Contents

Preface to Second Edition Preface to First Edition List of Figures

xix xxi xxiii

I PUBLIC ECONOMICS AND ECONOMIC EFFICIENCY 1 An Introduction to Public Economics 1.1 Public Economics 1.2 Methods 1.3 Analyzing Policy 1.4 Preview 1.5 Scope

3 3 3 5 6 9

2 Equilibrium and Efficiency 2.1 Introduction 2.2 Economic Models 2.3 Competitive Economies 2.4 The Exchange Economy 2.5 Production and Exchange 2.6 Efficiency of Competition 2.6.1 Single Consumer 2.6.2 Pareto-Efficiency 2.6.3 Efficiency in an Exchange Economy 2.6.4 Extension to Production 2.7 Lump-Sum Taxation 2.8 Discussion of Assumptions 2.9 Summary

13 13 13 14 15 22 26 27 31 33 37 39 41 43

3 Behavioral Economics 3.1 Introduction 3.2 Behavioral Individuals 3.2.1 Simple Example: How Much to Save? 3.2.2 Present-Bias 3.2.3 The (β, δ) Model of Self-Control 3.2.4 Reference-Dependence Bias 3.2.5 The Gambler’s Fallacy

51 51 53 53 54 55 57 58

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3.3

3.4

3.5

3.6

3.7

3.2.6 Confirmation Bias 3.2.7 Confidence Bias 3.2.8 Framing Bias 3.2.9 Conformism Bias 3.2.10 Identity and Social Norms Behavioral Markets 3.3.1 Money Pump 3.3.2 Complementary Mistakes 3.3.3 Rationality Tug-of-War Behavioral Policy 3.4.1 Internalities versus Externalities 3.4.2 Automatic Enrollment 3.4.3 The SMarT Plan 3.4.4 Complementarity Behavioral Welfare 3.5.1 New Welfare Criterion 3.5.2 Choice-Based Welfare Analysis 3.5.3 Refinement and Structural Modeling 3.5.4 Application: Global Warming Other-Regarding Preferences 3.6.1 Ultimatum Game 3.6.2 Social Preferences 3.6.3 Market Impact Conclusions

59 60 60 62 63 64 65 65 67 67 68 69 69 70 71 71 72 73 74 76 76 77 78 80

II GOVERNMENT 4 Public Sector Statistics 4.1 Introduction 4.2 Historical Development 4.3 Composition of Expenditure 4.4 Revenue 4.5 Government Debt 4.6 Measuring the Government 4.7 Conclusions

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89 89 89 94 97 107 112 114

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5 Theories of the Public Sector 5.1 Introduction 5.2 Justification for the Public Sector 5.2.1 The Minimal State 5.2.2 Market versus Government 5.2.3 Equity 5.2.4 Efficiency and Equity 5.3 Public Sector Growth 5.3.1 Development Models 5.3.2 Wagner’s Law 5.3.3 Baumol’s Law 5.3.4 A Political Model 5.3.5 Ratchet Effect 5.4 Excessive Government 5.4.1 Bureaucracy 5.4.2 Budget-Setting 5.4.3 Monopoly Power 5.4.4 Corruption 5.4.5 Government Agency 5.4.6 Cost Diffusion 5.5 Conclusions

119 119 119 119 121 122 123 123 123 124 125 126 128 129 130 132 133 134 135 137 138

III DEPARTURES FROM EFFICIENCY 6 Public Goods 6.1 Introduction 6.2 Definitions 6.3 Private Provision 6.4 Efficient Provision 6.5 Voting 6.6 Personalized Prices 6.7 Mechanism Design 6.7.1 Examples of Preference Revelation 6.7.2 Clarke–Groves Mechanism 6.7.3 Clarke Tax 6.7.4 Further Comments

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147 147 148 150 154 156 159 163 163 166 168 169

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6.8

More on Private Provision 6.8.1 Neutrality and Population Size 6.8.2 Experimental Evidence 6.8.3 Modifications 6.9 Fund-Raising Campaigns 6.9.1 The Contribution Campaign 6.9.2 The Subscription Campaign 6.10 Conclusions

