PUBLC FINANCE AND PUBLIC POLICY - · PDF fileTHIRD EDITION PUBLC FINANCE AND PUBLIC POLICY...

THIRD EDITION

PUBLC FINANCEAND PUBLIC POLICY

JONATHAN GRUBERMassachusetts Institute of Technology

Worth Publishers

Brief Contents

Preface xxvii

PART I Introduction and Background1 Why Study Public Finance? 12 Theoretical Tools'of Public Finance 253 Empirical Tools of Public Finance 634 Budget Analysis and Deficit Financing 91

PART I I Externalities and Public Goods5 Externalities: Problems and Solutions 1216 Externalities in Action: Environmental and Health Externalities 1497 Public Goods 1818 Cost-Benefit Analysis , 2059 Political Economy 227

10 State and Local Government Expenditures 26111 Education \ 289

PART I I I Social Insurance and Redistribution12 Social Insurance: The New Function of Government 31913 Social Security 35314 Unemployment Insurance, Disability Insurance, and Workers' Compensation .38915 Health Insurance I: Health Economics and Private Health Insurance 41916 Health Insurance II: Medicare, Medicaid, and Health Care Reform 45317 Income Distribution and Welfare Programs .489

PART IV Taxation in Theory and Practice18 Taxation in the United States and Around the World 52319 The Equity Implications of Taxation: Tax Incidence 55720 Tax Inefficiencies and Their Implications for Optimal Taxation 58921 Taxes on Labor Supply 62322 Taxes on Savings 64723 Taxes on Risk Taking and Wealth 67524 Corporate Taxation 70125 Fundamental Tax Reform 737

Glossary G-l

References R-l

Name Index NI-1

Subject Index " . SI-1

vi

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 I n t r o d u c t i o nWhen Should the Government Intervene in the Economy? 3 a n d

Application: The Measles Epidemic of 1989-1991 5 BacknroundHow Might the Government Intervene? 6What Are the Effects of Alternative Interventions? 7

Application: The Congressional Budget Office: Government Scorekeepers 8Why Do Governments Do What They Do? 9

1.2 Why Study Public Finance? Facts on Government in the UnitedStates and Around the World 10

The Size and Growth of Government 10Decentralization 12Spending, Taxes, Deficits, and Debts 12Distribution of Spending 13Distribution of Revenue Sources 17Regulatory Role of the Government 19

1 .3 Why Study Public Finance Now? Policy Debates over SocialSecurity, Health Care, and Education 20

Social Security 20Health Care 21Education 21 \

1.4 Conclusion 22

Highlights 22

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 29 :

Budget Constraints 31Putting It All Together: Constrained Choice 33The Effects of Price Changes: Substitution and Income Effects 35

VII

2 . 2 Putting the Tools to Work: TANF and LaborSupply Among Single Mothers 37

Identifying the Budget Constraint 38

The Effect of TANF on the Budget Constraint 39

2 . 3 Equilibrium and Social Welfare 43

Demand Curves 44Supply Curves 46Equilibrium 48Social Efficiency 49

Competitive Equilibrium Maximizes Social Efficiency 50"" From Social Efficiency to Social Welfare: The Role of Equity 52

Choosing an Equity Criterion 54

2 . 4 Welfare Implications of Benefit Reductions:

The TANF Example Continued 55

2 . 5 Conclusion 57

Highlights 57



OPPENDIX TO CHflPTER 2 The Mathematics of Utility Maximization . .60

CHAPTER 3 Empirical Tools of Public Finance 63

3 . 1 The Important Distinction BetweenCorrelation and Causality 64

The Problem 65

3 . 2 Measuring Causation with Data We'd Like to Have:Randomized Trials 66

Randomized Trials as a Solution 67The Problem of Bias 67

Randomized Trials of ERT 69Randomized Trials in the TANF Context 69

Why We Need to Go Beyond Randomized Trials 70

3 . 3 Estimating Causation with Data We Actually Get:Observational Data 71

Time Series Analysis 72Cross-Sectional Regression Analysis 75Quasi-Experiments 80Structural Modeling 83

VIII

3.4 Conclusion 85

Highlights . . . . ' . 85



RPPENDIXTO CHRPTER 3 Cross-Sectional Regression Analysis 88

CHAPTER 4 Budget Analysis and Deficit Financing 91

4.1 Government Budgeting 93The Budget Deficit in Recent Years 93The Budget Process 94

Application: Efforts to Control the Deficit 95Budget Policies and Deficits at the State Level 97

