Updated: 02 Oct 2007

Lecture Notes:

ECON 635: PUBLIC ECONOMICS

Lecture 1

2

Four Functions of Public Finance

• Allocation

• Distribution

• Stabilization

• Growth

3

Allocation

• An organized society requires the consumption of

public goods and services that would be unprofitable

to produce privately

• Public goods include:

– Defense,

– Law and order, justice

– Infrastructure

– Taxation is used to raise funds to pay for

production of these goods and services

4

Redistribution• Very difficult to do in a short period of time

• Redistributing wealth does not change individual

incomes much.

• Redistribution is impossible to do via the tax system

alone.

• Redistribution through expenditure system is much more

promising.

• Redistribution should be related to the role of

governments in promoting growth.

5

Redistribution (cont’d)• Only through growth can people in developing countries

be lifted out of economic backwardness

• Public education, health services

• Rural roads, rural telephone, electricity and public water

supplies all ways that people can change their position in

life overtime

• Important to consider changing income distribution

between generations

6

Stabilization• A short run objective

• Outgrowth of the Keynesian revolution in

economics.

• The main objective to keep actual level of

income close to its potential.

• The target is full employment and price

stability.

• Inflation extremely damaging to poor and

reduces the efficiency of market system.

7

Growth• Probably the most important objective when per capita

incomes are low

• Sources of Per Capita growth

– Capital accumulation, Human capital (education, health), and

Productivity change

• Tools of taxation and public expenditure need to be focused

on how to promote growth

• Need policies that encourage investors to reinvest their

business surpluses not take them out of country

• Government budget surplus important for providing savings

for private sector to borrow

8

1. Avoid false technicism in economic policymaking.

2. Keep budgets under adequate control.

3. Keep inflationary pressures under reasonable control.

4. Take advantage of international trade.

5. Recognize that some types and patterns of trade restrictions

are far worse than others, and work both to liberalize and

rationalize them. (For example, uniform tariff rates are not as

damaging as import quotas)

6. If import restrictions are excessive, and reducing them is

politically impossible, mount an indirect attack on the

problem by increasing incentives to export.

Twelve Lessons of Economic Policy

9

7. Make tax systems simple, easy to administer, and (as much

as possible) neutral and non-distorting with respect to

resource allocation.

8. Avoid excessive income tax rates 35 to 40% are

representing a plausible marginal rate that should not be

exceeded).

9. Avoid excessive use of tax incentives to achieve particular

objectives.

10. Use price and wage controls sparingly, if at all.

11. Rarely can an economic justification be found for quotas,

licenses, and similar quantitative restrictions on output,

imports, exports, etc.

Twelve Lessons of Economic Policy (Cont’d)

10

12. The borderline of public-sector and private-sector activity

should be clear and well-defined. When the two compete in a

given area, the same rules should govern their operations.

Twelve Lessons of Economic Policy (Cont’d)

11

Five Important Innovations of Tax Policy

a) It is a possible to introduce more progressivity in a value

added tax system, but that its benefits have to be weighted

against significant extra vulnerability to evasion.

b) Significant differentiation among rates of import tariffs can

lead to huge economic inefficiencies by giving vastly

different degrees of effective protection to different

activities.

c) Personal income tax rates above 35 to 40 percent are very

hard to justify in light of their efficiency and incentive costs.

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d) Labor is likely to bear the burden of any unilateral rise

in the rate of tax on the income of corporations (or

businesses in general), once an open-economy setting

is put in place.

e) It is much easier to index a tax system for inflation than

people think. By its nature full indexation promotes

both equity and efficiency.

Five Important Innovations of Tax Policy (Cont’d)

13

Pattern of Tax Revenue Collection(Approximation)

Category of Countries Ratio of Tax Revenue to GNP

i) Low Income countries 15%

(per capita income Less than $400)

ii) Low Middle income 20%

(per capita income $400 to $1,600)

iii) Upper Middle income 30%

iv) High Income Industrialized countries

45%

(Source: Wagner's Law – State takes an expanding share of GNP as per capita incomes rise.)

