Modern Fiscal Issues: Essays in Honour of Carl S. Shoup 9781442631984

Table of contents :
Contents
Preface
Contributors
ONE. The theory of public finance
1. Public goods: the polar case
2. Joint production, externality, and public goods
3. The design of governments
4. Inter-nation equity
5. Customs unions, tax unions, development unions
6. Tax neutrality of instantaneous versus economic depreciation
7. Cumulative averaging after thirty years
TWO. Public finance in practice
8. Government revenue, the national income, and all that
9. Scale and effectiveness of urban government: a commentary
10. Environmental quality, the market, and public finance
11. The German Stabilization Law: a new experiment
12. The logical approach of the new estate duty in Great Britain
13. Ecuador's value added tax: the first in the Andean Common Market
14. Technical assistance in taxation in developing countries
15. Property taxation
16. The evolution of sales taxation, 1915-1972
Bibliography: works of Carl S. Shoup

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Edited by Richard M . Bird and John G. Head

Modern Fiscal Issues

ESSAYS I N HONO R OF CAR L S. SHOUP

UNIVERSITY O F TORONT O PRESS

i Universit y of Toront o Pres s 1972 Toronto an d Buffal o Printed in Canad a ISBN 0-8020-1900-5 Microfiche ISB N 0-8020-0241-2 LC 72-83387

Contents

Preface vi i Contributors i x ONE THE THEOR Y O F PUBLI C FINANC E 1 Public goods: the polar cas e / 3 JOHN G . HEA D

2 Joint production , externality , and public goods /18 HIROFUMI SHIBAT A

3 The design of governments / 45

RICHARD M . BIR D an d DOUGLA S G . HARTL E

4 Inter-nation equit y / 63

RICHARD A . M U S G R A V E and PEGG Y B . MUSGRAV E

5 Customs unions, tax unions, development unions / 86 DOUGLAS DOSSE R

6 Tax neutrality of instantaneous versus economic depreciation / 105 MELVIN WHIT E an d ANN E WHIT E

7 Cumulative averagin g after thirt y years /117 WILLIAM VICKRE Y

TWO PUBLIC FINANC E I N PRACTIC E 8 Government revenue , the national income , and all that/ 137 A.R. PRES T 9 Scale and effectivenes s o f urban government: a commentary / 164 LYLE C . FITC H

10 Environmental quality , th e market, an d public finance / 187 HUGH MACAULA Y 11

The German Stabilizatio n Law : a new experiment / 225 FRITZ NEUMAR K 12

The logical approac h o f the new estate dut y in Great Britai n / 247 G.S.A. WHEATCROF T

13 Ecuador's valu e added tax: the first in the Andean Commo n Market / 257 MARION HAMILTO N GILLI M 14

Technical assistanc e i n taxation i n developing countries / 278 OLIVER OLDMA N an d STANLE Y S . SURRE Y

15 Property taxatio n / 292

C. LOWEL L HARRIS S

16 The evolution o f sales taxation, 1915-197 2 / 318 JOHN F . DU E

Bibliography: works of Carl S . Shoup / 345

Preface

The essay s in thi s volum e have bee n contribute d b y a fe w of th e many colleagues an d student s wh o hav e benefite d fro m Car l Shoup' s fort y productive year s as a leading teacher an d schola r o f public finance. The range of the papers reflects not only the nature of the challenges now facing students of public finance but also the wide scope of Carl Shoup's work and interests. Th e enlarge d subjec t matte r encompasse d i n moder n publi c finance is illustrated, for example , i n the chapter s o n public expenditur e theory and on environmental quality, while the continuing need to pursue in greate r dept h mor e traditional question s o n income taxation an d ta x structure is demonstrated elsewhere. Following in the grand tradition of his illustrious predecessors at Columbia (E.R.A. Seligman and R.M. Haig), Carl Shoup has contributed greatly to both the broadening and the deepening of the study of public finance in all these respects, an d many more. In several instances, indeed, his own work has largel y shape d th e moder n discussion , for example , throug h hi s in fluential early studies of the value added tax and of fiscal harmonization, as well as through his path-breaking fiscal missions to Japan and Venezuela. These missions not onl y illustrate th e concer n for applyin g analysis of a high orde r t o real-worl d problems whic h has long been demonstrated i n Shoup's work - an d which is shared b y most of the contributors t o this volume, as their essays show - bu t also stil l stand as models of technical assistance reports for developing countries. Although it would be presumptuous as well as premature to attempt here an appraisal o f Carl Shoup's work , since all the returns are not in and he continues t o mak e outstandin g contribution s t o th e literature , i t i s thus

viii Moder n Fisca l Issue s abundantly clear that he has influenced markedly the development of public finance thought , not only in North America, but throughout the world, both by his published work and by his countless untraceable contributions to the stream o f knowledg e throug h student s an d colleagues , includin g thos e represented here. In recognition of both his warm human qualities and the high standard s o f analytical probit y an d judicious practicality whic h hi s work has for so long set for all of us, the contributors t o this volume join in dedicating it to Carl Shou p - teacher , scholar , an d friend.

Contributors

R I C H A R D M . BIRD is professor of economics and associat e o f the Institute for the Quantitative Analysis of Social and Economic Policy, University of Toronto D O U G L A S D O S S E R I S professor of economic theory, University of York, England J O H N F . DUE is professor of economics, University of Illinois, Urban a L Y L E C . FITC H is president of the Institute of Public Administration, New York M A R i O N H A M i L T O N G i L L i M i s professor of economics, Barnard College, Columbia University, New York c. L O W E L L H A R R i s s i s professor of economics, Columbi a University , New York, and economic consultant of Tax Foundation, In c D O U G L A S G. H A R T LE is deputy secretary of the Treasury Board , Ottawa J O H N G . HEAD is professor of economics, Dalhousie University, Halifax H U G H M A C A U L A Y i s alumni professor of economics, Clemson University, South Carolin a

PEGGY B. M U S G R A VE is associate professor of economics, Northeastern University, Boston RICHARD A. MUSGRAVE is H.H. Burban k professor o f political economy, Harvard University , Cambridge, Mass . F R i T Z N E U M A R K i s emeritus professor of economics, Johann Wolfgang Goethe University, Frankfur t O L i V E R O L D M A N i s professor of law and director o f the Internationa l Tax Program, Harvard University, Cambridge, Mass. A. R. pREST is professor of economics, London School of Economics, London H i R O F U M i S H i B A T A i s professor of economics, University of Kentucky S T A N L E Y S . S U R R E Y is Jeremiah Smith Jr professor of law, Harvard University, Cambridge, Mass . w i L L i A M V i C K R E Y i s professor of economics, Columbia University, New York G. s. A. WHEAT CROFT is professor emeritus of English law, Universit y of London A N N E WHITE is associated with Melvin White in consulting and research M E L V I N W H I TE is professor of economics, Brooklyn College and th e Graduate Centre, City University of New York

ONE

The theory of public finance

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JOHN G . HEA D

1 Public goods: the polar case

One of the most remarkable features of the modern fiscal literature has been the increasing attention devoted to a normative theory of public expenditure based on the concept of a public good. The theory of public goods was first developed and debate d i n the Continenta l public finance literature o f the late 19th century. The modern discussion dates, however, from the appearance of Samuelson's three pioneering papers in the mid-1950s [15-17] and Musgrave's Theory o f Public Finance in 1959 [11 ]. These contributions have served both to revive interest in the older literature and to spark a number of lively controversies an d furthe r development s in the basi c theory. B y the end o f the 1960 s some of the majo r controversie s appeared t o hav e been resolved, though others continued unabated. Both the considerable degree of convergence and the continuing differences can be seen by comparing the important discussion s by Musgrave [12] , Samuelson [21] , and Buchanan [3] published towards the end of the period. Carl Shoup has taken an active part in these debates both through publications and correspondence - our first contact was through correspondence on my first attempt to review the discussion [8 ] - an d the conceptual framewor k develope d i n his recent treatise [23 , ch. 4] constitutes a most important contribution to the subject. This paper provides a review of that part of the modern discussion which is concerned with the polar case of a pure public good. THE CONCEP T O F A PUR E PUBLI C GOO D

Like th e earl y Continenta l discussion , th e moder n debat e opene d wit h considerable confusio n regardin g th e meanin g and precis e characteristic s of the public goods concept .

4 Moder n Fisca l Issues Definition In his two basic papers [15,16 ], Samuelson defines a pure public or collective consumption goo d a s on e whic h i s consume d full y an d equall y b y al l members of the relevant group:'... each man's consumption o f it, X 2l an d X22 respectively , is related to the total by a condition of equality rather than of summation. Thus, by definition, X2l = X 2, an d X 22 = X 2 [16 , p.350]. Musgrave defines a corresponding concept of pure social wants, which 'are those wants satisfied b y services that must be consumed in equal amounts by all' [11 , p.8]. It seems reasonably clear that 'equal consumption' is here to b e interpreted i n term s of quantities of homogeneous-quality services, though bot h Samuelso n an d Musgrav e offe r a somewha t broader inter pretation i n more recent papers [12 , 21 ], evidently in response to criticis m of the original concept . Characteristics In thei r origina l contribution s Musgrav e and Samuelso n appea r t o em phasize quit e differen t aspect s o f th e publi c good s concept . Subsequen t discussion has revealed no less than three distinct characteristics . Joint supply. I n Samuelson' s definitio n th e first and most obvious charac teristic is that the services of a pure public good are in joint suppl y in the special sense that, once a unit of the service is made available to one person, an identical-quality service unit can be made available to othe r persons a t no extra cost. These descriptively identical services to the various members of the community are strictly joint products analogou s to the descriptively different joint products, such as meat and hides, of traditional Marshallia n examples. This joint supply analogy has been developed in detail by Shoup [22] an d Buchana n [1 , 3]. Shou p ha s suggeste d th e ter m 'multiple-use r products' for the joint products in the public goods case to distinguish them from th e 'multiple-commodity products' o f the Marshallian concept . This characteristic o f 'equal potential availability ' has been the subject of a continuin g terminologica l dispute . Samuelso n ha s strongl y resiste d the join t suppl y terminology , mainl y becaus e o f th e radicall y differen t requirements fo r Pareto-efficienc y an d consequen t implication s fo r de centralized market performance [19,20]. A similar problem, however, arises with differen t categorie s o f purely private goods classifie d accordin g t o production conditions , e.g. , increasin g o r decreasin g return s t o scale . I t should b e possibl e t o acknowledg e th e presenc e o f joint supply , whils t recognizing with Samuelson [19, p.202, n.5] that in terms of market situation

Public goods 5 the precise Marshallian analog y woul d b e th e join t suppl y o f variou s descriptively different products, the demand for which is monopsonistic. In his original contribution Musgrave uses the term 'joint consumption' [11, p.10 , n.l] and ha s been followed b y some other writers . Samuelson also refers a t on e point t o 'jointnes s o f demand' [15 , p.389]. I n hi s more recent discussion [12], Musgrave employs the somewhat similar term 'non rivalness i n consumption. ' Thi s terminolog y seem s unfortunate . I n th e much-discussed case of television services, for example , traditional usage would surely suggest that the T V signal is jointly supplie d t o many users, whilst the signa l and th e TV set are jointly consumed or demanded by the individual users. As in th e earl y Continenta l literature , th e ter m indivisibilit y ha s als o been widely used, notably by Buchanan [3] . 'Equal potential availability ' is undoubtedly a form of indivisibility, and this latter term has the advantage of carrying the appropriate supply-side connotations. I n his Biarritz paper [21], Samuelson uses the term 'consumption externality' which risks confusing th e joint suppl y or indivisibility characteristic wit h th e traditiona l Pigovian price-exclusio n problem . I n his Public Finance [23] , Shou p now employs the term 'collective consumption.' The differences in question here are, of course, purely semantic, but must be very confusing to the non-specialist . Impossibility o f exclusion. In Musgrave's original discussion a second quite distinct characteristi c is given primary emphasis: 'People who do not pa y for the services cannot be excluded from the benefits that result...' [11, p.8]. Once a unit of the service is made available to any one person, a service unit of identical quality not only can but must be made available to all persons. Price exclusion is literally impossible . This characteristi c i s not discusse d explicitly in Samuelson' s firs t tw o papers [15 , 16] . It is , however, clearly implied, sinc e equal consumption holds by definition onl y where price-exclusion is impossible. It is also evident in his choice of illustrative examples, e.g., a n outdoor circu s and nationa l defense [16 , p.350] , an d i n hi s repeate d reference s to 'externa l effects. ' Samuelson is, however, quite explicit in regarding the jointness character istic as in some sense more basic. Thus, illustrating by reference to television services, h e warns that'... you would be wrong to think tha t the essence of the phenomenon is inherent in the fact that the broadcaster is not able to refuse th e servic e t o whateve r individual s h e pleases ' [17 , p.355 , italic s added]. In this he is now followed by both Musgrave [12] and Buchanan [3].

6 Moder n Fisca l Issues Price-exclusion problem s are , o f course, familiar from th e literature a s the crucial distinguishing characteristic o f the traditional Pigovian concep t of external economies. The public good is simply an extreme case in which, once produced, the full amount of the benefit spills over and can be enjoyed by all persons without payment. Both Samuelso n an d Musgrav e clearl y recogniz e fro m th e outse t tha t the jointness characteristic does not necessarily imply impossibility of priceexclusion. Samuelso n illustrate s b y referenc e t o subscriptio n televisio n [17, p.335] an d Musgrav e by reference t o entranc e fee s fo r a circus per formance [11 , p . 10, n.l]. Ther e has , however , bee n som e disput e a s t o whether impossibility of price-exclusion necessarily implies Samuelsonian jointness. Suc h a relationshi p wa s originall y asserte d b y Musgrav e [11 , p. 10, n.l]. It now seems clear, however, that this is not generally the case. As Shoup has particularly emphasized [23, pp.80-4], the total cost of supplying a given standard o f service to all persons is not generally independent of the siz e of the relevant group. I n case s such as crime prevention or stree t services it is simply not true that once a unit of service is made available t o one person, a n identical-quality servic e unit ca n be made available t o al l other persons regardless o f group size at no extra cost. Depending upon the nature of the cost function and the size of the relevant group, Samuelsonian jointness may not apply, even though for such services price-exclusion may be prohibitively costl y if not literall y impossible. It seem s that Musgrave now concedes this point [12 , pp.127-8]. Impossibility o f rejection. Whe n th e possibilit y i s recognize d tha t som e individuals may place a negative marginal valuation on the public good, a third characteristic, impossibility o f rejection, may be distinguished. I f the equal consumption condition is still to hold by definition, the service must be fully consumed by those who would choose, i f possible, to consume less than the total amount available, even at a zero price. This characteristi c o f non-rejectabilit y i s no t explicitl y note d i n th e original contribution s o f either Musgrav e or Samuelson . Samuelson doe s recognize th e possibl e existenc e of negative marginal evaluations , bu t h e appears t o envisage the possibility of unequal consumption in such cases: 'Mathematically, we could without loss of generality set X2' = an y function of X 2> relaxin g strict equality' [16 , p.350, n.l ]. Impossibility of rejection is, however, clearly implied in his more recent Biarritz paper [21 , p. 104, n.l ]. It i s als o a necessar y implication o f Musgrave' s origina l definition . Th e existence of this third characteristic has been independently noted by Shoup [23] and others.

Public goods 7 Like impossibilit y o f exclusion , impossibilit y o f rejectio n i s closel y related to the traditional Pigovian externality concept, and simply represents a special case of external diseconomies. Impossibility of exclusion evidently does not necessaril y imply impossibility of rejection. Of Samuelson's firs t two examples of a public good, an outdoor circus and national defense, both are effectivel y non-excludable , bu t th e circu s i s readily rejectabl e thoug h national defense is not. Similarly it is clear that jointness does not necessarily imply non-rejectability or vice-versa. In the light of the above discussion it is clear that the pure public good is a compound o f as many as three quite distinct characteristics. Specia l form s of joint supply , external economies, and external diseconomies, can all be discerned. Eve n i f w e wer e provisionall y t o ignor e th e non-rejectabilit y characteristic, an d assum e that publi c goods ar e 'goods' over all relevant ranges, the pure public good is still a double-polar case of joint supply and impossibility of exclusion. In th e following discussion we shall regard th e latter two characteristics a s fundamental. PROVISION O F PUBLIC GOOD S

As in the early Continental literature, it is clear from the original discussions by Samuelson and Musgrave that the pure public good is taken as an extreme case to illustrate the need for public provision. For Samuelson it is a 'strong polar case ' whic h th e studen t o f publi c expenditur e ca n se t agains t th e equally extreme Walrasian model of a purely private econom y [16, p.350]. For Musgrave it is a case'... where the market mechanism fails altogether... Social wants must be satisfied through the budget if they are to be satisfied at all' [11, pp.8-9 ]. It is clearly recognized by both Samuelson and Musgrave that political provision for public goods must pose difficult problems. There is, however, a clear implication that the market failure problem is such that the political mechanism could hardly prove inferior. The benchmark of optimal provision The firs t ste p i n Samuelson' s analysis , an d perhap s hi s majo r positiv e contribution, i s th e rigorou s statemen t an d derivatio n o f th e optimu m conditions fo r publi c good s supply . A s i n moder n welfar e analysi s o f a private good s economy , thes e condition s provid e a benchmar k fo r th e assessment of market performance and political provision. Samuelson's centra l findin g i s that th e condition s for efficient resource allocation i n a worl d wit h a publi c goo d diffe r radicall y fro m th e mor e familiar condition s fo r a private good s world . I n th e simpl e two-person ,

8 Moder n Fisca l Issue s two-good case of his 1955 paper [16] , he shows that, where one of the two goods is public, the marginal rate of transformation must equal the summed marginal rates of substitution, i.e., MRS 1 + MRS 2 = MT . This contrasts with the corresponding private goods case in which we require MRS1 = MRS 2 = MT. In accordanc e wit h hi s 'socia l welfar e function' approac h t o welfar e economics Samuelson then goes on to determine the conditions for a welfare maximum where '... th e social welfare significanc e o f a unit of any private good allocate d t o private individual s must at the margin be the sam e for each and every person' [16 , p.353]. This further distributional requirement is, however, no different fro m that for an all-private-goods world. Samuelson's treatment o f the distributional aspect s has been the cause of considerable confusion and dispute. Buchanan in particular ha s argued strongly that the normative theory of public goods should not g o beyond the conditions for efficient resourc e allocation [3 , pp.193-7]. This is a basic question of welfare methodology which continues essentially unresolved.1 Problems of market provision In view of its fundamental importance, it is surprising to find that Samuelson and Musgrav e devote relatively little spac e to th e analysi s of market per formance i n public goods supply. This has proved particularl y confusin g as it appears that each is focussing on the market failure problems caused by only one of the two basic public goods characteristics. Though some aspects remain controversial, the position ha s been considerably clarified b y subsequent discussio n in whic h th e marke t failur e problem s cause d b y th e joint supply and non-exclusion characteristics have been analysed separately. In th e followin g revie w we shall focus o n questions of allocative efficienc y and ignor e distributiona l considerations. This is appropriate whethe r we follow Samuelson or Buchanan on welfare methodology. In the Samuelson framework th e marke t mechanism is generally incapable o f handling th e distribution proble m wit h o r withou t the presenc e o f publi c goods ; th e central question at issue is whether it is capable of handling the allocatio n problem. Joint goods Abstracting completely from the existence of price-exclusion problems, the possibility of market supply of 'purely joint goods' can be considered. The first point to note is that Samuelson's derivation of the conditions 1 Fo r a recent discussion , see Head [9] .

Public goods 9 for allocatively efficient suppl y of pure public goods holds without essential modification for purely joint goods. This is easily seen once it is recognized that the equal consumption conditio n o n which it is based is necessary fo r Pareto-efficiency eve n where it doe s no t hol d b y definition. (W e abstrac t from th e possibility o f negative marginal evaluation. ) Th e basic allocativ e requirement, £MR S = MT , therefore derives from th e joint supply charac teristic an d i s unaffected b y the presence o r absenc e o f nonexcludability . The question is, therefore, whethe r a market mechanism can be expected to satisfy thi s requirement. Tw o main types of market structure have been considered, perfect competition and monopoly. Perfect competition. In his first paper Samuelson appears to argue that even if we could abstract from the fundamental problem of preference concealment a competitiv e marke t mechanis m woul d stil l be incapable o f ensuring an allocatively efficient suppl y of purely joint goods [15 , p.389]. This question has been examined in detail recentl y by Thompson [24] , who reaches th e surprising conclusio n tha t purel y joint good s wil l b e oversupplied b y a competitive market. Thompson explicitl y assumes that bot h producers and consumers have perfect knowledg e of all preference functions . Under thes e conditions h e argues tha t perfec t competitio n wil l produc e a syste m o f rationa l pric e discrimination such that each consumer is charged a unit price equal to his marginal valuation. (I t is clear from Thompson' s discussio n that this uni t price i s to b e interpreted a s the all-or-nothin g pric e pe r uni t in term s of private good at which the consumer would just be willing to purchase a given quantity o f service; it is therefore equa l t o average valuation rathe r tha n 'marginal' valuation.) No consumer would be willing to pay more; and no seller would be willing to accept less, since a concession to any one customer would force the seller to grant a similar concession to all his other customers. Free entry and exit from th e industry ensures that in equilibrium summed unit prices, and hence summed average valuations, just equal marginal cost (the minimum average cost of the marginal firm). If average valuation were equal t o margina l valuatio n (o r margina l rat e o f substitution ) for each consumer, th e allocativ e requiremen t ]>>R S = M T would therefor e b e satisfied. In fact, of course, average valuation necessarily exceeds marginal valuation fo r eac h consumer , an d £MR S < MT . Purely joint good s ar e therefore over-supplied under perfect competition. To illustrate the possible degree of misallocation involved , Thompson note s that in the special case of constant costs the community would be just as well off with a zero output of the joint good [24 , p.7] .

10 Moder n Fiscal Issues The analysis of this specia l cas e is still controversial. 2 If, however , we provisionally accep t Thompson' s analysi s as correct, th e basi c objectio n remains tha t th e perfec t knowledge assumption i s hopelessly unrealistic . According to both Samuelson and Musgrave, the central problem of public goods supply is that consumers will not reveal their preferences for publi c goods. Eve n in the Thompso n mode l of perfectly competitive provision , this proble m dul y emerge s whe n th e perfec t knowledg e assumptio n i s relaxed. Assuming that the seller still attempts to set discriminatory prices equal to averag e valuation, eac h consumer now has an incentive to mask his true preferences in an attempt to attract a lower price. As a result it is likely that the whole attempt t o discriminat e would be abandoned. Wit h non-discriminatory pricin g the proble m o f strategi c concealmen t o f tru e preferences disappear s i n th e competitiv e model. Outpu t i s no t Pareto efficient, however , since a unifor m price mus t exclud e some individual s who could otherwise enjoy additional units of service at the existing level of output at no extra cost. Others, moreover, would be willing to pay more for the existing level of output which tends as a result to be too low. Monopoly. Th e problem s o f competitiv e marke t provisio n d o not , o f course, exclud e the possibility tha t som e other marketin g technique may prove superior . Th e effect s o f conferrin g a lega l monopol y o n a singl e producer hav e bee n muc h discusse d i n th e recen t literature , notabl y i n connection with the Minasian-Samuelson debate [2 , 10, 18, 19]. Abstracting from preference-concealment problems, a profit-maximizing monopolist would clearly choose, if possible, to discriminat e perfectly, i n order to cream off the full amount of consumer surplus. Since the services of a joint good cannot generally be retraded, price discrimination is feasible and the resulting output should be Pareto optimal. This is easy to see if we imagine the monopolis t to sel l units o f the servic e incrementally to eac h consumer. For a particular consume r he will therefore charge a very high price for the first units, and the incremental price charged will fall steadily for additiona l units . Fo r th e marginal unit the price charged must equa l marginal valuation or marginal rate o f substitution. Profit wil l clearly be maximized by pushing output to the point where summed marginal prices 2 O f three recently publishe d comments on Thompson's paper, Owen [13 ] concludes that nothing would b e produced, Rodgers [14 ] that Pareto-efficient discriminator y pricing would result, and Ganguly [7 ] that a Pareto-optimal output would b e produced with non-discriminatory pricing ! All three seem , however , t o be incorrect, as Thompson argues in his reply [25] ,

Public goods 1 1 ust equal marginal cost, i.e., wher e £MR S = MT . A t thi s point eac h consumer is in effect paying the all-or-nothing price per unit at which he would just b e willin g to purchas e th e tota l output , an d thes e summe d all-or nothing prices exceed marginal cost. In contrast to the case of perfect competition, however , this exces s is not compete d awa y by the entr y of new firms attracted by the monopoly profit, and output remains Pareto optimal. As Samuelson has particularly emphasize d [19 , p.201], the knowledge assumptions underlying this analysis are once again hopelessly unrealistic . No monopolist coul d possibly possess suc h detailed informatio n o n con sumer preferenc e functions. Th e monopolis t i s effectivel y i n a bilatera l monopoly relationshi p wit h each consumer . H e is therefore faced wit h a whole host of small-number preference-revelation problems, a s each consumer has every incentive to misrepresent hi s preferences in an attempt to obtain a better bargain. At most, only a very crude approximation to perfect discrimination is conceivable and some under-expansion of the service seems likely. If , o n accoun t o f informatio n problem s o r becaus e o f franchis e requirements, uniform pricing is adopted, inefficiency and under-expansion are onc e agai n inevitable . Thi s i s tru e eve n i f th e monopolis t i s price regulated to ensure price-marginal cost equality. Public goods The above discussion clearl y demonstrate s tha t marketing technique s ar e not generally capable o f ensuring an allocatively efficien t suppl y of purely joint goods. Ther e is no sign, however, of the traditional conclusio n that, in the case of public goods, littl e or nothing can be provided throug h th e market. Although the amount supplied may well be suboptimal, substantial quantities can nevertheless be marketed, and in very special cases a grossly excessive output is conceivable. The traditiona l conclusio n is , however , t o b e foun d i n Musgrave' s original contributio n t o th e mode m discussio n [11 , pp.8-9] , Musgrav e specifically attribute s th e complet e failur e of the marke t t o impossibilit y of exclusion: 'People who do not pay for the services cannot be excluded from th e benefits that result; and sinc e they cannot b e excluded from th e benefits, the y will not engag e i n voluntar y payments . Henc e th e marke t cannot satisf y suc h wants. Budgetary provision i s needed if they are to be satisfied a t all' [11 , p.8]. In the analysis of purely joint good s this secon d major publi c good s characteristi c i s completel y ignored . I t i s therefor e interesting t o reconside r th e marke t failur e proble m whe n th e furthe r characteristic of impossibility of exclusion is superimposed o n joint supply. If price exclusion is impossible it might appear that even the suboptima l

12 Moder n Fisca l Issues quantities which might be expected under uniform pricing of a purely joint good will no longer be forthcoming. Nothing can be charged and nothin g will therefor e b e provided . Eve n th e artificia l devic e o f a n omniscien t monopolist would seem to fail, since although he may be able to design a set of Pareto-efficien t differentia l prices , thi s pric e se t i s no w completel y unenforceable. Market failure is again complete. This conclusion, however , requires modification when it is recognized that, even if price-exclusion is impossible, some individuals may nevertheless be willin g t o contribut e voluntarily . Particularl y wher e th e numbe r o f consumers i s small , substantia l amount s ma y be purchased , eve n under completely independen t adjustment . Moreover , i n small-numbe r cases , consumers may be able to reach a voluntary agreement among themselves to purchas e a mor e nearl y Pareto-optima l quantity . Thi s possibilit y ha s been stresse d particularl y i n th e moder n externalit y literatur e stemmin g from the pioneering paper by Coase [5 ]. However, small-number preferencerevelation problems arise, analogous to those we have just considered in the joint supply context, as each consumer has an incentive to misrepresent his preferences in an attempt to obtain a better bargain. Pareto-optimal supply could not therefore in general be expected. As Musgrave explicitly recognizes [11 , pp.9-10], the dramati c marke t failure implications of non-excludability emerge only where large numbers of potentia l consumer s are involved. This seem s the appropriat e cas e t o consider in connection with a pure public good since the efficient siz e of the sharing group is literally infinite. In this situation'... the satisfaction derived by an y individua l consume r i s independen t o f hi s ow n contribution ' [11, p.9]. Accordin g t o Musgrave , nothing wil l therefore be contribute d voluntarily; non-revelatio n o f preference s is complete . Eve n her e som e modification i s necessary to take account o f the fact that small quantitie s may well be purchased even under independent behavior. Complete market failure strictl y require s no t merel y large number s of consumers but als o that summed marginal evaluations fall short of marginal cost over all ranges of output for any subgroup of consumers of critically small size. Even in the more general large-number case , however, the traditional conclusio n stil l holds in the sense that output will be enormously suboptimal . As Buchanan has particularly emphasize d [3] , there is in this cas e no strategic concealment of true preferences in an attempt to achieve a better bargain. Behaviou r is strictly independent; other consumers are treated as part of the natural environment. These large-number preference-revelation problems associate d wit h non-excludabilit y shoul d therefor e be clearl y

Public goods 1 3 distinguished fro m th e small-numbe r preference-revelation problem s en countered in the joint suppl y context, and from small-numbe r preferencerevelation problems in general. These distinctions have been the subject of considerable confusion and debate in the modern literature, bu t the major differences see m now to have been resolved. Conclusion. The above analysis shows that both joint suppl y and impossi bility of exclusion pose significant market failure problems. For the standard large-number case of a pure public good it seem s reasonable to conclude that impossibilit y o f exclusion is the more potent cause of market failure . (We abstract fro m th e somewha t artificia l analysis o f competitiv e over supply.) From this point of view the current emphasis on joint supply as the essential public goods characteristic seem s rather misleading . Problems of political provision

The demonstration o f significant market failure problems in public good s supply provides, o f course, n o guarantee tha t governmen t can do better. In thei r origina l contribution s bot h Samuelso n and Musgrav e explicitly recognize tha t politica l provisio n fo r publi c good s mus t pos e difficul t problems. Th e problem o f determining individual preferences is particu larly stressed by both.

Voluntary exchange models The moder n discussion of political provisio n has bee n very strongly influenced by the early Continental literature, especiall y the benefit theorie s of Wicksell and Lindahl. As a result, there has been a general tendency to regard a pseudo-market solution as some sort of a model or ideal for collective provision. This is true, for example, of Musgrave [11,12] and Buchanan [2, 3], thoug h Samuelso n [15 , 21 ] provides a notabl e exception . In thi s solution, following Lindahl, each person is to be charged a price per unit of public good equal to his marginal evaluation or marginal rate of substitution in terms of numeraire private good, and output is pushed to the point where the sum of these tax-prices just equals marginal cost of the public good. At such a point, £MR S = MT > and output is Pareto optimal. If w e assume that the political planner has full knowledge of all preference functions, i t is clearly true that efficien t allocatio n ca n be achieved in this way. Marginal evaluations are known and tax-prices per unit can be charged which just equal marginal evaluation at a Pareto optima l level of output. However, as Samuelson has particularly emphasized in recent contributions [19,21 ], efficient allocation can equally well be achieved in other ways. For

14 Moder n Fiscal Issues example, a more Wicksellian solution would be to require that tax prices be set equal to marginal evaluation only for th e marginal unit o f public good; different price s might be charged for infra-marginal units. More generally there is no necessity to establish an y market-type or 'voluntary exchange' relationship betwee n tax-pric e an d margina l evaluation . I f individua l preferences are known, tax-prices hav e no conceivable allocative function to perform. The central problem o f public goods supply is, however, that true preferences are unknown. The crucial question is therefore whether the political consensus model with simultaneous determination of public goods quantity and tax-pric e provide s a n efficien t preference-revelatio n mechanism . Th e allocative performanc e o f thes e voluntar y exchang e model s ha s bee n analysed i n detail i n the modern literature. I n general, however, it seems clear that preference-revelation problems arise which are precisely analogous to those which we have already discussed in a market context. In small-number models of the sort analysed by Lindahl each party has an obvious incentive to conceal true preferences in an attempt to obtain a more advantageous agreemen t in terms of public goods quantity and taxprice. Some approach to an allocatively efficient solutio n should, however, be possible. There is still some dispute on this issue with some writers, such as Buchanan [3 ], stressing the incentive to Pareto-optimal agreements, while others, suc h a s Samuelso n [21 , p . 107] an d Musgrav e [11 , pp.79-80] , emphasize the bargaining difficulties . In large-number models the basic Wicksellian dilemma arises that each person may refuse to contribute voluntaril y since public goods quantity is seen t o b e virtuall y independen t o f hi s ow n ta x contribution . Genuin e bargaining may therefore prove impossible. In spite of Buchanan's ingenious argument to the contrary [3, pp.92-4] it seems very doubtful whether possession o f th e vet o i n th e Wicksellia n mode l coul d significantl y improve performance a s compare d wit h th e correspondin g large-numbe r marke t situation. Majority-voting models The problems o f political provision hav e also bee n explored in the mor e realistic setting of majority voting. Thus, for example, Anthony Downs [6] has analyse d th e problem s o f publi c good s suppl y i n a majority-votin g model characterized by competition for political power between two votemaximizing politica l parties . I f bot h partie s hav e ful l knowledg e o f al l preference functions, competition for votes will tend to force the adoption

Public goods 1 5 of a Pareto-optimal program. This is in contrast to the corresponding case of market provision where the introduction of competition between omniscient profit-maximizin g firm s produce s over-expansio n o f publi c good s supply. Since the rational voter's choice should depend only upon his total net utility, there is no obviou s reason why the program chose n by either party shoul d b e presente d i n voluntar y exchange form wit h a n explici t tax-price (margina l o r average ) fo r th e publi c goo d equa l t o margina l evaluation. Th e sam e Pareto-optimal progra m (wit h an y accompanying redistributive measures ) coul d b e presente d i n infinitel y man y differen t ways, all of equivalent vote-catching potential. When we relax the unrealistic assumption that the parties have full knowledge of voter preference maps, we encounter preference-revelation problems. If it is believed that, for distributional or other reasons, tax shares will be related to revealed preferences, voters will have an obvious incentive to behave strategically . I n it s attemp t t o desig n a vote-maximizin g Paretooptimal program, each party finds itself in a bilateral monopoly relationship with the voters, each of whom has every incentive to misrepresent his true preferences in an attempt to obtain a lower tax burden. Evidently no close approach t o Paret o optimalit y coul d reasonabl y b e expecte d i n large number cases. It is interesting to notice that this problem is closely analogous to that of the profit-maximizing monopolist attempting to supply a purely joint goo d throug h th e market . I n contras t t o thi s latter case , however , where under-supply seemed likely, there is no obviou s reason to suppos e that output will be too small rather than too large. Analysis of the Downs model serves to bring out very clearly the possible advantages of the political mechanism in public goods supply. Although the preference-revelation problem s owin g to th e joint suppl y characteristi c remain, there is no sig n of the fundamental non-exclusio n problem that , since nothing can be charged, nothing will be provided. Possession o f the tax power (or printing press) effectively transform s the public good into a joint goo d fo r purpose s o f political provision . B y contrast, th e political mechanism has no obvious advantage over the market system in relation to the joint supply characteristic. Here again it seems that the current emphasis on joint supply as the essential public goods characteristic is very misleading. Finally th e log-rollin g model s o f Buchana n and Tulloc k [4 ] serve t o warn us of 'political externalities' which may impair political performance further. Unde r majority voting, interest group s may combine to suppor t projects yielding special benefits, the cost of which is borne by the community at large. As a result some of the advantages of public provision in relation

16 Moder n Fiscal Issue s to the non-excludability characteristic may be dissipated by the emergence of analogous problems in the political process. Under realistic assumption s of imperfect knowledge, a similar inefficiency can be predicted in the Downs model. Contrary to Buchanan and Tullock, however, there is nothing in the logic of this argument to suggest the necessity of over-expansion rather than under-expansion. INTERPRETATION O F THE PARABL E

Over the past fifteen years , since it was first discussed in the modern literature, the Musgrave-Samuelson polar case has been repeatedly criticized on the ground s tha t fe w if any public service s fit the origina l definition . I n reply, Samuelso n ha s argue d tha t consideratio n o f th e pola r cas e ma y nevertheless yiel d insight s fo r publi c expenditur e theor y comparabl e t o those of the equally extreme Walrasian model of private expenditures [16, p.350]. The theory of a pure public good therefore provides a parable of public expenditure problems . Although the modern debate has undoubtedly served to clarify a number of obscurities in the original Musgrave-Samuelson formulation, the central policy implicatio n o f th e parabl e ha s no t bee n clearl y brough t out . I n particular, ou r analysis suggests that th e current emphasis on jointness as the essential characteristic o f the public goods concept is dangerously misleading. Th e political mechanism has an obvious comparative advantag e over the market in dealing with problems of non-excludability. It ha s no such advantage in relation to the jointness characteristic . Although the pure public goods concept is of little direct practical importance, it ca n readily be generalized to cove r the wide range o f goods exhibiting elements of either or both the joint supply and non-excludability characteristic. Ou r analysis suggests that here again any significant advan tages from public intervention will be found to derive fundamentally fro m the non-excludabilit y elements rather tha n fro m generalize d joint suppl y problems. Almos t alon e amongs t recen t contributor s t o th e discussion , Carl Shou p has explicitly recognized the primacy of the non-excludabilit y characteristic i n hi s definitio n o f a generalize d publi c good s concep t [23, pp.66-7]. REFERENCES

1 J.M . Buchanan , Joint supply, ex- theor y and practice: a note on the ternality and optimality, Economic^ Minasian-Samuelso n discussion, Nov. 1966 , 404-15 Journal o f La w an d Economicsp, 2 J.M . Buchanan , Public goods in Oct . 1967,193- 7

Public goods 1 7 3 J.M . Buchanan , The Demand and Supply o f Public Goods, Chicago 1968 4 J.M . Buchana n and G. Tullock, The Calculus of Consent, Ann Arbo r 1962 5 R.H . Coase , The problem of social cost, Journal of Law an d Economics, Oct. 1960, 1-44 6 A . Downs, An Economic Theory o f Democracy, New York 1957 7 S.K . Ganguly, The perfectly com petitive production o f collective goods: comment, Review of Economics and Statistics, Nov. 1969, 478-9 8 J.G . Head , Public goods and public policy, Public Finance, no.3, 1962, 197-221 9 J.G . Head , Welfar e methodology and the multi-branch budget, ibid., no.4, 1968 , 405-24 10 J.A. Minasian, Television pricing and the theory of public goods, Journal of Law and Economics, Oct . 1964, 71-8 0 11 R.A . Musgrave, The Theory o f Public Finance, New York 1959 12 R.A. Musgrave, Provisio n for socia l goods, in J. Margolis and H. Guitton, eds., Public Economics, London 1969, 124-4 4 13 B.M . Owen, The perfectly com petitive production of collective goods: comment, Review of Economics and Statistics, Nov. 1969, 475-6 14 J.D . Rodgers , The perfectly com petitive production of collective goods: comment, ibid., 476-8

15 P.A. Samuelson, The pure theory of public expenditure, ibid., Nov. 1954, 387-9 16 P.A . Samuelson, Diagrammatic exposition of a theory of public expenditure, ibid., Nov. 1955, 350-6 17 P.A. Samuelson, Aspects of public expenditure theories, ibid., Nov. 1958, 332- 8 18 P.A . Samuelson, Public goods and subscription TV : correction o f th e record, Journal of Law an d Economics, Oct. 1964 , 81- 3 19 P.A. Samuelson, Pitfalls i n th e analysis of public goods, ibid., Oct. 1967, 199-204 20 P.A . Samuelson, Contrast between welfare conditions for joint supply and for public goods, Review of Economics and Statistics, Feb. 196 9 26-30 21 P.A . Samuelson, Pure theory of public expenditure and taxation, in J. Margolis and H. Guitton, eds., Public Economics, London 1969, 98-123 22 C.S . Shoup, Public goods and joint production, Rivista internazionale di scienze economiche e commerciali, Mar. 1965 , 254-64 23 C.S . Shoup , Public Finance, Chicago 1969 24 E . A. Thompson, The perfectly competitive production o f collective goods, Review of Economics and Statistics, Feb. 1968 , 1-1 2 25 E.A . Thompson, Th e perfectly competitive production of collective goods: reply, ibid., Nov. 1969, 479-82

HIROFUMI SHIBAT A

2

Joint production, externality, and public goods* The apparent similarities between the concepts of joint production, externality, an d public goods have long been alluded to by many economists. But a systematic analysis of their interrelations had to wait until Professor Shoup's contribution o f 1965 [15]1. His lead was then quickly followed by a successio n o f papers contribute d b y othe r leadin g figures in th e field, namely, those by Professors Buchanan [1] and Samuelson [11]. This paper will deal with essentially the same problems that have preoccupied predecessor s i n the area. It doe s not, however , profess t o b e a summary of the preceding studies, in which the discussion generally evolved around the similarities and difference between joint production and public goods. I n thi s pape r th e scop e o f the compariso n i s enlarged: the basic model o f joint productio n i s formulated principally a s the basi s fo r th e analysis of the phenomena of interdependence in production an d in consumption, and attention i s focussed on the differences between production and consumptio n externality , joint productio n bein g treated a s a specia l case of the former and a public good as a special case of the latter, respectively. Elucidation o f the conditions necessary for a non-competitive bu t voluntary solution, tha t is, a negotiated settlement, to yield a determinate and efficient resource allocation where there is interdependence between the decision-making units, is the main objective of this paper. * Th e original draft o f this paper was written while the author was reader in economics at the University of York, and was presented at a seminar at the University. The author is indebted to the participants in the seminar for helpfu l comments. He has also received a great deal of help from discussio n with Dr Aiko N. Shibata . 1 Professo r J. Head's article [4] , which appeared in 1962, represents a partial exception.

