don't have standing (with caveats)
-We'll count intrinsic value attached to animals
-For example, we don't count the disutility to my dog of his
death, but we do count the disutility to me over losing my dog
-How do we take into account cultural differences?
How Do We Actually Conduct Our Analysis:
-Two outcomes (with and without)
-Need to estimate incremental benefits and incremental costs
-The difference between benefits and costs with or without the
policy
-Benefit with minus benefit without
-Costs with minus costs without
-Always calculate the baseline first
-This is NOT before and after analysis
-Farming with fertilizer vs. farming with organic products
-We expect crop yields to increase by 10% using organic
products
-With before and after, the benefit is 10%
-With CBA, there would be some benefits to continue to use
fertilizer
-With fertilizer, we expect crop yields to increase by 6%
-This makes our net benefit 4% (our incremental change)
Picking Back up with With-Without Analysis:
-Organic Farming vs. the Use of Fertilizer Example
-Erosion
-Not taking into account the alternative with before and after
-Costs
-Thought of in the same terms as benefits
-Discount Rates important to think about
-How do we collect the data?
-Two approaches
1.) Collect separate data for the with policy and the baseline
policy
-Can now calculate your incrementals
2.) Collect data directly that measures the incremental effect
-Need to do it for both benefits and costs
-Back to the farming example
-What will our yields be for using fertilizer and organics
-Try to determine the current value of the crop (typically look at
current market prices)
-Need to build some assumptions about what you think future
prices are going to look like
-Example
-Suppose crop is valued at $100,000
-Can assume that current real prices are going to be stable over
time
-Then we can figure out our future payoffs between the two
options
-If we think value is going to compound (10% return)
-For organics, should be $110,000 for first year, $121,000 for
second year, …
-Fertilizer should be $106,000 for first year, $112,000 for
second year, …
-Need to think through opportunity costs as well
-This is going to help inform the baseline model
-In our current example, you recommend organics, but this
means more land
-The opportunity cost is the cost of the extra land
-Nature preserve vs. other use for the land example (in this case
Walmart)
-What happens when we have policies that have an effect over
time?
-Need to think in terms of present value
-Need to determine a discount rate
-I want benefits now
-Benefits in the future are worth less to me
-How do we calculate present value?
-Try to select multiple discount rates to make your argument
more convincing
-Define the present as the first day that resources are
committed
-Framing the Analysis
-Need a decision criteria (What should be the outcome of our
CBA?)
-3 Decision Types
1.) Just look at one single policy, and then decide whether or
not to pursue it.
-If we employ NPV, do it when it's positive
2.) We can consider several mutually exclusive alternative
policies, and then determine which, if any, to implement.
-Policies will be mutually exclusive if the acceptance of one
requires the abandonment of another
-What this allows us to do is determine if this is Kaldor-Hicks
efficient
-Example
-Building a bridge across a river
-Multiple possible spots, but we can only pick one
-What is the best spot to place this bridge?
3.) Consider several non-mutually exclusive policies, and then
decide upon a possible subset to pursue.
-We can consider several different aspects.
-Bridge Example
-If we only build one bridge, we could have congestion issues.
-Could build bridges in multiple locations.
-As we build more bridges, the marginal value of any one bridge
will go down.
-Just use net present value (NPV)= PVB-PVC
-Allows us to figure out and assess the value of a policy
-Need to be mindful of any budget constraint that exists; can
only do things where PVC is less than the budget constraint
Bridge
PVB
PVC
NPV
A
200
100
100
B
250
100
150
C
210
100
110
A,B
370
200
170
A,C
350
200
150
B,C
300
200
100
A,B,C
380
300
80
-Option 1
-Any of them would work (they are all positive)
-Relative time/energy in evaluating a single policy is low
compared to the other two options
-Option 2
-Analyze A, B, and C
-Would pick B
-Option 3
-Analyze A,B; A,C; B,C; and A,B,C
-Would pick A,B
-Police Dept., New Park, Reservoir
Turning to the Discount Rate
-One of the biggest issues that we're faced with
-What should the discount rate be?
-What criteria should go into or be used to determine that rate?
-How might the discount rate fluctuate over time?
-How might it be different for different projects?
-Really big doctrinal debate around it
-Two competing approaches (no consensus over one or the
other)
1.)
2.)
-Regardless of the approach you take, there are multiple rates
you could use
-Small changes in the discount rate can take you from a positive
to a negative NPV
-Do we need to adjust our discount rates to account for social
values or could we use weighted averages for rates?
-When it comes to the discount rate, it has a real effect on how
we evaluate intergenerational and environmental concerns
-Environmental groups would argue that you should not be
applying a discount rate
-Any policy change today that accrues benefits on people
tomorrow, we should do it (there are more people in the future,
and the benefits will be exponentially larger)
-Two reasons for applying a discount rate
1.) Any time that we pursue a policy, obviously there is an
opportunity cost attached to that
-If nothing else, it's good to know what our opportunity cost is
2.) Since we accept that individuals prefer a dollar today to a
dollar tomorrow, we can augment this to say that so does
society
-Therefore, clearly we need to discount the future
-Three rates we can apply (Each one has theoretical support)
1.) The rate of return from the best alternative investment
-The pretax rate of return that would be generated if those
resources had been allocated to their next best investme nt
-Recognizes that capital funds have a social opportunity cost
-By pursuing a given policy today, society has to give up the
potential future cash flow from the next best alternative
-Will our net present benefit be greater than the foregone
return?
-Issues:
-What does public use always imply? It has to come from a
private source (i.e. taxes).
-Opportunity cost from taking private resources
-Is public use preferable to private use?
-General Rules to Apply
-Always apply a before-tax rate of return
-The before-tax rate should also be the marginal rate (ROR on
the last dollar invested)
-Need to consider risk duration and fluctuations (with more
risk/duration, we typically expect a better return)
2.) The cost of borrowing funds
-What is the rate at which we can borrow funds for that
organization (for the federal government, you can look at the
yield of treasury bonds?
-Generally the easiest to apply since there is market data on
this
-Will we generate returns that more than cover the costs of
borrowing?
-Cuts at the societal opportunity costs
3.) The social rate of time preference
-Theoretically, we can think this one through, but it's hard to do
practically
-The rate at which society is willing to trade present for future
consumption
-Society's time preference is going to be different than an
individual's time preference; generally thought to be lower than
an individual's
-Is the policy's future social value large enough to compensate
for the foregone present consumption?
-All based on NPV
-How do we determine this rate? Doesn't exist in the market.
-Theoretically, what you do is take the pure rate of time
preference. What is the social utility for consumption now
rather than later? Then you multiply that with the elasticity of
the marginal utility for consumption. Then, multiply that by the
growth rate of consumption.
-Hard to quantify some of this, but you might use proxies
-Could use the long-term yield on government bonds
-Really, you want to use one of the first two options
-Should you be applying a risk-free rate or should you use a rate
higher than this?
-The higher your discount rate, the lower your NPV
-The discount rate you use will likely have large impacts on
your NPV
-In the 1970s, most federal agencies used a discount rate of 10%
(you end up with a lot of negative NPVs)
-They lowered it to about 7%
-Takeaways
-Any time you are looking at multiple policies, use the same
discount rate (obviously cheating if you don’t)
-Given the fact that any discount rate can bring controversy, try
to consider as many rates as possible
Time Horizon
-What should this be?
-Typically, two ways to consider this
1.) Apply whatever the useful life of a capital investment is
(just an engineering question; very objective number)
2.) Look at the time period over which benefits actually
transpire (can be a little more subjective, but sometimes it is
hard to get the first one)
Additional Things in Identifying Costs and Benefits
-Always want to think in terms of WTP
-Always distinguish between things with market prices and
things without market prices
-Think about the direct effects as well as the externalities (focus
on technological externalities)
-Example: Dam
-WTP for a new dam
-Build a dam for electricity production
-Direct Benefits
-More electrical consumption (what are people willing to pay
for additional electricity?)
-Direct Costs
-What do the resources for building the dam cost?
-Externalities
-Downstream from the dam is farmland; flooding decreases
-Increased crop yield
-Benefit (what's the willingness to pay for an increased crop
yield?)
-Houses on the other side of the dam; more flooding
-These houses have to go away
-Cost (negative externality)
-Eminent Domain
-We're going to destroy your home
-More lakes (recreational benefits that accrue from this)
-Never include pecuniary externalities
-These are just transfers between consumer and producer
surplus
-Never worry about income changes
-These are multiplier effects and you do not consider these in
CBA
-Reasons for this
1.) Assumed full employment and price stability
2.) Basically, we think of these as being offsetting.
-If we take a dollar and use it for policy A, and this nets a $1.50
in increased income, then this could also be used for policy B.
Either policy is going to net the same multiplier, by
assumption.
3.) Income effects generally considered part of input-output
analysis or economic impact analysis.
-EIA looks at the multiplier effect.
Lecture Notes
I. What are the goals of public policy?
II. How do we go about making collective decisions?
a. Can be individual or societal
III. How can we go about evaluating normative issues?
IV. Financial Crisis
a. Why don't we provide temporary housing?
b. How do we deal with externalities?
c. Moral Hazard-If you subsidize risky behavior, what are
people going to do? You'll promote risky behavior.
V. Tax Policy
a. Any change to the tax code will be distortionary.
VI. Own up to these tradeoffs.
VII. Normative framework by which we can address these
issues.
a. Identify and clarify normatively valuable goals.
b. Define and describe the tradeoffs.
c. Offer foundational arguments.
i. Which normative goals are actually valuable?
ii. How do we balance the trade-off between these normative
values?
VIII. Evaluate goals based on:
a. Private Morality (How should I behave?)
b. Public Morality (How should the government behave?)
c. Collective Action Problem
IX. What normative frameworks do you have then?
X. Utilitarianism
a. Jeremy Bentham
b. JS Mill
c. Fundamentally a consequentialist framework (assess rightness
or wrongness based on the consequences)
i. Human welfare (or utility) is the consequence here
ii. A good act is anything that maximizes social utility
d. Which policies do we pursue in the utilitarian framework?
i. Need to think about overall (or aggregate) utility. (Sum
utilities)
ii. Average "utility." (Sum utilities and divide by number of
individuals)
e. Using aggregate utility (in terms of population)
i. Keep adding people until the benefit of the last child born has
a utility of 0
f. Using average utility (in terms of population)
i. Have children as long as the utility of doing so is higher than
the average
g. Why be a utilitarian?
i. Treats all individuals as equals
ii. Provides a framework for balancing tradeoffs
iii. Allows us to transform philosophical problems into
empirical questions
iv. Provides for social contract arguments
1. John Harsany (lays groundwork for John Rawls)
2. If we're all agreeing to it, then it should increase utility
3. Particularist
a. We're all behind the veil of ignorance, and we're identical in
the same econo-position.
b. Is there a contract which specifies the rules of the game that
we're willing to sign?
c. We'll end up with a society that is only dependent on our
shared humanity.
d. Harsany argues that we will be utilitarians behind the veil,
but Rawls does not.