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  Pattern of Tax Revenue CollectionCountry GNP/Capital Rev/GDP Non-tax Rev/Rev

YEAR US $ 1999 1997 1997

Nepal 220 12.60% 13.65%

Bolivia 1010 24.35% 11.00%

Egypt 1400 28.95% 33.55%

Turkey 2900 21.95% 12.88%

Mexico 4400 19.10% 14.27%

Brazil 4420 37.30% 14.10%

Chile 4740 25.54% 17.33%

Kuwait 15000 46.90% 95.55%

Canada 19320 40.19% 17.05%

Italy 19710 45.40% 11.02%

UK 22640 39.13% 12.45%

Sweden 25040 58.90% 10.20%

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Composition of Government Revenues

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Composition of Government Expenditures

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• Rapid growth in size over the past 50 years• Two reasons:

a. Desire to increase rate of growth and industrialization

- growth in state owned enterprises.

- this trend is reversing

b. Growth in social program

- social security

- health expenditure

- unemployment insurance

- welfare programs• Need to think how these objectives and programs can be

more effectively delivered. E.g. public-private partnerships.

What is the Appropriate Size of the Public Sector?

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1. Current expenditures on personnel explode ?

2. Investment expenditures have huge cost over runs ?

3. Crop failures ?

4. Exchange rate fluctuations ?

5. Rapid increase in military expenditures ?

6. A contingent liability comes due

- e.g. Guarantee of bank deposits

- Guarantee of exchange rate

- Guarantee of state enterprise loans

What are the most frequent causes of Government Budget Crisis ?

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Principles to Evaluate a Good Tax System

Revenue Adequacy

• The taxes introduced should be sufficient to finance and fund the

government expenditure requirements over time.

• Tax revenues should increase at a rate equal to or greater than the growth

of GNP.

• The entire tax system should evolve as the economy changes.

• Inadequate revenues will force the government to resort to borrowing,

selling state assets or printing money (inflation).

• Deficit financing by domestic borrowing leads to the crowding out of

private sector credit given by commercial banks.

• Deficit financing by foreign borrowing is limited and economically

expensive.

• Deficit financing by Central Bank borrowing leads to inflation.

• High inflation usually leads to financial crises.

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Principles to Evaluate a Good Tax System (Cont’d)

Stability

• The stability of tax revenues is important for good government.

• Revenue instability will cause new programs to be poorly implemented.

• Stability in the tax rules and rates over time allows the private sector to make long term plans more efficiently.

For the stability of a tax system, it is necessary that:

a. the legislation be well written to eliminate unintended tax exemptions or deductions (loopholes)

b. the statutory rates of tax for each of the taxes are not so high as to create powerful incentives to promote tax avoidance schemes or to stimulate tax evasion activity

c. the tax revenue is adequate and grows in a consistent fashion

d. the tax system is simple and the combined cost of administration and compliance is low

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Principles to Evaluate a Good Tax System (Cont’d)Simplicity • A Tax system should be simple so that it is easy to comply with by

taxpayers. • Simplicity must apply to the administration of the law as well as its

legal structure. • A complex tax system imposes high level of compliance costs on tax

payers and a high cost of administration on the government.

• Tax neutrality needed for growth.• Growth comes about primarily through the expansion of savings and

expansion of investment into high return activities.• The tax system should not create major distortions in consumption

and production behavior. • A tax should not change the investment decisions by favoring one

set of investments over the others.• The tax system should not create a disincentive to work.• Well-designed tax systems should encourage competitive growth in

all sectors of the economy.

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Principles to Evaluate a Good Tax System (Cont’d)

Economic Efficiency • A tax is efficient if the dead weight loss or efficiency cost is small.

• High differential tax rates create larger economic efficiency costs.

• The economic efficiency of a tax is an important consideration when designing a tax system.

• Estimates of efficiency cost range from 5 to 150 percent of additional tax revenues.

Low Administration and Compliance Costs

• A good tax system has low administration and compliance costs.

These costs are part of the economic cost of having a tax system.

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Tax Systems Before and After Reforms

• Design of a tax reform depends on the existing elements

of the tax system

• Considerable differences in the existing tax policies and

economic systems of various countries

• The legislative and administrative set-up also vary from

country to country

• For the former Socialist economies of Eastern Europe

and the former Union of Soviet Socialist Republics a

completely new tax system has had to be created

PRINCIPLES OF TAX REFORM

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Tax Systems Before and After Reforms (Cont’d)

In many developing countries tax reforms need to

concentrate only on redesigning the existing tax system.

