second edition public finance and public policy - gbv · second edition public finance and public...

SECOND EDITION

Public Financeand Public Policy

Massachusetts Institute of Technology

Worth Publishers

Preface xxvii

FART I Introduction and Background

1 Why Study, Public Finance? 12 Theoretical Toblifof Public Finance 25

Appendix: The Mathematics of Utility Maximization 603 Empirical Tools of Public Finance 62

Appendix: Cross-Sectional Regression Analysis 874 Tools of'jBudget Analysis 90

?•

PART I I Externalities and Public Goods

5 Externalities: Problems and Solutions' 1206 Externalities in Action: Environmental and Health Externalities 1507 Public Goods 177

Appendix: The Mathematics of Public Goods Provision 1988 Cost-Benefit Analysis 2019 Political Economy • 223

10 State and Local Government Expenditures 25611 Education 285

PART I I I Social Insurance and Redistribution

12 Social Insurance: The New Function of Government 314Appendix: Mathematical Models of Expected Utility 345

13 Social Security 34814 Unemployment Insurance, Disability Insurance, and Workers' Compensation . 384

Appendix: Advanced Quasi-Experimental Analysis 41115 Health Insurance I: Health Economics and Private Health Insurance . . . .41316 Health Insurance II: Medicare, Medicaid, and Health Care Reform 44317 Income Distribution and Welfare Programs 478

PART IV Taxation in Theory and Practice

18 Taxation in the United States and Around the World 51219 The Equity Implications of Taxation: Tax Incidence 545

Appendix: The Mathematics of Tax Incidence 57520 Tax Inefficiencies and Their Implications for Optimal Taxation 577

Appendix: The Mathematics of Optimal Taxation 60821 Taxes on Labor Supply 61122 Taxes on Savings 63523 Taxes on Risk Taking and Wealth 66324 Corporate Taxation 68925 Fundamental Tax Reform 724

Glossary G-l Name Index NI-1v i References R-l Subject Index SI-1

Contents

Preface xxvii

CHAPTER 1 Why Study Public Finance? . . , 1 H P A R T I

1.1 The Four Questions of Public Finance 3 IntroductionWhen Should the Government Intervene in the Economy? 4 a n d

Application: The Measles Epidemic of 1989-1991* 5 RarkfirniinHHow Might the Government Intervene? 7 •What Are the Effects of Alternative Interventions? 8 \

Application: The Congressional Budget Office: Government Scorekeepers 9Why Do Governments Do What They Do? 10

1.2 Why Study Public Finance? Facts on Governmentin the United States and Around the World 11

The Size and Growth of Government 11Decentralization 12 •«Spending, Taxes, Deficits, and Debts 13Distribution of Spending 15Distribution of Revenue Sources 18Regulatory Role of the Government 18

1.3 Why Study Public Finance Now? Policy Debates overSocial Security, Health Care, and Education 20

Social Security 20Healthcare 21Education 22

1.4 Conclusion 23

Highlights 23

Questions and Problems 23

Advanced Questions 24

CHAPTER 2 Theoretical Tools of Public Finance 25

2.1 Constrained Utility Maximization 26Preferences and Indifference Curves 27Utility Mapping of Preferences 29Budget Constraints 31Putting It All Together: Constrained Choice 33The Effects of Price Changes: Substitution and Income Effects 35

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2.2 Putting the Tools to Work: TANF and Labor SupplyAmong Single Mothers 37

Identifying the Budget Constraint 38The Effect of TANF on the Budget Constraint 39

2 . 3 Equilibrium and Social Welfare 43

Demand Curves 44Supply Curves 46Equilibrium 48

Social Efficiency 49Competitive Equilibrium Maximizes Social Efficiency 50From Social Efficiency to Social Welfare: The Role of Equity 52Choosing an Equity Criterion 54

2 . 4 Welfare Implications of Benefit Reductions:

The TANF Example Continued 55

2 . 5 Conclusion 57

Highlights 57

Questions and Problems •. 58


APPENDIX The Mathematics of Utility Maximization 60

CHAPTER 3 Empirical Tools of Public Finance 62

3.1 The Important Distinction Between Correlation andCausality 63

The Problem 64

3.2 Measuring Causation with Data We'd Like to Have:Randomized Trials 65

Randomized Trials as a Solution 66

The Problem of Bias 66Randomized Trials of ERT 68

Randomized Trials in the TANF Context 68Why We Need to Go Beyond Randomized Trials 69

