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The Optimal Size of Public Spending and the Distortionary Cost of Taxation

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  • Yew-Kwang Ng

Abstract

Feldstein (1997) reviews his and others' contributions in the distortionary costs of taxation, arriving at a remarkable estimate that the cost per incremental dollar of government spending is a very high $2.65. Kaplow (1996) argues that it is optimal to supply a public good whenever the benefit/cost ratio exceeds one, contrary to the orthodox position since Pigou (1928) that the benefits of public goods must exceed their direct costs by an amount sufficient to outweigh the distortionary costs of taxation. This paper largely reconciles these two apparently opposing positions. The large distortionary costs exist on the revenue side but is largely offset by the negative distortionary costs or distributional gain on the spending side. However, both Kaplow's and Feldstein's arguments have to be subject to important qualifications. Additional arguments relevant to the central public finance question "How big should the public spending be?" are also reviewed. The prevalence of environmental disruption effects, the existence of burden-free taxes on diamond goods, and the importance of relative-income effects all favor the lowering of the required benefit/cost ratio for public goods and, as a rule, more public spending. The reason for the difference between the existence of distortion (in comparison to a lumpsum tax) as emphasized by Browning and Liu (1998) and the unitary marginal cost of public fund is also explained graphically.

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Bibliographic Info

Paper provided by Monash University, Department of Economics in its series Monash Economics Working Papers with number archive-19.

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Length: 20 pages
Date of creation: 2000
Date of revision:
Publication status: Published in National Tax Journal 53:2 (June 2000) pp 253-72.
Handle: RePEc:mos:moswps:archive-19

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Postal: Department of Economics, Monash University, Victoria 3800, Australia
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Web page: http://www.buseco.monash.edu.au/eco/
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References

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  1. Ng, Yew-Kwang, 1975. "Non-Economic Activities, Indirect Externalities, and Third-Best Politics," Kyklos, Wiley Blackwell, vol. 28(3), pages 507-25.
  2. Ng, Yew-Kwang, 1987. "Relative-Income Effects and the Appropriate Level of Public Expenditure," Oxford Economic Papers, Oxford University Press, vol. 39(2), pages 293-300, June.
  3. Yew-Kwang Ng & Guang-Zhen Sun, 2006. "Introduction," Division of Labor & Transaction Costs (DLTC), World Scientific Publishing Co. Pte. Ltd., vol. 1(02), pages 99-103.
  4. Ng, Yew-Kwang & Wang, Jianguo, 1993. "Relative income, aspiration, environmental quality, individual and political myopia : Why may the rat-race for material growth be welfare-reducing?," Mathematical Social Sciences, Elsevier, vol. 26(1), pages 3-23, July.
  5. Ng, Yew-Kwang, 1977. "Towards a Theory of Third-Best," Public Finance = Finances publiques, , vol. 32(1), pages 1-15.
  6. Ng, Yew-Kwang, 1987. "Diamonds Are a Government's Best Friend: Burden-Free Taxes on Goods Valued for Their Values," American Economic Review, American Economic Association, vol. 77(1), pages 186-91, March.
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Citations

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Cited by:
  1. Wendner, Ronald & Goulder, Lawrence H., 2008. "Status Effects, Public Goods Provision, and the Excess Burden," MPRA Paper 8260, University Library of Munich, Germany.
  2. Richard M. bird, 2003. "Taxation in Latin America: Reflections on Sustainability and the Balance between Equity and Efficiency," International Tax Program Papers 0306, International Tax Program, Institute for International Business, Joseph L. Rotman School of Management, University of Toronto.
  3. Louis Kaplow, 2004. "On the (Ir)Relevence of Distribution and Labor Supply Distortion of Government Policy," NBER Working Papers 10490, National Bureau of Economic Research, Inc.
  4. Louis Kaplow, 2010. "Optimal Control of Externalities in the Presence of Income Taxation," STICERD - Public Economics Programme Discussion Papers 02, Suntory and Toyota International Centres for Economics and Related Disciplines, LSE.
  5. Wendner, Ronald & Goulder, Lawrence H., 2008. "Status effects, public goods provision, and excess burden," Journal of Public Economics, Elsevier, vol. 92(10-11), pages 1968-1985, October.
  6. Richard G. Lipsey, 2012. "A critique of Ng's third-best theory," Discussion Papers dp12-02, Department of Economics, Simon Fraser University.
  7. Martin, Will & Anderson, James E., 2005. "Costs of taxation and the benefits of public goods : the role of income effects," Policy Research Working Paper Series 3700, The World Bank.
  8. Joel Slemrod & Shlomo Yitzhaki, 2001. "Integrating Expenditure and Tax Decisions: The Marginal Cost of Funds and the Marginal Benefit of Projects," NBER Working Papers 8196, National Bureau of Economic Research, Inc.
  9. Louis Kaplow, 2006. "Optimal Control of Externalities in the Presence of Income Taxation," NBER Working Papers 12339, National Bureau of Economic Research, Inc.
  10. Kaplow, Louis, 2006. "Public goods and the distribution of income," European Economic Review, Elsevier, vol. 50(7), pages 1627-1660, October.
  11. Massimo Florio & Sara Colautti, 2005. "A logistic growth theory of public expenditures: A study of five countries over 100 years," Public Choice, Springer, vol. 122(3), pages 355-393, March.
  12. Louis Kaplow, 2003. "Transition Policy: A Conceptual Framework," NBER Working Papers 9596, National Bureau of Economic Research, Inc.
  13. José Manuel González-Páramo, . "Midiendo El Coste Marginal En Bienestar De Una Reforma Impositiva," Working Papers 32-02 Classification-JEL , Instituto de Estudios Fiscales.
  14. Parry, Ian, 2000. "Comparing the Marginal Excess Burden of Labor, Gasoline, Cigarette and Alcohol Taxes: An Application to the United Kingdom," Discussion Papers dp-00-33-rev, Resources For the Future.
  15. Yew-Kwang Ng, 2004. "Optimal Environmental Charges/Taxes: Easy to Estimate and Surplus-yielding," Environmental & Resource Economics, European Association of Environmental and Resource Economists, vol. 28(4), pages 395-408, August.
  16. Johansson-Stenman, Olof, 2001. "Should We Use Distributional Weights in CBA When Income Taxes Can Deal with Equity?," Working Papers in Economics 35, University of Gothenburg, Department of Economics.
  17. Barnett, W.S. & Masse, Leonard N., 2007. "Comparative benefit-cost analysis of the Abecedarian program and its policy implications," Economics of Education Review, Elsevier, vol. 26(1), pages 113-125, February.

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