-Pecuniary and technological externalities
-Back to the veil of ignorance
-N individuals
-A potential social arrangements
-a included in A
U1(a)
U2(a)
…
UN(a)
-Each one of us has an equal opportunity to end up at any one of
these utility levels (1/N)
-What is our expected utility? [EU]
a1
N=2
10=utils
a2
N=2
100=utils; 0=utils
-Whichever state of the world maximizes average utility, we're
going to go with it
-Risk neutral
-Problems with utilitarianism
-Can't measure utility
-The Matrix problem
-The Trolley Ride
-The Organ Harvest Problem
-How do we evaluate equity across generations? Should we treat
the utility of future generations equally? How do we work
around this?
-Discount rate (discount the utility to future generations):
intertemporal tradeoffs
-Egalitarianism
-Also a consequentialist framework
-We judge the morality of an act based on whether it increases
or decreases equality
-Types of equality
(1) Equality of Outcomes
-Equality of wealth* (Split it 50/50)
-Problems
(1) How do we prioritize? (Ms. Smarty vs. Mr. Dolt-give it to
Mr. Dolt)
(2) Incentive problem (if we steal from Mrs. Smarty, she won't
have an incentive to go on and do great things)
(3) Leveling Down Problem (Lots of people would be worse off
as this normative framework would pick SOW2)
-State of the World 1: You=$1 Million
Me=$500 K
-**State of the World 2: You=$500K
Me=$500K
-Could still have redistribution (still have the first two
problems; they just wouldn't be as strong)
-Equality of utility* (Give more resources to Mr. Sad in relation
to Mr. Happy)
(2) Communitarianism
-Share resources in the spirit of community
-Comes largely from the philosopher G.A. Cohen
-Emphasizes cooperation over competition
-Ideal society like a camping trip
-Issue of human nature (largely indoctrination)***
More on Egalitarianism
3.) Rawlsian Egalitarianism
-What state of the world would we be willing to accept behind
the veil of ignorance?
a1>a2
-Society will pick SOW1 only if the worst person off would be
better off in state of the world 1 than in state of the world 2
Un(a1)>Un(a2)
-Rawl's Difference People
-Floor on what we will end up
-Society should have inequality, but only to the extent that it
increases the welfare of the worst off in society
-Overcomes the leveling down problem
-Works around the incentive problem
4.) Equality of Opportunity
-Every person should have the same chance to advance, and we
should remove barriers that prevent that from happening
-G.A. Cohen (Three Types)
(1) Bourgeois EO
-Eliminate status restrictions, either formal or informal
-Access to opportunities should not be affected by irrelevant
facts
-Should only be determined by your fitness for the opportunity
-Issues
-What becomes a relevant fact and an irrelevant fact? (i.e.
Luck)
(2) Left-Liberal EO
-Eliminate circumstances of birth and upbringing which cause a
substantial disadvantage
-Talent
(3) Socialist EO
-Eliminate inequality arising from native differences
-Access to opportunity should not be affected by factors
relevant to a person's fitness for a given opportunity
-Reduce inequality down to personal choices
-Attempts to eliminate luck (i.e. also called luck
egalitarianism)
[1] Luck Elimination
-Ronald Dwarkin (1981)
-Justice requires that a person's fate is determined by things
within that person's control
-Differences caused in well-being caused by something outside
of my control are unjust
-Any inequality driven by choices and taste are acceptable
-Provide equal access to fundamental resources
-Dwarkin claims that a person identifies with a preference if
she's glad to hold it
-If not, then this person is not responsible for the consequences
of this preference (example of a drug addict)
-As a policy prescription, we should correct for this; help this
person overcome the addiction in the example
Deontology
-Fixes all of the consequentialist problems
-Opens up a new can of worms
-We will judge the goodness or badness of a policy or social
arrangement by its conformity to some moral norm or duty
rather than consequences
-We'll think in terms of rights (i.e. life, liberty, and the pursuit
of happiness)
-We have or desire rights not because they increase social
welfare, but rather because they are birthrights as human
beings
-Couching everything in terms of a right just cheapens the
concept of a right
-Rights
-A right granted to one person implies a duty upon another
-If a person has a right to something or another, then obviously
someone else has a duty to provide it
-Positive vs. Negative Rights
-Immanuel Kant
-Tied up in the ability to extend these rights universally
-Rights derived from human nature (not from divine revelation
or human rights) in the Kantian perspective
-Humans are rational creatures, and our fundamental purpose is
autonomy
-A rational person is autonomous if she is only bound by the
moral laws that she would rationally will herself to be bound
by
-These laws must be internally generated by a person's own
rationality*
-Rationally willed means a person would be rationally willing to
universalize the law
-A right is something that I rationally choose, but I'm not only
willing to impose it on you, but also on myself
-Categorical Imperative
More on the Categorical Imperative:
-For any action to be moral, it must be that I would be willing
to make the principle that motivates the action to be a universal
law
-Can't deviate from it in any sense
-We should never treat another individual's humanity as a
means; all individuals should be treated as ends in and of
themselves
-Doesn't create any sort of specific instruction (i.e. a specific
duty); gives a tool, however, to create lots of duties (i.e. rights)
-Would we be willing to universalize this thing? We can't,
however, universalize something that is going to treat someone
as a means.
-Issues:
-What happens when multiple duties come into conflict?
*Example
-Duty not to lie
-What if a murderer asked you where his next victim was?
-Torture in the face of a ticking time bomb?
-Cannot violate a deontological duty even to prevent others
from violating those duties
Libertarianism
-Subset of particular kind of deontological approach
-Normative good is maximizing human freedom
-What is freedom?
-Kant's Take
-Freedom is about self-actualization
-Live in accordance with the dictates of rationality
-We can't be free if we are slaves to things like utility or wealth
maximization
-Sen's Capabilities Approach to Development
-Absence of Coercion
-Freedom and rights run up against each other
-John Locke: State of Nature
-Life ---> Inalienable (Cannot be taken away, even by myself)
-Liberty ------> Inalienable
-Property -------> Imprescriptable (Cannot be taken away except
through proper procedural means)
-Maximizes social utility
-Robert Nozick
-Only way to evaluate a social arrangement is based on its
degree of respect for self-ownership
-Individuals have absolute ownership over our own bodies
-If we have absolute ownership over our own bodies, what does
that mean in regards to what we create of value? We have
ownership over that as well. Denying these is denying self-
ownership.
-You cannot have any concept of what someone deserves.
Individuals are due whatever there bodies create.
-Even if we start out with equal wealth, we won't stay that way.
-Inequality does not matter in this framework.
-Issues
-Ownership of property; to end up with ownership, you have to
create it
-Locke claims that you have to mix your labor with the physical
world; how do I come to ownership over the physical world?
-People typically come to own land by war and conquest (i.e.
might makes right)
-Nozick would accept a one-time property
transfer/redistribution (you would reset ownership rights)
-Libertarianism grounded in deontological approaches is
unwilling to accept tradeoffs
-Even if you have a situation where a small amount of taxation
would create benefits (over its costs), this is still a big no-no
-Collective Preferences (cont.)
-Universal domain or unrestricted domain
-All preferences of all voters should be allowed or included
-Transitivity has to hold
-Pairwise voting is intransitive
-Condorcet Paradox
-Voting will be unstable (every time you vote, there will be a
new decision)
-Agenda setter
-Example: 1976 Presidential Election (Reagan, Ford, and
Carter)
-Unanimity
-If x is at least as good as y for all individuals, then x will be
chosen
-Corollary: One person strictly prefers x
-Independence of Irrelevant Alternatives (IIA)
-Borda Counts violate this
-We can take cardinal utilities and turn them into an ordinal
social ranking
-The only social procedure in which this is possible is if you
have a dictator
-Arrow's Impossibility Theorem (Kenneth Arrow)
-It is impossible to convert individual cardinal utility into an
ordinal preference scale that will maximize social utility, save
for a dictatorship
-Fifth Assumption: Non-dictatorship (i.e. there is no person
such that whenever this person prefers any x to any y, socially x
is preferred to y)
-It becomes impossible to do what we are trying to do (i.e.
discover social preferences)
-Easiest way to prove Arrow's Impossibility Theorem; having a
dictator violates the fifth assumption
-Any group of N individuals
-Subset of individuals g (decisive group; regardless of everyone
else, this group's preferences become the social preferences)
-Can break this group up which would make other group
decisive group
-Eventually this breaks down to more groups, until you get to
one (i.e. the dictator); this dictator violates the fifth
assumption
Introduction
-Public Economics is a Major Field
1.) Constitutional Political Economy (Choice of Constraint;
What are the rules that govern everyday politics?)
2.) Public Choice (What can government do given the incentives
and constraints that exist?)
3.) Public Finance (What should government do?)
-Blackboard Economics
-Implementation is a completely different issue (and this
basically becomes public choice).
-This is the focus of this section of the class.
4.) Law and Economics (Economic analysis of the law; laws are
prices.)
-Ways to Raise Revenue
-Tax
-Taxes are a double edged sword (there are benefits and there
are costs)
-Benefits
1.) Raises revenue to provide certain things.
-Cost
-Always and everywhere, all taxes are distortionary (with the
exception of one-a lump sum tax, hard to practically
implement); will change incentives and lead to individuals
changing behavior
-Taxes change relative prices
-Income taxes makes it more expensive to work. People would
be expected to trade work for leisure.
-Borrow
-Monetary Policy (Print Money)
-Two Broad Categories of Tax Analysis
1.) Positive Principles of Taxation
-Only concerned with the effects of a tax
-Who bears the burden of the tax?
-What are the unintended consequences of a tax?
2.) Analysis of Actual Tax Policy
-Normative Analysis
-What is a fair tax burden?
-Who should bear that burden?
-Big Questions
-What is optimal tax policy, and what should this look like?
-All taxes are distortionary, and the DWL is the excess burden.