Joint production 1 9 A MODE L O F JOINT PRODUCTIO N

Like a sheep in production of woollen goods and mutton products, in a case of joint productio n w e can usuall y identify a n intermediat e product, dif ferent component s o f which enter th e productio n processe s o f final consumption goods. Therefore , we assume for a given economy a production possibility schedule involving an intermediate product, goo d «, (1

)

This implicit functio n defines th e se t of inputs and output s which may be feasibly attained a t the same time. All inputs are included in it as negative outputs s o that and Hereinafter, for notational convenience , for dF/dX t, w e will write Ft. From (1), by letting dX t = 0 (i = 1 , ..., n - 1 ; i ^ j), and dF = 0, we obtain (2

)

The left-hand sid e of (2) is the margina l rat e o f transformation o f good j into good n. In a competitive economy it is equal to the ratio of market price of good n to that of good/ In what follows, goody will be the numeraire. Next, we assume that th e intermediate product, goo d «, is used exhaustively by two industries as one of their inputs in the following way: industry A uses it for the production of a final consumption good a, and in the course of processing it th e industry necessarily produces a byproduct z, and th e byproduct enter s int o th e productio n proces s o f industr y B , producing another final consumption good, b. 2 I n terms of the standard examples of Marshallian join t product , w e may conceive of goods «, a, z, b, and industries A and B , as representing , respectively , steers , meat , hides , a leathe r product, th e meat product industry , and the leather produc t industry , o r alternatively, wheat , flour , straw , stra w hats , flou r mills , an d stra w ha t manufacturers. Thus we have the following production functio n regardin g each good: For good a, (3 The production o f good a necessarily produces a byproduct, goo d z, thus 2 W e can, of course, reverse th e situations s o that industr y B processing n produce s a byproduct, y, and y in turn enters into the production process of good a. In the following, w e consider z as the byproduct, bearin g i n mind that th e same argu ment ca n be made with respect to y .

)

20 Moder n Fisca l Issues (4

)

Xz the n in turn enters the production function of good b, (5

)

All X$ not used for production of goods a and b will be used for production of other goods, whose production functions ar e given as Xk = X h(Xf), wher e (6 ) i = 1 , ..., n - 1 , and h = 1 , ..., m. Note that the byproduct, z, is not necessarily always a 'good.' It could be a 'bad ' from th e viewpoint of industry B (i.e., QX b/QXz < 0) , as in the case of industrial waste that firms in B must remove in order to produce good b. In other words, regardless of whether it is a good or a bad, it enters into the production process of good b, once it is produced along with good a. We now wish to fin d th e necessar y condition for maximizin g any on e good, say ft, for any given feasible level of the other goods: and (7

)

(8 ) The other relevan t constrain t is the production function for the econom y given in (1), where , and (9 )

(10 ) The problem ma y be expressed i n the for m o f the followin g Lagrangea n function:

(11) From the necessar y condition s associate d wit h (11 ) above , assumin g th e second order condition is fulfilled, the following condition for the maximum Xt(Xa), subjec t to the foregoing constraints, ca n be derived: (12

)

In words, a necessary condition for a technological optimum is that the sum of margina l rate s o f technical substitutio n o f X i fo r X n (th e rati o o f th e

Joint productio n 2 1 marginal physica l produc t o f X i t o tha t o f X n) o f the tw o good s jointly produced from the common input, X n, must be equal to the marginal rate of transformation o f X n int o X t. For a diagrammatic illustration o f the efficient solutions , let us assume an economy consisting of industry A, producing X a, industr y B, producing Xb9 an d th e res t o f the economy . All basi c factors o f production o f th e economy are assumed to be given, with perfectly inelastic supply curves. In Figure 2.1, the quantities of X J9 th e numeraire good, and X n, the intermediate good, are measured on the vertical and horizontal axes, respectively. The economy's productio n possibilit y frontie r is given by the curve, TT' 9 the slope of which indicates the marginal rate of transformation shown in equation (2) , whic h is assume d here , fo r simplicity , t o b e constant . Th e

FIGURE 2. 1

22 Moder n Fiscal Issues quantity of X j whic h is not used for production of X a an d X b determines the outputs o f all other final consumption goods. Let the outpu t level of all other good s be fixed and represente d in terms of the numerair e good by OAT. Then O BOA shows the quantity of inputs available for the production of X a an d X b, i n terms of X J9 an d the line O AC, drawn parallel to the lin e TT'9 represent s al l possible efficien t combination s of X n an d X j availabl e for th e two industries . The production function s of good a and good b, namely, (13

) )

(14

are represented, assumin g X z i s positive and a monotonic non-increasin g function o f X n9 b y isoquants J fls and /fts, respectively. 3 Good 6's isoquants are drawn as usual with reference to the Xj an d X n axes, OB being the origin. Good a's isoquants ar e drawn with reference to the X j axi s and the O AC line, OA being the origin, in the following manner: the quantities of Xj an d Xn9 require d to produce a given output of X a9 represente d by an isoquant , say V, ar e measured by the vertical distance between a point on that isoquant, sa y /, and the line O AC (i.e., JG\ an d by the horizontal distanc e between the sam e point an d the vertical axis O BT (i.e., KJ) 9 respectively. 4 Though A' S isoquants sho w more convexity than is usual, it can easily be seen that they convey exactly the same information as those drawn in the usual manner. But when isoquants are drawn in this way, the slope of each isoquant with respect to the horizontal axis represents the negative value of the difference between the marginal rate of technical substitution o f Xj fo r Xn i n production o f X a an d the marginal rate of transformation of Xj int o Xn. Thus the slope of good a's isoquant is (15

)

Consequently, a t an y tangenc y point betwee n A'S and B' S isoquants th e following relationship holds:

(i?

or (16

3 Th e measuring scale of X z i s so taken that a given X n correspond s to X z(XR) units of X z, s o as to show the isoquants of goods a and b on the same diagram. 4 Fo r a further explanatio n o f the construction o f this type of diagram, see H. Shibata [13] .

)

)

Joint productio n 2 3 Equation (17 ) is identical t o equatio n (12) . In othe r words, any tangency point satisfied the production efficienc y condition . Th e locus of these tan gency points, VW, is therefore the production contract curve, representing all feasible efficien t configuration s o f output s o f X a an d X b whe n O AT is fixed. Tracing output combinations of Xa an d X b, we can generate the usual iso-cost o r iso-outla y curv e shown in Figur e 2.2 . I f th e outpu t o f othe r goods, O AT, is changed, the length of O BOA changes causing a shift o f the tangency points an d generatin g a new contract curv e and iso-cos t curve .

FIGURE 2. 2

In othe r words , there i s one production contrac t curv e corresponding t o each o f th e variou s outpu t level s o f othe r good s (represente d b y O AT, namely the quantit y of the numeraire good, X J9 availabl e for transformation into good s other tha n X a an d X b). Th e series of contract curve s thus represents all efficient configurations of X a, X b an d Xj. Clearly, if the byproduct, z , is divisible, and i f it can be withheld fro m firms which do not pay the price, then it can be made the subject of ordinary market transactions. Assumin g that there is a large number of competing

24 Moder n Fiscal Issues firms producing good a, and that the same is true for firms producing good b, these firms , b y definition , tak e th e price s o f thei r fina l products , inter mediate products, an d input s as given. Let P a, Pb, P i9 P n9 an d P z b e th e market prices of goods a, b, /, w, and z, respectively. A firm in industry B, say s (s = 1,... , L), will maximize its profit function , (18

)

subject to its production function , (19

)

From the Lagrangian function , (20

)

the relevant first order condition for this maximization may be written5 as (21

)

Industry B'S production function is given by where (22

)

By lettin g dX b = 0, d^ = 0 , i = 1 , ..., n — 1, and i ^ 7, we can obtai n that (23 ) similarly from (19), for firm s, (24 ) However, condition (21) implies that thi s ratio is the same for all firms in industry B. Thus so that (25

)

(26 ) On the other hand , fo r a firm in industry A, say r (r = 1 , ..., Af), if its 5 I n the remainder o f the paper, we assume that th e relevant second order condi tions are fulfilled .

Joint productio n 2 5 byproduct is sold at a price, P Z9 it amounts to a decrease (if P2 > 0), or an increase (if Pz < 0), in the 'net' price of the input, X n. Th e profits function of r is therefore given by (27

)

Firm r will maximize the above function subject to its implicit productio n function, (28

)

The relevant first order condition may be written (29

)

The industry A'S production function is given by where (30

)

By an identical argument applied to industry B, and assuming for al l frims

(31 (32

By substituting for Pz in (32) Pz in (26) we obtain

(33

) )

)

which may be rewritten as

(34) Thus this competitive solution satisfies the production efficienc y conditio n (12). PRODUCTION INTERDEPENDENC E AN D PRODUCTIO N EXTERNALITY

The relevance o f the model o f joint production, a s formulated above, t o production externality , i s evident at once . Th e preceding sectio n showed that th e so-called 'duality ' - a correspondence betwee n Pareto-efficienc y and market performance - would be maintained in the case of joint production if, in addition t o all other products, th e byproduct was also competi tively marketable. We shall now examin e specifically the effec t o f join t

26 Moder n Fiscal Issues production i n the case s where the byproduc t canno t b e marketed i n the usual way to se e whether or not solution s spontaneously obtaine d unde r these circumstances satisfy th e Pareto-efficiency condition . Since the Pareto-efficienc y conditio n for productio n i s defined i n (12) , the mos t logica l definitio n of a n externality , i n th e sens e that i t ca n b e distinguished from the simple interdependent relationship indicated by the equations (3) and (5), is to identify i t with a situation in which, in spite of the presence of the relationship indicated by (3) and (5), the condition (12) does not hold.6 Thus we shall say that a marginal production externality is present when

(35

)

The situation can be divided into external economies and diseconomies. A marginal external economy in production i s defined to be present when (36) and a marginal external diseconomy in production is defined to exist when (37

)

An externality relationship i s thus characterized as a situation in which good n is not utilized optimally, in the sense that a small change in the use of good n (an increase in the case of an external economy and a decrease in the case of a diseconomy) makes it possible to increase the outputs of both X a and X b, o r at least o f either on e of them, without reducing outputs of all other goods ; and any marginal externality thus defined implie s the possibility of mutually profitable trade between the parties involved.For instance, in our example in the previous section, if for some reason or other, the price of z, P2, happens to be equal to zero, then A reaches its equilibrium when where

an d (38

(39

) )

Ifat and (40 (41 6 Her e we mean that an interdependent relationship is not identical to an externality relationship. Th e latter necessarily implies a Pareto non-optimum situation but the former does not.

) )

Joint production 2 7 there exists a marginal external economy, for The situatio n ma y be explained from Figur e 2.1. A'S production poin t that prevails when Pz i s zero is where one of A'S isoquants is tangent to a horizontal line indicating the price line which A faces, namely Pn — Pz = P n. Let the productio n point be 5. Th e isoquants of A and B both containing point S delimit an area.7 It is clear at once that by moving to a point located within this area, the outputs of both goods a and b, or of at least one good, can be increased without increasing the combined costs or, in other words, without reducin g the output s of all other goods. In this sense any output combination represente d b y a point located within this area may be called 'Pareto preferred' to the output combination represented by S. Indeed, bot h firm s wil l benefi t b y movin g inside this Pareto-preferre d area. At S 9 firm B'S isoquant is not tangen t t o it s price line (P z = 0) ; t o maximize its profits, it requires more of z, and as long as it pays for B to offe r A a price, Pz, to obtai n more of z. From A'S point of view, the fact tha t the byproduct, z , can be sold at a price amounts to a reduction of the net price of input X n9 represente d by a clockwise rotation of the pric e lin e DE. Th e optimalit y conditio n suggests that A use X n mor e intensively and sell z to B, as long as The possibility of trade remains to be exploited until Pz become s equal to the valu e o f th e margina l produc t o f z i n productio n o f X b an d P n — Pz(dXz/dXn) equal s that o f goo d n in production of X a. Th e slop e of th e isoquants at that tangency point indicates the equilibrium price of z, Pz. At the equilibrium under the prevailing market prices of outputs and inputs, the quantity of X b demande d will require a quantity of X z a s an input just large enough to absorb the quantity that A will necessarily release in order to produce the quantity o f X a demanded . If both parties behave as pricetakers, the quantitie s o f X z demande d an d supplie d wil l b e brought int o equality through Pz, and Pz automatically determines the share of the common cost of input X n betwee n the two final products. Clearly, if a byproduct is marketable competitively, there will be no diffi culty in organizing its trade, an d a n interdependence does not lea d to a n 7 Th e shaded area enclosed by /fl2 and I b2.

28 Moder n Fisca l Issues external economy or diseconomy, but there are many byproducts usually not regarded as commodities exchangeable in the market in an ordinary fashion. This doe s no t imply , however , that al l o f these 'non-marketable ' good s cannot be rendered exchangeable when there are opportunities fo r mutually beneficial trade. Under some circumstances, the y will be, and in fact sometimes have been, made subjects of trade, an d th e apparent absenc e of an ordinary market fo r the byproduct doe s not necessarily impl y an externa l economy or diseconomy. Indeed , unawarenes s of this fact was apparentl y the essence of the criticisms that Coase [3] , levelle d against th e Pigovia n analysis of externality . Coase instanced a herd of cattle, a part of which strayed and destroyed the crop s o f a nearb y farm . Althoug h hi s exampl e did no t contai n an y explicit byproduct, i t can easily be framed i n terms of our model. Let our Xa9 X n, X Z9 X b, A , and B be, respectively , cattl e sold a t market , a herd o f cattle, straying cattle, wheat sold a t market, a cattle breeder , and a grain farmer. Thus, in his case, the byproduct is the straying cattle, their numbers being a function of the size of the herd. The byproduct is a 'bad' from th e farmer's point of view, and it necessarily enters into the production functions of wheat and creates &prima facie cas e of 'external diseconomy.' However, an external diseconomy in the sense we defined in (37) above, indicating a Pareto non-optimum situation , ma y not be present. Suppose that the prevailing legal situation is such that the cattle breeder (A) is not legall y responsibl e fo r the damage. I t ma y appear a t first that, under this legal situation, A will increase the size of the herd ( X n ) unti l th e value of the marginal product of the herd equals its price (Pn), or A'S 'private' optimum output where (42

)

When (43

)

and, by assumption, (44

)

Thus a t A' S private optimu m the farme r (B ) has t o suffe r th e damag e imposed upon him by A. (At X n = X ns, the total damage imposed upon the farmer equal s the reduction o f wheat output cause d by the straying cattle associated wit h X ns9 th e siz e of herd , multiplie d b y th e pric e o f wheat. ) But, a s Coase argues, the situatio n i s not stable . Th e farmer (B ) will soon

Joint productio n 2 9 find that it pays him to bribe A into reducing the size of the herd, so long as the revenu e from th e additiona l crop s save d fro m damag e i s larger , o r equal to, whatever he has to pay for an additional reductio n in the size of the herd (and hence the number of straying cattle). H e reaches his equilibrium when the price he has to pay (Pz) is just equal to the marginal damage saved or , an d (45 ) (46 ) From th e cattl e breeder' s (A'S ) poin t o f vie w th e pric e offere d b y th e farmer is now a part of the opportunity cos t that he incurs in expanding his herd: that is, he must forego this sum if he chooses to increase the size of his herd. The new optimum size for his herd is then the one where the value of the marginal product o f the herd equals this opportunity cost, the price of the herd plus the compensation (P z): and (47

) (48 ) The equations fro m (45 ) to (48 ) together sho w that th e solutio n reache d after full adjustment involving voluntary negotiation will satisfy the Pareto optimum o r productio n efficienc y conditio n (12) , an d ther e remain s n o external diseconomy which has to be corrected by a third party, such as the government. Alternatively, if the law makes the cattle breeder liable for the damage, he will find that it pays him to expand the herd only to the extent that th e net revenue from the additional cattle is larger or equal to his required payments for the extra damage that the additional strayin g cattle would cause to the crops. Thus, the marginal cost of his herd is the price of the herd plus the compensation, namely [P n — Pb(QXb/dXn)]. H e reaches his equilibrium, as regards the size of herd, when This again satisfies the efficiency conditio n (12). It is evident that as long as Pa9 P b, and P n remai n unchanged , th e optimu m siz e of th e her d wil l b e exactly the same whichever legal arrangement is chosen. Coase ha s thus show n that (1) a situation o f interdependence wit h no apparent competitiv e market for the byproduct does not necessarily imply a situation with nonoptimum resource allocation o r a marginal externality, and that (2) the outcome of trade betwee n the two parties involve d is in-

30 Moder n Fisca l Issue s variant with respect to the manner in which the law assigns the liability fo r damage. Two points mus t be noted i n connection with Coase's theorem . First , there i s generally a one-to-on e relationship between an efficien t resourc e allocation an d the corresponding distribution of income. Therefore, if the legal delimitation of the right and responsibility of the person who engages in som e activity affect s th e incom e distribution pattern , i t wil l also affec t the pattern o f efficient resourc e allocation through a change in the demand pattern. Wha t Coase, limiting himself to the analysis of production exter nality, implicitly did present was, in fact, a corollary o f this proposition . Since the law which assigns to business firms (not individuals ) the liabilit y for damag e has n o effec t o n the distribution o f income, for unspecialize d factors o f productio n ar e freel y mobil e betwee n businesses, i t doe s no t influence the pattern of the income distribution. To put it another way, the Coase theorem must be qualified in such a way that if there are specialized factors of production, th e returns of which are affected b y a change in the law, the law will influence income distribution and, therefore, it will change the pattern of optimum resource allocation t o the extent that income redistribution affects the demand pattern. Thus Coase's theorem is based on the implicit assumptio n tha t al l factor s o f productio n ar e non-specifi c t o production o f the goods in question . Secondly, although there are always 'possibilities' of trade in an exter nality relationship , unles s th e possibilitie s ar e i n fac t full y exploite d spontaneously, a suboptima l resourc e allocation wil l remain uncorrecte d and the relevance of Pigovian policy recommendations will remain largely undiminished.8 Th e importanc e o f Coase' s analysis , fro m th e policy maker's poin t o f view, therefore, wa s to poin t ou t tha t eve n if an inter dependence appears to be present - under certain circumstances, though, it is important t o stress, not always - th e possibilities o f trade might in fact be fully exploited spontaneously, so that no further government intervention would be required to secure an efficient resource allocation. Bu t under what circumstances ? It is crucial to discern in this connection that the numerous examples cited b y Coas e ar e instance s o f production interdependenc e i n which the related parties are identifiable and each producer is in competition with others in the market for his product. For instance, in the above example, 8 Thu s the presence of possibilities of negotiation, or of the gains fro m trade itself , is not the sufficient conditio n that enable s u s to declare that a Pareto-optimum condition will in fact b e reached and tha t government intervention o n efficienc y grounds is unnecessary. For a contrary view, see Turvey [16 , p.313] .

Joint productio n 3 1 only one grain farmer an d one cattle breede r are in one 'region.' Yet it is implicitly assume d that ther e ar e many such 'regions ' s o that there does exist a perfectly competitive market for the final consumption goods, and that the values of the marginal products of the final goods correctly reflect the socia l benefit s obtainabl e fro m thes e goods . I n othe r words , som e natural barrier s - distance , geographica l features , etc. - becom e effectiv e exclusion devices which divide the whole economy up into many competing regions, limitin g a n externalit y relationshi p t o on e within a n identifiabl e pair o f producer s i n eac h region , th e pai r i n tur n competin g wit h th e producers o f the rest of the economy. The importance o f this implicit assumption becomes clear at once, if we consider a n interdependen t relationshi p involvin g a larg e numbe r o f the producers i n th e entir e economy . Professo r Meade' s exampl e [5 ] of th e bee-keeper's bee s feeding on the neighboring apple grower's apple blossoms may serve to illustrate the point. Let us assume that within each industry, there are large numbers of independent competing firms, i.e., bee-keepers and apple-farmers , an d the y togethe r compris e the entir e economy . The nectar collectable fro m appl e blossoms is the byproduct in our interpreta tion, and apples, honey, and apple trees correspond to our X a, X b, an d X n respectively. As already demonstrated , i f P z = 0 , or i f no paymen t is made by th e bee-keepers to th e appl e grower s for th e nectar extracte d fro m th e appl e blossoms by their bees , th e numbe r o f appl e trees planted wil l b e much smaller than that required for the bee-keepers to attain their optimum input combination. Therefore, there are possibilities of mutually beneficial trade. Every one of the bee-keepers may wish to bribe the apple growers to induce them to plant more apple trees. However, if bees fly over a fairly wide area, a bee-keeper doe s not know which apple-farmers he should subsidiz e and whether hi s subsid y wil l in fac t b e pai d of f by a n increas e i n th e hone y production o f his own bees. If every one of the bee-keepers is to hold back his offer in the hope that someone else might subsidize apple growers on his behalf, th e externalit y coul d well , i n fact , remai n uncorrected. 9 I n th e absence o f pressur e o f competitio n fro m othe r economies , th e strategi c behavior most likely persists and in fact prevents the externality from being 9 Th e erection of a large fenc e might b e suggested bu t that would not appea r t o be a feasibl e solution . Eve n if it were possible, if all other pair s o f apple grower s an d bee-keepers were fenced into their respectiv e units , a t leas t on e pair coul d sav e the cost of erecting its own fence. Each of the pairs may refrain fro m buildin g a fence in the hope that it may become this last lucky pair , particularly if the cost of a fence is substantial.

32 Moder n Fisca l Issues corrected i n spite of the definit e presence of the 'possibilities ' of mutually beneficial trade . But since there doe s exist a clear advantag e i n internalizin g the exter nality, a merger of all the bee-keepers may well be worked out. Sinc e it is assumed that there is only one region in the entire economy , the merged firm becomes the monopolist in its final product marke t and the monopsonist in relation to the apple growers. Since all the apple growers are also likely to merge into one firm to gain strength in bargaining with the monopsonistic bee-keepers, a bilateral-monopoly situation is the most likely outcome, unless these two monopolists can merge into one firm. The specia l circumstance s involved i n th e Coas e cas e ar e no w clear . First it is a case in which some unspecified natural barriers , i.e. , distance , terrain, etc. , effectivel y separat e on e region fro m another , an d wher e in each regio n al l farmers and cattl e raiser s hav e already merge d into thei r respective regiona l monopolie s and , therefore , th e interrelationshi p i s exclusive between the pair who are identifiable. Second, the existence of a large number of similar regions and consequential competitio n i n the final product market s make s i t impossibl e for eac h regiona l 'monopolist ' t o indulge in the game of bilateral monopoly. Had ther e been many farmers or many cattle raiser s in the sam e 'region,' the free ride r problem would certainly have arisen. Had there been only one farmer and one cattle raiser in th e entir e economy , a n uncertai n resul t characteristi c o f the bilatera l monopoly would have resulted. In short, a production externalit y may be corrected spontaneousl y b y bilatera l negotiatio n betwee n th e partie s i f there exist s som e low cos t o r natura l exclusio n devices that mak e thei r interdependence exclusive among a n identifiabl e pair an d effectiv e com petition i n their final product markets makes it imperative for them to fully exploit economies arising from internalizing the externality. CONSUMPTION EXTERNALIT Y AN D PUBLI C GOOD S

A model of consumption externality including the case usually referred to as public goods, can be formulated, ostensibly at least, such that it parallel s exactly that of production. Let us now take A, B, Xn, and X z t o be individual A, individual B, the good consumed by A, and th e byproduct of A'S consuming good «, respectively. Instead o f output X a an d X b, w e now have utility indexes of individuals A and B represented by U a and U b, respectively.10 As 10 I f w e assume the econom y consist s of two groups , A and B , and eac h grou p ha s a consistent set of ordinal preferences wit h respect to the consumption o f variou s goods, we can replac e individuals A and B by groups A and B .

Joint productio n 3 3 in the case of joint production, we assume the byproduct, z, will enter the utility function o f B either harmfully o r beneficially. 11 We assum e that A' S and B' S preferences are represente d b y regularly smooth and convex utility functions given as follows, respectively, (49 ) where (50 ) (51 ) and th e productio n conditio n o f th e communit y consisting of these tw o individuals is represented by where (52

)

By a procedure analogou s to that o f deriving efficient productio n conditions presented earlier, to find Pareto-optimum conditions, we maximize the Lagrangian function,

(53

)

Expressing relevant first order condition s fo r th e maximizatio n as ratio s yields the following necessary condition for a maximum Ua (or U b) subject to the foregoing constraints:

4)

The situation is illustrated diagrammatically in Figure 2.3, analogous to Figure 2.1. On the vertical axis, quantities of the numeraire commodity are measured. O AD an d O BD no w represen t A' S and B' S total resource s (o r income) respectivel y i n term s o f Xj. Th e horizonta l axi s measure s th e quantities of Xn an d X z consumed. 12 The //, Ia2 .. . and Ibl9Ib2 .. . are now read a s th e indifferenc e curve s of A and B respectively. Since the wa y o f constructing Figure 2.3, which now contains indifference curves , is exactly analogous to that o f Figure 2.1, at any tangency point of A'S and B'S indif1 1 The reader is reminded tha t the argument tha t follow s can be repeated in exactl y the sam e wa y in terms o f the byproduc t o f B'S consumption o f good « , denote d by y, instead o f A'S byproduct, z . 12 A s in Figure 2.1, the scal e o f X z i s so taken tha t a given X n correspond s t o Xz(Xn) unit s o f X Z9 assumin g X z(Xn) i s positive an d a monotonic non-increasin g function o f X n.

34 Moder n Fisca l Issue s

FIGURE 2. 3

ference curves , the Pareto-optimu m condition expressed in equatio n (54 ) holds. Thus the locus of these points, VW, is the contract curve. By reading off A' S and B' S utility level s along th e contrac t curve, w e can obtai n th e Samuelsonian utility possibility frontier, Figure 2.4, which is analogous t o the iso-cost production possibility frontier shown in Figure 2.2. Each point of thi s frontie r determine s th e maximu m o f U a attainable for an y give n level of U b and vice versa. The frontier will shift outwards or inwards, if the initial incomes of either or both of the two parties involved are increased or decreased. The optimality condition specifie d i n (54) or illustrated i n Figure 2.3 is

Joint production 3 5

Social Welfar e Contours

FIGURE 2. 4

exactly the sam e as the optimu m condition for a public good specifie d b y Samuelson [9]. The sum of the marginal rates of substitution of individuals (parties) must be equal to the marginal cost of the collective consumptio n good, X n. (Not e that, however, the marginal rate of substitution o f X n fo r Xj nee d not be positive for all individuals.) It is also the same as the Pareto equilibrium condition used in various articles on externality, including that of Buchanan and Stubblebine [2] . The result is hardly surprising, however, for i f we substitute fo r X z i n (50 ) X z i n (51) , th e equation s (49 ) and (50 ) together produc e th e definitio n o f publi c good s specifie d b y Samuelso n [9,10,12], as well as the definition of the presence of an externality given by Buchanan and Stubblebine [2] . The apparent similarity in the expression between the production inter dependence given by equations (3-5) an d the consumption interdependence given b y equation s (49-51 ) abov e ma y sugges t tha t internalizatio n o f a consumption externalit y is possible alon g simila r lines to th e argument s

36 Moder n Fisca l Issues presented i n connection wit h the productio n externality . I n fact , i f bot h individuals A and B were to behave as price-takers a pseudo-market solution would be possible. For example, if the byproduct, X z, i s sold at a price, Pz, it amounts to a reductio n in th e pric e o f X n an d A' S consumption of X n (hence outpu t o f X z) wil l be greater tha n i t woul d b e if the byproduct s could not be sold.13 Thus A'S supply of the byproduct is a function of P2. In Figur e 2.3 , th e suppl y of X 2 i s shown by the locu s of tangency point s between A'S indifference curve s and variou s rays extended from D (DSP). The slope of a ray represents the price of Xz. B' S demand for X z i s shown by the locu s o f the tangenc y points between B'S indifference curve s and th e same rays (DRP). Th e point o f intersection o f these two curves (P) gives the equilibrium price and quantity of Xz. Sinc e at the intersection the indifference curves of A and B are tangent to the same ray, they must be tangent to each other, assuring that the solution thus attained is a Pareto optimum or on the contract curve, VW . However, sinc e in th e consumptio n interdependence a s define d abov e the same quantity of Xn must enter into the utility functions of all individuals, the real situation is similar to the bilateral monopoly and the price-taking behavior coul d not be expected.14 The quantity of the byproduct and the share of the cost of X n betwee n A and B must be determined by some other means. I n th e absenc e of a governmenta l fiat, it mus t be determined by voluntary negotiation. Th e failur e o f such negotiation t o exploi t full y al l possible gains from trade implies that the existing solution is a Pareto non 13 I n th e case o f consumption, example s o f byproducts whic h are 'goods' and ca n be sold a t positive prices appear somewhat unusual . The reason is not becaus e they are absent, bu t w e are used t o defining any activity producin g marketabl e byproducts a s 'production' rather than consumptio n o f the activity, eve n thoug h the one who controls the activity derive s utility fro m the activity itsel f i n addition to the utility derived fro m the use of the money incom e obtaine d from the sales of the byproducts. However, examples o f byproducts which ar e 'bad' are easily recognizable. I n connection wit h this point, it shoul d b e noted tha t many interdependent relationship s whic h appear a t first sight a s a producer-consumer inter dependence ma y in fact be a consumer-consumer interdependence . 14 I f X z i s divisible in the sens e that differen t individual s ca n produc e an d consum e different quantitie s an d it can be made subjec t t o price exclusion, th e usual competitive marke t solutio n i s possible. Suc h a market solutio n ca n also be illustrated in Figure 2.3 as the intersection point of DSP and DRP, but in this case A and B must represent group s o f individuals each o f which consists o f a large number o f people, and indifferenc e curves o f A and B represent 'com munity' indifference curves o f group A and grou p B , respectively .

Joint production 3 7 optimum. Her e w e may defin e a marginal consumptio n externalit y to b e present when the situation expresse d in equation (54) is absent, or (55

)

In paralle l wit h ou r analysi s o f productio n externality , w e can defin e a marginal external economy in consumption to be present when (56) and a marginal external diseconomy in consumption to be present when (57) One possible caus e of externality is that the technological and/o r lega l conditions preven t A from receivin g a price fo r th e byproduc t (i f the by product i s a 'good' from B' S point o f view) or from bein g charged a price for disposing of it (if the byproduct is a 'bad' from B'S point of view). When Pz = 0 , A's private optimalit y conditio n i s (QU a/dXJ/(QUa/dXj)= FJF p which show s tha t ther e exist s a n externalit y define d a s (55 ) unles s (dUbldX^($UbIQXj) happen s t o b e zero . Th e equation s als o sho w tha t there ar e possibilitie s fo r mutuall y beneficia l trade . If , fo r example , th e law imposes no restriction on A'S consumption o f X n, w e know that A may (not necessarily 'will ' for a reason we shall discuss below) reach his utility maximizing optimum in isolation where (dUa/dXn)/(dUa/dXj= ) FJFj. Le t such X n b e X HS. O n th e othe r hand , whe n X n = X ns an d P z = 0 , i f [(QUbldXg)l(QUbIQX^y(dXgldX^ =¥ 0 , B is no t a t hi s privat e optimum . I f (dUb/dX2)/(dUb/dXj) > 0 , B wants t o obtai n mor e o f z an d ma y tr y t o subsidize A to increas e A' s consumptio n o f X n; o n th e othe r hand , i f (dUb/dXz)/(dUb/dXj) < 0 , B wishes to reduc e X z an d attempt s t o brib e A into reducing his use of X n. This situation may be illustrated in Figures 2.3 and 2.5. In both figures, A'S optimu m i n isolatio n (whe n th e la w impose s n o restrictio n o n A'S consuming good X n) wil l be point 5 , wher e one o f A'S indifference curve s is tangent t o A'S budget lin e DE, where Xn = X ns. A t point S, if B'S indifference curv e ha s a negativ e slop e [-(dU b/QXJI(QUbldXj) < 0 ] a s i n Figure 2.3, it indicates that A'S consumption of Xn become s the source of an external economy to B at S. A'S and B'S indifference curves containing point 5 mark off the area of Pareto-preferred solutions of S, that is, a set of solutions by moving to one of which from S no-one would be made worse off and a t least on e party made better off. This is so because if A'S use of X n increase s beyond X ns alon g its budget line DE, A's utility position is worsened while

38 Moder n Fiscal Issues

FIGURE 2. 5

that o f B is increased , bu t th e minimu m compensatio n i n mone y (Xj) necessary to keep A at least as well off as before15 is smaller than the monetary equivalent of the improvement occurring to B.16 If, on the other hand, at point SB'S indifference curve has a positive slope [-(9 U b /6X n )/(dU b /6Xj) > 0] , a s i n Figur e 2.5 , A' S consumption o f X n impose s a n externa l diseconomy on B at S. Since in this case, the Pareto-preferred solutio n area is located t o the lef t o f S, A'S use of X n mus t be curtailed an d B must bribe A to induce him to reduce his consumption o f X n. 15 I t i s shown a s the vertical distanc e between A' S indifference curv e containing S and its 'private' budget line, DE, at X n > X ns. 16 I t i s shown a s the vertical distance between B' S indifference curve containing S and the horizontal line, DE , at X n > X ns.

