A new edition of a comprehensive text, updated throughout, with new material on behavioral economics, international taxation, cost-benefit analysis, and the economics of climate policy.

Public economics studies how government taxing and spending activities affect the economy—economic efficiency and the distribution of income and wealth. This comprehensive text on public economics covers the core topics of market failure and taxation as well as recent developments in both policy and the academic literature. It is unique not only in its broad scope but in its balance between public finance and public choice and its combination of theory and relevant empirical evidence.

The book covers the theory and methodology of public economics; presents a historical and theoretical overview of the public sector; and discusses such topics as departures from efficiency (including imperfect competition and asymmetric information), issues in political economy, equity, taxation, fiscal federalism, and tax competition among independent jurisdictions. Suggestions for further reading, from classic papers to recent research, appear in each chapter, as do exercises. The mathematics has been kept to a minimum without sacrificing intellectual rigor; the book remains analytical rather than discursive. This second edition has been thoroughly updated throughout. It offers new chapters on behavioral economics, limits to redistribution, international taxation, cost-benefit analysis, and the economics of climate policy. Additional exercises have been added and many sections revised in response to advice from readers of the first edition.

About the Author

Jean Hindriks is Professor in the Economics Department and Codirector of the Center for Operations Research and Econometrics (CORE) at the Université Catholique de Louvain.

Gareth D. Myles is Head of Department and Professor of Economics at the University of Exeter and a Research Fellow at the Institute for Fiscal Studies. He is the author of Public Economics.

Preface to Second Edition xix Preface to First Edition xxi List of Figures xxiii I PUBLIC ECONOMICS AND ECONOMIC EFFICIENCY 1 An Introduction to Public Economics 3 1.1 Public Economics 3 1.2 Methods 3 1.3 Analyzing Policy 5 1.4 Preview 6 1.5 Scope 9 2 Equilibrium and Efficiency 13 2.1 Introduction 13 2.2 Economic Models 13 2.3 Competitive Economies 14 2.4 The Exchange Economy 15 2.5 Production and Exchange 22 2.6 Efficiency of Competition 26 2.6.1 Single Consumer 27 2.6.2 Pareto-Efficiency 31 2.6.3 Efficiency in an Exchange Economy 33 2.6.4 Extension to Production 37 2.7 Lump-Sum Taxation 39 2.8 Discussion of Assumptions 41 2.9 Summary 43 3 Behavioral Economics 51 3.1 Introduction 51 3.2 Behavioral Individuals 53 3.2.1 Simple Example: How Much to Save? 53 3.2.2 Present-Bias 54 3.2.3 The (β, δ) Model of Self-Control 55 3.2.4 Reference-Dependence Bias 57 3.2.5 The Gambler’s Fallacy 58 3.2.6 Confirmation Bias 59 3.2.7 Confidence Bias 60 3.2.8 Framing Bias 60 3.2.9 Conformism Bias 62 3.2.10 Identity and Social Norms 63 3.3 Behavioral Markets 64 3.3.1 Money Pump 65 3.3.2 Complementary Mistakes 65 3.3.3 Rationality Tug-of-War 67 3.4 Behavioral Policy 67 3.4.1 Internalities versus Externalities 68 3.4.2 Automatic Enrollment 69 3.4.3 The SMarT Plan 69 3.4.4 Complementarity 70 3.5 Behavioral Welfare 71 3.5.1 New Welfare Criterion 71 3.5.2 Choice-Based Welfare Analysis 72 3.5.3 Refinement and Structural Modeling 73 3.5.4 Application: Global Warming 74 3.6 Other-Regarding Preferences 76 3.6.1 Ultimatum Game 76 3.6.2 Social Preferences 77 3.6.3 Market Impact 78 3.7 Conclusions 80 II GOVERNMENT 4 Public Sector Statistics 89 4.1 Introduction 89 4.2 Historical Development 89 4.3 Composition of Expenditure 94 