-Taxes will create excess burden, and we care about minimizing
this. How can we do this?
-Tradeoff Between Efficiency and Equity
-Think about what little is known about the new proposals to
eliminate tax loopholes. By closing these, we create excess
burden.
-What can you do with tax rates overall instead of these
loopholes (these are tax expenditures and you would get more
revenue by closing them)? We can lower tax rates and we will
be revenue neutral.
-Who benefits from these loopholes? A bunch of people. Those
people will get mad and revolt against the politicians in office.
-SALT subsidizes states with higher state and local property
taxes (it allows them to deduct these from their federal taxes).
Slemrod (Optimal Taxation and Optimal Tax Systems):
-What should government do?
-Optimal tax policy is our normative approach to understanding
taxation
-Not always practical
-Doesn't always assume tax evasion and things like this
-Fair amount of consensus about it; at least the end result, as it's
all theoretically neat
-Administrative costs are the biggest issue
-Number of costs
-Who wants to pay a tax, so we need enforcement
-Tax evasion is also distortionary (this creates an excess
burden)
-Tax avoidance as well
-Trying to minimize excess burden/deadweight loss (criterion
for optimal)
-Three Basic Assumptions
1.) We assume that individual preferences, technolo gy, and
market structure are known.
2.) We assume that there is some set amount of revenue that has
to be raised, and there are only limited tax instruments that
allow that to happen.
-Corollary: There are zero administrative costs.
3.) We will rank the outcomes that we get and choose the
optimal tax system given the constraints.
-Which taxes would be preferable? Given different taxes that we
employ, what can we expect emerge?
-Any tax, no matter what, will be distortionary in the sense that
it changes relative prices (the exception is the lump sum tax)
-Lump sum tax examples would be like a head tax or a poll tax
-Looking at a unit tax or commodity tax
-This is essentially just a tax on goods
-Sort of like a sales tax, but not exactly the same thing
-A uniform commodity tax is not optimal; it will lead to
significant distortions
-As you tax commodities, it reduces the relative price of leisure
-Ramsey Rule
-Basically, the way you want to tax commodities is by the
inverse elasticity rule
-Tax relatively more inelastic goods (in terms of demand) at a
relatively higher rate
-Goods that are relatively more elastic, tax them relatively
lower
-All due to the fact that leisure is a substitute good
-If good are relatively complementary to leisure, tax them really
high (example: snow skis)
-For substitutes to leisure, tax low (example: work uniforms)
-Want to minimize the distortion caused by the initial
introduction of the commodity tax
-This all assumes that everyone is equally endowed
-Could also include endowment effects
-Tax luxury goods really highly and tax necessary goods really
lowly
-Care about equity concerns here
-Could also just have an income tax to address these different
endowments (may or may not be more distortionary than an
adjusted Ramsey tax)
-Progression of Taxes (In Terms of Distortionary Behavior)
-Lump sum tax
-Commodity tax
-Income tax
-Production tax (example: VAT)
-Taxes on capital income
-Income depends on how you define it (somewhat arbitrary)
-If we want to tax capital income, we have to be specific about
what we are taxing
-If I buy a home and earn income off of this by renting it out, I
am really paying income to myself
-Some other examples
-Introduces a lot of complexity into the tax code
-The models that evaluate this (whether or not we want to tax
capital income)
-Assume there are two periods
-Tradeoff between consumption and leisure
-I only work in the first period, and don't work in the second
period
-If first period consumption is more substitutable, then tax
second period consumption (i.e. you would tax capital income)
-If second period consumption is more substitutable, the
subsidize first period income (i.e. subsidize capital income)
-If substitutability is equal between periods, then don't tax
capital income (impose a commodity or wage tax instead)
-Want to avoid distortions for investment incentives
-Taxes on Production
-If you can set commodity taxes optimally and there are zero
economic profits, do not tax production (the optimal tax rate on
production is 0)
-Optimal corporate income and capital gains tax along with
tariffs should be 0
-Don't tax production, tax consumption
-Highly restrictive
-How do we deal with heterogeneous individuals?
-Commodity taxes cannot be progressive
-Taxes for low income people would be relatively low and taxes
for high income people would be relatively high
-The former could just buy stuff for the latter (tax arbitrage)
-Can tax income progressively
-James Mirlees (won the Nobel Prize on this)
-What should be the optimal marginal income tax rate for the
top earner? This should be 0.
-There should be 1 tax bracket. This is a flat tax. (Usually
comes out between 40-50%; some estimates go as high as 70%)
-Why?
-The more tax brackets there are, the more distortionary the tax
is.
-Doesn't decrease revenue generated, doesn't leave anyone
worse off, and in fact, incentivizes people to work more.
-Example
-Top Income Earner at a Point in Time has $500 Million
-40% tax
-Tax Burden is $200 Million
-For time in memoriam, anything he makes above $500 Million
goes untaxed, so he has an incentive to work as much as
possible. Good from an efficiency standpoint, but can be
disastrous in terms of equity.
-Rawlsian Social Welfare Function will get you to 50%.
-Problems with this
-To get these outcomes, you need really highly stylized facts. In
the real world, pretty much none of it holds.
-If we have a situation where one tax bracket is optimal,
redistribution becomes difficult if this is something we care
about.
Optimal Taxation Continued:
-Administrative Costs
-Not costless to administer any tax.
-Real people and resources collecting the tax, enforcing the tax,
penalizing/incarcerating in the extreme, etc.
-Why do people pay taxes? Probability around the world of
getting caught not paying is generally 0. In the US, it's a little
tougher to avoid. Interesting paper idea.
-Compliance costs and technological changes can make pretty
extensive differences in optimal tax policy.
-Tariffs are highly distortionary. If you have another option,
optimal tax policy says that you should not do this.
-Import tariffs were one of the main sources of revenue for the
US government in the 19th century. Income tax is less
distortionary than this.
-Low administrative costs for import tariffs.
-Really hard to cheat on them. (Logistics of trying to cheat an
import tax is ridiculously complex. Even if you could, the tax is
likely not high enough to cover the costs of smuggling, though
it could be.)
-First Income Tax was in the UK in the 1850s
-Administrative costs of implementing this is incredibly high,
comparatively.
-Whenever you create a tax, you also create an incentive for two
other things.
-Tax Avoidance
-Looking for loopholes.
-Completely legal ways of not having to pay a tax.
-At the end of the day, any tax is just a law. In the same
fashion, a law is just words, which in turn, is good for
manipulation (job for lawyers).
-Tax Evasion
-You just don't pay your taxes.
-This is the illegal thing.
-Ensuring that people aren't just evading their taxes is
extremely costly. The more there is, the more costly a particular
tax policy is going to be.
-In addition, this reduces revenue the more prevalent this is.
-What should a tax structure look like to minimi ze this?
-Taxing Capital
-Issues
-Can become problematic from an efficiency standpoint as it
creates weird incentives. You would invest in areas that see
relatively lower taxes on capital or you would go long (long
investments in areas that tax capital lightly and short
investments in areas that tax capital heavily).
-The problem is that it distorts investment, but in a way to
avoid the tax.
-Slows Growth
-You can write off debt, but you cannot write off stock, even
though both are equally valid ways of raising capital.
-This creates an incentive to rely on bonds and debt.
-If the economy goes in the tank, these firms have a higher
chance of going under.
-Relatively better ways of raising revenue, but there are
realities that may make some of these methods difficult to
implement.
-What effects do taxes actually have on individual behavior?
-Always and everywhere it is distortionary
-Two Things
-What causes the distortion?
-A change in relative prices. It occurs because of the
substitution effect.
-Income effects are non-distortionary.
-Tax Incidence
-Who bears the burden of a tax?
-Two Types
1.) Statutory
-This is who the law says has to pay the tax.
-Sales tax, for example.
2.) Actual
-Who actually bears the burden of the tax.
-Determined by the elasticities of supply and demand.
-No such thing as a perfectly inelastic good. For insulin,
example, the substitute is that you just die. (Not perfect, but it
is still a substitute.)
-Unit Tax Example
-Whether you impose a tax on the buyer or the seller, what is
the ultimate outcome?
-Both parties will bear the same proportion of the tax?
-Look to the right
-Four Concepts
1.) Tax Revenue
-Qt(Pt-Ps)
-Shaded rectangle in example to the right.
2.) Tax Base
-The people who pay the tax.
-In the example to the right, how many cars get sold? (i.e. Qt)
3.) Tax Rate
Pt-Ps (In the example to the right)
4.) Excess Burden or Deadweight Loss
-Triangle ABC (Red Shading)
-Substitution Causes This
-Lost Gains from Trade
-Would you prefer a tax on you/me over a tax on business? No.
Why? Either way,
the tax burden will be shared by buyer and seller.
-Distortions Arise due to Substitution Effects
-Issues of Equity
-Who should bear the burden of the tax?
-Possible and likely that a relatively more efficient tax policy is
more inequitable
-Doing that will minimize the deadweight loss, but not
particularly equitable (think about a flat tax)
-Progressive income tax system will be more equitable, even
though it's less efficient
-Ways to look at some of these issues
1.) Benefits Principle
-Who gets the most benefit from the tax?
-If you benefit relatively more from a given expenditure, you
should have to pay more of the related tax
-Lindahl Tax
-Base the tax on your true willingness to pay for a given
service
-It will be provided publicly in its optimal amount
-Individually each one of us wants this, but we won't provide it
privately; group demand is higher, so if we work collectively to
provide it, we can all gain utility
-We vote to decide what we want publicly; the issue becomes
that we are always willing to vote for benefits
-Incentive to overproduce; to overcome this, you base tax rates
on willingness to pay
-Problems with lying about WTP
-Vickery Auction; award something to the second highest
bidder
-Lots of examples of this in use (for instance, user fees for
parks)
-Big downside: If we strictly apply this, we can't have a social
safety net or any type of welfare
-Eliminates economic rents for capture
2.) Ability to Pay Principle
-If you are someone of greater means, you should pay more (and
vice-versa)
-Allows for social safety nets
-Calls for redistribution schemes
-Relation Between this Principle and the Benefits Principle: As
our incomes go up, we demand more publicly provided goods
-Wealthier individuals tend to pay more in both cases
-Two Ways to Implement This:
1.) Horizontal Equity
-Individuals with the same income pay the same
-Regardless of life choice, everyone at the level of income
should pay the same; is this fair?
-Think about households with kids vs. those without.
-Should we individually penalize or promote individuals based
on life choices?
