The Efficiency in the Public Finance Sector - Essay Example

Public Finance Assignment The growth of an economy and the prosperity and welfare of its citizens depend upon the existence of an efficient public sector and a tax system which is designed to yield the needed revenues in an equitable fashion. This can be fully explained by understanding efficiency and tax systems. The meaning of efficiency would be to allocate resources in such a way so that market does not fail. Therefore; we would consider two main types of efficiencies, the productive efficiency and the parreto efficiency. Productive efficiency occurs when the economy is getting maximum output from its resources, whereas, parreto efficiency occurs where it is impossible to make one better off without making at least one worse off. The efficiency in the public sector is distorted by market failures. Market failures are those situations where conditions necessary to achieve the market efficient solution fail to exist or are repudiated somehow. Some the examples of market failures include the existence of public goods and externalities, imperfect competition, incomplete information, uncertainty and many more. When market fails in the public sector, inefficiencies are at its peak and intervention from a vast external force is much needed, this is the part where government intervenes in the market. The intervention of the government involves the four branches known as the Musgrave’s 4 branches which are; allocation branch, distributional branch, stabilization branch and regulatory branch. First, the allocation branch is activated when one of the following four principles are violated; a lucid system of property rights, complete information to buyers and sellers, excludable principle and rivalry in consumption. So for commodities where property rights cannot be assigned to a single individual, these common property resources fail the market due to the problem called tragedy of the commons, as these goods are for free and individuals’ tend to over use them. This over usage of the goods would mean rapid deterioration of the goods and that less of the goods would be available to others. This is a violation of the principle of having a clear system of property rights. The allocation branch corrects this inefficiency by communally owning the property rights rather than rights being privately owned and this means for each resource government allocates the right to use that resource. In addition, inefficiency also arises from pure public goods that are non-excludable and non-rival in consumption. In the case of non-excludable you cannot exclude any individual from consuming it and in the case of non-rival the marginal cost of adding another person to consume the good is zero. A perfect example would be the national defence. Public goods are provided by the public sector through the budget. As these goods are non-excludable there is no incentive for a private profit maximizing producer to produce these goods, since the producer is unable to charge a price. In the case a price has to be paid to use a service, this will discourage use and excess capacity is likely to result, resulting in an inefficient parreto outcome. As a consequence of the parreto outcome, market fails to provide public goods resulting in inefficiency and therefore the government intervenes to re-allocate its resources to subcontract the production of the goods to private producer. This ensures competition, quality of the goods and much wanted production of public goods, resulting in an efficient market. Lastly, inefficiencies exist wherever there are externalities. This kind of inefficiency can be either positive or negative. Existence of a negative externality would result in an over-production of the good whereas; positive eternality would mean that under-production. The government intervenes through the allocation branch, adopting the Coase (1960) theorem by applying Pigovian approach. The Pigovian approach applies a Pigovian tax on negative externalities and Pigovian subsidy for positive externalities. The distributive role of the government is concerned with the distribution of income and welfare between individuals and households. In this case inefficiency here arises when the distribution is not in line of what the society considers to be socially just since each individual have their own taste and preferences. Alternative views of government objectives are the following; egalitarian which is a preference where you believe that everyone should be equal, libertarian which is a preference of maximizing your own utility and wanting minimal or no state intervention, utilitarian which is a preference where you want to maximize all individuals utilities and rawlsian which is a preference where you maximize the position of the least well off in the society. The government deals with this inefficiency by redistributing income and welfare by using progressive taxes to finance cash benefits, subsidies and publicly owned goods and services. The regulatory role of government is responsible for regulating certain unregulated market outcomes that cause uncertainty and inefficiency. These inefficiencies arise from monopolies, externalities, inadequate trading arrangements, nepotism of free market capitalism, unhealthy working conditions and many more. The government regulates these by introducing legislations, consumer protection acts and forming commissions. The stabilization role becomes active when market fails to produce a parreto efficient outcome, this occurs when economic activities are not coordinated resulting in a disequilibrium, which is in the following forms, underemployment of capital and labour, rising price level, imbalance on country’s trading account. Government uses fiscal and monetary policy instruments to restore the equilibrium; it can adjust interest rate, exchange rate, targeted money supply, and taxes to bring stability into the system. Though intervention