170 170 174 176 178 179 181 182

7 Club Goods and Local Public Goods 7.1 Introduction 7.2 Definitions 7.3 Single-Product Clubs 7.3.1 Fixed Utilization 7.3.2 Variable Utilization 7.3.3 Two-Part Tariff 7.4 Clubs and the Economy 7.4.1 Small Clubs 7.4.2 Large Clubs 7.4.3 Conclusion 7.5 Local Public Goods 7.6 The Tiebout Hypothesis 7.7 Empirical Tests 7.8 Conclusions

191 191 192 193 194 196 197 199 200 200 207 208 212 214 216

8 Externalities 8.1 Introduction 8.2 Externalities Defined 8.3 Market Inefficiency 8.4 Externality Examples 8.4.1 River Pollution 8.4.2 Traffic Jams 8.4.3 Pecuniary Externality 8.4.4 The Rat Race Problem 8.4.5 The Tragedy of the Commons 8.4.6 Bandwagon Effect 8.5 Pigouvian Taxation 8.6 Licenses

223 223 224 225 228 228 229 230 232 233 235 236 239

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8.7 Internalization 8.8 The Coase Theorem 8.9 Nonconvexity 8.10 Conclusions

241 242 247 248

9 Imperfect Competition 9.1 Introduction 9.2 Concepts of Competition 9.3 Market Structure 9.3.1 Defining the Market 9.3.2 Measuring Competition 9.4 Welfare 9.4.1 Inefficiency 9.4.2 Incomplete Information 9.4.3 Measures of Welfare Loss 9.5 Tax Incidence 9.6 Specific and Ad valorem Taxation 9.7 Regulation of Monopoly 9.8 Regulation of Oligopoly 9.8.1 Detecting Collusion 9.8.2 Merger Policy 9.9 Unions and Taxation 9.10 Monopsony 9.11 Conclusions

255 255 256 257 257 258 260 260 263 264 268 274 277 282 282 283 285 286 288

10 Asymmetric Information 10.1 Introduction 10.2 Hidden Knowledge and Hidden Action 10.3 Actions or Knowledge? 10.4 Market Unraveling 10.4.1 Hazard Insurance 10.4.2 Government Intervention 10.5 Screening 10.5.1 Perfect Information Equilibrium 10.5.2 Imperfect Information Equilibrium 10.5.3 Government Intervention 10.6 Signaling 10.6.1 Educational Signaling 10.6.2 Implications

297 297 300 301 302 302 305 307 308 310 313 314 316 321

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10.7

Moral Hazard (Hidden Action) 10.7.1 Moral Hazard in Insurance 10.7.2 Effort Observable 10.7.3 Effort Unobservable 10.7.4 Second-Best Contract 10.7.5 Government Intervention 10.8 Public Provision of Health Care 10.8.1 Efficiency 10.8.2 Redistributive Politics 10.9 Evidence 10.10 Conclusions

323 323 325 326 327 329 330 330 332 334 336

IV POLITICAL ECONOMY 11 11.1 11.2 11.3 11.4

11.5

11.6 11.7 11.8

11.9

Voting Introduction Stability Impossibility Majority Rule 11.4.1 May’s Theorem 11.4.2 Condorcet Winner 11.4.3 Median Voter Theorems 11.4.4 Multidimensional Voting 11.4.5 Agenda Manipulation Alternatives to Majority Rule 11.5.1 Borda Voting 11.5.2 Plurality Voting 11.5.3 Approval Voting 11.5.4 Runoff Voting The Paradox of Voting The “Alabama” Paradox Political Competition 11.8.1 Downsian Model 11.8.2 Policy Divergence 11.8.3 Multidimensional Competition 11.8.4 “Swing Voter” Politics 11.8.5 Citizen-Candidate Model Conclusions

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345 345 345 347 350 350 351 351 356 358 361 361 363 363 364 365 371 372 372 373 376 377 379 381

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12 12.1 12.2 12.3

12.4 12.5 12.6

12.7 12.8 12.9

Rent-Seeking Introduction Definitions Rent-Seeking Games 12.3.1 Deterministic Game 12.3.2 Probabilistic Game 12.3.3 Free-Entry 12.3.4 Risk Aversion 12.3.5 Conclusions Social Cost of Monopoly Equilibrium Effects Government Policy 12.6.1 Lobbying 12.6.2 Rent Creation 12.6.3 Conclusions Informative Lobbying Controlling Rent-Seeking Conclusions