3 . 3 Estimating Causation with Data We Actually Get:Observational Data 70

Time Series Analysis 71Cross-Sectional Regression Analysis 74Quasi-Experiments 79Structural Modeling 82

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3.4 Conclusion 84

Highlights ' 84



RPPENDIX Cross-Sectional Regression Analysis ^ 87

CHAPTER 4 Tools of Budget*Analysis ; 90

4.1 Government Budgeting \ 92

The Budget Deficit in Recent Years 92 *The Budget Process 93

Application: Efforts to Control the Deficit 94Budget Policies and Deficits at the State Level 96

4.2 Measuring the Budgetary Position of the Government:Alternative Approaches 96

Real vs. Nominal 97The Standardized Deficit 98Cash vs. Capital Accounting 100Static vs. Dynamic Scoring 101

4.3 Do Current Debts and Deficits Mean Anything?A Long-Run Perspective 102

Background: Present Discounted Value 102Why Current Labels May Be Meaningless 103Alternative Measures of Long-Run Government Budgets 104What Does the U.S. Government Do? 108

Application: The Financial Shenanigans of 2001 111

4 . 4 Why Do We Care About t h e Government 's Fiscal Posit ion? . 1 1 2

Short-Run vs. Long-Run Effects of the Government on the Macroeconomy 112Background: Savings and Economic Growth 113The Federal Budget, Interest Rates, and Economic Growth 114Intergenerational Equity 116

4.5 Conclusion 117

Highlights 118



IX

PART I I H

Externalitiesand PublicGoods

CHAPTER 5 Externalities: Problems and Solutions 120

5.1 Externality Theory 122Economics of Negative Production Externalities 122Negative Consumption Externalities 125

Application: The Externality of SUVs 126Positive Externalities 127

5 . 2 Private-Sector Solutions to Negative Externalities 129

The Solution 129The Problems with Coasian Solutions 131

5 . 3 Public-Sector Remedies for Externalities 133

Corrective Taxation 134Subsidies 135Regulation 136

Application: Taxes and Regulation in Practice: The Case of the Baltic Sea 136

5 . 4 Distinctions Between Price and Quantity Approaches toAddressing Externalities 138

Basic Model 138Price Regulation (Taxes) vs. Quantity Regulation in This Model 140 •Multiple Plants with Different Reduction Costs 140Uncertainty About Costs of Reduction 143

5.5 Conclusion 147

Highlights 147



CHAPTER 6 Externalities in Action: Environmental andHealth Externalities 150

6.1 Add Rain 151The Damage of Acid Rain 151History of Acid Rain Regulation 152

Empirical Evidence: Estimating the Adverse Health Effects of Particulates 154Has the Clean Air Act Been a Success? 155

6 . 2 Global Warming 156

The Kyoto Treaty 158Can Trading Make Kyoto More Cost-Effective? 159What Does the Future Hold? 162

Application: The Montreal Protocol 162

6.3 The Economics of Smoking 163The Externalities of Smoking 165Should We Care Only About Externalities, orDo "Internalizes" Matter Also? 168

6.4 The Economics of Other Addictive Behaviors 171

Drinking 171Illicit Drugs 172Obesity 173 ;

Summary 174 v

6.5 Conclusion ". 174

Highlights * 174

Questions and Problems * 175


CHAPTER 7 Public Goods 177

7.1 Optimal Provision of Public Goods 178Optimal Provision of Private Goods 179Optimal Provision of Public Goods 181

7.2 Private Provision of Public Goods 183

Private-Sector Underprovision 184Application: The Free Rider Problem in Practice 185

Can Private Providers Overcome the Free Rider Problem? 186Application: Business Improvement Districts 186

When Is Private Provision Likely to Overcome the Free Rider Problem? 188

7.3 Public Provision of Public Goods 190

Private Responses to Public Provision: The Problem of Crowd-Out 191Measuring the Costs and Benefits of Public Goods 193How Can We Measure Preferences for the Public Good? 193

Empirical Evidence: Measuring Crowd-Out 194

7.4 Conclusion 195

Highlights 195



APPENDIX The Mathematics of Public Goods Provision 198

XI

CHAPTER 8 Cost-Benefit Analysis 201

8 . 1 Measuring the Costs of Public Projects 202

The Example 203Measuring Current Costs 204Measuring Future Costs 205

8 . 2 Measuring the Benefits of Public Projects 206

Valuing Driving Time Saved 206Application: The Problems of Contingent Valuation 209

