PUBLC FINANCE AND PUBLIC POLICY

THIRD EDITION

PUBLC FINANCE AND PUBLIC POLICY JONATHAN GRUBER Massachusetts Institute of Technology

Worth Publishers

Brief Contents Preface

xxvii

PART I Introduction and Background 1 Why Study Public Finance? 2 Theoretical Tools'of Public Finance 3 Empirical Tools of Public Finance 4 Budget Analysis and Deficit Financing PART I I Externalities and Public Goods 5 Externalities: Problems and Solutions 6 Externalities in Action: Environmental and Health Externalities 7 Public Goods 8 Cost-Benefit Analysis , 9 Political Economy 10 State and Local Government Expenditures 11 Education \

121 149 181 205 227 261 289

PART I I I Social Insurance and Redistribution 12 Social Insurance: The New Function of Government 13 Social Security 14 Unemployment Insurance, Disability Insurance, and Workers' Compensation 15 Health Insurance I: Health Economics and Private Health Insurance 16 Health Insurance II: Medicare, Medicaid, and Health Care Reform 17 Income Distribution and Welfare Programs

319 353 .389 419 453 .489

PART IV Taxation in Theory and Practice 18 Taxation in the United States and Around the World 19 The Equity Implications of Taxation: Tax Incidence 20 Tax Inefficiencies and Their Implications for Optimal Taxation 21 Taxes on Labor Supply 22 Taxes on Savings 23 Taxes on Risk Taking and Wealth 24 Corporate Taxation 25 Fundamental Tax Reform

523 557 589 623 647 675 701 737

Glossary

G-l

References Name Index Subject Index

vi

1 25 63 91

R-l NI-1 " . SI-1

Contents Preface

xxvii

CHAPTER 1 Why Study Public Finance? :

1

1.1 The Four Questions of Public Finance When Should the Government Intervene in the Economy? 3

3

Application: The Measles Epidemic of 1989-1991 5

H PA RT

I

Introduction and

Backnround

How Might the Government Intervene? 6 What Are the Effects of Alternative Interventions? 7 Application: The Congressional Budget Office: Government Scorekeepers 8 Why Do Governments Do What They Do? 9 1.2 Why Study Public Finance? Facts on Government i n the United States and Around the World 10 The Size and Growth of Government 10 Decentralization 12 Spending, Taxes, Deficits, and Debts 12 Distribution of Spending 13 Distribution of Revenue Sources 17 Regulatory Role of the Government 19 1 . 3 Why Study Public Finance Now? Policy Debates over Social Security, Health Care, and Education Social Security 20 Health Care 21 Education 21 \

20

1.4 Conclusion

22

Highlights

22

Questions and Problems

23

Advanced Questions

24

CHAPTER 2 Theoretical Tools of Public Finance

25

2 . 1 Constrained Utility Maximization Preferences and Indifference Curves 27 Utility Mapping of Preferences 29 Budget Constraints 31 Putting It All Together: Constrained Choice 33 The Effects of Price Changes: Substitution and Income Effects 35

26 :

VII

2 . 2 Putting the Tools to Work: TANF and Labor Supply Among Single Mothers Identifying the Budget Constraint 38 The Effect of TANF on the Budget Constraint 39 2.3

Equilibrium and Social Welfare

37

43

Demand Curves 44 Supply Curves 46 Equilibrium 48 Social Efficiency 49 Competitive Equilibrium Maximizes Social Efficiency 50 "" From Social Efficiency to Social Welfare: The Role of Equity 52 Choosing an Equity Criterion 54 2.4

Welfare Implications of Benefit Reductions:

The TANF Example Continued

55

2.5

57

Conclusion

Highlights

57


58

Advanced Questions

59

OPPENDIX TO CHflPTER 2 The Mathematics of Utility Maximization

CHAPTER 3 Empirical Tools of Public Finance 3 . 1 The Important Distinction Between Correlation and Causality

. .60

63 64

The Problem 65 3 . 2 Measuring Causation with Data We'd Like to Have: Randomized Trials

66

Randomized Trials as a Solution 67 The Problem of Bias 67 Randomized Trials of ERT 69 Randomized Trials in the TANF Context 69 Why We Need to Go Beyond Randomized Trials 70 3 . 3 Estimating Causation with Data We Actually Get: Observational Data Time Series Analysis 72 Cross-Sectional Regression Analysis 75 Quasi-Experiments 80 Structural Modeling 83 VIII

71

3.4 Conclusion

85

Highlights

85

....'.


