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ANALYSING TAXES AND PUBLIC SPENDING

  • Published Date: May 2014

ANALYSING TAXES AND PUBLIC SPENDING: Time for economists to abandon their pejorative language

The anti-tax rhetoric evident in much lay discussion of public policy draws considerable support from the prevalent negative language of professional economic discourse. According to Professor Charles Manski, writing in the May 2014 issue of the Economic Journal, analysis of optimal income taxation doesn’t have to employ the pejorative concepts of ‘inefficiency’, ‘distortion’ and ‘deadweight loss’. Indeed, he concludes:

‘I think it overdue for the profession to discard them and make analysis of taxation and public spending distortion-free.’

Manski notes that many prominent applied public economists aim to measure the social cost of income tax relative to the utterly implausible alternative of a lump-sum tax. This focuses attention entirely on the social cost of financing government spending, with no regard to the potential social benefits. He says:

‘If applied economists are to contribute fair and balanced analysis of public policy, I think it essential that we jointly evaluate taxation and public spending within a framework that restricts attention to feasible tax instruments and that makes a reasonable effort to approximate the structure of the actual economy.’

A constructive approach, he argues, is to specify a social-welfare function and determine the welfare achieved by alternative feasible taxation and spending policies. An appropriate social-welfare function recognises both the costs of taxation and the benefits of tax-financed spending, making it unnecessary to invoke one-sided concepts such as inefficiency, distortion and deadweight loss.

Nobel laureate James Mirrlees made no mention of any of these concepts in his seminal 1971 study of optimal income taxation, Manski notes. In Mirrlees’ work and the body of research stemming from it, the specified social-welfare function is the only normative concept required for evaluation of public policy.

The gross inadequacy of deadweight loss and related concepts for policy analysis is particularly striking when considering tax-financed public spending for infrastructure that aims to enhance private productivity. Even as strong a proponent of private enterprise as Milton Friedman recognised the need for government to provide infrastructure for voluntary exchange, writing in 1955 that:

‘In… a free private enterprise exchange economy, government’s primary role is to preserve the rules of the game by enforcing contracts, preventing coercion, and keeping markets free’.

Friedman's statement focuses on the need for government to provide laws, regulations and a justice system to enforce them. Many other governmental functions might reasonably be added, including formation and execution of monetary policy, provision and oversight of transport and communications, protection of the environment and support of research. Each of these and other functions may be performed with varying intensity, at correspondingly varying cost. Taxation is the main mechanism that governments use to finance infrastructure.

In the new study, Manski analyses optimal income taxation to finance public spending on infrastructure. Following Mirrlees, he supposes that each member of a population allocates time to paid work and to the various non-paid activities that economists have traditionally called ‘leisure’; people have heterogeneous wages; an income-tax schedule is applied to gross income, yielding net income; people allocate time to maximise utility, which increases with net income and leisure; social welfare is utilitarian; and the chosen policy must balance the public budget, equating tax revenues and government spending.

Departing from Mirrlees’ setup, Manski considers the use of tax revenue to finance public spending on infrastructure; he supposes that people may have heterogeneous preferences for income, leisure, and public spending; and that the social planner may have partial knowledge of population preferences and of the productivity of infrastructure spending.

The essential feature of the new research is the transparent way that it characterises how public spending on infrastructure may enhance private productivity. Manski supposes that wages are person-specific positive constants multiplied by an aggregate production function expressing the wage-enhancing effect of infrastructure spending. This contrasts sharply with the common research practice of considering wages to be fixed.

Analysis of optimal policy is particularly simple in an illustrative setting that yields easily interpretable closed-form findings. In this setting, the planner only considers tax schedules that make the tax proportional to gross individual income. People have Cobb-Douglas income-leisure preferences and no non-labour income. These assumptions imply that time-allocation choices are invariant to policy.

The assumptions imply that optimal infrastructure spending is determined by the shape of the aggregate production function expressing the private productivity of public spending. Increasing the tax rate is socially beneficial if and only if the additional infrastructure spending enabled by the tax rise yields a more than commensurate increase in wages. The optimal public-spending level maximises aggregate net (after tax) income.

ENDS


Notes for editors: ‘Choosing Size of Government Under Ambiguity: Infrastructure Spending and Income Taxation’ by Charles Manski is published in the Conference issue of the Economic Journal.

Charles Manski is at Northwestern University.

Professor Manski talks about evidence-based research and policy in this Royal Economic Society short film, ‘Decisions in an Uncertain World’:

For further information: contact Romesh Vaitilingam on +44-7768-661095 (email: romesh@vaitilingam.com; Twitter: @econromesh); or Charles Manski via email: cfmanski@northwestern.edu