• Where reforms are extensive, their implementation could

spread over a number of years.

• Appropriate tax rules for the implementation is an important

component required for the success of a tax reform.

• A general understanding or consensus must be reached

among concerned economists, lawyers, and legislators for

successful legislation and implementation of these rules.

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Implementation of Reforms

• The actual implementation of a tax reform depends on the will of the political leaders and the capabilities of the tax administration of the country

• Political leadership has a major role in legislation of acts and rules

• Difficult to produce an integrated tax reform which has the support of all the interest groups.

• Political leadership often seeks to influence the tax administration in order to favor special interest groups, and this destroys tax systems

• The tax administration in a particular country may be slack and inactive

• For effective implementation of tax reforms, a prime requisite is that reforms in the administrative setup keep pace with the changes in the tax system and in the way the tax clients operates.

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• Design of tax reform will also depend on the type of tax which is the object of reform

• Main categories of taxes:

a) Direct Taxes

* personal income tax

* business or corporate tax

b) Indirect Taxes

* sales taxes (Value Added Tax)

* excise taxes

• trade taxes

c) Property Taxes

* wealth tax

* estate and gift tax

* asset tax

d) User Charges

* users charges

* environmental taxes

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Direct Taxes

A) Income Tax:

Before Reform After Reform

High top rates (40%-75%) (Statutory Tax)

Top rates falling (20%-35%)

Many rates Very few rates

Many exemptions Most exemptions eliminated

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Direct Taxes (Cont’d)

B) Corporate Income Tax:

Before Reform After Reform

High marginal tax rates Convergence of top statutory tax rates for personal and corporate tax systems

Incentives with tax holidays

Elimination of special incentives

Double taxation Integration of corporate and personal taxes

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Reduction of top marginal income rates since 1984 (Number in parentheses indicates the number of tax brackets)

Country Individuals Corporations

Before After Before After

Australia 60% (5) 49%(4) 46% 39%

Canada 34%(10) 29%(3) 28% 23%

Finland 50% 43% 52% 40%

Germany 56% 53% 56% 50%

Portugal 41/48% 37% 60/68 45%

Barbados 60% 50% 45% 35%

Colombia 49% 31% 40% 30%

El Salvador 60% 35% 30% 35%

Guatemala 42% 34% 48% 34%

Jamaica 58% 33% 45% 33%

New Zealand 66% (5) 33%(3) 45% 28%

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Reduction of top marginal income rates since 1984 (Number in parentheses indicates the number of tax brackets)

Country Individuals Corporations

Before After Before

After

Zambia 80% 35% 50% 35/45

Denmark 73% 68% 40% 50%

U.S.A. 50% 28% 46% 34%

Indonesia 45% 35% 45% 35%

Singapore 45% 33% 40% 33%

Botswana 75% 50% 35% 40%

Mauritius 70% 35% 66% 35%

U.K. 60% 40% 52% 35%

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Indirect Taxes

A) Sales Tax:

Before Reform After Reform

Many rates Value Added Tax (one positive rate and zero rate)

Many exemptions Small number of exemptions

Narrow base Broad base plus a selective number of excise taxes (cigarettes and liquor etc.)

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Indirect Taxes (Cont’d)

B) Trade Taxes (Import Duties):

Before Reform After Reform

High tariff rates Top rates loweredTarget around the world for a single rate. In free trade areas the target rate is zero.

Wide dispersal among rates (in India 90 different tax rates on steel alone)

Fewer rates

Quantitative controls No quotas

• While in 1950 no country had a Value Added Tax, by 1993 more than 80 countries had adopted some form of VAT Tax

• By 2001, over 120 countries have introduced VAT

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• Evolution of the tax system of South Cyprus 1990-2001 after it began preparations to enter into the European Union.

• South Cyprus had a history of a very old fashion tax system that was badly in need of reform.

