The marginal cost of public funds is one at the optimal tax system

Bas Jacobs

doi:10.1007/s10797-017-9481-0

Abstract

This paper develops a Mirrlees framework with skill and preference heterogeneity to analyze optimal linear and nonlinear redistributive taxes, optimal provision of public goods, and the marginal cost of public funds (MCF). It is shown that the MCF equals one at the optimal tax system, for both lump-sum and distortionary taxes, for linear and nonlinear taxes, and for both income and consumption taxes. By allowing for redistributional concerns, the marginal excess burden of distortionary taxes is shown to be equal to the marginal distributional gain at the optimal tax system. Consequently, the modified Samuelson rule should not be corrected for the marginal cost of public funds. Outside the optimum, the marginal cost of public funds for distortionary taxes can be either smaller or larger than one. The findings of this paper have potentially important implications for applied tax policy and social cost–benefit analysis.

Highlights

The marginal cost of public funds is the ratio of the social marginal value of a unit of resources raised by the government and the social marginal value of a unit of resources in the private sector.1 The marginal cost of public funds is a measure indicating the scarcity of public resources
This paper aims to resolve the issues in the literature by defining the marginal cost of public funds as the ratio of the social marginal value of public income and Diamond (1975)’s measure of the social marginal value of private income
The main result of this paper is that the cost side of the Samuelson rule does not include a measure for the marginal cost of public funds

Summary

Introduction

The marginal cost of public funds is the ratio of the social marginal value of a unit of resources raised by the government and the social marginal value of a unit of resources in the private sector. The marginal cost of public funds is a measure indicating the scarcity of public resources. The marginal cost of public funds is a measure indicating the scarcity of public resources. Ever since Pigou (1947), many scholars and policymakers are convinced that the marginal cost of public funds must be larger than one, since the government relies on distortionary taxes to finance its outlays. If the marginal cost of public funds is larger than one, this has important normative consequences for the determination of optimal public policy in many fields. The optimal level of public goods provision should be lower, and the optimal size of the government should be smaller, if the marginal cost of public funds is higher. Many other examples can be given, but the message is clear: The marginal cost of public funds has a tremendous impact on how governments should evaluate the desirability of public policies.

Objectives

Findings

Discussion

Conclusion