4.4 Revenue 97 4.5 Government Debt 107 4.6 Measuring the Government 112 4.7 Conclusions 114 5 Theories of the Public Sector 119 5.1 Introduction 119 5.2 Justification for the Public Sector 119 5.2.1 The Minimal State 119 5.2.2 Market versus Government 121 5.2.3 Equity 122 5.2.4 Efficiency and Equity 123 5.3 Public Sector Growth 123 5.3.1 Development Models 123 5.3.2 Wagner’s Law 124 5.3.3 Baumol’s Law 125 5.3.4 A Political Model 126 5.3.5 Ratchet Effect 128 5.4 Excessive Government 129 5.4.1 Bureaucracy 130 5.4.2 Budget-Setting 132 5.4.3 Monopoly Power 133 5.4.4 Corruption 134 5.4.5 Government Agency 135 5.4.6 Cost Diffusion 137 5.5 Conclusions 138 III DEPARTURES FROM EFFICIENCY 6 Public Goods 147 6.1 Introduction 147 6.2 Definitions 148 6.3 Private Provision 150 6.4 Efficient Provision 154 6.5 Voting 156 6.6 Personalized Prices 159 6.7 Mechanism Design 163 6.7.1 Examples of Preference Revelation 163 6.7.2 Clarke–Groves Mechanism 166 6.7.3 Clarke Tax 168 6.7.4 Further Comments 169 6.8 More on Private Provision 170 6.8.1 Neutrality and Population Size 170 6.8.2 Experimental Evidence 174 6.8.3 Modifications 176 6.9 Fund-Raising Campaigns 178 6.9.1 The Contribution Campaign 179 6.9.2 The Subscription Campaign 181 6.10 Conclusions 182 7 Club Goods and Local Public Goods 191 7.1 Introduction 191 7.2 Definitions 192 7.3 Single-Product Clubs 193 7.3.1 Fixed Utilization 194 7.3.2 Variable Utilization 196 7.3.3 Two-Part Tariff 197 7.4 Clubs and the Economy 199 7.4.1 Small Clubs 200 7.4.2 Large Clubs 200 7.4.3 Conclusion 207 7.5 Local Public Goods 208 7.6 The Tiebout Hypothesis 212 7.7 Empirical Tests 214 7.8 Conclusions 216 8 Externalities 223 8.1 Introduction 223 8.2 Externalities Defined 224 8.3 Market Inefficiency 225 8.4 Externality Examples 228 8.4.1 River Pollution 228 8.4.2 Traffic Jams 229 8.4.3 Pecuniary Externality 230 8.4.4 The Rat Race Problem 232 8.4.5 The Tragedy of the Commons 233 8.4.6 Bandwagon Effect 235 8.5 Pigouvian Taxation 236 8.6 Licenses 239 8.7 Internalization 241 8.8 The Coase Theorem 242 8.9 Nonconvexity 247 8.10 Conclusions 248 9 Imperfect Competition 255 9.1 Introduction 255 9.2 Concepts of Competition 256 9.3 Market Structure 257 9.3.1 Defining the Market 257 9.3.2 Measuring Competition 258 9.4 Welfare 260 9.4.1 Inefficiency 260 9.4.2 Incomplete Information 263 9.4.3 Measures of Welfare Loss 264 9.5 Tax Incidence 268 9.6 Specific and Ad valorem Taxation 274 9.7 Regulation of Monopoly 277 9.8 Regulation of Oligopoly 282 9.8.1 Detecting Collusion 282 9.8.2 Merger Policy 283 9.9 Unions and Taxation 285 9.10 Monopsony 286 9.11 Conclusions 288 10 Asymmetric Information 297 10.1 Introduction 297 10.2 Hidden Knowledge and Hidden Action 300 10.3 Actions or Knowledge? 301 10.4 Market Unraveling 302 10.4.1 Hazard Insurance 302 10.4.2 Government Intervention 305 10.5 Screening 307 10.5.1 Perfect Information Equilibrium 308 10.5.2 Imperfect Information Equilibrium 310 10.5.3 Government Intervention 313 10.6 Signaling 314 10.6.1 Educational Signaling 316 10.6.2 Implications 321 10.7 Moral Hazard (Hidden Action) 323 10.7.1 Moral Hazard in Insurance 323 10.7.2 Effort Observable 325 10.7.3 Effort Unobservable 326 10.7.4 Second-Best Contract 327 10.7.5 Government Intervention 329 10.8 Public Provision of Health Care 330 10.8.1 Efficiency 330 10.8.2 Redistributive Politics 332 10.9 Evidence 334 10.10 Conclusions 336 IV POLITICAL ECONOMY 11 Voting 345 11.1 Introduction 345 11.2 Stability 345 11.3 Impossibility 347 11.4 Majority Rule 350 11.4.1 May’s Theorem 350 11.4.2 Condorcet Winner 351 11.4.3 Median Voter Theorems 351 11.4.4 Multidimensional Voting 356 11.4.5 Agenda Manipulation 358 11.5 Alternatives to Majority Rule 361 11.5.1 Borda Voting 361 11.5.2 Plurality Voting 