Public Sector Economics
Taxes and Market Distortions – Theory
Main Lessons
• rational foundations of policy distortions
• how policy distortions are a result of “incomplete
markets”
• why labor supply is so important
• tax equivalencies
• wealth vs. substitution effect of a tax
• rigorous definition of deadweight cost
• the “taxable income elasticity”
• measuring marginal tax rates
• public policy needs market analysis
• applications of the results to other economics
fields
Rational Foundations
• Olson’s Logic of Collective Action
– people do not voluntarily and unilaterally pay taxes (in the
amount they are forced to pay) or otherwise contribute to
collective goods, even if they appreciate the way tax
revenues are used, because they rely on others to make the
contribution
– restaurant example
– is this logic correct?
• in large groups?
• how else can tax distortions be explained?
• tax payments vs. user fees
– eg., Feldstein-Samwick on SS “contributions”
– mandatory employee benefits
• voluntary contributions
• “excessive” tax compliance, “insufficient” take-up
Soviet Collective Farms
Marxism-Leninism insisted
that small-scale production
in agriculture was
“uneconomic, conducive to
low productivity and
absorbing too much of the
labor force of the country.”
Dolot, Miron (2011)
Image credit: http://www.eonimages.com/media/5c62b78c-3e50-11e0-b
No U.S. copyright applies.
Chinese Communes
MaoZedong
Zedongtouts
on
Mao
communes:
“Their
advantage
in
“the
superiority
of is
large
combining
industry,
cooperatives”
agriculture, commerce,
education, and the military
for more convenient
management.”
Jisheng (2012)
Image credit: http://chineseposters.net/photographs/a62-938.php
Image credit: http://iftf.typepad.com/photos/uncategorized/great_leap_fo
Soviet Collective Farms
“…the land was no longer
theirs. They could work that
land, but there was no
guarantee that they could
harvest the crop.”
Dolot, Miron (2011)
Image credit: http://www.eonimages.com/media/5c62b78c-3e50-11e0-b
No U.S. copyright applies.
Chinese Communes
“the state monopoly stifled
incentives for increasing
production…
deprived peasants of their
right to obtain food and
made them dependent on
the government for every
meal, while punishing them
for applying individual
effort in food production.”
Jisheng (2012)
Image credit: http://chineseposters.net/photographs/a62-938.php
Image credit: http://iftf.typepad.com/photos/uncategorized/great_leap_fo
Soviet Collective Farms
“the Soviet economy is
proof that, contrary to what
many skeptics had earlier
believed, a socialist
command economy can
function and even thrive.”
Paul Samuelson and
William Nordhaus (1989!)
Image credit: http://www.eonimages.com/media/5c62b78c-3e50-11e0-b
No U.S. copyright applies.
Soviet Collective Farms
“[surprised:] Private
allotments of land on the
collective farm often have
much higher, not lower
productivity than the
collectivized sectors.”
Paul Samuelson (1976)
Image credit: http://www.eonimages.com/media/5c62b78c-3e50-11e0-b
No U.S. copyright applies.
Soviet Collectivization
“That is why buildings in
the Soviet Union – like
public housing in the
United States – look
decrepit within a year or
two of their construction.”
Milton and Rose Friedman
(1980)
Image credit: http://www.eonimages.com/media/5c62b78c-3e50-11e0-b
No U.S. copyright applies.