Empirical Evidence: Valuing Time Savings 210Valuing Saved Lives 211

Application: Valuing Life 211Discounting Future Benefits 216Cost-Effectiveness Analysis 216

8 . 3 Putting I t All Together 217

Other Issues in Cost-Benefit Analysis 217

8 . 4 Conclusion 219

Highlights 219



CHAPTER 9 Political Economy 223

9 . 1 Unanimous Consent on Public Goods Levels 225

Lindahl Pricing 225Problems with Lindahl Pricing 227

9 . 2 Mechanisms for Aggregating Individual Preferences 228

Application: Direct Democracy in the United States 228Majority Voting: When'It Works 230Majority Voting: When It Doesn't Work 232Arrow's Impossibility Theorem 233Restricting Preferences to Solve the Impossibility Problem 233Median Voter Theory 235The Potential Inefficiency of the Median Voter Outcome 235Summary 236

9 . 3 Representative Democracy 237

Vote-Maximizing Politicians Represent the Median Voter 237Assumptions of the Median Voter Model 238

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Lobbying 240

Application: Farm Policy in the United States 241Evidence on the Median Voter Model for Representative Democracy 242

Empirical Evidence: Testing the Median Voter Model 243

9.4 Public Choice Theory: The Foundations ofGovernment Failure 244

Size-Maximizing Bureaucracy 244Problems with Privatization 245 I _

Application: Contracting Out with Non-Competitive Bidding 247Leviathan Theory 248Corruption 249 " ^

Application: Government Corruption 249The Implications of Government Failure 251 *

Empirical Evidence: Government Failures and Economic Growth 252

9.5 Conclusion .253

Highlights 253



CHAPTER 10 State and Local Government Expenditures . . 2 5 6

1 0 . 1 Fiscal Federalism in the United States and Abroad 258

Spending and Revenue of State and Local Governments 259Fiscal Federalism Abroad 260

1 0 . 2 Optimal Fiscal Federalism 262

The Tiebout Model 262Problems with the Tiebout Model 264Evidence on the Tiebout Model 266

Empirical Evidence: Evidence for Capitalization from California's

Proposition 13 268Optimal Fiscal Federalism 268

10 .3 Redistribution Across Communities 270

Should We Care? 271Tools of Redistribution: Grants 272Redistribution in Action: School Finance Equalization 277

Empirical Evidence: The Flypaper Effect 278Application: School Finance Equalization and Property Tax Limitations inCalifornia 280

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10.4 Conclusion 280

Highlights 281



CHAPTER 11 Education 285

1 1 . 1 Why Should the Government Be Involved in Education? . . . 287Productivity 287Citizenship 288Credit Market Failures 288Failure to Maximize Family Utility 288Redistribution 289

1 1 . 2 How Is the Government Involved in Education? 289

Free Public Education and Crowding Out 290Solving the Crowd-Out Problem: Vouchers 292Problems with Education Vouchers 295

1 1 . 3 Evidence on Competition in Education Markets 299

Direct Experience with Vouchers 299Experience with Public School Choice 299

Empirical Evidence: Estimating the Effects of Voucher Programs 300Experience with Public School Incentives 301Bottom Line on Vouchers and School Choice 302

1 1 . 4 Measuring the Returns to Education 302

Effects of Education Levels on Productivity 303Education as Human Capital Accumulation 303

Empirical Evidence: Estimating the Return to Education and Evidence forScreening 304

Effect of Education Levels on Other Outcomes 306The Impact of School Quality 306

1 1 . 5 The Role of the Government in Higher Education 306

Empirical Evidence: Estimating the Effects of School Quality 307

Current Government Role 308

What Is the Market Failure and How Should It Be Addressed? 309

1 1 . 6 Conclusion 310

Highlights 311


Advanced Questions 312XIV

CHAPTER 12 Social Insurance: The New Function of M PA RT I I IGovernment 314 Social

12.1 What Is Insurance and Why Do Individuals Value It? 316 Insurance andwhat is insurance? 316 RedistributionWhy Do Individuals Value Insurance? 317Formalizing This Intuition: Expected Utility Model 318