363 11.5.3 Approval Voting 363 11.5.4 Runoff Voting 364 11.6 The Paradox of Voting 365 11.7 The “Alabama” Paradox 371 11.8 Political Competition 372 11.8.1 Downsian Model 372 11.8.2 Policy Divergence 373 11.8.3 Multidimensional Competition 376 11.8.4 “Swing Voter” Politics 377 11.8.5 Citizen-Candidate Model 379 11.9 Conclusions 381 12 Rent-Seeking 387 12.1 Introduction 387 12.2 Definitions 388 12.3 Rent-Seeking Games 390 12.3.1 Deterministic Game 391 12.3.2 Probabilistic Game 394 12.3.3 Free-Entry 396 12.3.4 Risk Aversion 397 12.3.5 Conclusions 398 12.4 Social Cost of Monopoly 398 12.5 Equilibrium Effects 401 12.6 Government Policy 404 12.6.1 Lobbying 404 12.6.2 Rent Creation 406 12.6.3 Conclusions 408 12.7 Informative Lobbying 408 12.8 Controlling Rent-Seeking 413 12.9 Conclusions 414 V EQUITY AND DISTRIBUTION 13 Optimality and Comparability 423 13.1 Introduction 423 13.2 Social Optimality 424 13.3 Lump-Sum Taxes 427 13.4 Impossibility of Lump-Sum Taxes 430 13.5 Non–Tax Redistribution 434 13.6 Aspects of Pareto-Efficiency 436 13.7 Social Welfare Functions 440 13.8 Arrow’s Theorem 441 13.9 Interpersonal Comparability 443 13.10 Comparability and Social Welfare 446 13.11 Conclusions 450 14 Inequality and Poverty 457 14.1 Introduction 457 14.2 Measuring Income 458 14.3 Equivalence Scales 460 14.4 Inequality Measurement 466 14.4.1 The Setting 467 14.4.2 Statistical Measures 467 14.4.3 Inequality and Welfare 475 14.4.4 An Application 480 14.5 Poverty 481 14.5.1 Poverty and the Poverty Line 482 14.5.2 Poverty Measures 483 14.5.3 Two Applications 488 14.6 Unequal Opportunities 489 14.6.1 Defining Equality of Opportunity 490 14.6.2 Measuring Equality of Opportunity 491 14.6.3 Equal-Opportunity Policy 491 14.7 Intergenerational Inequality 492 14.7.1 Measuring Issues 492 14.7.2 Causal Mechanisms 493 14.8 Conclusions 496 VI TAXATION 15 Commodity Taxation 505 15.1 Introduction 505 15.2 Deadweight Loss 506 15.3 Optimal Taxation 509 15.4 Production Efficiency 513 15.5 Tax Rules 515 15.5.1 Inverse Elasticity Rule 516 15.5.2 Ramsey Rule 517 15.6 Equity Considerations 521 15.7 Applications 523 15.7.1 Reform 524 15.7.2 Optimality 526 15.8 Efficient Taxation 528 15.9 Public Sector Pricing 530 15.10 Conclusions 531 16 Income Taxation 537 16.1 Introduction 537 16.2 Equity and Efficiency 538 16.3 Taxation and Labor Supply 539 16.4 Empirical Evidence 544 16.5 Optimal Income Taxation 547 16.6 Two Specializations 555 16.6.1 Quasi-Linearity 555 16.6.2 Rawlsian Taxation 559 16.7 Numerical Results 561 16.8 Voting over a Flat Tax 563 16.9 Conclusions 565 17 Tax Evasion 575 17.1 Introduction 575 17.2 The Extent of Evasion 576 17.3 The Evasion Decision 578 17.4 Auditing and Punishment 585 17.5 Evidence on Evasion 588 17.6 Effect of Honesty 590 17.7 Tax Compliance Game 592 17.8 Behavioral Models 595 17.9 Compliance and Social Interaction 601 17.10 Conclusions 602 18 Limits to Redistribution 609 18.1 Introduction 609 18.2 Revelation Principle 611 18.3 The Tax Principle 616 18.4 Tax Mix: Separation Principle 622 18.5 Capital Income Tax 626 18.6 Non–Tax Redistribution 628 18.7 Conclusions 630 VII MULTIPLE JURISDICTIONS 19 Fiscal Federalism 637 19.1 Introduction 637 19.2 Arguments for Multi-level Government 638 19.2.1 Costs of Uniformity 639 19.2.2 Tiebout Hypothesis 641 19.2.3 Distributive Arguments 642 19.3 Optimal Structure: Efficiency versus Stability 642 19.4 Accountability 645 19.5 Risk-Sharing 648 19.5.1 Voluntary Risk-Sharing 648 19.5.2 Insurance versus Redistribution 651 19.6 Hard and Soft Budgets 652 19.7 Evidence on Decentralization 655 19.7.1 Decentralization around the World 655 19.7.2 Decentralization by Functions 657 19.7.3 Determinants of Decentralization 658 19.8 Conclusions 659 20 Fiscal