-Perhaps the rationale for various tax credits and loopholes
2.) Vertical Equity
-If you have more income, you pay more
-Justification for progressive tax systems
-Issues around incentives; ways to minimize this
-Luck elimination
-If the percentage paid stays equal as income rises, it's
proportional
-Can reduce administrative costs
-If the percentage paid decreases as income rises, it's regressive
(incentivizes people to work more to get out of higher tax
rates); the more you have to pay though, the harder it is to get
out of this (poverty trap; luck factors)
-If the percentage rises as income rises, it's progressive
-Another way to go about minimizing deadweight loss is a
consumption tax
-Sales tax
-You pay a tax on whatever you consume
-Relatively less distortionary (especially in comparison to an
income tax)
-An income tax will distort both my consumption and savings
behavior
-A consumption tax will only distort my consumption behavior
-Can substitute into leisure or saving (which earns interest
considered as income which can be taxed---double tax, highly
distortionary)
-More efficient, it disproportionately impacts relatively poor
people
-Could have a progressive or regressive consumption tax by
taxing consumption in the aggregate at tax time
-Can't do this on a sales tax as it incentivizes tax arbitrage
-If we look at a sales tax over time, it becomes less regressive;
people are less impacted since their incomes are rising over
time
-Things can look bad in a static sense, but how are these things
going to change dynamically (over time)?
-We'll start looking at specific taxes next time
Laffer Curve
-Paradoxically, you can increase revenue by increasing taxes up
to some point, but past this, revenue will go down
Average vs. Marginal Tax Rates
-We think at the margin, so we need to be concerned with what
the marginal tax rate is (this is what distorts prices due to
substitution effects)
-Should I earn another dollar or not (the marginal tax rate is the
rate you pay for each bracket of income)
-The more brackets you have, the more distortionary an income
tax becomes
-The optimal number of brackets is 1
-The amount that you pay divided by your total income is
average tax rate
-Average tax rates are a function of marginal tax rates
-If the top marginal tax rate is above your average tax rate, it's
progressive, and vice-versa (i.e. if the top marginal tax rate is
below your average tax rate, it's regressive)
-Just figure out the average tax rate for your assumed or
proposed bracket system, and you can just impose this as a flat
tax; it will raise the same amount of revenue and be less
distortionary
-Equity concerns still
-Negative income tax could address this: if you make less than
the tax/break, you get a tax credit (could be graduated or flat)
-Earned Income Tax Credit is essentially a negative income tax
-Implicit Tax Rate (downside to the EITC)
Income Tax: Double Tax on Savings
-Anything that is more than a single tax, you want to rid of it
-The amount of money that I save is based on my after-tax
income
-These dollars that earn interest are after-tax income are then
treated as income which is taxed
-Example
I want to buy a car at $20,000, and the interest rate I can earn is
10%. In a world of no tax, my opportunity cost is $2,000. We
have a 50% tax rate. Now I need, $40,000 of income to buy the
car. I also now need $4,000 of interest to cover my opportunity
cost. After the tax on interest, I end up with $1,000. To cover
all of this, I need a pre-tax income of $80,000. This becomes
highly distortionary. To be indifferent, I need to earn so much
more, so this increases the incentive to buy the car. I only have
to earn double to buy the car, but to earn the same amount on
interest, I have to earn quadruple.
So why do we do this? Dove doesn't know, so this might be a
good paper idea. I imagine there are a lot of public choice
issues here.
Corporate and Business Taxes
-When it comes to corporate taxation, corporations do not pay
taxes. They only collect them.
-Tax incidence matters.
-Consumers (passing off on higher prices), employers (reduction
in wage/employment), and shareholders (reductions in dividend
payments).
-We want resources flowing to their most highly valued
resources, everywhere and always. Corporate taxes distort this.
-How is it that capital flows?
-Taxes on dividends is a triple tax.
-Investments come out of after tax earnings.
-Dividends come out of after-tax profits.
-You pay taxes on the dividend.
-All this goes into tax avoidance (for example, incorporating in
foreign countries). Capital could receive a higher return in a no-
tax world, but outside of that, capital flows to some really weird
things.
-Capital gains taxes are 15% depending and 20% depending.
-Corporate tax rate is 35%.

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-What goods should or should not be publicly provided -What eff

  • 1. -What goods should or should not be publicly provided? -What effect does changing the regulatory environment change economic activity? -How should we go about collecting revenue? -Does changing any of these things effect overall welfare, both individually and socially? How so? -What are the tradeoffs? -We're trying to assess what government should do. -Positive analysis=What is? -Normative analysis=What ought to be/should be? -Tradeoff between equity (i.e. fariness) and economic efficiency (MB>=MC) -Excess burden (in public finance) and deadweight loss (in economics) -Impose high taxes on more relatively inelastic goods to generate revenue (lack of substitutes, think about gas) -Ramsey Rule (will end up with a fairly efficient tax, not necessarily equitable) -Equality and efficiency are generally opposed to each other -Broad questions 1.) Is it possible to draw normative conclusions from positive analysis? 2.) Can we evaluate normative conclusions and try to predict outcomes through positive analysis? 3.) How can we go about measuring the expected or actual impact of a policy proposal? 4.) How do these issues impact individual or societal welfare (can we measure them and what is societal welfare)? 5.) What is the difference between blackboard economics and real world policy? -We need to have a way to analyze the effects of policy on overall welfare -At least in the US, all regulatory agencies are required to
  • 2. conduct cost-benefit analysis before implementing a regulation; needs to conclude whether or not to impose the regulation -Obviously, if no policy can survive cost-benefit analysis, then you're in a Pareto Optimal situation; if it can, then it is at least Kaldor-Hicks efficient -We are not measuring goodness or badness -What we are trying to do is evaluate whether a policy will be worth the costs; we're going to get at this through social welfare -Marginal cost is less than or equal to marginal benefit (stop at MC=MB) -Example: Cutting off your head for stealing from grandma; people will only steal when no one else is around, hence the only witness is grandma; the criminal is incentivized to murder grandma as well -Optimal level of crime is greater than 0 -Caveats with Cost-Benefit Analysis 1.) CBA is not about money. 2.) Not about inputs and outputs. 3.) CBA is about welfare. 4.) Requires a common denominator in order to express heterogeneous items into homogenous flows. This is where money comes into CBA. It allows us to compare these different measures that we have. -We need to think in terms of outputs and the effects that these outputs have on welfare. These are going to become a means to increase welfare. -Utlimately, we need to think terms of the social value that is achieved through the outputs that we obtain relative to the opportunity costs of the project. -Minor League Baseball Stadium Example: Troy evaluates the
  • 3. success of the stadium based on attendance. Could just set the ticket price to 0 and subsidize the owner of the stadium to incentive him to do so. -Social welfare will decline; personally beneficial, but socially wasteful -We're hoping to measure this change in welfare (going to try to figure out people's willingness to pay WTP) -You can apply CBA whether you assume a benevolent dictator or a policy driven completely by special interests -Assumptions 1.) We assume the benevolent dictator model. -What does it mean to act in the general interest of society? Public agents are going to consider all relevant costs and benefits regardless of who the beneficiaries and the losers are. If society improves, then we are going to undertake the project. -In order to do this, we have to analyze counterfactuals. -2 Major Problems 1.) We need to build a counterfactual world where the project did not exist and then forecast what would have happened. 2.) We need to create a counterfactual with the policy and then forecast how that would happen. -There are problems with CBA. However, if you believe that this is all garbage, ask yourself, "Do we believe it is the case that firms are profit maximizers?" If so, well, firms use CBA for determining whether or not a project should be taken on. Given this, it provides evidence for the efficacy of CBA. -Things to Spell Out in CBA 1.) Objective -Examining relevant alternatives -Are we actually maximizing net benefits, not just increasing them?