Joint productio n 3 9 We began ou r discussio n o f an externa l econom y by assuming that, in the absence of a restrictive law on A'S activity, A would reach a position suc h as S. But A will probably not move to such a position if he anticipates that B will contribute to his cost of using X^11 Th e best strategy required for A is to behav e in suc h manner a s to induc e B to bea r th e maximu m possibl e share of the total cost of X n. I n other words, A will try to make the solution as close as possible to a position such as M (in Figure 2.3) where A'S indifference curv e is tangent t o B' S indifference curv e containing point D, the minimum acceptable level for B assuming B himself cannot produce X n.18 If A were to move to S before he enters negotiation with B, the move would deny him automatically all possibilities of reaching any solution better than one represente d b y hi s indifferenc e curv e I a2 tangen t t o B' S indifferenc e curve containing point 5 , namely Ib3. On the other hand, B'S strategy is to behave s o a s t o mak e th e solutio n a s clos e a s possibl e t o N, wher e B'S indifference curv e is tangent t o A' S indifference curv e containing poin t S, la1, the minimum utility level acceptable to A. Thus, if we take into accoun t possible gam e theoretic strategie s tha t ma y well develop betwee n the bar gaining protagonists, w e can only delimit possible solutions within the area located between the indifference curve of A containing point S and that of B containing poin t D . Obviously , i f A (B) cannot financ e X n alone , tha t i s (WfiXJKQUJdXj) < P,JPj[(aU bldXJI(dUbldXj) < PJPj] a t A poin t S (R) coincide s with point D.19 This game theoretic strategy element was very much stressed by Samuelson i n his theory o f public expenditure [9, 10, 12] . Indeed , consumptio n externality associated wit h X n9 a s presented above , is identical to th e case usually referre d t o a s a publi c good , X n bein g the publi c good. W e can imagine tha t polic e protectio n provide d fo r A yields a byproduc t which provides incidenta l police protection fo r B , and vice versa. Admittedly, a public good is often defined as 'the good once provided available equally to all,' an d thi s definition may not fit in wel l with consumption externality. But the effectiveness or utility of a public good, say, fire protection, that one will derive from a given expenditure will often vary significantly depending 17 However , so far as I am aware, most of the literature on externality seems to accept uncritically poin t S (ofte n calle d the status quo position) as the position where A stands before A and B enter their negotiation . 18 I f B can produce X z b y himself, th e minimum acceptabl e level i s lb2 which is tangent t o B' S own budget lin e DF. In thi s case point D in the tex t shoul d b e reread as point R . 19 Discussion s on public good s usually make th e assumption, albeit implicitly , tha t one party alone cannot mee t th e total cos t o f the public goo d i n question .

40 Moder n Fiscal Issues upon whether the protection i s provided for him directly or incidentally . We should then regard the fire protection provided for A (A area) denoted by X n'9 a s a different public good from that provided for B (B area), denoted by X nb. Onl y when these two fire protections, X na an d X nb, ar e perfectl y mutually substitutable i n terms of A'S and B'S utility functions, can the fire protection as a whole be considered 'a public good available equally to all.' In other words,when a consumption interdependence is given as a reciprocal form given as,20 and (58 ) (59 ) and, in addition to the above, when and the Pareto equilibriu m conditions of the system of equations (58) and (59) become equal to the system usually used to define a public good, namely, and (60 ) (61 ) It may be argued that the strict interpretation o f a public good implies this type of situation. However, if this interpretation is rejected as being unduly restrictive, a case o f public good s mus t be identified wit h an instance o f unidirectional consumption externality.21 COMPARISON BETWEE N PRODUCTIO N AN D CONSUMPTIO N EXTERNALIT Y

It has been shown that the fact that there exists an interdependent relationship in production or in consumption does not itself necessarily lead to an external economy or diseconomy, assuming, of course, that these terms are used, a s usually, to denot e a situatio n o f inefficient resourc e allocation; and that onl y when an interdependent relationshi p occur s in the circumstances where spontaneous internalization o f an externality is difficult, th e external economy or diseconomy may remain uncorrected. In these respects, production an d consumption interdependenc e posses s a simila r outlook . Nevertheless, there are the following basic differences between them. 20 Not e tha t X na an d X nb denot e th e quantities o f expenditure mad e i n different way s and no t distributio n of the cost of X n betwee n A and B . Thus this formulation i s different from Professor Musgrave' s [7] . 21 Se e Samuelson's recent redefinitio n o f public good s [12] , an d also Oakland [8] .

Joint production 4 1 In th e cas e o f productio n interdependence , a s ha s bee n shown, even where the byproduct is not marketable in the usual manner, if the pair of parties involved in the externality in question is competing with other pairs, the existenc e o f competitiv e market s fo r thei r fina l product s (a s wel l as input markets ) wil l give rise t o a pressur e o n the m t o reac h a n efficien t solution by means of inter-firm negotiation. Moreover , there is no indeter minancy of 'the' efficient solutio n nor uncertainty as to the outcome of the negotiation. Th e reaso n i s tha t i n productio n th e profi t maximizatin g combination of outputs is objectively given and known to both protagonists, with reference to the market prices of the final products and inputs and the production technology. As long as the production technolog y is universally known, deliberat e deception i s impossible. I n th e absenc e o f possibilities for bluffing and strategic behavior they can readily agree on the output an d resource allocation that maximizes their joint profits. After all, under these conditions a s long as resources owned by each firm are not specifi c to th e production o f any particular good , ther e i s nothing which prevents each firm from internalizing externality by producing all of the interrelated final consumption goods in question. As compared wit h the objective production possibility schedule and the joint profits schedule thus available in production interdependence, in the case of consumption there are onl y subjective individual utility schedules and no unique social welfare function t o which the negotiating parties can refer. Eve n if the locus of the utility possibility frontier i s somehow ascertained afte r a serie s o f negotiations, bot h partie s ar e no t likel y to agre e upon a single solution as the one which maximizes their 'joint utilities' an d will maneuver in orde r t o reac h th e solution s whic h they conside r inde pendently to be the best for themselves or for the group as a whole. Therefore, internalization o f externality will be far more difficult in consumption than in production . The second significant difference betwee n consumption and productio n interdependence i s the effect o f the law on the outcome of negotiation. I n a production externality , th e possession b y one or the other party of a legal right to undertake an activity creating an intermediate byproduct did not influence the outcome of the bilateral bargaining. The production optimum was uniquely determined with reference to the given market demand for the final products reflectin g th e underlyin g income distribution. Ther e i s n o analogy to this in the case of consumption externalities where the law plays a significan t rol e i n determinin g the locatio n o f the final settlement an d distribution of welfare between the individuals involved.

42 Moder n Fisca l Issue s This ma y b e bes t explaine d i n term s o f a consumptio n externa l dis economy. As shown in Figure 2.5, if the law does not restrict A'S consumption of Xn, the set of possible solutions is the area demarcated by A'S and B'S indifference curve s containing point S (i.e., /fl3 an d V). Poin t S indicates the optimum that A can reach if he acts independently under this law. The law giving A a right to consume Xn unhindere d thus amounts to a guarantee that A' S utility leve l will neve r b e reduce d t o th e leve l indicate d b y th e indifference curve containing point S. The law in effect impose s upon B the primary burden of inducing A to move to a solution represented by a point other than S. O n the othe r hand , i f the law gives B the power to vet o A'S consuming Xn (or imposes a negotiable prohibitive law) it is A, this time, who must bribe B in order to obtain the latter's permission for him to consume Xn. The set of possible solutions under this law is delimited by A'S and B'S indifference curve s containing the point D where the output o f X n i s zero (i.e., V an d /b3). Thus the second type of law guarantees that B' S utility level will never be below the level that B can reach at D . The initiative and burden for relocating the final solution now rests on A. Thus the law significantly alter s th e quantit y o f X n a s wel l a s relativ e welfar e o f A and B attainable at the final negotiated settlement . The reaso n fo r th e difference s ha s alread y bee n given . The owner s of unspecialized factors of production ca n shift their factors between differen t industries without reducing their returns, and to the extent that all factors are unspecialized , incom e distribution an d henc e demand condition s ar e invariant with respect to a change in the law, and so are the optimum output combination an d resourc e allocation. O n the othe r hand, individual s are not al l alike in their tastes; they are in effect specialize d in consumption of some goods. A smoker, by definition, cannot become a non-smoker without worsening his welfare position. He cannot remai n 'unharmed' when a law generally prohibitin g smokin g replace s on e that generall y permit s it . I n Figure 2.4, where VW is the utility possibility frontier , A being the smoker and B the non-smoker an d the points S and D correspond t o S and D of Figure 2.5, respectively, the northeast quadrant s o f S and D show the two mutually exclusive sets of all possible negotiate d settlement s representing the situations under the permissive and prohibitive laws,22 respectively. It should be noted in this connection that, as can clearly be inferred fro m Figures 2.4 and 2.5, the choice between the permissive and prohibitive law involves a matter o f ethical judgment: comparison o f the level s of one's social welfare contours representing settlement s under the alternative laws . 22 Thi s terminology is due to Professor E.J . Misha n [6] .

Joint production 4 3 Since th e possibl e welfar e distribution s unde r th e alternativ e law s ar e significantly different, differen t from the case of production externality, one cannot use such a criterion as which law can more likely bring the negotiated settlement on or near the Paretian frontier. 23 Th e social welfare contour s may well indicate that any inefficient solutio n such as breached under one legal arrangement (th e permissive law) is indeed preferred to al l possibl e efficient one s attainabl e unde r th e alternativ e la w (th e prohibitiv e law) , represented b y the segment JH o f VW . Moreover, th e choic e o f policy instrument i s by no mean s limited t o these two extrem e laws. A quot a o n the quantit y of smoking permitted, zoning, a tax-subsidy scheme, etc., can locate possible solutions, negotiated or otherwise, anywhere between these two extremes.24 Thus the regulatory measure and legal delimitation of rights that a government uses to remedy consumption externalities must be selected in relation to the social welfare function tha t th e government wishes to employ , while those which affec t production externalities can be choosen solely on efficiency grounds . 23 Fo r a n argument i n favor of a general prohibitiv e law based o n this criterion, see EJ. Mishan [6] . 24 Fo r example , i n Figure 2.5 , i f the government set s a quota o f size D G on con sumption o f X n, G being a point o f intersection betwee n A'S budget lin e and th e contract curve, i t uniquel y determines efficientl y relativ e welfar e positions of th e two individuals involve d i n this case. As to a tax-subsidy approach , see Shibata [14]. REFERENCES

1 Jame s M. Buchanan, Join t supply , externality an d optimality , Economica 33 , 1966 , 404-15 2 Jame s M . Buchanan an d W.M . Craig Stubblebine , Externality , ibid. 29, 1962 , 371-84 3 Ronal d H . Coase , Th e problem o f social cost, Journal of La w and Economics 111, 1960 , 1-4 4 4 Joh n G. Head, Public good s and public policy , Public Finance 17, 1962, 197-21 9 5 Jame s E. Meade, Externa l eco nomics an d diseconomies i n a com petitive situation, Economic Journal 62, 1952 , 54-6 7 6 E.J . Mishan , Paret o optimality an d the law , Oxford Economic Papers,

1967, 255-28 7 7 Richar d A . Musgrave, Provision fo r social goods, in J. Margolis and H. Guitton , eds. , Public Economics, London 1969 , 124-4 4 8 Willia m H . Oakland, Join t goods , Economica 36, 1969 , 253-68 9 Pau l A. Samuelson, The pure theory of public expenditure , Review of Economics and Statistics 36 , 1954, 387- 9 10 Paul A. Samuelson, Diagrammatic exposition of a theory of public expenditure, ibid. 37, 1955, 350- 6 11 Pau l A. Samuelson, Contras t between welfare conditions fo r joint supply and fo r public goods , ibid. 51, 1969, 26-3 0

44 Moder n Fiscal Issues 12 Paul A. Samuelson, Pure theory of public expenditure and taxation, in J. Margolis and H. Guitton, eds. , Public Economics, London 1969 , 98-123 13 Hirofum i Shibata , A bargaining model of the pure theory of public expenditure, Journal of Political Economy 79 , 1971, 1-2 9 14 Hirofum i Shibata, Pareto-optimality,

trade and the Pigovian corrective tax, Economica 39, 1972, 190-202 15 Car l S. Shoup, Public goods an d joint production, Rivista internazionale di scienze economiche e commerciali 7, 1965, 254-64 16 Ralp h Turvey, On divergences between social cost and private cost, Economica 30, 1963, 309-313

RICHARD M . BIR D an d DOUGLAS G . HARTL E

3

The design of governments*

The design of government decision-making units is today a problem of great theoretical an d practica l interest . Th e politica l fermen t i n man y urba n areas, the apparent inability of many traditional units of state and provincial government to cop e wit h their changin g environment, and th e increase d economic interdependence o f nation-states hav e called int o questio n th e relevance in today's world of the scope and division of powers of governments at all levels. At the same time as these practical problems crowd upon us, however , it appear s to man y that certai n ne w developments i n eco nomic and political theory ought to provide a useful guid e to the 'optimal' size and structure of political subdivision s in a given geographical area. The concept s an d method s o f conventiona l welfar e economics , fo r example - Paret o optimization , 'economic efficiency,' an d the rest - see m clearly relevant, if one is interested in the efficient (least-cost) production of public services. 1 S o is th e burgeonin g literatur e o n externalitie s and o n concepts of property rights , as, for example, in the oft-discussed 'spillover' problem [14 , pp.527-74]. Perhaps th e mos t obviou s connection o f all t o most economists, however, is with the public finance literature on public goods [8 , 15] , an d fisca l federalis m [17 , ch.25 ; 12 , ch.12]. Ye t anothe r potential contribution from traditional economic theory to the design of an

1

Research support for this paper was provided b y an Izaak Walton Killam Award made through the Canada Council. Earlie r version s of portions of the argument were presented in a joint paper delivered by the authors to the Canadian Economic Association i n June 1969 . For a useful summar y of the relevant ideas, see [14, pp.422-524; 17, ch. 4-5].

46 Moder n Fisca l Issues optimal government structure may be found in the theory of internationa l trade an d factor flows under conditions of fixed and flexible exchange rates [10,11 ], as to some extent illustrated in some writings on regional economics and in the new literature on fiscal harmonization [16] . Turning to political theory, there are, of course, some relevant ideas on the design of governmental structures in the traditional writings on nationalism, federalism , and intergovernmenta l relation s i n general , particularl y within metropolitan areas [5; 18; 19, pp.229-70]. A few recent 'economic' models of administrative and political behavio r (broadly conceived) seem even more relevant in their stress on the importance of the cost of obtaining information, making decisions, and bargaining.2 There i s thu s voluminou s theoretica l discussio n o f al l thes e partia l aspects of the problem of what is the 'best' governmental decision-making structure. Bu t there i s (it appears) n o conceptua l schem e that i s general enough to incorporate all of these diverse elements, yet specific enough to be relevant in any meaningful sense to the real world and to permit the formulation o f potentially testable hypotheses. This paper offer s a first sketch of the possibl e shap e o f suc h a scheme. 3 Furthermore , althoug h relation s between government s have lon g bee n th e subjec t o f analysi s b y publi c finance scholars, the structure of the governments concerned has been taken generally to be fixed. This analysis is concerned with the effects of removing this constraint . FORMULATION O F TH E PROBLE M

We assume as our fundamental objective that it is desired to maximize the welfare, broadly conceived, of individuals within a given geographic area. We further assum e that the welfare of individuals is determined in part by the extent to which their wants for collective goods and services are satisfied. These tw o assumptions ar e al l that ar e needed to enabl e u s to pos e th e problem directly concerning us in this paper: Does the structure of government - the configuration of governmental decision-making units - con fronting individuals affect thei r welfare through its effect upo n the quality and quantity of the collective goods and services which are provided and the costs of providing them ? If it does, what is the structure of government which will provide the 'right' collective goods and services at lower cost? 2 [9 ] summarizes muc h o f the relevant analysis . Se e also [4 , 6]. 3 Charle s Tiebou t i n [19 ] perhap s come s closer to some of our central concern s than most other writers, althoug h hi s assumptions o f pure public goods , Ushaped cost curves, an d onl y benefi t taxe s sharpl y limi t hi s conclusions.

Design o f governments 4 7 This general problem involve s a good man y subsidiar y questions. Fo r example: (a) How shoul d governmen t be organized in term s of decisionmaking units? (b) Wha t powers should these decision-making units have? (c) D o their decisions need to be coordinated ? (d) I f so, how should they be coordinated? Governmenta l institutions in mos t countrie s reflect chanc e and history more than careful design. Our question then is: what would an efficient syste m of governmental decision-making units look like ? To begin with, let us consider the case of a large contiguous land mass call it a 'continent' - which is divided into sovereign 'nations,' each of which has a single unitary government. Within each of these unitary states, however, there are a number of'regions' based on geography, culture, economics, and the many other forces whic h affec t th e spatial organizatio n o f human populations. Finally , withi n each o f thes e regions there ar e man y 'communities,' or sub-units within which, we assume, there tends generally to be stronger similarit y o f economi c an d socia l characteristics , an d henc e o f preferences, than there is between communities. It should be noted that this initial setting of the problem is considerably more complex than that in most earlier discussions. We do not assume that man live s in equal-sized , evenly-spaced, homogeneous communities on a flat, undifferentiated plain . Rather, our abstract world of nations, regions, and communitie s is, like the real world, characterized b y unevenness and clustering: 'It is a world in which clusters of settlement, nodes of transport, centers o f culture , area s an d center s o f language , division s of cast e an d class, barrier s betwee n markets, shar p regiona l difference s i n wealth an d interdependence, an d th e uneve n impact o f critical historica l event s an d social institution s al l act together to produc e a highly differentiated an d clustered worl d o f regions , peoples , an d nations ' [5 , p.187]. Sinc e i t i s precisely thi s kin d o f uneve n an d differentiate d organizatio n o f huma n activities whic h an y 'optimal ' configuratio n o f governmenta l decision making activities must fit, it seem s most usefu l t o star t without assuming away much of the problem . Within our hypothetical continent, ther e are various barriers impeding the flo w o f goods , capital , an d peopl e betwee n differen t communities , regions, and nations. The higher the unit in this hierarchy, the greater th e height of these barriers wil l be, as a rule. Some of these barriers aris e fro m deliberate publi c policies: for example , tariffs , discriminator y purchasin g policies, an d immigratio n controls . It i s these artificially-create d barrier s that we are, i n part, attempting t o explai n here. 4 Other barriers , particu 4 Ho w a small segment of the population can induce a majority t o create such

48 Moder n Fiscal Issue s larly to the movement of factors, may be characterized a s 'social,' though they too have substantial economi c content: the risk and uncertainty that the propert y o f stranger s might be expropriated, lack o f information on conditions elsewhere , an d i n genera l th e differenc e betwee n presen t an d prospective environments as reflected in language, customs, climate, region, food habits, and the like. In addition t o these various deterrents, there are also, of course, many inducements to factor and product flows between units. A better resourc e base i n terms o f sources o f raw materials an d climate , difference s i n th e marginal productivity o f factors, differences i n the degree of political an d social stability , improve d informationa l flow s (owing , fo r instance , t o changes i n communicatio n technology) , th e desir e fo r chang e an d fo r improved real income - all these, as well as the more prosaic desire to reduce transportation costs or to take advantage of differential fiscal pressures, may lead to movements of goods and factors between units. AN ECONOMICALL Y EFFICIENT GOVERNMENTAL STRUCTURE

In this setting, let us return to the initial question: what structure of government is 'optimal' in the sense of providing the 'right' collective goods, including prestige and self-respect, at the lowest cost? To begin with, assume that attitudes within a nation are such that people do no t car e i n whic h region o r communit y they live . Where should th e decision boundaries for the public sector be drawn in this case? To answer this question we must specify further that we are concerned not only with the relatively uninteresting case of 'pure' public goods but also with the more general class of the many non-private goods generally provided by governments, in which the service received by the individual depends to some extent on his spatial location with respect to the unit of production. It will also be recalled tha t we assume the population t o b e located i n irregular spatia l clusters in accordance with the features of the natural and social landscape, and that there is some, but not perfect, factor and product mobility . In these circumstances, th e optimal structure o f governmental decision making unit s withi n th e natio n wil l b e dictate d b y consideration s o f economic efficienc y alon e (ignorin g certai n importan t intangibl e factor s for the moment). barriers against its own best interests (let us assume) and in favor of the private interests of the elite minority is an interesting question which we have explored at length elsewhere: see [7].

Design of governments 4 9 TECHNICAL EFFICIENC Y

Some studies o f government reorganizatio n appea r to identif y economi c efficiency wit h what we may call 'technical efficiency' i n the production of public services. By 'technical efficiency' we mean that the unit of production is just large enough to attain the lowest feasible unit cost of production - or, to phrase it differently, tha t the population served is at least large enough to support the technically least-cost method of production. This approach , therefore, tend s t o determin e the optima l governmenta l structur e mainly by reference to the economies of scale in the production o f public services. It has a superficially appealing simplicity (and potential numeracy) about it which appears to have attracted man y who have argued, for example, that developments in public administration and changes in the nature of services provided b y government require increased centralization in all developed countries in order to captur e thes e economies of scale (and to internaliz e externalities). I t is not clear, however , that the technically efficien t siz e of government has in fact grown with respect to many labor-intensive functions of government. There are also many serious difficulties in trying to apply the criterion of technical efficiency. One problem is that very little is known about the shape of the relevant cost curves [14, 17]. Another is that what little we do know indicates tha t i t i s probabl e tha t almos t ever y functio n performe d b y government ha s a different 'technicall y efficient ' siz e in term s o f optima l size of population (and/o r area ) served . Further , sinc e each 'function ' o f government in reality usually consists of a group of subfunctions, eac h of which may perhaps be most efficiently performed on a different geographi c basis, the clear guide to government structure apparently afforded b y this approach soo n fades awa y into obscurity . Where we do know something about the effects of scale on the provision of public services, there appears to be little evidence of either economies o r diseconomies over a broad range of population served . Unless then, we are prepared t o make the very strong assumption that there are sharp discontinuities in the hierarchy of functions when ranked by economies of scale5 and hence clustering of functions, a n assumption for which there appears to be no empirical warrant, it appear s that setting up governmental decision-making unit s on the basis of minimizing production costs would yield an exceedingly complex system indeed. Furthermore, the minimum efficient scal e of production of public goods and service s i s not necessaril y a relevant fac t in determining th e optima l 5 Suc h an assumption is made, for example, in [2] .

50 Moder n Fisca l Issues governmental organizatio n a t all . Ther e i s no presumption tha t the uni t which produces a public service has to be that which consumes it (that is, provides publi c service s to it s inhabitants) . Afte r all , on e o f th e funda mental division s made in elementar y public finance texts is between th e provision an d the production o f public services . This distinction ha s been recognized increasingl y in practice i n the real world with the developmen t of intergovernmenta l agreement s (betwee n government s o n th e sam e o r different levels) . We shal l retur n late r t o som e of the possibl e use s (an d obvious limitations) of such devices. DEMAND CONSIDERATION S

More importan t tha n th e limitation s impose d o n th e usefulnes s o f th e 'technical efficiency' criterio n by its theoretical an d empirical ambiguity is the fac t tha t i t completel y ignore s deman d considerations . Minimizin g production cost s i s not th e sam e as maximizing welfare. If the welfar e of the inhabitant s o f ou r continen t i s t o b e maximized , a n economicall y efficient governmenta l structure mus t tak e int o accoun t th e demand fo r public services as well as the conditions of their supply. Since different people like different bundles of public goods and services, those who like the same things will tend to congregate together , fo r mos t collective service s hav e a n importan t spatia l dimension . Thi s argumen t suggests that a high degree of decentralization i n governmental decisionmaking will most efficiently provid e the 'right' mix of collective goods and services i f factor s are highl y mobile and people can mov e to tha t unit in which their tastes are best satisfied. Even if, as in the real world, mobility is restricted, most people will learn in any case, perhaps, to like most o f what the shared social norms say they have to consume collectively. People who live together are likely to share the same values either because they move to locations where the values of others accord with their own, or because, even if ther e i s no mobility , the y lear n thei r value s fro m th e sam e source , o r through observin g each other, o r through the operation o f social control s which instil value systems. From this sharing of common values emerges a sense of identity with the communit y as wel l a s som e degree of common tastes. Note that ther e seem s to b e no nee d fo r an y formal hierarchy o f governmental structure in this simple model. SPILLOVERS When any government decides to provide a collective service to its citizens,

Design of governments 5 1 however, some of the benefit s fro m tha t service will ofte n 'spil l over' th e governmental unit' s boundarie s an d b e consume d b y resident s o f othe r jurisdictions. Th e usua l argumen t i s tha t eac h governmen t will , quit e properly, b e concerned primarily with satisfying the preferences of its own residents (and voters) and will hence consider only the benefits and costs of different actions as they affect them. Public services will thus be extended to the point at which the marginal internal benefits (those felt within the unit) equal marginal internal costs. There may well be a divergence between this point and the 'socially' optimal point at which marginal social benefits equal marginal social costs . Since each government's decisions affect those taken by the others, ther e is no presumption that the 'distortion' resulting from spillout s and spillin s (of both benefits and taxes) will necessarily result in either over-productio n or under-production i n the public sector.6 Whatever their net effect o n the relative size of the public sector, however , the existenc e of spillovers will clearly resul t i n distortion s o f th e relativ e price s o f privat e an d publi c goods an d service s withi n each governmenta l jurisdiction an d henc e i n non-optimal decisions. INTERNALIZING EXTERNALITIE S

The only way to remove this source of inefficiency, man y have argued, is to ensure that those benefitin g fro m collectiv e services are exhausted within the relevant decision boundaries. The 'economically optimal constitution' 7 will thus be determined by the geographic range of the spillover effects o f collective action. Unfortunately, the apparent conceptual simplicity of this dictum once again fades away when we consider a few obvious complications. Two such complication s hav e already been mentioned in referenc e to economies of scale. One is that the relevant geographic range of externalities in the consumption o f a collective service may be quite different fro m th e range appropriate to its least-cost production. Furthermore, even assuming we could ever know the range of relevant externalities with any certainty, there seems no reason to expect it to be identical, or even closely related, for any two governmental functions or for there to be significant discontinuities in the ordering of functions in this respect. The rule of internalizing spillovers 6 Sinc e spillover s hav e bot h incom e and substitutio n effects , thei r ne t effec t o n th e relative size of the publi c secto r i s indeterminate: see [21] , 7 Th e phrase gomes from [3] .

52 Moder n Fisca l Issues thus yields no more certain o r simple a 'constitution' than the admittedl y much less satisfactory rule of minimizing production costs. 8 Furthermore, th e 'social optimum ' to whic h this argument lead s us is the usual tenuous creature familiar from welfar e economics. Not onl y is it defined with respect to the present distribution of real income, an extremely severe limitation given the importance of government as redistributor, but its determination requires that we have a single set of values against which to judge the 'optimality ' o f the solution . Fo r a solutio n t o b e 'optimal,' there mus t therefor e be a determinat e (national ) socia l welfar e functio n that is substantially shared by most residents. But as we initially (and, we believe, realistically) assumed, the very existence of communities and regions means there are conflicting values in at least some relevant respects . Even if w e could overcome the man y empirical an d conceptua l difficultie s an d derive 'the' economically efficien t constitution , th e assumptions neede d to make this construct 'th e best' are thus so strong an d so unrealistic tha t it does not offe r u s a very useful guide. One reason fo r this inadequacy i s the diversity of interests an d share d values (for example, as among different region s an d communities ) in th e real world . Th e resolutio n o f conflict s arisin g fro m thi s diversit y i s th e domain of politics. Another reason is that we have as yet said nothing of the very real costs of obtaining information and makin g decisions. An y conceivable governmenta l structure wil l stil l leav e u s wit h thes e problems : redrawing boundaries to internaliz e spillovers may transform them fro m inter- to intra-community problems, but it will not 'solve' them. Since not everyone agrees on everything, conflict is inherent in all collective decisionmaking. I t canno t b e avoide d b y alterin g governmenta l structures. Th e 'economically efficient' constitutio n is not, therefore, the same as, or even necessarily a reliable guide to, the 'politically efficient' constitution . The argument to this point may now be briefly summarized as follows: assuming tha t th e consumptio n o f mos t collectiv e service s i s spatiall y differentiated an d that people hav e different taste s fo r collectiv e services , collective demand s wil l in genera l b e mos t efficientl y satisfie d by a hig h 8 I n addition, t o tell us to internalize externalitie s i s not a sufficient guid e to defin e exactly what solution i s required t o attain Pareto optimality: onc e we take int o account th e fact tha t the site of production o f most non-private good s affect s their pattern of consumption, ther e is no reason t o believe that Pareto optimization means we must enlarge districts and facilities to encompass all spillovers, as appears to be conventionally assumed. We may, alternatively, shift th e site of production.

Design o f governments 5 3 degree o f autonomou s fisca l decentralization . O n th e othe r hand , th e existence of spillovers suggests that larger units of organization ar e needed to internalize the relevant externalities arising as a result of the provisio n and financing of collective goods and services. There is thus an apparent conflic t in the economic criteria for the organization of governmental decision-making units. The problem is accentuated by the fac t tha t on e would expect th e 'optimal ' size from bot h point s o f view - th e avoidance o f spillovers an d the satisfaction o f heterogeneou s preferences - t o be different for every function an d subfunction of government. There can thus be no unique solution in economic terms to the question posed initially concerning the 'optimal' structure of government. A POLITICALL Y EFFICIEN T GOVERNMENTA L STRUCTUR E

The main argument o f the preceding sectio n assume d that ther e were no regional or community loyalties. In the nature of things, however, as noted earlier, people tend to live in irregular clusters in a pattern shaped by history, geographic inertia , an d productio n condition s (includin g the benefi t an d cost incidence of existing public services) as well as by more explicitly social factors. Eve n if there i s not th e hig h degre e of factor mobility needed t o permit peopl e wit h pre-determined simila r preferences to group together , shared history , economi c conditions , an d cultura l value s ar e likel y t o produce more homogeneity in preferences, including those towards collective services, within communities and regions than between them, through, for example, the socialization process by which children and newcomers are integrated into the community, part of which is the striving for the respec t of others. The smaller and more isolated (in the sense of less interaction an d information flows) the geographic uni t with which we are concerned, th e more likely it is that there will be relative homogeneity of values within the unit. Resident s of such communities will ten d t o b e 'loyal' to thei r com munity, that is, to be willing to act in pursuit of such collective goods as group status. When these loyalties exist, all members of a group can gain potentially from collectiv e action tha t adds t o th e prestige o r self-respec t o f the group - as politicians are well aware!9 The collective good 'group prestige' is closely related to what has, in the traditional political literature, bee n called a 'sense of community.' Like the economic argumen t fo r fiscal decentralization outline d earlier , thi s argu ment has been used as a reason for determining the appropriate structure of 9 Thi s argument is elaborated in [7] .

54 Moder n Fiscal Issues government in accordance wit h the relative homogeneity of values among residents: 'A government region should possess, to a reasonable degree , a combination o f historical , geographic , economic , an d socia l character istics, such that some sense of community already exists and shows promise of further development subsequen t t o th e creatio n o f the region ' [13 , n , pp.507-8]. Two other criteria found i n th e politica l literatur e concernin g the ap propriate siz e an d structur e o f governmenta l unit s ar e 'balance ' an d 'access.' 'Balance ' apparentl y mean s that conflict s shoul d to som e extent be internalize d wit h th e governmenta l unit : 'Ever y uni t o f governmen t should be responsible for a sufficient number of functions so that its governing processes involve a resolution o f conflicting interests, wit h significant responsibility for balancing out government needs and resources' [1 , p.6]. This criterion is most important when we consider the redistributive function of government , as is done below. 'Access' appear s i n part t o mea n that government should , in som e meaningful sense , be comprehensible to th e average man, and i n part tha t h e should, at leas t potentially, b e able t o control and influenc e hi s political masters . It is thus innately desirable to promote'... the most widespread participation possibl e on the part of all or virtually all individual citizens.' As with a 'sense of community,' but unlike 'balance,' it would seem that '.. . th e capacity o f government t o promot e access is in part an inverse function o f size [13, n, p.503].10 The traditional politica l literatur e i s replete wit h further arguments in favor o f 'maximum feasible decentralization' : (1) the need for specialize d knowledge o f local conditions ; (2 ) the desirabilit y of flexibility and tria l by experiment with respect to changes in governmental functions; (3 ) the desirability of promoting local initiative and responsibility. Obviously this list is neither complete nor mutually exclusive. Nor are any of these criteria particularly clear. Yet they suffice fo r our present purpose, which is simply to not e tha t onc e these factor s are taken int o accoun t th e confuse d and obscure shape of the 'optimal' constitution whic h we might have felt abl e to perceive, however darkly, through the economic optic employed earlier, becomes even more confused an d obscure. POLITICAL EXTERNALITIE S

Perhaps the point might be strengthened in the minds of economists if we 10 The Advisory Commissio n [1 , pp.56, 278] appears to be of two minds on th e connection between siz e and accessibility, but i n full agreemen t on the importance of the latter as a criterion of government design.

Design of governments 55 rephrase it in terms of more familiar, though not necessarily more meaningful, terminology . Unles s th e taste s an d preference s of al l resident s of a decision-making unit ar e identical, those in th e minorit y with respect t o any collective decisio n are subject to a 'political externality' in that thei r preferences will be overridden by the majority. To minimize this externality, given clustering of preferences, a governmental decision-making unit may be needed at every street corner or at least in every elementary school district. This resul t i s muc h th e sam e a s tha t reache d i n respec t t o th e efficien t satisfaction of collective demands when spillovers are ignored. The validity of the notion that small groups will make 'better' decisions clearly depends upon the degree of homogeneity of group preferences - and upon how easily differences can be readily compromised through bargaining. The greater the amount of 'involuntary' migration (t o see k employment, for example ) o r class differences, the less valid this argument and the greater the importance of the redistributive and stabilizing roles of higher-level governments. It i s importan t t o recognize , then , tha t thi s criterio n o f minimizing political externalitie s thoug h smalle r unit s o f governmen t ma y conflic t directly with that o f minimizing economic externalities in the provision of collective goods and services (including redistribution and full employment) through internalizing spillovers in larger governmental units. DECISION-MAKING COST S

Another approach t o the problem o f the optimal siz e of governments is to consider the costs of obtaining information and reaching a decision, that is, to work with a 'satisficing' rather than a maximizing model. Several points might be made in this connection. One is that the cost of reaching decisions probably rises as more people are involved, assuming that they have different tastes and preferences. In a population of given size, the greater the percentage of the population that is involved in the decision-making process, th e greater th e cost. Conversely , the more heterogeneous the population, th e larger the proportion that must be involved to reduce political externalities by a given amount. This analysis suggests, again, that more homogeneous (smaller?) units are generally more efficient tha n less homogeneous ones.11 Another argumen t in favor of relatively smal l governmental decision making units is the view , familiar from administrativ e theory, tha t som e 11 Furthermore , within a given unit , one might postulate a 'least cost' decision rule at the point where th e marginal cost in terms of adding to the cost of decisionmaking by adding one more person to the decision set, i s just equal to the mar ginal cos t in terms of political externalities by leaving hi m out. Se e [4, ch.6]. This 'solution' too requires a determinate social welfare function .