387 387 388 390 391 394 396 397 398 398 401 404 404 406 408 408 413 414

V EQUITY AND DISTRIBUTION 13 13.1 13.2 13.3 13.4 13.5 13.6 13.7 13.8 13.9 13.10 13.11

Optimality and Comparability Introduction Social Optimality Lump-Sum Taxes Impossibility of Lump-Sum Taxes Non–Tax Redistribution Aspects of Pareto-Efficiency Social Welfare Functions Arrow’s Theorem Interpersonal Comparability Comparability and Social Welfare Conclusions

423 423 424 427 430 434 436 440 441 443 446 450

14 14.1 14.2 14.3

Inequality and Poverty Introduction Measuring Income Equivalence Scales

457 457 458 460

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14.4

14.5

14.6

14.7

14.8

Inequality Measurement 14.4.1 The Setting 14.4.2 Statistical Measures 14.4.3 Inequality and Welfare 14.4.4 An Application Poverty 14.5.1 Poverty and the Poverty Line 14.5.2 Poverty Measures 14.5.3 Two Applications Unequal Opportunities 14.6.1 Defining Equality of Opportunity 14.6.2 Measuring Equality of Opportunity 14.6.3 Equal-Opportunity Policy Intergenerational Inequality 14.7.1 Measuring Issues 14.7.2 Causal Mechanisms Conclusions

466 467 467 475 480 481 482 483 488 489 490 491 491 492 492 493 496

VI TAXATION 15 Commodity Taxation 15.1 Introduction 15.2 Deadweight Loss 15.3 Optimal Taxation 15.4 Production Efficiency 15.5 Tax Rules 15.5.1 Inverse Elasticity Rule 15.5.2 Ramsey Rule 15.6 Equity Considerations 15.7 Applications 15.7.1 Reform 15.7.2 Optimality 15.8 Efficient Taxation 15.9 Public Sector Pricing 15.10 Conclusions

505 505 506 509 513 515 516 517 521 523 524 526 528 530 531

16 16.1 16.2

537 537 538

Income Taxation Introduction Equity and Efficiency

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16.3 Taxation and Labor Supply 16.4 Empirical Evidence 16.5 Optimal Income Taxation 16.6 Two Specializations 16.6.1 Quasi-Linearity 16.6.2 Rawlsian Taxation 16.7 Numerical Results 16.8 Voting over a Flat Tax 16.9 Conclusions

539 544 547 555 555 559 561 563 565

17 17.1 17.2 17.3 17.4 17.5 17.6 17.7 17.8 17.9 17.10

575 575 576 578 585 588 590 592 595 601 602

Tax Evasion Introduction The Extent of Evasion The Evasion Decision Auditing and Punishment Evidence on Evasion Effect of Honesty Tax Compliance Game Behavioral Models Compliance and Social Interaction Conclusions

18 Limits to Redistribution 18.1 Introduction 18.2 Revelation Principle 18.3 The Tax Principle 18.4 Tax Mix: Separation Principle 18.5 Capital Income Tax 18.6 Non–Tax Redistribution 18.7 Conclusions

609 609 611 616 622 626 628 630

VII MULTIPLE JURISDICTIONS 19 Fiscal Federalism 19.1 Introduction 19.2 Arguments for Multi-level Government 19.2.1 Costs of Uniformity 19.2.2 Tiebout Hypothesis 19.2.3 Distributive Arguments

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637 637 638 639 641 642

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19.3 Optimal Structure: Efficiency versus Stability 19.4 Accountability 19.5 Risk-Sharing 19.5.1 Voluntary Risk-Sharing 19.5.2 Insurance versus Redistribution 19.6 Hard and Soft Budgets 19.7 Evidence on Decentralization 19.7.1 Decentralization around the World 19.7.2 Decentralization by Functions 19.7.3 Determinants of Decentralization 19.8 Conclusions

642 645 648 648 651 652 655 655 657 658 659

20 Fiscal Competition 20.1 Introduction 20.2 Tax Competition 20.2.1 Competitive Behavior 20.2.2 Strategic Behavior 20.2.3 Size Matters 20.2.4 Public input provision 20.2.5 Tax Overlap 20.2.6 Tax Exporting 20.2.7 Efficient Tax Competition 20.3 Income Distribution 20.3.1 Perfect Mobility 20.3.2 Imperfect Mobility 20.3.3 Race to the Bottom 20.4 Intergovernmental Transfers 20.4.1 Efficiency 20.4.2 Redistribution 20.4.3 Flypaper Effect 20.5 Evidence 20.5.1 Race to the Bottom 20.5.2 Race to the Top 20.5.3 Tax Mimicking 20.6 Conclusions

