Public Goods, Tax Policies, and Unemployment in LDCs

Abstract

1. Introduction Traditionally, an analytically convenient and widely used assumption in the international trade and development economics literature has been that of lump-sum distribution of direct (e.g., income) or indirect (e.g., consumption, tariff) tax revenue when various policy implications of such instruments (e.g., terms of trade or welfare effects) were to be examined. This analytical shortcut, however, hardly ever constitutes a real-world practice either in rich developed or in poorer developing economies. On the other hand, another extensive branch of economics, the public finance literature, has adopted a more realistic approach regarding the economic activity of a government. A government is viewed, among other things, as a provider of public (collective) consumption goods and/or of public inputs that enhance the productive capacity of the private sector. Being so, it can use revenues from nondistortionary (e.g., lump-sum) taxes or distortionary (e.g., consumption) taxes to finance the provision of such goods and services. Within this public finance context, a long-standing proposition states that when nondistortionary taxes are used to finance the provision of a public good, the first-best efficiency rule requires that the sum of the marginal rates of substitution (i.e., the social marginal benefit) equal the marginal rate of transformation (i.e., the social, marginal cost) (e.g., see Samuelson 1954). When distortionary taxes are used to finance the provision of the public good, Pigou (1947) argued that the social marginal cost exceeds the private marginal cost because of the induced indirect cost from raising tax revenue through distortionary taxation. Stiglitz and Dasgupta (1971), Atkinson and Stem (1974), and Wildasin (1984), among others, demonstrate that in certain cases (e.g., when the taxed and the public goods are complements in consumption), Pigou's argument fails to hold and the social cost may fall short of the private marginal cost.' Because of its more realistic appeal, this public finance approach to the use of tax revenue has been subsequently adopted by the relevant international trade and development economics literature. Recently, the efficiency rule for public good provision has been examined in the context of a small open economy by, among others, Feehan (1988) when tariff revenue finances the provision of the public good in an economy producing two traded goods and a nontraded public consumption good. Michael and Hatzipanayotou (1995) examine the same issue and derive the formulae for the optimal tax rates on traded or nontraded goods in an economy producing many traded and nontraded goods and where consumption tax revenue finances the provision of the public good. Michael and Hatzipanayotou (1997) demonstrate the failure of the first-best efficiency rule when lump-sum taxes are used to finance the provision of a public good in a small open economy in the presence of trade restrictions (i.e., a tariff or a VER). Two features in the above reviewed studies of the international trade/development economics and public finance literature motivate the present paper. First, all these studies derive the efficiency rule for public good provision in the context of a small open or closed economy with full employment. Unemployment, however, to a lesser or to a larger extent remains a structural feature of many developed or developing economies. From an analytical standpoint, the existence of such a distortion may alter both the optimal tax formulae and the efficiency rule for public good provision. Second, the above reviewed literature considers the case where a government uses a single policy instrument (e.g., lump-sum taxes, income taxes, tariffs) to finance the provision of the public good. More than often, however, governments may have at their disposal several tax instruments that they can simultaneously use in order to raise revenue for financing the provision of public consumption goods. …