56 Moder n Fisca l Issues degree o f decentralizatio n i s essentia l fo r effectiv e problem-solvin g i n a complex environment. (Decentralization als o involves a hierarchial structure of government since, as argued below, people have some shared values which require collective decisions above the community level.) As Herber t Simon has noted: 'An organizatio n will tend t o assum e hierarchial for m whenever the environment is complex relative to the problem-solving and communicating power s o f th e organizatio n member s an d thei r tools . Hierarchy is the adaptive form for finite intelligence to assume in the face of complexity' [22 , p. 119]. Again, then , w e have an argumen t for factorin g complex reality into more coherent and comprehensible units - fo r introducing into the collective decision process an element of 'disjointedness' in the form of autonomous separate and overlapping geographic governments in order t o reduc e the need for the costly transmission an d processing of information an d to make the problems faced a t least potentially solvabl e by ou r decidedl y finit e intelligence . Sinc e an y organizatio n a s larg e a s 'government' thu s has t o dra w lines somewhere for purpose s o f rationa l calculation an d responsibility , i t shoul d b e noted tha t ther e wil l alway s be some spillovers - no t because th e boundary lines between geographi c units ar e draw n in a particula r way , but simpl y because ther e mus t b e boundaries. Rationalit y wil l thu s b e aide d b y subdividin g the decision making structure into more manageable parts, eac h of which, by limiting the issues to b e debated a t an y one time, wil l be able (in theory) to tak e more adequately into account the ramifications of any change. The argumen t t o thi s poin t i s thu s ver y simila r t o tha t customaril y deployed in orde r t o demonstrat e that perfec t competitio n is an efficien t solution to th e problem o f determining the 'correct ' outpu t an d pric e of private goods and services. Just as the application o f the competitive model to the real world has to be severely tempered by the reality of concern with income distribution and of market imperfections, however, so similar, indeed much worse, difficulties arise in applying the market analogue in the public sphere. But in neither case does it follow that the answer to these difficulties is t o centraliz e al l decision s no r eve n necessaril y t o coordinat e the m centrally to any great extent. HIGHER-LEVEL SHARE D VALUE S

Thus far, we have shown that not onl y the comple x deman d an d suppl y conditions of most collective services, but also the multiplicity and clustering of interests characterizin g th e real world, mean that a complex and decentralized organizatio n i s needed to make the 'right' collective decisions, no

Design o f governments 5 7 matter wha t th e forma l structur e o f governmen t look s like . Ther e are , however, importan t share d value s abov e th e loca l level . Fo r example , everyone want s a highe r rea l income , an d on e means t o thi s goa l i s t o facilitate regiona l specializatio n b y reducing barrier s t o trad e an d facto r flows. Another higher-level value may concern redistribution in the sense, for instance , tha t no person in the region (or nation, o r continent) shoul d starve, o r b e ill-clothed, o r whatever . Resident s of different communitie s and regions may also be concerned with the prestige of their nation relative to other nations - in sports, in the arts, in military might, and so on. How can these collective needs above the local level be satisfied ? Three sort s o f solution s t o thi s proble m ar e conceivable : (1 ) a rigi d allocation o f powers and responsibilities with a central government taking on, for example, the central planning of industrial location an d redistribu tion a s it s sol e an d exclusiv e functions ; (2 ) a mixe d multijurisdictiona l system with, for example , joint responsibilitie s i n some areas, conditiona l grants, and all the other overlapping and confusing paraphernalia generall y associated wit h suc h systems ; an d (3 ) finally, a syste m with n o forma l coordination o f the independent regional and community decisions, so that solutions are reached through an endless process of horizontal and vertical bargaining and informal arrangements. Each of these solutions has its advantages and disadvantages. The first, the rigid constitution, reduce s overt transactions cost s but may (especially if ver y centralized) increas e considerably wha t w e hav e calle d politica l externalities a s well as the costs o f misallocation arisin g from lagge d an d inappropriate responses to changing circumstances. The mixed system has some of the same advantages and problems, but to a lesser degree. Its very vagueness and somewha t ambiguou s nature make s it mor e adaptabl e t o changes in environment or tastes, however, unless it too is encumbered by too rigi d a constitutiona l framework . In a changin g world , thi s greate r adaptability constitutes a great potential advantage. These two alternatives have been much discussed in the literature on federalism. What about th e third system , uncoordinated decentralization ? Is there any way in which it might produce a 'satisfactory' basket of collective goods and services? MARKETING PUBLI C SERVICE S

Suppose independen t jurisdictions contrac t wit h on e anothe r fo r publi c services in a perfect market, that is, one characterized by free entry, perfect knowledge, and only lump-sum benefit taxes. We might then perhaps expect the resulting level of public goods and services to approach something we

58 Moder n Fisca l Issues could call an 'optimum,' the more closely so the more the requisite bargains are small-grou p rathe r tha n large-grou p bargains . Thes e condition s ar e highly unrealistic , howeve r - jus t a s the analogous conditions are in the private goods market. Furthermore , i t may be justifiably pointed ou t that in the nature of a 'pure' public good it will be to the interests of each unit to pretend it does not really want the service anyway, since if it is in fact pro vided no one can be excluded from enjoying it. Few of the services provided by governments are of this 'pure' a nature, however, so one may doubt th e applicability o f this dictum to the many important governmenta l activities in which benefit is clearly affected by location so that only contiguous units are involved i n reaching agreement . Redistributio n doe s pose a proble m however. Nevertheless, i t ma y perhaps b e argue d tha t th e nee d fo r bargainin g between community governments and between community, regional, an d national governments, in order to bring about production of such collective goods a s redistribution, ma y improve rather tha n reduc e the chance s of preference revelatio n relativ e t o th e situatio n i n on e unit , sinc e one ca n hardly imagine the representative of a unit negotiating for very long without revealing his preferences, if he is to maintain the confidence of those who have elected him [20] . Another relevan t questio n i s whether the possibility o f reaching agree ments betwee n different unit s i s improved or reduce d b y th e postulate d situation o f greater homogeneity of preferences within units than between them. A conflict in orderings between units may perhaps b e productive in the sense of stimulating better analysis and a search for solutions. Within units, too , a diversity o f views may permit rathe r tha n bloc k change s i n policies in order to adap t to changin g circumstances, since relatively few people wil l have to b e converte d t o chang e th e organization' s decision . These points need to be explored further. Despite th e potentia l virtue s and feasibilit y o f self-coordinated decentralization, ther e are obviously high costs and many problems in relying on bargaining betwee n units . Th e natura l desir e t o avoi d thes e difficultie s appears i n many countries to have locked the governmental system into a rigid mold b y precisely definin g th e role s (responsibilities an d powers ) of each governmental unit , thus making it difficult t o adjust to the inevitably changing conditions facin g collectiv e decision-makers . A looser 'market ' arrangement has the potential advantage, in addition to its greater responsiveness t o demand , o f increase d adaptabilit y t o change s i n demand . Though the bargaining procedure is liable to be slow and cumbersome, it

Design o f governments 5 9 may nevertheless produce desire d result s more quickly than a more rigid centralized system which makes it more difficult to call attention to the need for changed policies and to brin g them about. Ho w important i s the time dimension in bargaining? How easy should it be to change the rules of the game? All these are question s t o whic h we have no answers , and whic h require much more research. It is interesting to note, however, that a rather vague mixed jurisdictional system may be best as it avoids the worse pitfalls of either extreme - though perhaps at the risk of falling between two stools! REDISTRIBUTION

A final complex, and similarly unsatisfactorily resolved, point concerns the importance of redistribution. Unlik e the generally allocative view of collective services and political values taken above, consideration of redistribution (itself perhaps bes t thought o f as a collective good with a large minimum efficient siz e of production) suggests the desirability of fairly large, heterogeneous decision-making units. A prerequisite for a concern with redistribution is a 'sense of community' or intergroup conscienc e which leads people to believe that it is not righ t that an y membe r o f som e large r geographi c se t (region , nation , world ) starves, or is ill-housed, or is deprived of his 'rightful' opportunitie s i n life. Such a belie f ma y arise fro m mora l teaching s a s institutionalized i n th e society an d i n persona l conscienc e an d thu s ma y b e necessar y fo r self respect; it may arise from fear of what the deprived will do if they are no t helped; it may reflect concern with the effect of visible and unlovely poverty on the national image in the international prestige stakes . Whatever its origins, it appears to be concern with redistribution which underlies the political factor labeled 'balance' above, since it allegedly takes a comprehensive variety of interests to appraise 'the public interest' in this respect. (I n th e term s use d immediately above, th e decision-makin g unit must include sufficient individual s interested in all the relevant dimensions of the problem to produce creative conflict within the group, hence leading to the production o f information, a search for a solution, and a purposeful compromise.) Although the acceptance of humanitarian redistribution as a shared value is not necessarily inconsistent with primary reliance on autonomous decentralized governmental units - since one can envisage them agreeing on some nationally reputable minimum standard without being coerced or bribed - in general redistribution appear s to be the principal factor we have located whic h points to increased centralization as desirable in most actual situations .

60 Moder n Fisca l Issues Finally, it is perhaps worth noting that all the same factors that influence the desig n o f an 'optimal ' nationa l constitutio n ar e als o a t wor k o n the international scene . The role of the national elite s and the importance o f national prestige , fo r example , i s muc h th e same : th e greate r nationa l loyalties, the more difficult it is to agree to reduce barriers between nations and th e mor e likel y i s unproductive conflict . Jus t a s with redistribution within a nation, so it is hard to persuade wealthy nations to subsidize poorer nations - potential or actual competitors - unless continental consciousness is stronge r tha n nationa l consciousness . Eve n i f ther e wer e no nationa l loyalties, however, the millenium would not arrive since all the same problems woul d stil l hav e t o b e resolved : a 'on e world ' governmen t fo r al l purposes is even harder to envisage than a 'one nation' government. CONCLUSION One inference that may be drawn from th e preceding discussion is that the simplistic notio n tha t 'bad' collective decision s ca n be easily corrected b y altering the structure of government is almost surely wrong. The problems inherent i n making the 'correct' collective decisions in a complex societ y will continu e t o exis t no matte r wha t governmenta l for m i s adopted. I n particular, ther e i s in genera l n o clea r implicatio n i n theor y tha t bigge r governmental unit s wil l produc e 'better ' decision s i n term s o f satisfyin g individual preference s than smalle r ones ; no r doe s th e convers e follow . Furthermore, sinc e it is, in a real sense, communities which make governments, and the nature of social structure and communication is as complex and irregula r a s it is, no simpl e solutio n i s likely to b e right fo r uniform application throughout an y large nation. There is thus clearly no case for full centralization of decisions in a nonhomogeneous societ y wit h non-omniscien t administrators . O n th e othe r hand, som e centralization, howeve r accomplished , seem s necessar y fo r redistribution, stabilization , an d th e reductio n o f barrier s t o th e inter regional trade and factor flows needed to increase real income. A nationa l or continental government is therefore needed. The economies-of-scale and internalizing-externalities argument s i n genera l point, thoug h no t i n any very clear-cut way, to the need for some intermediate regional level or levels of government. I n terms of the cost of decision-making, th e costs of transmitting information , an d th e differen t intensitie s wit h whic h differen t people wan t different things, there is also, of course, a very strong cas e in terms of economic and politica l efficiency for a community level (or levels) of government.

Design o f governments 6 1 The 'optimal' system of government is thus likely to be hierarchical and decentralized; it would also be very complicated, were it not for the simplifications necessarily imposed by man's limited capacity, which, together with the political value of comprehensibility, requires a moderately simple system. The optima l wa y to produc e th e requisit e degre e o f flexibility and non uniformity withi n thi s relativel y simpl e constitutiona l framewor k would then b e throug h intergovernmenta l transfer s an d agreement s o f variou s sorts. The attemp t t o desig n a n optima l syste m o f governmenta l decision making units on either a national or international level thus leads to a system at least as complicated as that now existing in the United States and Canada, for guideline s suggested by economic and political theory are neither clear nor unambiguous . Comple x problem s requir e comple x organizationa l structures. This conclusion does not, however, mean that we live in the best of all possible worlds, for there is undoubtedly ample scope for improvin g governmental structure in the small, if not in the large. The precise form of an optima l governmenta l structur e i n Nort h Americ a (o r anywhere ) probably woul d be quite different fro m tha t which we now have in many respects - with , fo r example, mor e metropolita n regiona l governments . But it appears that the three- (or four-) tier governments and complex intergovernmental arrangements which we now have reflect no t onl y the con fused an d confusin g heritag e o f th e past , bu t als o a sensibl e structura l attempt to cope with the complex and changing world in which we live. The main problem with present governmental structures is not that they are complex, but rather that they are too rigid. Changes which loosen thi s rigidity wil l increas e th e potentia l adaptabilit y an d henc e suitabilit y o f governmental decision-makin g units ; thos e whic h increas e structura l rigidity - whethe r in the direction o f more or less centralization - wil l in general mak e matters worse . Despit e th e fascination whic h the idea o f a permanent solutio n t o ou r governmenta l (o r other ) problem s apparentl y exercises for most people, it thus emphasizes completely the wrong quality in today' s world , fo r wha t i s neede d i s a n adaptiv e rathe r tha n a fixed organizational structure . The optimal desig n of government thus emerges from thi s analysi s a s a movin g compromis e rathe r tha n a n inscrutabl e truth. REFERENCES

1 Advisor y Commissio n on Inter-governmental Relations, Performance o f Urban Functions, Washington, 196 3

62 Moder n Fiscal Issue s 2 Alber t Breton, A theory of government grants, Canadian Journal of Economics and Political Science xxxi, May 1965 , 175-8 7 3 Alber t Breton, A theory of the demand fo r publi c goods, ibid. xxxn, Nov. 1966 , 455-67 4 Jame s M. Buchanan and Gordo n Tullock, The Calculus of Consent, Ann Arbor , 196 2 5 Kar l W. Deutsch, Nationalism and Social Communication, 2nd ed., Cambridge, Mass. 1966 6 Anthon y Downs, An Economic Theory o f Democracy, New Yor k 1957 7 Dougla s G. Hartle and Richard M. Bird, The demand fo r loca l political autonomy: an individualistic theory, Journal of Conflict Resolution, xv, 1971 , 443-5 6 8 J.G . Head , Th e theory of public goods, Rivista di diritto finanziario e scienza delle finanze xxvii, June 1968, 209-3 6 9 Charle s E . Lindblom, Th e PolicyMaking Process, Englewood Cliffs , NJ 1968 10 Ronald I. McKinnon , Optimum currency areas, American Economic Review LHI, Sept. 1963 , 717-2 5 11 Rober t Mundell , A theory of optimum currency areas, ibid. LI, Sept. 1961, 657-64 12 R.A . Musgrave, Fiscal Systems, New Haven and London 196 9

13 Ontari o Committee on Taxation , Report, 3 vols., Toronto 196 7 14 Harve y S. Perloff an d Lowde n Wingo Jr., Issues in Urban Economics, Baltimore 1968 15 P.A . Samuelson, The pure theory of public expenditure, Review of Economics and Statistics xxxvi, Nov. 1954 , 387-9 16 Car l S . Shoup, ed., Fiscal Harmonization in Common Markets, 2 vols., New York 1967 17 Car l S. Shoup, Public Finance, Chicago 196 9 18 Georg e Stigler , The tenable range of functions o f local government, in Edmund S. Phelps, ed., Private Wants an d Public Needs, Ne w Yor k 1962, 137-4 6 19 Universities-Nationa l Bureau Conference, Public Finances: Needs, Sources, Utilization, Princeton 196 1 20 Rober t Warren , A municipal services market model of metropolitan organization, Journal of th e American Institute o f Planners, Aug. 1964, 193-204 21 Ala n Williams, The optimal provision of public goods in a system of local government, Journal of Political Economy LXXIV , Feb. 1966 , 18-33 22 A.M . Willms and W.D.K. Kernaghan, eds. Public Administration in Canada, Toronto 1968 .

RICHARD A . MUSGRAV E an d PEGG Y B . MUSGRAV E

4

Inter-nation equity

The issue of tax equity in a unitary fiscal setting is relatively simple. Only equity among individuals has to be considered and that in terms of a single tax system . The situation i s more complicate d i n a multiple-unit system, whether composed o f member states within a nation o r a group of nations. Since the various units are engaged in trade, involvin g product a s well as factor flows, the question arises how should such inter-state or international transactions be taxed? This complicates realizatio n o f equity among individuals an d create s th e additiona l proble m o f equit y amon g state s an d nations.1 Our concern here is with the inter-nation aspect and its relation t o inter-individual equity. This paper explore s inter-nation equity , as it applie s to the taxation of income and profits. 2 Issue s of inter-nation equity in this case arise in two situations. One comes about as the result of factor movements and the other where a business transacts i n more than on e jurisdiction. Th e former has been primaril y th e concer n o f internationa l ta x treaties ; th e latte r ha s 1 Anothe r aspec t of inter-nation equity wit h which we are not concerne d here arise s in the case of benefit spillover s or of joint ventures such as the St Lawrence Seaway o r NATO , where the cost has to b e allocated between jurisdictions . 2 Analogou s problems arise with product taxation, but are not dealt with here. Thus efficiency consideration s favor us e of the destination principl e bu t th e resulting distribution of national gain may not b e acceptable. Net exporters of taxed product s (o r of products taxed a t highe r rates ) will do better unde r th e origin principle while net importers will gain fro m destination. It appears that the Common Marke t plan s t o use intergovernmental transfer s t o adjust fo r this and to obtain a result more nearly in line with inter-nation equity , whil e otherwise adherin g t o the origin principle .

64 Moder n Fisca l Issues been the central issue in the coordination o f state corporation taxe s in the United States and is also a matter of vital international concern. HISTORICAL BACKGROUND AND CURREN T PRACTICE

Beginning with the case of factor movements, our discussion will be largely in terms of capital flows and the taxation of capital income. In recent years, labor movement (especially within the Common Market) has also emerged as an important factor, but capital movement still poses the major and more complex issue. I f residents o f country A invest in a business incorporate d in B and operating in c, who should be permitted to tax the income on such capital and at what rate ? Should there be a rule pertaining to this, or should unrestricted multipl e taxatio n apply ? Moreover , i f ther e ar e suc h rules , should they apply equally at the corporate and individual level of taxation ? Historical background The search for principles in international revenu e and tax-base allocatio n is nothing new. The allocation o f property as a tax base between property situs and owner's domicile was discussed first by the Italian theologians of the thirteenth century. 3 The German Cameralists considered the matter i n the sixteent h an d seventeent h centuries , whil e the international treatmen t of death dutie s was a topic o f much discussion in the eighteenth century . Towards the end of the nineteenth century, the discussion was resumed in terms o f incom e taxation . Thi s i s wher e th e emphasi s ha s remained . Throughout, 'doubl e taxation' was considered an evi l and attempt s wer e made t o avoi d i t b y appropriate tax-base allocation. 4 I n th e 1870s , bot h Germany and Switzerland moved to prevent multiple taxation by member states an d cantons . Subsequentl y th e matte r wa s discusse d extensively within th e Britis h Empire , leadin g t o recommendation s b y th e Roya l Commission o n the Income Tax (1919) and subsequent legislation t o avoid double taxation of income between the United Kingdom and the Dominions. 3 Fo r a brief history of the subject, see [8, ch.2]. 4 Th e term 'double taxation' is ambiguous in the international setting (taxation of a given activity by more than one government) no less than in the domestic setting (multiple taxation of a given activity by a single government). In both cases, what matters is the combined tax burden and its relation to the tax burden borne by other activities. In the domestic setting, multiple taxes may simply be an administrative device to obtain a desired total burden, in which case it is entirely unobjectionable. In the international setting, taxation of a given activity by various governments is similarly unobjectionable provided that such taxes are coordinated to give an appropriate total burden.

Inter-nation equit y 6 5 International tax treaties date back to 1843 and greatly increased in number after world war i. During th e twentie s th e proble m wa s considere d i n severa l report s sponsored by the Leagu e of Nations. In 1920 , a Committee of Economic Experts was assembled by the International Chamber of Commerce to propose a genera l se t o f principles fo r tax-burde n allocatio n [8 , ch.6]. Th e distinguished membershi p o f th e Committe e include d Luig i Einaudi , E.R.A. Seligman, and Sir Josiah Stamp. The basic approach was to derive an elaborate schema of tax classification and to apply a concept of'economic allegiance' allowing for (a) the location of production or of source of income, (b) the location at which the final product is used or the income is received, (c) the location of the legal machinery by which property rights are enforced, and (d) th e domicile of the property owner. Ideally, different type s of taxes would be imposed on the situs of wealth or of source of income as split up among various locations according to each of these four factors. In practice, such a solution was not considered feasible , and it was recommended that property taxes on tangible wealth as well as in rem taxes on income derived from suc h wealth be allocated accordin g to situs of property and source of income. Taxes on movable and intangible property, as well as the personal income tax, in turn were to be assigned to the country of domicile. In the latter case , th e ide a o f creditin g foreig n agains t domesti c taxe s b y th e domicile country was rejected as too favorable to the debtor countries. These recommendation s wer e submitted subsequentl y to a Committe e of Technica l Experts , assemble d b y th e Leagu e o f Nation s [8 , ch.7] . Reporting in 1927, the Technical Experts followed the previous committe e in it s general recommendations, bu t wen t further i n retaining the sourc e principle for certai n non-persona l taxes , including 'schedular' (as distinct from global) taxes on income. In a subsequent report (1929) these principles were reaffirmed, an d it was recommended that profits from business enterprises b e taxed a t th e plac e o f permanent establishment. Thereafter , th e continuing work of a permanent fiscal committee of the League of Nations led t o th e Mode l Conventions of Mexico (1943) and Londo n (1946), th e major provisions of which were similar to those later adopted in the Model Tax Treat y Conventio n o n Incom e an d Capita l draw n u p b y th e OEC D Fiscal Committee in 1963. Though not binding, this draft convention is widely regarded as the basic framework for good international manners in this matter and has served as a mode l fo r subsequen t ta x treatie s amon g membe r countries. It s basi c philosophy has much in common with the earlier recommendations of the

66 Moder n Fisca l Issue s League of Nations. A schedular approach was again taken, with profits as well a s othe r incom e and capita l gain s earne d o n immovabl e propert y assigned to the country of source. The right to tax dividends and interest payments wa s largely assigne d t o th e residenc e countr y wit h maximum withholding rates of 15 per cent for dividends (5 per cent in the case of intercorporate dividend s with ownershi p connectio n o f a t leas t 2 5 per cent ) and 1 0 per cent for interest permitted t o the country of source. Royaltie s were to be free o f tax in the source country, being entirely assigned to th e residence country as were capital gain s earned on certain 'movable' assets . The only (and somewha t circular) justification given for this jurisdictiona l division seem s to hav e been the 'clos e economic connectio n betwee n th e source o f income an d th e Stat e of Source' [1 , p.78, para.l ] said t o exis t with respec t t o thos e primar y form s o f incom e arisin g fro m productiv e assets in the country of source.5 The above notion is also implicit in the criterion of'permanent establish ment' which plays an important rol e in the Model Treaty. The right to tax business profits b y the country of source is limited to profit s arisin g fro m the so-calle d permanen t establishment , a somewha t les s tha n clear-cu t concept. Th e category o f permanent establishment exclude s certain ancil lary service activities which are 'so far antecedent to the actual realization of profits b y the parent body that no profits can properly b e allocated t o it' [1, p.74, para.2], and those which are of an intermittent an d casual nature. Current practice

Current practic e unde r bot h individua l an d corporatio n incom e ta x reflects a mixture of two norms, one being the residence and the other the source, o r territoriality, principle , henceforth simply referred t o as source rule. The residence principle, a s applied t o th e individual income tax, hold s that all income earned by an individual - whethe r at home or abroad - is taxable by his country of residence (and/or citizenship) . As in the domestic setting, the tax is applied to investment income only in so far as it is received by the individual and not as it accrues in the form of undistributed corporate profits retaine d abroad . The corresponding principl e fo r the corporatio n 5 Th e principle o f source taxation wa s also endorsed by the Fiscal and Financia l Committee of the EE C in the 'Neumar k Report' on the grounds (a) that i t is more efficient fo r the country wher e the activity takes place to administe r th e tax, an d (b) tha t it is politically desirabl e for the foreigner t o be taxed wher e h e earns his income. [10 , para.3458.25] .

Inter-nation equit y 6 7 income ta x i s tha t o f plac e o f incorporatio n and/o r management . Th e United States , for instance , taxe s global incom e of us-incorporated com panies, whil e the Unite d Kingdo m base s it s 'residence ' criterio n fo r th e corporation o n the locus of management. As with the personal income tax, however, domestic corporations ar e usually not taxed on their share in the undistributed profits of foreign corporations, suc h tax being deferred to the time of distribution. The source of income rule says that income is taxable in the jurisdiction in whic h it originates . Thi s 'sourc e rule,' a s it applie s t o busines s profits under the corporation tax , is generally defined in tax treaties to permit the source country to tax the profits of any permanent establishment operating within its borders, but only so as not to discriminate between income accruing to domestic and foreign ownership. These source and non-discrimination rules , however , ar e applicable i n full onl y to profit s taxes. A partial application o f the rule pertains to th e personal income tax o n dividends, rentals, and interest on which withholding taxes are usually imposed by the country of source. Most tax treaties provide for these withholding taxes to be imposed at reciprocally equa l rates. It is in deference to the source country's primary right (or ability) to tax that th e countr y o f residenc e (incorporation ) generall y modifies it s ow n taxation o f foreign-source income either by giving outright exemption, by allowing foreign taxes to be deducted from taxable income or to be credited against th e domesti c tax. However , where dividends from a foreign sub sidiary are paid to a parent company at home before being distributed to the latter's individua l shareholders, the foreign withholding tax is not 'passe d through' as a credit agains t the individual income tax.6 SINGLE-SOURCE COUNTRY: TYPE S O F EQUITY

In this and the following sections we deal with the claims of the country of residence of owners (country A), the country of source of income (country B), and the country of incorporation (countr y c). How should these claims be divided, and o n which rules of inter-nation equit y should the divisio n be based? To simplify , w e assume that th e entire operation (productio n an d sales) is in B. Thus there is no problem o f determining the income source . The problem of determining this source arises where corporations operat e across countries (Bl9 B2 , etc.) and will be dealt with in the final section. 6 A proposal to pass through to the individual shareholde r foreign withholdin g taxes o n dividends pai d to a parent company at home was made in a recent Canadian report on tax reform [7 , vol.4, p.516].

68 Moder n Fisca l Issue s Posing the problem While th e foregoin g sketch o f pas t an d presen t practic e bring s ou t th e complexities involved , pas t discussio n ha s bee n i n pragmati c an d lega l terms, an d no clear pictur e emerge s as to wha t the underlying principles should be. In approaching the matter, we distinguish between (a) the problem of inter-nation equity , (b) the problem o f inter-individual equity , an d (c) th e avoidanc e o f distorting effect s o n international capital flows . Th e key point is that appropriate solutions to (b) and (c) may be applied while leaving open the issue posed by (a). Inter-nation equity Inter-nation equity deals with the allocation of national gain and loss. Let x, a resident of A, invest in B. Income earned thereon constitutes a national 'gain' t o countr y A. If countr y B taxes the incom e earned by x, th e gai n accruing to country A as a nation is reduced. This is the issue of inter-nation equity. The fact that the gain accrues to B'S treasury is not the crucial point. B may pass this gain on to its tax-payers by tax reduction, but it still retains the nationa l gain . Similarly, A has suffere d a national loss due to B' S tax. This national loss results, whether A gives a credit to x for taxes paid to B, thereby suffering a treasury loss, or whether the income is taxed again and x is left to bear the burden. National gain or loss may or may not be accompanied b y a treasur y gain o r loss ; th e latte r i s a matte r o f intra-natio n transfer betwee n treasury and individual and does not affec t th e existence of national gain or loss. It is thus the national gain or loss (not the treasury gain or loss) that is the subject of inter-nation equity as defined here. 7 Views of inter-individual equity Fairness require s that a taxpayer's liabilit y payable to his country of residence shoul d b e th e sam e whethe r incom e i s derive d fro m foreig n o r domestic sources. 8 Bu t 'ta x liability ' ma y be define d i n internationa l o r national terms . If country A takes an international view of individual equity, tax liability will be interpreted a s total (i.e., domestic plus foreign) liability. Taxes are 7 Thi s concept o f inter-nation equity might be extended furthe r to include not only the division of income from an y given unit of foreign capital but als o any alloca tion effect s o f taxation o n the capital itself . This aspect leads to th e concept o f the 'optimum tax' analogous t o that o f the 'optimum tariff.' Se e [2; 3; 4, ch.13, 14]. 8 I t is assumed fo r purposes of this discussion tha t the country o f 'primary tax allegiance' is the country of residence, rathe r than domicil e o r nationality.

Inter-nation equity 6 9 taxes, and it does not matter to whom they are paid. If x has his primary tax allegiance in country A and earns capital income in B, his total taxes (payable to A and B ) should be the sam e as if his entire income had bee n earned in A. A'S tax la w should be controlling, bu t this does not mea n that B cannot tax such income. If the income is taxed only by A, no further problem arises; but if it is taxed by B, individual equity requires that A should grant a credit to x fo r hi s taxe s pai d t o B . By granting thi s credit , horizonta l equit y between x and other taxpayers of A is established. But, as noted before, the credit does not involve a matter o f inter-nation equit y since it constitutes a transfer fro m treasury to taxpayer within A only. If country A takes a national view of individual equity, equal treatment is defined i n term s o f A' S taxes only . I n thi s case , A will conside r B' S taxes imposed on x as expenses and permit x to deduct them. The tax reduction resulting therefrom is again a n intra-A transfer between treasury and tax payer and does not involve the issue of inter-nation equity . The latter was settled by B imposing its tax, the choice between credit and deduction on the part o f A being an internal matter o f individual equity only. An equitabl e treatment of x by the laws of his country of residence (be it in terms of international o r national equity ) may thus be achieved whether B is permitted to tax the income or not. Relation of the two equity concepts The issue of inter-nation equity is thus settled by whether and how B will tax. Inter-individual equity (between x and his co-residents in A) in turn depends on A' S response t o B' S tax, whic h respons e als o determine s th e ta x bas e available to A'S treasury. It is misleading, therefore, to think of inter-nation equity between the countries of residence and source in terms of a division of treasury gains. Rather, it should be thought of in terms of national-gain sharing or revenue participation b y B, the country of income source. Inter-nation equity vs. efficiency Efficiency o f capital movement, similarly, may be assured independently of how national gain s are assigned. Efficiency, a s seen from a world point of view, requires that an investor's choice of country in which to invest should not be affected by tax differentials. H e should pay the same tax wherever he invests. Th e mos t readil y implemente d metho d fo r accomplishin g thi s objective is taxation b y B with a credit for th e foreig n ta x grante d b y A, a practice whic h is also consistent with the international vie w of individual equity. Provided that A takes this view, efficiency i s assured whether or no t the income is taxed by B.

70 Moder n Fiscal Issues But what if efficiency i s viewed more narrowly from the point of view of national interest ? Efficiency then requires that foreign investment be carried to the point where the return net of foreign tax equals the domestic retur n before tax. This may be accomplished by the deduction method, also called for b y the nationa l vie w of individual equity. As before, we find that th e efficiency criterio n can be met whether or not B is permitted t o tax. Conclusion Restating the matter, inter-nation equit y involves the question o f whether B should be permitted to tax the income which A'S investors derive from investment in B. If such a tax is imposed by B, it thereby derives a national gain which, in turn, reduces A'S national gain derived from its foreign investment. This may o r ma y not involv e a loss for A' S treasury, depending on how A chooses to treat (overlook, deduct, or credit) B'S tax. The treatment, however, has a bearing on individual equity and the efficiency o f capital flows. These two issues may be dealt with one way or another (as, for instance, via crediting or deduction procedures) whatever is done about B'S right to tax.9 SINGLE SOURCE COUNTRY ! CRITERI A FOR INTER-NATION EQUIT Y

Having separated the issues of individual equity and efficiency fro m that of inter-nation equity, we may now turn to various principles of inter-nation equity.

Allocation under benefit taxation One such principle an d muc h the mos t clear-cu t follow s unde r a benefi t rule. Under a system of benefit taxation each jurisdiction would charge for services which it has rendered. Income taxes would play a minimal role in such a system. Direct charges would be imposed on the consumer for final public good s provide d t o hi m an d o n th e firms for intermediat e good s provided to them. Company taxation would thus be imposed largely by the jurisdiction in which the production process occurs and the benefits (intermediate goods ) were received. Moreover , th e natur e o f the tax woul d be quite different fro m that of a profits tax. If a general proxy were used, this might be furnished bes t by an ad valorem tax on cost payments, assuming intermediate public services to reduc e all private costs equally. In a competitive system , this woul d amoun t t o allocatio n o f the profit s ta x bas e according t o valu e added, bu t no t necessaril y so in the real world where 9 Fo r fulle r analysi s of the matters discussed in this section, see [5; 6, ch.10].

Inter-nation equit y 7 1 mark-ups a t variou s stage s o f production ma y differ . Inter-natio n equit y under the benefit principle would be self-implementing. While such a system would make for a neat solution to our problem, it is unfortunately not a realistic view of the matter. Mos t taxes are not imposed on a benefit basis , so that inter-nation equit y is not secure d automaticall y in this fashion. Another allocatio n rul e must be found to deal with general, non-benefit taxation. A t the same time, the benefit idea may be allowed for in allocating gains among nations, i.e., a country should be entitled to charge for the cost of public services which it has rendered to the foreign investor . Residency vs. territoriality Let us return to our example of x, a resident in A, deriving income from a n investment in B, and briefly restate the preceding argument. In the absence of taxes the earnings from thi s investment accrue to A as a 'national gain.' This will remain the case whether o r not A imposes a tax, a s such a tax is merely an intra-nation transfe r between A'S treasury an d x . I f B imposes a tax, the situatio n i s changed. A' S national gai n is reduced an d part thereof is transferre d t o B . The questio n o f inter-natio n equit y therefor e i s only whether B should be permitted t o tax, and if so, by how much. What d o th e lega l principle s o f residenc y an d sourc e impl y i n thi s respect? I f th e 'residency ' principl e i s interprete d simpl y a s sayin g tha t country A is entitled t o tax x's income because x is a resident of A, it has no bearing o n inter-nation equity . Such national gai n as country A derives is obtained b y it whether A'S treasury imposes a tax or not.10 The sourc e principl e mean s that a country i s permitted t o ta x income which results from activitie s undertaken i n its borders. Tha t is to sa y B is permitted t o ta x x' s incom e an d thu s t o appropriat e par t o f A'S national gain. This will be the case whether or not A also taxes this income under the residency principle. Thus , w e have the asymmetric result that inter-natio n equity is affected i f the residenc y principle is supplemented by source, bu t not if source is supplemented b y the residency principle . If the source rule is to be applied, i t should b e non-discriminatory. Th e legal philosoph y o n which the rule i s based i s that a sovereign country is 10 Usin g a more far-reachin g interpretation , th e residence principl e may be taken t o mean that only th e country of residence i s permitted t o tax income. In thi s cas e the rule would defin e inter-nation equity . Th e country of source woul d be barre d from taxin g (and derivin g a national gai n from) foreig n investmen t income . Application o f the source principl e would be ruled out .

72 Moder n Fisca l Issues entitled to tax all activity which occurs within its borders. Give n this view and following the general principle of equality under the law, it follows that all activity within the borde r shoul d be treated alike . Therefore, B should tax income received by x as if it were received by B'S own residents. A rule of non-discrimination should apply. 11 Emphasis o n activity withi n the jurisdiction explains wh y the territoriality principle has been associated traditionall y with in rem taxes, whereas the residency principle has been associated wit h the individual income tax. There is , however , no compellin g reaso n fo r this association . Th e terri toriality rul e may also be interpreted t o mea n that B should be permitte d to tax the income (qua income tax) which x has earned from his operation s in B. While the associatio n o f income taxation wit h residency makes sense in th e contex t o f inter-individua l equit y (th e ne t liabilit y payabl e b y x should afford hi m equal treatment with other residents of A), this does no t hold for the quite different issu e of inter-nation equity. National rental Both the residency and source rules are essentially legal concepts and do not carry a clear economi c content. 12 A more meaningfu l approac h from th e economist's poin t o f view may be derived by taking a broader loo k a t the national gain , includin g gain s othe r tha n thos e whic h accru e vi a profi t sharing through ta x participation. As residents of country A invest in B, A'S capital earning s are moved above the level which would be obtained fro m domestic investment . To be sure, the net gain to country A falls short of its increased capital income because its labor income will be reduced. However, within certain limit s o f capital export a t least, country A will gain. Labor income in B will gain from the capital inflow while its own capital income will 11 Th e interpretation of this rule if applied t o th e individual income tax raises a question whether B, in determining the marginal rate at whic h x's incom e is to b e taxed, shoul d consider hi s income earned in B only, or his total income includin g that earne d i n A. B'S share will be larger if the latter view is taken, since a higher marginal rate will apply. This procedure, whil e correct i n principle, i s difficult i n practice a s it would require the filing of multiple returns. 12 I t i s interesting, therefore, to note that economists hav e tended to use the term 'taxation by country o f income source ' rather than 'territoriality. ' This may only be a difference i n words since in both cases B is entitled to ta x and th e territor iality rule is also a source rule. At the same time the legal philosophy of the territoriality rule, combined with equal treatment unde r the law, suggests nondiscrimination, whereas the economists' notio n of source carrie s no such connotation.

Inter-nation equity 7 3 fall, but, on balance, B also stands to gain. The question is whether this gain is enough. If B is capital poor but ric h in other resources, A'S gain (over and abov e the alternative gain from hom e investment in A) tends to be large. B might, with some justification, argue that it should obtain a rental or royalty share in A'S gain over and above the addition to its labor income; and the appro priate way for B to obtain this gain would be to charge a tax. If thi s approac h i s taken, suc h a charg e woul d be independent o f B'S own tax structure. A s against the 'treat income accruing to foreigners as if accrued to residents' principle of the source rule, the approach now becomes one o f charging a renta l o r royalt y o n foreig n operations, an d t o d o s o outside the domestic tax system. The tax, in fact, becomes an in rem tax on operations by foreigners. This leaves open the question of how high the rental charge should be. Should it equal B'S income loss from its own capital, a fraction of A'S national gain from no t investin g at home, o r what othe r rul e should be followed? The matter i s complicated further sinc e capital inflo w migh t bring intan gible gains such as technical and managerial know-how as well as intangible burdens such as foreign control an d slowed-dow n emergence of a native entrepreneurial class . Obviously, there i s no precis e level at whic h to fix the rental , bu t th e general notio n i s not withou t appeal. Suc h is the cas e especially sinc e appropriate creditin g o r deductin g devices may b e used by the capital-exporting country to neutralize effects o f the national rental on capital flows and indiv dual tax equity. There is nothing in the logic of the national rental approach whic h suggests that rates on foreigners would be the sam e a s thos e applicabl e t o th e resident s o f th e capital-importin g country. Quit e possibly, th e nationa l renta l woul d be below the capital importing country's corporation tax . In additio n t o th e nationa l rental , a countr y ma y impos e a benefi t charge to defra y th e cos t o f public services rendered to th e operation s o f foreign-owned capital. As noted before, such a charge may be imposed (as a matte r o f inter-nation equity ) even though domesti c taxation i s largely on a non-benefit basis. It is not likely, however, that such a supplement to the nationa l renta l woul d be very large sinc e only a smal l part o f public expenditures tend s t o g o into provision o f intermediat e service s for pro duction. Thus, a modest charge might be set internationally,13 and a higher 13 A s discussed a t othe r points in this paper , there remains th e objectio n tha t profits ar e not th e appropriate base for benefit taxation.

