Lectures on public economics, updated edition

Lectures on Public Economics



Lectures on Public Economics

Anthony B. Atkinson
Joseph E. Stiglitz

Princeton University Press
Princeton and Oxford


Copyright © 2015 by Princeton University Press
Published by Princeton University Press, 41 William Street, Princeton, New Jersey 08540
In the United Kingdom: Princeton University Press, 6 Oxford Street, Woodstock, Oxfordshire OX20 1TW
press.princeton.edu
Originally published in 1980 by McGraw-­Hill.
All Rights Reserved
Library of Congress Cataloging-in-Publication Data
Atkinson, A. B. (Anthony Barnes), 1944–
  Lectures on public economics / Anthony B. Atkinson, Joseph E. Stiglitz ;
introduction by Anthony B. Atkinson ; introduction by Joseph E. Stiglitz.
   pages cm
  “Originally published in 1980 by McGraw-Hill”—Title page verso.
  Includes bibliographical references and index.
  ISBN 978-0-691-16641-4 (hardback)
  1. Finance, Public.  2. Welfare economics.  I. Stiglitz, Joseph E.  II. Title.
  HJ141.A74 2015
 336—dc23

2014044336
British Library Cataloging-­in-­Publication Data is available
This book has been composed in Minion and Myriad
Printed on acid-­free paper. ∞
Printed in the United States of America
10 9 8 7 6 5 4 3 2 1


For Siobhan, Michael, Richard, Sarah, Charles, and Edward



Contents

Introductionxi
Prefacexxvii
Introductory Note to the 1980 Edition

xxix

P A R T O N E   T H E A N A LY S I S O F P O L I C Y
Lecture 1  Introduction: Public Economics
1–­1 Introduction
1–­2 Role of the Government
1–­3 Guide to the Lectures
Note: The Public Sector—­Statistical Background

3
3
4

8
12

Lecture 2  Household Decisions, Income Taxation, and Labour Supply
19
2–­1 Introduction
19
2–­2 Income Taxation and Labour Supply
26
2–­3 Broader Models of Labour Supply
36
2–­4 Empirical Evidence on Labour Supply
40
2–­5 Concluding Comments
47
Note on the Expenditure Function
48
Reading50
Lecture 3  Taxation, Savings, and Decisions over Time
51
3–­1 Intertemporal Decisions and Taxation
51
3–­2 The Basic Intertemporal Model
56
3–­3 Developments of the Model and Alternative Views
66
3–­4 Empirical Evidence—­Taxation and the Interest Elasticity of Savings
74
3–­5 Concluding Comments
77

Reading78
Lecture 4  Taxation and Risk-­Taking
79
4–­1 Risk-­Taking and Portfolio Allocation
79
4–­2 Effects of Taxation
85
4–­3 Special Provisions of the Tax System
91
4–­4 Generalization of Results
96
4–­5 Concluding Comments
102
Note on Risk Aversion
103
Reading104
Lecture 5  Taxation and the Firm
5–­1 Taxes and the Firm
5–­2 Corporation Tax and the Cost of Capital
5–­3 Taxation and Investment

105
105
108
117


viii 

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 C ontents
5–­4 A Wider View of Investment
123
5–­5 Empirical Investigation of Taxation and Investment
127
5–­6 Concluding Comments
130
Reading131
Lecture 6  Tax Incidence: Simple Competitive Equilibrium Model
132
6–­1 Introduction: Tax Incidence
132
6–­2 Static Two-­Sector Model
136
6–­3 Incidence of Corporation Tax
142
6–­4 General Tax Incidence
147
6–­5 Incidence in a Two-­Class Economy
155
6–­6 Numerical Applications of the Model
159
6–­7 Concluding Comments
163
Note on the Cost Function
164
Reading165
Lecture 7  Tax Incidence: Departures from the Standard Model
166