  • 4. 2.) Identification of Costs and Benefits -If a project already has only direct effects, then this is pretty easy and straightforward -Tons of indirect effects; this will be the problem 3.) How do we measure the costs and benefits? -With market goods, we'll evaluate willingness to pay (WTP) -Evaluate and consider someone's stated preference (what would you pay) -Shadow prices: These are going to approximate the social opportunity costs of whatever input we're looking at. 4.) Aggregate Costs and Benefits -Will accrue across different time periods and affect different people -Need homogenous way to analyze this heterogeneous effect -Discount factor (How do we discount future costs and benefits?) 5.) Interpret Everything -How do we interpret our results and decision criteria (assumed discount rate, cost benefits, etc.)? -How sensitive are your results? -Your job is just to present 6.) Comparison with Your Relevant Base Case -Counterfactual with status quo 7.) Consider both Economic and Financial Feasibility -Economic Return: Social costs and social benefits -Financial Return: Revenues relative to costs (i.e. accounting) -Park in the City of Troy example (budget constraint) -All of this needs to be couched in economics -What is a benefit? -What is a cost? -How do you calculate them? -Just a means to assess whether decisions and choices promote efficiency and the efficient allocation of scarce resources -Need a second assumption; first assumption was that we just assume a benevolent dictator -Economic Rationality: Utility maximization subject to a budget
  • 5. constraint and individual choice -We also assume that the government's goal/utility comes from maximizing social welfare (intention) -Might be able to bake in a political feasibility component, but your job is really just to present the costs and benefits of a policy -CBA will be focused on efficiency -We do not generally worry about equity; sometime s, but we're just going to focus on the efficiency aspect in this class -Each individual is treated equally -Social bads for some can be outweighed by the social goods to others -How do we actually view future generations? -The costs to the few in the current period is likely to be greatly outweighed by the benefit that accrues to many in the future (when there are likely more people) -Have to figure out how to discount the future -Can still apply CBA in deontological environments (i.e. with those ethics) -Will think in terms of cost-effectiveness -State a goal -Example: Marijuana is a social bad. We're going to end marijuana use. -How can we get to this goal in a cost-effective way? What are the relevant alternatives? There's not just one way to get there. -How do we value non-human rights? -Include or exclude; If you exclude, you need to explain why if it has an impact. -How do we actually go about deriving social costs and benefits? -Necessary to look at individual market transactions and those valuations that we hold -Ultimately, we will need to consider consumer and producer surplus (can derive WTP from this) -Can also think about this in terms of individual preference and citizen preference (for example, voting)
  • 6. -Assume for now that we can look at market transactions -Derive consumer/producer surplus -We also have to evaluate how people do or might behave in markets (from this, we can estimate social costs and social benefits) -Will couch this into WTP and consumer sovereignty -This means that individuals within society and the behavior of those individuals will inform us about whether or not to pursue a policy -Won't worry about problems around WTP and income distributions for now (taking this as given) -Consumer surplus -How much surplus value will be generated for society? Can address this now. -Can break this down into 2 questions 1.) How much do different members of society value the policy? -How much would each member be willing to pay for the policy? This tells me social benefit. 2.) What does society actually pay for the policy? -This tells me social costs. *From these two questions, we can figure out our net benefit. -Total benefit minus total cost (NB=TB-TC) -Once we have net social benefit and consumer surplus, now we can understand economic value, with which we can measure WTP 2.) Social Costs: Opportunity Costs of the Resources Used -Determined by an individual's WTP for the foregone use of the resource *Example: Commercial Fishing and Fish Population Policy -We're going to increase commercial fishing -Think in terms of net benefit calculation (society's WTP for an
  • 7. increased fish catch relative to the opportunity costs of the resources used to increase the catch) -We don't care about increased employment or increased income; WTP is only meant to reflect consumer demand for additional fish -WTP is what's important in evaluating both benefits and costs -Figuring out TR: See how much expenditures increase by -Consumer surplus is tougher (can't figure this out directly) Sunstein: The Cost-Benefit State -If we're going to have regulation, it should typically be tied to CBA -Makes the argument on both economic and democratic grounds -Without CBA, there is a strong incentive attracting regulatory capture or interest-group pressures; also such regulation tends to be tied to anecdotal evidence, which is highly unreliable -Administrative state as we know it evolved out of the New Deal -Used to be that state and local governments handled their own crises; during the Great Depression, state and local governments went broke -What starts to happen is that very rapidly we task many of these responsibilities to the Federal government -Agencies governed by very open-ended statutes and laws, and hence, they are granted lots of discretion -Ended up throwing checks and balances out the window -Have a situation in which there is uncertainty regarding the justification of any given regulation; no criteria to evaluate this -Regulation ultimately is a cost; if it's overly so, then this comes at the expense of economic activity
  • 8. -Many court decisions that have found against regulations based on their costliness; outside the question of the constitutionality of the regulation -CBA tends to reduce special-interest influences -Nominally, it increases transparency -Three Qualifications 1.) Should not require CBA simply to impose undue procedural requirements on agencies 2.) CBA should have the presumption that economic incentives and market solutions can fix the problem 3.) Really hard to value social goods; CBA has a serious methodological problem here -Need to balance variables -Which of these actually need to be balanced, and how should they be valued -5 Features to Consensus Regarding the Problems in Existing Government Regulation 1.) Real consensus that government needs to be better at priority setting. -Regulatory costs are really poorly allocated -Real lack of consistency across agencies 2.) Government should have a presumption for flexible market- based incentives, rather than rigid commands. -4 Problems in Markets 1.) Information Asymmetries 2.) Externalities (Positive and Negative) ----->Emphasis is Here (for purposes of this class) -Where a negative externality exists, I am not fully internalizing the cost; I will overproduce 3.) Monopolies 4.) Public Goods (Can't Price It) -Nonrivalrous -Nonexcludable
  • 9. -Taxing away the externality generally better than regulating it 1.) Tax creates revenue for government; we can theoretically use this revenue to create some other social benefit 2.) Tax avoidance (will incentivize you to minimize tax burden by producing less of the externality through innovation; a regulation prevents this innovation by specifying what a firm has to do) -As long as you are not a marginal firm, you will support the tax as it will get rid of some of your competition -Producers of substitute goods will also support the tax Private Public -Need to think in terms of a spectrum -Providing it privately will lead to a misallocation of resources -The limit moves us along this spectrum -Movie example -Only person in movie theater; the price should be 0 -At a price of 0, eventually the theater fills up -Suddenly you have congestion and, hence, rivalry -Whatever might be non-rivalrous becomes rivalrous
  • 10. -Producing goods in a private sphere incentivize individuals to produce efficiently and innovate (improve quality, etc.) -Markets are more efficient, but they are not necessarily more equitable -No profit and loss signals in governmental efforts to improve equity (chronic over and underproduction) -Tradeoff between efficiency and equity Starting back on CBA (Sunstein Article) 1.) Government should engage in better priority setting 2.) Government should have a presumption in favor of flexible market-based incentives rather than rigid commands -Means and ends thing -If we're going to have a regulation, then we need to be focused on the ends of that regulation (for example, lowering pollution; just establish this as the end instead of directing the means to getting there) 3.) Government should be aware of and attempt to counteract harmful unintended consequences -Always and everywhere avoid unintended consequences -Health tradeoffs -Inhaler example 4.) Government needs more information and it should create better incentives to compile and provide accurate information. -Scientific uncertainty can make measuring the harms of something difficult 5.) Technocratic, economic, and democratic judgments all have their appropriate place. -Government needs to respond to reasonable judgments about risk -At the end of the day, people are really bad at assessing risk -You don't want voter demand driving regulation -Nothing undemocratic about refusing to go along with factual ignorance; point of having representative democracy 6.) Government should concentrate on basic ends rather than means.
  • 11. -Need to avoid the special interest effect Picking up on Sunstein 6th Point: 6.) Government should concentrate on basic ends rather than means. -Incentives on industry from regulation -Maximize your gains by manipulating the regulation to benefit you -Minimize your costs from the regulation -Regulatory capture -Industry typically comes up with the regulations -Focus on performance standards rather than design standards -Best approach is generally some broad-based tax scheme across all industries -If you go to regulatory means, you creating a real incentive for special interests -Market forces should be the means to achieve the ends Benefits to CBA: -Helps us overcome regulation by anecdote -Any time you have a regulatory environment/administrative state, it creates an automatic incentive for special interest effects -CBA can make their influence more transparent Turning Back to CBA in General: -How do we calculate willingness-to-pay? Net benefits NB=Total Benefits-Total Costs Social Benefits Social Costs -What do we do when market prices don't exist? -When we have market prices:
  • 12. -What is our willingness to pay for increased commercial fishing? *If you do CBA for everything, then this creates strong status quo bias -Also creates strong incentives to litigate every single thing -Issues with consumer surplus -Options 1.) Ignore it. 2.) Estimate elasticity of demand. -Statistical regression Quantity= alpha1 + beta1Price + error term -Beta1 should be negative -Look at data over time -Time series (one observation over many periods of time) as opposed to cross-sectional or panel Qt= alpha1 + beta1Pricet + error termt -Want as many observations as possible -Daily price observation -Weekly -Monthly -Quarterly (would only have 4 observations per year; need lots and lots of years) -Log everything to estimate elasticity -This is really close to percent change -There's probably other things affecting quantity other than price -To isolate the effect of price, we need to include control variables
  • 13. -Want to get as close to a natural experiment as possible, so that we can tease out causation -Need economic theory and intuition (really common sense) to determine controls -Will never be perfect, as it is practically impossible to control for everything you need to control for -What happens when we're faced with a situation of non-market goods (no market price)? -Example: Environmental Quality -Options 1.) Consider surrogate markets. -For example, in regards to finding WTP for school quality, you can look at the housing market. -Home prices are generally a pretty good market to turn to for most stuff like this -Look at the effect of distance to good school in home prices -Have to control for everything else affecting home prices 2.) Create hypothetical markets. -Try to simulate a market and calculate WTP. -Shadow prices -Think in terms of black markets 3.) Survey -Lots of complications and issues here -Who is society? -Who needs to be included in our analysis? -To properly conduct CBA, we need to know the relevant agents (those whom the costs and benefits are being imposed on) -You can get different answers based on whom you include or how many people you include -How do we treat socially unacceptable behaviors? -For example, crime is a benefit to criminals -This kind of stuff practically isn't going to get counted, but it raises an ethical or philosophical question? -How do we count future generations? -Future generations should be included if something has an
  • 14. effect over multiple time periods -You have calculate net benefits for which you have to calculate WTP -Someone not born yet doesn't have a WTP -To get around this, you assume preferences today are the same as preferences tomorrow -Sunset clause? -What do we do with non-human nature (i.e. animals)? -CBA only anthropocentric society -Non human entities don't have standing (with caveats) -We'll count intrinsic value attached to animals -For example, we don't count the disutility to my dog of his death, but we do count the disutility to me over losing my dog -How do we take into account cultural differences? How Do We Actually Conduct Our Analysis: -Two outcomes (with and without) -Need to estimate incremental benefits and incremental costs -The difference between benefits and costs with or without the policy -Benefit with minus benefit without -Costs with minus costs without -Always calculate the baseline first -This is NOT before and after analysis -Farming with fertilizer vs. farming with organic products -We expect crop yields to increase by 10% using organic products -With before and after, the benefit is 10%
  • 15. -With CBA, there would be some benefits to continue to use fertilizer -With fertilizer, we expect crop yields to increase by 6% -This makes our net benefit 4% (our incremental change) Picking Back up with With-Without Analysis: -Organic Farming vs. the Use of Fertilizer Example -Erosion -Not taking into account the alternative with before and after -Costs -Thought of in the same terms as benefits -Discount Rates important to think about -How do we collect the data? -Two approaches 1.) Collect separate data for the with policy and the baseline policy -Can now calculate your incrementals 2.) Collect data directly that measures the incremental effect -Need to do it for both benefits and costs -Back to the farming example -What will our yields be for using fertilizer and organics -Try to determine the current value of the crop (typically look at current market prices) -Need to build some assumptions about what you think future prices are going to look like -Example -Suppose crop is valued at $100,000 -Can assume that current real prices are going to be stable over time -Then we can figure out our future payoffs between the two options -If we think value is going to compound (10% return) -For organics, should be $110,000 for first year, $121,000 for
  • 16. second year, … -Fertilizer should be $106,000 for first year, $112,000 for second year, … -Need to think through opportunity costs as well -This is going to help inform the baseline model -In our current example, you recommend organics, but this means more land -The opportunity cost is the cost of the extra land -Nature preserve vs. other use for the land example (in this case Walmart) -What happens when we have policies that have an effect over time? -Need to think in terms of present value -Need to determine a discount rate -I want benefits now -Benefits in the future are worth less to me -How do we calculate present value? -Try to select multiple discount rates to make your argument more convincing -Define the present as the first day that resources are committed -Framing the Analysis -Need a decision criteria (What should be the outcome of our CBA?) -3 Decision Types 1.) Just look at one single policy, and then decide whether or not to pursue it. -If we employ NPV, do it when it's positive 2.) We can consider several mutually exclusive alternative policies, and then determine which, if any, to implement. -Policies will be mutually exclusive if the acceptance of one requires the abandonment of another
  • 17. -What this allows us to do is determine if this is Kaldor-Hicks efficient -Example -Building a bridge across a river -Multiple possible spots, but we can only pick one -What is the best spot to place this bridge? 3.) Consider several non-mutually exclusive policies, and then decide upon a possible subset to pursue. -We can consider several different aspects. -Bridge Example -If we only build one bridge, we could have congestion issues. -Could build bridges in multiple locations. -As we build more bridges, the marginal value of any one bridge will go down. -Just use net present value (NPV)= PVB-PVC -Allows us to figure out and assess the value of a policy -Need to be mindful of any budget constraint that exists; can only do things where PVC is less than the budget constraint Bridge PVB PVC NPV A 200 100 100 B 250 100 150 C 210 100 110
  • 18. A,B 370 200 170 A,C 350 200 150 B,C 300 200 100 A,B,C 380 300 80 -Option 1 -Any of them would work (they are all positive) -Relative time/energy in evaluating a single policy is low compared to the other two options -Option 2 -Analyze A, B, and C -Would pick B -Option 3 -Analyze A,B; A,C; B,C; and A,B,C -Would pick A,B -Police Dept., New Park, Reservoir Turning to the Discount Rate -One of the biggest issues that we're faced with -What should the discount rate be? -What criteria should go into or be used to determine that rate? -How might the discount rate fluctuate over time?
