Updated: 02 Oct 2007
Lecture Notes:
ECON 635:
PUBLIC ECONOMICS
Lecture 1
Four Functions of Public Finance
• Allocation
• Distribution
• Stabilization
• Growth
1
Allocation
• An organized society requires the consumption of
public goods and services that would be unprofitable
to produce privately
• Public goods include:
– Defense,
– Law and order, justice
– Infrastructure
– Taxation is used to raise funds to pay for
production of these goods and services
2
Redistribution
• Very difficult to do in a short period of time
• Redistributing
wealth
does
not
change
individual
incomes much.
• Redistribution is impossible to do via the tax system
alone.
• Redistribution through expenditure system is much more
promising.
• Redistribution
should
be
related
to
the
role
of
governments in promoting growth.
3
Redistribution (cont’d)
• Only through growth can people in developing countries
be lifted out of economic backwardness
• Public education, health services
• Rural roads, rural telephone, electricity and public water
supplies all ways that people can change their position in
life overtime
• Important to consider changing income distribution
between generations
4
Stabilization
• A short run objective
• Outgrowth of the Keynesian revolution in
economics.
• The main objective to keep actual level of
income close to its potential.
• The target is full employment and price
stability.
• Inflation extremely damaging to poor and
reduces the efficiency of market system.
5
Growth
• Probably the most important objective when per capita
incomes are low
• Sources of Per Capita growth
– Capital accumulation, Human capital (education, health), and
Productivity change
• Tools of taxation and public expenditure need to be focused
on how to promote growth
• Need policies that encourage investors to reinvest their
business surpluses not take them out of country
• Government budget surplus important for providing savings
for private sector to borrow
6
Twelve Lessons of Economic Policy
1.
Avoid false technicism in economic policymaking.
2.
Keep budgets under adequate control.
3.
Keep inflationary pressures under reasonable control.
4.
Take advantage of international trade.
5.
Recognize that some types and patterns of trade restrictions
are far worse than others, and work both to liberalize and
rationalize them. (For example, uniform tariff rates are not as
damaging as import quotas)
6.
If import restrictions are excessive, and reducing them is
politically impossible, mount an indirect attack on the
problem by increasing incentives to export.
7
Twelve Lessons of Economic Policy (Cont’d)
7.
Make tax systems simple, easy to administer, and (as much
as possible) neutral and non-distorting with respect to
resource allocation.
8.
Avoid excessive income
tax rates 35
to 40% are
representing a plausible marginal rate that should not be
exceeded).
9.
Avoid excessive use of tax incentives to achieve particular
objectives.
10. Use price and wage controls sparingly, if at all.
11. Rarely can an economic justification be found for quotas,
licenses, and similar quantitative restrictions on output,
imports, exports, etc.
8
Twelve Lessons of Economic Policy (Cont’d)
12. The borderline of public-sector and private-sector activity
should be clear and well-defined. When the two compete in
a given area, the same rules should govern their operations.
9
Five Important Innovations of Tax Policy
a)
It is a possible to introduce more progressivity in a value
added tax system, but that its benefits have to be weighted
against significant extra vulnerability to evasion.
b)
Significant differentiation among rates of import tariffs can
lead to huge economic inefficiencies by giving vastly
different
degrees
of
effective protection to different
activities.
c)
Personal income tax rates above 35 to 40 percent are very
hard to justify in light of their efficiency and incentive costs.
10
Five Important Innovations of Tax Policy
(Cont’d)
d)
Labor is likely to bear the burden of any unilateral rise
in the rate of tax on the income of corporations (or
businesses in general), once an open-economy setting
is put in place.
e)
It is much easier to index a tax system for inflation than
people think. By its nature full indexation promotes
both equity and efficiency.
11
Pattern of Tax Revenue Collection
(Approximation)
Category of Countries
i)
Low Income countries
Ratio of Tax Revenue to GNP
15%
(per capita income Less
than $400)
ii)
Low Middle income
20%
(per capita income $400
to $1,600)
iii)
Upper Middle income
30%
iv)
High Income
Industrialized countries
45%
(Source: Wagner's Law – State takes an expanding share of
GNP as per capita incomes rise.)