4.2 Measuring the Budgetary Position of the Government:Alternative Approaches 98

Real vs. Nominal 98The Standardized Deficit 99Cash vs. Capital Accounting 100Static vs. Dynamic Scoring 102

4.3 Do Current Debts and Deficits Mean Anything?A Long-Run Perspective 103

Background: Present Discounted Value 103Why Current Labels May Be Meaningless 104Alternative Measures of Long-Run Government Budgets 105What Does the U.S. Government Do? 109

Application: The Financial Shenanigans of 2001 112

4.4 Why Do We Care About the Government'sFiscal Position? : 113

Short-Run vs. Long-Run Effects of the Government on the Macroeconomy 113

Background: Savings and Economic Growth 114

The Federal Budget, Interest Rates, and Economic Growth 115

Intergenerational Equity 117

4.5 Conclusion 118

Highlights 119



IX

PART I I

Externalitiesand PublicGoods

CHAPTER 5 Externalities: Problems and Solutions 121

5 . 1 Externality Theory 123

Economics of Negative Production Externalities 123Negative Consumption Externalities 126

Application: The Externality of SUVs 127Positive Externalities 128

5 . 2 Private-Sector Solutions to Negative Externalities 130

The Solution 130The Problems with Coasian Solutions 132

5 . 3 Public-Sector Remedies for Externalities 134

Corrective Taxation 135Subsidies 136Regulation 137

5 . 4 Distinctions Between Price and Quantity Approachesto Addressing Externalities 137

Basic Model 137Price Regulation (Taxes) vs. Quantity Regulation in This Model 139Multiple Plants with Different Reduction Costs 140Uncertainty About Costs of Reduction 143

5 . 5 Conclusion 146

Highlights 146



CHAPTER 6 Externalities in Action: Environmental and HealthExternalities 149

6 . 1 Acid Rain 150

The Damage of Acid Rain 150

History of Acid Rain Regulation 151

Empirical Evidence: Estimating the Adverse Health Effects of Particulates 152Has the Clean Air Act Been a Success? 154

6 . 2 Global Warming 155

Application: The Montreal Protocol 157The Kyoto Treaty 158Can Trading Make Kyoto More Cost-Effective? 158What Does the Future Hold? 161

Application: Congress Takes on Global Warming 162

6.3 The Economics of Smoking . . . . * 165

The Externalities of Smoking 166Should We Care Only About Externalities, or Do "Internalities" Matter Also? 170

6.4 The Economics of Other Addictive Behaviors 173

Drinking 173

Illicit Drugs 174Application: Public Policy Toward Obesity 174

Summary 177 - --

6.5 Conclusion 177

Highlights 178



CHAPTER 7 Public Goods 181

7.1 Optimal Provision of Public Goods 182

Optimal Provision of Private Goods 183

Optimal Provision of Public Goods 185

7.2 Private Provision of Public Goods 187

Private-Sector Underprovision 188Application: The Free Rider Problem in Practice 189

Can Private Providers Overcome the Free Rider Problem? 190

Application: Business Improvement Districts 190When Is Private Provision Likely to Overcome the Free Rider Problem? 192

7.3 Public Provision of Public Goods 194

Private Responses to Public Provision: The Problem of Crowd-Out 195Measuring the Costs and Benefits of Public Goods 197How Can We Measure Preferences for the Public Good? 197

Empirical Evidence: Measuring Crowd-Out 198

7.4 Conclusion 199

Highlights 200



flPPENDIX TO CHfiPTER 7 The Mathematics of PublicGoods Provision 202

XI

CHAPTER 8 Cost-Benefit Analysis 205

8 . 1 Measuring the Costs of Public Projects 206

The Example 207Measuring Current Costs 208Measuring Future Costs 209

8 . 2 Measuring the Benefits of Public Projects 210

Valuing Driving Time Saved 210

Application: The Problems of Contingent Valuation 213Empirical Evidence: Valuing Time Savings 214

Valuing Saved Lives 215

Application: Valuing Life 215Discounting Future Benefits 220Cost-Effectiveness Analysis 220