  • 19. -How might it be different for different projects? -Really big doctrinal debate around it -Two competing approaches (no consensus over one or the other) 1.) 2.) -Regardless of the approach you take, there are multiple rates you could use -Small changes in the discount rate can take you from a positive to a negative NPV -Do we need to adjust our discount rates to account for social values or could we use weighted averages for rates? -When it comes to the discount rate, it has a real effect on how we evaluate intergenerational and environmental concerns -Environmental groups would argue that you should not be applying a discount rate -Any policy change today that accrues benefits on people tomorrow, we should do it (there are more people in the future, and the benefits will be exponentially larger) -Two reasons for applying a discount rate 1.) Any time that we pursue a policy, obviously there is an opportunity cost attached to that -If nothing else, it's good to know what our opportunity cost is 2.) Since we accept that individuals prefer a dollar today to a dollar tomorrow, we can augment this to say that so does society -Therefore, clearly we need to discount the future -Three rates we can apply (Each one has theoretical support) 1.) The rate of return from the best alternative investment -The pretax rate of return that would be generated if those resources had been allocated to their next best investme nt -Recognizes that capital funds have a social opportunity cost -By pursuing a given policy today, society has to give up the potential future cash flow from the next best alternative -Will our net present benefit be greater than the foregone return?
  • 20. -Issues: -What does public use always imply? It has to come from a private source (i.e. taxes). -Opportunity cost from taking private resources -Is public use preferable to private use? -General Rules to Apply -Always apply a before-tax rate of return -The before-tax rate should also be the marginal rate (ROR on the last dollar invested) -Need to consider risk duration and fluctuations (with more risk/duration, we typically expect a better return) 2.) The cost of borrowing funds -What is the rate at which we can borrow funds for that organization (for the federal government, you can look at the yield of treasury bonds? -Generally the easiest to apply since there is market data on this -Will we generate returns that more than cover the costs of borrowing? -Cuts at the societal opportunity costs 3.) The social rate of time preference -Theoretically, we can think this one through, but it's hard to do practically -The rate at which society is willing to trade present for future consumption -Society's time preference is going to be different than an individual's time preference; generally thought to be lower than an individual's -Is the policy's future social value large enough to compensate for the foregone present consumption? -All based on NPV -How do we determine this rate? Doesn't exist in the market. -Theoretically, what you do is take the pure rate of time preference. What is the social utility for consumption now rather than later? Then you multiply that with the elasticity of the marginal utility for consumption. Then, multiply that by the
  • 21. growth rate of consumption. -Hard to quantify some of this, but you might use proxies -Could use the long-term yield on government bonds -Really, you want to use one of the first two options -Should you be applying a risk-free rate or should you use a rate higher than this? -The higher your discount rate, the lower your NPV -The discount rate you use will likely have large impacts on your NPV -In the 1970s, most federal agencies used a discount rate of 10% (you end up with a lot of negative NPVs) -They lowered it to about 7% -Takeaways -Any time you are looking at multiple policies, use the same discount rate (obviously cheating if you don’t) -Given the fact that any discount rate can bring controversy, try to consider as many rates as possible Time Horizon -What should this be? -Typically, two ways to consider this 1.) Apply whatever the useful life of a capital investment is (just an engineering question; very objective number) 2.) Look at the time period over which benefits actually transpire (can be a little more subjective, but sometimes it is hard to get the first one) Additional Things in Identifying Costs and Benefits -Always want to think in terms of WTP -Always distinguish between things with market prices and things without market prices -Think about the direct effects as well as the externalities (focus on technological externalities) -Example: Dam -WTP for a new dam -Build a dam for electricity production -Direct Benefits -More electrical consumption (what are people willing to pay
  • 22. for additional electricity?) -Direct Costs -What do the resources for building the dam cost? -Externalities -Downstream from the dam is farmland; flooding decreases -Increased crop yield -Benefit (what's the willingness to pay for an increased crop yield?) -Houses on the other side of the dam; more flooding -These houses have to go away -Cost (negative externality) -Eminent Domain -We're going to destroy your home -More lakes (recreational benefits that accrue from this) -Never include pecuniary externalities -These are just transfers between consumer and producer surplus -Never worry about income changes -These are multiplier effects and you do not consider these in CBA -Reasons for this 1.) Assumed full employment and price stability 2.) Basically, we think of these as being offsetting. -If we take a dollar and use it for policy A, and this nets a $1.50 in increased income, then this could also be used for policy B. Either policy is going to net the same multiplier, by assumption. 3.) Income effects generally considered part of input-output analysis or economic impact analysis. -EIA looks at the multiplier effect. Lecture Notes I. What are the goals of public policy? II. How do we go about making collective decisions?
  • 23. a. Can be individual or societal III. How can we go about evaluating normative issues? IV. Financial Crisis a. Why don't we provide temporary housing? b. How do we deal with externalities? c. Moral Hazard-If you subsidize risky behavior, what are people going to do? You'll promote risky behavior. V. Tax Policy a. Any change to the tax code will be distortionary. VI. Own up to these tradeoffs. VII. Normative framework by which we can address these issues. a. Identify and clarify normatively valuable goals. b. Define and describe the tradeoffs. c. Offer foundational arguments. i. Which normative goals are actually valuable? ii. How do we balance the trade-off between these normative values? VIII. Evaluate goals based on: a. Private Morality (How should I behave?) b. Public Morality (How should the government behave?) c. Collective Action Problem IX. What normative frameworks do you have then? X. Utilitarianism a. Jeremy Bentham b. JS Mill c. Fundamentally a consequentialist framework (assess rightness or wrongness based on the consequences) i. Human welfare (or utility) is the consequence here ii. A good act is anything that maximizes social utility d. Which policies do we pursue in the utilitarian framework? i. Need to think about overall (or aggregate) utility. (Sum utilities) ii. Average "utility." (Sum utilities and divide by number of individuals) e. Using aggregate utility (in terms of population)
  • 24. i. Keep adding people until the benefit of the last child born has a utility of 0 f. Using average utility (in terms of population) i. Have children as long as the utility of doing so is higher than the average g. Why be a utilitarian? i. Treats all individuals as equals ii. Provides a framework for balancing tradeoffs iii. Allows us to transform philosophical problems into empirical questions iv. Provides for social contract arguments 1. John Harsany (lays groundwork for John Rawls) 2. If we're all agreeing to it, then it should increase utility 3. Particularist a. We're all behind the veil of ignorance, and we're identical in the same econo-position. b. Is there a contract which specifies the rules of the game that we're willing to sign? c. We'll end up with a society that is only dependent on our shared humanity. d. Harsany argues that we will be utilitarians behind the veil, but Rawls does not. -Pecuniary and technological externalities -Back to the veil of ignorance -N individuals -A potential social arrangements -a included in A U1(a) U2(a) … UN(a)
  • 25. -Each one of us has an equal opportunity to end up at any one of these utility levels (1/N) -What is our expected utility? [EU] a1 N=2 10=utils a2 N=2 100=utils; 0=utils -Whichever state of the world maximizes average utility, we're going to go with it -Risk neutral -Problems with utilitarianism -Can't measure utility -The Matrix problem -The Trolley Ride -The Organ Harvest Problem -How do we evaluate equity across generations? Should we treat the utility of future generations equally? How do we work around this? -Discount rate (discount the utility to future generations): intertemporal tradeoffs -Egalitarianism -Also a consequentialist framework -We judge the morality of an act based on whether it increases or decreases equality -Types of equality (1) Equality of Outcomes -Equality of wealth* (Split it 50/50) -Problems (1) How do we prioritize? (Ms. Smarty vs. Mr. Dolt-give it to
  • 26. Mr. Dolt) (2) Incentive problem (if we steal from Mrs. Smarty, she won't have an incentive to go on and do great things) (3) Leveling Down Problem (Lots of people would be worse off as this normative framework would pick SOW2) -State of the World 1: You=$1 Million Me=$500 K -**State of the World 2: You=$500K Me=$500K -Could still have redistribution (still have the first two problems; they just wouldn't be as strong) -Equality of utility* (Give more resources to Mr. Sad in relation to Mr. Happy) (2) Communitarianism -Share resources in the spirit of community -Comes largely from the philosopher G.A. Cohen -Emphasizes cooperation over competition -Ideal society like a camping trip -Issue of human nature (largely indoctrination)*** More on Egalitarianism 3.) Rawlsian Egalitarianism -What state of the world would we be willing to accept behind the veil of ignorance? a1>a2 -Society will pick SOW1 only if the worst person off would be better off in state of the world 1 than in state of the world 2 Un(a1)>Un(a2) -Rawl's Difference People -Floor on what we will end up -Society should have inequality, but only to the extent that it increases the welfare of the worst off in society -Overcomes the leveling down problem
  • 27. -Works around the incentive problem 4.) Equality of Opportunity -Every person should have the same chance to advance, and we should remove barriers that prevent that from happening -G.A. Cohen (Three Types) (1) Bourgeois EO -Eliminate status restrictions, either formal or informal -Access to opportunities should not be affected by irrelevant facts -Should only be determined by your fitness for the opportunity -Issues -What becomes a relevant fact and an irrelevant fact? (i.e. Luck) (2) Left-Liberal EO -Eliminate circumstances of birth and upbringing which cause a substantial disadvantage -Talent (3) Socialist EO -Eliminate inequality arising from native differences -Access to opportunity should not be affected by factors relevant to a person's fitness for a given opportunity -Reduce inequality down to personal choices -Attempts to eliminate luck (i.e. also called luck egalitarianism) [1] Luck Elimination -Ronald Dwarkin (1981) -Justice requires that a person's fate is determined by things within that person's control -Differences caused in well-being caused by something outside of my control are unjust -Any inequality driven by choices and taste are acceptable -Provide equal access to fundamental resources -Dwarkin claims that a person identifies with a preference if she's glad to hold it -If not, then this person is not responsible for the consequences of this preference (example of a drug addict)
  • 28. -As a policy prescription, we should correct for this; help this person overcome the addiction in the example Deontology -Fixes all of the consequentialist problems -Opens up a new can of worms -We will judge the goodness or badness of a policy or social arrangement by its conformity to some moral norm or duty rather than consequences -We'll think in terms of rights (i.e. life, liberty, and the pursuit of happiness) -We have or desire rights not because they increase social welfare, but rather because they are birthrights as human beings -Couching everything in terms of a right just cheapens the concept of a right -Rights -A right granted to one person implies a duty upon another -If a person has a right to something or another, then obviously someone else has a duty to provide it -Positive vs. Negative Rights -Immanuel Kant -Tied up in the ability to extend these rights universally -Rights derived from human nature (not from divine revelation or human rights) in the Kantian perspective -Humans are rational creatures, and our fundamental purpose is autonomy -A rational person is autonomous if she is only bound by the moral laws that she would rationally will herself to be bound by -These laws must be internally generated by a person's own rationality* -Rationally willed means a person would be rationally willing to universalize the law -A right is something that I rationally choose, but I'm not only willing to impose it on you, but also on myself -Categorical Imperative