12.2 Why Have Social Insurance? Asymmetric Information andAdverse Selection 321

Asymmetric Information 321Example with Full Information 322 * -

Example with Asymmetric Information 322The Problem of Adverse Selection 324 \Does Asymmetric Information Necessarily Lead to Market Failure? 325

Application: Adverse Selection and Health Insurance "Death Spirals" 326How Does the Government Address Adverse Selection? 327

12.3 Other Reasons for Government Intervention inInsurance Markets 328

Externalities 328 w

Administrative Costs 328Redistribution 329Paternalism 329Application: Flood Insurance and the Samaritan's Dilemma 329

12.4 Social Insurance vs. Self-Insurance: How MuchConsumption Smoothing? 332

Example: Unemployment Insurance 332

Lessons for Consumption-Smoothing Role of Social Insurance 336

12.5 The Problem with Insurance: Moral Hazard 337

Application: The Problems with Assessing Workers' Compensation Injuries 338What Determines Moral Hazard? 339Moral Hazard Is Multidimensional 339The Consequences of Moral Hazard 339

12.6 Putting I t All Together: Optimal Social Insurance 340

12.7 Conclusion 341

Highlights 342



APPENDIX Mathematical Models of Expected Utility 345

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CHAPTER 13 Social Security 348

1 3 . 1 What Is Social Security and How Does It Work? 349Program Details 350

Application: Why Choose 35 Years? 350How Does Social Security Work Over Time? 354

Application: Ida May Fuller 355How Does Social Security Redistribute in Practice? 357

1 3 . 2 Consumption-Smoothing Benefits of Social Security . . . .359

Rationales for Social Security 359Does Social Security Smooth Consumption? 360Social Security and Private Savings 361Living Standards of the Elderly 361

1 3 . 3 Social Security and Retirement 362

Theory 362Empirical Evidence: Measuring the Crowd-Out Effect of Social Security

on Savings 363Evidence 364

Application: Implicit Social Security Taxes and Retirement Behavior 367Implications 369

1 3 . 4 Social Security Reform 369

Reform Round I: The Greenspan Commission 370Application: The Social Security Trust Fund and National Savings 371

Incremental Reforms 372Fundamental Reforms 374

Application: Company Stock in 401(k) Plans 378Application: Mixed Proposals for Social Security Reform 379


Highlights 380



CHAPTER 14 Unemployment Insurance, Disability Insurance,and Workers' Compensation 384

1 4 . 1 Institutional Features of Unemployment Insurance,Disability Insurance, and Workers' Compensation 385

Institutional Features of Unemployment Insurance 385Institutional Features of Disability Insurance 387Institutional Features of Workers' Compensation 388

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Comparison of the Features of Ul, Dl, and WC 390Application: The Duration of Social Insurance Benefits Around the World 391

14 .2 Consumption-Smoothing Benefits of Social InsurancePrograms 392

14 .3 Moral Hazard Effects of Social Insurance Programs 393

Moral Hazard Effects of Unemployment Insurance 393Evidence for Moral Hazard in Dl 395 ^

Empirical Evidence: Moral Hazard Effects of Unemployment Insurance 396Evidence for Moral Hazard in WC 398

Empirical Evidence: Moral Hazard Effects of DI-399Empirical Evidence: Krueger's Study of Workers' Compensation 400

t

14.4 The Costs and Benefits of Social Insurance to Firms . . . .400The Effects of Partial Experience Rating in Ul on Layoffs 401The "Benefits" of Partial Experience Rating 403

Application: The "Cash Cow" of Partial Experience Rating 403Workers' Compensation and Firms 404

14.5 Implications for Program Reform 405

Benefits Generosity 4*05Targeting 405Experience Rating 406Worker Self-Insurance? 406

Application: Reforming Ul 407

14.6 Conclusion 408

Highlights 408



HPPENDIX Advanced Quasi-Experimental Analysis 411

CHAPTER 15 Health Insurance I: Health Economics andPrivate Health Insurance 413

15.1 An Overview of Health Care in the United States 415How Health Insurance Works: The Basics 415Private Insurance 416Medicare 420Medicaid 421TRICARE/CHAMPVA 421The Uninsured 421

Empirical Evidence: Health Insurance and Mobility 423xvii

15 .2 How Generous Should Insurance Be to Patients? 424Consumption-Smoothing Benefits of Health Insurance for Patients 425Moral Hazard Costs of Health Insurance for Patients 426How Elastic Is the Demand for Medical Care? The RAND Health InsuranceExperiment 429

