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The Development of Public Sector. Public Finance 5. Fiscal Neutrality and Economic Efficiency. Neutral Fiscal system that provides collective goods and services “efficiently”. Efficiency means that there is nothing provided by the government with which to compare in the market.

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fiscal neutrality and economic efficiency
Fiscal Neutrality and Economic Efficiency
  • Neutral Fiscal system that provides collective goods and services “efficiently”.
  • Efficiency means that there is nothing provided by the government with which to compare in the market.
  • Example: if no police services were provided by government , private people would change there behavior by hiring more private detective.
fiscal neutrality and economic efficiency3
Fiscal Neutrality and Economic Efficiency
  • If the fiscal system provide collective goods without any social purpose, the market analogy come to mined.
  • We may begin in this way to get better ideas of what is meant by “ efficiency”.
market efficiency
Market efficiency
  • We say a commodity is efficiently produced if the price reflect the marginal cost .
  • Example: a pair of shoes is priced at SR250 and marginal cost equal SR250, the consumer who purchase shoes is “directing” the economy to devote resources to shoes production which could, otherwise , be used to produce SR250 worth in alternative employment.
Should the price be SR300,we could say that the consumer is not confronted with “true” alternative.
  • The shoes are not provide “efficiently” unless the price SR250.
  • Marginal Rate of substitution among goods in consumption (MRSc) equal to Marginal Rate of substitution among goods in production (MRSp).
  • If this condition is not satisfy , it can be shown that that at least one person in the group can be made better off without any one else in the system being made worse off by some rearrangement.
The collective good is indivisible and therefore can not be priced.
  • The market analogy can’t be fully applied, if it could be , there would be no need for government.
  • Some method of financing such services or distributing the cost, this is the conceptual origin of the tax system.
  • The marginal rate of substitution among both private and collective goods in consumption are equal to the marginal rate of substitution among both private and collective.
  • For a single collective good , an “efficient” total quantity is provided when the aggregate marginal evaluation of that good by all citizen is equal to the marginal cost.
  • Two fisherman Moahammed and Ali
  • The decision they confronted is
  • whether to build fishing net (collective good) 10 feet long or 12 feet long.
  • The difference in the total cost of building the two net is 6 days labor.
  • Mohammed estimate the additional length (2feet) to be worth 4 days labor to him,
  • If Ali consider the larger net to be worth , as much as 2 days labor time, the “collectivity” should decide to build the net.
aggregative marginal condition individual marginal condition
Aggregative Marginal Condition & Individual Marginal Condition
  • With the provision of collective good , the first of these condition may be satisfied without the second.
  • If the combined marginal evaluation of added length exceeds 6 days the incremental should be made on aggregative efficiency ground
  • That is , regardless of the distribution of the “taxes” among them.
neutrality full neutrality
Neutrality & Full neutrality
  • Neutrality Is present in one sense , when aggregative marginal condition is met
  • Full neutrality is not present , until and unless each person has assigned to him a share in the cost that is equal to his own marginal evaluation.
fiscal neutrality a geometric analysis
Fiscal neutrality: A geometric Analysis
  • A two consumer model








Sum of ME=MC

wicksell s principle of taxation
Wicksell’s Principle of Taxation
  • To organize an efficient fiscal system
  • First: Tie each decision on public expenditure to a decision on the distribution of the tax burden.
  • Second: Majority rule to be replaced by some rule of relative unanimity (5/6)
second order efficiency
Second Order Efficiency
  • The fully “efficient” fiscal system serve as a norm When the system devoted to provision of collective good for allocation function exclusively. However, Societies have shown a willingness to sacrifice “efficiency” to employ the fisc for redistribution of income.
  • Taxes and spending are not related in decision making.
  • If an individual is faced with a tax bill that does not reflect his own marginal evaluation of the increment of public services being financed , this tax charge takes on the characteristics of a net withdrawal of real income.
second order efficiency13
Second Order Efficiency
  • The norm of “least price distortion” requires that the tax system be designed to minimize the welfare loss resulting from any inefficient choices caused by tax-induced changes in the structure of relative price.
  • The more general the tax , the less it will interfere with individual choice.
what implication arise from the principle of least price distortion
What implication arise from the principle of “least price distortion”
  • The Lump-sum tax: a tax levied upon the individual independently of his income.
  • The general proportionate income tax: The individual is attracted to consume more leisure than without tax.
  • The general sale tax: if levied on the whole range of commodities is to be preferred over the tax which concentrate on few commodities.
  • The lump-sum subsidy: Effect on the expenditure side are similar to those on the tax side.
the conception of general expenditure
The conception of general expenditure
  • The “least price distortion” has been applied to tax distribution , but not to the distribution of public expenditures.
equity and efficiency
Equity and Efficiency
  • Equal treatment for equal: has been applied to the distribution of taxes , but not to the distribution of expenditure.
  • It serve to prevent differential effect on separate group and individual.
  • The meaningfulness of the equity principle depends on the way in which “equals” are defined.