How much to tax and how to spend tax money?

How much should people be taxed and what should tax revenues be spent on? Surprisingly, these topics have mostly been treated in isolation in academic research. The literature on income redistribution through taxes and transfers disregards how tax revenue is spent. Likewise, the bulk of the public expenditure literature deals with what goods and services are publicly provided, independently of taxation. Finally, the size of the government is a highly debated topic.

Joan Esteban and Laura Mayoral provide an integrated analysis of the three dimensions of public finance in their Barcelona Graduate School of Economics Working Paper (No. 743) “A Politico-Economic Model of Public Expenditure and Income Taxation”. Their model determines the consensus income tax schedule, the composition of public expenditure, and the size of government.

Choosing between egalitarian or meritocratic redistribution

In the model, income is taxed and used to finance the goods and services provided by the government. The government can target the individual beneficiaries of its expenditure by choosing the weight given to different segments of the income ladder. The government can choose from allocations ranging from egalitarianism with uniform benefits across the population to an incentive motivated scheme, where public benefits are in accordance with the individual taxes paid. In other words, the government can choose any policy between everybody receiving the same or everybody receives as much as she contributes.

The substitutability between public and private goods

Individual attitudes towards taxation critically depends on the substitutability of public goods relative to the ones individuals can purchase in the market. For instance, when security is the monopoly of the state police, rich individuals with a high demand for security have to accept a well-funded government because there is no substitute in the market. Therefore, the substitutability between public and private goods and services is critical for the attitudes of the rich towards taxation.

The relationship between inequality and redistribution of tax revenues

The authors assume that, given the voted expenditure policy, the political actors look for a way to distribute the tax burden that minimizes controversy. Given any expenditure policy, they show that there exists a unique consensual tax function. Knowing that the tax will be adapted to make it consensual, the expenditure policy is chosen by majority voting. Therefore, the total tax revenue, and hence the size of the government, are determined together with the shape of the tax function. More egalitarian minded expenditure policies come at the cost of reducing the size of the government to make fiscal policy unanimously acceptable. The chosen egalitarian bias in the expenditure policy is proportional to the gap between taxes paid by the mean and median earners. This means that the more unequal a society, the more equal the redistribution of tax revenues.

How the substitutability between public and private goods can reduce taxation

The degree of substitutability between private and public goods is essential in the relationship between the egalitarian bias and taxation. If the two types of goods are substitutes, the rich will prefer to purchase privately, and thereby will reduce taxation. For example, if public health services are publicly provided equally to all, but are also available privately, then the rich will demand low taxation. On the other hand, if private health care is not available, then the rich will accept a high level of taxation, despite having to finance the public supply to the poor out of their own pockets. Therefore, the rich will lobby more strongly for increasing the substitutability between public and private goods by privatizing as many public services as possible rather than worrying about the shape of the income tax schedule.

Empirical evidence from the health care sector

Esteban and Mayoral empirically test the model predictions using a panel of 131 countries for the period 1981-2008, finding that the theoretical predictions of the model are borne out in the data. They find that indeed the marginal tax rate is increasing in inequality when the substitutability between private and public goods is low. However, for high substitutability they find the relation to be negative. For the size of the state, the marginal effect of inequality on the size of the state is found to be decreasing in the substitutability between private and public goods.

Privatization – A tale from reality

The authors emphasize the critical importance of the substitutability between the publicly and market supplied goods. The more services are privatized the more dispensable is the state, thereby reducing the willingness to pay taxes. Their findings provide an additional insight to the effects of the trend to privatize traditionally public services, such as health and education, in many countries. Developing a full political economy approach of privatizations is the next step on their research agenda.

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