is considered to be removing inefficiencies in the market, some intervention policies cause the government failure. This results to failure in the whole market. The public sector intervention fails to correct the market failure instead it increases it. These failures include; government intervention can result in changes that are very unpredictable and capricious. For example, rent subsidies by government can decrease the supply of private rented accommodation. Moreover, information failure occurs on the government side, as they do not know enough to make efficient decision about allocating its scarce resources. Furthermore, bureaucracy also causes government failure, since it is very expensive to administer and also government has to make sure that no agency problems exist, as this would mean bureaucrats not performing its objectives for economy welfare. In addition to this, implementing the policies requires complex systems and involves a lot of reconciliation, which can break down any time, causing catastrophic failures. Lastly, concerns have been raised on behaviour of politicians and bureaucrats, as they might act in the interests of lobby groups that invest resources in the interest of the politicians for a favour in return, that favour might be licencing laws, tariffs, and regulation in the interest of the specific lobbies rather than the total social welfare. There are the two basic theorems of welfare economics. The first is that competitive equilibrium is always parreto efficient and the other is that any desired parreto efficient allocation as a market-based equilibrium can be achieved using an appropriate lump-sum scheme. In theory these theorems are perfect but in the real world the assumptions for these theorems fail to hold causing an inefficient allocation and in-equilibrium in the market. The assumption for first theorem is absence of externalities and for the second theorem is perfect competition, increasing returns, private production and most importantly the ability to levy lump-sum taxes. We will see how public sector intervenes to restore the efficiency in the market. In the presence of externality, pigou (1920) prescribed that each individual should pay a tax reflecting the marginal damage he inflicts to other or receive a subsidy if he incurs a marginal benefit. This would ensure a parreto outcome though problems do exist in implementing Pigovian taxes as well, difficulties of measurement and administration arise resulting prevention of a full application of the tax policy. Additionally, the inability to levy lump-sum taxation gave way for other options such as commodity taxation and income taxation. Ramsey (1927) explained the commodity taxation; he maintained that commodities should be taxed in such a way so that for a consumer there should be minimal loss in utility arising from taxation. This way the government could easily raise revenue and consumer surplus also existed but the problem arrived when deadweight loss also know as excess burden of tax appeared causing inefficiency. For this Ramsey proposed that high levels of tax should only be applied to products having highly inelastic demand, though this does not finishes the deadweight loss, but it does decrease it to minute. This was argued on equity grounds, which mentions that tax should be applied to expensive goods that are for the rich and not products that are a need for everyone, as both are goods have highly inelastic demand curve. Here efficiency-equity trade-off exists, where it depends on the government if it prefers equity or efficiency. Furthermore, Diamond and Mirrlees further argued that to achieve productive efficiency all public sector entities should use the same prices in planning public sector investments using social cost-benefit analysis. This would introduce aggregate efficiency as public and private sector taken together, resulting in public sector efficiency. However, this would not be a feature of the optimum taxation, as commodities might have to be taxed depending on view of the decision taker on the distribution of income resulting from profits. Lastly, the absence of perfectly competitive market also implies inefficiency; this absence means existence of monopolies, oligopolies or price rigidities. This problem is dealt by the application of lump-sum tax principle on these sectors; efficiency would be achieved on taxing these as these earning abnormal profits by exploiting the market. According to Benjamin Franklin letter to Jean-Baptiste Leroy in 1789; in the world today nothing can be said to be certain, except death and taxes.” There are two types of tax systems; the benefit principle and ability-to-pay principle. The benefit principle states that a person would pay taxes according to the benefit that he receives, this means individuals are assumed to adjust their consumption until their marginal benefit equals marginal cost. However, there are problems with administrating a tax based upon the benefit principle, as it would be very difficult to measure benefits that the individual receiver, individuals would even lie about their benefits received if try to obtain the level of benefits received. Also, confusion arises since it is arduous to measure the distribution of benefits received from public services, as for example if poor receives more benefit meaning he has to pay more tax. The other approach is the ability to pay principle; this principle states that tax should be levied according to taxpayer’s ability to pay. This means that individuals paying taxes would show the sacrifice that they have to make when tax levied on them, individuals making same sacrifices would pay the same amount of tax. A tax system would be regarded as good and efficient if it is, economically efficient, administratively efficient, flexible, politically responsive, and fair. Economically efficient means that the tax system should not distort prices as this change in prices affect the allocation