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How Big Should Government Be?

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  • Martin Feldstein

Abstract

The appropriate size and role of government depends on the deadweight burden caused by incremental transfers of funds from the private sector. The magnitude of that burden depends on the increases in tax rates required to raise incremental revenue and on the deadweight loss that results from higher tax rates. Both components depend on the full range of behavioral responses of taxpayers to increases in tax rates. The first part of this paper explains why the official method of revenue estimation used by the Treasury and the Congress underestimates the tax rate increases required to raise additional revenue. This is closely related to the on-going debate about the use of `dynamic' revenue estimation. The second part of the paper emphasizes that the deadweight burden caused by a tax rate increase depends not just on the response of labor force participation and average working hours but also on other dimensions of labor supply, on the forms in which compensation is paid, on the individuals' spending on tax favored (deductible or excludable) forms of consumption, and on the intertemporal allocation of consumption. Recent econometric work implies that the deadweight burden caused by incremental taxation (the marginal excess burden) may exceed one dollar per dollar of revenue raised, making the cost of incremental government spending more than two dollars for each dollar of government spending.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 5868.

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Date of creation: Dec 1996
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Publication status: published as NTJ, Vol. 50, no. 2 (June 1997): 197-213.
Handle: RePEc:nbr:nberwo:5868

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  1. Alan J. Auerbach, 1996. "Dynamic Revenue Estimation," Journal of Economic Perspectives, American Economic Association, vol. 10(1), pages 141-157, Winter.
  2. Feldstein, Martin S, 1978. "The Welfare Cost of Capital Income Taxation," Journal of Political Economy, University of Chicago Press, vol. 86(2), pages S29-51, April.
  3. Ballard, Charles L & Shoven, John B & Whalley, John, 1985. "General Equilibrium Computations of the Marginal Welfare Costs of Taxes in the United States," American Economic Review, American Economic Association, vol. 75(1), pages 128-38, March.
  4. Stuart, Charles E, 1984. "Welfare Costs per Dollar of Additional Tax Revenue in the United States," American Economic Review, American Economic Association, vol. 74(3), pages 352-62, June.
  5. Arnold Harberger, 1964. "Taxation, Resource Allocation, and Welfare," NBER Chapters, in: The Role of Direct and Indirect Taxes in the Federal Reserve System, pages 25-80 National Bureau of Economic Research, Inc.
  6. Joel Slemrod & Shlomo Yitzhaki, 1995. "The Costs of Taxation and the Marginal Cost of Funds," IMF Working Papers 95/83, International Monetary Fund.
  7. Browning, Edgar K, 1987. "On the Marginal Welfare Cost of Taxation," American Economic Review, American Economic Association, vol. 77(1), pages 11-23, March.
  8. James M. Poterba & Andrew A. Samwick, 1995. "Stock Ownership Patterns, Stock Market Fluctuations, and Consumption," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 26(2), pages 295-372.
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Cited by:
  1. Austan Goolsbee, 1997. "What Happens When You Tax the Rich? Evidence from Executive Compensation," NBER Working Papers 6333, National Bureau of Economic Research, Inc.
  2. 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.
  3. 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.
  4. John C. Driscoll & Steinar Holden, 2004. "Coordinación, trato justo y persistencia de la inflación," Monetaria, Centro de Estudios Monetarios Latinoamericanos, vol. 0(2), pages 97-129, abril-jun.
  5. Buisan, Ana & Caballero, Juan C. & Campa, Jose M. & Jimenez, Noelia, 2004. "La importancia de la histéresis en las exportaciones de manufacturas de los países de la UEM," IESE Research Papers D/561, IESE Business School.
  6. Carlos Esteban Posada & José Fernando Escobar, 2004. "Crecimiento económico y gasto público: experiencias internacionales y el caso colombiano, 1982-99," Monetaria, Centro de Estudios Monetarios Latinoamericanos, vol. 0(2), pages 131-167, abril-jun.
  7. Carlos Esteban Posada & José Fernando Escobar, . "Crecimiento Económico y Gasto Público: Una Interpretación de las Experiencias Internacionales y del Caso Colombiano (1982-1999)," Borradores de Economia 258, Banco de la Republica de Colombia.
  8. Slemrod, Joel & Yitzhaki, Shlomo, 2001. "Integrating Expenditure and Tax Decisions: The Marginal Cost of Funds and the Marginal Benefit of Projects," National Tax Journal, National Tax Association, vol. 54(n. 2), pages 189-202, June.
  9. Parry, Ian W. H. & Bento, Antonio M., 2000. "Tax Deductions, Environmental Policy, and the "Double Dividend" Hypothesis," Journal of Environmental Economics and Management, Elsevier, vol. 39(1), pages 67-96, January.
  10. 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.

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