12
Pattern of Tax Revenue Collection
Country
GNP/Capital
Rev/GDP
Non-tax Rev/Rev
YEAR
US $ 1999
1997
1997
Nepal
220
12.60%
13.65%
Bolivia
1010
24.35%
11.00%
Egypt
1400
28.95%
33.55%
Turkey
2900
21.95%
12.88%
Mexico
4400
19.10%
14.27%
Brazil
4420
37.30%
14.10%
Chile
4740
25.54%
17.33%
Kuwait
15000
46.90%
95.55%
Canada
19320
40.19%
17.05%
Italy
19710
45.40%
11.02%
UK
22640
39.13%
12.45%
Sweden
25040
58.90%
10.20%
13
Composition of Government Revenues
Nepal
1991
A) GNP per Capital US$ (Atlas)
GNP per Capital US$ (PPP)
B) Ratio Rev to GDP
C) Percentage of Revenue
1 Direct Tax
2 Social Security
3 Domestic taxes on goods&services
4 Trade
5 Tax on property
6 Other taxes
7 Non-tax revenue
8 Grants
TOTAL
D) Percentage of Expenditure
1 Defense
2 General Public Services
6.11%
0.00%
30.38%
24.20%
4.48%
0.00%
17.60%
17.21%
100%
5.06%
3.84%
Turkey
1999 1990
Malaysia
United Kingdom
1999 1988
1997 1990
1999
220
1219
11.50%
2900
6126
23.88%
15.76%
0%
30.63%
24.31%
2.88%
0%
15.08%
11.08%
100.00%
41.00% 37.58%
0.00%
0.00%
30.57% 37.73%
5.83%
1.45%
0.18%
2.83%
2.65%
3.58%
14.49% 16.66%
2.83%
0.04%
100.00% 100.00%
5.47% 11.71%
3.95% 25.18%
8.15%
3.45%
3400
7963
23.11%
30.53%
0.72%
17.68%
16.70%
0.38%
2.05%
31.66%
0.00%
100.00%
36.32%
1.23%
26.39%
12.63%
0.65%
4.68%
17.92%
0.00%
100.00%
22640
20883
36.90%
38.93%
16.86%
27.40%
0.02%
6.84%
0.00%
8.78%
0.86%
100.00%
8.82% 11.14% 10.75%
9.46% 11.01% 3.30%
39.33%
16.85%
30.72%
0.00%
7.14%
0.00%
4.84%
0.97%
100.00%
7.10%
4.18%14
4 Trade
24.20% 24.31% 5.83% 1.45% 16.70% 12.63% 0.02%
0.00%
5 Tax on property
4.48% 2.88% 0.18% 2.83% 0.38% 0.65% 6.84%
7.14%
6 Other taxes
0% 2.65% 3.58% Expenditures
2.05% 4.68% 0.00%
0.00%
Composition0.00%
of Government
7 Non-tax revenue
17.60% 15.08% 14.49% 16.66% 31.66% 17.92% 8.78%
4.84%
8 Grants
17.21%
0.86% Kingdom0.97%
Nepal 11.08% 2.83%
Turkey 0.04% 0.00%
Malaysia 0.00% United
1991 100% 100.00%
1999 1990
1999 1988
1997 1990
1999
TOTAL
100.00% 100.00%
100.00% 100.00%
100.00% 100.00%
D) Percentage of Expenditure
A)1 Defense
GNP per Capital US$ (Atlas)
220 11.71% 8.15%
2900 8.82% 11.14%
3400 10.75%
22640
5.06% 5.47%
7.10%
GNP perPublic
CapitalServices
US$ (PPP)
1219 25.18% 3.45%
6126 9.46% 11.01%
7963 3.30%
20883
2 General
3.84% 3.95%
4.18%
B)3 Public
Ratio Order
Rev toand
GDPSafety
4.53% 11.50%
6.00% 0.00% 23.88%
4.59% 5.75% 23.11%
5.29% 3.23% 36.90%
3.49%
C)4 Education
Percentage of Revenue
9.15% 14.04% 19.18% 11.28% 19.62% 22.80% 2.58%
3.73%
15 Direct
6.11%
SocialTax
Security,Health&Housing
8.36% 15.76%
13.22% 41.00%
7.03% 37.58%
14.82% 30.53%
14.78% 36.32%
20.77% 38.93%
47.88% 39.33%
54.16%
26 Social
Security
0.00%
0% 0.00%
Recr.,Cultr.,Relig.Affrs.