85

Advanced Questions

86

RPPENDIXTO CHRPTER 3 Cross-Sectional Regression Analysis

88

CHAPTER 4 Budget Analysis and Deficit Financing

91

4.1 Government Budgeting

93

The Budget Deficit in Recent Years 93 The Budget Process 94 Application: Efforts to Control the Deficit 95 Budget Policies and Deficits at the State Level 97 4 . 2 Measuring the Budgetary Position of the Government: Alternative Approaches

98

Real vs. Nominal 98 The Standardized Deficit 99 Cash vs. Capital Accounting 100 Static vs. Dynamic Scoring 102 4 . 3 Do Current Debts and Deficits Mean Anything? A Long-Run Perspective

103

Background: Present Discounted Value 103 Why Current Labels May Be Meaningless 104 Alternative Measures of Long-Run Government Budgets 105 What Does the U.S. Government Do? 109 Application: The Financial Shenanigans of 2001 112 4 . 4 Why Do We Care About the Government's Fiscal Position? : Short-Run vs. Long-Run Effects of the Government on the Macroeconomy 113 Background: Savings and Economic Growth 114 The Federal Budget, Interest Rates, and Economic Growth 115 Intergenerational Equity 117

113

4.5 Conclusion

118

Highlights

119


119

Advanced Questions

120 IX

PART

II

Externalities and Public Goods

CHAPTER 5 Externalities: Problems and Solutions 5.1

121

Externality Theory

123

Economics of Negative Production Externalities 123 Negative Consumption Externalities 126 Application: The Externality of SUVs 127 Positive Externalities 128 5.2

Private-Sector Solutions to Negative Externalities

130

The Solution 130 The Problems with Coasian Solutions 132 5.3

Public-Sector Remedies for Externalities

134

Corrective Taxation 135 Subsidies 136 Regulation 137 5 . 4 Distinctions Between Price and Quantity Approaches to Addressing Externalities

137

Basic Model 137 Price Regulation (Taxes) vs. Quantity Regulation in This Model 139 Multiple Plants with Different Reduction Costs 140 Uncertainty About Costs of Reduction 143 5.5

Conclusion

146

Highlights

146


147

Advanced Questions

148

CHAPTER 6 Externalities in Action: Environmental and Health Externalities 149 6 . 1 Acid Rain

150

The Damage of Acid Rain 150 History of Acid Rain Regulation 151 Empirical Evidence: Estimating the Adverse Health Effects of Particulates 152 Has the Clean Air Act Been a Success? 154 6.2

Global Warming

Application: The Montreal Protocol 157 The Kyoto Treaty 158 Can Trading Make Kyoto More Cost-Effective? 158 What Does the Future Hold? 161 Application: Congress Takes on Global Warming 162

155

6.3 The Economics of Smoking . . . . *

165

The Externalities of Smoking 166 Should We Care Only About Externalities, or Do "Internalities" Matter Also? 170 6.4 The Economics of Other Addictive Behaviors Drinking 173 Illicit Drugs 174 Application: Public Policy Toward Obesity 174 Summary 177

173

- --

6.5 Conclusion

177

Highlights

178


178

Advanced Questions

179

CHAPTER 7 Public Goods 7 . 1 Optimal Provision of Public Goods

181 182

Optimal Provision of Private Goods 183 Optimal Provision of Public Goods 185 7.2 Private Provision of Public Goods

