Evaluating Public Expenditures When Governments Must Rely on Distortionary Taxation

Abstract

This paper offers simple, robust operational rules for evaluating public spending in distorted economies-rules that are more complex than the border price rule but involve only one additional parameter: the marginal cost of funds.

Anderson and Martin provide simple, robust rules for evaluating public spending in distorted economies. Their analysis integrates within a clean, unified framework previous treatments of project evaluation as special cases.

Until recently it was widely believed that government projects could be evaluated without reference to the cost of raising tax revenues. The classic border price rule provided a simple and apparently robust procedure for project evaluation. But the border price rule developed in shadow pricing literature requires very strong assumptions to be valid when governments must rely on distortionary taxation and are unable or unwilling to cover the costs of the project through user charges.

Anderson and Martin use a rigorous formal model in which governments must rely on distortionary taxation to explore the welfare consequences of governments providing different types of goods. They show that the border price rule is accurate only in one rather special case: when project outputs are sold at their full value to consumers - something that is difficult to do with a public good such as a lighthouse or a functioning judicial system.

When a publicly provided good is sold for less than its full value to consumers, one must take into account the implications for government revenues of providing public goods. Anderson and Martin present project evaluation rules that are more complex than the border price rule but involve only one additional parameter: the compensated marginal cost of funds for the taxes on which the government relies.

The rules suggested involve adjusting the fiscal revenues the project generates (or destroys) by the marginal cost of funds before comparing them with the assessed benefits to project producers and consumers.

In the case of a protected but tradable good provided by the government, the result is a shadow price that is below the world market price. Where projects produce output that is sold without charge, the costs of the project inputs must also be adjusted using the marginal cost of funds.

In intermediate cases where the government levies user charges that fall below the full value of the goods to the private sector, the revenue shortfall from the project must be adjusted by the marginal cost of funds.

This paper - a product of Trade, Development Research Group - is part of a larger effort in the group to assess the consequences of policy interventions. Will Martin may be contacted at [e-mail].