Lectures on Public Economics: Updated Edition

by Anthony B. Atkinson, Joseph E. Stiglitz

Overview

The definitive textbook on public finance—now back in print for the first time in years

This classic introduction to public finance remains the best advanced-level textbook on the subject ever written. First published in 1980, Lectures on Public Economics still tops reading lists at many leading universities despite the fact that the book has been out of print for years. This new edition makes it readily available again to a new generation of students and practitioners in public economics.

The lectures presented here examine the behavioral responses of households and firms to tax changes. Topics include the effects of taxation on labor supply, savings, risk-taking, the firm, debt, and economic growth. The book then delves into normative questions such as the design of tax systems, optimal taxation, public sector pricing, and public goods, including local public goods.

Written by two of the world's preeminent economists, this edition of Lectures on Public Economics features a new introduction by Anthony Atkinson and Joseph Stiglitz that discusses the latest developments in the field and areas for future research.

• The definitive advanced-level textbook on public economics
• Examines the effects of taxation on households and firms
• Covers tax system design, optimal taxation, public sector pricing, and more
• Includes suggestions for further reading
• Additional resources available online

Product Details

ISBN-13:	9780691166414
Publisher:	Princeton University Press
Publication date:	05/26/2015
Edition description:	Updated edition with a New introduction by the authors
Pages:	568
Product dimensions:	7.30(w) x 10.20(h) x 1.70(d)

About the Author

Anthony B. Atkinson is Centennial Professor at the London School of Economics and an honorary fellow of Nuffield College, University of Oxford. His books include Public Economics in an Age of Austerity. Joseph E. Stiglitz is University Professor at Columbia University and winner of the Nobel Prize in economics. His books include The Price of Inequality: How Today's Divided Society Endangers Our Future.

Read an Excerpt

Lectures on Public Economics

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By Anthony B. Atkinson, Joseph E. Stiglitz

PRINCETON UNIVERSITY PRESS

Copyright © 2015 Princeton University Press
All rights reserved.
ISBN: 978-0-691-16641-4

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CHAPTER 1

LECTURE ONE

Introduction: Public Economics

1–1 Introduction

These Lectures are concerned with the economics of the public sector. We are all constantly affected by the economic decisions of the government. This is most noticeable in the taxes we pay. Income tax, sales taxes, local taxes, and social security contributions account for a substantial proportion of our income. Owners of capital are affected by taxes on corporate profits, inheritance taxes, and capital gains taxes. Almost all of us are at one time or another recipients of income from the government: for example, via social security programmes. A large proportion of workers are paid by the government or produce goods sold to the government. Many children go to schools supported by the government. We enjoy municipal parks, swimming pools, roads, and other publicly provided facilities. Many people are concerned about public policy towards the environment or about the conservation of natural resources.

In these Lectures we attempt to describe in a systematic manner the principal consequences of such economic activities by the government and their relation to social objectives. In Part One we examine the effects of various tax and expenditure policies. This "positive" section of the book is concerned with such questions as "Does income taxation discourage work effort or risk-taking?" or "What is the incidence of the corporation tax?" In contrast, in Part Two we present the "normative" theory of public finance, which is an attempt to postulate some simple criteria for government decision-making and to follow through their logical implications. Thus, it deals with such issues as the degree of progression for the income tax, the choice between direct and indirect taxation, the provision of public goods, and pricing rules for public enterprises.

In addressing these questions, we make no attempt to provide a comprehensive coverage. The choice of the title Lectures on ... is intended to dispel any impression that the book is an exhaustive account of public economics. The aim of the Lectures is to illustrate the current state of the art, to give some flavour of the strengths and weaknesses of recent developments, and to point to areas where future research is necessary.

The ways in which the book falls short of being comprehensive should be clear from the Table of Contents. Most seriously, no attempt is made to cover stabilization and macroeconomic policy. This is an essential element in any global view of the role of the government, and many issues are dominated by macroeconomic considerations. However, the economics of publishing have changed since the time when Musgrave could devote 210 pages of The Theory of Public Finance (1959) to stabilization policy, and there are many excellent treatments in the literature. Our emphasis is therefore on goals other than those of stabilization.