Empirical Evidence: Estimating the Elasticity of Demand for Medical Care 430Optimal Health Insurance 431Why Is Insurance So Generous in the United States? 432

Application: Health Savings Accounts 433

1 5 . 3 How Generous Should Insurance Be to Medical'Providers? . ; 436

Managed Care and Prospective Reimbursement 436The Impacts of Managed Care 438How Should Providers Be Reimbursed? 439

1 5 . 4 Conclusion ' 439

Highlights 440



CHAPTER 16 Health Insurance I I : Medicare, Medicaid, andHealth Care Reform 443

16 .1 The Medicaid Program for Low-Income Mothers andChildren 445

How Medicaid Works 445

Who Is Eligible for Medicaid? 446What Health Services Does Medicaid Cover? 446How Do Providers Get Paid? 447

1 6 . 2 What Are the Effects of the Medicaid Program? 447

How Does Medicaid Affect Health? A Framework 447How Does Medicaid Affect Health? Evidence 448

Empirical Evidence: Using State Medicaid Expansions to Estimate ProgramEffects 451

1 6 . 3 The Medicare Program 452

How Medicare Works 452Application: The Medicare Prescription Drug Debate 453

1 6 . 4 What Are the Effects of the Medicare Program? 456

The Prospective Payment System 457

Empirical Evidence on the Move to the PPS 457

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Problems with PPS 458Lesson: The Difficulty of Partial Reform 459Medicare Managed Care 460

Should Medicare Move to a Full-Choice Plan? Premium Support 462Application: A Premium Support System for Medicare 462

Gaps in Medicare Coverage 464

16.5 Long-Term Care 465

Financing Long-Term Care 465 v . _..

16.6 Lessons for Health Care Reform in the United States . . . .466

Rising Health Care Costs 466 * ^

The Uninsured 468Incremental Reforms 469 *Fundamental Reform: Public National Health Insurance 471Fundamental Reform: Private-Sector Solutions 472

16.7 Conclusion 474

Highlights 474



CHAPTER 17 Income Distribution and Welfare Programs . . .478

17.1 Facts on Income Distribution in the United States 480Relative Income Inequality 480Absolute Deprivation and Poverty Rates 481

Application: Problems in Poverty Line Measurement 483What Matters—Relative or Absolute Deprivation? 484

17.2 Welfare Policy in the United States 485

Cash Welfare Programs 486In-Kind Programs 487

17.3 The Moral Hazard Costs of Welfare Policy 488

Moral Hazard Effects of a Means-Tested Transfer System 489Solving Moral Hazard by Lowering the Benefit Reduction Rate 492The "Iron Triangle" of Redistributive Programs 494

17.4 Reducing the Moral Hazard of Welfare 494

Moving to Categorical Welfare Payments 494Using "Ordeal Mechanisms" 497

Application: An Example of Ordeal Mechanisms 499Increasing Outside Options 500

Empirical Evidence: The Canadian Self-Sufficiency Project 502

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P A R T I V

Taxation inTheory andPractice

V

17.5 Welfare Reform 506Changes Due to Welfare Reform 506Effects of the 1996 Welfare Reform 506

Empirical Evidence: Estimating the Impact of Welfare Reform 507

17.6 Conclusion 508

Highlights 509



CHAPTER IS Taxation in the United States and Aroundthe World 512

18 .1 Types of Taxation 513Taxes on Earnings 513Taxes on Individual Income 514Taxes on Corporate Income 514Taxes on Wealth 514Taxes on Consumption 514Taxation Around the World 514

18 .2 Structure of the Individual Income Tax in theUnited States 516

Computing the Tax Base 517Tax Rates and Taxes Paid 518

Application: The Coming AMT Time Bomb 520

1 8 . 3 Measuring the Fairness of Tax Systems 521

Average and Marginal Tax Rates 521Vertical and Horizontal Equity 522Measuring Vertical Equity 523

Application: The Political Process of Measuring Tax Fairness 523

1 8 . 4 Defining the Income Tax Base 525

The Haig-Simons Comprehensive Income Definition 525Deviations Due to Ability-to-Pay Considerations 526Deviations Due to Costs of Earning Income 527