74 Moder n Fiscal Issues TABLE 4.1 Per capit a incom e o f capital-exporting country ($) Per capita incom e of capital-importing country ($) Below 250 250-500 500-1000 1000+

below 250

250-500 500-100

40 30 20 10

50 5 40 4 30 3 20 2

0

1000+

Tax rates (per cent) 5 5 5 5

60 50 40 30

rate be applied where intermediate services can be show n to b e unusually large. Distributional considerations

Finally, it might be argued that the taxation of income from foreign-owned capital shoul d b e use d a s a n instrumen t o f internationa l redistribution . With a highly unequal distribution o f resource endowments and per capita income amon g countries an d i n the absenc e o f an adequat e metho d fo r dealing with the problem, a n appropriate patter n o f tax-imposed nationa l gains and losses might be used to secure some degree of adjustment. In the context of a corporation ta x in particular, it might be desirable to apply a uniform rate schedule, agreed upon by international convention and applicable in all capital-importing countries. To allow for the redistribution norm, such a rate schedule should not be based on reciprocity or equal rates (as is now common for withholding rates) but migh t be constructed alon g the lines of Table 4.1. These rates would be substituted for both the corporation an d withholdin g ta x no w impose d b y B on incom e accruin g t o A'S investors. Th e applicabl e rate s a s show n i n th e tabl e woul d b e relate d inversely to per capita income in the capital-importing country and directly to per capita income in the capital-exporting country. This would improve the relative position of low-income countries. Now it might be objected that the vertical progression reflected i n the above rat e schedul e woul d no t b e beneficia l t o low-incom e countrie s because it would deter capital inflow. This, however, would be the case only if th e capital-exportin g countr y faile d t o maintai n individua l equity an d investment-flow neutralit y amon g it s resident s b y appropriat e crediting . General acceptanc e of such a schedule would avoid the possibility of lowincome countrie s imposin g extrem e rates whic h woul d the n hav e t o b e recouped b y the treasuries o f high-income countries. Also , adoptio n of a

Inter-nation equit y 7 5 common rat e schedul e would forestal l low-rat e competitio n fo r foreig n capital by low-income countries.14 SINGLE-SOURCE COUNTRY: PROBLEMS O F INCORPORATION

In thi s section , som e additional aspect s o f the single-sourc e country case are considered. So far, no allowance was made for the fact that investment is usually in corporate form and that income is taxed at both the corporat e and the individual level. In fact, the issue of inter-nation equit y is largely dealt wit h in terms of corporate rathe r tha n individua l incom e taxation . With th e introductio n o f th e corporatio n int o th e picture , tw o furthe r problems arise: (1) the country of incorporation enter s as a third potentia l claimant for tax revenue; and (2) there is the problem of taxing at both the corporation an d the shareholder level. Residence principle applied to corporation

As long as the source rule is followed, the place of incorporation doe s not matter. But it does matter if the residence rule is applied to the corporatio n tax. This discussion , dealin g wit h th e taxatio n o f corporation s an d thei r subsidiaries, necessaril y view s th e corporatio n ta x a s a n 'absolute ' ta x imposed on the corporation as such. If we consider the position of individual shareholders who are residents in A but deriv e income from investmen t in corporations i n B, the problem depends on how corporation ta x is viewed, i.e., as (1) an individual income tax on the shareholder, or as (2) an absolute tax on the corporation. Under (1) the source principle calls for taxation by B and the residence principle for taxation by A, with (given the internationa l equity view) crediting of B'S tax. Under (2), A has no claim and B is entitled to tax under either the sourc e or residence principle. If residence is interpreted as place of incorporation, the distribution of national gain will now depend o n where incorporation occurs . This problem is of particular im portance for the case where a corporation earns income through its foreign subsidiary: th e questio n arise s as to whethe r residence is in th e countr y of incorporation o f the parent corporation o r of its subsidiary. 1. Suppose first that a corporation is incorporated in A, has a branch in B, and derives earnings from the operation of that branch in B. Looking at the corporation ta x as an 'absolute tax,' i.e., imposed on the corporation 'a s such' rathe r tha n o n the shareholder , shoul d A tax th e branc h income ? Under the sourc e rule the answe r is clearly no, but wha t if the residenc e 14 I n this connection, see also n.7 above.

76 Modern Fisca l Issue s rule holds? In fact, what does it mean to apply the residence rule under an absolute corporation tax? Presumably the country of incorporation would be the corporation's residence . Thus, only A would be entitled to tax. If B also taxes under the source rule, A may credit B'S tax, this being the practice followed under us law. The principle is the same as that developed above. 2. Suppose next that the corporation incorporate d in A operates a subsidiary which is incorporated i n B and derive s income from busines s in B. Country B is now both the country of source and o f incorporation for th e subsidiary. Again, there is no problem under the source rule, as B alone is entitled to tax. But interpretation o f the residence rule is now difficult. I f residence is now defined a s being in B, then the residence principle strictly interpreted mean s that onl y B is eligibl e t o ta x th e entir e profit s of th e subsidiary, while A would be eligible only to tax such partof the profits as is remitted to the parent corporation i n A. The nex t questio n i s whether consideration s o f inter-taxpaye r equit y (now applied to horizontal equity among corporations) call s for A to credit B'S tax. The answer is no, because this would not b e compatible with the principle o f deferral which is based on the recognition of parent an d subsidiary as distinct entities. If A has no right to tax the undistributed profits of the subsidiary, why should it credit its corporation (the parent) for the tax paid by B'S corporation (th e subsidiary) ? The us practice o f granting deferral and then crediting is thus inconsistent and one or the other (preferably deferral) should be abolished. This would mean abandoning the country of incorporatio n qu a residenc e approach whil e applying a global ta x t o the parent.15 3. Difficulties are compounded in a situation where the subsidiary incorporated in B (and earning income in B) in turn has subsidiaries incorporated in c and earning income in c. This is a so-called two-tier problem in which the issues raised in the preceding section are expanded further. This will not be followed through her e beyond noting that it accentuates the inconsistency involved in both giving deferral and allowing an 'indirect' tax credit. 15 Actually , the problem is complicated because B applies not onl y its corporatio n tax to the subsidiary, but also a withholding tax to dividends paid to the parent. An argument may be made that it is consistent for A to credit this withholding tax while granting deferment, the reason being that the withholding tax may be considered as being imposed on the parent directly. Current us practice is to permit both a 'direct' credit for withholding tax but also (and not properly so, since there is deferral) an 'indirect' credit for B'S corporation tax . It may also be noted that in the case of portfolio investment the proper procedure of giving the direct credit only is followed.

Inter-nation equit y 7 7 In other words, in the absence of incorporated subsidiaries , the choice is between permittin g taxatio n b y B (source rule ) o r b y A only (exclusive residence principle). Give n the existence of subsidiaries, there is the addi tional problem of determining the 'residence' of the subsidiary, be it a s its place o f incorporation o r th e place o f incorporation o f its parent. I f th e parent incorporated i n A has a subsidiar y incorporated i n c bu t earning income in B, application o f the source rule will determine whether B can tax. Suppose that it can do so and thus derives a national gain at the expense of A or c, depending on where the residence is taken to be. But this is not all. If residence is taken to be in c and c thus is permitted to impose a further tax, A will suffe r a n additional loss. The national loss to A in this case depends not only on the level of taxation in B, but also in c. Whereas in the absence of subsidiaries the matter of national loss was determined by the applicatio n of th e sourc e rule only, we now se e that th e operatio n o f the residenc e principle enters into the picture. Individual tax plus corporation tax Turning no w to th e fac t tha t corporatio n profit s are taxe d a t bot h th e corporate an d the shareholder level , should non-discrimination unde r the source rule be interpreted as permitting B to impose both an individual and a corporation ta x on foreign capital, provide d it does so on earnings from its domestic capital? We see no reason why this should not be the case. If the source reasoning applies to the one tax, it should also apply to the other. At the same time, it must be admitted that non-discrimination is easier to apply with regard to the corporate tha n with regard to the individual tax. Short of requiring x to file a return in B, the latter may have to be approximated (as is the case in current practice) by a flat withholding tax imposed by B on dividends flowing to A. 16 Nevertheless, the role of the withholding tax as an approximation to a properly assessed individual tax makes it clear that the level of a country's withholding rate should be a function o f its own individual income tax rate 16 Not e also tha t i f B has a n integrated tax , non-discriminatio n b y B will leave x i n the sam e positio n a s residents o f B only if A passes B'S tax on to him as a credit against hi s individual income tax . If at th e same tim e A has an absolute tax, thi s will not b e compatible wit h individual equit y in A, and creditin g agains t A'S corporation tax is called for . Th e essence o f non-discrimination rest s on equa l treatment o f x by B; it doe s not requir e tha t after A' S tax treatment i s allowed fo r the final position o f x must be the same as it would be if he were a resident o f B. Rather, horizontal equity for A is determined b y equal treatmen t wit h other residents of A under th e la w o f A.

78 Moder n Fiscal Issues schedule, corresponding, say, to the marginal rate paid by its shareholders on the average dividend dollar. It follow s fro m thi s that the idea of reciprocity i n withholdin g rate s i s inappropriat e i n th e contex t o f non discrimination. National rental approach Under the national renta l approach , take n in its pure form, th e two-tier issue is irrelevant. B imposes its tax o n income earned by foreign capital , outside it s ow n ta x (individua l o r corporate ) syste m applicable t o B'S residents. Or, i f the rental charge is collected as a part of B'S income and corporation taxes, what now matters (with regard to inter-nation equity) is the combine d take o f B under both taxes . Separat e consideratio n o f th e 'proper' charge under either tax is meaningless in this context. Moreover, under the national rental view, c would clearly be disqualified as a claimant for ta x revenue since it does not contribute to the economic sources of A'S national gain. CONCLUSION ON SINGLE-SOURCE CASE

It i s difficult t o compress the various strands o f the preceding discussion into a neat set of conclusions, but the following judgments emerge. Inter-nation equity A solution to inter-nation equit y in line with the principle of taxation by residence onl y would b e undesirable . I t woul d b e inequitabl e fro m th e point o f vie w o f sourc e countries, especiall y for th e cas e of low-income countries. Moreover, for the all-important subsidiary case and the corporation tax it would involve the arbitrary decision of where corporate residence is to be recognized. The principl e o f taxation b y sourc e is preferable. While it raise s th e difficulty of determining source (see next section), this difficulty can be overcome in line with meaningful economic principles. The appropriate rate at which the source country should tax may be set in line with either the principle of non-discrimination (i.e., taxing profits of foreigners at the same rate as profits of domestic capital) or in line with the national rental principle. Tempered possibly by distributional considerations , a se t of rental rate s might be agreed upon on an international basis. The latter is our preferred solution. In the absence of subsidiaries, the above would take care of the problem; but give n subsidiaries, a n additional problem of inter-nation equity arises with the levels of taxation chosen by the respective countries of residence of the subsidiar y corporations . No w i t migh t be argue d tha t th e primar y

Inter-nation equity 7 9 concern of inter-nation equit y is to distinguis h between the claims of the source country and all other countries , an d there is something to b e said for thi s view . However , th e distributio n o f claim s amon g th e differen t countries of incorporation (qu a residence of corporations) i s also relevant. A possible solution here is to provide that the country of incorporation is entitled to ta x onl y if it is either the country of source or the country of primary tax allegiance 17 for individual shareholders owning a substantia l proportion of the equity. Whichever principle is recognized, and whatever rate structure is set to achieve wha t i s considered inter-natio n equity , efficienc y effect s ma y b e neutralized by appropriate treatment of foreign taxes within each national tax system. Taxpayer equity Taxpayer equity in the international context is primarily a matter of horizontal equity among corporate taxpayers . Whatever the rate at which the source country taxes, the country of residence may deal with the tax paid in th e sourc e country in lin e with its ow n choice betwee n viewing intertaxpayer equity on international o r national grounds, i.e., i t may credit or deduct. However, whichever solution is chosen, it should be applied consistently . Thus, i f on e adopts th e internationa l vie w which underlies the u s credi t provision, suc h credit should be given to the us corporation onl y for such foreign taxes as it pays against its profits earned abroad. Sinc e the foreign tax is paid by the subsidiary, this implies that the profits of the subsidiary must also be considered the profits of the parent. If so, there is no justification for deferral of us tax until foreign earnings are repatriated. Alterna tively, deferra l ma y b e justifie d b y stric t applicatio n o f th e residenc e (country o f incorporation ) principle . Bu t th e creditin g o f foreig n taxe s placed on the foreign corporation i s then no longer justified. Implications for tax treaties Regarding improvements of tax treaty practices, the following suggestions might be made. 1. Tax-treaty formulatio n shoul d no t b e left t o purel y bilateral agree ments. An internationally agreed-upon framework, analogous to the GAT T rules for the treatment of commodity taxes, is called for. This is needed in particular i f redistributiona l consideration s ar e t o b e introduce d an d i f 17 W e leave open the question of whether thi s should be defined in terms of residence or citizenship or by other criteria.

80 Moder n Fiscal Issue s this i s to b e don e withou t interferin g wit h capita l flows to low*incom e countries and without inviting low-rate competition amon g them, such as is solicited by the tax-sparing practice. 2. In considering the appropriat e arrangemen t between any two countries, the treatment of withholding tax and corporation tax should be considered jointly, not separately . Thus , attentio n wil l be directed a t B' S total take, which is what matters from the inter-nation equit y point of view. 3. The principles of reciprocity, while meaningful as a bargaining device, have little economic justification, no r ar e they compatible wit h the non discrimination requirement of a legal territoriality rule, especially where the source countr y ha s a n integrate d system . Non-discriminatio n call s fo r withholding rates tuned to each country's own personal rate structure . 4. The non-discrimination principle , while in line with the territorialit y rule, is incompatible wit h the national rental or redistributional approach . High incom e countries shoul d allo w fo r thi s i n tax-treat y arrangements with low-income countries. 5. Separate treatment of certain income sources (e.g., interest, royalties , etc.) are a carryover from a schedular approach to income tax and should give way to a global approach, combinin g all gains of capital incom e into one total. This is called fo r unde r th e logic o f either th e territoriality o r national renta l view. Other suggestion s may be added to this list, and those made here may have to b e revised afte r furthe r consideration . Th e subject matter, a s we recognize, is highly complex, especially if considerations of administrative feasibility (whic h we have largely overlooked) are added. Nevertheless, it seems evident that the matte r need s rethinking, extendin g the discussio n beyond the narrow confines o f the legal residence and territoriality rules . This is called for in the relationships among developed countries, but even more so in their dealings with low-income countries . Implications of shifting

Finally, it should be noted that the above argument has been developed on the assumptio n tha t th e corporatio n ta x fall s o n profits . Th e situatio n changes if we assume that it is shifted to consumers. A profits tax imposed by B is no w equivalen t t o a consumptio n ta x o n th e consumer s of B'S product. This is the case whether the capital involved is owned by residents of A or B. Assuming consumption to occur in B, no national gain to B or loss to A results.18 18 The reader will recall that in the present discussion we assume the entire product

Inter-nation equity 8 1 Imposition o f a profits tax by A on its foreign investment (assuming the tax to be shifted in B) now results in a national loss to B and gain to A. This cannot be defended by any of the rules considered here, whether on benefit, territoriality, o r nationa l renta l grounds . Fo r redistributiona l reasons , similarly, taxation by A would be inappropriate, since the capital exportin g country wil l hardly b e th e low-incom e country . Th e residenc e principl e must b e rejected in thi s case . In th e all-shiftin g world, country A should exempt foreign earnings of its residents from it s profits tax, for th e same reason that under GATT rules exports are exempt from commodity tax.19 EQUITY IN TH E MULTI-SOURCE CAS E

To isolate the first problem posed by the taxation o f income from foreign investment, we have assumed earlier that the capita l whic h residents of A invest in B is invested in a company whose entire operation is in B. We now turn to th e second problem, whic h arises if the operations o f a company extend over more than one country. This poses no difficulty under the pure residence principle. But under the other rules which involve the determination o f sourc e (sourc e rule , nationa l rental , redistribution) , ther e no w arises the further problem of how to divide the income among the participating countries. In terms of our previous illustration, there now exists a set of BS among whom the ta x bas e must be divided. Assuming that they apply the same rate, the national loss to A will be the same, but the distribution o f the nationa l gain among the B S will differ. I f these rates differ, th e total loss to A will be affected as well. Background This problem has been the subject of much discussion as it applies to th e taxation o f corporation profit s by individual states i n th e us . Whil e th e taxation of profits fro m a single-state company is uniformly based o n th e territoriality (source ) principle, the division of the tax base for a company operating acros s stat e border s ha s bee n handle d i n a variet y o f ways . Among these, the so-called formula apportionment or allocation method is most generall y used , wit h othe r technique s represente d b y th e separat e accounting an d specia l allocatio n method s [9 , ch.Sf.]. I n mos t cases, th e of the firm to be sold in B. If export occurs, B may achieve a national gain. But such national loss to A as may result will be qua importer of products, rather than exporter of capital. 19 Complication s which arise if the tax is shifted i n one country but not in the other, or shifted i n varying degrees, cannot be dealt with here.

82 Moder n Fiscal Issues locations of property, payroll, and sales are given equal weight. The assumption had been that the inclusion of sales would be helpful to the less industrialized states, but a recent study has shown that the distribution of the tax base among states is not changed greatly if sales are excluded. The reason, of course, is that the more industrialized states also offer the larger markets for sal e [9 , ch.16]. Because of this and sinc e the sale s component is most difficult t o administer , i t ha s bee n recommende d recently tha t th e sale s factor b e droppe d an d a unifor m property-payrol l formul a b e adopte d [9, ch.39]. Assuming no shifting , thi s ma y be a reasonable solution, bu t to the extent that shifting occurs, inter-nation equity would suggest that the sales component in the formula be retained and given increased weight. As noted before, at the international level, a different approach has been taken. Primar y relianc e unde r th e Mode l Treat y i s o n th e concep t o f 'permanent establishment.' Under this approach, each permanent establish ment operating in one country as an affiliate to a parent company in another is to be treated fo r tax purposes a s a separate entit y and profits must be assigned t o i t usin g arm's-length accounting . Th e latter the n become s a crucial facto r in the Model Treaty approach t o apportionmen t o f profits. The underlying rationale appear s to be more or less similar to that of the separate accounting approach at the us level and the same difficulties apply . Division of profits among those earned by operations within various jurisdictions would be a meaningful approac h i f it could be accomplished, bu t the difficulties o f separate accounting are considerable, and the concept of 'permanent establishment' itself is rather vague. Certain activities are considered as being conducted by a permanent establishment while others such as sales activities are often largely excluded. Determination of source

Neither the discussion of base allocation amon g the us states nor the literature on international agreements is very enlightening in explaining what the underlying principle shoul d be. 20 Presumably, the objective is to divide up the tax base in line with the territorial origi n of profits. Given this principle, the problem becomes one of economic imputation. This problem, it must again be noted, is quite different fro m that which arises under benefit taxation. There, the issue is one of determining the situs at which public services were rendered. In the absence of 'itemized billing,' a proxy might be furnished by the situs of cost incurred, assuming the pro20 Unfortunately , the extensive analysis of the problem in the Report of the House Judiciary Committee [9 ] contains little discussion of this aspect.

Inter-nation equit y 8 3 vision for intermediate publi c goods t o be a constant matchin g factor in relation t o othe r on-sit e costs incurred , i.e. , valu e added les s profits. As noted before, the logic of the approach would point to an ad valor em charge on suc h costs . Unde r competitiv e assumptions this woul d be simila r t o allocation b y value added, but it would have nothing to do with a profits tax. Th e us typ e apportionment formul a is in line with this i n s o far a s value added by payroll is concerned, but not with regard to the capital and sales factors . Th e capita l facto r (i n the benefi t context ) shoul d ente r b y depreciation rather than by value of capital and the sales factor should enter by sales margin rather than gross sales. By overweighing capital and sales, the formula greatly underweighs the labor component . Our concern, however, is not wit h a benefit ta x but wit h a tax o n the earnings of capital an d with tracing the source of these earnings. The first and obvious question is why this should not be identified with the locatio n at which the actual operation o f the capital occurs . Thus, profits would be imputed according to the location o f capital use, including fixed capital as well as working capital. Payroll would enter the formula via average working capital neede d for wag e payments, an d sale s would enter vi a investment i n sale s establishments. Payrol l an d sale s would thus be accounte d for, bu t their weigh t would be much less than i n the apportionment for mula o f the u s type, while the weight of capital would be much greater. Such an allocation woul d be in line with the source concept, calling for the taxation o f capital earning s where the capital operates . Bu t it involves the assumption that the return to capital is the same in all locations. This would be the case in a competitive equilibrium where the return to capital is equalized at the margin and intramarginal profits are assigned as rents to other factors . However , thes e ar e hardl y realisti c assumption s to make . Suppose first that the product market is competitive, but that the particular location of production permits production at lower cost, the gains of which accrue (at least i n part) to capital . I n this case, capita l operatin g i n tha t particular location should be assigned a higher share in profits. The problem, in principle, would have to be solved by 'separate accounting' for the firm's operation i n each country, with the arm's-length rule being used to divide costs an d receipt s amon g th e componen t unit s operatin g i n variou s countries.21 As a compromise , th e location-of-capita l approac h (broadl y defined ) might be use d as the rule , wit h specia l allowance being made for exces s 21 Thi s solution, which more o r less resembles actual international practice , does, however, suffer fro m a number of complications. One of these is that not al l

84 Moder n Fiscal Issue s returns in certain situations, such as involve the use of raw materials and low labor costs , where such an adjustment is clearly appropriate. Thi s may be looked upon as but another way of expressing the excess-earnings feature of the national rental norm. Assignment of a larger share in the base is essentially the same as permitting the charging of a high tax rate on profits fro m an unweighted capital base . Another complicatio n arise s wher e th e produc t marke t i s non-com petitive. Suppose the firm has a monopolistic position and is able to sell at differentiated price s in various markets. I n maximizin g profits from tota l sales, the averag e return per uni t o f sale will differ amon g markets. Thi s being the case , i s there justification for differentia l treatmen t o f the sale s factor, givin g more favorable treatment t o th e country i n which a larger share of the monopoly profits originate? In principle, it is difficult t o deny that there is some justification for such an allowance, but it would be diffi cult to implement. The determination o f price differentials (afte r allowin g for difference s i n selling costs) would hardly be a feasible procedure. Th e national rental idea, it appears, is both more feasible and meaningful on the production than on the sales side of the picture. Conclusion

The conclusion wit h regar d t o bas e allocatio n i s straightforward fo r th e benefit setting. Allocation shoul d be on a cost-incurred basis. For the case of general revenue, the problem does not arise if the pure residence principle is used. Under source rules, location o f capital offer s th e most reasonabl e first approximation. Thi s should be tempered, however, by allowance for excess returns where they clearly occur . Applied to the allocation o f tax bases among us states, i t appears tha t the three-factor formula, with more or less equal weights given to capital , payroll, an d sales , meet s neithe r requirement . Fo r benefi t purpose s i t grossly underweights payroll, whil e for genera l revenue, capital is underweighted. A reasonable solutio n migh t be to divid e the tax bill int o tw o parts, including (1) a benefit charge based on costs incurred and (2) a profits foreign busines s i s done throug h permanen t establishments . Ye t foreign activit y conducted outside permanen t establishment s cannot be accounted for by separate accounting. Apar t from this th e concept of arm's length pricin g i s frequently difficult i n application i f not i n principle. Fo r thi s reason, treatment o f the firm as a unit wit h apportionment according to location of activity ma y be preferable . See P.B. Musgrave, 'Internationa l division o f tax base and the les s develope d countries,' a paper prepare d fo r the UN Division o f Public Financ e an d Fiscal Institutions, 1970 .

Inter-nation equit y 8 5 tax based largely on capital location. Presumably the latter would command the larger part o f the yield. Applied to the international setting, which involves the finance of central government expenditure, the benefit component tends to be less important. The permanent establishmen t approac h i s hardly satisfactory . Implemen tation o f a bona fide separate accountin g approach i s exceedingly difficul t and th e dividing line between what does an d wha t does not constitut e a separate establishmen t i s arbitrary . Us e o f a comple x apportionmen t formula, on the other hand, requires multiple returns and is hardly feasible in the absence of international administration . Ultimately , the only satisfactory solutio n (i n lin e wit h th e conclusion s o f th e precedin g section ) would be the taxation o f such income on an international basi s with subsequent allocation o f proceeds on an apportionment basi s among the participating countries, making allowance for distributional considerations. This is especiall y calle d fo r i n vie w o f the rapi d growt h o f the multinationa l corporation. In conclusion , it shoul d b e noted tha t th e problems deal t wit h above cannot be wholly separated. The issue of source allocation is clearly linked to tha t o f charging differential rate s unde r the national renta l approach . Assigning a large r shar e o f the sourc e t o a particula r jurisdictio n a t a uniform rat e o f tax is equivalent to assignin g it a smaller share but per mitting a higher rate. On the whole, it would seem desirable to implement redistributional objectives through rate differentiation whil e attempting to divide the source in line with 'true' economic imputation. REFERENCES

1 Draft Double Taxation Convention on Income and Capital, Repor t of the OEC D Fiscal Committee, 196 3 2 Koich i Hamada, Strategic aspects of taxation o n foreign investmen t income, Quarterly Journal o f Economics LXXX, Aug. 196 6 3 Ronal d W. Jones, International capital movements an d the theory of tariffs an d trade , Quarterly Journal of Economics LXXXI, Feb. 196 7 4 Murra y C . Kemp, Th e Pure Theory of International Trade, Englewoo d Cliffs, N J 196 4 5 Pegg y B. Musgrave, United States Taxation of Foreign Investment

Income, Cambridge, Mass . 196 9 6 Richar d A . Musgrave, Fiscal Systems, Ne w Haven, Conn . 196 9 7 Report of the Royal Commission on Taxation, 6 vols., Ottawa 196 7 8 Edwi n R.A. Seligman , Double Taxation and International Fiscal Cooperation, New York 192 8 9 State Taxation of Interstate Commerce, Report o f the Special Sub committee o n State Taxation of Interstate Commerce, Committe e of the Judiciary, Hous e of Representatives, Washingto n 196 4 10 Ta x Harmonization in the Common Market, Commerc e Clearing House 1963

DOUGLAS DOSSE R

5

Customs unions, tax unions, development union s

The theory o f customs unions has, excep t for som e recent qualifications , been expounded for group s o f developed countrie s [19,20 , 32]; similarly, the theory of tax unions. The aim of the first two sections of this paper is to extend and qualif y suc h theory for groups of less-developed countries. A s one does so, the more the lines between trade policy, tax policy, and general development policy for such a group become vaguer and less legitimate. I t may be best, therefore, to give up most of the old notions and concepts used for developed countries and work towards a theory of development unions. CUSTOMS UNIO N THEOR Y AN D LES S DEVELOPE D COUNTRIE S

It is long since clear that if standard customs union theory (that for developed countries ) i s applie d t o les s develope d countries , custom s union s between them will usually be found to be undesirable. The simplest Vinerian proposition that trade diversion exceeds trade creation where the partner s are complementary in products, produce s thi s outcom e whe n applied t o less-developed countries , fo r developin g countrie s ar e complementar y t o manufacturing countrie s an d t o eac h other . Man y o f th e mor e refine d post-Vinerian propositions lead to the same result. For example, Brown [6] has pointed out that the Lipsey propositions that (a) customs union is more likely to raise welfare the higher is the proportion of trade with the country's union partne r an d th e lowe r i s the proportio n wit h th e outsid e world , and (b) customs union is more likely to raise welfare the lower is the volume of foreign trade relative to domestic purchases prior to the formation of the union, are exactly controverted by the fact that developing countries usually trade with developed countries rather than with each other and often have very large foreign trade sectors in relation t o national output.

Customs unions 8 7 One group of writers has therefore viewed conventional customs union theory as entirely irrelevant t o developing countries [1 , 21, 23]. However, another group has added qualifications to the conventional theory to make it applicable [4 , 8, 12, 16, 18, 24, 31]. The qualifications of these writers follow two themes: industrializatio n and import substitution. The industrialization issue in customs union theory is best emphasized by Cooper and Massell [8]. Let us use their analysis as a building block, and consider Linder's approach [18] , which emphasizes the import substitution aspect, a s we go along. The essence of the Cooper and Massell position is that a dollar's worth of home-produced industria l outpu t ma y be considered more valuable than a dollar's worth of imports of that output because of the external economies that are obtained from the mere fact that it is produced at home. One way of taking account of this is the adjustment of market prices for social benefit s and costs. A choice of product mix flying in the face of international specialization can increase the value of national income, using these socially adjusted values, compared wit h the marke t valu e of national outpu t tha t marke t forces would decide. Cooper and MasselFs method is presented slightly differently: it involves the ranking of home industrial activities according to the excess cost compared with the imported product, so that the process of substitution of home industry for imports can stop when excess cost becomes so great as to outweigh the benefi t o f the externa l economies of industrialization. In othe r words, the social cost - the excess cost of production at home - equals the social benefit at the margin. Actually, there is an obscurity on the demand side in Cooper and Massell. Their downward sloping, central-planners' demand curve for industrialization does not explicitly account for the fact tha t different hom e industries carry different degree s of industrialization benefit per unit of output. Consequently, the recognition of the social cost and social benefit of each industry individually is a bette r approach . Furthermore , i t i s capable o f extension to incorporate the Linder approach an d other factors. The Linder approach is , in effect, t o weight a dollar's worth of home output as more valuable than a dollar's wort h of the same imported produc t becaus e no scarce foreign exchange is used. The socia l cost is the same , namely the excess cost of producing at home. The excess benefit or social benefit is this time the value of the particular categor y of foreign exchang e saved. Thus both socia l cos t an d socia l benefit s var y accordin g t o th e typ e o f home activity as before. Putting these two approaches togethe r we can see that the establishmen t

88 Moder n Fisca l Issues of a home activity involve s a socia l cos t and a t least tw o social benefits. The first social benefit , o f industrialization i n general, is , it is true, muc h more diffuse than the second, which involves foreign exchange. But a proxy can be used for it, for example, new wage or urban employment creation. There are now two distinct factors on the benefit side; the social or excess cost sid e ma y b e articulate d similarly . I n developmen t economics , th e availability o f foreign exchange and o f capital resource s ar e see n as twin obstacles to development - the foreign exchange gap versus the savings gap. It might be desirable, therefore, to evaluate industries not merely by their excess unit cost o f production ove r the cost o f the imported product, bu t to tak e int o accoun t th e variation s i n capita l requirement s fo r hom e production o f each commodity. We have arrived, then, at a system of evaluating each possible candidat e for hom e production, compare d wit h importing th e product , b y at leas t two factors on the benefits side and two on the cost side: wage employment and foreign exchange saving benefits and loss of real national incom e and use of scarce capital resources on the cost side. Although measurable, they are not commensurate, and a weighting system is required to include them in one evaluation function . The preceding analysis could relate to a single less-developed country, but since integration i s our primary concern, we must now relate it to customs unions. All o f th e substitutio n o f import s b y ne w hom e activitie s unde r th e evaluation criteri a above , rememberin g the y g o agains t internationa l specialization according to comparative advantage, would previously have been reckoned as trade diversion. But now they are beneficial to the country concerned. Also it is a world welfare gain, if world welfare is built o n the welfare functions of the less-developed countries. But, of course, it is either a world welfare gain or loss according to whether one's viewpoint is that of developed or less-developed countries . In a union of two less-developed countries, both in the above situation , we can also study trade creation of the standard theory, and arrive at a new welfare meanin g her e too . Conside r tha t bot h countrie s hav e a lis t o f industries where the social benefits exceed the social costs. We may assume that some of these industries are common to both lists. When the two countries for m a union , onl y on e country nee d develo p a commo n industry , normally the least cost/maximum benefit one , taking accoun t o f the tw o elements of cost and of benefit discussed above. It is true that the costs and benefits ma y have to b e weighted relatively to th e foreig n exchang e gap /

Customs unions 8 9 savings gap situation o f each country in particular. Thi s will be taken u p again later. But it can be seen that the excess benefit over cost of the more advantageous country undertaking output for both countries, provides an analogue t o the trade creation o f customs union theory, where the lowest cost partner produces for both, cost interpreted in conventional terms. These common industries, and the separate industries which each country requires to develop on its own, are protected by an appropriate an d agreed set of tariffs o n the part of the two countries. The other feature which is introduced with the common industry one, is the distributiona l problem. Th e criteria ma y indicate that all common industries be located in one of the partners. This question has been discussed by Robson [28 ] and others, and fiscal measures of compensation are ofte n contemplated. We ca n summariz e the relatio n o f thi s approac h fo r less-develope d countries t o standar d custom s unio n theory . Instea d o f viewin g trade creation a s beneficial and trade diversion as harmful, and judging the net desirability of a customs union on the balance between the two, we find that in th e cas e o f less-developed countries , eac h o f th e tw o effect s o f trad e creation and trade diversion must be divided into a constituent beneficial and harmful part. Trade diversion is beneficial up to the point where social benefits exceed social costs (beneficial for the country concerned and possibly for th e world); it is harmful beyon d that margin. Trade creation is beneficial (to the union and to the world) except where it leads to an undesirable concentration of the benefits in one country - thu s it is beneficial up to the point o f conformin g with som e agreed distributiona l rule , an d harmfu l after that. The establishmen t of blanke t protection, suc h as a commo n externa l tariff around the union of less-developed countries, would run the union into a mixture of beneficial and harmful trade creation and beneficial and harmful trad e diversion. It may be possible to select out the beneficial effects by a much differentiated syste m of tariff levels facing the world. Alternatively, the economies may be so matched that a blanket protectionism produces a considerable exces s of beneficial over harmful effects . Th e question arises as t o whethe r an y proposition s ca n b e mad e tha t th e beneficia l effect s would be large in such a circumstance, propositions based on the structure of th e constituen t less-develope d countries . T o attemp t t o adduc e suc h propositions i s strongly in the tradition o f the Viner-Meade-Lipsey treatment of standard customs union theory. A few are suggested here: (i) There exist home activities for whic h there are large potential excesse s of socia l

90 Moder n Fiscal Issues benefits ove r socia l cos t whe n they ar e substitute d fo r presen t imports , (ii) Many of these same home activities appear in the lists of the partners of the prospective union, (iii) But these common industries themselves show large divergences in the excess of social benefit over social cost, country by country. However, policy working through partial o r differentiate d tarif f struc tures when a group of less-developed countries forms, e.g., market by market, product by product, may be more fruitful an d is certainly more typical of the usual modes of action in such countries. TAX UNIO N THEOR Y AN D LESS-DEVELOPE D COUNTRIE S

We can follow the same procedure as in the case of customs union theory and examine the applicability of standard tax union theory to less-developed countries. It i s already recognize d tha t ta x unio n theor y i s more complex tha n customs union theory. The statement of the pre-union position of the potential members is more complicated, involvin g as it does diverse structures, principles, an d rate s o f taxation, som e or al l of which might have to b e brought into a common form. And the changes involved in a tax harmonization progra m ma y involv e equalizatio n o r planne d difference s i n al l o f these aspects, compared with the simple reduction of tariff rates of customs unions. Finally, the effects of such changes need to be more widely evaluated than o n the customary allocative efficienc y o f customs union theory, and even where the developed countries are concerned, effect s o n growth, the balance of payments, etc., should be included. If we take thes e stage s on e by one, we shall se e the inapplicabilit y o f much of current tax union work when less-developed countries are involved, not onl y as regards th e final-stage evaluation criteri a (a s was the case in customs union theory) but fo r the earlier phases of tax union analysis as well. In the statement of initial comparative position for developed countries, it is not too difficult to reconcile different structures and rates to a common form. Fo r example , th e equivalen t ne t value-adde d ta x rate s o f gros s multi-stage (cascade) taxes have been calculated [10]. Similarly, corporation taxes with different structure s -integrated o r separated fro m the personal income tax - can be reconciled, and excises fall on largely the same type of goods i n differen t develope d countries . Thu s th e initia l positio n ca n b e stated in general terms for the three classes of taxes - sales taxes, corporation

Customs unions 9 1 tax, an d excises - whic h will be subject t o a general ta x harmonization policy, going by EEC experience. In less-developed countries, the situation is very different. Th e diversity of taxes between the countries of a potential unio n is likely to b e funda mentally sharper . T o begin with, corporation taxe s are likely to b e nonexistent or unimportant, and personal direct taxes to be often dominated by very individualistic systems including native head and hut taxes. Thus only indirect taxes are a candidate for general harmonization i n less-develope d countries, plus special taxation measures -more or less individual deals for foreign corporations. These areas , indirec t taxation , etc. , contai n fe w common elements to synthesize into a tax harmonization policy . Ther e is not usually a general sales tax in a less-developed country, and if so, it is confined to urban areas. Whether a levy takes the form of an excise, an export levy, a surcharge on the price charged by a state monopoly, etc., it tends to be concentrated o n products which are important in that country - oil, coffee, cocoa, natural fibers , metallic minerals , hydroelectricity , etc . - and whic h ar e the dominan t products will vary from country to country. Thus the idea o f a common system of taxation fo r mos t groupings of less-developed countries is largely meaningless.1 It appears , therefore , tha t th e applicatio n o f recently-develope d ta x union theory to less-developed countries fails to get past even the first stage statement of the initial tax situation - in a form enabling appropriate comparisons of one country with another as a pre-requisite for harmonization. We might briefly consider the subsequent stages as if it were possible to proceed wit h a ta x harmonizatio n progra m i n th e Europea n style . Th e second stage of agreement on a policy of change of the existing situation towards harmonize d norm s ma y involv e structura l change , chang e i n jurisdictional principle and/or rate change. It is evident that structural change would involve much more swingeing changes in the tax system than in the case of developed countries. There , it is a matter, to take indirect taxes, of changing from on e form o f general sales tax, such as the German cascade system or British purchase tax system, to a value-added form; th e change is marginal in the sense that a system 1 A s is the extension of tax harmonization programs of unions of developed economies to associate members. Consider the problem of the future application of the EE C value added tax in Greece and Turkey.