187

Private-Sector Underprovision 188 Application: The Free Rider Problem in Practice 189 Can Private Providers Overcome the Free Rider Problem? 190 Application: Business Improvement Districts 190 When Is Private Provision Likely to Overcome the Free Rider Problem? 192 7.3 Public Provision of Public Goods

194

Private Responses to Public Provision: The Problem of Crowd-Out 195 Measuring the Costs and Benefits of Public Goods 197 How Can We Measure Preferences for the Public Good? 197 Empirical Evidence: Measuring Crowd-Out 198

7.4 Conclusion

199

Highlights

200


200

Advanced Questions

201

flPPENDIX TO CHfiPTER 7 The Mathematics of Public Goods Provision

202

XI

CHAPTER 8 Cost-Benefit Analysis 8.1

Measuring the Costs of Public Projects

205 206

The Example 207 Measuring Current Costs 208 Measuring Future Costs 209 8.2

Measuring the Benefits of Public Projects

210

Valuing Driving Time Saved 210 Application: The Problems of Contingent Valuation 213 Empirical Evidence: Valuing Time Savings 214 Valuing Saved Lives 215 Application: Valuing Life 215 Discounting Future Benefits 220 Cost-Effectiveness Analysis 220 8.3

Putting I t All Together

221

Other Issues in Cost-Benefit Analysis 221 8.4

Conclusion

223

Highlights

223


224

Advanced Questions

225

CHAPTER 9 Political Economy 9 . 1 Unanimous Consent on Public Goods Levels

227 229

Lindahl Pricing 229 Problems with Lindahl Pricing 231 9.2

Mechanisms for Aggregating Individual Preferences

232

Application: Direct Democracy in the United States 232 Majority Voting: When It Works 234 Majority Voting: When It Doesn't Work 236 Arrow's Impossibility Theorem 237 Restricting Preferences to Solve the Impossibility Problem 237 Median Voter Theory 239 The Potential Inefficiency of the Median Voter Outcome 239 Summary 240 9.3

Representative Democracy

Vote-Maximizing Politicians Represent the Median Voter 241 Assumptions of the Median Voter Model 242 Lobbying 244 Application: Farm Policy in the United States 245 Evidence on the Median Voter Model for Representative Democracy 247 Empirical Evidence: Testing the Median Voter Model 248 xii

241

9 . 4 Public Choice Theory: The Foundations of Government Failure

249

Size-Maximizing Bureaucracy 249 Problems with Privatization 250 Application: Contracting Out with Non-Competitive Bidding 251 Leviathan Theory 253 Corruption 254 Application: Government Corruption 254 Empirical Evidence: Government Failures and Economic Growth 257 The Implications of Government Failure 258 9 . 5 Conclusion

258

Highlights

258


259

Advanced Questions

260

CHAPTER 10 State and Local Government Expenditures . . .

261

1 0 . 1 Fiscal Federalism in the United States and Abroad

263

Spending and Revenue of State and Local Governments 264 Fiscal Federalism Abroad 265 1 0 . 2 Optimal Fiscal Federalism

267

The Tiebout Model 267 Problems with the Tiebout Model 269 Evidence on the Tiebout Model 271 Optimal Fiscal Federalism 273 Empirical Evidence: Evidence for Capitalization from California's Proposition 13 274 i | I [ i | t

1 0 . 3 Redistribution Across Communities

275

Should We Care? 276 Tools of Redistribution: Grants 277 Redistribution in Action: School Finance Equalization 282 Empirical Evidence: The Flypaper Effect 283 Application: School Finance Equalization and Property Tax Limitations in California 285

I |

10.4 Conclusion Highlights Questions and Problems Advanced Questions

285 .286 286 287

xiii

CHAPTER 11 Education 1 1 . 1 Why Should the Government Be Involved in Education?

289 292

Productivity 292 Citizenship 293 Credit Market Failures 293 Failure to Maximize Family Utility 293 Redistribution 294 11.2

How Is the Government Involved in Education?