7–­1 Introduction
166
7–­2 Market Imperfections
167
7–­3 Monopolistic Competition
172
7–­4 Structure of Production
180
7–­5 Non-­Market-­Clearing
184
7–­6 Concluding Comments
188
Reading188
Lecture 8  Taxation and Debt in a Growing Economy
189
8–­1 Introduction
189
8–­2 An Aggregate Model of Equilibrium Growth
191
8–­3 Growth and Taxation
197
8–­4 Taxation in a Life-­Cycle Model
202
8–­5 Burden of the National Debt
208
8–­6 Concluding Comments
214
Reading215
Lecture 9  Distributional Effect of Taxation and Public Expenditure
216

9–­1 Taxation, Spending, and Redistribution
216
222
9–­2 Modelling the Distribution of Income
9–­3 Distributional Incidence
231
9–­4 Empirical Studies of the Redistributive Impact of the Government
Budget235
9–­5 Concluding Comments
244
Reading245
Lecture 10  Theories of the State and Public Economics
246
10–­1 Introduction
246
10–­2 Voting and Decisions
250
10–­3 Administration and Bureaucracies
259
10–­4 Power, Interest Groups, and Marxist Theories
263
10–­5 Empirical Studies of Public Expenditure
268
Reading274


C ontents  

•

  ix

P art T w o   T h e D es i g n o f P o l i c y
Lecture 11  Introduction to Part Two: Normative Analysis
277
11–­1 Introduction
277
11–­2 Normative Theories of the State
279
11–­3 Pareto Efficiency and Welfare Economics
285
11–­4 Standard Public Finance Objectives
291
11–­5 Range of Government Instruments
296
Note on the Measurement of Income Inequality
302
Reading303
Lecture 12  The Structure of Indirect Taxation
304
12–­1 Introduction
304
12–­2 The Ramsey Tax Problem
308
313
12–­3 Application of the Ramsey Results
12–­4 Partial Welfare Improvements and Tax Reform
318
12–­5 Optimal Taxation in a Many-­Person Economy
322

12–­6 Concluding Comments
327
Reading327
Lecture 13  The Structure of Income Taxation
328
13–­1 Introduction
328
13–­2 A Simple Model
331
13–­3 Linear Income Tax
338
13–­4 General Income Tax
343
13–­5 Concluding Comments
352
Reading353
Lecture 14  A More General Treatment of the Optimal Tax Problem
354
14–­1 Introduction
354
14–­2 Indirect Taxes and Linear Direct Taxation
357
14–­3 Nonlinear Tax Schedules and Tax Exemptions
364
14–­4 Taxation of Savings
370
14–­5 Externalities in Consumption and Corrective Taxes
378
14–­6 Concluding Comments
381

Reading382
383
Lecture 15  Public Sector Pricing and Production
15–­1 Introduction
383
15–­2 Departures from Marginal Cost Pricing
386
15–­3 Choice of Technique and Production Efficiency
394
15–­4 Cost–­Benefit Analysis and Social Rate of Discount
398
15–­5 Concluding Comments
402
Reading403
Lecture 16  Public Goods and Publicly Provided Private Goods
404
16–­1 Introduction
404
16–­2 Optimum Provision of Pure Public Goods—­Efficiency
408
16–­3 Optimum Provision of Pure Public Goods—­Distribution
415
16–­4 Publicly Provided Private Goods
417
16–­5 Equilibrium Levels of Public Expenditure
424
16–­6 Revelation of Preferences
430
Reading434

x 

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 C ontents
Lecture 17  Local Public Goods
435
17–­1 Introduction
435
17–­2 Optimum Provision of Local Public Goods
437
17–­3 Market Equilibria and Optimality: Identical Individuals
446
17–­4 Market Equilibria and Optimality: Heterogeneous Individuals
452
17–­5 Fiscal Federalism
461
Reading465
Lecture 18  Public Economics: Theory and Policy
18–­1 On the Sources of Disagreement in Policy Analysis
18–­2 Thinking about Policy: Taxation
18–­3 Thinking about Policy: Expenditures
18–­4 Policy Reform and Political Economy