92 Moder n Fiscal Issues of usage and administration exists for the raising of a tax across the country on al l o r man y wholesale/retail outlets . Again , corporatio n ta x change s involve essentially 'paper' changes in corporation and governmen t offices. But structural change for harmonization in less-developed countries would involve the setting up of entirely new administration systems in some of the countries - and often in a context inimical in terms of politics or tax morality at the existing state of economic development. Jurisdictional principl e chang e mean s a chang e betwee n origi n an d destination principle for indirect taxes, or a source and residence basis for direct taxes. This has little meaning for less-developed countries. Levies on imports have to be on the destination principle, and levies on exports (export duties) on an origin basis, as these provide the main sources of government revenue for many less-developed countries. The same must apply in so far as indirect taxes take the place of import an d export duties in the revenue system of countries where a highly-developed personal income tax system is premature. And the levies on particular products, such as oil and metallic minerals, whether they be construed as excise, royalty or corporation tax , are usually the subject of a deal between the home government and foreign corporation where the standard distinctions of Jurisdictional principle have no meaning. Enough has been said about th e conceptual difficultie s o f structural o r Jurisdictional harmonizatio n i n less-develope d countrie s t o mak e rat e harmonization a n even more academic question. The tax systems of these countries are usually so diverse and particularized a s to make a differenc e in kind in the meaning and application o f the tax harmonization idea s of developed countries. T o follow those ideas in fact implies creating new tax systems, suc h a s a general sale s tax syste m or a corporation tax, i n lessdeveloped countries; this goes beyond the scope of tax harmonization . The final stage in tax harmonization analysis is the evaluation of agreed changes of the existing structures on various criteria. Compared wit h standard customs union theory and its single criterion of efficien t resourc e allocation , standar d ta x unio n theor y doe s se e th e need for more elaboration on the criteria side. Recent work evaluates the revenue an d incom e distributio n effect s o f a ta x harmonizatio n policy , called 'neutrality ' effects , an d th e effect s o n trad e an d th e balanc e o f payments, inflatio n an d unemployment , an d productivit y an d regiona l growth, all as 'welfare' effect s [9 , ch.l ]. It i s interesting that the nee d has been fel t t o broade n the criteri a fo r customs union s between less-developed countrie s i n a similar wa y to th e

Customs union s 9 3 divergence o f standar d ta x unio n theor y fro m standar d custom s union theory. We might compare the two wider lists of criteria. There is a certain degree of conformity: Tax unions for developed Customs union for less-developed countries countries Revenue effects — Distributional effects — Allocative (o r trade) effects Ditt o Balance of payments Foreig n exchang e saving Inflation/employment balance Industrializatio n (employment creation) Regional policy — — Capita l creation and utilization In each case, the competitive nature of the objectives has been recognized. In th e less-developed countries ' case , thi s ha s perhaps bee n systematize d more i n explici t trade-off s between , fo r example , reductio n o f allocativ e efficiency an d trad e an d foreig n exchang e saving on foreig n imports. I n both cases , the necessity has bee n recognized o f non-economic factors t o reconcile the conflictin g gains and losse s through each list occasioned b y each ta x harmonizatio n o r tarif f policy . Th e compariso n o f th e list s is instructive. The interesting question is to ask what list should apply were a tax union analysis for a group of less-developed countries in fact possible? The lis t fo r less-develope d countrie s i s obviousl y mor e fittin g fo r thei r economic situation. But the revenue and distribution effects of the left-hand column might well be included - and in a different, mor e significant, sense. The reason fo r their inclusion in the developed countries ' cas e arose fro m the desirability of evaluating the 'differential incidence' of a tax harmonization policy. However , in the less-developed countries ' situatio n it may be undeniable that a n increase in government revenues, and a change in distribution, i s clearly an economi c aim o f the government . The increase i n government revenue may be necessary to build infrastructure, in the absence of private savings, and in the presence of an archaic tax system - a necessary prerequisite t o development itself. And distributional chang e may similarly be essential in the transition fro m dependent to independent political status. Thus th e lis t o f criteri a fo r evaluatio n o f a ta x unio n betwee n less developed countries should be extended to the six factors. And is there any reason wh y such a lis t shoul d no t b e applied equall y to custom s union s

94 Moder n Fisca l Issues between them? For the revenue aspects (if not the distributional) of import and expor t dutie s ar e o f immensel y greater proportiona l importanc e i n less-developed countries , unlik e the case of most mature economies. Consequently, we suggest the same extended list for both customs unions and tax unions between less-developed countries . An d this is only part of the integrated approach t o tariff an d tax questions which we want to pro pound. Remember, from our customs union section, that the object is normally to promote som e home activity at the cost o f some income loss compare d with specialization followin g comparative advantage. This costs capital, but yields foreign exchange and creates employment. (But also we may now wish to add revenue and distributional change. ) Now a particular home activity may be promoted b y either tariff o r tax measures. These can be regarded as alternatives, especially bearing in mind our emphasis on the non-general nature of much taxation i n less-developed countries. In place of the agreed sectoral tariff, w e would find a union-agreed ta x concession, eithe r by rate or a structural provisio n to protect the sector which had scored well on the development cost-benefit rule. Thus, the simplest way to view tax unions in the context of less-developed countries ma y be as providing alternativ e mean s to promot e th e chose n union sectoral developments compare d wit h tariff protection. Indeed, th e two (o r more ) means, tariff vs . tax, t o promot e a certai n hom e activit y themselves yiel d tw o competitiv e policies . Fo r almos t certainly , eve n if each promotes the same scale of activity, there will be differing implication s for revenue , distribution, etc . This limited approach t o tax harmonization between developing countries -tax concessions seen as a supplement to tariff policy for chosen sectoral development - avoid s the big questions o f the changes to be assumed for large categorie s of tax -equalization, planne d differentials , etc. - an d of trade and welfare effects o f such grand measures . What is required is the study of the relative efficiency of using tariff versus tax concessio n measure s to promot e a selecte d home activity, wher e the development cost-benefit calculus is the same for both cases. DEVELOPMENT UNION S

The central ide a of this section can be stated a t the outset. The old idea of trade creation and trade diversion as a result of tariff change on the formation of a customs union can be reinterpreted a s development creation and development diversion.

Customs unions 9 5 If the tariff o r tax arrangements made in a customs union or tax union lead t o developmen t of countries outside the union , this is development diversion; if they are conducive to economic development of the member states, that is development creation. Such a reinterpretation is vital to a customs union or tax union theory for less-developed countries . I t ca n quickl y b e see n ho w inappropriat e th e Vinerian concepts are. When such countries are involved, the trade creation following from increased international specializatio n ma y land the m with primary products or other products with low income elasticities of demand, whilst manufacturing industry is developed in outside (and probably more advanced) economies. In this way, trade creation ma y be accompanied by development diversion . The convers e is seen , wher e development in th e less-developed states is achieved by trade restriction . The analogue may not be exact, but enough has been said to demonstrate a doctrinal point: that to label a customs union as 'desirable' because trade creation i s stron g ca n b e perniciously misleadin g fo r th e polic y o f lessdeveloped countries. In pressin g th e compariso n an d contras t betwee n trade creatio n an d development creation, we have a fairly easy measure of the former, and wellknown (though not to say sound) methods of estimating potential benefi t from hypothetical tariff and tax changes.2 If less-developed countries should pay heed rather t o developmen t creation , i t is necessary to try to define , and find measurable proxies for, the expanded criteria . Views can differ widely, of course, but one suggestion is to take our own criteria function fo r judging a customs or tax union as itself a measure of welfare change in the development sense: where E = employment creatio n (a s a prox y fo r 'industrialization') , F = foreign exchang e saving , K = availability o f capital resources , an d T = volume of trade, where all of these variables are functions of the tariff or tax which may be altered by union. Whilst this formulation is very broad, it so turns out that a good deal of standard development theory lies beneath it, both as regards the functional relationships between a tariff o r tax and each of the four right-han d vari ables, bu t als o a s regard s functiona l relation s betwee n those variable s themselves. 2 See , fo r example, [3] .

96 Moder n Fisca l Issues In orde r t o coordinat e thi s vie w of customs unio n an d ta x unio n fo r less-developed countrie s wit h aspect s o f developmen t economics , som e reformulation is desirable. More specifically, the evaluation functio n w e have suggested earlier t o judge the desirability of a union (using a cost-benefit approach) has been : where A ^(development creation) consist s of industrialization (A£ ) at th e cost of trade ( — AT"), the foreign exchange reserve is increased by net import saving, bu t reduce d b y import requirement s o f the industrializatio n program, and the available capital reserves are augmented by any new savings due to the fiscal program, but reduced by capital used for industrialization . APT is measure d ove r th e developmen t pla n period , perhap s on e year , perhaps five. This approac h generalize s th e variou s amendment s t o custom s unio n (and tax union) theory on behalf of less-developed countries, bu t does not as ye t incorporat e som e leadin g idea s o f developmen t economics . W e propose t o coordinat e i t i n genera l wit h (a ) saving s gap versus foreig n exchange gap theory,3 (b) the choice of techniques problem in less-developed countries,4 (c) unlimited supplie s of labor flowing out o f zero-labor productivity agriculture [14, 17], and (d) some aspects of fiscal policy for growth [5; 11; 25, par t n; 26; 27]. That saving s gap-foreign exchang e gap theory is not accounte d fo r is evident from th e fact tha t there is no recognition that increase s in W may be brought to a dead stop if either F* or K* become zero. To take accoun t o f this, it is useful t o re-stat e th e approach a s a constrained maximizatio n of the trade an d employmen t variables, wher e for choice of t (a positive tariff o r fiscal policy, where t0 represents zero tariff s and a 'neutral' fiscal policy), we maximize W with the following constraints : ma subject to

(1 (2

(3

) )

)

(4

)

(5

)

3 Usin g [7 ] and [22] . 4 Thi s will hardly be touched on , but a vast literature stem s from [13 , 15, 29].

Customs unions 9 7 The first constraint, equation (2), represents the trade-off between home industrialization (measure d b y the prox y o f new wage employment) an d real nationa l incom e foregone (measured b y trad e lost) ; i t i s i n fac t a derivation fro m th e Cooper-Massel l 'suppl y o f industrialization' curves , shown i n Figure s 5.1 and 5.2 , where their 'centra l planner s deman d fo r industrialization' curv e i s replace d b y a communit y or centra l planner s preference system.

FIGURE 5. 1

Equation (3) is the production function for home industrialization where foreign exchange and capital are taken as two separate factors of production. This equatio n coul d b e use d to introduc e varie d assumption s about th e 'choice of techniques,' o r taken a s simply a homogeneous linear o r fixed coefficient productio n function ; thi s simpl e course we shall take s o as t o concentrate o n the other development aspects . Finally we have the foreign exchange and capital constraints, equations (4) and (5), either of which may become binding for a tariff or tax harmonization program during the development plan period. The model can now be used to brin g the capital an d foreign exchang e constraints into the union welfare function . If w e may assume unlimited supplies o f labor int o wag e employment , only F and ^i T are limits to expansion of production up to any desired limit

98 Mode m Fiscal Issues

FIGURE 5. 2

of development of home industry. But the ceilings of F* and K* 9 working through the production function, may or may not prevent the achievement of the Cooper-Massell typ e optimum: see Figure 5.3. As in Chenery and Strout, the savings gap or foreign exchange gap may become binding, an d limit planned industria l expansion . Th e assumption of non-substitutability between Fand Kis made here as in the corresponding work in development theory. If we follow the Chenery and Strout approach, the savings gap will be binding in phase n of development (phase I is characterized by skill limitations, and ends when investment is sufficient to achieve the targe t growt h rate , whic h is thereafte r sustainable), an d th e foreig n exchange gap is binding in phase in. The converse must also hold: when in phase i i th e saving s ga p i s effectiv e ther e i s 'surplus ' potentia l foreig n exchange, and vice-versa in phase in. The model so far ha s not mad e explicit reference t o th e union of lessdeveloped countries that is our essential concern. The way is now open t o see the benefits that could accrue from th e union of countries in differen t phases o f development . I t i s not onl y that th e bindin g restrain t o n on e country reaching the trade-wage employment optimum may be eased by a pooling of foreign exchange or capital reserves, but that the model is more fundamentally change d whe n a development unio n is formed and welfare

Customs unions 9 9

FIGURE 5. 3

may be increased b y (a) shifts outwards of the trade-employment function, as well as (b) removal of constraints on the feasible domain of that function. Taking each of these aspects in turn, the shif t o f the trade-employment function occur s because some members of the unio n have a comparative advantage ove r other s an d ca n produc e for th e union , rather tha n eac h attempting that home activity themselves. Neither would, of course, produce the goo d i n questio n given fre e trade . Thi s is not quit e the sam e case as 'trade creation ' i n a custom s union, fo r th e pay-of f i n industrializatio n benefits (proxied by wage-employment) may also be affected b y the particular distribution of industries agreed upon within the union. New trade , create d b y th e fac t o f union , a t n o extr a penalt y o f rea l national income foregone, is represented by AC in Figure 5.4. The pivoting of the curve from CD to CE would denote a gain to the union from a particular locatio n o f industr y whic h pulle d on e membe r int o a ne w stag e o f development. A Rostovian approac h could b e fitted in here, o r we could use the Fei and Ranis model. Here, recall, the chie f stages of development are, t o begi n with, o f increasing rea l nationa l incom e as zero-marginal productivity labo r flows out o f the agricultural or subsistence sector into positive marginal productivity employment in urban or industrial employment, until, later, positive marginal productivity reigns in all employments.

100 Modern Fisca l Issues

FIGURE 5. 4

As the location of industry in the union falls to a greater extent in the earlystage members, 5 the curve swings outward. Thus, if all members are in the positive-productivity stag e when the union is formed, there is additional rea l income from the 'pure' trade creation o f be, with no extra industrializatio n benefits beyond Oa, but if some members are in the stage of increasing real national incom e simpl y fro m labo r mobility , ther e ma y b e additiona l 'industrialization' benefit o f ce. A simple example would occur if 'within union' comparative advantage put protected agricultura l activit y in the member where agricultural labo r productivity ha d alread y becom e positive , bu t industria l activit y i n th e country where labor was a free good in the real opportunity cost sense. If we were allowed to include the idea of common market in a development union , wit h unhindere d mobilit y o f labor , th e possibilitie s o f Fei Ranis typ e rea l incom e increas e (o r outwar d movemen t o f th e trad e employment curve ) would be greater. But suc h mobility i s an unrealisti c enough event even among developed economies. The outward shif t o f the trade-employment curve , whether just 'trade creation' o r more , doe s give th e prospec t o f reaching a highe r optimum 5 Ther e are major distributio n problems here, of course, very fully deal t with in [2] and [28] .

Customs unions 10 1

FIGURE 5. 5

between trad e an d industrialization . Bu t if th e previou s optio n wa s unobtainable owing to the savings or foreign exchange restraint, little gain may actually b e achieved . Equilibrium changes, i n Figur e 5.5 , fro m e± t o e 2, with a minor increase in welfare, compared with the unconstrained optim a ofe± ande 2'. As mentioned earlier, however, if there are pooling or swap arrangements over capita l resource s and foreig n exchange , th e saving s gap o r foreig n exchange ga p ma y b e relieve d fo r a give n member . Thi s i s particularl y likely if the members are in different Chenery-Strout stages of development. It must be remembered, however, that each activity in each country has a doubl e effect , positiv e an d negative , a s far a s the stoc k o f capital an d foreign exchange is concerned. It is a peculiar problem, in that a choice, through policy instruments, of a particular location of activities in the union, will have different expansionary effects o n the trade-employment frontier for a country, but different effect s again on the position of the binding constraint. And in some cases, the best net effect ma y come from a smaller frontier expansion.

102 Modern Fisca l Issues We have so far subdued the question o f the policy instruments used in the union to achiev e the desired o r target level s of industrialization. This has been deliberate in the sense mentioned earlier that we considered that a customs union or tax union theory for less-developed countries would not stand by itself, but only gained meaning within development theory. The ide a o f developmen t unio n comprehend s tarif f unio n an d ta x harmonization, fo r thes e ar e alternativ e polic y mean s o f actin g o n th e trade-employment frontier, and the constraints upo n it. But they are no t indifferent means . The next dimension is that the trade-employment curve and the constraints on it are themselves affected b y the policy means. This can be seen from a few simple examples. Home activities may be developed behind tariff walls , or fostered by particular ta x arrangements . Clearly, th e differenc e betwee n tariffs an d taxes, and between , say, use of indirect taxes , corporation taxes , tax holidays or othe r concessions , ma y affect th e shift o f the trade-employment frontier o n union, considering the effect o n labor utilization in the Fei-Ranis sense of different ta x measures. And the choice must influence capital resources, e.g., by differential effect s on home savings, and also foreign exchange, e.g., according to the effect o n the influx of foreign corporate funds . What the previous analysis of 'development unions' does is to suggest a calculus to assess this or that measure of tariff or tax-harmonization. Each such measur e affect s th e possibilit y frontie r betwee n short-run nationa l income (trade measuring the degree of conformity to maximum specialization) and industrializatio n (measure d by new wage-employment). It als o affects th e constraint s whic h migh t b e preventin g th e obtainin g o f th e desired position on that frontier. But, further, th e changes in the position of a country on union are also dependent upon the context of that union. The omens seem most favorable for countrie s i n earl y stage s o f Fei-Rani s developmen t a s regard s agricultural-industrial productivity, and different Chenery-Strou t development as regards savings and foreign exchange gaps. There is a potential gain for a less-developed country enjoining a union, varying with the comparative state of development of the partners, all for a given prospective specific tariff or tax policy. And for a given group of lessdeveloped countries, the potential gai n will vary according to the tariff o r tax harmonization proposed. Standard customs union theory can be seen as a special case. It is a special case of the 'context' dimension,because the (developed) countries considered do not diffe r i n Fei-Ranis o r Chenery-Strout characteristics, sinc e all have

Customs union s 10 3 reached th e 'final' stag e of development. Nor d o they differ i n the 'policy' dimension, becaus e the tarif f program , suc h as zero internal tariff s an d a common external, is singular. The same applies to standard tax union theory, once the form of indirect or direct tax union is specified. Clearly, suc h a specia l cas e o f custom s (o r tax ) unio n theor y i s quit e inappropriate for a group of less-developed countries, becaus e of both th e 'context' dimension and the situatio n reveale d above o f the necessity of a much mor e piecemea l an d variegate d fisca l polic y i n less-develope d countries. REFERENCES

1 R.L . Allen , Integration i n less developed countries , Kyklos fasc. 3, 1961 2 F . Andic, S. Andic, and D. Dosser, A Theory of Economic Integration for Developing Countries, London 1971 3 B . Balassa and associates , Trade Liberalisation Among Industrial Countries, Baltimore 196 7 4 R.S . Bhambri , Custom s unio n and under-developed countries , Economia Internazionale, May 196 2 5 R . Bir d and O. Oldman, Readings on Taxation in Developing Countries, Baltimore 1964 6 A.J . Brown , Customs union vs. economic separatis m i n developing countries, i and n, Yorkshire Bulletin, May 196 1 7 H.B . Chener y an d A.M. Strout , Foreign assistanc e an d economi c development, American Economic Review, Sept. 1966 8 C.A . Coope r an d B.F. Massell , Toward a general theory of custom s unions for developing countries , Journal o f Political Economy, Oct. 1964 9 D . Dosser , ed. , Th e British Tax System and Entry into the Common Market, forthcoming 10 D . Dosser, S.S. Hans, and T. Hitiris, Trade and welfar e effect s o f ta x

harmonisation, Manchester School, Dec. 196 9 11 J . Due , Taxation and Economic Development in Tropical Africa, Cambridge, Mass . 1963 12 ECLA , Th e Latin American Common Market, U N sales no.57.n.G.4, New York 195 9 I S O . Eckstein, Investmen t criteri a for economic developmen t and th e theory of intertemporal welfar e economics, Quarterly Journal o f Economics, Feb. 195 7 14 J.C.H . Fei and G . Ranis , Development of the Labour Surplus Economy: Theory an d Policy, Homewood, 111 . 1964 15 A.O . Hirschman, Th e Strategy of Economic Development, New Have n 1958 16 H . Kitamura, Economi c theor y an d regional economic integration of Asia, in M.S. Wionzcek, ed., Latin American Economic Integration, London 196 6 17 A . Lewis , Economic developmen t with unlimited supplie s of labour, Manchester School, 1954 18 S.B . Linder, Trade an d Trade Policy for Development, London 196 6 19 R . Lipsey , The theory of custom s unions: a general survey, Economic Journal, Sept . 196 0 20 J . Meade , Th e Theory o f Customs

104 Moder n Fiscal Issues Unions, Amsterdam 1955 21 G.M . Meier , Effects o f a customs union on economic development, Social and Economic Studies, March 1960 22 R.F . Mikesell , The Economics of Foreign Aid, Chicago 1968 23 R.F . Mikesell , The movement toward regional trading groups in Latin America, in A.O. Hirschman, ed., Latin American Issues: Essays and Comments, New York 1961 24 R.F . Mikesell , The theory of common markets as applied to regional arrangements among developed countries, in R.F. Harro d and D.C . Hague, eds., International Trade Theory in a Developing World, London 1963 25 R . Musgrave , Fiscal Systems, New Haven 1969

26 A.T . Peacoc k and G . Shaw , Fiscal Policy and Employment Creation in Developing Countries, Paris 197 1 27 A.R . Prest, Public Finance in Underdeveloped Countries, London 1962 28 P . Robson, Fiscal Compensation as a Means of Contributing to an Equitable Distribution of the Costs and Benefits Associated with Economic Groupings of Less Developed Countries, Geneva 1970 29 A.K . Sen, Choice of capital intensit y further considered , Quarterly Journal of Economics, Aug. 1959 30 C.S . Shoup , Fiscal Harmonization in Common Markets, New York 1967 31 V.L . Urquidi, Free Trade an d Economic Integration in Latin America, Berkeley 1962 32 J . Viner , The Customs Union Issue, New York 1950

MELVIN WHIT E an d ANN E WHIT E

6

Tax neutrality of instantaneous versus economic depreciation*

A usefu l poin t o f departur e fo r thi s pape r i s provide d b y th e followin g quotations regarding the neutrality of tax-allowed depreciation:1 Fundamental theore m of tax-rate invariance: If and only if true loss of economic value i s permitte d a s a ta x deductibl e depreciatio n expens e wil l th e presen t discounted valu e o f a cash-receip t strea m b e independen t o f th e rat e o f ta x (Samuelson [4 , p.604]). The effec t o n investmen t incentive s o f a proportiona l ta x levie d onl y o n business income can be neutralized (a) if the amount expended on durable goods can be deducted from taxable income in the year when made and (b) th e government will pay for an y 'losses' of the firm at th e sam e rate as it taxes the firm' s income (Brow n [1]) . A ta x tha t permit s instantaneou s depreciatio n leave s th e interna l rat e o f discount unchanged . I t is a perfectly neutral solution, so neutral in fact a s to be a zero tax (Musgrave [3 , p.343]). The subject t o b e investigated here is the relationship between the ta x situations for which deductibility of economic depreciation produces neutrality, as implied by the Samuelson theorem, and those for which instan taneous write-of f (o r expensing ) i s neutral , a s conclude d b y Brow n an d * Thi s paper has benefited considerabl y from criticism o f earlier drafts by Professo r Gary Brown and Professo r Car l Shou p an d member s o f his public finance seminar at Columbi a University . Thank s are also due to Professor Bernar d Oku n of the City University o f New York an d M r Emil Sunley of the Treasury Departmen t for helpfu l comments. 1 Se e also [5 , pp.301-2], and [6] .

106 Moder n Fiscal Issues Musgrave. I n th e discussio n tha t follows , i t wil l be show n that th e neutrality or non-neutrality of alternative depreciation rules depends essentially on whether the tax is applied economy-wid e or to a limited sector, an d on whether interest expens e is or is not deductible . Further , i t is shown that the onl y trul y neutral , effectiv e incom e ta x i s a genera l on e permittin g deduction of economic depreciation. The other instances of neutrality are either the result of no tax in effect being imposed, or of a tax being imposed that is equivalent to a capital levy with the income generated by new asset purchases remaining free o f tax. The neutrality criterion employed is an unchanged rental cost of capital services. Thi s i s a n appropriat e criterio n sinc e renta l cost , a s recentl y formulated b y Jorgenson an d associates [2 ] is the relevant input price for determining the optimum capital stock. And it is a convenient criterion since the algebrai c expressio n o f th e influenc e o f income taxe s o n renta l cos t readily accommodates varyin g depreciation rules . The equation for renta l cost i s developed briefl y below . Later, whe n the openin g quotations ar e returned to specifically, the relationship of rental cost to present discounted value and internal rate of return, as alternative bases for neutrality criteria, is taken up. The alternativ e ta x situation s tha t ar e examine d hav e i n commo n a proportional rate and provision for complete loss offset - including treasury reimbursement if necessary. These alternatives are distinguished as follows: a general tax that permits deduction of economic depreciation and one that permits deductio n o f th e ful l pric e o f th e capita l asse t a t th e instan t o f purchase; a partial - one-industr y or one-sector - tax which provides the same depreciatio n alternative s an d als o th e alternative s o f allowin g an d disallowing the deduction of interest expense. The general framework assumed for the discussion is the familiar on e of a competitiv e economy with perfect capita l markets , in which a unifor m rate o f return prevails, in which investment decisions are made by profit maximizing firms, and in which forecasts of earnings streams are held with complete certainty. Since the concern here is only with detecting the presence and direction of tax-caused initial changes in investment incentives - rathe r than wit h evaluating thei r aggregativ e consequences which would requir e a complete model2 - such variables as the before-tax rate of interest, capita l goods prices, and productivity schedules are taken as given. 2 Knowledg e of such incentive effects woul d b e a necessary ingredient fo r a com plete model.

Tax neutralit y 10 7 The rental cost o f capital service s is the amount per time period tha t a firm should charge itself for the use of its own capital facilitie s in order to determine the optimu m amoun t an d kin d o f facilities to employ ; it i s an amount just sufficient t o cover economic depreciation3 and yield the going rate of return on invested funds. It would be an explicit payment for a firm that actually rented its capital equipmen t from a n external owner. When the gross earnings expected from a n asset each year are just equal to the rental cost, the present worth of the stream of earnings is just equal to the price of the asset - whic h would then be a marginal acquisition for the profit-maximizin g firm. To sho w this for discret e accounting periods, let: 5 = th e rate of economic depreciation4; ct = the rental cost of capital services fo r perio d t\ q 0 = th e origina l pric e o f th e asset , purchase d a t year-end; qt = qQ(l — 8)' = th e remaining value of the asset at the end of period t;r = the market rate of interest ;z = th e present value of the depreciation allowance on one dollar o f asset value; u — the tax rate. The equation for rental cost in the absence of tax is: (1

)

and th e present worth o f a stream o f earnings just equa l to renta l cos t is given by the expression: (2

)

which is, as stated, equa l to q 0.5 The converse is also true: namely, that all earnings streams that have a present worth equal to the original cost of the asset generating the m are actually rental cost streams in that each period's 3 Economi c depreciatio n fo r a single asset for one year is the present valu e of the expected earnings stream as of the beginning of the year minus the present value of the remaining earnings stream as of the beginning of the next year. This is the decline in the value of the asset that would take place in a rational market for capital goods. If a tax is present, it is the decline in the present value of the before-tax earnings stream . 4 Th e assumption of proportional depreciatio n o f assets simplifies th e analysis and is probably not unrealisti c as a generalization. It doe s imply that th e anticipated annual earnings also are proportional to the declining asset value. 5 Expressio n (2) becomes:

108 Mode m Fiscal Issues earnings must be equal to the interest on the remaining value of the asse t plus the decline in the present worth of the asset over the period.6 Consider first the introduction of an economy-wide proportional ta x on income from capita l at rat e u 9 which permits economic depreciation a s a deductible expense. The tax provisions can be explicitly incorporated int o the rental cost equation by considering the tax as applying at rate u to the earnings stream gross of depreciation, and the tax value of the depreciation deductions as a stream of negative tax payments or rebates.7 Whatever the pattern of these rebates, their present worth can be computed and considered as an offse t to , o r reductio n in, th e net acquisition cost o f the asset . Th e equation for the new rental cost, c/, becomes: c/(l - u ) = (1 - uz)q t^[r(\ - 11 ) + 5], (3

)

where z is the present worth of the depreciation deduction on one dollar of asset value computed at the interest rate r(l — w), and uz is its tax value to the firm.8 The rental cost thus is that amount of gross earnings which, after tax at rate u on those gross earnings, would leave an amount just sufficien t to cove r economic depreciation plu s the going after-tax rate o f return on the net amount invested (which is original cost net of the present worth of the tax rebates attributabl e t o th e depreciation allowance) . Th e after-tax rate o f return is the relevant rate irrespective of how the asset purchase is actually financed: if the firm borrows, its interest cost is deductible; if the firm equity finances, its opportunity cos t is the after-tax retur n open to i t elsewhere in the economy. If tax-deductible depreciation conforms to economi c depreciation, the n it must be equal to §q t_ x = S# 0(l — 8)' ~ *. The present value of a stream of such deductions for q Q equal to one dollar is given by: (4

)

With this expression for z, the equation for rental cost becomes: (5

6 Se e n.17 for proof . 7 Thi s approach was originated by Gary Brown [1] . 8 Thi s is a discrete formulation o f Jorgenson's equation [2 , p.393, equation (6)], omitting the investment credit term.

)

Tax neutrality 10 9 That is , th e renta l cos t i s the sam e as it wa s in th e absenc e o f tax. Th e general, proportional income tax allowing deduction of economic depreciation is thus neutral on the criterion of unchanged rental cost. Accelerated depreciation, as a general term, can be defined as the allowance of a stream of depreciation deductions the tax value of which has a present wort h exceedin g that provide d b y economi c depreciation . Th e limiting case is an instantaneou s write-off o f the acquisitio n pric e o f th e asset, which could be approximated by expensing.9 For a general tax permittin g instantaneous write-off, th e valu e of z is unity, and the rental cost formula becomes: (6

)

Thus in this case rental cost is reduced by an amount equal to the tax rate times the interest cos t o n the remainin g value of the asset. 10 I t provide s incentives for a general expansion of the capital stock, incentives which are larger the higher is the tax rate. Also the reduction in rental cost is proportionately greate r fo r slowl y depreciating (long-lived) assets sinc e interes t cost for them is a larger proportion of the total rental cost. Thus allowance of instantaneous write-off produces an un-neutral distribution of incentives to expan d a s among short an d long-live d assets, favorin g th e latte r an d favoring industries employing a relatively high ratio of long- to short-lived assets.11 (The treatment of depreciation on assets already in use at the time the tax is introduced is discussed later.) 9 Actually , a s Sunley has pointed ou t t o the authors, expensing i s the limiting case only for depreciation rule s restricted to allocatin g th e historical cos t total . Percentage depletion, for example, goes beyond this , amounting t o more than 100 per cent o f original cost. 10 Accelerated depreciation is often viewed a s a form o f interest-free loa n from th e treasury, for example [5 , p.302]. For instantaneou s write-of f the loan i s initially the tax rate times the cost of the asset, with subsequen t annua l repayment s repre sented b y the absence of allowance fo r economic depreciation . I n any one yea r the gain t o the firm is the interest o n the remaining valu e of the loan, o r ruqt,lt This i s precisely th e reduction in rental cost shown in equation (6). 11 Thi s conclusio n assume s tha t there i s a significant volume of non-depreciabl e assets i n the economy t o which the instantaneous write-of f provisio n doe s no t apply. Th e earnings rat e on these asset s woul d b e reduced b y the statutory ta x rate and thus the opportunity cos t woul d be reduced fo r funds t o be invested i n assets eligibl e fo r th e write-off. In discussion , Shou p ha s emphasized tha t if instantaneous write-of f were allowed fo r all assets o f any sort, then the stimulativ e effect woul d not occur . However, fro m the analysis develope d below , i t would appear that in such a case no tax would i n effect b e imposed anywhere .

110 Moder n Fisca l Issue s To produc e a stimulu s to expan d th e capita l stoc k i n a manne r tha t would be neutral as among assets depreciating a t varying rates, the appro priate polic y would be one that reduce d the rental cost of capital propor tionately for all types of assets covered. A tax resulting in such proportionate reductions would have no substitution effect amon g capital assets. That is , at a given size capital stock, there would be no cost advantage to substituting one type of capital service for another - which would be a form of neutrality. A uniform investment tax credit would provide such a neutral stimulus to investment, so long as the credit is deducted from th e original cost of the asset for depreciation computation (which was provided for in the Revenue Act of 1962 but repealed in 1964.) Such a credit would not, of course, offse t an un-neutral depreciation policy, but it would not aggravate non-neutrality. Suppose no w that the ta x i s partial i n coverage, applying only to on e industry or sector of the economy, and that this partial tax permits deduction of economic depreciation but not interest cost. Gross earnings must be large enoug h s o that afte r th e ta x ther e remain s an amoun t sufficien t t o cover economi c depreciatio n an d the be f ore-tax rat e of return, sinc e thi s last i s th e industry' s borrowin g cos t an d th e rat e o f retur n prevailin g elsewhere. The equation fo r rental cost, equation (3), must be rewritten to cover r instead of r(l — u): (7

)

With economi c depreciatio n allowe d an d th e discoun t rat e a t r , z = 8 / (r + 5) , as can be seen from equatio n (4). Then (8

)

The new rental cos t is higher than the original rental cost and the increase is greater th e highe r the ta x rate . Th e tax i s un-neutral in that i t set s up incentives fo r a reductio n i n th e siz e o f thi s sector' s capita l stoc k an d discriminates among assets of varying lives. If, o n th e othe r hand , instantaneou s write-of f i s allowe d instea d o f economic depreciation, th e partial tax with non-deductible interest becomes neutral. Th e value of z i n equatio n (7 ) is unity and c t' become s equal t o (r + S)q t-i, or identical t o rental cost in the absence of tax. But this neutrality is a consequence of the fact that the tax law actually imposes no tax on the income generated by new capital acquisitions. The tax value of the write-off at the time of purchase of the asset is uq0. The present value of the future tax payments for which the firm (being entitled to no further depreciation deduction) is liable, is given by:

Tax neutrality 1 1 1 (cf. equations (1) and (2)). Thus the tax value of the write-off exactl y offsets th e present worth of the future tax liability, and the net tax burden is zero. Instantaneous write-of f fo r ne w asset s mus t b e combine d wit h som e specified treatment o f depreciation o n assets already in place when the tax is introduced. I f no depreciatio n expens e is permitted fo r suc h assets, th e present value of the after-tax earnings to be generated ove r the remaining life is given by:

where qh refers to the value of an asset immediately prior to the imposition of the tax . Th e tax become s a capital levy on the firm' s alread y existin g capital stoc k at a rate equal to w. 12 If some depreciation is allowed on old assets, the capital levy will be less, but to the extent that allowed depreciation falls short of instantaneous deduction of the remaining value of these assets at the time the tax is imposed, some capital lev y will result. If th e firm' s capita l stoc k i s arbitraril y assume d t o remai n constant , irrespective of the depreciation deduction allowed, then the annual amount of the deductio n woul d be the sam e for instantaneou s an d fo r economi c depreciation.13 The amount o f capital purchase s necessary in each perio d to maintain the value of the capital stock (which is the deductible allowance under instantaneous write-off ) must be just equal to the actual depreciation on th e existin g stock (whic h is wha t woul d b e allowe d unde r economi c depreciation). Thi s equalit y o f th e deduction s resultin g fro m th e tw o depreciation rules , give n the particula r assumptio n o f a constan t capita l stock, is not inconsistent with the view that when instantaneous write-off is permitted, the tax is equivalent to a capital levy. For if the treasury did, by direct statute , impos e a capita l lev y equa l t o uq h an d th e proceed s wer e invested a t the market rate , r, the annual yield would be ruqh. This is precisely what the annual income tax would be on a firm that maintaine d a constant capital stoc k equal to qh.14 12 Shoul d th e loss in capital valu e be allowed as a deduction, the n th e net los s would become ( 1 — u)uqh. 13 Thi s would b e true immediately afte r the imposition o f the tax onl y if unde r instantaneous write-off no depreciation is allowed on existing capital stock; otherwise it will become tru e when all old assets are retired. 14 Accordin g t o a comment o n this paper b y Brown, alternativel y the tax might be

112 Moder n Fisca l Issue s However, a firm would not b e likely to maintai n th e identical capita l stock under both instantaneous write-off and economic depreciation, eve n though it would pay the same tax in either case. There would be a substantial differential i n the tax o n net earnings from expansion o f the capital stoc k (zero for instantaneous write-off; ta x at rate u for economic depreciation ) so that the optimum capital stock would not be expected to be the same in both cases . Finally, t o turn to a partial tax under which interest cost is deductible: the interest deductio n would have to be limited to interest o n funds equa l to the remaining value of capital assets purchased after the tax is imposed. Otherwise taxed firms would borrow indefinitely, invest the funds in industries not subject to tax, and claim the interest cost as a tax deduction. Firms can be assumed to borrow the full cost of capital assets, however, since the tax would make it advantageous to do so. (Such a tax is clearly not neutral with respect to methods of finance.) If economic depreciation i s permitted wit h this type of tax, renta l cos t is defined by equations (3), (4), and (5), with the r(l — u) term in equation (3) reflecting a n interes t cos t belo w tha t prevailin g outside th e industry rather tha n representin g the going rate o f return everywhere as it di d for the genera l tax. Agai n the renta l cos t i s unchanged from it s value in th e absence of tax. Bu t the apparent neutralit y here also reflect s th e fact tha t no tax is in fact levied. This can be seen readily since both economic depreciation and interest cost are fully deductible for the firm and the tax does not apply to the interest earnings of lenders, who are outside the taxed industry. Thus the entire rental income of capital generated in the industry is exempt from tax and the treasury gains no revenue. If instantaneous depreciation is allowed under a partial tax, with interest deductible, z = 1 in equatio n (3 ) and, a s in th e cas e o f the genera l tax , ct' = [r(l — u) + 8]^_i = c t — urqt-t.Thus rental cost for the industry would be reduced and incentives given for expansion of its capital stock . In this case, the treasury would actually be subsidizing the acquisition of viewed a s remaining a continuous capital levy which affect s th e value of assets acquired after th e tax law is introduced, once they have become part of the firm' s stock. Such assets , having bee n instantaneously written off , lose value immediatel y after purchase , since no further depreciatio n deduction can be taken on them. This is a loss of capital value that would no t take place in the absence of tax. Bu t it would appea r that, from the firm's viewpoint, the loss is canceled by the tax value o f the instantaneous write-off. In capital levy terms, then, the net loss to a firm imposed by the tax is still the loss in value onl y o f assets already in place prior to the introduction of the tax .