The Virtues of Collective Ownership
• E.g., journalists on single-payer health care
– Europeans have healthcare payroll taxes withheld from pay
– Americans have insurance premiums withheld from pay
– Supposedly no difference (per $ withheld)
1,100.00
BCBS FAMILY PREMIUM
5,500.00
1,951.28
1,100.00
110.00
390.26
549.99
1,100.00
National HI Tax
110.00
549.99
Roberts family NHI benefits are independent
of what (if anything) James pays
5,500.00
1,951.28
1,100.00
390.26
1,100.00
BCBS family premium
110.00
549.99
Roberts family gets BCBS benefits ONLY if
James pays in full
5,500.00
1,951.28
1,100.00
390.26
The Virtues of Collective Ownership
• E.g., journalists on single-payer health care
– Europeans have healthcare payroll taxes withheld from pay
– Americans have insurance premiums withheld from pay
– Supposedly no difference (per $ withheld)
• Public ownership is simpler/less costly
– U.S. physicians annual spend $61k more (than Canadian
docs) dealing with insurance companies
– See also Peter Diamond on the administrative costs of
retirement accounts: SSA has proportionally less admin cost
• Government’s large scale permits it to invest more in
each decision and share the resulting wisdom
• Government gets a bulk discount  more people served
• Only real costs of public ownership: government faced
with “difficult decisions”
• These arguments work for most industries: health,
education, groceries, airlines, housing, banking
Table 2.3. Payroll taxes earmarked for medical
benefits in the U.S. and Western Europe, 2010
Country
U.S. (before the ACA)
Austria
Luxembourg
Greece
Belgium
Finland
France
Germany
Netherlands
Medical benefits
payroll tax rate, employee equivalent
2.5
4.2
4.4
4.5
5.1
5.3
6.4
9.0
15.2
Western Europe average
6.8
In addition, Switzerland has an individual mandate with premiums
capped at 8 percent of income.
Source: Philipson, et al., Health Affairs 2012.
Source: Philipson, et al., Health Affairs 2012.
Source: Philipson, et al., Health Affairs 2012.
Rational Foundations (cont’d)
How complete are markets in Public Finance?
• complete enough that:
– profits are zero
– goods (factor) prices equal marginal cost (product)
• not so complete that there are contracts on untaxed
goods (otherwise lump sum taxation is possible)
• [not a complete set of policy contingent claims]
• insufficient substitutes for complete markets. eg,
– altruism
– voluntary provision
Labor Tax Conversion Factors
Wealth vs. Substitution Effects
c
slope = 𝑤
slope = 1 − 𝜏 𝑤
𝜈 + 𝑓 𝑛 − 𝑤𝑛
𝑓 𝑛 − 𝑤𝑛
0
n
c
dg
dg
0
n
substitution effect
wealth effect
combined effect
Table 5.1. Sliding Scale Exchange Subsidies
as a function of household income for the calendar year
Income as a
ratio to FPL
1
1.33
1.5
2
2.5
3
4
4+
Percentage of income
owed as premium
2%
3%
4%
6.3%
8.05%
9.5%
9.5%
full premium
Discount on out-of-pocket cost
(jumps when crossing thresholds)
80%
80%
57%
10%
0%
0%
0%
0%
Notes on interval
premium percentage is constant on this interval, jumping at 1.33
premium percentage is constant on this interval
premium jumps here because the premium cap is eliminated
Notes: (a) the first column indicates the bottom threshold of the income interval
(b) income percentages change continuously between thresholds unless otherwise noted.
(c) FPL = federal poverty line.
(d) Income percentages for 2015-18, and any year thereafter in which the exchange subsides are less than 0.504% of GDP, are indexed to the excess
of health cost inflation over income growth.
Figure 5.1. 2016 health payments as a function of family income and
policy type
Payments by subsidy-eligible participants, ratio to FPL
1
full price
0.9
family of 4, parents aged 50, actual
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
1
1.5
2
2.5
3
3.5
family income, ratio to FPL
4
4.5
5
Figure 5.1. 2016 health payments as a function of family income and
policy type
Payments by subsidy-eligible participants, ratio to FPL
1
full price
0.9
family of 4, parents aged 50, actual
0.8
family of 4, 28% approx.