• Tax system was full of exemptions and incentives

Tax Reform Process in South Cyprus

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South Cyprus Fiscal Issues in 1990:

Public sector deficit – 5.3% of GDP

Individual Income tax – 3.9% of GDP

Corporation Income tax – 1.4% of GDP

Import duties – 3.4% of GDP

Selective excises – 0.0% of GDP

VAT – 0.0% of GDP

Other Indirect Taxes – 8.1% of GDP

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• South Cyprus 1991 began reform process with changes to income tax to reduce burden.

– Introduced VAT in 1992 at a rate of 5%.– 1993 raised VAT rate to 8% – Income tax changes in 1996– 2000 raised VAT rate to 10% – 2002 raised VAT rate to 13%– Major reform of Income Tax System– 2003 will raise VAT rate to 15%

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Direct and Indirect Taxes as Share of GDP.

0,0

2,0

4,0

6,0

8,0

10,0

12,0

14,0

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

Year

GD

P %

Direct Taxes

Indirect Taxes

37

Direct Taxes as Share of Total Tax Revenues.

0,0

10,0

20,0

30,0

40,0

50,0

60,0

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

Year

% T

ota

l T

ax

Rev

en

ues

Direct Taxes / Total Direct & Indirect Taxes

38

Composition of Indirect Taxes as Share of GDP.

0,0

1,0

2,0

3,0

4,0

5,0

6,0

7,0

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

Year

GD

P % Import Duties

Selective Excises

Value Added Tax (VAT)

Other Indirect Taxes

39

South Cyprus Fiscal Situation 2001:

Public sector deficit – 2.8% of GDP

Less distortionary tax system

Individual income tax – 4.4% of GDP

Corporate income tax – 3.9% of GDP

Import duties – 1.3% of GDP

Selective Excises – 3.0% of GDP

Value Added Taxes – 5.9% of GDP

Other indirect taxes – 2.1% of GDP

40

Revenue Buoyancies of South Cyprus Taxes, 1990-2002.

Total Taxes 1.59

Total Direct Taxes 1.77

Total Indirect Taxes 1.46

Individual Income Tax 1.07

Corporation Income Tax 3.46

Other Direct Taxes 1.32

Total Indirect Taxes 1.46

Import Duties -1.56

Selective Excises 1.25

Value Added Tax 3.72

Other Indirect Taxes -.93

41

South Cyprus 2001:

Per capita income – US$ 13,500Real growth rate 1995-01 – 4.2%Tourism makes up – 20% of GDPImports – 41.1% of GDPExports – 11.9 of GDPDomestic Savings – 14.0% of GDPDomestic Investment – 18.5% of GDPRate of inflation – 2.0 %Unemployment rate – 3.0%

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The Challenge Facing North Cyprus

• Total Tax Revenues - 35 % of GDP

• Total Expenditure - 63% of GDP

• Deficit - 28% of GDP

• Substantial Public Sector Budget Deficit

43

Tax Collections 2003 as Percentages of GDP.

Direct Taxes 10.24% 8.93%

Indirect Taxes 14.85% 16.54%

- VAT 7.75% 7.67%Import Duties (tariffs) 0.51% 0.79%Selective Excises 4.60% 7.76%Other 1.98% 0.32%

Social Security Contribution 5.22% 5.22%

Other non-tax revenue 6.01% 5.11%

Total Revenue 36.67% 35.80%

Total Revenue (Excluding SSC) 31.10% 30.58%

South Cyprus

North Cyprus

44

Public Sector Expenditures, Excluding Social Security and public pensions, 2004 as percentages of GDP

SOUTH CYPRUS

NORTH CYPRUS

Wages & salaries 10.96% 17.19%Capital Expenditure 3.77% 7.87%Debt Service 4.96% 5.09%

Others (excluding social security

and public pensions) 14.96% 16.46%

Total Expenditures 34.65% 46.62%

Total Revenue (Excluding SSC) 31.10% 30.58%

Cash Deficit -3.55% -16.04%

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Cash Deficits of Social Security and Public Pension Systems of North and South Cyprus

SOUTH CYPRUS NORTH CYPRUS

Cyprus Pounds % of GDP Cyprus Pounds % of GDP

Social Security Contributions 368 5.22% 36 5.22%

Social security payments 418 5.93% 67 9.76%

Public Pensions (Pre 1987 employes) - - 48 6.99%

Cash Deficit of Pension System -50 -0.71% -79 -11.53%