294

Free Public Education and Crowding Out 295 Solving the Crowd-Out Problem: Vouchers 297 Problems with Educational Vouchers 300 1 1 . 3 Evidence on Competition in Education Markets

304

Direct Experience with Vouchers 304 Experience with Public School Choice 304 Empirical Evidence: Estimating the Effects of Voucher Programs 305 Experience with Public School Incentives 306 Bottom Line on Vouchers and School Choice 307 11.4

Measuring the Returns to Education

307

Effects of Education Levels on Productivity 308 Effect of Education Levels on Other Outcomes 309 Empirical Evidence: Estimating the Return to Education and Evidence for Screening 310 The Impact of School Quality 310 1 1 . 5 The Role of the Government in Higher Education

311

Empirical Evidence: Estimating the Effects of School Quality 312 Current Government Role 313 What Is the Market Failure and How Should It Be Addressed? 314

H PART

III

Social Insurance and Redistribution

XIV

1 1 . 6 Conclusion

315

Highlights

316


316

Advanced Questions

317

CHAPTER 12 Social Insurance: The New Function of Government

319

1 2 . 1 What Is Insurance and Why Do Individuals Value It? . . . > .321 What Is Insurance? 321 Why Do Individuals Value Insurance? 322 Formalizing This Intuition: Expected Utility Model 323

1 2 . 2 Why Have Social Insurance? Asymmetric Information and Adverse Selection

326

Asymmetric Information 326 Example with Full Information 327 Example with Asymmetric Information 327 The Problem of Adverse Selection 329 Does Asymmetric Information Necessarily Lead to Market Failure? 330 Application: Adverse Selection and Health Insurance "Death Spirals" 331 How Does the Government Address Adverse Selection? 332-' 1 2 . 3 Other Reasons for Government Intervention in Insurance Markets

333

Externalities 333 Administrative Costs 333 Redistribution 334 Paternalism 334 Application: Flood Insurance and the Samaritan's Dilemma 334 12.4 Social Insurance vs. Self-Insurance: How Much Consumption Smoothing?

337

Example: Unemployment Insurance 337 Lessons for Consumption-Smoothing Role of Social Insurance 341 1 2 . 5 The Problem with Insurance: Moral Hazard

342

Application: The Problems with Assessing Workers' Compensation Injuries 343 What Determines Moral Hazard? 344 Moral Hazard Is Multidimensional 344 The Consequences of Moral Hazard 345 1 2 . 6 Putting I t All Together: Optimal Social Insurance

346

1 2 . 7 Conclusion

346

Highlights

347


347

Advanced Questions

348

APPENDIX TO CHAPTER 12 Mathematical Models of Expected Utility

350

CHAPTER 13 Social Security 1 3 . 1 What Is Social Security and How Does I t Work?

353 354

Program Details 355 Application: Why Choose 35 Years? 355

xv

How Does Social Security Work Over Time? 359 Application: Ida May Fuller 360 How Does Social Security Redistribute in Practice? 362 1 3 . 2 Consumption-Smoothing Benefits of Social Security

364

Rationales for Social Security 364 Does Social Security Smooth Consumption? 365 Social Security and Private Savings 366 Living Standards of the Elderly 366 1 3 . 3 Social Security and Retirement Theory 367 Empirical Evidence: Measuring the Crowd-Out Effect of Social Security on Savings 368 Evidence 369 Application: Implicit Social Security Taxes and Retirement Behavior 372 Implications 374

367

1 3 . 4 Social Security Reform

374

Reform Round I: The Greenspan Commission 375 Application: The Social Security Trust Fund and National Savings 376 Incremental Reforms 377 Fundamental Reforms 379 Application: Company Stock in 401(k) Plans 383 Application: Mixed Proposals for Social Security Reform 384 1 3 . 5 Conclusion

385

Highlights

385


386

Advanced Questions

387

CHAPTER 14 Unemployment Insurance, Disability Insurance, and Workers' Compensation 1 4 . 1 Institutional Features of Unemployment Insurance, Disability Insurance, and Workers' Compensation

