updated 02 oct 2007 lecture notes econ 635 public economics lecture 1 n.
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Updated: 02 Oct 2007 Lecture Notes: ECON 635: PUBLIC ECONOMICS Lecture 1. Four Functions of Public Finance. Allocation Distribution Stabilization Growth. Allocation. An organized society requires the consumption of public goods and services that would be unprofitable to produce privately

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four functions of public finance
Four Functions of Public Finance
  • Allocation
  • Distribution
  • Stabilization
  • Growth
  • An organized society requires the consumption of public goods and services that would be unprofitable to produce privately
  • Public goods include:
    • Defense,
    • Law and order, justice
    • Infrastructure
    • Taxation is used to raise funds to pay for production of these goods and services
  • Very difficult to do in a short period of time
  • Redistributing wealth does not change individual incomes much.
  • Redistribution is impossible to do via the tax system alone.
  • Redistribution through expenditure system is much more promising.
  • Redistribution should be related to the role of governments in promoting growth.
redistribution cont d
Redistribution (cont’d)

Only through growth can people in developing countries be lifted out of economic backwardness

Public education, health services

Rural roads, rural telephone, electricity and public water supplies all ways that people can change their position in life overtime

Important to consider changing income distribution between generations



  • A short run objective
  • Outgrowth of the Keynesian revolution in economics.
  • The main objective to keep actual level of income close to its potential.
  • The target is full employment and price stability.
  • Inflation extremely damaging to poor and reduces the efficiency of market system.


  • Probably the most important objective when per capita incomes are low
  • Sources of Per Capita growth
    • Capital accumulation, Human capital (education, health), and Productivity change
  • Tools of taxation and public expenditure need to be focused on how to promote growth
  • Need policies that encourage investors to reinvest their business surpluses not take them out of country
  • Government budget surplus important for providing savings for private sector to borrow

Twelve Lessons of Economic Policy

  • Avoid false technicism in economic policymaking.
  • Keep budgets under adequate control.
  • Keep inflationary pressures under reasonable control.
  • Take advantage of international trade.
  • Recognize that some types and patterns of trade restrictions are far worse than others, and work both to liberalize and rationalize them. (For example, uniform tariff rates are not as damaging as import quotas)
  • If import restrictions are excessive, and reducing them is politically impossible, mount an indirect attack on the problem by increasing incentives to export.

Twelve Lessons of Economic Policy (Cont’d)

  • Make tax systems simple, easy to administer, and (as much as possible) neutral and non-distorting with respect to resource allocation.
  • Avoid excessive income tax rates 35 to 40% are representing a plausible marginal rate that should not be exceeded).
  • Avoid excessive use of tax incentives to achieve particular objectives.
  • Use price and wage controls sparingly, if at all.
  • Rarely can an economic justification be found for quotas, licenses, and similar quantitative restrictions on output, imports, exports, etc.

Twelve Lessons of Economic Policy (Cont’d)

  • The borderline of public-sector and private-sector activity should be clear and well-defined. When the two compete in a given area, the same rules should govern their operations.
five important innovations of tax policy
Five Important Innovations of Tax Policy
  • It is a possible to introduce more progressivity in a value added tax system, but that its benefits have to be weighted against significant extra vulnerability to evasion.
  • Significant differentiation among rates of import tariffs can lead to huge economic inefficiencies by giving vastly different degrees of effective protection to different activities.
  • Personal income tax rates above 35 to 40 percent are very hard to justify in light of their efficiency and incentive costs.
five important innovations of tax policy cont d
Five Important Innovations of Tax Policy (Cont’d)
  • Labor is likely to bear the burden of any unilateral rise in the rate of tax on the income of corporations (or businesses in general), once an open-economy setting is put in place.
  • It is much easier to index a tax system for inflation than people think. By its nature full indexation promotes both equity and efficiency.

Pattern of Tax Revenue Collection(Approximation)

(Source: Wagner's Law – State takes an expanding share of GNP as per capita incomes rise.)


What is the Appropriate Size of the Public Sector?

