Chapter 5: Efficiency CBA Part 2: Distortionary vs corrective taxation; Opportunity cost of public funds Flashcards
How do taxes and subsidies change economic behaviour?
A tax (subsidy) on a commodity reduces (increases) quantity traded in the market place
Distortive tax/subsidy
Moves the economy further away from MSB=MSC
- We usually assume taxes/subsidies to be distortionary
Corrective tax/subsidy
Designed to counter the negative effects on the efficiency of resource allocation resulting from missing/incomplete markets
A corrective tax (subsidy) is intended to discourage (encourage) an activity that is at too high (low) a level as a result of market forces
Does the efficiency CBA shadow pricing rule apply to both distortionary and corrective taxes/subsidies?
Only distortionary taxes or subsidies
If a corrective tax (subsidy) is at the efficient level…
It is equal to the marginal external cost (benefit)
Efficiency shadow pricing rule: corrective taxes/subsidies
OUTPUT:
- SUPPLY CURVE: - satisfies existing demand from alternative source; satisfies additional demand
INPUT:
- DEMAND CURVE: - sourced from alternative market use; sourced from additional supply
How can we tell whether an output (input) satisfies additional demand (represents additional supply) or replaces existing demand (is sourced from existing supply)?
In the absence of information to the contrary, assume additional demand/supply
How can we tell if a tax/subsidy is distortionary or corrective?
In the absence of information to the contrary, assume distortionary
Two reasons why the market rate of interest may not be a good indicator of efficiency price/opportunity cost of capital from a public sector/social viewpoint
- The social discount rate may be lower than the market rate of interest
- The marginal cost of public funds may exceed unity (i.e. $1 of public funds costs more than $1)
Why does the market discount future benefits and costs?
- Impatience: people value utility today more highly than utility tomorrow
- Diminishing marginal utility of consumption: people expect to be wealthier in the future. An extra $1 in the future will add less to utility than an extra $1 today
The observed market interest rate
Is the sum of the utility discount factor (reflecting impatience) and the utility growth factor (reflecting diminishing marginal utility of consumption)
Why do people argue that a social discount rate, lower than the market rate of interest, should be used?
We shouldn’t discount utility of future generations who are not able to participate in markets which determine levels of current investment, and hence future utility levels
What is the appropriate discount rate for public projects?
- Reasonable to employ a utility growth factor -> If future generations are going to be wealthier, we should take this into account
- Not reasonable to employ a utility discount factor -> we should not treat the utility of future generations as any less important than the present generation
Raising public funds to undertake public investment projects involve three types of costs
- Collection costs: cost of running the tax office
- Compliance costs: costs incurred by taxpayers
- Deadweight loss: costs of misallocation of resources as people respond to prices distorted by taxes
Why can compliance and collection costs be ignored?
- Largely fixed - they do not change when he amount of tax collected changes by a small amount
- Any given project will involve relatively small changes in the flow of public funds
