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Evaluating public expenditures when governments must rely on distortionary taxation

  • Anderson, James E.
  • Martin, Will

Anderson and Martin provide simple, robust rules for evaluating public spending in distorted economies. Their analysis integrates, within a clean unified framework, previous treatments of project evaluation as special cases. In this paper, the authors use a general system of fiscal accounting for marginal changes in the provision of public that allows them to account for various approaches to the funding of government projects. They obtain two key results that seem likely to be useful for project evaluation. Firstly, the shadow prices of traded (as well as non-traded) goods are not generally equal to their world prices, but differ from world prices by an amount that depends upon the impact of the project on government revenues and on the Marginal Cost of Funds (MCF). Secondly, the costs of a government project need to be adjusted by the Marginal Cost of Funds before being compared with the benefits accruing from the project. The analysis leads to operational rules for project evaluation that are only slightly more complex than the border pricing rule. To conduct the analysis, the authors utilize a framework that makes explicit the role of government in providing public goods and services subject to a budget constraint. They consider first in Section 1 a general welfare analysis of the provision of a public good which is purchased from the rest of the world and paid for out of distortionary tax revenue. In Section 2 they consider the nature of the resulting shadow prices in more detail. In Section 3 the authors consider the role of the MCF in evaluating the cost of project inputs. Section 4 deals with user charges for public goods, which are of course only feasible when such goods are excludable. Section 5 places the results in the context of the earlier literature in order to clarify the relationship between their results and those obtained by earlier authors. Section 6 provides some simple numerical examples to highlight the potential importance allowing for the costs of raising funds.

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Paper provided by The World Bank in its series Policy Research Working Paper Series with number 1981.

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Date of creation: 30 Sep 1998
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Handle: RePEc:wbk:wbrwps:1981
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  1. Squire, Lyn, 1989. "Project evaluation in theory and practice," Handbook of Development Economics, in: Hollis Chenery & T.N. Srinivasan (ed.), Handbook of Development Economics, edition 1, volume 2, chapter 21, pages 1093-1137 Elsevier.
  2. Dreze, Jean & Stern, Nicholas, 1987. "The theory of cost-benefit analysis," Handbook of Public Economics, in: A. J. Auerbach & M. Feldstein (ed.), Handbook of Public Economics, edition 1, volume 2, chapter 14, pages 909-989 Elsevier.
  3. Warr, Peter G., 1979. "Shadow prices, market prices and project losses," Economics Letters, Elsevier, vol. 2(4), pages 363-367.
  4. Dinwiddy, Caroline & Teal, Francis, 1987. "Project Appraisal and Foreign Exchange Constraints: A Comment," Economic Journal, Royal Economic Society, vol. 97(386), pages 479-86, June.
  5. Fane, George, 1991. "The Social Opportunity Cost of Foreign Exchange: A Partial Defence of Harberger et al," The Economic Record, The Economic Society of Australia, vol. 67(199), pages 307-16, December.
  6. Tower, Edward & Pursell, Garry G, 1987. "On Shadow Pricing Labour and Foreign Exchange," Oxford Economic Papers, Oxford University Press, vol. 39(2), pages 318-32, June.
  7. Alan J. Auerbach, 1982. "The Theory of Excess Burden and Optimal Taxation," NBER Working Papers 1025, National Bureau of Economic Research, Inc.
  8. Harberger, Arnold C, 1997. "New Frontiers in Project Evaluation? A Comment on Devarajan, Squire, and Suthiwart-Narueput," World Bank Research Observer, World Bank Group, vol. 12(1), pages 73-79, February.
  9. Anderson, J-E, 1997. "Revenue Neutral Trade Reform With Many Households, Quotas and Tariffs," Papers 626, Stockholm - International Economic Studies.
  10. Bell, Clive & Devarajan, Shantayanan, 1983. "Shadow Prices for Project Evaluation under Alternative Macroeconomic Specifications," The Quarterly Journal of Economics, MIT Press, vol. 98(3), pages 457-77, August.
  11. Dinwiddy, Caroline & Teal, Francis, 1989. "Relative shadow prices and the shadow exchange rate," Journal of Public Economics, Elsevier, vol. 40(3), pages 349-358, December.
  12. James E. Anderson & Will Martin, 1996. "The Welfare Analysis of Fiscal Policy: A Simple Unified Account," Boston College Working Papers in Economics 316., Boston College Department of Economics.
  13. Neary, J Peter, 1995. "Trade Liberalisation and Shadow Prices in the Presence of Tariffs and Quotas," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 36(3), pages 531-54, August.
  14. Devarajan, Shantayanan & Squire, Lyn & Suthiwart-Narueput, Sethaput, 1997. "Beyond Rate of Return: Reorienting Project Appraisal," World Bank Research Observer, World Bank Group, vol. 12(1), pages 35-46, February.
  15. Warr, Peter G, 1977. "On the Shadow Pricing of Traded Commodities," Journal of Political Economy, University of Chicago Press, vol. 85(4), pages 865-72, August.
  16. James E. Anderson, 1996. "Trade Reform with a Government Budget Constraint," NBER Working Papers 5827, National Bureau of Economic Research, Inc.
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