667 667 667 668 669 675 676 676 679 681 683 683 684 687 688 688 691 692 693 693 695 695 696

21 21.1

705 705

Issues in International Taxation Introduction

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21.2

21.3

21.4 21.5

21.6 21.7 21.8 21.9 21.10

International Efficiency 21.2.1 Efficient Allocations 21.2.2 Markets and Efficiency 21.2.3 Taxation and Efficiency Capital and Corporations 21.3.1 Capital Taxes 21.3.2 Corporate Taxation 21.3.3 Formula Apportionment 21.3.4 Summary Transfer Pricing Location 21.5.1 Locational Choice 21.5.2 Agglomeration Rents 21.5.3 Evidence Harmonization of Taxes Tax Principles Tariff Policy 21.8.1 Welfare Cost of Tariffs Trade Agreements Conclusions

706 707 708 710 711 711 713 717 719 719 722 723 724 725 727 731 734 735 738 743

VIII ISSUES OF TIME 22 22.1 22.2

22.3

22.4

22.5 22.6

Intertemporal Efficiency Introduction Overlapping Generations 22.2.1 Time and Generations 22.2.2 Consumers 22.2.3 Production Equilibrium 22.3.1 Intertemporal Equilibrium 22.3.2 Steady State Optimality and Efficiency 22.4.1 The Golden Rule 22.4.2 Pareto-Efficiency Testing Efficiency Conclusions

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753 753 755 755 756 757 760 761 761 764 764 767 771 772

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23 23.1 23.2 23.3 23.4 23.5 23.6 23.7 23.8 23.9 23.10

Social Security Introduction Types of System The Pensions Crisis The Simplest Program Social Security and Production Population Growth Sustaining a Program Ricardian Equivalence Social Security Reform Conclusions

777 777 778 780 783 785 789 792 796 799 804

24 24.1 24.2

Economic Growth Introduction Exogenous Growth 24.2.1 Constant Savings Rate 24.2.2 Optimal Taxation Endogenous Growth 24.3.1 Models of Endogenous Growth 24.3.2 Government Expenditure Policy Reform Empirical Evidence Conclusions

811 811 812 812 819 825 826 828 831 835 839

24.3

24.4 24.5 24.6

IX APPLICATIONS 25 Cost–Benefit Analysis 25.1 Introduction 25.2 What Is Cost–Benefit Analysis? 25.2.1 Simple Example 25.2.2 Broader Approach 25.3 The Process of CBA 25.3.1 Discounting Future Values 25.4 Principles of CBA 25.4.1 Common Unit of Measurement 25.4.2 Revealed Preferences 25.4.3 Valuing Market Goods: Marshallian Surplus

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849 849 850 851 852 853 855 858 858 859 860

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25.5 25.6

25.7

25.8

25.4.4 Valuing Non-market Goods: Hedonic Prices 25.4.5 Impact Assessment 25.4.6 Decision Criteria 25.4.7 Difficulties for CBA Valuing Life Valuing the Future 25.6.1 Intertemporal Arbitrage 25.6.2 The UK Green Book 25.6.3 Adjustment for Risk Theoretical Foundations of CBA 25.7.1 Social Welfare Evaluation 25.7.2 Distributive Weights 25.7.3 Market Prices and Shadow Prices Conclusions

861 862 863 864 867 871 872 875 877 878 879 884 885 899

26 Economics of Climate Policy 26.1 Introduction 26.2 Special Features 26.3 The Science of Global Warming 26.3.1 Greenhouse Gases and Temperatures 26.3.2 Controversies 26.3.3 Predictions 26.4 Integrating Economics and Climate 26.4.1 Sources of Damage 26.4.2 Modeling Economic Damage 26.4.3 Effects of Policy 26.5 Competing Generations 26.6 Ecological Discounting 26.7 Climate Policy in Practice 26.7.1 Pricing and Policies 26.7.2 The EU Emissions Trading Scheme 26.7.3 International Agreements 26.7.4 Prices or Quantities 26.7.5 Other Policies 26.8 Conclusions

897 897 899 902 902 906 909 912 913 914 917 919 926 931 931 933 936 939 941 942

Index

000

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