  • 29. More on the Categorical Imperative: -For any action to be moral, it must be that I would be willing to make the principle that motivates the action to be a universal law -Can't deviate from it in any sense -We should never treat another individual's humanity as a means; all individuals should be treated as ends in and of themselves -Doesn't create any sort of specific instruction (i.e. a specific duty); gives a tool, however, to create lots of duties (i.e. rights) -Would we be willing to universalize this thing? We can't, however, universalize something that is going to treat someone as a means. -Issues: -What happens when multiple duties come into conflict? *Example -Duty not to lie -What if a murderer asked you where his next victim was? -Torture in the face of a ticking time bomb? -Cannot violate a deontological duty even to prevent others from violating those duties Libertarianism -Subset of particular kind of deontological approach -Normative good is maximizing human freedom -What is freedom? -Kant's Take -Freedom is about self-actualization -Live in accordance with the dictates of rationality -We can't be free if we are slaves to things like utility or wealth maximization -Sen's Capabilities Approach to Development -Absence of Coercion
  • 30. -Freedom and rights run up against each other -John Locke: State of Nature -Life ---> Inalienable (Cannot be taken away, even by myself) -Liberty ------> Inalienable -Property -------> Imprescriptable (Cannot be taken away except through proper procedural means) -Maximizes social utility -Robert Nozick -Only way to evaluate a social arrangement is based on its degree of respect for self-ownership -Individuals have absolute ownership over our own bodies -If we have absolute ownership over our own bodies, what does that mean in regards to what we create of value? We have ownership over that as well. Denying these is denying self- ownership. -You cannot have any concept of what someone deserves. Individuals are due whatever there bodies create. -Even if we start out with equal wealth, we won't stay that way. -Inequality does not matter in this framework. -Issues -Ownership of property; to end up with ownership, you have to create it -Locke claims that you have to mix your labor with the physical world; how do I come to ownership over the physical world? -People typically come to own land by war and conquest (i.e. might makes right) -Nozick would accept a one-time property transfer/redistribution (you would reset ownership rights) -Libertarianism grounded in deontological approaches is unwilling to accept tradeoffs -Even if you have a situation where a small amount of taxation would create benefits (over its costs), this is still a big no-no -Collective Preferences (cont.) -Universal domain or unrestricted domain -All preferences of all voters should be allowed or included
  • 31. -Transitivity has to hold -Pairwise voting is intransitive -Condorcet Paradox -Voting will be unstable (every time you vote, there will be a new decision) -Agenda setter -Example: 1976 Presidential Election (Reagan, Ford, and Carter) -Unanimity -If x is at least as good as y for all individuals, then x will be chosen -Corollary: One person strictly prefers x -Independence of Irrelevant Alternatives (IIA) -Borda Counts violate this -We can take cardinal utilities and turn them into an ordinal social ranking -The only social procedure in which this is possible is if you have a dictator -Arrow's Impossibility Theorem (Kenneth Arrow) -It is impossible to convert individual cardinal utility into an ordinal preference scale that will maximize social utility, save for a dictatorship -Fifth Assumption: Non-dictatorship (i.e. there is no person such that whenever this person prefers any x to any y, socially x is preferred to y) -It becomes impossible to do what we are trying to do (i.e. discover social preferences) -Easiest way to prove Arrow's Impossibility Theorem; having a dictator violates the fifth assumption -Any group of N individuals -Subset of individuals g (decisive group; regardless of everyone else, this group's preferences become the social preferences) -Can break this group up which would make other group decisive group -Eventually this breaks down to more groups, until you get to one (i.e. the dictator); this dictator violates the fifth
  • 32. assumption Introduction -Public Economics is a Major Field 1.) Constitutional Political Economy (Choice of Constraint; What are the rules that govern everyday politics?) 2.) Public Choice (What can government do given the incentives and constraints that exist?) 3.) Public Finance (What should government do?) -Blackboard Economics -Implementation is a completely different issue (and this basically becomes public choice). -This is the focus of this section of the class. 4.) Law and Economics (Economic analysis of the law; laws are prices.) -Ways to Raise Revenue -Tax -Taxes are a double edged sword (there are benefits and there are costs) -Benefits 1.) Raises revenue to provide certain things. -Cost -Always and everywhere, all taxes are distortionary (with the exception of one-a lump sum tax, hard to practically implement); will change incentives and lead to individuals changing behavior -Taxes change relative prices -Income taxes makes it more expensive to work. People would be expected to trade work for leisure. -Borrow -Monetary Policy (Print Money) -Two Broad Categories of Tax Analysis 1.) Positive Principles of Taxation -Only concerned with the effects of a tax
  • 33. -Who bears the burden of the tax? -What are the unintended consequences of a tax? 2.) Analysis of Actual Tax Policy -Normative Analysis -What is a fair tax burden? -Who should bear that burden? -Big Questions -What is optimal tax policy, and what should this look like? -All taxes are distortionary, and the DWL is the excess burden. -Taxes will create excess burden, and we care about minimizing this. How can we do this? -Tradeoff Between Efficiency and Equity -Think about what little is known about the new proposals to eliminate tax loopholes. By closing these, we create excess burden. -What can you do with tax rates overall instead of these loopholes (these are tax expenditures and you would get more revenue by closing them)? We can lower tax rates and we will be revenue neutral. -Who benefits from these loopholes? A bunch of people. Those people will get mad and revolt against the politicians in office. -SALT subsidizes states with higher state and local property taxes (it allows them to deduct these from their federal taxes). Slemrod (Optimal Taxation and Optimal Tax Systems): -What should government do? -Optimal tax policy is our normative approach to understanding taxation -Not always practical -Doesn't always assume tax evasion and things like this -Fair amount of consensus about it; at least the end result, as it's all theoretically neat -Administrative costs are the biggest issue
  • 34. -Number of costs -Who wants to pay a tax, so we need enforcement -Tax evasion is also distortionary (this creates an excess burden) -Tax avoidance as well -Trying to minimize excess burden/deadweight loss (criterion for optimal) -Three Basic Assumptions 1.) We assume that individual preferences, technolo gy, and market structure are known. 2.) We assume that there is some set amount of revenue that has to be raised, and there are only limited tax instruments that allow that to happen. -Corollary: There are zero administrative costs. 3.) We will rank the outcomes that we get and choose the optimal tax system given the constraints. -Which taxes would be preferable? Given different taxes that we employ, what can we expect emerge? -Any tax, no matter what, will be distortionary in the sense that it changes relative prices (the exception is the lump sum tax) -Lump sum tax examples would be like a head tax or a poll tax -Looking at a unit tax or commodity tax -This is essentially just a tax on goods -Sort of like a sales tax, but not exactly the same thing -A uniform commodity tax is not optimal; it will lead to significant distortions -As you tax commodities, it reduces the relative price of leisure -Ramsey Rule -Basically, the way you want to tax commodities is by the inverse elasticity rule -Tax relatively more inelastic goods (in terms of demand) at a relatively higher rate -Goods that are relatively more elastic, tax them relatively lower -All due to the fact that leisure is a substitute good -If good are relatively complementary to leisure, tax them really
  • 35. high (example: snow skis) -For substitutes to leisure, tax low (example: work uniforms) -Want to minimize the distortion caused by the initial introduction of the commodity tax -This all assumes that everyone is equally endowed -Could also include endowment effects -Tax luxury goods really highly and tax necessary goods really lowly -Care about equity concerns here -Could also just have an income tax to address these different endowments (may or may not be more distortionary than an adjusted Ramsey tax) -Progression of Taxes (In Terms of Distortionary Behavior) -Lump sum tax -Commodity tax -Income tax -Production tax (example: VAT) -Taxes on capital income -Income depends on how you define it (somewhat arbitrary) -If we want to tax capital income, we have to be specific about what we are taxing -If I buy a home and earn income off of this by renting it out, I am really paying income to myself -Some other examples -Introduces a lot of complexity into the tax code -The models that evaluate this (whether or not we want to tax capital income) -Assume there are two periods -Tradeoff between consumption and leisure -I only work in the first period, and don't work in the second period -If first period consumption is more substitutable, then tax second period consumption (i.e. you would tax capital income) -If second period consumption is more substitutable, the subsidize first period income (i.e. subsidize capital income) -If substitutability is equal between periods, then don't tax
  • 36. capital income (impose a commodity or wage tax instead) -Want to avoid distortions for investment incentives -Taxes on Production -If you can set commodity taxes optimally and there are zero economic profits, do not tax production (the optimal tax rate on production is 0) -Optimal corporate income and capital gains tax along with tariffs should be 0 -Don't tax production, tax consumption -Highly restrictive -How do we deal with heterogeneous individuals? -Commodity taxes cannot be progressive -Taxes for low income people would be relatively low and taxes for high income people would be relatively high -The former could just buy stuff for the latter (tax arbitrage) -Can tax income progressively -James Mirlees (won the Nobel Prize on this) -What should be the optimal marginal income tax rate for the top earner? This should be 0. -There should be 1 tax bracket. This is a flat tax. (Usually comes out between 40-50%; some estimates go as high as 70%) -Why? -The more tax brackets there are, the more distortionary the tax is. -Doesn't decrease revenue generated, doesn't leave anyone worse off, and in fact, incentivizes people to work more. -Example -Top Income Earner at a Point in Time has $500 Million -40% tax -Tax Burden is $200 Million -For time in memoriam, anything he makes above $500 Million goes untaxed, so he has an incentive to work as much as possible. Good from an efficiency standpoint, but can be disastrous in terms of equity. -Rawlsian Social Welfare Function will get you to 50%. -Problems with this
  • 37. -To get these outcomes, you need really highly stylized facts. In the real world, pretty much none of it holds. -If we have a situation where one tax bracket is optimal, redistribution becomes difficult if this is something we care about. Optimal Taxation Continued: -Administrative Costs -Not costless to administer any tax. -Real people and resources collecting the tax, enforcing the tax, penalizing/incarcerating in the extreme, etc. -Why do people pay taxes? Probability around the world of getting caught not paying is generally 0. In the US, it's a little tougher to avoid. Interesting paper idea. -Compliance costs and technological changes can make pretty extensive differences in optimal tax policy. -Tariffs are highly distortionary. If you have another option, optimal tax policy says that you should not do this. -Import tariffs were one of the main sources of revenue for the US government in the 19th century. Income tax is less distortionary than this. -Low administrative costs for import tariffs. -Really hard to cheat on them. (Logistics of trying to cheat an import tax is ridiculously complex. Even if you could, the tax is likely not high enough to cover the costs of smuggling, though it could be.) -First Income Tax was in the UK in the 1850s -Administrative costs of implementing this is incredibly high, comparatively. -Whenever you create a tax, you also create an incentive for two other things. -Tax Avoidance -Looking for loopholes. -Completely legal ways of not having to pay a tax.