Competition 667 20.1 Introduction 667 20.2 Tax Competition 667 20.2.1 Competitive Behavior 668 20.2.2 Strategic Behavior 669 20.2.3 Size Matters 675 20.2.4 Public input provision 676 20.2.5 Tax Overlap 676 20.2.6 Tax Exporting 679 20.2.7 Efficient Tax Competition 681 20.3 Income Distribution 683 20.3.1 Perfect Mobility 683 20.3.2 Imperfect Mobility 684 20.3.3 Race to the Bottom 687 20.4 Intergovernmental Transfers 688 20.4.1 Efficiency 688 20.4.2 Redistribution 691 20.4.3 Flypaper Effect 692 20.5 Evidence 693 20.5.1 Race to the Bottom 693 20.5.2 Race to the Top 695 20.5.3 Tax Mimicking 695 20.6 Conclusions 696 21 Issues in International Taxation 705 21.1 Introduction 705 21.2 International Efficiency 706 21.2.1 Efficient Allocations 707 21.2.2 Markets and Efficiency 708 21.2.3 Taxation and Efficiency 710 21.3 Capital and Corporations 711 21.3.1 Capital Taxes 711 21.3.2 Corporate Taxation 713 21.3.3 Formula Apportionment 717 21.3.4 Summary 719 21.4 Transfer Pricing 719 21.5 Location 722 21.5.1 Locational Choice 723 21.5.2 Agglomeration Rents 724 21.5.3 Evidence 725 21.6 Harmonization of Taxes 727 21.7 Tax Principles 731 21.8 Tariff Policy 734 21.8.1 Welfare Cost of Tariffs 735 21.9 Trade Agreements 738 21.10 Conclusions 743 VIII ISSUES OF TIME 22 Intertemporal Efficiency 753 22.1 Introduction 753 22.2 Overlapping Generations 755 22.2.1 Time and Generations 755 22.2.2 Consumers 756 22.2.3 Production 757 22.3 Equilibrium 760 22.3.1 Intertemporal Equilibrium 761 22.3.2 Steady State 761 22.4 Optimality and Efficiency 764 22.4.1 The Golden Rule 764 22.4.2 Pareto-Efficiency 767 22.5 Testing Efficiency 771 22.6 Conclusions 772 23 Social Security 777 23.1 Introduction 777 23.2 Types of System 778 23.3 The Pensions Crisis 780 23.4 The Simplest Program 783 23.5 Social Security and Production 785 23.6 Population Growth 789 23.7 Sustaining a Program 792 23.8 Ricardian Equivalence 796 23.9 Social Security Reform 799 23.10 Conclusions 804 24 Economic Growth 811 24.1 Introduction 811 24.2 Exogenous Growth 812 24.2.1 Constant Savings Rate 812 24.2.2 Optimal Taxation 819 24.3 Endogenous Growth 825 24.3.1 Models of Endogenous Growth 826 24.3.2 Government Expenditure 828 24.4 Policy Reform 831 24.5 Empirical Evidence 835 24.6 Conclusions 839 IX APPLICATIONS 25 Cost–Benefit Analysis 849 25.1 Introduction 849 25.2 What Is Cost–Benefit Analysis? 850 25.2.1 Simple Example 851 25.2.2 Broader Approach 852 25.3 The Process of CBA 853 25.3.1 Discounting Future Values 855 25.4 Principles of CBA 858 25.4.1 Common Unit of Measurement 858 25.4.2 Revealed Preferences 859 25.4.3 Valuing Market Goods: Marshallian Surplus 860 25.4.4 Valuing Non-market Goods: Hedonic Prices 861 25.4.5 Impact Assessment 862 25.4.6 Decision Criteria 863 25.4.7 Difficulties for CBA 864 25.5 Valuing Life 867 25.6 Valuing the Future 871 25.6.1 Intertemporal Arbitrage 872 25.6.2 The UK Green Book 875 25.6.3 Adjustment for Risk 877 25.7 Theoretical Foundations of CBA 878 25.7.1 Social Welfare Evaluation 879 25.7.2 Distributive Weights 884 25.7.3 Market Prices and Shadow Prices 885 25.8 Conclusions 899 26 Economics of Climate Policy 897 26.1 Introduction 897 26.2 Special Features 899 26.3 The Science of Global Warming 902 26.3.1 Greenhouse Gases and Temperatures 902 26.3.2 Controversies 906 26.3.3 Predictions 909 26.4 Integrating Economics and Climate 912 26.4.1 Sources of Damage 913 26.4.2 Modeling Economic Damage 914 26.4.3 Effects of Policy 917 26.5 Competing Generations 919 26.6 Ecological Discounting 926 26.7 Climate Policy in Practice 931 26.7.1 Pricing and Policies 931 26.7.2 The EU Emissions Trading Scheme 933 26.7.3 International Agreements 936 26.7.4 Prices or Quantities 939 26.7.5 Other Policies 941 26.8 Conclusions 942 Index 000