8 . 3 Putting I t All Together 221

Other Issues in Cost-Benefit Analysis 221

8 . 4 Conclusion 223

Highlights 223



CHAPTER 9 Political Economy 227

9 . 1 Unanimous Consent on Public Goods Levels 229

Lindahl Pricing 229

Problems with Lindahl Pricing 231

9 . 2 Mechanisms for Aggregating Individual Preferences 232

Application: Direct Democracy in the United States 232Majority Voting: When It Works 234Majority Voting: When It Doesn't Work 236Arrow's Impossibility Theorem 237Restricting Preferences to Solve the Impossibility Problem 237Median Voter Theory 239

The Potential Inefficiency of the Median Voter Outcome 239Summary 240

9 . 3 Representative Democracy 241

Vote-Maximizing Politicians Represent the Median Voter 241

Assumptions of the Median Voter Model 242Lobbying 244

Application: Farm Policy in the United States 245Evidence on the Median Voter Model for Representative Democracy 247

Empirical Evidence: Testing the Median Voter Model 248

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9.4 Public Choice Theory: The Foundationsof Government Failure 249

Size-Maximizing Bureaucracy 249Problems with Privatization 250

Application: Contracting Out with Non-Competitive Bidding 251Leviathan Theory 253Corruption 254

Application: Government Corruption 254Empirical Evidence: Government Failures and Economic Growth 257

The Implications of Government Failure 258

9.5 Conclusion 258

Highlights 258



C H A P T E R 1 0 S t a t e a n d L o c a l G o v e r n m e n t E x p e n d i t u r e s . . . 2 6 1

1 0 . 1 Fiscal Federalism in the United States and Abroad 263

Spending and Revenue of State and Local Governments 264

Fiscal Federalism Abroad 265

1 0 . 2 Optimal Fiscal Federalism 267

The Tiebout Model 267Problems with the Tiebout Model 269Evidence on the Tiebout Model 271Optimal Fiscal Federalism 273

Empirical Evidence: Evidence for Capitalization from California'sProposition 13 274

i 1 0 . 3 Redistribution Across Communities 275

| Should We Care? 276

I Tools of Redistribution: Grants 277[ Redistribution in Action: School Finance Equalization 282i Empirical Evidence: The Flypaper Effect 283

| Application: School Finance Equalization and Propertyt Tax Limitations in California 285

I

| 10.4 Conclusion 285

Highlights .286

Questions and Problems 286Advanced Questions 287

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H PART I I I

SocialInsurance andRedistribution

CHAPTER 11 Education 289

1 1 . 1 Why Should the Government Be Involvedin Education? 292

Productivity 292Citizenship 293Credit Market Failures 293

Failure to Maximize Family Utility 293Redistribution 294 -

1 1 . 2 How Is the Government Involved in Education? 294

Free Public Education and Crowding Out 295Solving the Crowd-Out Problem: Vouchers 297Problems with Educational Vouchers 300

1 1 . 3 Evidence on Competition in Education Markets 304

Direct Experience with Vouchers 304Experience with Public School Choice 304

Empirical Evidence: Estimating the Effects of Voucher Programs 305Experience with Public School Incentives 306Bottom Line on Vouchers and School Choice 307

1 1 . 4 Measuring the Returns to Education 307

Effects of Education Levels on Productivity 308Effect of Education Levels on Other Outcomes 309

Empirical Evidence: Estimating the Return to Education and Evidencefor Screening 310

The Impact of School Quality 310

1 1 . 5 The Role of the Government in Higher Education 311

Empirical Evidence: Estimating the Effects of School Quality 312

Current Government Role 313What Is the Market Failure and How Should It Be Addressed? 314

1 1 . 6 Conclusion 315

Highlights 316



CHAPTER 12 Social Insurance: The New Functionof Government 319

1 2 . 1 What Is Insurance and Why Do Individuals Value It? . . . > .321What Is Insurance? 321

Why Do Individuals Value Insurance? 322

Formalizing This Intuition: Expected Utility Model 323

XIV

12.2 Why Have Social Insurance? Asymmetric Informationand Adverse Selection 326

Asymmetric Information 326Example with Full Information 327Example with Asymmetric Information 327The Problem of Adverse Selection 329

Does Asymmetric Information Necessarily Lead to Market Failure? 330Application: Adverse Selection and Health Insurance "Death Spirals" 331