0.00% 0.00%
0.73% 0.00%
1.12% 0.72%
0.00% 1.23%
0.00% 16.86%
0.39% 16.85%
0.29%
37 Services
Domestic taxes on goods&services 30.38%
53.70% 30.63%
35.25% 30.57%
17.86% 37.73%
9.31% 17.68%
21.62% 26.39%
21.62% 27.40%
8.97% 30.72%
4.35%
48 Trade
24.20%
5.83% 47.28%
1.45% 16.70%
0.02%
0.00%
Others
15.36% 24.31%
22.05% 18.30%
18.72% 12.63%
11.46% 22.90%
22.71%
5TOTAL
Tax on property
4.48% 100.00%
2.88% 100.00%
0.18% 2.83%
0.38% 100.00%
0.65% 100.00%
6.84% 100.00%
7.14%
100.00%
100% 100.00%
6(Government
Other taxes Finance Statistics Yearbook, IMF
0.00%
0% Financial
2.65% Statistics.)
3.58% 2.05% 4.68% 0.00%
0.00%
2000, International
7 Non-tax revenue
17.60% 15.08% 14.49% 16.66% 31.66% 17.92% 8.78%
4.84%
8 Grants
17.21% 11.08% 2.83% 0.04% 0.00% 0.00% 0.86%
0.97%15
What is the Appropriate Size of the Public
Sector?
•
•
•
Rapid growth in size over the past 50 years
Two reasons:
a. Desire to increase rate of growth and industrialization
growth in state owned enterprises.
this trend is reversing
b. Growth in social program
social security
health expenditure
unemployment insurance
welfare programs
Need to think how these objectives and programs can be
more effectively delivered. E.g. public-private partnerships.
16
What are the most frequent causes of
Government Budget Crisis ?
1.
Current expenditures on personnel explode ?
2.
Investment expenditures have huge cost over runs ?
3.
Crop failures ?
4.
Exchange rate fluctuations ?
5.
Rapid increase in military expenditures ?
6.
A contingent liability comes due
-
e.g. Guarantee of bank deposits
-
Guarantee of exchange rate
-
Guarantee of state enterprise loans
17
Principles to Evaluate a Good Tax System
Revenue Adequacy
•
The taxes introduced should be sufficient to finance and fund the
government expenditure requirements over time.
•
Tax revenues should increase at a rate equal to or greater than the growth
of GNP.
•
The entire tax system should evolve as the economy changes.
•
Inadequate revenues will force the government to resort to borrowing,
selling state assets or printing money (inflation).
•
Deficit financing by domestic borrowing leads to the crowding out of
private sector credit given by commercial banks.
•
Deficit financing by foreign borrowing is limited and economically
expensive.
•
Deficit financing by Central Bank borrowing leads to inflation.
•
High inflation usually leads to financial crises.
18
Principles to Evaluate a Good Tax System (Cont’d)
Stability
•
The stability of tax revenues is important for good government.
•
Revenue instability will
implemented.
•
Stability in the tax rules and rates over time allows the private sector
to make long term plans more efficiently.
cause new
programs
to be poorly
For the stability of a tax system, it is necessary that:
a. the legislation be well written to eliminate unintended tax exemptions
or deductions (loopholes)
b. the statutory rates of tax for each of the taxes are not so high as to
create powerful incentives to promote tax avoidance schemes or to
stimulate tax evasion activity
c. the tax revenue is adequate and grows in a consistent fashion
d. the tax system is simple and the combined cost of administration and
compliance is low
19
Principles to Evaluate a Good Tax System (Cont’d)
Simplicity
• A Tax system should be simple so that it is easy to comply with by
taxpayers.
• Simplicity must apply to the administration of the law as well as its
legal structure.
• A complex tax system imposes high level of compliance costs on tax
payers and a high cost of administration on the government.
• Tax neutrality needed for growth.
• Growth comes about primarily through the expansion of savings and
expansion of investment into high return activities.
• The tax system should not create major distortions in consumption
and production behavior.
• A tax should not change the investment decisions by favoring one
set of investments over the others.
• The tax system should not create a disincentive to work.
• Well-designed tax systems should encourage competitive growth in
all sectors of the economy.
20
Principles to Evaluate a Good Tax System
(Cont’d)
Economic Efficiency
• A tax is efficient if the dead weight loss or efficiency cost is small.
• High differential tax rates create larger economic efficiency costs.
• The economic efficiency of a tax is an important consideration when
designing a tax system.
• Estimates of efficiency cost range from 5 to 150 percent of additional
tax revenues.
Low Administration and Compliance Costs
• A good tax system has low administration and compliance costs.
These costs are part of the economic cost of having a tax system.