466
466
470
476
479

Bibliography481
Author Index

509

Subject Index

513


Introduction

Public economics is an exciting topic. It deals with key issues facing governments all
round the world. The subject matter—taxes, government spending, and the national
debt—is very much in the minds of citizens and their elected representatives. What
is more, it draws on the whole range of economics. To understand public policy, it is
necessary to consider how households and firms make decisions, how they interact in
a market economy, and how the economy develops over time.
Excitement about the subject led us to write Lectures on Public Economics in the
1970s (the book was first published in 1980). Our aim was to bring together the recent developments in the subject, which had given it a central place in the modern
microeconomics of general equilibrium and in the theory of second-best welfare economics. We believed this repositioning to be important. Those who had early contributed to such developments, such as Paul Samuelson, Leif Johansen, Peter Diamond,
and James Mirrlees, were economists with wide interests, as were we ourselves. Public
economics was very much part of the economics mainstream. Our book was directed
therefore at graduate students in economics as a whole, and not only as a specialist
treatise in public finance. It was—and remains—our view that all professional economists should understand the “grammar of arguments about policy”.
Would we write the book differently today? Yes. But it would mostly involve addition, not subtraction. The subject has made significant progress. In this Introduction, we identify some of the areas where in recent decades there have been major
advances. There are equally areas where the field of public economics, and economics more generally, is in need of new thinking. In highlighting these areas, we are
of course being selective, providing hints of some of the topics that we might have
covered had we ever managed to write a second volume of our Lectures. There are

many other aspects that should be discussed. It is certainly not possible for us to sur­­
vey the entire rich literature that has appeared in the third of a century since the book
was written. We refer the reader to the Handbook of Public Economics, of which to
date five volumes have appeared since 1985, edited by Alan Auerbach and Martin
Feldstein (now joined by Raj Chetty and Emmanuel Saez). In the field of taxation,
extensive coverage is provided by the background papers for the Mirrlees Review
of taxation in the United Kingdom (Mirrlees, 2010) and by Robin Boadway (2012).

International and Global Public Economics
Reading Lectures on Public Economics in the twenty-first century, one is immediately
struck by the absence (noted on page 4) of any discussion of the international dimension of public finance. If we were writing the book today, this would be different.
Indeed, one of us (JES) has written extensively on globalization, and the other (ABA)
is writing a book on global public economics. Fiscal policy cannot be analysed simply
in terms of a nation-state in a closed economy. This is true of tax policy where the
threat of tax competition limits what national governments can achieve. The firm


xii 

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 Introduction
analysed in Lecture 5 has to consider choices not just about investment and its financing but also about the location of production and indeed of its headquarters. National
governments in turn have to allow for these reactions when designing tax policy. Per­­
sonal taxpayers make choices regarding location and fiscal domicile. Migration decisions are influenced by taxation and by government spending policy.
National government conduct of fiscal policy now has to be set in a context of
international competition and international co-operation. What is more, it is evident
that there are global problems that require a global response, such as the trading im­­
balances, the funding of development, and the challenge of climate change. This means
that we have to consider the public finances of global policy ambitions—such as the