  • Rapid growth in size over the past 50 years
  • Two reasons:
    • Desire to increase rate of growth and industrialization
    • - growth in state owned enterprises.
    • - this trend is reversing
    • b. Growth in social program
    • - social security
    • - health expenditure
    • - unemployment insurance
    • - welfare programs
  • Need to think how these objectives and programs can be more effectively delivered. E.g. public-private partnerships.

What are the most frequent causes of Government Budget Crisis ?

  • Current expenditures on personnel explode ?
  • Investment expenditures have huge cost over runs ?
  • Crop failures ?
  • Exchange rate fluctuations ?
  • Rapid increase in military expenditures ?
  • A contingent liability comes due
    • e.g. Guarantee of bank deposits
    • Guarantee of exchange rate
    • Guarantee of state enterprise loans

Principles to Evaluate a Good Tax System

  • Revenue Adequacy
  • The taxes introduced should be sufficient to finance and fund the government expenditure requirements over time.
  • Tax revenues should increase at a rate equal to or greater than the growth of GNP.
  • The entire tax system should evolve as the economy changes.
  • Inadequate revenues will force the government to resort to borrowing, selling state assets or printing money (inflation).
  • Deficit financing by domestic borrowing leads to the crowding out of private sector credit given by commercial banks.
  • Deficit financing by foreign borrowing is limited and economically expensive.
  • Deficit financing by Central Bank borrowing leads to inflation.
  • High inflation usually leads to financial crises.
principles to evaluate a good tax system cont d
Principles to Evaluate a Good Tax System (Cont’d)


  • The stability of tax revenues is important for good government.
  • Revenue instability will cause new programs to be poorly implemented.
  • Stability in the tax rules and rates over time allows the private sector to make long term plans more efficiently.

For the stability of a tax system, it is necessary that:

  • the legislation be well written to eliminate unintended tax exemptions or deductions (loopholes)
  • the statutory rates of tax for each of the taxes are not so high as to create powerful incentives to promote tax avoidance schemes or to stimulate tax evasion activity
  • the tax revenue is adequate and grows in a consistent fashion
  • the tax system is simple and the combined cost of administration and compliance is low
principles to evaluate a good tax system cont d1
Principles to Evaluate a Good Tax System (Cont’d)


  • A Tax system should be simple so that it is easy to comply with by taxpayers.
  • Simplicity must apply to the administration of the law as well as its legal structure.
  • A complex tax system imposes high level of compliance costs on tax payers and a high cost of administration on the government.
  • Tax neutralityneeded for growth.
  • Growth comes about primarily through the expansion of savings and expansion of investment into high return activities.
  • The tax system should not create major distortions in consumption and production behavior.
  • A tax should not change the investment decisions by favoring one set of investments over the others.
  • The tax system should not create a disincentive to work.
  • Well-designed tax systems should encourage competitive growth in all sectors of the economy.
principles to evaluate a good tax system cont d2
Principles to Evaluate a Good Tax System (Cont’d)

Economic Efficiency

  • A tax is efficient if the dead weight loss or efficiency cost is small.
  • High differential tax rates create larger economic efficiency costs.
  • The economic efficiency of a tax is an important consideration when designing a tax system.
  • Estimates of efficiency cost range from 5 to 150 percent of additional tax revenues.

Low Administration and Compliance Costs

  • A good tax system has low administration and compliance costs. These costs are part of the economic cost of having a tax system.


  • Tax Systems Before and After Reforms
  • Design of a tax reform depends on the existing elements of the tax system
  • Considerable differences in the existing tax policies and economic systems of various countries
  • The legislative and administrative set-up also vary from country to country
  • For the former Socialist economies of Eastern Europe and the former Union of Soviet Socialist Republics a completely new tax system has had to be created

Tax Systems Before and After Reforms (Cont’d)

  • In many developing countries tax reforms need to concentrate only on redesigning the existing tax system.
  • Where reforms are extensive, their implementation could spread over a number of years.
  • Appropriate tax rules for the implementation is an important component required for the success of a tax reform.
  • A general understanding or consensus must be reached among concerned economists, lawyers, and legislators for successful legislation and implementation of these rules.

