Fiscal Externalities and Efficient Transfers in a Federation

This paper investigates properties of the second best allocation in a fiscal federal system in which both federal tax and intergovernmental grants are involved and the taxation is distortionary. Also, optimal federal grants and tax policies in a decentralized fiscal system are examined. Our major findings are: (i) the second best does not require the equalization of marginal cost of public funds across regions in a conventional form; (ii) matching grants based on either the local tax rates or tax revenues should be introduced to internalize the tax externality; and (iii) once lump-sum and matching grants are optimized, federal tax policy becomes redundant so the optimal fiscal gap is indeterminate.     

Environmental Policy and Public Revenue with International Capital Mobility

In the presence of preexisting distortionary taxes, it is often argued that auctioned emission permits are preferable to non-auctioned permits, because the former generate revenues that may be used to reduce other taxes. This paper shows that when capital is internationally mobile, it may be optimal to use a combination of non-auctioned and auctioned emission permits, for both environmental and fiscal reasons. By letting the number of non-auctioned permits be a positive function of the amount of capital used domestically, they will attract capital to the home country. This may create environmental benefits in terms of reduced transboundary pollution and may lead to increased public revenue because the price of emission permits may increase and because the tax base may be enhanced. It is also shown that the optimal number of non-auctioned permits may increase as the marginal costs of public funds increase. JEL Code: D62, F21, Q28     

The effects of tax rate changes on tax bases and the marginal cost of public funds for Canadian provincial governments

The efficiency losses from taxation vary directly with the responsiveness of a government??s tax bases to tax-rate increases. We estimate the dynamic responses of tax bases to changes in tax rates using aggregate panel data from Canadian provinces over the period 1972 to 2006. Our preferred empirical results indicate that a one percentage point increase in corporate income, personal income, and sales tax rates is associated with a 3.67, 0.76, and 1.17 percent reduction in their respective tax bases in the short run. The corresponding long-run tax base semi-elasticity estimates are higher: ?13.60, ?3.63, and ?3.18, respectively. We use the tax base elasticity estimates to calculate the marginal cost of public funds (MCF) for the provinces?? three major taxes. Our computations indicate that the corporate income had the highest MCF and that the sales tax had the lowest MCF in all provinces in 2006. The MCF for the personal income tax ranged from 1.44 in Alberta to 3.81 in Quebec. Our results imply that there would have been significant welfare gains in 2006 from reductions in provincial corporate income tax rates. Our computations also indicate that the equalization grant formula may reduce the perceived MCF of the provinces that receive these grants, and that increases in provincial corporate and personal income taxes can cause significant reductions in federal tax revenues.     

The Marginal Cost of Funds and the Shadow Prices of Public Sector Inputs and Outputs

Existing studies on the marginal cost of funds (MCF) do not incorporate the public sector inputs explicitly. Incorporating labor and capital as public sector inputs raises questions concerning the definition and the usage of the MCF, and its relation to public sector shadow prices. This paper finds that the MCF should be defined based on the excess revenue rather than the gross revenue; that general equilibrium effects on individuals' net income and government's inframarginal expenditures should be incorporated; and that the MCF measures an element in the shadow price that is solely attributable to the marginal financing, justifying the role of the MCF in cost-benefit analysis and tax reform.     

The Costs of Restrictive Trade Policies in the Presence of Factor Tax Distortions

This paper uses a numerical general equilibrium model to examine the quantitative importance of pre-existing factor tax distortions for the welfare effects of tariffs and import quotas. The presence of pre-existing taxes can greatly raise the costs of these policies, possibly by over several hundred percent. For a tariff much of this extra cost can be offset if tariff revenues are used to reduce distortionary taxes. Hence there can be a large cost discrepancy between tariffs and quotas. The optimal tariff for a country with market power in trade can be reduced to zero, unless revenues finance cuts in distortionary taxes.     

Laffer effect, gross substitution, marginal cost of public funds and the level property of public good provision

This paper examines the Laffer effect in the Ramsey tax-model with linear consumption taxes and a representative consumer. It is assumed that the private goods and the public good are weakly separable. It is demonstrated that if all of the private goods are weak gross complements to each other, then the Laffer effect does not exist, in other words, higher tax rates can always achieve more tax revenue. In contrast, if all of the private goods are strict gross substitutes, then the Laffer effect does exist. Moreover, if all of the private goods are weak gross substitutes, then the government cannot fully acquire the leisure endowment through taxes on consumption goods. We also show that gross substitution works to raise the marginal cost of public funds.     