Even with this restriction, the coverage is selective. Some readers will no doubt be horrified or disappointed by the omissions, which include the international aspects of taxation, the economics of property rights, externalities in production, the fiscal problems of economic development, and the administration of taxes and benefits. We hope however they will feel that this selective treatment is justified by the greater depth in which we have been able to discuss the subjects covered. These include, on the taxation side, income and wealth taxes, levies on the transfer of wealth, corporation tax, and indirect taxes. The expenditure side covers the provision of goods and services by central and local governments, and—to a lesser extent—transfer payments. Other subjects included are the national debt and the policy of public enterprises/ utilities.

As will be clear from the Lecture titles, the book stresses those subjects in which there has been considerable recent research. This is particularly true of the incidence and design of taxation, which receives rather more emphasis than the expenditure side. The past decade has indeed seen a rapid expansion of the literature, most notably in econometric investigation of the effects of taxation and in theoretical analysis of the optimal design of tax policy.

Finally, we should emphasize the obvious fact that many areas are still unresearched. Despite the long tradition of public finance, and despite the recent influx into the field of economic theorists and econometricians, a great many important issues have yet to be discussed, let alone resolved.

1–2 Role of the Government

At the beginning of this Lecture we described some of the ways in which the government affects the typical individual. The state, however, has a much more basic role to play in that its first function is to establish and enforce the "rules of the economic game". We are concerned with modern mixed capitalist economies, such as the United States, Canada, Western Europe, and Japan, where these rules typically include the legal enforceability of contracts, provisions for bankruptcy, laws defining property rights, and liabilities. This basic framework has much to do with how the economy performs, and the other functions of government are very much affected by the kind of ground rules under which the private economy operates. It may indeed be argued that the tax and expenditure activities of the government are of minor significance in relation to its primary function "of preserving and stabilizing the property relations of the capitalist economy" (Gordon, 1972, p. 322). This is not a view we find totally convincing, and we consider that it is still valuable to analyse, as in these Lectures, the impact of fiscal instruments within a given economic system. At the same time, we recognize that it gives only a partial picture of the state's role in modern society, and we return to this below.

Even within the framework of a mixed capitalist economy, the government has a wide range of instruments at its disposal. These Lectures focus on taxation, public spending, and state participation in production (public enterprises/utilities); but in addition the government may make use of direct controls (e.g., rationing, central planning, zoning, licensing), regulation (e.g., of public utilities in the United States, of prices and wages in many countries), legislation controlling firms (e.g., antimonopoly, pollution, safety) or unions, and monetary and debt policy (and the regulation of monetary institutions). These are areas of state activity that are of actual, or potential, importance. What is more, they overlap considerably with the instruments studied here. Thus, in the case of air pollution caused by automobiles, a government may decide to set minimal standards to be followed in automobile manufacture. It could, however, choose to impose taxes related to the amount of pollution, or to subsidize research into the production of pollution-free automobiles. In the same way, monetary and fiscal policy are closely interrelated.

There may therefore be difficulties in drawing precise demarcation lines. The reader also needs to bear in mind that the effects of the instruments considered may depend on other aspects of government activity. The design of taxation or expenditure may rest critically on the availability of other policies. At the same time, the fiscal instruments on which we concentrate in these Lectures are used in a major way in most modern capitalist economies. (In the Note at the end of this Lecture we provide some background evidence on the importance of different instruments.)

Welfare Economics and Government Intervention

The standard justification of state intervention takes as its starting point the behaviour of the economy in the absence of the government, that is, in the hypothetical situation of a free market economy. From the basic theorems of welfare economics, if this economy is perfectly competitive and there is a full set of markets (conditions discussed in greater detail in Lecture 11), then, assuming that an equilibrium exists, it is Pareto-efficient; i.e., no one can be made better off without someone else being worse off. If it is assumed that social decisions should be based on individual welfare, and that individuals are likely to know better than the government what makes them happy, this creates a presumption that state intervention is not necessary on efficiency grounds. For some, this efficiency argument for decentralization understates the full value of the free market, since they value the right to choose in itself; others believe that there is a relationship between the form of economic organization and political control.

The proposition about the efficiency of competitive equilibrium is used as a reference point to explain the roles of government activity. The first of these is that Pareto efficiency does not ensure that the distribution that emerges from the competitive process is in accord with the prevailing concepts of equity (whatever these may be). One of the primary activities of the government is indeed redistribution. Ideally, this would be achieved through measures that did not destroy the efficiency properties, and much of welfare economics is based on the assumption that nondistortionary ("lump-sum") taxes and transfers can be carried out. For reasons discussed later, such instruments are not typically available in a sufficiently flexible form, and the government has to employ income and wealth taxes, social security benefits related to unemployment or wages, etc. This introduces a trade-off between equity and efficiency which is one of the themes of Part Two of the book.