How Does the Government Address Adverse Selection? 332- '

12.3 Other Reasons for Government Interventionin Insurance Markets 333

Externalities 333Administrative Costs 333Redistribution 334Paternalism 334

Application: Flood Insurance and the Samaritan's Dilemma 334

12.4 Social Insurance vs. Self-Insurance:How Much Consumption Smoothing? 337

Example: Unemployment Insurance 337Lessons for Consumption-Smoothing Role of Social Insurance 341

12.5 The Problem with Insurance: Moral Hazard 342

Application: The Problems with Assessing Workers'Compensation Injuries 343

What Determines Moral Hazard? 344Moral Hazard Is Multidimensional 344The Consequences of Moral Hazard 345

12.6 Putting I t All Together: Optimal Social Insurance 346

12.7 Conclusion 346

Highlights 347



APPENDIX TO CHAPTER 12 Mathematical Modelsof Expected Utility 350

CHAPTER 13 Social Security 353

13.1 What Is Social Security and How Does I t Work? 354

Program Details 355Application: Why Choose 35 Years? 355

xv

How Does Social Security Work Over Time? 359Application: Ida May Fuller 360

How Does Social Security Redistribute in Practice? 362

1 3 . 2 Consumption-Smoothing Benefitsof Social Security 364

Rationales for Social Security 364Does Social Security Smooth Consumption? 365Social Security and Private Savings 366Living Standards of the Elderly 366

1 3 . 3 Social Security and Retirement 367

Theory 367

Empirical Evidence: Measuring the Crowd-Out Effect of SocialSecurity on Savings 368

Evidence 369Application: Implicit Social Security Taxes and Retirement Behavior 372

Implications 374

1 3 . 4 Social Security Reform 374

Reform Round I: The Greenspan Commission 375

Application: The Social Security Trust Fund and National Savings 376

Incremental Reforms 377

Fundamental Reforms 379

Application: Company Stock in 401(k) Plans 383

Application: Mixed Proposals for Social Security Reform 384


Highlights 385



CHAPTER 14 Unemployment Insurance, DisabilityInsurance, and Workers' Compensation 389

1 4 . 1 Institutional Features of UnemploymentInsurance, Disability Insurance,and Workers' Compensation 391

Institutional Features of Unemployment Insurance 391Institutional Features of Disability Insurance 393Institutional Features of Workers' Compensation 394Comparison of the Features of Ul, Dl, and WC 395

Application: The Duration of Social Insurance Benefits Around the World 396

1 4 . 2 Consumption-Smoothing Benefitsof Social Insurance Programs 397

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14.3 Moral Hazard Effects of Social Insurance Programs 398

Moral Hazard Effects of Unemployment Insurance 398Empirical Evidence: Moral Hazard Effects of Unemployment Insurance 400

Evidence for Moral Hazard in Dl 402

Evidence for Moral Hazard in WC 403Empirical Evidence: Moral Hazard Effects of Dl 404Empirical Evidence: Krueger's Study of Workers' Compensation 405

14.4 The Costs and Benefits of Social Insurance to Firms 406

The Effects of Partial Experience Rating in Ul on Layoffs 406The "Benefits" of Partial Experience Rating 408

Application: The "Cash Cow" of Partial Experience Rating 408Workers' Compensation and Firms 409

14.5 Implications for Program Reform 410

Benefits Generosity 410Targeting 410Experience Rating 411Worker Self-Insurance? 411

Application: Reforming Ul 412

14.6 Conclusion 413

Highlights 413



APPENDIX TO CHAPTER 14 Advanced Quasi-Experimental Analysis . .416

ICHAPTER 15 Health Insurance I: Health Economicsand Private Health Insurance 419

15 .1 An Overview of Health Care in the United States 421

How Health Insurance Works: The Basics 422Private Insurance 423Medicare 427Medicaid 427TRICARE/CHAMPVA 428The Uninsured 428

Empirical Evidence: Health Insurance and Mobility 430

15 .2 How Generous Should Insurance Be to Patients? 432

Consumption-Smoothing Benefits of Health Insurance for Patients 432Moral Hazard Costs of Health Insurance for Patients 433

Application: The Problem with McAllen, Texas 436

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How Elastic Is the Demand for Medical Care? The RAND HealthInsurance Experiment 438