Sustainable Development Goals—and the design of policy by the responsible international organizations. Where there are global public goods to be financed, there has
to be agreement on burden-sharing.
We should emphasize, however, that the intellectual frameworks developed in our
Lectures still provide the basis of much of the analyses of these questions. The theory
of local public goods (Lecture 17), for instance, described the limiting case of a world
in which factors of production were freely mobile, though the benefits of public expenditures were limited to those living in the community. It was a straightforward
matter to go from national public goods (à la Samuelson) to local public goods, and
from there to global public goods—goods (such as knowledge, or those that affect
the global environment, global security, or global health) that affect the well-being of
everyone in the world (Stiglitz, 1995, 1999a). Similar issues are raised in the ongoing
discussions concerning fiscal federalism and decentralization, which have become
the center of key political debates. There are important political economy questions
(see the discussion below): are lower levels of government actually more responsive
to their citizens? To what extent are the consequences of the decisions made by one
political entity borne by others?
With the extension to global public economics come new challenges, particularly
to the normative branch of public economics. On what basis should we evaluate policy? Presumably we would not simply carry over a purely national evaluation of the
costs and benefits. But do we move to a fully fledged worldview—global cosmopolitanism? This would mean giving equal weight to all citizens of the world. For many
people that would be a step too far, not least because of the limited sphere of control
of national governments. The challenge is illustrated by the UK Treasury document
setting out the basis on which public investments should be assessed: “all impacts (including costs and benefits, both direct and indirect) on non-UK residents and firms
should be identified and quantified separately”. But it goes on to say that “generally,
proposals should not proceed if, despite a net benefit overall, there is a net cost to the
UK” (HM Treasury, 2011, 21n). This appears to be adopting a global perspective but
rejecting a global evaluation. In reality, national governments attach some weight to
the well-being of those outside their borders but stop a long way short of giving equal
weight. The implications of such an intermediate position need to be considered as
part of global welfare economics (Atkinson, 2014).

Behavioural Public Finance

If we were rewriting the book, we would certainly pay more attention to the issues
raised in the recent literature on behavioural public economics. Behavioural economics provides a broader view of economic decision-making than the standard micro-


Introduction  

•

  xiii

economics that largely underlay Lectures on Public Economics. Integrating insights
from psychology, sociology, and neuroscience, behavioural models provide a richer
account of the responses of households and firms to public policy. We now recognize
that there are many arenas in which an individual’s behaviour is not well-described
as if they maximized a well-defined utility function. This is especially true when it
comes to making decisions under uncertainty. The probability judgements may not
correspond to any reasonable estimate of the likelihood of the occurrence of the relevant events. Decisions can be affected by how the choices are posed: framing matters a great deal. One individual’s preferences may be affected by those of another.
Again, this poses challenges for descriptive economics, and even more for normative
economics.
Even if an individual’s behaviour seems irrational (from the perspective of the
standard utility maximizing model), it can still be predictably irrational (to use the
term of Ariely, 2008). That is the whole thrust of  behavioural economics. And because
there are systematic aspects to these behavioural responses, governments need to take
them into account in formulating public policy. Thus while behavioural economics
provides a strong cautionary note against using the old models to analyse the consequences of certain policy changes, it also provides new instruments for government
intervention. Standard theory, for instance, suggests that it should make little difference to consumption if, when the government lowers taxes, it simultaneously lowers
the withholding rate. Individuals facing the same budget constraint behave the same
way. But behavioural economists have suggested that if individuals see more money
in their bank account or on their take-home pay slips, they will spend more. People
would be “nudged” to spend (Sunstein and Thaler, 2008). (These ideas actually influenced the design of the US tax cut in 2009.)

The importance of these issues came to the fore well before behavioural economics gained the prominence that it has today. In the United States, individuals could
put up to $2,000 a year into tax-exempt “IRA” accounts (where interest was exempt
while it was being earned). For higher-income individuals, saving more than $2,000
a year, there was no marginal incentive, and standard theory thus predicted there
would be only an income effect. Since the individual lifetime budget constraint had
shifted out, consumption should increase—just the opposite of the intended effect.
But the evidence was that the IRA accounts “worked”—people did save more. The
explanation was simple: banks could “sell” savings. Thus, not only may the impact of
a public measure be markedly different from that predicted by the standard model,
but behavioural economics suggests new ways of attaining public purposes—for instance, increasing savings—by changing the “frames” in which these issues are viewed
and by nudging.
In some cases, behavioural economics represents only a mild change; it does not
even necessarily imply the abandonment of maximization. As put by Matthew Rabin,
“people have reasonably focused goals, and maximize these goals reasonably well”
(2013, 538); the problem is that they make “mistakes” in the maximand and in the
identification of the choice set faced. Rabin describes this as “quasi-maximization”,
listing four common mistakes: narrow bracketing, where people maximize their true
utility function but focus on only one aspect of the budget set; present bias, as with
hyperbolic discounting; projection bias, where people mispredict the utility from future situations (for example, acting myopically); and incorrect expectations regard­­
ing future events.
But in other cases, the effects can be more profound, as the examples given earlier illustrate. This is also illustrated by the equivalence results for taxation that we