Application: What Are Appropriate Business Deductions? 527

1 8 . 5 Externality/Public Goods Rationales for Deviating fromHaig-Simons . 528

Charitable Giving 529Spending Crowd-Out vs. Tax Subsidy Crowd-In 529Consumer Sovereignty vs. Imperfect Information 531

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Housing 532Tax Deductions vs. Tax Credits 534

Application: The Refundability Debate 535'Bottom Line: Tax Expenditures 537

18 .6 The Appropriate Unit of Taxation 538

The Problem of the "Marriage Tax" 538Marriage Taxes in Practice 540

18 .7 Conclusion '. ~ 542

Highlights & 542

Questions and Problems \ 543


CHAPTER 19 The Equity Implications of Taxation:Tax Incidence 545

19.1 The Three Rules of Tax Incidence 547The Statutory Burden of a Tax Does Not Describe Who Really Bears the Tax 547The Side of the Market on Which the Tax Is Imposed Is Irrelevant to theDistribution of the Tax Burdens 549Parties with Inelastic Supply or Demand Bear Taxes; Parties with Elastic Supply orDemand Avoid Them 552Reminder: Tax Incidence Is About Prices, Not Quantities 555

19.2 Tax Incidence Extensions 556

Tax Incidence in Factor Markets 556Tax Incidence in Imperfectly Competitive Markets 560Balanced Budget Tax Incidence 562

19.3 General Equilibrium Tax Incidence 563

Effects of a Restaurant Tax: A General Equilibrium Example 563Issues to Consider in General Equilibrium Incidence Analysis 565

19.4 The Incidence of Taxation in the United States 568

CBO Incidence Assumptions 568Empirical Evidence: The Incidence of Excise Taxation 569

Results of CBO Incidence Analysis 569Current vs. Lifetime Income Incidence 572

19.5 Conclusion 572

Highlights 573


xxi


flPPENDix The Mathematics of Tax Incidence 575

CHAPTER 20 Tax Inefficiencies and Their Implications forOptimal Taxation 577

20 .1 Taxation and Economic Efficiency 578

Graphical Approach 578Elasticities Determine Tax Inefficiency 580

Application:; Tax Avoidance in Practice 581Determinants of Deadweight Loss 582Deadweight Los,s and the Design of Efficient Tax Systems 584

Application: The Deadweight Loss of Taxing Wireless Communications 586

20 .2 Optimal Commodity Taxation : 586

Ramsey Taxation: The Theory of Optimal Commodity Taxation 586Inverse Elasticity Rule 588Equity Implications of the Ramsey Model 588

Application: Price Reform in Pakistan 589

20.3 Optimal Income Taxes 592

A Simple Example 593General Model with Behavioral Effects 593An Example 596The Structure of Optimal Income Tax Rates: A Simulation Exercise 597

20.4 Tax-Benefit Linkages and the Financing ofSocial Insurance Programs 600

The Model 600Issues Raised by Tax-Benefit Linkage Analysis 602

Empirical Evidence: A Group-Specific Employer Mandate 604

20.5 Conclusion 605

Highlights 605



APPENDIX The Mathematics of Optimal Taxation 608

CHAPTER 21 Taxes on Labor Supply 611

21 .1 Taxation and Labor Supply—Theory 613

XXII

Basic Theory 613Limitations of the Theory: Constraints on Hours Worked andOvertime Pay Rules 615

21.2 Taxation and Labor Supply—Evidence 616

Empirical Evidence: Estimating the Elasticity of Labor Supply 617Limitations of Existing Studies 618

21.3 Tax Policy to Promote Labor Supply: The Earned IncomeTax Credit 619

Background on the EITC 619Impact of EITC on Labor Supply: Theory 621 •>Impact of EITC on Labor Supply: Evidence 622

Empirical Evidence: The Effect of the EITC on Single Mother Labor Supply 624Summary of the Evidence 625

Application: EITC Reform 625

21.4 The Tax Treatment of Child Care and I ts Impact onLabor Supply 627

The Tax Treatment of Child Care 627Empirical Evidence: Thejiffect of Child Care Costs on Maternal Labor Supply 628

Options for Resolving Tax Wedges 630Comparing the Options 631

21.5 Conclusion 631

Highlights 632



CHAPTER 22 Taxes on Savings 635

22.1 Taxation and Savings—Theory and Evidence . 636

Traditional Theory 636Evidence: How Does the After-Tax Interest Rate Affect Savings? 641Inflation and the Taxation of Savings 641

