Public Finance (MPA405) Dr. Khurrum S. Mughal

Lecture 22: Introduction to Government Finance Public Finance

Criteria for Evaluating Alternative Methods of Government Finance Equity –The distribution of the burden of government finance should coincide with commonly held notions of fairness and ability-to-pay. Efficiency –The system of government finance should raise revenues with only a minimal loss in efficiency in the private sector. Administrative ease –A government finance system should be relatively easy to administer in a consistent manner without excessive costs to collect, enforce, and comply with taxes and tax laws.

Criteria for Evaluating Alternative Methods of Government Finance Equity Vs Efficiency Trade-off Equitable taxes might cause losses in efficiency Efficient taxes might be deemed inequitable by many citizens

Tax Compliance and Evasion Tax Evasion is the term for illegal ways of avoiding paying taxes. It is typically the result of not declaring income or overstating otherwise legal deductions. Tax Avoidance is the term for the legal ways of avoiding paying taxes, typically the result of avoiding activities that are taxed, delaying the time in which taxes are owed, or taking an action designed to lower a tax burden.

Tax Compliance and Evasion Marginal Benefit and Cost associated with tax evasion – Benefit in terms of having to pay less tax – Cost are the monetary and nonmonetary penalties, if caught In presence of Progressive Taxation: – MB and MTR declines as more income goes unreported – MC rises because probability of being audited increases with more income being unreported

Reducing Tax Evasion Cost and Benefit Unreported Income per Year (Dollars) 0D* 1 B MC MB 2 D* A MC MB = MTR Cost and Benefit Unreported Income per Year (Dollars) 0 MC 2 C MC 1 Cost and Benefit Unreported Income per Year (Dollars) 0 MB = MTR E 1 E E 2 E E1E1 MB 1 = MTR 1 D* 2 1 2

Alternatives to Taxation Debt Finance is the means of financing expenditures through the issuing of bonds. –People willingly buy bonds because the interest payment is sufficient to offset the requirement of current consumption –Taxes are used to pay off debt Inflationary Finance is the means of financing expenditures through the printing of money. –Reduction in real value, inflationary tax, reduces command over resources in private sector

Inflationary Finance Guns per Year Butter per Year 0 B2B2 G2G2 G1G1 C I A T'B1B1 T

More alternatives to Taxation Donations –Money (but more usually time) is voluntarily given to government. Military service or work in the Peace Corps can be considered a donation when the compensation is less than the market value of the time. User Charges –Payments by users of the government service can be expected. Examples include tuition, fees paid to enter state parks, greens fees at publicly owned golf courses. Earmarked Taxes –Taxes can be implemented to fund specific public goods. Examples include gasoline taxes and tolls designed to fund road and bridge repair.

User Charges & Efficiency Price excludable goods generate external benefits Trash Pick up example – MSB = MPB + MEB – To ensure efficient quantity price charged is when MSC=MPB – Additional amount is to be subsidized

User Charges and Efficiency Charges Trash Pickups per Year 0 Q* C* C* + S* MSB = MPB + MEB MPB MSC S* Z* Z

User Charges & Efficiency Can also create efficiency if benefits of government goods are congestible Road Congestion example – No price required if traffic is below the point of congestion – Above that, price may be charged equivalent to the point where MSB=MSC

User Charges for a Congestible Government-Supplied Service User Charges (Cents per Mile) Vehicles per Mile per Hour 0 E1E1 20 E2E2 D 2 = MSB 2 D 1 = MSB 1 MSC E* N*

Government Enterprise Local Utilities Lotteries