Environmental taxation and the double dividend: A reader's guide

There has been considerable debate as to whether the revenue-neutral substitution of environmental taxes for ordinary income taxes might offer a double dividend: not only (1) improve the environment but also (2) reduce certain costs of the tax system. This paper articulates different notions of double dividend and examines the theoretical and empirical evidence for each. It also connects the double-dividend issue with principles of optimal environmental taxation in a second-best setting.A weak double-dividend claim-that returning tax revenues through cuts in distortionary taxes leads to cost savings relative to the case where revenues are returned lump sum-is easily defended on theoretical grounds and (thankfully) receives wide support from numerical simulations. The stronger versions contend that revenueneutral swaps of environmental taxes for ordinary distortionary taxes involve zero or negative gross costs. Theoretical analyses and numerical results tend to cast doubt on the strong double-dividend claim, although the theoretical case is not air-tight and the numerical evidence is mixed.     

The Capital Tax and Welfare Effects from Asymmetric Information on Equity Markets

This paper explores the implications of informational asymmetries between domestic and foreign investors for optimal capital tax rates and welfare. It adopts a model in which asymmetric information implies a home bias in equity. The paper finds that asymmetric information may raise capital tax rates by reducing the marginal cost of taxation. Furthermore, it shows that investors may gain from informational asymmetries. Although asymmetric information increases the uncertainty as perceived by investors, it may also increase tax rates and allow for a higher consumption of public goods. This reflects that asymmetric information may reduce the distortionary effects of competition among governments.     

The optimal mix of taxes on money,consumption and income

We determine the optimal combination of taxes on money, consumption and income in transactions technology models where exogenous government expenditures must be financed with distortionary taxes. We show that the optimal policy does not tax money, regardless of whether the government can use as alternative fiscal instruments an income tax, a consumption tax, or the two taxes jointly. These results are at odds with recent literature. We argue that the reason for this divergence is an inappropriate specification of the transactions technology adopted in the literature.     

The Marginal Cost of Public Funds in Closed and Small Open Economies

The efficiency cost of taxation has become an increasingly important consideration in the evaluation of alternative tax policy options. This paper provides a review of estimates of the efficiency costs of taxation and presents some new estimates for small open economies. The available studies suggest that, in closed economies, the distortions from taxation are highest for corporate taxes and lowest for wage taxes. This efficiency ranking of different taxes does not hold in small open economies. It is shown that, in a small open economy, this ranking is reversed. Personal income taxes are less distortionary than wage taxes primarily because the link between domestic saving and investment is severed. Corporate taxes are also less distortionary for a variety of factors, such as changes in depreciation levels, payments to foreigners and terms of trade.     

Fiscal policy with banks and financial frictions

We assess the role of banks to the transmission of optimal and exogenous changes in fiscal policy to the economy. We built-up a dynamic stochastic general equilibrium model with patient and impatient agents, banks and a government to find that banks and their associated capital-adequacy constraint mitigate the negative spill-over effects to the economy from higher taxes. Specifically, we confirm that labour income tax is the most distortionary fiscal instrument. The optimal choice of a housing tax is the most favorable funding source to a temporary increase in public spending. The combination of housing and labour taxes is the most preferred tax bundle to be optimally chosen under negative output shocks. Moreover, a permanent increase in housing tax is beneficial if it is welfare enhancing and the existence of banks benefits mainly impatient households under permanently higher consumption taxes. Finally, these results remain robust to various robustness checks.     

Financing Public Goods with Income Taxation: Provision Rules vs. Provision Level

Due to the use of distortionary taxation, many believe that real-world economies should attain a lower level of public expenditures than in a situation where lump-sum taxes are available. The present paper examines this hypothesis by means of the two-type self-selection model of income taxation. Based on the findings of Boadway and Keen (1993), I provide sufficient conditions for both a lower and a higher level of public expenditures in second best than in first best. In particular, it is shown that the separability assumption of Christiansen (1981) leads to under-provision of the public good in the income tax optimum.     