  • 38. -At the end of the day, any tax is just a law. In the same fashion, a law is just words, which in turn, is good for manipulation (job for lawyers). -Tax Evasion -You just don't pay your taxes. -This is the illegal thing. -Ensuring that people aren't just evading their taxes is extremely costly. The more there is, the more costly a particular tax policy is going to be. -In addition, this reduces revenue the more prevalent this is. -What should a tax structure look like to minimi ze this? -Taxing Capital -Issues -Can become problematic from an efficiency standpoint as it creates weird incentives. You would invest in areas that see relatively lower taxes on capital or you would go long (long investments in areas that tax capital lightly and short investments in areas that tax capital heavily). -The problem is that it distorts investment, but in a way to avoid the tax. -Slows Growth -You can write off debt, but you cannot write off stock, even though both are equally valid ways of raising capital. -This creates an incentive to rely on bonds and debt. -If the economy goes in the tank, these firms have a higher chance of going under. -Relatively better ways of raising revenue, but there are realities that may make some of these methods difficult to implement. -What effects do taxes actually have on individual behavior? -Always and everywhere it is distortionary -Two Things -What causes the distortion? -A change in relative prices. It occurs because of the substitution effect. -Income effects are non-distortionary.
  • 39. -Tax Incidence -Who bears the burden of a tax? -Two Types 1.) Statutory -This is who the law says has to pay the tax. -Sales tax, for example. 2.) Actual -Who actually bears the burden of the tax. -Determined by the elasticities of supply and demand. -No such thing as a perfectly inelastic good. For insulin, example, the substitute is that you just die. (Not perfect, but it is still a substitute.) -Unit Tax Example -Whether you impose a tax on the buyer or the seller, what is the ultimate outcome? -Both parties will bear the same proportion of the tax? -Look to the right -Four Concepts 1.) Tax Revenue -Qt(Pt-Ps) -Shaded rectangle in example to the right. 2.) Tax Base -The people who pay the tax. -In the example to the right, how many cars get sold? (i.e. Qt) 3.) Tax Rate Pt-Ps (In the example to the right) 4.) Excess Burden or Deadweight Loss -Triangle ABC (Red Shading) -Substitution Causes This -Lost Gains from Trade -Would you prefer a tax on you/me over a tax on business? No. Why? Either way, the tax burden will be shared by buyer and seller. -Distortions Arise due to Substitution Effects -Issues of Equity
  • 40. -Who should bear the burden of the tax? -Possible and likely that a relatively more efficient tax policy is more inequitable -Doing that will minimize the deadweight loss, but not particularly equitable (think about a flat tax) -Progressive income tax system will be more equitable, even though it's less efficient -Ways to look at some of these issues 1.) Benefits Principle -Who gets the most benefit from the tax? -If you benefit relatively more from a given expenditure, you should have to pay more of the related tax -Lindahl Tax -Base the tax on your true willingness to pay for a given service -It will be provided publicly in its optimal amount -Individually each one of us wants this, but we won't provide it privately; group demand is higher, so if we work collectively to provide it, we can all gain utility -We vote to decide what we want publicly; the issue becomes that we are always willing to vote for benefits -Incentive to overproduce; to overcome this, you base tax rates on willingness to pay -Problems with lying about WTP -Vickery Auction; award something to the second highest bidder -Lots of examples of this in use (for instance, user fees for parks) -Big downside: If we strictly apply this, we can't have a social safety net or any type of welfare -Eliminates economic rents for capture 2.) Ability to Pay Principle -If you are someone of greater means, you should pay more (and vice-versa) -Allows for social safety nets -Calls for redistribution schemes
  • 41. -Relation Between this Principle and the Benefits Principle: As our incomes go up, we demand more publicly provided goods -Wealthier individuals tend to pay more in both cases -Two Ways to Implement This: 1.) Horizontal Equity -Individuals with the same income pay the same -Regardless of life choice, everyone at the level of income should pay the same; is this fair? -Think about households with kids vs. those without. -Should we individually penalize or promote individuals based on life choices? -Perhaps the rationale for various tax credits and loopholes 2.) Vertical Equity -If you have more income, you pay more -Justification for progressive tax systems -Issues around incentives; ways to minimize this -Luck elimination -If the percentage paid stays equal as income rises, it's proportional -Can reduce administrative costs -If the percentage paid decreases as income rises, it's regressive (incentivizes people to work more to get out of higher tax rates); the more you have to pay though, the harder it is to get out of this (poverty trap; luck factors) -If the percentage rises as income rises, it's progressive -Another way to go about minimizing deadweight loss is a consumption tax -Sales tax -You pay a tax on whatever you consume -Relatively less distortionary (especially in comparison to an income tax) -An income tax will distort both my consumption and savings behavior -A consumption tax will only distort my consumption behavior -Can substitute into leisure or saving (which earns interest considered as income which can be taxed---double tax, highly
  • 42. distortionary) -More efficient, it disproportionately impacts relatively poor people -Could have a progressive or regressive consumption tax by taxing consumption in the aggregate at tax time -Can't do this on a sales tax as it incentivizes tax arbitrage -If we look at a sales tax over time, it becomes less regressive; people are less impacted since their incomes are rising over time -Things can look bad in a static sense, but how are these things going to change dynamically (over time)? -We'll start looking at specific taxes next time Laffer Curve -Paradoxically, you can increase revenue by increasing taxes up to some point, but past this, revenue will go down Average vs. Marginal Tax Rates -We think at the margin, so we need to be concerned with what the marginal tax rate is (this is what distorts prices due to substitution effects) -Should I earn another dollar or not (the marginal tax rate is the rate you pay for each bracket of income) -The more brackets you have, the more distortionary an income tax becomes -The optimal number of brackets is 1 -The amount that you pay divided by your total income is average tax rate -Average tax rates are a function of marginal tax rates -If the top marginal tax rate is above your average tax rate, it's progressive, and vice-versa (i.e. if the top marginal tax rate is below your average tax rate, it's regressive) -Just figure out the average tax rate for your assumed or proposed bracket system, and you can just impose this as a flat tax; it will raise the same amount of revenue and be less distortionary -Equity concerns still -Negative income tax could address this: if you make less than
  • 43. the tax/break, you get a tax credit (could be graduated or flat) -Earned Income Tax Credit is essentially a negative income tax -Implicit Tax Rate (downside to the EITC) Income Tax: Double Tax on Savings -Anything that is more than a single tax, you want to rid of it -The amount of money that I save is based on my after-tax income -These dollars that earn interest are after-tax income are then treated as income which is taxed -Example I want to buy a car at $20,000, and the interest rate I can earn is 10%. In a world of no tax, my opportunity cost is $2,000. We have a 50% tax rate. Now I need, $40,000 of income to buy the car. I also now need $4,000 of interest to cover my opportunity cost. After the tax on interest, I end up with $1,000. To cover all of this, I need a pre-tax income of $80,000. This becomes highly distortionary. To be indifferent, I need to earn so much more, so this increases the incentive to buy the car. I only have to earn double to buy the car, but to earn the same amount on interest, I have to earn quadruple. So why do we do this? Dove doesn't know, so this might be a good paper idea. I imagine there are a lot of public choice issues here. Corporate and Business Taxes -When it comes to corporate taxation, corporations do not pay taxes. They only collect them. -Tax incidence matters. -Consumers (passing off on higher prices), employers (reduction in wage/employment), and shareholders (reductions in dividend payments). -We want resources flowing to their most highly valued resources, everywhere and always. Corporate taxes distort this. -How is it that capital flows?
  • 44. -Taxes on dividends is a triple tax. -Investments come out of after tax earnings. -Dividends come out of after-tax profits. -You pay taxes on the dividend. -All this goes into tax avoidance (for example, incorporating in foreign countries). Capital could receive a higher return in a no- tax world, but outside of that, capital flows to some really weird things. -Capital gains taxes are 15% depending and 20% depending. -Corporate tax rate is 35%.