Public Finance (MPA405)

Dr. Khurrum S. Mughal

Lecture 22: Introduction to Government Finance

Public Finance

Criteria for Evaluating Alternative Methods of Government Finance

• Equity– The distribution of the burden of government finance

should coincide with commonly held notions of fairness and ability-to-pay. 

• Efficiency– The system of government finance should raise revenues

with only a minimal loss in efficiency in the private sector. 

• Administrative ease– A government finance system should be relatively easy to

administer in a consistent manner without excessive costs to collect, enforce, and comply with taxes and tax laws.

Criteria for Evaluating Alternative Methods of Government Finance

Equity Vs Efficiency Trade-off

• Equitable taxes might cause losses in efficiency

• Efficient taxes might be deemed inequitable by many citizens

Tax Compliance and Evasion

• Tax Evasion is the term for illegal ways of avoiding paying taxes. It is typically the result of not declaring income or overstating otherwise legal deductions. 

• Tax Avoidance is the term for the legal ways of avoiding paying taxes, typically the result of avoiding activities that are taxed, delaying the time in which taxes are owed, or taking an action designed to lower a tax burden.

Tax Compliance and Evasion

• Marginal Benefit and Cost associated with tax evasion– Benefit in terms of having to pay less tax– Cost are the monetary and nonmonetary penalties, if caught

• In presence of Progressive Taxation: – MB and MTR declines as more income goes unreported– MC rises because probability of being audited increases with more

income being unreported

Reducing Tax Evasion

Cos

t and

Ben

efit

Unreported Income per Year (Dollars)

0 D* 1

B

MC

MB2

D*

A

MC

MB = MTR

Cos

t and

Ben

efit

Unreported Income per Year (Dollars)

0

MC2 C

MC1

Cos

t and

Ben

efit

Unreported Income per Year (Dollars)

0

MB = MTR

E

1 E

E 2

E

E1

MB1 = MTR1

D* 2

D* 1

D* 2

Alternatives to Taxation

• Debt Finance is the means of financing expenditures through the issuing of bonds.– People willingly buy bonds because the interest

payment is sufficient to offset the requirement of current consumption

– Taxes are used to pay off debt

• Inflationary Finance is the means of financing expenditures through the printing of money.– Reduction in real value, inflationary tax, reduces

command over resources in private sector

Inflationary Finance

Gu

ns

pe

r Y

ea

r

Butter per Year 0 B2

G2

G1

C I

A

T' B1

T

More alternatives to Taxation • Donations

– Money (but more usually time) is voluntarily given to government. Military service or work in the Peace Corps can be considered a donation when the compensation is less than the market value of the time. 

• User Charges– Payments by users of the government service can be

expected. Examples include tuition, fees paid to enter state parks, greens fees at publicly owned golf courses.

• Earmarked Taxes– Taxes can be implemented to fund specific public goods.

Examples include gasoline taxes and tolls designed to fund road and bridge repair.

User Charges & Efficiency• Price excludable goods generate external benefits

• Trash Pick up example– MSB = MPB + MEB– To ensure efficient quantity price charged is when MSC=MPB– Additional amount is to be subsidized

User Charges and Efficiency

Ch

arg

es

Trash Pickups per Year 0 Q*

C*

C* + S*

MSB = MPB + MEB

MPB

MSC

S*

Z*

Z

User Charges & Efficiency• Can also create efficiency if benefits of government

goods are congestible

• Road Congestion example– No price required if traffic is below the point of congestion– Above that, price may be charged equivalent to the point

where MSB=MSC

User Charges for a Congestible Government-Supplied Service

Us

er

Ch

arg

es

(C

en

ts p

er

Mile

)

Vehicles per Mile per Hour

0

E1

20

E2

D2 = MSB2 D1 = MSB1 MSC

80 100 120 150

E*

N*

Government Enterprise

• Local Utilities• Lotteries