Empirical Evidence: Estimating the Elasticity of Demand for Medical Care 439Optimal Health Insurance 440Why Is Insurance So Generous in the United States? 441

Application: Health Savings Accounts 442

1 5 . 3 How Generous Should Insurance Be to Medical Providers? . .445

Managed Care and Prospective Reimbursement 445The Impacts of Managed Care 447How Should Providers Be Reimbursed? 448


Highlights 449



CHAPTER 16 Health Insurance I I : Medicare, Medicaid,and Health Care Reform 453

1 6 . 1 The Medicaid Program for Low-incomeMothers and Children 455

How Medicaid Works 455Who Is Eligible for Medicaid? 456What Health Services Does Medicaid Cover? 456How Do Providers Get Paid? 457

1 6 . 2 What Are the Effects of the Medicaid Program? 457

How Does Medicaid Affect Health? A Framework 457

How Does Medicaid Affect Health? Evidence 458Empirical Evidence: Using State Medicaid Expansions to EstimateProgram Effects 461

1 6 . 3 The Medicare Program 462

How Medicare Works 462Application: The Medicare Prescription Drug Debate 463

1 6 . 4 What Are the Effects of the Medicare Program? 466

The Prospective Payment System 466

Empirical Evidence on the Move to the PPS 467Problems with PPS 467Lesson: The Difficulty of Partial Reform 469

Medicare Managed Care 469Should Medicare Move to a Full Choice Plan? Premium Support 472

Application: A Premium Support System for Medicare 472Gaps in Medicare Coverage 474

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16.5 Long-term Care 475

Financing Long-term Care 475

16.6 Lessons for Health Care Reform in the United States 476

Rising Health Care Costs 476

The Uninsured 478National Health Insurance 479

Application: The Massachusetts Experiment with IncrementalUniversalism 480 '"

Reform Efforts in 2009 482

16.7 Conclusion 484

Highlights 484



CHAPTER 17 Income Distribution and Welfare Programs 489

17 .1 Facts.on Income Distribution in the United States 491

Relative Income Inequality 491

Absolute Deprivation and Poverty Rates 492Application: Problems in Poverty Line Measurement 494

What Matters—Relative or Absolute Deprivation? 496

17.2 Welfare Policy in the United States 496

Cash Welfare Programs 497In-Kind Programs 498 ;

17.3 The Moral Hazard Costs of Welfare Policy 499

Moral Hazard Effects of a Means-Tested Transfer System 500

Solving Moral Hazard by Lowering the Benefit Reduction Rate 503

The "Iron Triangle" of Redistributive Programs 505

17.4 Reducing the Moral Hazard of Welfare 505

Moving to Categorical Welfare Payments 505Using "Ordeal Mechanisms" 508

Application: An Example of Ordeal Mechanisms 510Increasing Outside Options 511

Empirical Evidence: The Canadian Self-Sufficiency Project 513

17.5 Welfare Reform 517

Changes Due to Welfare Reform 517Effects of the 1996 Welfare Reform 517

Empirical Evidence: Estimating the Impact of Welfare Reform 518

XIX

PART I V

Taxation inTheory andPractice

17 .6 Conclusion 519

Highlights 520



CHAPTER 18 Taxation in the United Statesand Around the World 523

1 8 . 1 Types of Taxation 524

Taxes on Earnings 524

Taxes on Individual Income 525Taxes on Corporate Income 525Taxes on Wealth 525Taxes on Consumption 525Taxation Around the World 525

1 8 . 2 Structure of the Individual Income Taxin the United States 527

Computing the Tax Base 527Tax Rates and Taxes Paid 529

Application: The Coming AMT Timebomb 531

1 8 . 3 Measuring the Fairness of Tax Systems 532

Average and Marginal Tax Rates 532Vertical and Horizontal Equity 533Measuring Vertical Equity 534

Application: The Political Process of Measuring Tax Fairness 534

1 8 . 4 Defining the Income Tax Base 536

The Haig-Simons Comprehensive Income Definition 536

Deviations Due to Ability-to-Pay Considerations 537Deviations Due to Costs of Earning Income 538

Application: What Are Appropriate Business Deductions? 538

1 8 . 5 Externality/Public Goods Rationalesfor Deviating from Haig-Simons 539

Charitable Giving 540

Spending Crowd-Out Versus Tax Subsidy Crowd-In 540Consumer Sovereignty Versus Imperfect Information 542Housing 543