389

391

Institutional Features of Unemployment Insurance 391 Institutional Features of Disability Insurance 393 Institutional Features of Workers' Compensation 394 Comparison of the Features of Ul, Dl, and WC 395 Application: The Duration of Social Insurance Benefits Around the World 396 1 4 . 2 Consumption-Smoothing Benefits of Social Insurance Programs

xvi

397

1 4 . 3 Moral Hazard Effects of Social Insurance Programs

398

Moral Hazard Effects of Unemployment Insurance 398 Empirical Evidence: Moral Hazard Effects of Unemployment Insurance 400 Evidence for Moral Hazard in Dl 402 Evidence for Moral Hazard in WC 403 Empirical Evidence: Moral Hazard Effects of Dl 404 Empirical Evidence: Krueger's Study of Workers' Compensation 405 1 4 . 4 The Costs and Benefits of Social Insurance to Firms

406

The Effects of Partial Experience Rating in Ul on Layoffs 406 The "Benefits" of Partial Experience Rating 408 Application: The "Cash Cow" of Partial Experience Rating 408 Workers' Compensation and Firms 409 1 4 . 5 Implications for Program Reform

410

Benefits Generosity 410 Targeting 410 Experience Rating 411 Worker Self-Insurance? 411 Application: Reforming Ul 412 1 4 . 6 Conclusion

413

Highlights

413


414

Advanced Questions

414

APPENDIX TO CHAPTER 14 Advanced Quasi-Experimental Analysis . .416

I CHAPTER 15 Health Insurance I: Health Economics and Private Health Insurance

419

1 5 . 1 An Overview of Health Care in the United States

421

How Health Insurance Works: The Basics 422 Private Insurance 423 Medicare 427 Medicaid 427 TRICARE/CHAMPVA 428 The Uninsured 428 Empirical Evidence: Health Insurance and Mobility 430 1 5 . 2 How Generous Should Insurance Be to Patients?

432

Consumption-Smoothing Benefits of Health Insurance for Patients 432 Moral Hazard Costs of Health Insurance for Patients 433 Application: The Problem with McAllen, Texas 436 XVII

How Elastic Is the Demand for Medical Care? The RAND Health Insurance Experiment 438 Empirical Evidence: Estimating the Elasticity of Demand for Medical Care 439 Optimal Health Insurance 440 Why Is Insurance So Generous in the United States? 441 Application: Health Savings Accounts 442 1 5 . 3 How Generous Should Insurance Be to Medical Providers? . .445 Managed Care and Prospective Reimbursement 445 The Impacts of Managed Care 447 How Should Providers Be Reimbursed? 448 1 5 . 4 Conclusion

448

Highlights

449


449

Advanced Questions

450

CHAPTER 16 Health Insurance I I : Medicare, Medicaid, and Health Care Reform

453

1 6 . 1 The Medicaid Program for Low-income Mothers and Children

455

How Medicaid Works 455 Who Is Eligible for Medicaid? 456 What Health Services Does Medicaid Cover? 456 How Do Providers Get Paid? 457 1 6 . 2 What Are the Effects of the Medicaid Program?

457

How Does Medicaid Affect Health? A Framework 457 How Does Medicaid Affect Health? Evidence 458 Empirical Evidence: Using State Medicaid Expansions to Estimate Program Effects 461 1 6 . 3 The Medicare Program

462

How Medicare Works 462 Application: The Medicare Prescription Drug Debate 463 1 6 . 4 What Are the Effects of the Medicare Program? The Prospective Payment System 466 Empirical Evidence on the Move to the PPS 467 Problems with PPS 467 Lesson: The Difficulty of Partial Reform 469 Medicare Managed Care 469 Should Medicare Move to a Full Choice Plan? Premium Support 472 Application: A Premium Support System for Medicare 472 Gaps in Medicare Coverage 474 XVIII

466

1 6 . 5 Long-term Care

475

Financing Long-term Care 475 1 6 . 6 Lessons for Health Care Reform in the United States