Second, the economy may not be perfectly competitive. It is the expressed object of antitrust policy to ensure that firms do not collude or that individual firms do not obtain a sufficiently large share of any market that they can, by restricting their output, increase the price to consumers. But there are some cases where it would be inefficient to have a large number of competing firms. It is widely recognized that in many production processes there is an initial stage of increasing returns to scale. If the point of minimum average costs occurs at so high an output that a single firm would have a significant portion of the market, then, although it might be feasible to divide the firm up into competing units, this would increase costs. Notable examples of such "natural monopolies" are telephones and electricity. In the absence of government intervention, these industries would be likely to be controlled by a few firms, with consequent monopoly power. Accordingly, governments may control such industries directly (as in the United Kingdom) or regulate them (as in the United States).

One central set of economic activities in which the assumption of increasing returns to scale seems to be particularly important is research and development. There may be competition—in the sense of free entry—in these activities, yet a firm that discovers a new product or a new process has a significant effect on the market, even if only temporarily. There is not the perfect competition of the basic theorems of welfare economics, and the resource allocation generated by the market is not in general Pareto-efficient.

Even if the economy were competitive, it may not ensure a Pareto-efficient allocation of resources. The theorem requires that there be a full set of markets for all relevant dates in the future and for all risks. Typically, a full set of futures and insurance markets does not in fact exist. There may be partial substitutes, for example the stock market, but it can be shown that the allocation remains inefficient in many circumstances, and indeed opening additional markets may worsen the allocation (Newbery and Stiglitz, 1979). Similarly, the theorem presupposes perfect information, or that the information that is available is not affected by the actions of individuals. The analysis of markets with imperfect information has only recently begun, but it is already apparent that the welfare economics theorems need to be modified significantly (Stiglitz, 1980). The presence of imperfect information is likely to confer monopoly power. Where competition is maintained an equilibrium may not exist, and when it does exist it may not be Pareto-efficient.

Furthermore, the basic theorem requires that the full equilibrium should be attained. Yet, because of incomplete markets or imperfect information or other reasons, capitalist economies have frequently been characterized by under-utilization of resources (of a kind that creates a strong presumption of inefficiency). Most dramatic of these failures of the market economy are the fluctuations that periodically lead to substantial unemployment. It is now accepted as a responsibility of the government to ensure a low level of unemployment (although views as to what is acceptably "small" may change over time). More generally, the fact that the market economy can lead to such massive under-utilization of resources calls in question the appropriateness of the competitive equilibrium model. It is not obvious that—as some economists have suggested—once the problem of unemployment has been "solved", the classical model of the market economy, with its welfare implications, becomes applicable. It is more reasonable to suppose that the problem of unemployment is only the worst symptom of the failure of the market. There are indeed many other examples that suggest the limited applicability of the competitive equilibrium model: persistent shortage of particular skills, balance of payments disequilibria, regional problems, unanticipated inflation, etc.

Even if the economy is well described by the competitive equilibrium model, the outcome may not be efficient because of externalities. There are innumerable examples where the actions of an individual or firm affect others directly (not through the price system). Because economic agents take into account only the direct effects upon themselves, not the effect on others, the decisions they make are likely not to be "efficient". Air and water pollution are perhaps the most notable examples, and there has been much controversy about the appropriate method of handling these, e.g., regulation, taxes, or subsidies.

A particular category of commodities for which the market will not necessarily ensure the correct supply are public goods, of which defence and basic research are conventional examples. These have the characteristic that the consumption of these commodities by one individual need not detract from that available to others. (A more precise characterization is provided in Lecture 16.) Some of these goods are specific to particular locations (e.g., the transmission of radio or television), and are referred to as local public goods (see Lecture 17).