Tax neutralit y 11 3 new assets for a particular industry, and the tax in effect would be negative. The annual tax to be paid out of earnings before any tax-induced expansion takes place (i.e., the annual tax on an asset earning the original rental cos t (r + 5)) , can be formulated most simply as the tax rate times the depreciation component of the earnings stream. This is because the full interest earnings are deductible , bu t n o furthe r depreciatio n i s allowabl e afte r th e initia l write-off. The present value of this stream of tax liabilities is:

This is less than uq Q9 the value of the initial write-off. 15 Thus , for a partial tax which permits the deduction of interest cost, it is economic depreciation which is neutral, an d eliminates th e tax, while instantaneous depreciatio n actually provides a subsidy. The discussion ca n now be related briefl y t o the views expressed in the opening quotations . Samuelson' s theore m refer s t o th e firs t typ e o f ta x discussed, the general tax with deducibility of economic depreciation. The theorem is perfectly general, and implies that an earnings stream which, in the absence of tax, has a present value equal to a given original cost of an asset, wil l continu e t o hav e th e identica l presen t valu e onc e th e ta x i s imposed.16 As already noted, suc h earnings streams are necessarily renta l cost streams. 17 Therefore Samuelson's theore m implies the neutrality o f a 15 Ther e is some question as to whether these future ta x payments should be discounted by the cost of funds within the taxed industry, as is done above, or by the going rate elsewhere -i.e. , by r. The tax would be negative in either case. 16 Actually the theorem does not even require that all investors are subject to th e same tax rate, as is assumed here; only that each investor is subject to a rate that is uniform over all his income and ove r time. 17 That is, with no tax in effect, an y stream that discounts to a specified present value, will be one that in every year will just equal the decline in present value from beginning to end of the year (economic depreciation) plus interest on the beginning year value at the rate used for discounting. This can be demonstrated using Samuelson's notation and his translation of the general valuation formula to apply to discrete periods. (See [4, p.605].) Simplifying by assuming a constant interest rate, i, with V t the present value at th e beginning of period t and Nj the earnings for period j:

or which is depreciation plus interest.

114 Moder n Fiscal Issue s general tax allowing economic depreciation on the criterion of an unchanged rental cost. Cary Brown's analysis is also conducted in terms of the effect o f the ta x law on present value s of future earning s streams . Firms are envisioned a s ranking potential purchase s of durable goods on the basis of the excess of the presen t valu e o f futur e ne t receipt s ove r acquisitio n cost . The y ar e presumed to schedule all purchases for which the excess is positive - stoppin g at the point at which the net receipts stream has a present valu e just equa l to acquisition cost. (That is, in the terms used here, the annual earnings are just sufficien t t o cove r rental cost. ) The effec t o f tax-allowed depreciatio n is shown as a reduction i n the net acquisition cost of the asset to the firm, with a disincentive produced wheneve r this reduction is less than propor tional to the tax rate. For hi s analysis, Brow n specificall y assume s that ther e ar e alternativ e sources of income for investors free of the tax on business income, and that interest cannot be taken by firms as a deductible expense. Hence the interest rate that firms must use for discounting futur e tax receipts an d tax rebates is unaffecte d b y the tax . I n othe r words , hi s is the cas e o f a partia l tax , interest non-deductible . Th e neutralization attribute d t o expensin g in the opening quotation , therefore , reflect s a zer o effectiv e ta x o n ne w investment, an d whateve r tax i s collected i s the equivalen t of a capital lev y o n assets acquired prior to the introduction o f the tax. Were interest assumed to b e deductible , a s Brow n points ou t [1 , p.314] , expensin g woul d n o longer be neutralizing but stimulative . Musgrave's criterio n o f neutrality i s a proportional chang e in interna l rates of return on all depreciable assets . The only truly neutral depreciatio n rule h e formulate s i s instantaneou s depreciation , an d thi s rul e implie s removal o f the tax from ne w investment. Actually, withi n th e framewor k assume d here , Musgrave' s criterio n would identify a s neutral th e sam e tax situation s a s does the criterio n o f unchanged renta l cost . I n a perfec t capita l marke t th e interna l rat e o f return everywher e is the marke t rat e o f interest. A genera l ta x allowin g deduction o f economic depreciation (whic h leaves rental cost unchanged ) becomes a tax on interest earnings generated by the asset. All interest earnings ar e reduce d proportionally , thereb y conformin g t o th e Musgrav e criterion. A partial tax with interest and economic depreciation deductibl e becomes a zero tax and of course meets the criterion in that the internal rate of retur n i s completely unaffected . An d finally , unde r a partia l ta x with interest no t deductible , instantaneou s write-of f produce s neutrality on the

Tax neutralit y 11 5 rental cost criterion, and since a zero tax on new investment is implied, also fulfills Musgrave' s criterion. Musgrave, however , derives his conclusio n o f neutralit y an d zero-ta x burden for instantaneous write-off withou t reference t o th e tax treatmen t of interest cost - tha t topic being taken up in a later section - an d without explicit statemen t as to whether the tax is a partial or a general one. From his illustration, i t woul d appear tha t h e considers his criterion t o b e fulfilled by instantaneou s write-of f i n situation s that woul d not confor m t o neutrality a s conceived here. He derives the zero tax burde n by assuming immediate investmen t o f th e rebate s provide d b y th e write-of f - thes e rebates constitutin g a diminishing series that accumulates under a 5 0 per cent tax to a sum equal to the initial investment. The rebates are invested at the pre-tax internal rate of return, thereby earning an amount sufficient t o cover th e ful l ta x fo r whic h the investo r is liable. Bu t this implie s a tax induced expansion of the capital stoc k - a doubling of the original investment if the tax rate is 50 per cent - and also requires the assumption that the earnings rate remains unaffected b y such expansion. It may be noted that, in principle, Musgrave's criterion could be fulfilled by a depreciatio n rul e othe r tha n instantaneou s write-off , stil l withou t referring to a market rate of interest and without implying an expansion of the capital stock. A present value of an asse t for each year of its life can be calculated b y discountin g th e remainin g earnings strea m b y th e origina l internal rate of return. If the tax-allowed depreciation equals the decline in present valu e so calculated, then it would correspond t o th e allowance of economic depreciation in the analysis given above of a general tax, but with the internal rate of return taking the place of the market rate. All internal rates of retur n would be reduced proportionately, while tax revenue would be effectively generated . CONCLUSION

The two forms that a neutral tax can take are a lump sum levy and a tax at a uniform rate on all alternative income sources open to the taxed investor. Neither produce s a n incentiv e for th e investor t o alte r hi s decisions with respect t o ne w acquisition of capital assets . A purported incom e tax that permits instantaneous write-off can only provide neutrality of the first form: i.e., i t can be in effec t a capital levy o n assets in place, but a zero tax o n income generated b y all subsequently purchased assets. Moreover , this is the case only when the tax is partial and interest is non-deductible. For a n effective incom e tax to be neutral, the tax must be general, and

116 Moder n Fisca l Issue s economic depreciatio n an d interes t expens e must b e deductible . Instan taneous write-off, o r expensing, under a general tax, would be stimulative to investment , favoring long-lived ove r short-live d assets . (An d al l assets classified as non-depreciable would be discriminated against. ) Finally, a n observatio n ma y be in orde r wit h regar d t o depreciatio n policy for the present complex system of taxation o f income from capital , which includes the corporate an d individual taxes. Whether the system is considered to be more realistically represente d by the case of a partial ta x or a general tax, the import of the analysis undertaken here is that so long as interest remains deductible, expensing cannot be neutral, and allowance of economic depreciation is necessary for neutrality . REFERENCES

1 E . Gary Brown, Business-incom e taxation an d investment incentives , reprinted i n R.A. Musgrav e and C.S. Shoup , eds. , Readings i n the Economics of Taxation, Homewood , 111. 1959 2 R.E . Hal l an d D.W. Jorgenson , Ta x policy and investment behavior , American Economic Review, June 1967 3 Richar d A. Musgrave , Theory o f

Public Finance, New York 195 9 4 Pau l A. Samuelson, Tax deducti bility of economic depreciatio n t o insure invarian t valuations , Journal of Political Economy, Dec. 196 4 5 Car l S. Shoup, Public Finance, Chicago 196 9 6 Verno n Smith, Ta x depreciatio n policy and investment theory , International Economic Review, Jan. 1963

WILLIAM VICKRE Y

7 Cumulative averaging after thirt y years

It is perhaps peculiarly fitting that an article on cumulative averaging should be included in this volume , since it wa s largely as a result o f discussions between Carl Shoup and myself, back in the summer of 1938, over possible methods of taxing capital gains, that the concept o f cumulative averaging developed. As we devised and rejected one scheme after another , eithe r on grounds of what then seeme d to b e intolerable administrativ e complexity or on grounds that under some circumstances capricious results would occur that would have unacceptable incentive effects, the idea emerged that ideally, at least, the method of taxation should be such that the tax should be completely neutral with respect to the time at which a gain is realized, i.e., that the tax-paye r shoul d hav e n o incentiv e in th e lon g run fo r preferrin g to realize at one time rather than another on account of the tax. From thi s it was a short step to requiring neutrality with respect to the time of realization or reporting of all forms of income. It then remained only to work out the implications of this requirement for the formulation of the tax, and to devise procedures fo r the assessment o f th e tax tha t woul d b e administrativel y feasible. The scheme that was developed as a result of these stipulations1 involved considering al l payments o f income tax, with respect t o incom e reporte d since some base starting date , a s interest-bearing deposit s in a tax-payer' s account with the treasury. The accumulated balance in this account would 1 Th e basic concept of cumulative averagin g was first published i n [4] . The scheme was developed further an d describe d more fully i n [3 , pp. 172-95, 285-7, an d 417-27].

118 Moder n Fiscal Issue s then be available as a credit against whatever tax is found to be due for the entire period to date, on the basis of the total income thus far reported for the period, according to a tax schedule appropriate t o the period covered. The tax payment currently due would then be the excess, if any, of the cumulative tax s o computed ove r the amount in the tax-payer's account . Eventually, when the averaging period is closed, as by the death of the tax-payer or in accordance wit h some other appropriat e criterion, al l unrealized gains or losses and accruals of income not previously reported are brought to account through a valuatio n o f the asset s o f the tax-paye r a t tha t tim e (suc h a s would in any case be required for estate tax purposes), and the corresponding final tax payment o r refund made. It is readily seen that if this procedure is followed the present value of the tax payments , compute d a s o f an y give n date usin g the rate s o f interes t credited o n the tax-payer's accoun t as the discounting factor, wil l remain unaffected b y an y shift s i n th e reportin g o f income within the averagin g period. All that is required for the neutrality of the tax, with respect to the timing of realization, t o be assured, is that th e shiftin g o f the reporting of income betwee n the give n averaging period a s a whole , an d previou s o r subsequent periods, shoul d be effectively blocked . It is immediately apparent that if the method of assessment is such as to make it a matter of relative indifference to the tax-payer and to the treasury whether a gros s incom e ite m o r a deductio n i s reporte d i n on e yea r o r another, man y of the intricate rule s governing the timing of the reportin g of such items become essentially redundant and can be dropped, with great consequent simplification of the tax law. We will return to thi s presently. There remains, of course, the matter of preventing double counting of items or complete omissions, as well as the preventing of the shiftin g o f income from on e tax-paye r t o another , bu t tha t i s anothe r matte r outsid e th e province of averaging. Although man y of thos e wh o have discusse d averaging schemes have dismissed cumulativ e averagin g ou t o f han d a s bein g to o complicate d [2, vol.3, pp.257], it actually turns out that the procedures required for the calculation of the tax under this scheme are not at all complicated, and that the administration is quite simple. For an y given year, indeed, the calculations required in computing an individual's tax under cumulative averaging turn ou t t o b e substantiall y simple r tha n thos e fo r an y othe r for m o f averaging in common use. The procedure is as follows: the current cumulated income is obtained by adding to the corresponding cumulated income, as reporte d i n th e previou s year' s return , th e ne t incom e (afte r persona l

Cumulative averagin g 11 9 exemptions) fo r th e current year , inclusiv e of the interest credite d o n th e tax deposi t accoun t (whic h is, in effect , t o b e treated n o differentl y fro m interest earned on any other type of deposit). On this new cumulated income the tax-payer computes, by means of an appropriate ta x table, the total tax due for th e entire averagin g period t o date . This computatio n o f the tax from th e table is in every way similar to the computation now required for the tax for a single year, the only difference bein g that the tax-payer must use a table appropriate t o the number of years in his averaging period: if this is the sevent h year of his averaging period, th e correspondin g seven year table wil l contain incom e and ta x figures roughly seven times what they would be for a one-year table, the percentage tax rates being roughly the same. From this total tax due can then be deducted the amount, including accrued interest, in the tax-payer's tax deposit account, and the balance will be the tax currently due. The only additional operation s tha t are required, over and above those required for a simple annual return, consis t of the carrying forward fro m the previous return of the three items of cumulative income, cumulative tax balance, an d th e year with which averaging began: a multiplication b y a rate of interest, thre e additions, an d on e subtraction. B y way of contrast , the fairly straightforward averaging scheme included in the 196 9 Canadian proposals fo r tax reform [ 1 ] would require carrying forward four incom e items, possibly from fou r separate returns, four addition s (one of them of five items), two subtractions, two tax table computations (rather than one), three one-digit divisions, and one multiplication by five. The computations required fo r th e curren t Unite d State s averagin g provisions can b e eve n more complex . Whil e in th e simples t possible cas e the computation s ar e comparable t o thos e o f the Canadia n proposal , th e supplementar y form provided fo r applyin g the averaging provisions contains space for n o less than fifty-two entries. O f course, it is contemplated tha t the us averaging provisions wil l be resorted t o onl y in a relativel y small number of case s involving relatively sever e fluctuations of income, but thi s in turn mean s that onl y the mor e extrem e inequities due to fluctuatin g income s will b e rectified, and then only partially . If abatement o f inequities due to fluctuatin g income s were the only issue, one might perhaps b e willing to accept a n averaging method which, while complex, woul d be applied relativel y infrequently, rathe r tha n on e which, while simpler, woul d by its nature have to be applied i n a routine fashion eac h yea r b y whole classes o f tax-payers, eve n if at firs t onl y th e tax-payers wit h income s i n th e uppe r bracket s woul d b e involved . Bu t

120 Modern Fisca l Issues while the objective of most averaging devices is limited to reducing excess burdens o n fluctuatin g incomes , i t ha s becom e increasingl y clear , sinc e cumulative averaging was first devised, that in addition to dealing with the fluctuating incom e problem , cumulativ e averagin g ha s a n eve n mor e important function to perform in serving as a key element in a far-reaching simplification o f the entire structure o f the personal income tax. Indeed, the original motivation for the development of the idea arose, as noted above , fro m a desir e to eliminat e th e complexities involved in th e separate treatmen t o f capital gain s and t o d o awa y with the consequen t need fo r elaborat e an d ofte n arbitrar y criteri a fo r th e sysiphea n tas k o f distinguishing suc h gain s fro m ordinar y income . Bu t th e simplificatio n possibilities exten d beyond capital gain s to all forms o f time-allocation o f income, includin g suc h matter s a s depreciatio n rates , expensin g versu s capitalization o f outlays, accruals of premium and discount, bad debt and contingent liabilit y reserves , an d distribute d versu s undistribute d profits . Cumulative averaging would enable drastic simplification s to b e made in the ta x la w covering al l o f these areas , amountin g i n man y cases t o th e complete deletio n o f entire sections . A recent check indicated tha t if ful l advantage were taken of the various opportunities for simplification, adoption of cumulative averaging would enable the currently applicable text of the internal revenue code to be cut in half, and the regulations probably by an even greater proportion [5] . Another indication is that of the 16 1 pages of the 197 0 edition o f Your Federal Income Tax, the tax-payers' guide put out by the Internal Revenue Service to aid the general tax-payer, seventy-fiv e pages of the material consisted of matter that could be greatly abbreviated, and in most cases eliminated entirely, if cumulative averaging were in effect. If cumulative averaging has so much to offer for so little, one may well ask why, in the thirty years that have elapsed since the proposal wa s first put forward, i t ha s bee n firs t ignore d an d the n passe d ove r in favo r o f less thorough an d more complicated averagin g methods ? It seem s possible t o point to a number of factors that have contributed to this result, the understanding of which may place the future of cumulative averaging in a different light. Perhaps th e mos t importan t facto r ha s bee n the fac t tha t cumulativ e averaging has had the reputation o f being excessively complicated. In th e original presentation, indeed , the principle was presented that the present value of the tax paid on the cumulative basis should be so calculated a s to be the same as that pai d o n the annual basis by a tax-payer with an equivalent constan t incom e ove r th e period . T o thos e no t perseverin g t o a

Cumulative averaging 12 1 discussion of the practical application methods , this formulation seemed to promise formidabl e complexity . O n late r examination , however , thi s standard turned out to be not a necessary nor even a particularly desirabl e one. Bu t thoug h al l that thi s standar d implie d wa s a particula r rul e by which th e variou s tax table s fo r th e variou s averagin g period s migh t b e constructed fro m th e tables in effect o n an annual basis for the individual component years , the definition o f the tax in these terms cast an aura o f complexity ove r th e entir e procedure . Eve n thoug h th e tax-paye r nee d know nothing about the method of constructing the tables in order to use them (any more than he has to understand the legislative history behind the present tables), it would presumably be necessary to explain the method of constructing the tables to maintain a consistent pattern among them to the congressmen called upon to enact the legislation. I n addition it may have been felt tha t tax-payers would be disturbed a t bein g asked to us e tables derived in a way they did not fully understand, even if the mode of use were quite simple. Moreover, i n the initial presentation i t was felt necessar y to demonstrate tha t th e cumulative averaging method would never result in a curren t ta x payment that would be unduly large relativ e to the income reported for the immediately preceding yea r (a failing that had led to the abandonment of some previous averaging schemes), and the mathematics that were used for this demonstration were moderately involved. All of this apparently create d a n impressio n o f complexit y tha t ha s no t ye t bee n dissipated. Subsequent analysis has made it clear that there is no real advantage in using a constant income as a standard, but that on the contrary there is good reason fo r departin g somewha t fro m it . Th e ta x table s fo r th e variou s averaging period s ca n i n fac t b e determine d quit e independently of on e another without breaching the neutrality of the tax with respect to shifts of income within any given averaging period. The consideration governin g the desired relatio n betwee n the ta x table s is chiefl y on e o f achieving equity between tax-payers with differing averaging periods. If a constant income is used as a standard, then in general tax-payers whose averaging periods are cut short for one reason or another, whether by death, change of residence, citizenship, marita l status , o r otherwise, wil l bear higher burdens, if their average incomes vary from on e averaging period t o another , tha n thos e averaging ove r th e combine d period s o r ove r longer periods. Whil e thi s differential i s a fa r les s seriou s matte r tha n thos e arisin g fro m incom e fluctuation in the absence of averaging, it is a differential which it would be desirable to minimize. Such differentials can indeed be significantly reduced

122 Moder n Fisca l Issues without any added administrative or compliance burden simply by computing the tax tables for the various periods on the basis of generating a total present value of tax that would be the same as that which would be paid on an annual basis on an equivalent income that had some standard pattern of fluctuation impressed on it. For example, a tax on the income of a tax-payer covering the years from age twenty to age sixty could be computed so as to be comparable to the tax that would have resulted on an annual basis if his cumulated income had been generated by an annual income that started a t a relatively low level and had increased steadily at, say, 5 per cent per year. Or more elaborate patterns o f fluctuations could b e used as a basis. Th e result of this procedure would be that the tax-payer with an average degree of fluctuation in his income over the years would find that he would bear the same ultimate tax, whether he was able to continu e his averaging period uninterruptedly over a long period, or whether the total period were split up into tw o o r mor e separat e averagin g periods. Tax-payer s with unusually fluctuating incomes , especiall y i n term s o f long perio d variation , woul d generally find a slight advantage in having longer averaging periods, while persons wit h unusuall y stabl e income s migh t fin d a sligh t advantag e i n having their income experience broken up into a number of shorter averaging periods fo r ta x purposes . Bu t sinc e such differences woul d usually be relatively smal l and their direction ofte n har d to predict, an d since in any case the closing of an averaging period would normally be tied to an important even t suc h a s marriage , death , divorce , o r chang e o f residenc e o r citizenship that is not likely to be avoided, postponed, or advanced for the sake o f mino r an d problematica l ta x advantages , an y remainin g non neutrality o f the tax at this point is unlikely to have serious consequences. Such a modified standar d fo r the setting up of tax tables does , indeed , reduce greatly the seriousness of the problem of dealing with changes in the status of the tax-payer, which was a problem often thought of as presenting formidable difficultie s wit h cumulative averaging . Fo r a country suc h a s Canada, th e proble m migh t b e considere d mos t seriou s wit h respec t t o international migration of tax-payers, though in the United States it would be primarily change of marital statu s that would be of concern. Concep tually th e simples t metho d o f dealing with change o f status i s simply t o break th e averaging period a t each such change, requiring a valuation of assets to be made at such times, with a bringing to account of all unrealized accruals revealed by such a valuation, so as to block the artificial shifting of reported incom e from on e averaging period t o another. Us e of an appro priate standar d patter n o f income fluctuation in setting up the tables wil l then reduce the impact o f the change o f status on the over-all tax burde n

Cumulative averaging 12 3 to a minimum. A slightly more elaborate method, which would reduce the impact o f marital chang e stil l further, woul d be to spli t th e incom e of a married couple in two and require the inclusion of each half of the income in a separat e cumulativ e average income for eac h spouse , continuin g the averaging period for each spouse right on through changes in marital status, and computing a separate tax for each spouse based on his own history prior to marriage. There would still have to be an inventory of assets at the time of change of marital statu s in order to block transfers of income from on e spouse to th e other wit h respect t o income for periods during which they were not married, but the degree to which the over-all tax burden would be dependent o n suc h a valuatio n woul d be considerably reduced, i n many cases being uncertain in direction at the time the valuation is made, so that there would be less difficulty than otherwise with the valuation process. The problem o f change of marital status of course occurs with other averaging schemes as well: in the curren t u s schem e a very elaborate se t of rules is required to deal with it. In any case, the problem o f dealing with change of status does not seem to be an insuperable one. Aside from practical considerations , cumulativ e averaging is sometimes objected to on grounds that as a matter of general philosophy a lifetime of income is too much to consider as a unit for tax assessment.2 The objection seems to b e to long-ter m averagin g in general rathe r tha n t o cumulative averaging specifically , though th e objectio n ha s particular applicatio n t o cumulative averaging in that cumulative averaging loses much of its appeal if the averagin g periods ar e mad e too shor t an d relativel y frequent asse t valuations ar e required . The objectio n i s often articulated rathe r loosely , so that it is difficult t o discern the precise nature of the objection, but ther e appear to be three somewhat distinct aspects to this category of opposition. One aspect appears to consist of a feeling that in embarking on cumulative averaging on e i s undertakin g a ver y long-ter m commitmen t t o a rathe r specific pattern, and since, in the nature of the case, there can be no absolute guarantee tha t th e futur e step s require d t o carr y ou t th e progra m wil l actually be implemented as promised, som e of the beneficia l effect s o f th e promised neutralit y o f the ta x ma y not i n fac t b e forthcoming. I t i s no t merely a matter o f an administration being confident that the program will actually be carried out by its successors, but also one of persuading the taxpayer tha t this wil l occur a s planned. I f the tax-payer has doubts o n this 2 '...w e could se e no justification fo r using a lifetime, or the lengthy periods described above, as the interval ove r which incom e should b e averaged' [2 , vol.3, p.257].

124 Moder n Fisca l Issue s score he may well take a 'bird in the hand is worth two in the bush' attitude, and continue t o act to minimize his current tax liabilities, discountin g hi s increased futur e ta x liabilitie s no t onl y for futurity , but , i n addition , t o reflect a n unquenchable hope that in the event he may be able to wriggle out of these liabilities in some fashion or other. If controls on depreciation and other means of deferring the realization o f income are relaxed, such a tax-payer might be able to do more in this direction than previously. It may be possible to counte r thi s tendency to som e extent by offering relativel y high rates o f interest t o be applied in accumulating the tax-payer's cumu lative ta x account, but a t best i t is likely to be some time before the tax payer come s to fee l th e sam e degree o f securit y in thi s non-transferabl e balance as he does in a transferable government bond, and offering a higher rate o f interest ma y actuall y inhibi t th e developmen t o f suc h a sens e of security. A second, slightly related consideration is that in some sense the cumulation o f income an d ta x ove r long periods conflict s wit h the notio n o f a statute o f limitations . Bu t th e statut e o f limitation s ha s alway s been a somewhat difficul t concep t to appl y in the field of income taxation wher e what is income now cannot i n practice b e entirely freed fro m dependenc e on accounting entries made many years previously. A third , an d possibl y mor e deepl y felt , elemen t i n thi s philosophica l opposition i s the notion tha t in some sense, after th e lapse o f a sufficien t number of years, an individual's personality changes to such an extent that his current tax liability should not be made to depend on what his income was a long time ago. A man in his fifties is considered in some sense a differen t person fro m th e sam e ma n in hi s twenties, an d th e fac t tha t th e earlie r personality had a low income is considered to be no reason for reducing the tax on the later personality, and an earlier high income no reason for either a higher tax in later years of low income, as with moving average methods, nor a higher earlier tax a reason for a lower tax payment in the later years of lo w incomes, as with cumulativ e or los s carry-back methods . Suc h a n attitude ma y be related t o the fact that in a number of cases variations in income ove r tim e wil l entai l variation s i n expenditur e ove r time , eithe r because the individual does not foresee the changes in income with sufficient certainty to make the adjustment, or because he is simply unable to borrow against his future prospects. In such a case there is a real difference between the impact of a given tax on an individual with an uneven income and that of a n equivalen t ta x o n a n individua l wit h a n equivalen t stead y incom e (in terms of present value). It is not clear, however, whether consideratio n

Cumulative averaging 12 5 of the dependence o f the pattern of expenditure o n the pattern of income would argu e fo r les s o r mor e concessio n t o th e varyin g income tha n i s afforded b y long-term averaging, cumulative or other . There are actually two almost diametrically opposed positions which can be taken with respect to such situations. One is that the tax should be levied in such a way as to produce minimum aggregate sacrific e in terms of some utility concept . Unde r thi s theory , i f A has a n incom e o f $10,00 0 for a n early twenty-yea r period , compensate d b y a $50,00 0 incom e i n a late r twenty-year period, wherea s B has a steady $30,00 0 incom e for the entir e forty years , an d i f th e pattern s o f consumptio n ar e constraine d b y a n inability or an unwillingness on A'S part to borrow against uncertain futur e prospects, it can well be held that a progressive tax assessed without averaging, by impinging more heavily on the spending out of the $50,000 income, would impos e a smalle r tota l sacrific e tha n a n average d ta x tha t woul d attempt t o adjust A'S tax payments in the later period s o as to equalize the tax between A and B over the entire forty years. Much as one might want to compensate A for hi s earl y relative impoverishmen t an d lo w standar d o f living b y tax adjustmen t in th e late r period , thi s ca n b e done onl y by a transfer o f income to th e current A , to who m each dolla r transferre d will have a very low marginal utility, at an inordinately high cost in utility to other tax-payer s suc h as B. Even in the mos t extreme case, however, such an argument would hardly justify a total absence of long-term averaging , which would imply that A would have to pay a tax during the later perio d equivalent to that paid by c who has had a $50,000 income all along. Both because c is likely to have a larger stock of accumulated consumer durables, and because A, in the process of adapting his lifestyle to his improved status, is likely to have had to make additional purchases and take a loss from the obsolescence o f earlier purchase s relativ e to curren t need s and standards , there is reason t o judge that the marginal utilit y of income to A is higher than th e marginal utilit y of income to c , s o that for minimum aggregat e sacrifice th e marginal rate on A should b e lower than that on c, eve n if it were admitted tha t A'S rate should be higher than B'S. The contrary view is, of course, that A has suffered sufficientl y relative t o B if, whether from inabilit y to forecas t o r inability to borrow , A has bee n unable to allocat e hi s resources to consumptio n ove r time in the manne r that woul d have turned ou t t o b e most satisfactor y for him, and tha t t o impose a higher tax burden on A in addition to this inherent handicap is to compound th e disadvantage . Thu s it ca n be argued that , even though i n such cases long-term averaging does not produce the ideally desired result ,

126 Moder n Fisca l Issue s it would still remain true that long-term averagin g would be a step in the direction o f suc h a goa l relativ e t o annua l assessment , o r t o averagin g limited t o shorte r periods . I f on e makes the norma l assumptio n tha t th e social welfar e function has a smooth dome-like shape near the maximum, rather tha n a shar p pea k (an d give n th e uncertaintie s surroundin g the function i t woul d be difficul t t o clai m otherwise , a t leas t i n term s o f a n ex ante consensu s concept) , the n thi s consideratio n provide s a n adde d argument i n favo r o f long-ter m averagin g rathe r tha n agains t it , sinc e abating a n inequit y i n a regio n somewha t remove d fro m th e optimu m would the n b e mor e importan t tha n a correspondin g abatemen t i n it s immediate neighborhood, wher e the welfare function is not so steep. To highligh t th e poin t wit h a n admittedl y extrem e case , suppos e a childless ol d prospecto r P with a lif e expectanc y of onl y five years, afte r grubbing aroun d fo r fift y year s ekin g ou t a bar e subsistence , suddenl y strikes a bonanza worth $1,000,000. Even total tax exemption would hardly enable him to make up for the grubby years sufficiently t o leave him well enough off to make most of us willing to choose his lifetime lot rather tha n that of a salaried man s who had enjoyed a steady income throughout the fifty years o f $20,000 , subjec t t o a $500 0 tax . A concep t o f equit y tha t attempts t o equaliz e the lot s o f P and s would thu s call fo r goin g much further tha n lifetim e averaging. On the other hand , eve n taxing him on a five-year averagin g basis, so as to produce a tax at the same rate as would be paid b y an individua l who ha s ha d $200,00 0 a year mos t o f his life , sa y 55 per cent, leaving him with the capability o f spending say $100,000 a year over the remainder of his life, would appeal to some as being over-generous, given the windfall nature of his income and his presumed lack of experience in the fine art of large scale spending, and to others as being too rigorous , given th e prospector's nee d to mak e up fo r los t tim e and th e additiona l costs involved in establishing himself in his new prosperity. But to go all the way to lifetime averaging and reduce the tax to only 25 per cent, leaving the prospector wit h an extra $50,000 a year that he will hardly know what to do with, at the cost o f getting the corresponding su m elsewhere, will seem to many to be too high a price to pay in an attempt to approach an unattainable equity goal that may itself appear questionable . While suc h a n extrem e cas e ma y serv e t o dramatiz e a n issue , i t i s obviously no t typical , an d i t woul d b e wron g t o determin e polic y b y focussing attentio n o n such cases. To the extent that th e individuals concerned i n fac t d o adjus t thei r consumptio n pattern s i n relatio n t o thei r over-all resources, rather than keeping the time pattern of their consumption

Cumulative averagin g 12 7 approximately i n lin e with that o f their income , neithe r o f the mutuall y offsetting argument s presented abov e holds. Suc h adjustment of expenditure i s particularly likel y t o happe n i n cases where a high income in th e earlier year s o f a tax-paye r i s o f suc h a natur e a s t o cas t doubt s o n it s extended duration , a s wit h athleti c o r entertainmen t stars , o r wher e the income is in the nature of a windfall. Yet it is precisely in cases such as these that existin g averagin g method s fal l down . A professiona l athlete , fo r example, who starts at age twenty with an income of $3600 which increases steadily to reach $100,00 0 per year at age forty, after which he retires from active participatio n i n athletic s o n a n incom e of $25,000 , wil l obtain n o benefit whatever from th e current us averaging provisions if, as could well happen, current income never exceeds four-thirds of the previous four-year average b y more tha n the require d $3000 . H e would, i n any case, deriv e relatively littl e benefi t fro m an y averagin g schem e limite d t o a five-year period, a s seems to be the general lengt h of averaging periods bein g considered currently . I n such cases it is difficult t o find any cogent reaso n fo r saying that long-term averagin g is inappropriate. Setting forth a clear-cut case of a high-income period followe d by a lowincome period, in which there is no saving for the rainy day , i s somewhat more difficult than for the reverse sequence. But while such cases can perhaps be discounted as being too infrequent to be a dominant concern in the consideration of averaging, for the sake of analytical symmetry we may consider the case, for example, of D, who expected to continue until his retirement in a $50,000 executive job, but in mid-career finds the company dissolving and his specialize d skill s unmarketabl e elsewhere , s o tha t h e i s dow n t o a n income of $10,000 with accumulated savings far below what he would have set aside had the event been foreseen. On the basis of a clean break with the past and no 'carryove r of personality' one might accept th e idea that the current ta x o n D should b e th e sam e as that o n E with a stead y $10,00 0 income, as occurs with no averaging, or with averaging schemes, such as the current us scheme, that apply only where current income is above the average rather than below. It would require a hypothesis that whatever carryover from the past there is causes on balance a reduction in the marginal utility of income at a specified curren t incom e level to justify, o n the basis of the minimum sacrifice criterion , a higher current ta x o n D than on E. This is, indeed, what would result from a moving average type of averaging that has a sufficiently long period to span the two income periods, and what happens, to a lesser extent, wit h the Australian typ e o f averaging which applies to the current incom e a rate of tax determined b y reference to an average of

128 Mode m Fiscal Issues current and past incomes. Moving average schemes seem, however, to have been largely abandoned, in part because they produced this effect, possibly to an excessive degree, and this may also have been a factor in the demise of the Australian type of averaging. Cumulative averaging , however , produce s th e opposit e result i n suc h cases, i n lin e with what happens wit h loss-carrybacks for mor e extreme cases and briefe r periods. Th e effective margina l rate on the last dolla r of D'S $10,000 income is roughly equal to that on B'S $30,000 income, but th e total ta x payable on the $10,00 0 income is lower than that payable on E'S similar current income, by reason o f the credit resulting from reassigning , in effect , income , originall y falling i n th e uppe r bracket s an d originall y paying taxe s a t th e highe r rate s applicabl e t o thes e brackets , t o lowe r brackets taxable at lower rates. Looked at from a strictly current cash flow standpoint, this would, indeed, again run counter to a principle of maximizing total utility or minimizing sacrifice in the short run . However , in thi s particular contex t cumulative averaging operates in a manner that can be considered t o b e closely parallel t o th e wa y in which social security and unemployment insuranc e program s operate . In bot h o f these programs , benefit payments in periods of unemployment or retirement are increasing functions of income earned in previous periods. The effect is quite analogous to makin g tax payment s vary inversely with previou s income, an d i t i s difficult t o see how one can logically object to the operation of cumulative averaging i n suc h circumstance s a s these withou t implicitl y condemnin g the corresponding features of the social security system. Even on minimum sacrifice grounds, these aspects of the social security system and of cumulative averaging can in principle be rationalized, b y the notion that previous experience at a high income level increases, rather than decreases, th e marginal utilit y of income at a given lower level of curren t income. The intensity of an effec t o f this sort, tha t woul d be required t o justify eithe r cumulativ e averagin g o r the socia l securit y provisions o n a minimum sacrific e basi s without carryover of identity, seems likely to b e greater tha n mos t observer s woul d fee l exist s in fact , thoug h a s thi s i s essentially a subjectiv e matte r ther e i s little tha t ca n b e sai d her e wit h assurance. Accordingly, it seems difficult t o justify the pattern of the social security syste m withou t assumin g some carryover o f identit y eve n ove r fairly lon g periods, an d difficul t t o allo w such considerations as justifications for the social security system without also allowing them on behalf of cumulative averaging . Indeed, the main rationale for social security systems is that of the pur-

Cumulative averaging 12 9 chase by tax payments of benefits to accrue in later periods of low income. To b e sure, th e actuaria l equivalenc e i s often remote , an d i n som e case s higher benefits are based on higher previous incomes even in the absence of a highe r previou s tax . Bu t i t i s no t to o far-fetche d t o vie w cumulativ e averaging as a supplement to the social security system, in which payment of tax on a high income creates a right to a contingent future benefi t in the form of a tax abatement, or refund, in the event of a low future income. Accordingly, to justify objections to cumulative averaging on the basis of the excessive length of the averaging period for cases of declining income, it would be necessary to find some excuse for not applying these same objections t o th e socia l securit y system , a seemingl y difficult task . Indeed, th e effect o f the man y existing provisions in the tax law , which are designed , somewhat tortuously and with significant discriminatory lock-in effects, t o enable individuals to defe r taxatio n o f a portion o f their earnings, can be distinguished from tha t of cumulative averaging only in that they require specific actio n o n the part of the tax-payer, ofte n a t considerabl e cos t i n terms of accounting expense s and loss of freedom of action. It is difficult t o see why a patter n o f taxatio n i s desirabl e i f achieve d b y th e tax-paye r deliberately and a t a cost, bu t undesirabl e if achieved automatically an d without overheads. The corresponding objection to the application o f cumulative averaging over long periods in cases of increasing income has a slightly better case, but still depends for its validity on the absence of any anticipation o n the part of the tax-payer of his future higher income, plus a denial of the notion that equity would require the tax-payer to be allowed to mak e up for lost time , plus the acceptance o f something akin to minimum sacrifice as a criterion for taxation . Whe n examined i n thi s way , th e objection s t o long-ter m averaging seem weak indeed, compare d t o th e outstandin g advantage s in terms of simplicity and equity in other directions . Th e continued presenta tion of such objection s seems to be based more on a reflex reaction t o something new than on a well thought ou t position . A more potent objection , though one not ofte n explicitl y articulated, is that a large part of the advantages associated with cumulative averaging are obtainable onl y in conjunction with major tax reform in other directions , involving, as a minimum, full inclusion of capital gains and losses in income on the same basis as other income. The thought o f proposing no t only the averaging schem e itself , bu t als o a shar p departur e fro m a n elaborat e scheme of capital gain s taxation buil t u p ove r decades , i s enough t o giv e even the most enthusiastic reformer pause. At the very least, one can antici-

130 Moder n Fisca l Issue s pate a rather significant transition problem: unless the change is made with substantial retroactiv e effect, on e can expect a flood of capital transactions designed to realize gains under the old, more favorable conditions, rathe r than allo w them t o b e carried forwar d into th e ne w regime, an d eve n of transactions at fictitiously high prices designed to buy a future fully deductible loss (or reduction of fully taxable gain) with a partial tax on an immediate gain. Give n th e month s o f open debat e whic h the enactmen t o f such farreaching legislation would require in the United States, it would be difficul t to secur e acceptance o f a sufficien t degre e of retroactivity t o obviat e thi s result. The problem woul d be less severe in parliamentary regimes, but i t would still pose a serious problem. To avoid th e waste involved i n the spate of transactions that might b e thus stimulated, it might be felt desirable to offe r tax-payer s the alternative of voluntaril y writing up thei r asset s t o curren t marke t value , payin g a n immediate tax on the corresponding capital gai n under the old rates. Thi s would involve a formidable task o f checking to insure that the valuation s thus tendere d b y th e tax-payer s wer e no t excessive , particularl y a s thi s would be a concentrated, non-recurrin g task coinciding with the introduction of a new system with its shake-down problems. One could expect that tax-payers would by and large write up their gains, but save the high basis of assets tha t ha d accrue d losses . It woul d do little goo d t o require that any tax-payer takin g advantag e o f this write-up provisio n mus t d o this for all assets, reportin g losse s a s wel l a s gains : thos e fo r who m thi s woul d b e disadvantageous woul d simpl y g o bac k t o selectiv e marke t transactions unless, indeed , revaluatio n wer e mad e mandator y fo r al l tax-payer s i n specified classes , e.g. , al l thos e wh o ha d reporte d income s o f $50,00 0 o r over in any of the preceding five years. On e way or another the transition could be handled, but it would be a strain. But while reform of capital gains taxation would be essential to achieving any major part of the simplification obtainable through cumulative averaging, this does not mea n that cumulativ e averaging would not b e practica l and advantageous , eve n in the absence o f such reform. Absence o f capital gains reform would of course give rise to a temptation to be stingy about the scope of averaging: since the capital gains provisions are in part rationalized on th e groun d tha t they offe r a n offse t t o th e greate r irregularit y of such income, it could be considered making a double allowance if income from capital gains were not onl y partially exempte d from tax , but mad e subjec t to averagin g o n the taxable portion a s well. However, in view of the very

Cumulative averaging 13 1 slight degree to which the capital gains treatment can in practice be justified as bein g in lie u o f averaging, and th e significan t discriminatio n that stil l remains between tax-payers whos e capital gain s are i n fact highl y erratic and small relative to other income, and those whose capital gains are more nearly regular and constitute a large fraction of their income, this seems an altogether inadequat e justificatio n fo r th e substantia l adde d complexity that this imposes on the averaging process. For example , the form use d in the current us averaging provision has thirty-six out of fifty-two entries that are concerne d wit h excludin g capita l gain s an d othe r specia l form s o f income from the scope of averaging. Since the scope of averaging is already severely restricte d b y th e requiremen t tha t curren t incom e excee d four thirds of the average income of the previous four years by more than $3000, there would seem to be no need for the further restrictions an d their adde d complexity as a means of limiting the number of cases in which averaging would be used, and little or nothing to be gained by them in terms of equity. The whol e thing , whe n examine d i n detail , begin s to loo k lik e a gree n whiskers project. 3 In Canada, th e fact that the proposed ne w averaging provisions may be introduced, alon g with a treatment o f capital gain s that approximates ful l taxation, may save the scheme from the growth of such excrescences. Thus, while the complexities in the existing law can spread their contagion into an averaging plan to make it more complicated than it would normally be, this need not happen if it is determined that complications will not be introduced merely to restric t th e scop e of averaging to cases where it is conceptually appropriate, bu t wil l b e eschewe d unles s th e realisti c consequence s o f omitting the complexit y ar e sufficien t t o justify it . Cumulativ e averaging can be kept simple, and, even if initially introduced on an optional basis, or restricted t o certai n classe s o f tax-payers , sa y thos e wit h income s ove r $10,000 o r eve n $30,000 , woul d b e fa r simple r tha n existin g averagin g provisions. Mor e important , i t woul d la y th e groundwor k fo r possibl e further simplificatio n in other aspects of the tax law. Another aspec t o f the objectio n t o cumulativ e averaging , base d o n its entailing widespread refor m of other aspects of the tax law, is resistance t o 3 To r h e had hit upon a plan To dye his whiskers green, And then to use so large a fan That the y could not be seen.'