476

Rising Health Care Costs 476 The Uninsured 478 National Health Insurance 479 Application: The Massachusetts Experiment with Incremental Universalism 480 '" Reform Efforts in 2009 482 1 6 . 7 Conclusion

484

Highlights

484


485

Advanced Questions

486

CHAPTER 17 Income Distribution and Welfare Programs 1 7 . 1 Facts.on Income Distribution in the United States

489 491

Relative Income Inequality 491 Absolute Deprivation and Poverty Rates 492 Application: Problems in Poverty Line Measurement 494 What Matters—Relative or Absolute Deprivation? 496 1 7 . 2 Welfare Policy in the United States Cash Welfare Programs 497 In-Kind Programs 498

496

;

1 7 . 3 The Moral Hazard Costs of Welfare Policy

499

Moral Hazard Effects of a Means-Tested Transfer System 500 Solving Moral Hazard by Lowering the Benefit Reduction Rate 503 The "Iron Triangle" of Redistributive Programs 505 1 7 . 4 Reducing the Moral Hazard of Welfare

505

Moving to Categorical Welfare Payments 505 Using "Ordeal Mechanisms" 508 Application: An Example of Ordeal Mechanisms 510 Increasing Outside Options 511 Empirical Evidence: The Canadian Self-Sufficiency Project 513 1 7 . 5 Welfare Reform

517

Changes Due to Welfare Reform 517 Effects of the 1996 Welfare Reform 517 Empirical Evidence: Estimating the Impact of Welfare Reform 518 XIX

PART

IV

Taxation in Theory and Practice

1 7 . 6 Conclusion

519

Highlights

520


520

Advanced Questions

521

CHAPTER 18 Taxation in the United States and Around the World

523

1 8 . 1 Types of Taxation

524

Taxes on Earnings 524 Taxes on Individual Income 525 Taxes on Corporate Income 525 Taxes on Wealth 525 Taxes on Consumption 525 Taxation Around the World 525 1 8 . 2 Structure of the Individual Income Tax in the United States

527

Computing the Tax Base 527 Tax Rates and Taxes Paid 529 Application: The Coming AMT Timebomb 531 1 8 . 3 Measuring the Fairness of Tax Systems

532

Average and Marginal Tax Rates 532 Vertical and Horizontal Equity 533 Measuring Vertical Equity 534 Application: The Political Process of Measuring Tax Fairness 534 18.4

Defining the Income Tax Base

536

The Haig-Simons Comprehensive Income Definition 536 Deviations Due to Ability-to-Pay Considerations 537 Deviations Due to Costs of Earning Income 538 Application: What Are Appropriate Business Deductions? 538 1 8 . 5 Externality/Public Goods Rationales for Deviating from Haig-Simons Charitable Giving 540 Spending Crowd-Out Versus Tax Subsidy Crowd-In 540 Consumer Sovereignty Versus Imperfect Information 542 Housing 543 Empirical Evidence: The Social Benefits of Homeownership 545 Tax Deductions Versus Tax Credits 546 Application: The Readability Debate 547 Bottom Line: Tax Expenditures 549

xx

539

•;..

1 8 . 6 The Appropriate Unit of Taxation

550

The Problem of the "Marriage Tax" 550 Marriage Taxes in Practice 552 1 8 . 7 Conclusion

554

Highlights

554

Questions and Problems Advanced Questions

555 556

CHAPTER 19 The Equity Implications of Taxation: Tax Incidence 1 9 . 1 The Three Rules of Tax Incidence

557 559

The Statutory Burden of a Tax Does Not Describe Who Really Bears the Tax 559 The Side of the Market on Which the Tax Is Imposed Is Irrelevant to the Distribution of the Tax Burdens 561 Parties with Inelastic Supply or Demand Bear Taxes; Parties with Elastic Supply or Demand Avoid Them 564 Reminder: Tax Incidence Is About Prices, Not Quantities 567 1 9 . 2 Tax Incidence Extensions