Finally, there are what Musgrave (1959) has called "merit wants". This is a category of goods where the state makes a judgement that certain goods are "good" or "bad", and attempts to encourage the former (e.g., education) and discourage the latter (e.g., alcohol). This is different from the arguments concerning externalities and public goods, in that with merit wants, the "public" judgement differs from the private evaluation, rejecting a purely individualistic view of society. This may lead to public spending on merit goods or taxes on "demerit" goods. The ethical basis of such judgements is a question of some dispute, and some writers have tried to bring such objectives within the framework of individualistic judgements, by extending the latter to include views about the nature of society. Thus, a person may have private interest in reducing the tax on tobacco, since cigarettes enter importantly in his private utility function, but recognize in his social judgements that a reduction in cigarette consumption would be desirable.

From this brief discussion, it should be clear that, even if we accept the basic theorem on the efficiency of the competitive economy as a valuable reference point, there remain important reasons for government intervention. These may be summarized under the following headings: (1) distribution, (2) failure of perfect competition, (3) absence of futures and insurance markets, (4) failure to attain full equilibrium, (5) externalities, (6) public goods, and (7) merit wants.

(Continues...)

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Table of Contents

Introduction xi

Preface xxvii

Introductory Note to the 1980 Edition xxix

Part 1 The Analysis of Policy

Lecture 1 Introduction: Public Economics 3

1-1 Introduction 3

1-2 Role of the Government 4

1-3 Guide to the Lectures 8

Note: The Public Sector?Statistical Background 12

Lecture 2 Household Decisions, Income Taxation, and Labour Supply 19

2-1 Introduction 19

2-2 Income Taxation and Labour Supply 26

2-3 Broader Models of Labour Supply 36

2-4 Empirical Evidence on Labour Supply 40

2-5 Concluding Comments 47

Note on the Expenditure Function 48

Reading 50

Lecture 3 Taxation, Savings, and Decisions over Time 51

3-1 Intertemporal Decisions and Taxation 51

3-2 The Basic Intertemporal Model 56

3-3 Developments of the Model and Alternative Views 66

3-4 Empirical Evidence-Taxation and the Interest Elasticity of Savings 74

3-5 Concluding Comments 77

Reading 78

Lecture 4 Taxation and Risk-Taking 79

4-1 Risk-Taking and Portfolio Allocation 79

4-2 Effects of Taxation 85

4-3 Special Provisions of the Tax System 91

4-4 Generalization of Results 96

4-5 Concluding Comments 102

Note on Risk Aversion 103

Reading 104

Lecture 5 Taxation and the Firm 105

5-1 Taxes and the Firm 105

5-2 Corporation Tax and the Cost of Capital 108

5-3 Taxation and Investment 117

5-4 A Wider View of Investment 123

5-5 Empirical Investigation of Taxation and Investment 127

5-6 Concluding Comments 130

Reading 131

Lecture 6 Tax Incidence: Simple Competitive Equilibrium Model 132

6-1 Introduction: Tax Incidence 132

6-2 Static Two-Sector Model 136

6-3 Incidence of Corporation Tax 142

6-4 General Tax Incidence 147

6-5 Incidence in a Two-Class Economy 155

6-6 Numerical Applications of the Model 159

6-7 Concluding Comments 163

Note on the Cost Function 164

Reading 165

Lecture 7 Tax Incidence: Departures from the Standard Model 166

7-1 Introduction 166

7-2 Market Imperfections 167

7-3 Monopolistic Competition 172

7-4 Structure of Production 180

7-5 Non-Market-Clearing 184

7-6 Concluding Comments 188

Reading 188

Lecture 8 Taxation and Debt in a Growing Economy 189

8-1 Introduction 189

8-2 An Aggregate Model of Equilibrium Growth 191

8-3 Growth and Taxation 197

8-4 Taxation in a Life-Cycle Model 202

8-5 Burden of the National Debt 208

8-6 Concluding Comments 214

Reading 215

Lecture 9 Distributional Effect of Taxation and Public Expenditure 216

9-1 Taxation, Spending, and Redistribution 216

9-2 Modelling the Distribution of Income 222

9-3 Distributional Incidence 231

9-4 Empirical Studies of the Redistribute Impact of the Government Budget 235

9-5 Concluding Comments 244

Reading 245

Lecture 10 Theories of the State and Public Economics 246

10-1 Introduction 246

10-2 Voting and Decisions 250

10-3 Administration and Bureaucracies 259

10-4 Power, Interest Groups, and Marxist Theories 263

10-5 Empirical Studies of Public Expenditure 268

Reading 274

Part 2 The Design of Policy

Lecture 11 Introduction to Part Two: Normative Analysis 277

