Essays in Public Finance

Abstract

This dissertation consists of three self-contained essays on public finance, that is, on the study of government revenue and expenditure. Taxation and public spending reflect society's values, priorities, as well as its political and informational constraints. This makes them a fascinating subject for economic research and a frequent topic of political debate. <br /> Economists have recently studied the optimal design of tax policy using the Mirrleesian mechanism design framework. At the core of this analysis lies a trade-off between equity and efficiency: In order to maximize social welfare, a utilitarian social planner wishes to redistribute consumption from individuals who have high income-earning ability to those with less income-earning ability. Because individual abilities are unobserved by the social planner, the optimal tax system must be incentive compatible and involves distortions of labor efforts. Chapters 1 and 2 of this thesis contain analyses of this trade-off and the resulting labor distortions. Researchers have also considered the effects of political competition on income taxes and public good provision. This part of the literature assumes that politicians design tax schedules in order to win elections instead of maximizing social welfare. Chapters 1 and 3 concern the political economy of taxation and public good provision. Methodologically, the analyses in all three chapters utilize tools from microeconomic theory, in particular mechanism design and game theory.<br /> Chapter 1 jointly studies public good provision and nonlinear income taxation. It argues that public revenue and spending should be analyzed simultaneously, because the two are interdependent. Specifically, it assumes that individual income earning ability is a function of innate talent and a public good. The public good in turn is financed by distortionary taxes. The chapter then studies how public good provision affects the efficiency of optimal income taxes and, conversely, how taxation affects the efficiency of public good provision. It first characterizes Pareto efficient allocations and an allocation that results from political competition over both public good provision and nonlinear income taxation. In the political equilibrium, the median voter's favorite policy is the Condorcet winner in an election. Further, it shows that public good provision helps to mitigate the incentive problems of income taxation and that the efficiency of public good provision is dependent on the position of the median voter in the income distribution.<br /> Chapter 2 studies optimal income taxation when individuals exhibit intention-based preferences. The chapter is based on the conventional income taxation model with individuals who differ in their skill type and a social planner who redistributes income subject to incentive compatibility and resource constraints. However, it augments the standard taxation mechanism by offering low-ability types the choice of exerting a higher labor effort, which results in a higher utility for high-ability types. Under intention-based preferences, this creates slack in the incentive constraint for high-ability types and allows us to implement an allocation that is Pareto superior to the allocation that results from the standard mechanism. The interpretation is that the rich do not mind helping the poor if they "do their part" by working harder. Interestingly, with intention-based preferences the optimal allocation lies outside the Pareto frontier of the standard model and relies on individuals' concern for procedural justice, which cannot be characterized as the maximization of a social welfare function.<br /> Chapter 3 characterizes demand for think tanks in the presence of academic experts. It poses the question: how can demand for think tanks co-exist with research that is made publicly available by academic researchers? To investigate this question the chapter proposes a model in which voters differ in their pre-tax incomes and exhibit uncertainty about the deadweight cost caused by taxation. For example, they might be uncertain about the elasticity of taxable income or the administrative cost of government. An academic expert observes the true deadweight cost of the tax system and communicates this information to the electorate via a cheap talk message. Additionally, voters can choose to pool their resources to finance a partisan think tank that has access to the same information as the academic expert. The chapter shows that individuals are willing to pay for a think tank if and only if the academic expert is partisan with probability greater than zero. That is, demand for think tanks exists if and only if academic experts represent the interests of a certain part of the electorate, instead of always providing truthful information.