22.2 Alternative Models of Savings 643

Precautionary Saving Models 643Self-Control Models 644

Empirical Evidence: Social Insurance and Personal Savings 645

22.3 Tax Incentives for Retirement Savings 646Available Tax Subsidies for Retirement Savings 647Why Do Tax Subsidies Raise the Return to Savings? 648

xxm

Theoretical Effects of Tax-Subsidized Retirement Savings 650Application: The Roth IRA 654

Implications of Alternative Models 656Private vs. National Savings 657

Empirical Evidence: Estimating the Impact of Tax Incentives for Savings onSavings Behavior 658

Evidence on Tax Incentives and Savings 660

2 2 . 4 Conclusion _ 660

Highlights 660



CHAPTER 23 Taxes on Risk Taking and Wealth 663

2 3 . 1 Taxation and Risk Taking 665

Basic Financial Investment Model 665

Real-World Complications 666Evidence on Taxation and Risk Taking 668Labor Investment Applications 668

2 3 . 2 Capital Gains Taxation 669

Current Tax Treatment of Capital Gains 669What Are the Arguments for Tax Preferences for Capital Gains? 671What Are the Arguments Against Tax Preferences for Capital Gains? 676

2 3 . 3 Transfer Taxation 676

Why Tax Wealth? Arguments for the Estate Tax 678Arguments Against the Estate Tax 679

23.4 Property Taxation 682

Who Bears the Property Tax? 683Types of Property Taxation 684

Application: Property Tax Breaks to Businesses 684


Highlights 687



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CHAPTER 24 Corporate Taxation 689

24.1 What Are Corporations and Why Do We Tax Them? 691

Ownership vs. Control 691Application: Executive Compensation and the Agency Problem 692

Firm Financing 694Why Do We Have a Corporate Tax? 695

2 4 . 2 T h e S t r u c t u r e o f t h e C o r p o r a t e T a x . . : . . _ = 6 9 6

Revenues 696Expenses 696

Application: What Is Economic Depreciation? The Case ofPersonal Computers 698

Corporate Tax Rate 699 \Investment Tax Credit 699

24.3 The Incidence of the Corporate Tax 700

24.4 The Consequences of the Corporate Tax for Investment . . .701

Theoretical Analysis of Corporate Tax and Investment Decisions 701Negative Effective Tax Rates 706Policy Implications of the Impact of the Corporate Tax on Investment 706

Application: The Impact of the 1981 and 1986 Tax Reforms onInvestment Incentives 707

Evidence on Taxes and Investment 708

2 4 . 5 T h e C o n s e q u e n c e s o f t h e C o r p o r a t e T a x f o r F i n a n c i n g . . . . 7 0 9

The Impact of Taxes on Financing 709Why Not All Debt? 710The Dividend Paradox 713How Should Dividends Be Taxed? 714

Application: The 2003 Dividend Tax Cut 715Corporate Tax Integration 716

24.6 Treatment of International Corporate Income 717

How to Tax International Income 717Application: A Tax Holiday for Foreign Profits 718

24.7 Conclusion 721

Highlights 721



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CHAPTER 25 Fundamental Tax Reform 724

2 5 . 1 Why Fundamental Tax Reform? 725

Improving Tax Compliance 726Application: Tax Evasion 726Application: The 1997 IRS Hearings and Their Fallout for Tax Collection 729

Making the Tax Code Simpler 730Improving Tax Efficiency 732Summary: The Benefits of Fundamental Tax Reform 735

2 5 . 2 The Politics and Economics of Tax Reform 735

Political Pressures for a Complicated Tax Code 736Economic Pressures Against Broadening the Tax Base 736

Application: Grandfathering in Virginia 739The Conundrum 739

Application: TRA 86 and Tax Shelters 740

2 5 . 3 Consumption Taxation 741

Why Might Consumption Make a Better Tax Base? 741

Why Might Consumption Be a Worse Tax Base? 744Designing a Consumption Tax 747Backing into Consumption Taxation: Cash-Flow Taxation 749

25.4 The Flat Tax 750Advantages of a Flat Tax 750Problems with the Flat Tax 751

Application: The 2005 Panel on Tax Reform 752


Highlights 754



Glossary G-l

References R-l

Name Index Nl-l

Subject Index . . ., Sl-l

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second edition public finance and public policy - gbv · second edition public finance and public...

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