132 Moder n Fisca l Issues reform as such. Even if, initially, it is proposed t o apply cumulative averaging only to an income tax unchanged in other respects, it nevertheless poses an inherent threat to powerfully entrenched forces. To the many groups of tax-payers that benefit fro m on e special provision o r another, cumulative averaging may be felt to expose more clearly the illogical or discriminator y nature o f the special privileges, and thus constitute a threat t o those who benefit from them. Even were one to offer a substantial reduction in the top bracket rate s as an offse t t o th e elimination o f the loopholes, an d eve n if this could be done in such a way that few, if any, individuals would be worse off a s a result o f the bargain, man y of those affected migh t well prefer the known evil of high top rates, applied only to the unwary and the financially immobile, to the possibility that having traded away their special positions a subsequen t congress , no t considerin g itsel f boun d b y what in any cas e would have to b e a somewhat vague bargain, migh t again raise the rate s against tax-payers now deprived of their shelters. Cumulative averaging, with its potential fo r simplification , may b e a n even more direct threat to lawyers and accountants whose knowledge of the intricacies o f the present ta x law is a valuable asse t whic h the y migh t b e loath to see become largely obsolete. For the same reason, it may also be a threat to thos e legislator s wh o value the power to trad e and manipulat e that a n intricate la w provides. While such individuals are not numerous , they ar e strategicall y placed t o influenc e th e developmen t of the tax law, and thei r opposition , eve n thoug h covertl y an d eve n subconsciousl y motivated, may be important. Nevertheless, it is reasonable t o hope that if the typical businessman can be made to realize that cumulative averaging offers the prospect of his being able to keep his accounts in any consistent way he sees fit, and to organize and formulat e hi s transactions t o sui t hi s ow n purposes withou t fea r o f unfavorable tax consequences to himself, or of special tax advantages that might b e elicite d b y his competitors , o r o f tax-motivated takeover s an d mergers, sufficientl y powerfu l suppor t fo r cumulativ e averagin g an d associated reforms may be generated to overcome the inertia and resistance of the entrenche d forces . Withou t cumulativ e averagin g a s a focus for a consistent reform program, experience with the 196 9 tax legislation seems to indicat e tha t piecemea l attempt s a t refor m are likely to generat e new complexities an d inequitie s as fas t a s th e ol d one s ar e cleane d up . An d without general reform, the personal income tax threatens to deteriorat e into such an unsatisfactory instrument that it may gradually lose its primacy as a revenue source and be forced to yield place to arbitrary o r regressive

Cumulative averagin g 13 3 forms o f taxation, suc h as the variou s form s o f corporation ta x an d th e value added tax . Far fro m bein g a particularly elegant , bu t comparativel y minor refinement, of the income tax, cumulative averaging may well be the essential key to retaining for the personal incom e tax its proper rol e in an adequately progressive revenue system. More than ever, it merits first place on any 'Agenda for Progressive Taxation' [5] . REFERENCES

1 Ho n EJ. Benson, Minister of 4 W . Vickrey, Averaging of income Finance, Proposals for Ta x Reform, fo r incom e tax purposes, Journal of Ottawa 196 9 Political Economy 47, June 193 9 2 Report o f th e Royal Commission on 5 W . Vickrey, Simplificatio n throug h Taxation, 6 vols, Ottawa 196 9 cumulativ e averaging, Law and 3 W . Vickrey, Agenda for Progressive Contemporary Problems, summer 1970 Taxation, New York 194 7

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TWO

Public finance in practice

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A. R . PRES T

8

Government revenue, the national income, and all that*

It has become a popular pastim e in recent years to make comparisons o f country tax efforts o n a time series or cross-section basis . On e example is the comments which usually appear in one place or another after the annual OECD national account s data are published. 1 Typically, international com parisons ar e mad e betwee n th e over-al l leve l o f taxatio n an d GNP , and between the proportions o f total taxation contribute d b y taxes on income, taxes o n expenditure , an d socia l securit y contribution s i n eac h country . Another example is the series of papers which has appeared in recent years on tax revenue/GN P ratios in developing countries [17 , 18 , 24, 26, 30, 57]. Typically, thes e contributions tr y to explai n the variance o f this rati o b y regression analysis, usin g such determining variables as income per head , degree of openness of the economy, etc. Our objective in this paper is to examine the rationale o f such compari sons as these and to ask which sorts of measures are relevant to which sorts of questions. This will in turn lea d to som e suggestions for re-classifyin g some o f th e governmen t revenu e item s foun d i n th e standar d for m o f national accounts, as laid down by the UN [53, 54] and OEE C [37]. One good reaso n - an d one good reason is enough - wh y it is wise to adopt a critical attitude to this spate of literature, is the varying nature of the conclusions drawn. The OECD figures have led to a good deal of argument in the UK about its nearness to the top of the tax revenue/GNP league, with the * Th e original stimulu s to work o n this subjec t cam e durin g the author's time as visiting schola r in the Fiscal Affairs Departmen t of the International Monetar y Fund in the summer o f 1968. H e would lik e to acknowledge thi s indebtedness. 1 Se e for example [19], commenting on the data in [33] . See also [13] .

138 Moder n Fisca l Issue s clear implication that there is something wrong and unenviable about suc h a position. The main burden of the papers about developing country data, on the othe r hand , ha s been that in some sense or othe r thos e countrie s with low tax/GNP ratios were lagging and should bestir themselves to greater effort. Thus it would seem that a country can only do right if it is somewhere in the middle of the distribution. Thi s may simply be a reflection of human unwillingness to be seen to be sitting on the end of a tree-branch; or it may imply that those countries towards the middle of the spectrum are in some sense or other neare r to an optimum position tha n the others. A t least, i t seems wort h askin g whethe r thes e polic y conclusion s ar e truly , o r onl y apparently, contradictory . There is an awkward logical problem at the very beginning: we cannot ask about the objectives of measurement without having some idea of what we propose t o measur e and ye t the precis e specificatio n o f measuremen t may itself affec t th e objectives . Le t us cut this Gordian kno t by assuming temporarily that there ar e unique ways o f measuring total revenu e of all levels o f government 2 an d th e appropriat e nationa l aggregat e (say , fo r simplicity, that this is GNP). We shall come back to the non-uniqueness of such measurements later. We may clear some matters out of the way without much ado. If we are concerned with the ratio o f total revenue to GNP , we are not going to shed much light o n the following: (1) The proportions o f GNP produced in th e public and private sectors, i.e., the percentage contribution fro m each of the two sectors to total value added. (2) The proportions of incomes of different kinds arising in the public sector. Thus it will usually be the case that a large proportion o f transfer payment s wil l arise there , bu t muc h smalle r pro portions i n th e cas e o f incom e fro m wor k an d incom e fro m property . (3) The proportion o f total expenditure o n goods and service s (or on the various categories, suc h as gross domestic capital formatio n or consumption) du e to th e public sector . (Revenu e data wil l reflect cost s of transfer payments as well as expenditure o n goods and services.) (4) The degree of government intervention i n the economy; this ma y have many non-fiscal dimensions (curren t accoun t operation s o f publi c enterprises , monetary policy, monopoly policy, etc.). If we rule out all these possibilities, wha t is left ? As a first approximation, we can say that we are measuring the costs of providing for the payments 2 W e shall have nothing to say about problems o f consolidating revenues o f the different layer s of government.

Government revenu e 13 9 which the community has decided to make on a collective rather tha n on a market basis.3 Two points have to be made in amplification. First, there is no necessary link, certainl y ove r shor t period s o f time , an d possibl y ove r lon g ones , between government revenue and expenditur e totals. S o the revenue/GN P ratio does not precisely measure the costs of collective provision,4 except in the purely formal sense when the net change in public-private indebtednes s corresponding to a budget surplus or deficit is counted as a collective cost. Rather, i t is more accurate t o sa y that we are measuring that part of the flow of incomes which is compulsorily diverted b y governments and s o is not a t th e direc t disposa l o f the citizenr y take n a s a whole . Tw o sub comments nee d to b e added. A s transfers from th e public t o th e privat e sector ma y be just a s much a sourc e o f spending powe r a s income fro m other source s such as work or property, i t may be better t o relate revenue collected to some aggregate which includes transfer payments (e.g., personal income plus undistributed profits ) rathe r tha n t o GN P which does not. We shall return to this later. W e also specifie d 'th e citizenry as a whole.' This seems necessar y to mak e i t clea r tha t w e are no t talkin g abou t a singl e individual's position. He may be able to escape a certain amount of taxation, e.g., by changing his consumption pattern, but this is not an option open to the citizenr y a s a whole , confronte d wit h payin g ove r a give n tota l o f taxation. The secon d poin t o f amplificatio n is that onl y b y acciden t woul d th e measure of any actual ratio correspond to a measure o f 'taxable capacity,' if indeed this phrase has any operational meanin g at all. We shall return to this. If w e ca n achiev e this low-leve l objectiv e o f measurin g th e actual revenue/GNP ratio, can we now see any higher-level objectives ? There would seem t o b e two mai n possibilities : we might wis h to compar e th e actual figure with some optimal ratio or with some maximum feasible ratio . 3 Cf . [48 , p.499]. When welfar e payments are added to those connected with government purchases of goods, and the total compared with GNP , we have 'a ratio that describes the proportion of total product that is distributed independently o f current productive effor t b y the recipients, or exercise by them o f property rights; for short, we say, distribute d without appea l to the market.' 4 Th e revenue rati o could eve n be less than that of the costs of the goods and services supplied by government o n a non-market basi s if the ratio of borrowing to taxation is high, and if the ratio of government transfe r payment s t o goods and services expenditure is low .

140 Moder n Fisca l Issue s The optimum ratio need not detain u s long, though fo r the reason tha t there is too much rather than too little to say. The ability to pay approach , as built up by Edgeworth, Dalton, an d Pigou does not provide a generally acceptable answer , as Musgrave has shown [30, pp.159-60; 32, ch.5]. No r can we derive a simple answer in terms of the efficient utilization of resources. For even if optimal decisions about total public goods expenditure could be reached by some political5 mechanism, there are well-known considerations of raising revenue for distributional and stabilization purposes to take into account. An d eithe r o f these can permit o f many possible answers at an y given time. People have been arguing about the optimal role of government in societ y fo r hundreds , i f not thousands , o f years; a realistic vie w must surely be that the process is not likely to come to an end in the foreseeable future. So thi s leave s u s wit h th e possibilit y o f comparin g a n actual wit h a maximum feasible ratio . We must beware that the latter is a slippery customer. First of all, the notion of a country's taxable capacity means very little. Clearly, any such figure would depend on whether revenue was being raised for making transfer payments or for public absorption of goods and services; the figure could be very much higher in the former case. How much higher would depend , i n part , o n th e compositio n o f governmen t spendin g o n goods and services; if it all goes on defense, that is a very different proposi tion fro m whe n it i s all being used to bu y foodstuff s whic h are then dis tributed t o people o n some non-market basis. And it goes without saying that th e concept o f 'subsistence' is so vague that we make no progress by postulating that government can in some sense skim off productive resources so that people are reduced to that level but no further.6 All in all, the notion of taxable capacit y make s much more sens e for a n individual than fo r a country. There is plenty of room for disagreement even in an individual's case, whethe r relative capacitie s shoul d b e determine d b y income in th e accounting sense, or in the Haig-Simons accretion sense, or by some combination o f income and capital in the accountants' sens e [56] . But the use of the concept seems much more relevant for sharing out a given tax burden 5 W e rule out the possibility that a purely market solutio n t o the public good s problem coul d b e found in the usual western-type economy . 6 I t ma y be that there is rather mor e i n such idea s from a purely short-term view point. Fo r instance , i t could b e maintained tha t on e can get some idea o f a country's war potential i n this way. But it is an entirely different matte r lookin g at the concept o f potentiality an d feasibility from a long-run (development ) poin t of view, e.g., gros s privat e investment ca n be cut down to a much lower level in the former tha n i n the latter case .

Government revenue 14 1 among individuals than for determining the total amount of revenue to be raised. Another approac h i s to specif y a particular ta x structure and then ask how each country' s actua l revenu e intake compares with that obtainabl e from th e applicatio n o f this standar d formula . One example is the com parison of actual tax intakes by the various us states relative to the yield of a standar d formul a [1] . Another is that b y Vit o Tanzi , wh o obtaine d a relationship between the ratio of individual (federal) income tax to personal income and income per head from cross-section data for the fifty us states; he then inserted income per head data for various western countries into the equation an d obtained hypothetical income tax ratios which were then, in turn, compare d wit h actual income tax ratio s [49-51] . Valuable as thes e studies are, it would not see m likely that on e can really hope to find solutions along these lines when one is comparing total tax revenue ratios fo r differing countries . This is a very different matter from looking at all taxes in the relatively homogeneous context of the different states of a single country; or a t inter-country comparisons of the yield of a single tax. Fo r instance , the inequality of income distribution might be very different i n a European country to that prevailin g in a us stat e with the same population an d the same mean income level; then it would not follow that one would obtain the same yield as in the us state when us federal income tax rates are applied t o the European country. Then there is the question of determining the stan dard yield. Why, for instance, is it more appropriate to appraise the UK personal income ta x burde n b y estimating what th e u s ta x structur e would yield if applied in that country than by applying, say, the German tax structure ? And supposing that one gets a different ranking of countries by making the two estimates ? Or still another ranking on another basis ? Probably the best one can do in searching for a maximum feasible ratio is t o for m a n assessmen t of th e mai n influence s (e.g. , incom e pe r head , openness, degre e of administrative capacity, etc.) , makin g for difference s in tax/GNF ratios between countries, and then compare actual ratios achieved with those predicted o n the basis of the formula [24]. One must be modest about suc h procedures; all that they can show is that any one country may have a very different tax/GN P ratio to the average relationship for broadly similar countries. If this is so, there is no presumption that they are right, and i t is wrong, in some absolute sense. 7 Healthy skepticism would seem 7 Cf . Sir Arthur Lewis , a propos the work o n the subject b y Alison Marti n and himself [26] : 'Such comparisons are obviously o f limited value . The y are relevant only i n cases where most countries have the same proportion or where difference s

142 Modern Fisca l Issue s to be in order here, as in other areas of economics, where attempts are made to establish target s in precise numerical terms. So it would seem that we have found some sort ofraison d'etre for these inter-country tax/GN P comparisons. If actual ratios diffe r fro m maximum feasible ratios, it is worth asking what are the benefits and costs of moving from one to the other. It is vital to emphasize the costs as well as the benefits; commentators have been prone to overlook the former ever since Xenophon wrote abou t th e 'Way s and Mean s to Increas e th e Revenue s of Athens.' If the actual ratio is less than the maximum feasible, the benefits of changing the ratio might take a number of forms such as facilitating mor e capital investment (e.g., if private capital investment is impeded by capital market imperfections) o r contributin g toward s greate r stabilit y o f th e econom y (e.g., a small change in the revenue-expenditure balance of a large public sector ma y be easie r t o enginee r than a large chang e in a smal l sector) . Costs ca n als o take man y forms: thes e may be economic in character ( a change in the averag e tax/GNP ratio ma y affect crucia l marginal tax rate s with repercussion s o n incentives to work , to save , etc.), o r the y ma y be political (riot, revolution , rebellion, etc.) . Even if the actua l rati o does no t diverg e fro m th e maximu m feasible ratio, this may still be very useful informatio n for som e policy decisions , e.g., i n connectio n wit h th e allocatio n o f transfers (ai d o r reparations) 8 between countries. Given tha t w e can i n thi s wa y establis h som e uses for thes e over-al l tax/national aggregate ratios, w e must now consider the questions initially put aside : th e mos t appropriat e definition s of total revenu e and o f th e national aggregat e to which it is to be related. We shall deal with revenue first, and the national aggregat e later. THE DEFINITIO N O F REVENUE

There are a number of well-known conundra in delineating the revenue total in a country. Before looking at these individually, let us see what can be said in general principle. Th e first proposition mus t be that we seek to include that elemen t o f purchasing powe r which individuals and institution s ar e compelled to hand ove r to government instead o f being allowed to retain can be closely related to som e measurabl e index . Eve n the n the y are merely sug gestive; if your country' s proportion is very different fro m what th e index suggests , you do not conclud e tha t it is wrong, bu t merely start trying to discove r wha t accounts for th e difference' [23 , p.210]. 8 Tax/nationa l income ratios were the basis fo r fixing German reparations payment s in the twenties. [51 , p.7] .

Government revenue 14 3 for direc t spending . As we shall see, this emphasis on compulsion enables us to go quite a long way in distinguishing what should be included fro m what should not. Asecond proposition mus t be that for cross-sectional o r time serie s comparisons we need a syste m of recording revenu e which is not affecte d b y th e differin g extent s t o whic h government s indulge i n market-type transactions ; or , wha t come s to somethin g very similar, we need to exclude those elements of revenue for which there is an immediate and directly related quid quo pro on the expenditure side. Let us now apply these two general principles to some of the well-known trouble causers on the revenue side.9 Commercial activities Let us contrast thre e possible situations : one when an activity (say, transport) i s wholl y private; on e whe n transport i s publicl y owne d but use r charges are levied; and the third, whe n public ownership still prevails but the financing is entirely from general revenues. On the principles set out above, we should include all elements of general revenue bu t exclud e user charges from th e publi c secto r total . Th e only exception woul d be if user charges were more than sufficien t t o cover th e sum o f operatin g expense s an d 'normal ' retur n o n capital , i.e. , where effectively ther e is an excise tax o n transport. Th e implication i s that an y element of 'normal' profit included i n user charges i s not included i n ou r revenue total. Otherwise, we should have a different total for two countries which were alike in all revenue aspects, excep t that in one the government indulges in market-type transactions in running a transport industry . And this woul d offen d agains t ou r secon d principle , tha t o f invarianc e t o differing extents of market-type transactions . Inevitably, there will be borderline cases. One example would be special statutory bodies which, in effect, act as agents of taxation (e.g., the marketing board s i n postwa r Wes t Africa) . Th e mos t reasonabl e answe r her e would b e that an y surpluse s over 'normal ' return s o n capita l shoul d b e included if, directly or indirectly, they are at the general disposal of government, but excluded if they are earmarked for the particular group of people covered by the system. Another distinction, which must be a very fine one, 9 Th e argument here is obviously akin to, and owes a lot to, Professor Shoup's discussion of the appropriate definition o f government expenditure [48 , pp.488-92). But the emphasis here is very different a s we are dealing with revenue. Another debt is to the incisive discussio n of these matters to be found i n [46, ch.7].

144 Moder n Fisca l Issue s is that between user charges and general revenue, e.g., it might be said that highway provisio n i s a for m o f publi c enterpris e wit h vehicl e licenses , gasoline taxes , an d th e lik e bein g use r charges . Th e decisio n her e mus t depend on detailed circumstances, e.g., whether there is a general effort t o levy charge s i n lin e wit h expenditure s o r whethe r commercia l principle s govern the supply of highway facilities in response to additional payments by consumers. 10 Fees and Fines Much the same arguments apply as in the commercial activities case. If the charge i s directl y relate d t o th e provisio n o f a servic e (e.g., a n aircraf t landing fee), without an element of excess profit, it seems best to exclude it. But if there is an element of excess profit (e.g., patent fees), or if there is n o quid pro quo (e.g., a fine for drunkenness), it should be included. Social security charges These tend to be compulsory, at least for large sections of the community. On the othe r hand , i t can be said that there i s an element of quid pro quo and that the government is, in a sense, performing a commercial-type function. However, it would seem that the importance o f the commercial-typ e element is not large in many social security systems. First, there is the argument that government fulfills a function which the private sector could not, in compelling the poorer an d more profligate members of society to make some contribution toward s their suppor t in old age. 11 Second, there is an element o f incom e redistribution , whethe r intra-generationa l o r inter generational, i n many schemes; this enhances the contrast wit h the usual private scheme . Third, although som e public scheme s incorporate 'exces s profits' elements at some periods of time, this is not the usual situation over the long run. So although th e case is not completely watertight, th e lesser sin seem s to b e t o incorporat e al l socia l securit y taxe s (includin g thos e levied in respect of government employees) in government revenue. Aid, grants,, gifts, etc. Grants between different level s of government in a country net ou t when their account s ar e consolidate d an d s o need no t b e discussed . But gifts , 10 [48 , p.491]. Similar issues arise with fees paid for publicl y provided education. 11 [31] . It shoul d be noted, however, that this argument only implies that people should be compelled to provide for their old age - no t that this provision should necessarily be undertaken through public, rather than private, schemes. See [ll,ch.ll].

Government revenu e 14 5 whether i n cas h o r i n kind , whethe r betwee n government s i n differen t countries, or whether from citizen s within a country to their government, must be considered. The answer would seem to be quite straightforward on our principles : the y mus t b e exclude d on th e ground s that the y d o no t satisfy the compulsion test.12 Loans Voluntary loans should clearly be excluded on the above principles. Com pulsory loan s ar e les s clear cu t a s i n effec t the y incorporate bot h a ta x element an d a voluntary loan element . But given tha t th e ta x elemen t is likely to be a large proportion o f the total, it seems simplest to include the whole amount involved [40, 48, pp.54, 425-6]. The same general argument applies t o import deposi t scheme s a fortiori in that the tax element is likely to be relatively larger, interest o n outstanding deposits being usually zero. Taxes on balance of payments items These consis t o f two mai n components : taxe s o n interes t an d dividen d flows t o an d fro m abroad , an d taxe s o n import s an d exports. 13 Le t u s postpone th e former for a while and concentrate o n the latter. It ma y be argued that, if taxes on exports or imports are shifted to foreign purchaser s or foreign suppliers, ther e is no burden on the domestic population an d so such taxe s shoul d b e exclude d fro m th e revenu e total . N o elemen t o f compulsion i s exercised in respect o f the domestic population, s o to speak . Inclusion seem s to be called for , nonetheless . First , there is the statistica l difficulty o f estimating th e exten t o f any shifting . Second , countries ofte n claim world-wide jurisdiction in respect of income taxes irrespective of their incidence; so it seems hard to deny the same idea in the case of commodity taxes. Third, with both impor t an d export taxes there is the possibility of an upwar d shif t i n real GNP due to a favorable movement of the terms of trade; it woul d see m odd t o exclud e such revenue s from th e numerator , whilst leavin g them fre e t o influenc e th e denominator , o f the tax-incom e ratio. The gross-net question

There ar e reall y tw o separat e question s here : first , whethe r some items should b e omitte d altogethe r (e.g. , impute d rent s o f government owner12 Reparation s on the other hand, are compulsory payment s an d s o should, i n general, be included, a s noted above. 13 Oi l and minera l royaltie s ca n b e thought o f under the exports tax heading fo r these purposes.

146 Modern Fisca l Issue s occupied buildings) , an d second , whethe r som e item s woul d b e bette r treated a s positive expenditure or as negative revenue (e.g., incom e taxes withheld from government employees), and others better treated as negative expenditure or as positive revenue (e.g., receipts from minor sales). Let us see how far we can get with the first question on the basis of the two principle s alread y se t out . Imputed rental s o f governmen t owneroccupied property ar e obviously important in that the decision to include or exclud e not onl y affect s th e tax/nationa l aggregat e ratio fo r an y on e country but, in so far as the amounts involved increase more or less than proportionately wit h GNP , omissio n will bias cross-sectio n comparisons. Our principle that th e tax/national aggregat e ratio should be invariant t o the degree of public production supplies us with the answer. For instance , if one government has bought or built administrative buildings in the past from ta x revenu e an d no w occupie s the m withou t an y curren t mone y outgoings (maintenance apart) it should not be regarded in a different light from another government which currently rents office accommodation and levies taxes to finance these outpayments. On this basis, one can argue that an imputed rent equal to depreciation (on replacement value), interest and a suitable risk margin should be included.14 Two qualifications should be made. Ideally, this rent imputation shoul d be extended to the highway system and not confined to buildings. But this raises eve n more serious statistica l problems , an d althoug h it i s possibl e in particular cases to make some rough approximations to an answer [43,8], we must accept tha t we cannot a s yet perform suc h exercises with much precision. Th e secon d qualificatio n i s that a s we exclude normal profits from publi c production activitie s we should, to be consistent, not impute rental value s i n respec t o f government-owne d building s use d for suc h purposes.15 There are various other cases of imputed income, which can be sorted out 14 Although it can be argued [48 , pp.53, 492] that there is an element o f double counting in GNP calculations which include both capital expenditure whe n it is made an d the depreciation on this expenditure i n subsequent years , i t does no t seem correct to generalize that in consequence the ratio of government revenu e (or expenditure) t o GN P is necessarily biased downwards. When , a s in the UK national accounts (see [6, pp.267-9, 310-11]), public sector revenue an d expenditure estimates include substantia l elements o f imputation i n respect of publi c owner-occupied property , th e element o f bias is minimal . 15 A s defense expenditure i s usually take n a s being o f a consumption rathe r tha n investment character , no question of imputing rent s arises for such item s as military equipment , fighting vehicles, etc.

Government revenue 14 7 in much the same way. Thus if a 'soft' loan is made by a government, should there be an element of imputed interest ? This surely depends on whether the loan is for 'production' or 'government' purposes; inevitably, the line will be blurred at times, but not always (e.g., a 'soft' loan to one's tourist industry is one thing; a similar loan t o a foreign countr y enterin g into a military alliance is another). Nor does the case of conscripted labor cause any major difficulty. If it is for military purposes, on e can say that a tax is being levied in kind and so should be included with other taxes, the basis of estimation being the differenc e betwee n the remuneratio n of the conscripts an d tha t necessary to attrac t th e sam e number of people o n a voluntary basis. If , on the other hand, labor is conscripted for production activities not associated with a war effort, ther e is no case for making any addition to the total of taxation . One other gross-ne t problem must be mentioned: the proposition tha t distortions i n cross-section comparison s can arise if some countries make social securit y transfer s tax-exemp t whils t other s ta x the m [19 , p.xix] . However, it will be convenient to defer this for the time being. Turning now to the negative and positive questions, we can very quickly dispose of the negative expenditure/positive revenue case. We have already argued that if minor fees amount to a commercial type activity, they shoul d not be included in the revenue total. Whether one should tak e the further step of formally removing the corresponding expenditure from the accounts of the administrative activities of government, or whether one should simply offset th e revenue element against this expenditure, is a question whic h is relevant t o public expenditure, but not revenue , totals. Incom e taxes and social securit y taxes levie d o n governmen t employees clearly shoul d b e included in revenue totals. The other question - positive expenditure or negative revenue - is more difficult. I t is also extremely important, e.g., the UK has had such particular problems as selective employment tax,16 and the investment grant system.17 16 Selectiv e employment tax , firs t introduced in 1966 , i s in effect a system o f highly discriminatory taxation on employment differentiating agains t the distributive and service trades . The collection syste m ha s been one of collecting th e tax fro m all establishments an d the n refundin g it to manufacturing industr y and simila r exempt categories . 17 I n 1966 , th e U K terminated it s system o f investment allowance s (unde r thi s syste m firms had bee n allowed t o make deduction s fro m taxable profits o n the basis of capital expenditure), bu t institute d a system o f investment grant s whic h was totally unrelated t o the tax system. Consequently , ceteris paribust tota l tax revenue was bound to rise after th e switchover.

148 Moder n Fisca l Issue s Our tw o mai n principle s o f compulsio n an d invarianc e t o governmen t production activitie s d o no t giv e u s an y lead here . O n balance , th e bes t answer seems to be to make the entries o n a gross basis. Thi s has several advantages: one has a more accurate picture of the flow of private spending power channeled through the public sector, comparisons between countries or over time are less likely to be vitiated, and in general more information is provided this way.18 The argument can, in fact, be taken further. Ideally , one would like to have a pictur e o f tax total s levie d o n a mor e o r les s comparabl e basis , e.g., on e would not onl y show corporation taxe s and investment subsidies without any element of offsetting, bu t on e would also correct the tax tota l for any downward bias resulting from accelerated depreciation allowances. But this woul d see m to b e too muc h a counsel of perfection for suc h an imperfect statistical world as the one we live in. Two small points should be added. Tax refunds can best be thought of as offsets o n th e revenu e side rather tha n a s addition s t o publi c spending ; after all, they are really corrections to overly high assessments of preceding years. And, to retur n to the question of the taxation o r tax-exemption of social security benefits, this is not really a major problem. The usual principle with social security is either that employee contributions ar e tax-deductibl e but benefits taxable (e.g., Canada); or that contributions are non-deductible but benefit s ar e non-taxabl e (e.g. , USA). 19 S o an y apparen t nee d fo r th e Canadian tax/income rati o to b e higher tha n tha t in the US A in orde r t o finance an appropriate leve l of net benefits may, in part at least, be offset by the deductibility of employee contributions against income tax in the former case. Timing The last taxatio n quer y is whether to take cash payments or accruals. O n balance, the answer seems to be the latter. Differential lags in tax collection could upse t cross-sectiona l comparison s substantiall y i f allowance s ar e not made for changes in tax reserves of individuals or business enterprises. And although it can be argued that cash receipts are more relevant as far as 18 E.g. , fo r gaugin g th e contractionary effects o f the tax syste m or th e total effects o f the social security system. Ther e is no case, however, fo r including th e contribu tions to a public secto r occupational pension fun d i n the revenue total : this shoul d be regarded as a commercial type activity , wit h all receipts of this kind excluded . 19 Th e 196 9 proposals for national superannuation an d socia l insuranc e i n the UK [34] were an exception, however .

Government revenue 14 9 a government's planning of short-term borrowing is concerned, the opposite is surel y more true when one brings fiscal policy consideration s into th e picture in that people's expenditure decisions are on the whole more likely to be related to tax accruals rather than to actual payments . THE DEFINITIO N O F A NATIONA L AGGREGAT E

There ar e a numbe r o f thing s t o sa y abou t choosin g th e appropriat e measure of economic activity to which the revenue total should be related . The first , an d mos t obvious , i s tha t whateve r els e is don e on e mus t b e consistent wit h th e decision s take n o n th e ta x side . I f w e are t o imput e rental value s o f government-owner-occupie d buildings , o r allo w fo r th e element o f ta x involve d i n conscription , correspondin g sum s mus t b e entered into the government expenditure total and into the national aggre gate of expenditure. All this is too obvious to need elaboration . In principle, we could choose one of the conventional gros s aggregates , or a wider or a narrower definition. Let us look at each of these alternatives in turn, to appraise thei r relative advantages . Conventional gross aggregates

Taking conventional gross aggregates, there seem to be two major questions of relevance. The first is the choice between GNP and GDP; the second is that between a market price and a factor cost measure. A numerical example may help to bring out the issues in the first case. Suppose we have the situation illustrate d i n Table 8.1. If there is no agreement betwee n A and B to limi t th e doubl e taxatio n o f propert y incom e flowing fro m one to the other, it might be argued that the most appropriat e figure is GDP plus property incom e from abroad , i.e., 13 0 in both cases. 20 If, a s is usual with double taxation agreements , prior tax rights belon g to the countr y where income originates the GD P figure (120 for A ; 100 for B) would b e most appropriate . I f prior ta x right s belon g to th e countr y of residence, GN P is more appropriate, i.e., 10 0 for A and 12 0 for B. TABLE 8.1 Country

GDP

Property income from abroa d

Property income to abroad

A B

120 100

10 30

30 10

GNP 100

120

20 Assuming no taxes are actually levied on foreign propert y income.

150 Moder n Fiscal Issues The choic e mus t clearl y b e tie d i n wit h th e decision , lef t ove r fro m before, abou t th e inclusion of taxes on property incom e flowing from an d to abroad. Mos t countries will levy some tax on both types of income, the exact coverage depending on the provisions of any double taxation agreements. And there woul d not see m to b e any valid grounds for excluding either component from the revenue total. If this be so, there would not seem to be a clear-cut answer about the national aggregate. GDP plus income from abroad (13 0 in both cases above) would be too large a total; on the othe r hand, to specify GDP in every case would give too small a figure for countries receiving a lot o f income from abroad . Perhap s th e best answe r is to say that one should take the larger of GDP or GNP; in that case, one would have the same total (120) for both A and B in the example above. The othe r majo r controvers y abou t conventiona l gros s aggregate s is whether one should take the market price or factor cost concept. The relative merits of the two have been debated very extensively in the literature [7,12 , 15,16,20-2,35,36,38 ], and it is not our intention here to go into the general case for one concept versus the other. Our sole concern is: which concept is likely to be more useful fo r the purpose of measuring actual o r maximum feasible tax/income ratios ? We judge that the market price concept i s the more relevant, fo r thre e reasons. First, we are interested i n comparing the totality o f tax revenue , as defined above, with a national aggregate. It does not therefore strike one as a priori sensible to take an aggregate (factor cost) which is quite specifi cally designed to exclude some taxes (i.e., indirect taxes, as conventionally defined, less subsidies). Second, if we take a market price estimate derived from the total of transactions i n the markets for goods and services, we do not have to worry whether the conventional distinction betwee n direct and indirect taxes means anything or not [42]; we can simply bypass the problem. The third reason for preferring the market price concept is that it seems to give a better pictur e o f tax/income ratios in the most relevant alternativ e situations tha n doe s its rival, assumin g for the sake of argument that the latter ca n be defined unambiguously . To illustrate, take a case where in year one we have a general income tax, assumed, for simplicity , to be collected at source. This is replaced in year two by a general excis e tax (but assumed , for simplicity, no t to appl y t o goods purchased b y government). Then we have the pattern illustrate d i n Table 8.2. It must be emphasized that we could have an infinite number of possible result s [32 , pp.364-71]; bu t tha t 2(d) an d 2(b) are particularl y interesting, or focal, ones. The substitution of an excise tax for an income

Government revenue 15 1 TABLE 8. 2

Year

Type of tax

Revenue collected

Factor cost

Market prices

%of tax to factor cost income

1 2(a) (W

Income tax Excise tax Excise tax

20 20 20

100 100 80

100 120 100

20 20 25

GNP (or GDP )

%of tax to market prices income

20.0 16.7 20.0

tax may lead to a rise in product prices, 2(