A Note on the Optimal Supply of Public Goods and the Distortionary Cost of Taxation
Harvard Law School; National Bureau of Economic Research (NBER)
National Tax Journal, March 1998
In a recent article, I demonstrated that, under standard simplifying assumptions, it is possible to finance a public good in a manner such that a Pareto improvement results whenever the simple cost-benefit test is satisfied -- that is, without any adjustment for the "marginal cost of funds." In particular, the method of finance involves adjusting the income tax so that the combined incidence of the tax adjustment and the public good is distribution neutral. One implication of this result is that, if the public good is financed in some other manner, the difference in outcome will be purely redistributive, so that any change in distortionary costs will be accompanied by an opposing change in redistributive benefits. I also showed how this analysis is applicable to determining the optimal level of environmental taxes.
Edgar Browning and Liqun Liu have written a critique of my article. It does not, however, disagree with any of these claims. Instead, their argument focuses on how one should interpret the term "distortion." It should not be surprising, however, that under any interpretation of the term -- including their preferred one -- my conclusions about how policy analysis should be conducted continue to be correct.
JEL Classification: H21, H23, H41, H43
Date posted: September 24, 1998