11-1 Introduction 277

11-2 Normative Theories of the State 279

11-3 Pareto Efficiency and Welfare Economics 285

11-4 Standard Public Finance Objectives 291

11-5 Range of Government Instruments 296

Note on the Measurement of Income Inequality 302

Reading 303

Lecture 12 The Structure of Indirect Taxation 304

12-1 Introduction 304

12-2 The Ramsey Tax Problem 308

12-3 Application of the Ramsey Results 313

12-4 Partial Welfare Improvements and Tax Reform 318

12-5 Optimal Taxation in a Many-Person Economy 322

12-6 Concluding Comments 327

Reading 327

Lecture 13 The Structure of Income Taxation 328

13-1 Introduction 328

13-2 A Simple Model 331

13-3 Linear Income Tax 338

13-4 General Income Tax 343

13-5 Concluding Comments 352

Reading 353

Lecture 14 A More General Treatment of the Optimal Tax Problem 354

14-1 Introduction 354

14-2 Indirect Taxes and Linear Direct Taxation 357

14-3 Nonlinear Tax Schedules and Tax Exemptions 364

14-4 Taxation of Savings 370

14-5 Externalities in Consumption and Corrective Taxes 378

14-6 Concluding Comments 381

Reading 382

Lecture 15 Public Sector Pricing and Production 383

15-1 Introduction 383

15-2 Departures from Marginal Cost Pricing 386

15-3 Choice of Technique and Production Efficiency 394

15-4 Cost-Benefit Analysis and Social Rate of Discount 398

15-5 Concluding Comments 402

Reading 403

Lecture 16 Public Goods and Publicly Provided Private Goods 404

16-1 Introduction 404

16-2 Optimum Provision of Pure Public Goods?Efficiency 408

16-3 Optimum Provision of Pure Public Goods?Distribution 415

16-4 Publicly Provided Private Goods 417

16-5 Equilibrium Levels of Public Expenditure 424

16-6 Revelation of Preferences 430

Reading 434

Lecture 17 Local Public Goods 435

17-1 Introduction 435

17-2 Optimum Provision of Local Public Goods 437

17-3 Market Equilibria and Optimality: Identical Individuals 446

17-4 Market Equilibria and Optimality: Heterogeneous Individuals 452

17-5 Fiscal Federalism 461

Reading 465

Lecture 18 Public Economics: Theory and Policy 466

18-1 On the Sources of Disagreement in Policy Analysis 466

18-2 Thinking about Policy: Taxation 470

18-3 Thinking about Policy: Expenditures 476

18-4 Policy Reform and Political Economy 479

Bibliography 481

Author Index 509

Subject Index 513

What People are Saying About This

From the Publisher

"This classic volume by two of the pioneers of modern public economics remains an essential reference for students of the field. The key theoretical results discussed in this volume—a number of which were discovered by the authors themselves—have stood the test of time and continue to be taught in public economics courses around the world, including my own course at Harvard."—Raj Chetty, Harvard University

"Lectures on Public Economics remains the most comprehensive and deepest textbook on the subject. The discussions presented here offer very insightful views on the limits of tax theory analysis that cannot be found in pure research articles, and help guide students who want to carry out research of their own."—Emmanuel Saez, University of California, Berkeley

"There is no other general textbook on public economics that comes close to the achievement of Atkinson and Stiglitz. The organization of the book, its level of analysis, and the clarity of the exposition are just right for graduate and advanced undergraduate students."—Frank Cowell, London School of Economics

Editorial Reviews

"This classic volume by two of the pioneers of modern public economics remains an essential reference for students of the field. The key theoretical results discussed in this volume—a number of which were discovered by the authors themselves—have stood the test of time and continue to be taught in public economics courses around the world, including my own course at Harvard."—Raj Chetty, Harvard University


"Lectures on Public Economics remains the most comprehensive and deepest textbook on the subject. The discussions presented here offer very insightful views on the limits of tax theory analysis that cannot be found in pure research articles, and help guide students who want to carry out research of their own."—Emmanuel Saez, University of California, Berkeley


"There is no other general textbook on public economics that comes close to the achievement of Atkinson and Stiglitz. The organization of the book, its level of analysis, and the clarity of the exposition are just right for graduate and advanced undergraduate students."—Frank Cowell, London School of Economics

From the Publisher