568

Tax Incidence in Factor Markets 568 Tax Incidence in Imperfectly Competitive Markets 572 Balanced Budget Tax Incidence 574 1 9 . 3 General Equilibrium Tax Incidence

575

Effects of a Restaurant Tax: A General Equilibrium Example 575 Issues to Consider in General Equilibrium Incidence Analysis 577 1 9 . 4 The Incidence of Taxation in the United States

580

CBO Incidence Assumptions 580 Empirical Evidence: The Incidence of Excise Taxation 581 Results of CBO Incidence Analysis 581 Current Versus Lifetime Income Incidence 584 19.5 Conclusion

584

Highlights

585


585

Advanced Questions

586

flPPENDIXTO CHfiPTER 19 The Mathematics of Tax Incidence

. . . . 587 XXI

CHAPTER 20 Tax Inefficiencies and Their Implications for Optimal Taxation 2 0 . 1 Taxation and Economic Efficiency

589 590

Graphical Approach 590 Elasticities Determine Tax Inefficiency 592 Application: Tax Avoidance in Practice 593 Determinants of Deadweight Loss 594 Deadweight Loss and-the Design of Efficient Tax Systems 595 Application: The Deadweight Loss of Taxing Wireless Communications 600 2 0 . 2 Optimal Commodity Taxation

601

Ramsey Taxation: The Theory of Optimal Commodity Taxation 601 Inverse Elasticity Rule 602 Equity Implications of the Ramsey Model 603 Application: Price Reform in Pakistan 603 2 0 . 3 Optimal Income Taxes

607

A Simple Example 607 General Model with Behavioral Effects 608 An Example 610 2 0 . 4 Tax-benefit Linkages and the Financing of Social Insurance Programs

611

The Model 611 Issues Raised by Tax-benefit Linkage Analysis 613 Empirical Evidence: A Group-Specific Employer Mandate 615

2 0 . 5 Conclusion

616

Highlights

616


617

Advanced Questions

617

APPENDIX TO CHRPTER 20 The Mathematics of Optimal Taxation . . .619

CHAPTER 21 Taxes on Labor Supply 2 1 . 1 Taxation and Labor Supply—Theory

623 625

Basic Theory 625 Limitations of the Theory: Constraints on Hours Worked and Overtime Pay Rules 627 2 1 . 2 Taxation and Labor Supply—Evidence Empirical Evidence: Estimating the Elasticity of Labor Supply 629 Limitations of Existing Studies 630

xxii

628

2 1 . 3 Tax Policy to Promote Labor Supply: The Earned Income Tax Credit

631

Background on the EITC 631 Impact of EITC on Labor Supply: Theory 633 Impact of EITC on Labor Supply: Evidence 634 Empirical Evidence: The Effect of the EITC on Single Mother Labor Supply 636 Summary of the Evidence 637 Application: EITC Reform 637 21.4 The Tax Treatment of Child Care and Its Impact on Labor Supply

639

The Tax Treatment of Child Care 639 Empirical Evidence: The Effect of Child Care Costs on Maternal Labor Supply 640 Options for Resolving Tax Wedges 642 Comparing the Options 643 21.5 Conclusion

643

Highlights

644


644

Advanced Questions

645

CHAPTER 22 Taxes on Savings 2 2 . 1 Taxation and Savings—Theory and Evidence

647 648

Traditional Theory 648 Evidence: How Does the After-Tax Interest Rate Affect Savings? 653 Inflation and the Taxation of Savings* 653 22.2 Alternative Models of Savings

655

Precautionary Savings Models 655 Self-Control Models 656 Empirical Evidence: Social Insurance and Personal Savings 657 22.3 Tax Incentives for Retirement Savings Available Tax Subsidies for Retirement Savings 659 Why Do Tax Subsidies Raise the Return to Savings? 660 Theoretical Effects of Tax-Subsidized Retirement Savings 662 Application: The Roth IRA 666 Implications of Alternative Models 668 Private vs. National Savings 669 Empirical Evidence: Estimating the Impact of Tax Incentives for Savings on Savings Behavior 670 Evidence on Tax Incentives and Savings 671