Empirical Evidence: The Social Benefits of Homeownership 545 •;..Tax Deductions Versus Tax Credits 546

Application: The Readability Debate 547Bottom Line: Tax Expenditures 549

xx

18.6 The Appropriate Unit of Taxation 550

The Problem of the "Marriage Tax" 550

Marriage Taxes in Practice 552

18.7 Conclusion 554

Highlights 554



CHAPTER 19 The Equity Implications of Taxation:Tax Incidence 557

19 .1 The Three Rules of Tax Incidence 559

The Statutory Burden of a Tax Does Not Describe Who ReallyBears the Tax 559The Side of the Market on Which the Tax Is Imposed Is Irrelevant to theDistribution of the Tax Burdens 561Parties with Inelastic Supply or Demand Bear Taxes;Parties with Elastic Supply or Demand Avoid Them 564Reminder: Tax Incidence Is About Prices, Not Quantities 567

19.2 Tax Incidence Extensions 568

Tax Incidence in Factor Markets 568

Tax Incidence in Imperfectly Competitive Markets 572

Balanced Budget Tax Incidence 574

19.3 General Equilibrium Tax Incidence 575

Effects of a Restaurant Tax: A General Equilibrium Example 575Issues to Consider in General Equilibrium Incidence Analysis 577

19.4 The Incidence of Taxation in the United States 580

CBO Incidence Assumptions 580Empirical Evidence: The Incidence of Excise Taxation 581

Results of CBO Incidence Analysis 581Current Versus Lifetime Income Incidence 584

19.5 Conclusion 584

Highlights 585



flPPENDIXTO CHfiPTER 19 The Mathematics of Tax Incidence . . . . 587

XXI

CHAPTER 20 Tax Inefficiencies and Their Implicationsfor Optimal Taxation 589

2 0 . 1 Taxation and Economic Efficiency 590

Graphical Approach 590

Elasticities Determine Tax Inefficiency 592Application: Tax Avoidance in Practice 593

Determinants of Deadweight Loss 594Deadweight Loss and-the Design of Efficient Tax Systems 595

Application: The Deadweight Loss of Taxing Wireless Communications 600

2 0 . 2 Optimal Commodity Taxation 601

Ramsey Taxation: The Theory of Optimal Commodity Taxation 601Inverse Elasticity Rule 602Equity Implications of the Ramsey Model 603

Application: Price Reform in Pakistan 603

2 0 . 3 Optimal Income Taxes 607

A Simple Example 607

General Model with Behavioral Effects 608An Example 610

2 0 . 4 Tax-benefit Linkages and the Financingof Social Insurance Programs 611

The Model 611Issues Raised by Tax-benefit Linkage Analysis 613

Empirical Evidence: A Group-Specific Employer Mandate 615


Highlights 616



APPENDIX TO CHRPTER 20 The Mathematics of Optimal Taxation . . .619

CHAPTER 21 Taxes on Labor Supply 623

2 1 . 1 Taxation and Labor Supply—Theory 625

Basic Theory 625Limitations of the Theory: Constraints on Hours Worked andOvertime Pay Rules 627

2 1 . 2 Taxation and Labor Supply—Evidence 628

Empirical Evidence: Estimating the Elasticity of Labor Supply 629Limitations of Existing Studies 630

xxii

21.3 Tax Policy to Promote Labor Supply:The Earned Income Tax Credit 631

Background on the EITC 631Impact of EITC on Labor Supply: Theory 633

Impact of EITC on Labor Supply: Evidence 634Empirical Evidence: The Effect of the EITC on Single Mother Labor Supply 636

Summary of the Evidence 637Application: EITC Reform 637

21.4 The Tax Treatment of Child Care andIts Impact on Labor Supply 639

The Tax Treatment of Child Care 639Empirical Evidence: The Effect of Child Care Costs on MaternalLabor Supply 640

Options for Resolving Tax Wedges 642Comparing the Options 643

21.5 Conclusion 643

Highlights 644



CHAPTER 22 Taxes on Savings 647

22.1 Taxation and Savings—Theory and Evidence 648

Traditional Theory 648Evidence: How Does the After-Tax Interest Rate Affect Savings? 653Inflation and the Taxation of Savings* 653

