Welfare Measurement and Public Goods in a Second Best Economy

This chapter concerns welfare measurement in economies, where the government raises revenue by means of distortionary taxation. A major issue is the treatment of (state-variable) public goods in the context of social accounting. Although the marginal value that the government attaches to a public good is model-specific (as it depends on the exact nature of the underlying decision-problem), the analysis explains how the direct resource cost of providing increments to the public good and the marginal cost of public funds can be used to measure this marginal value. The first part of the chapter is based on a representative-agent growth model with linear taxation, whereas the second part addresses a model with heterogeneous agents and nonlinear taxation. The latter model also provides a framework for analyzing redistribution in the context of social accounting, and enables me to compare the results with those that would follow in a first best resource allocation.