Implementation of Reforms

  • The actual implementation of a tax reform depends on the will of the political leaders and the capabilities of the tax administration of the country
  • Political leadership has a major role in legislation of acts and rules
  • Difficult to produce an integrated tax reform which has the support of all the interest groups.
  • Political leadership often seeks to influence the tax administration in order to favor special interest groups, and this destroys tax systems
  • The tax administration in a particular country may be slack and inactive
  • For effective implementation of tax reforms, a prime requisite is that reforms in the administrative setup keep pace with the changes in the tax system and in the way the tax clients operates.

Design of tax reform will also depend on the type of tax which is the object of reform

  • Main categories of taxes:
    • a) Direct Taxes
      • * personal income tax
      • * business or corporate tax
    • b) Indirect Taxes
      • * sales taxes (Value Added Tax)
      • * excise taxes
      • trade taxes
    • c) Property Taxes
      • * wealth tax
      • * estate and gift tax
      • * asset tax
    • d) User Charges
      • * users charges
      • * environmental taxes

Direct Taxes

A) Income Tax:


Direct Taxes (Cont’d)

B) Corporate Income Tax:


Reduction of top marginal income rates since 1984 (Number in parentheses indicates the number of tax brackets)


Reduction of top marginal income rates since 1984 (Number in parentheses indicates the number of tax brackets)


Indirect Taxes

A) Sales Tax:


Indirect Taxes (Cont’d)

B) Trade Taxes (Import Duties):

  • While in 1950 no country had a Value Added Tax, by 1993 more than 80 countries had adopted some form of VAT Tax
  • By 2001, over 120 countries have introduced VAT

Tax Reform Process in South Cyprus

  • Evolution of the tax system of South Cyprus 1990-2001 after it began preparations to enter into the European Union.
  • South Cyprus had a history of a very old fashion tax system that was badly in need of reform.
  • Tax system was full of exemptions and incentives
South Cyprus Fiscal Issues in 1990:

Public sector deficit – 5.3% of GDP

Individual Income tax – 3.9% of GDP

Corporation Income tax – 1.4% of GDP

Import duties – 3.4% of GDP

Selective excises – 0.0% of GDP

VAT – 0.0% of GDP

Other Indirect Taxes – 8.1% of GDP

South Cyprus 1991 began reform process with changes to income tax to reduce burden.
    • Introduced VAT in 1992 at a rate of 5%.
    • 1993 raised VAT rate to 8%
    • Income tax changes in 1996
    • 2000 raised VAT rate to 10%
    • 2002 raised VAT rate to 13%
    • Major reform of Income Tax System
    • 2003 will raise VAT rate to 15%
South Cyprus Fiscal Situation 2001:

Public sector deficit – 2.8% of GDP

Less distortionary tax system

Individual income tax – 4.4% of GDP

Corporate income tax – 3.9% of GDP

Import duties – 1.3% of GDP

Selective Excises – 3.0% of GDP

Value Added Taxes – 5.9% of GDP

Other indirect taxes – 2.1% of GDP

Revenue Buoyancies of South Cyprus Taxes, 1990-2002.

Total Taxes 1.59

Total Direct Taxes 1.77

Total Indirect Taxes 1.46

Individual Income Tax 1.07

Corporation Income Tax 3.46

Other Direct Taxes 1.32

Total Indirect Taxes 1.46

Import Duties -1.56

Selective Excises 1.25

Value Added Tax 3.72

Other Indirect Taxes -.93

South Cyprus 2001:

Per capita income – US$ 13,500

Real growth rate 1995-01 – 4.2%

Tourism makes up – 20% of GDP

Imports – 41.1% of GDP

Exports – 11.9 of GDP

Domestic Savings – 14.0% of GDP

Domestic Investment – 18.5% of GDP

Rate of inflation – 2.0 %

Unemployment rate – 3.0%

the challenge facing north cyprus
The Challenge Facing North Cyprus
  • Total Tax Revenues - 35 % of GDP
  • Total Expenditure - 63% of GDP
  • Deficit - 28% of GDP
  • Substantial Public Sector Budget Deficit

South Cyprus

North Cyprus




Wages & salaries



Capital Expenditure



Debt Service



Others (excluding social security and public pensions)



Total Expenditures



Total Revenue (Excluding SSC)



Cash Deficit