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
1
1.5
2
2.5
3
3.5
family income, ratio to FPL
4
4.5
5
Table 5.3. The ACA can erase the reward to work for exchange plan participants
An example of how unemployment can be "free" under the ACA
Scenario for the calendar year
10 months employed
Employed all year
Income sources
Employment
UI (only replaces half)
All sources
10 months
1 month
11 months
12 months
0 months
12 months
Work-related expense bases (number of months where expenses accrue)
IIT
11 months
12 months
Payroll tax
10 months
12 months
Work expense
10 months
12 months
Difference =
consequence of working
12 months rather than 10
2 months
-1 month
1 month
1 month
2 months
2 months
Expense amounts at the margin
IIT (including exchange subsidies) @ 64%
Employee payroll @ 7.65%
Work expense @ 10%
All expenses
0.6 months
0.2 months
0.2 months
1.0 months
Income sources net of work-related expenses
0.0 months
Notes: IIT denotes individual income taxes. UI denotes unemployment insurance benefits. To illustrate simply the economics of a 50
percent UI replacement rate, UI is assumed to fully replace employment income for half of the time unemployed rather than replacing half
of the income all of the time. The marginal rate is 15 percent for normal federal and state taxes, plus 21 percent for EITC phaseout, plus
28 percent loss of exchange subsidies that are based on calendar-year income. UI is taxable by the IIT, but not by the payroll tax.
Employment vs Earnings Tests
benefit
amount
b0
earningstested benefit
employmenttested benefit
0
(magnitude of) slope =
“benefit reduction rate”
beneficiary
earnings
Variations on the Employment Test
benefit
amount
b0
employmenttested benefit
0
beneficiary
earnings
Budget Set Induced by Income Taxes/Benefit Phaseouts
The horizontal axis measures beneficiary income, from highest to lowest.
The black segment is the budget set without taxes and benefits.
all other
goods
Tax paid/benefit foregone
MTR = 0%
MTR = 0%
MTR = 50%
MTR = 100%
MTR = 150%
b
0
-1*(full income)
0
-1*(wage income)
Nonlinear Budget Constraints
Instances of Nonlinear Taxation
• deductions
• employment-related tax breaks
– tax exempt savings
– health expenditures
– consumption at work, fringes
• tax evasion
• EITC [Earned Income Tax Credit]
• “progressivity”
[continuous and kinked versions]
• “compliance costs”
• effort
Table 3.2. The distribution of marginal penalty amounts among employees not offered coverage
Coverage year 2016. Dollar amounts in 2014 $.
Number of
penalties triggered by the
full-time
marginal employee
possible frequency distributions
employees
number
amount
w/o ACA
w/ ACA
average
< 49
0
0
0.650
0.650
0.650
49
10
$31,630
0.033
0.094
0.063
first
30
are
exempt
50
10.5
$33,212
0.022
0
0.011
51+
1
$3,163
0.296
0.256
0.276
Employee-weighted average $ amount: $2,684
$3,783
$3,233
Notes: Assumes zero part-time employees and ignores the "look back" for determining large-employer status.
The possible frequencies are employee-weighted and are for purposes of illustration.
Deadweight Loss
• also known as deadweight cost, excess burden
• 5 definitions
–
–
–
–
effect of policy on indirect utility (measured in “utils”)
area under the Marshallian demand curve (measured in $)
area under the Hicksian demand curve
additional income required to achieve old (pre-policy) utility
at new prices
– income change required to achieve new utility at old (prepolicy) prices
• equivalence results
• the “taxable income elasticity”
Nontaxed Activity as a Composite Good
• tax avoidance can occur on many margins
–
–
–
–
–
–
–
hours per week
weeks per year
work or not work
cheat or not cheat
occupational choice
compensation composition
…
• taxable income elasticity as a summary statistic
Market Analysis
Measuring “the Marginal Tax Rate”
• MTR = statutory tax rate?
– on a particular margin – substitution between tax base and
untaxed activities
– “tax base” may be of limited interest economically. eg.,
• model may be about “capital,” but only some capital income is
taxable
• model about “cigarettes,” but there are legal and illegal cigarette sales
• MTR = average tax rate?
– “progressivity”
– marginal vs. average substitution