Sunday, August 23, 2015

Public Finance in a Nutshell

Reply to: Money Is A Broken System Of Value


The “minor” detail that you’re missing from your otherwise excellent and entertaining analysis is the free-rider problem.

Of course the private sector isn’t going to spend enough money on cancer research! Because if it did spend enough money on cancer research then the free-rider problem wouldn’t be a real problem and we wouldn’t need the government to solve it by forcing people to contribute to public goods (aka “taxation”).

So, by arguing that cancer research is undersupplied… your beef really isn’t with the private sector… it’s with the public sector. The entire point of the public sector is to ensure that public goods, such as cancer research, are not undersupplied.

The question is… why would the public sector fail to supply enough cancer research? Well… if the public sector was actually effective at supplying the optimal amounts of goods… then we really wouldn’t need markets at all. Socialism would be an adequately effective system for ensuring that society’s limited resources are put to their most valuable uses. However, as I’m sure you’re aware, there’s considerable evidence that socialism is far from effective at efficiently allocating resources.

We’re stuck between a rock and a hard place. Because of the free-rider problem… the private sector won’t supply enough cancer research. But because of the preference revelation problem… the public sector won’t supply the optimal amount of cancer research… or conservation… or welfare… or defense… or infrastructure… or any other public good.

We “unbreak” this predicament simply by creating a market in the public sector (pragmatarianism). The supply of public goods would be determined by the actual demand for public goods. If you demand more cancer research and less unnecessary wars… then you’ll spend your taxes accordingly.

Less formally… in the private sector, when it comes to public goods, you have a big incentive to be a big fat liar. “No… I don’t really value cancer research that much…” However, once the cost of contributing to public goods is a foregone conclusion (aka “taxation”)… your incentive to lie goes out the window. In fact, you have the maximum incentive to be truthful. “I might as well spend my taxes on the public goods that I have the greatest demand for! Like cancer research!”

More formally…

Under most real-world taxing institutions, the tax price per unit at which collective goods are made available to the individual will depend, at least to some degree, on his own behavior. This element is not, however, important under the major tax institutions such as the personal income tax, the general sales tax, or the real property tax. With such structures, the individual may, by changing his private behavior, modify the tax base (and thus the tax price per unit of collective goods he utilizes), but he need not have any incentive to conceal his “true” preferences for public goods. — James Buchanan, The Economics of Earmarked Taxes

Buchanan published that paper in 1963… nearly a decade after another Nobel economist published the most widely cited paper on the topic…

But, and this is the point sensed by Wicksell but perhaps not fully appreciated by Lindahl, now it is in the selfish interest of each person to give false signals, to pretend to have less interest in a given collective consumption activity than he really has, etc. — Paul Samuelson, The Pure Theory of Public Expenditure

But, and this is the point sensed by Wicksell but perhaps not fully appreciated by Samuelson, now with democracy, because 1. around half the country doesn’t pay income taxes and 2. the burden isn’t evenly distributed among those who do pay income taxes (progressive taxation)… it is in the selfish interest of most voters to give false signals, to pretend to have more interest in a given collective consumer activity than he really has, etc.

If once the lower classes are definitely in possession of the power to legislate and tax, there will certainly be a danger that they may behave no more unselfishly than those classes which have so far been in power. In other words, there will be danger that the lower classes in power may impose the bulk of all taxes on the rich and may at the same time be so reckless and extravagant in approving public expenditures to which they themselves contribute but little that the nation’s mobile capital may soon be squandered fruitlessly. This may well break the lever of progress. — Knut Wicksell, A New Principle of Just Taxation

Wicksell published that in 1896. A few decades later…

As was noted in Chapter 3, expressions of malice and/or envy no less than expressions of altruism are cheaper in the voting booth than in the market. A German voter who in 1933 cast a ballot for Hitler was able to indulge his antisemitic sentiments at much less cost than she would have borne by organizing a pogrom. — Loren Lomasky, Geoffrey Brennan Democracy and Decision

After 9/11 plenty of people shouted for war… but why not? It’s not like the money was coming out of their pockets.

It should be painfully obvious that, when it comes to public goods… the free-rider problem is just as applicable to democracy as it is to the private sector. This really shouldn’t be news though. Here’s what Adam Smith, the founder of modern economics, wrote in 1776…

The people feeling, during the continuance of the war, the complete burden of it, would soon grow weary of it, and government, in order to humour them, would not be under the necessity of carrying it on longer than it was necessary to do so. The foresight of the heavy and unavoidable burdens of war would hinder the people from wantonly calling for it when there was no real or solid interest to fight for. — Adam Smith, Wealth of Nations

If you read Samuelson’s very short paper… then you’d realize that he doesn’t mention democracy at all. As strange as it may sound, he simply assumes omniscience on the part of government planners. Clearly he didn’t truly believe that government planners are omniscient! But from his perspective… discerning the actual demand for public goods was a very minor detail. Because he perceived that preference revelation was a minor detail… his grasp of economic reality was… tenuous… at best…

The Soviet economy is proof that, contrary to what many skeptics had earlier believed, a socialist command economy can function and even thrive. — Paul Samuelson, Economics

Back in the day, Economics was the most widely used economics textbook!

In summary… it’s human nature to want more for less. This works great when it comes to private goods because we all have the maximum incentive to shop around for better deals. Consumer choice gives producers the maximum incentive to offer better deals. Offering better deals depends on discovering better uses of society’s limited resources.

But when it comes to public goods… human nature doesn’t work so great. There’s considerable incentive to free-ride on other people’s contributions. So it’s reasonable to conclude that the private sector will undersupply public goods. The solution only requires one step though… taxation. That’s it! Because once the cost of contributing to public goods is a foregone conclusion… then human nature can work just as well for public goods as it does for private goods.

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