xiv 

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 Introduction
stressed—for example, in the discussion of taxation in general equilibrium in Section 6–4. If we simply look at the household budget constraint, then a proportional
income tax paid by the worker may appear equivalent to a proportional payroll tax

paid by the employer, but these may be perceived differently. As expressed by Peter
Diamond, “in standard modelling, we assume consistent behaviour across economic
environments, captured in preferences that are defined only in terms of commodities
acquired (absent externalities). One of the key messages of behavioural economics
is that context (also referred to as situation) matters in ways that are not recognized
in standard modelling” (2008, 1859). For example, standard analysis assumes that
(somehow) individuals are aware of the expected net burden of social security taxes—
that is, the difference between the expected receipts and expected contributions—and
it is only this difference that affects behaviour, with both income and substitution effects. However, there is little evidence that this is the case; the wider context matters.
As another example, “framing” the requirement that individuals purchase health insurance as a mandate, subject to a fine if the individual does not purchase insurance,
is equivalent to a tax imposed on individuals who do not purchase health insurance.
But there can be behavioural consequences to framing this requirement as a mandate
rather than as a tax.
While early work in behavioural economics focused on bringing insights from
psychology into the analysis (not only framing, but confirmatory and preconfirmatory bias), more recent work has sought to integrate insights from other social sciences. Behaviour is affected by norms, which can be culturally determined, even if
they may be affected, in part, by economics. Norms help explain markedly different
behaviour in societies with seemingly similar economic circumstances; differences
in work effort between Americans and Europeans and among European countries
have as much or more to do with norms and culture as with income and substitution effects.1 Again, this means both that conventional policies may have effects that
are different from those predicted by the standard model and that there is a whole
new set of mechanisms for changing individual behaviour and societal equilibrium.
Affirmative action may succeed in changing norms and expectations in a far more
powerful way than standard price interventions. Arguably, changes in views about
the environment have contributed more to changes in recycling practice than have
environmental taxes.2
From a normative standpoint, once individuals act as quasi-maximizers, or depart
more radically from the standard paradigm, we have to re-examine the welfare criterion. There is a potential conflict between basing welfare judgements on the “true”
utility function and basing them on the mistaken utility function employed by individuals. As it was put by Arthur Robson and Larry Samuelson, “experienced utilities are of no interest to a fiercely neoclassical economist—decision utilities suffice to
describe behaviour. However, if we are to consider welfare questions the difference
may be important. If experienced utilities do not match decision utilities, should we

persevere with the standard economists’ presumption that decision utilities are an ap­­
propriate guide to well-being? Alternatively, should we use [experienced utilities] to
over-ride their decision utilities?” (2011, 312). Difficulties in answering this question
have led to the issue being ducked. Raj Chetty and Amy Finkelstein note in their report on the NBER’s Program on Public Economics, “partly because welfare analysis
This is a subject that has generated a huge literature. See, e.g., Stiglitz (2008).
The 2015 World Development Report (World Bank, 2015) focuses not just on the importance of
behavioural economics for developmental policy but on the ways in which public policy can alter norms.
Some of these insights should be applicable to the economics of the public sector more generally.
1  
2  