22.2 Alternative Models of Savings 655

Precautionary Savings Models 655Self-Control Models 656

Empirical Evidence: Social Insurance and Personal Savings 657

22.3 Tax Incentives for Retirement Savings 658

Available Tax Subsidies for Retirement Savings 659Why Do Tax Subsidies Raise the Return to Savings? 660Theoretical Effects of Tax-Subsidized Retirement Savings 662

Application: The Roth IRA 666Implications of Alternative Models 668Private vs. National Savings 669 ;

Empirical Evidence: Estimating the Impact of Tax Incentives for Savings on

Savings Behavior 670

Evidence on Tax Incentives and Savings 671

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Highlights 673



CHAPTER 23 Taxes on Risk Taking and Wealth 675

2 3 . 1 Taxation and Risk Taking 677

Basic Financial Investment Model 677Real-World Complications 678Evidence on Taxation and Risk Taking 680

Labor Investment Applications 680

2 3 . 2 Capital Gains Taxation 681

Current Tax Treatment of Capital Gains 681What Are the Arguments for Tax Preferences for Capital Gains? 683What Are the Arguments Against Tax Preferences for Capital Gains? 688

2 3 . 3 Transfer Taxation , 688

Why Tax Wealth? Arguments for the Estate Tax 690Arguments Against the Estate Tax 691

2 3 . 4 Property Taxation 694

Who Bears the Property Tax? 695Types of Property Taxation 696

Application: Property Tax Breaks to Businesses 696

2 3.5 Conclusion 698

Highlights 699



CHAPTER 24 Corporate Taxation 701

2 4 . 1 What Are Corporations and Why Do We Tax Them? 703

Ownership vs. Control 704

Application: Executive Compensation and the Agency Problem 705Firm Financing 707Why Do We Have a Corporate Tax? 708

24 .2 The Structure of the Corporate Tax 709

Revenues 709

Expenses 709

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Application: What Is Economic Depreciation? The Case of Personal Computers 711Corporate Tax Rate 712Investment Tax Credit 712

24.3 The Incidence of the Corporate Tax 713

24.4 The Consequences of the Corporate Tax for Investment . . .714

Theoretical Analysis of Corporate Tax and Investment Decisions 714

Negative Effective Tax Rates 719 s - - -Policy Implications of the Impact of the Corporate Tax on Investment 719

Application: The Impact of the 1981 and 1986 Tax Reforms on InvestmentIncentives 720

Evidence on Taxes and Investment 721

24.5 The Consequences of the CorporateTax for Financing 722

The Impact of Taxes on Financing 722Why Not All Debt? 723The Dividend Paradox 726How Should Dividends Be Taxed? 727

Application: The 2003 Dividend Tax Cut 728Corporate Tax Integration 729

24.6 Treatment of International Corporate Income 730

How to Tax International Income 730

Application: A Tax Holiday for Foreign Profits 731

24.7 Conclusion 734

Highlights 734

Questions and Problems . . . \ 735


CHAPTER 25 Fundamental Tax Reform 737

25.1 Why Fundamental Tax Reform? 738

Improving Tax Compliance 739Application: Tax Evasion 739Application: The 1997 IRS Hearings and Their Fallout for Tax Collection 742

Making the Tax Code Simpler 743 ;.

Improving Tax Efficiency 745Summary: The Benefits of Fundamental Tax Reform 748

25.2 The Politics and Economics of Tax Reform 748

Political Pressures for a Complicated Tax Code 749Economic Pressures Against Broadening the Tax Base 749

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Application: Grandfathering in Virginia 752The Conundrum 752

Application: TRA 86 and Tax Shelters 753

2 5 . 3 Consumption Taxation 754

Why Might Consumption Make a Better Tax Base? 754Why Might Consumption Be a Worse Tax Base? 757Designing a Consumption Tax 760Backing Into Consumption Taxation: Cash-Flow Taxation 762

2 5 . 4 The Flat Tax 763

Advantages of a Flat Tax 763

Problems with the Flat Tax 764Application: The 2005 Panel on Tax Reform 765


Highlights 767



Glossary G-1

References R-l

Name Index Nl-l

Subject Index SI-1

XXVI

PUBLC FINANCE AND PUBLIC POLICY - · PDF fileTHIRD EDITION PUBLC FINANCE AND PUBLIC POLICY...

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