658

;

xxiii

2 2 . 4 Conclusion

672

Highlights

673


673

Advanced Questions

674

CHAPTER 23 Taxes on Risk Taking and Wealth

675

2 3 . 1 Taxation and Risk Taking

677

Basic Financial Investment Model 677 Real-World Complications 678 Evidence on Taxation and Risk Taking 680 Labor Investment Applications 680 2 3 . 2 Capital Gains Taxation

681

Current Tax Treatment of Capital Gains 681 What Are the Arguments for Tax Preferences for Capital Gains? 683 What Are the Arguments Against Tax Preferences for Capital Gains? 688 2 3 . 3 Transfer Taxation

,

688

Why Tax Wealth? Arguments for the Estate Tax 690 Arguments Against the Estate Tax 691 2 3 . 4 Property Taxation

694

Who Bears the Property Tax? 695 Types of Property Taxation 696 Application: Property Tax Breaks to Businesses 696 2 3.5 Conclusion

698

Highlights

699


699

Advanced Questions

700

CHAPTER 24 Corporate Taxation 2 4 . 1 What Are Corporations and Why Do We Tax Them?

701 703

Ownership vs. Control 704 Application: Executive Compensation and the Agency Problem 705 Firm Financing 707 Why Do We Have a Corporate Tax? 708 2 4 . 2 The Structure of the Corporate Tax Revenues 709 Expenses 709 xxiv

709

Application: What Is Economic Depreciation? The Case of Personal Computers 711 Corporate Tax Rate 712 Investment Tax Credit 712 2 4 . 3 The Incidence of the Corporate Tax 24.4 The Consequences of the Corporate Tax for Investment

713 . . .714

Theoretical Analysis of Corporate Tax and Investment Decisions 714 s Negative Effective Tax Rates 719 -- Policy Implications of the Impact of the Corporate Tax on Investment 719 Application: The Impact of the 1981 and 1986 Tax Reforms on Investment Incentives 720 Evidence on Taxes and Investment 721 24.5 The Consequences of the Corporate Tax for Financing

722

The Impact of Taxes on Financing 722 Why Not All Debt? 723 The Dividend Paradox 726 How Should Dividends Be Taxed? 727 Application: The 2003 Dividend Tax Cut 728 Corporate Tax Integration 729 24.6 Treatment of International Corporate Income

730

How to Tax International Income 730 Application: A Tax Holiday for Foreign Profits 731 24.7 Conclusion

734

Highlights

734

Questions and Problems . . . \

735

Advanced Questions

736

CHAPTER 25 Fundamental Tax Reform 2 5 . 1 Why Fundamental Tax Reform?

737 738

Improving Tax Compliance 739 Application: Tax Evasion 739 Application: The 1997 IRS Hearings and Their Fallout for Tax Collection 742 Making the Tax Code Simpler 743 ;. Improving Tax Efficiency 745 Summary: The Benefits of Fundamental Tax Reform 748 25.2 The Politics and Economics of Tax Reform

748

Political Pressures for a Complicated Tax Code 749 Economic Pressures Against Broadening the Tax Base 749 XXV

Application: Grandfathering in Virginia 752 The Conundrum 752 Application: TRA 86 and Tax Shelters 753 2 5 . 3 Consumption Taxation

754

Why Might Consumption Make a Better Tax Base? 754 Why Might Consumption Be a Worse Tax Base? 757 Designing a Consumption Tax 760 Backing Into Consumption Taxation: Cash-Flow Taxation 762 2 5 . 4 The Flat Tax

763

Advantages of a Flat Tax 763 Problems with the Flat Tax 764 Application: The 2005 Panel on Tax Reform 765

XXVI

2 5 . 5 Conclusion

767

Highlights

767


767

Advanced Questions

768

Glossary

G-1

References

R-l

Name Index

Nl-l

Subject Index

SI-1