21
PRINCIPLES OF TAX REFORM
Tax Systems Before and After Reforms
• Design of a tax reform depends on the existing elements
of the tax system
• Considerable differences in the existing tax policies and
economic systems of various countries
• The legislative and administrative set-up also vary from
country to country
• For the former Socialist economies of Eastern Europe
and the former Union of Soviet Socialist Republics a
completely new tax system has had to be created
22
Tax Systems Before and After Reforms (Cont’d)
In many developing countries tax reforms need to
concentrate only on redesigning the existing tax system.
• Where reforms are extensive, their implementation could
spread over a number of years.
• Appropriate tax rules for the implementation is an important
component required for the success of a tax reform.
• A general understanding or consensus must be reached
among concerned economists, lawyers, and legislators for
successful legislation and implementation of these rules.
23
Implementation of Reforms
•
The actual implementation of a tax reform depends on the will of
the political leaders and the capabilities of the tax administration of
the country
•
Political leadership has a major role in legislation of acts and rules
•
Difficult to produce an integrated tax reform which has the support
of all the interest groups.
•
Political leadership often seeks to influence the tax administration
in order to favor special interest groups, and this destroys tax
systems
•
The tax administration in a particular country may be slack and
inactive
•
For effective implementation of tax reforms, a prime requisite is
that reforms in the administrative setup keep pace with the
changes in the tax system and in the way the tax clients operates.
24
• Design of tax reform will also depend on the type of tax which is the
object of reform
• Main categories of taxes:
a) Direct Taxes
* personal income tax
* business or corporate tax
b) Indirect Taxes
* sales taxes (Value Added Tax)
* excise taxes
• trade taxes
c) Property Taxes
* wealth tax
* estate and gift tax
* asset tax
d) User Charges
* users charges
* environmental taxes
25
Direct Taxes
A) Income Tax:
Before Reform
After Reform
High top rates
(40%-75%)
(Statutory Tax)
Many rates
Top rates falling
(20%-35%)
Many exemptions
Most exemptions
eliminated
Very few rates
26
Direct Taxes (Cont’d)
B) Corporate Income Tax:
Before Reform
High marginal tax rates
Incentives with tax
holidays
Double taxation
After Reform
Convergence of top
statutory tax rates for
personal and corporate tax
systems
Elimination of special
incentives
Integration of corporate
and personal taxes
27
Reduction of top marginal income rates since 1984
(Number in parentheses indicates the number of tax brackets)
Country
Individuals
Before
After
Corporations
Before
After
Australia
60% (5)
49%(4)
46%
39%
Canada
34%(10)
29%(3)
28%
23%
Finland
50%
43%
52%
40%
Germany
56%
53%
56%
50%
Portugal
41/48%
37%
60/68
45%
Barbados
60%
50%
45%
35%
Colombia
49%
31%
40%
30%
El Salvador
60%
35%
30%
35%
Guatemala
42%
34%
48%
34%
Jamaica
58%
33%
45%
33%
66% (5)
33%(3)
45%
28%
New Zealand
28
Reduction of top marginal income rates since 1984
(Number in parentheses indicates the number of tax brackets)
Country
Individuals
Corporations
Before
After
Before
After
Zambia
80%
35%
50%
35/45
Denmark
73%
68%
40%
50%
U.S.A.
50%
28%
46%
34%
Indonesia
45%
35%
45%
35%
Singapore
45%
33%
40%
33%
Botswana
75%
50%
35%
40%
Mauritius
70%
35%
66%
35%
U.K.
60%
40%
52%
35%
29
Indirect Taxes
A) Sales Tax:
Before Reform
Many rates
Many exemptions
Narrow base
After Reform
Value Added Tax
(one positive rate and zero
rate)
Small number of
exemptions
Broad base plus a selective
number of excise taxes
(cigarettes and liquor etc.)
30
Indirect Taxes (Cont’d)
B) Trade Taxes (Import Duties):
Before Reform
After Reform
High tariff rates
Top rates lowered
Target around the world for a
single rate. In free trade areas the
target rate is zero.
Wide dispersal among rates
(in India 90 different tax rates on
steel alone)
Fewer rates
Quantitative controls
No quotas
• While in 1950 no country had a Value Added Tax, by 1993
more than 80 countries had adopted some form of VAT Tax
• By 2001, over 120 countries have introduced VAT
31
Tax Reform Process in South Cyprus
• Evolution of the tax system of South Cyprus
1990-2001 after it began preparations to enter
into the European Union.
• South Cyprus had a history of a very old fashion
tax system that was badly in need of reform.