Optimal redistributive tax and education policies in general equilibrium

This paper studies optimal linear and non-linear income taxes and education subsidies in two-type models with endogenous human capital formation, endogenous labor supply, and endogenous wage rates. Assuming constant human capital elasticities, human capital investment should be efficient under optimal linear policies, whether general equilibrium effects are present or not. Hence, education subsidies should not be used for distributional reasons. Due to general equilibrium effects, optimal linear income taxes may even become negative. Optimal non-linear policies exploit general equilibrium effects for redistribution. The high-skilled type optimally has a negative marginal income tax rate and a positive marginal education subsidy. The low-skilled type optimally faces a positive marginal income tax rate and a marginal tax on education. Simulations demonstrate that general equilibrium effects have only a modest effect on optimal non-linear policies.     

Should remittances be taxed or subsidized?

This paper analyzes the optimal nonlinear schedule of taxes and subsidies on remittances from emigrants. The analysis identifies conditions under which emigrants remitting small amounts of income face positive average and marginal subsidies on their remittances, whereas emigrants remitting relatively large amounts of income face positive marginal taxes. In this way, the tax system improves the distribution of income by indirectly taxing the “brain drain,” while simultaneously encouraging remittances that tend to go to low-income residents.     

An Investigation into Alternative Representations of the Marginal Cost of Public Funds

The literature on the marginal cost of public funds (MCF) and the marginal excess burden is presently a very rich one. A problem with this literature, is that several different measures are interpreted as MCF. This paper derives and compares some commonly used measures, and introduces an alternative. Performing a cross-comparison of the various measures seems to be a useful exercise in order to be able to distinguish between which measure is telling us what. Such a taxonomy might clarify the sense in which the different concepts should be used in future writings on this field.     

The stimulative effects of intergovernmental grants and the marginal cost of public funds

This paper tests the hypothesis that the stimulative effects of intergovernmental grants increase with the marginal cost of public funds of the recipient government. We present a simple theoretical framework that shows how a lump-sum transfer stimulates the marginal expenditures of a recipient government through an income effect and a price effect. We then test the prediction of this model using Canadian provincial data and exploit the discontinuity in the equalization grants allocation formula to identify the effects of grants. Our results indicate that the stimulative effects of lump-sum grants on spending increase with the provincial government’s marginal cost of public funds (MCF). One policy implication of our results is that higher intergovernmental transfers may be welfare improving if the federal government has a lower MCF than the provinces.     

A General Model of the Behavioral Response to Taxation

This paper generalizes the standard model of how taxes affect the labor-leisure choice by allowing individuals to change both their labor supply and avoidance effort in response to tax changes. Doing so reveals that the income and substitution effect of taxes depend on both preferences and the avoidance technology. Econometric analysis will not in general allow one to separately identify the two influences, unless one can specify observable determinants of the cost of avoidance. The effective marginal tax rate on working must be modified by the addition of an avoidance-facilitating effect, which measures how the cost of avoidance changes with higher income. This model provides a conceptual structure for evaluating to what extent, and in what situations, the opportunities for tax avoidance mitigate the real substitution response to taxation.     

On the irrelevance of government debt when taxes are distortionary

We consider a government that can only raise funds by levying distortionary taxes. We allow the government to collect taxes in a given period that are based on incomes earned in previous periods. We show that once we do so, given any debt path, the government can adjust its tax policy so as to attain that debt path without affecting equilibrium allocations or prices.     

A Second-Best Analysis of Environmental Subsidies

This paper examines the complications posed by pre-existing tax distortions in the economy, for the evaluation of a variety of subsidy policies that affect the environment. These complications include not only the efficiency cost of financing the subsidy by distortionary taxation, but also the interaction effects between the subsidized market and markets with pre-existing taxes. Studies that ignore both of these effects, or only incorporate the first type of effect, can be highly misleading.     

Optimal taxation and welfare benefits with monitoring of job search

In order to investigate the interaction between tax policy, welfare benefits, the government technology for monitoring and sanctioning inadequate search, workfare, and externalities from work, we incorporate endogenous job search and involuntary unemployment into a model of optimal nonlinear income taxation. In this setting, the government faces a trade-off between boosting employment of low-skilled agents and raising work effort of high-skilled workers. If sanctions for inadequate search effort can be targeted at high productivity types for whom it is socially optimal to search, the government can afford to levy higher labor taxes on marginal workers without discouraging these agents from seeking work. This allows for lower marginal taxes on work effort of agents with a job. In contrast to workfare, job externalities in the private sector raise marginal tax rates, as the government attaches more importance to boosting employment of low-skilled workers.