of resources at the end. This means that income tax would affect the hours of work that an individual supplies, resulting in leisure and savings. Being administratively efficient signifies that administrating of the tax system should be easy, it should be much complex, also the administrative and compliance costs should be very low, compliance costs include; time spent in filling tax forms and the records that the taxpayer need to show to the tax authorities, for a good tax system this should be as low as possible and easy to present as well. Furthermore, flexibility of a tax system shows how responsive is it when macro-economic conditions change, a good tax system should be very sensitive to these changes, as if a country going into recession, tax revenue fall resulting in average earning to fall, average tax rates have to fall and adjust as soon as it sees changes otherwise an economy can have an economic disaster in terms of a recession, taxes that respond quickly to changes in macro-economic conditions are referred to as automatic stabilizers. Moreover, the tax system should also be politically responsive; this means that when politicians make changes to the tax system, it should reflect the preferences of the majority and not the preferences of particular lobby groups upon which the elected party depends in times of elections. Lastly, the tax system should be fair; economists have divided fairness between horizontal equity and vertical equity. Horizontal equity means individuals who are identical, mostly in terms of income and wealth, will be treated equally when it comes to paying taxes, this means that the tax system does not discriminate between race, religion or gender. Whereas vertical equity considers individual with different economic positions to be treated differently, individuals with higher economic position to pay higher taxes, as they have higher ability to pay. The concepts of horizontal and vertical equity are refinements of the ability to pay principle. Another way of approaching fairness would be through benefit principle; people who consume more benefits have to pay higher taxes. Having all these conditions, a tax system is considered to be efficient and good. In addition to this, Adam Smith (1776) constituted a four maxims criterion for designing taxes. These were convenience of payment, equality, certainty and economy of collection. Equality in terms of taxations means that taxes should be in proportion to individual’s income. Furthermore, certainty certifies that taxes should be certain and clear, so that it does not come as a surprise to the individual in fact they should be able to plan and forecast their tax payments. Moreover, there should be high level of convenience to the taxpayer in terms of the time and the way; the tax authorities collect tax. Lastly, collection of taxes should be economical; the administration costs of collecting taxes should not be high, as this causes inefficiencies. Until now we have seen all the conditions for an efficient and good tax system, now we explain the problems that arise when designing an efficient and equitable tax system. The first problem is the costs associated with the taxes; these costs are divided into three categories administrative, compliance and distortion costs. Administrative costs are the costs of collection the taxation. High administrative costs would mean that the resources of the country are not being used efficiently and fewer resources would be available for other desired objectives. According to recent studies, cost of collecting taxes in developed is roughly around 1% and higher in developing countries. The compliance costs are the cost that the taxpayer incurs in order to comply with tax obligations, they also involve professional advice and consultancy costs. On the other hand, distortion costs also known as deadweight costs, arise when imposition of taxes alter prices, this means that individuals would base their decision on new prices that have been distorted by the taxes, this can result in an inefficient allocation of resources. So these high costs are a problem, when designing an efficient and equitable tax system. An additional problem that arises is the disincentive effect of taxation; this arises when individuals modify their behaviour after taxes, as they might work more in order to equalise their life style prior taxes, or they might reduce their consumptions, reduce their savings or also might increase their borrowing, some of the consequences will be beneficial, while others will imply a cost. This can be beneficial when goods like alcohol or cigarettes are taxed, as they are not healthy goods, so a tax would modify their behaviour and less consumption of these products. Additionally, when income is taxed, the individual will supply more hours of work, this is known as income effect. On the contrary, the individual might reduce his supply of work, as leisure seems more attractive than before. This is the disincentive effect of taxation and is know as substitution effect. This can go either way depending on the effect The graphical representations of efficiency in the private and public sector can be shown diagrammatically by comparing the efficiency and cost trade-offs in public and private firms. This clearly shows the difference in efficiency between private and public sectors. Additionally a representative of the allocative approach which has a big influence on efficiency can be explained by the graph below The positive and negative externalities and their influence represented below The income and substitution effect and its effect on efficiency is represented as shown below. References Blundell R. (2000): Work Incentives and “In Work” Benefits Reforms”; Oxford review of economic policy Vol 6 pp 27-44 Heady C. (1993): Optimal Taxation as a guide to policy; Fiscal Studies 14(1) pp15-41 Mirrless J. et al (2011): Dimensions of Tax design: The Mirrless review; Oxford press. Read More