• Tax system was full of exemptions and
incentives
32
South Cyprus Fiscal Issues in 1990:
Public sector deficit
Individual Income tax
Corporation Income tax
Import duties
Selective excises
VAT
Other Indirect Taxes
–
–
–
–
–
–
–
5.3% of GDP
3.9% of GDP
1.4% of GDP
3.4% of GDP
0.0% of GDP
0.0% of GDP
8.1% of GDP
33
• South Cyprus 1991 began reform process
with changes to income tax to reduce
burden.
– Introduced VAT in 1992 at a rate of 5%.
– 1993 raised VAT rate to 8%
– Income tax changes in 1996
– 2000 raised VAT rate to 10%
– 2002 raised VAT rate to 13%
– Major reform of Income Tax System
– 2003 will raise VAT rate to 15%
34
Direct and Indirect Taxes as Share of GDP.
GDP %
14,0
12,0
10,0
8,0
6,0
4,0
Direct Taxes
2,0
Indirect Taxes
Year
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
0,0
35
Direct Taxes as Share of Total Tax Revenues.
50,0
% Total Tax Revenues
60,0
Direct Taxes / Total Direct & Indirect Taxes
40,0
30,0
20,0
10,0
Year
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
0,0
36
Composition of Indirect Taxes as Share of GDP.
GDP %
7,0
Import Duties
Selective Excises
6,0
Value Added Tax (VAT)
Other Indirect Taxes
5,0
4,0
3,0
2,0
1,0
Year
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
0,0
37
South Cyprus Fiscal Situation 2001:
Public sector deficit
–
Less distortionary tax system
Individual income tax
–
Corporate income tax
–
Import duties
–
Selective Excises
–
Value Added Taxes
–
Other indirect taxes
–
2.8% of GDP
4.4% of GDP
3.9% of GDP
1.3% of GDP
3.0% of GDP
5.9% of GDP
2.1% of GDP
38
Revenue Buoyancies of South Cyprus Taxes,
1990-2002.
Total Taxes
Total Direct Taxes
Total Indirect Taxes
Individual Income Tax
Corporation Income Tax
Other Direct Taxes
Total Indirect Taxes
Import Duties
Selective Excises
Value Added Tax
Other Indirect Taxes
1.59
1.77
1.46
1.07
3.46
1.32
1.46
-1.56
1.25
3.72
-.93
39
South Cyprus 2001:
Per capita income
Real growth rate 1995-01
Tourism makes up
Imports
Exports
Domestic Savings
Domestic Investment
Rate of inflation
Unemployment rate
–
–
–
–
–
–
–
–
–
US$ 13,500
4.2%
20% of GDP
41.1% of GDP
11.9 of GDP
14.0% of GDP
18.5% of GDP
2.0 %
3.0%
40
The Challenge Facing North
Cyprus
• Total Tax Revenues -
35 % of GDP
• Total Expenditure
-
63% of GDP
• Deficit
-
28% of GDP
• Substantial Public Sector Budget Deficit
41
Tax Collections 2003 as Percentages of GDP.
South
Cyprus
North
Cyprus
Direct Taxes
10.24%
8.93%
Indirect Taxes
14.85%
16.54%
- VAT
Import Duties (tariffs)
Selective Excises
Other
7.75%
0.51%
4.60%
1.98%
7.67%
0.79%
7.76%
0.32%
Social Security Contribution
5.22%
5.22%
Other non-tax revenue
6.01%
5.11%
Total Revenue
36.67%
35.80%
Total Revenue (Excluding SSC)
31.10%
30.58%
42
Public Sector Expenditures, Excluding Social Security and
public pensions, 2004 as percentages of GDP
SOUTH
CYPRUS
10.96%
3.77%
4.96%
NORTH
CYPRUS
17.19%
7.87%
5.09%
14.96%
16.46%
Total Expenditures
34.65%
46.62%
Total Revenue (Excluding SSC)
31.10%
30.58%
Cash Deficit
-3.55%
-16.04%
Wages & salaries
Capital Expenditure
Debt Service
Others (excluding social security
and public pensions)
43
Cash Deficits of Social Security and Public
Pension Systems of North and South Cyprus
SOUTH CYPRUS
NORTH CYPRUS
Cyprus Pounds % of GDP Cyprus Pounds % of GDP
Social Security Contributions
368
5.22%
36
5.22%
Social security payments
418
5.93%
67
9.76%
-
48
6.99%
Public Pensions (Pre 1987 employes)
Cash Deficit of Pension System
-
-50
-0.71%
-79 -11.53%
44