Introduction  

•

  xv

in behavioral models is complex, much of the growth in the behavioral public economics literature has been in positive empirical work” (2012, 4). But the nettle has to
be seized.3
In particular, there are disconcerting consequences to focusing on “decision utilities”, or, in the case of decision-making under uncertainty, on the basis of subjective
probabilities that might consistently differ significantly from any meaningful “true”
probabilities. For instance, reforms that open up the possibility of more extensive
gambling between parties with different probability assessments will lead to an increase in ex ante utility for all parties. Indeed, government can create information
asymmetries that generate huge bets and seemingly huge gains in expected utility.
But such gambles are just zero sum; they lead to consumption volatility—in the extreme, they can lead ex post to individuals living in a state of deprivation (Guzman
and Stiglitz, forthcoming). Looking back on their lives, individuals may be filled with
regret. Surely these ex post states of mind have as much or more reality as the ex ante
perceptions (see Brunnermeier and Parker, 2005).

Empirical Public Finance
Part One of Lectures on Public Economics contains discussion of empirical evidence
on taxation and labour supply, taxation and savings, and taxation and investment,
and on the empirical implementation of computable general equilibrium models.
This is an area where the reader needs to supplement our discussion, since there has
since been an explosion of research.
Three elements generated this explosion. The first is the widespread availability
today of micro-data from household surveys and administrative records. It is hard
now to imagine how limited were the data available to researchers in the past. In the
United States, the 1967 Survey of Economic Inequality was much analysed because
it was one of the few sources of individual data—relating to a small sample (3,203
male heads of families). It is not just that there is more data. Administrative records,
for instance, enable us to have data about the top 1 per cent—information that it
would be almost impossible to glean from standard surveys. The second element,
induced by the availability of data, was the development of econometric techniques
for the analysis of such data. Here there have been fruitful exchanges between those
working on public economics and econometricians, covering such aspects as the treatment of complex budget constraints. The third element has been the renewal of interest by economists in experimental evidence, including both field and laboratory experiments. We say “renewal”, since we did devote 3½ pages of Lecture 2 to the negative
income tax experiments launched in New Jersey and elsewhere in the United States
in the 1960s.
This new empirical work has not only provided new evidence concerning household behaviour, but also (and perhaps most controversially) about the behaviour of
firms—how, for instance, investment, employment, and production decisions might
be affected by public policies. A great deal has been learned. At the same time, there
is much still to be done. This is well illustrated by the debate concerning the optimal
top rate of income tax, which depends on the estimated elasticity of taxable income.
As is observed in the report of the Mirrlees Review in the UK, “there is no escaping the uncertainty around the estimate” (Mirrlees, 2011, 109). The implied 95 per
cent confidence interval meant that the optimal tax rate on the top range could be as
For a recent attempt to do so, see Brunnermeier, Simsek, and Xiong (2014).

3  

xvi 

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 Introduction
low as 24 per cent or as high as 62 per cent. The views of most politicians could be
encompassed.4

Political Economy
This brings us to the way in which policy is actually decided. Lecture 10 is concerned
with positive theories of government, “seeking to ‘close’ the system, by incorporating
explicitly the behaviour of the state” (page 246). We review voting theories, models
of bureaucratic behaviour, and interest group models including class theories of the
state. Our discussion drew on the public choice school, associated particularly with
the work of James Buchanan and Gordon Tullock. In each of these areas there have
been important advances, but it is also clear that there is much more to be done.
At the time we wrote the Lectures several conundrums motivated our analysis.
It was evident even then that the median voter model (with “rational” voters) provides a poor description of the political equilibrium.5 It was also evident that there
were many Pareto-inferior policies. Why couldn’t political processes lead to reforms
that would make everyone better off? How could we explain such seeming collective
irrationality?6 But why the model performs so badly is not always so clear. In some
cases, there is ample evidence of disparities between voters’ perceptions and “reality”:
they underestimate, for instance, the extent of inequality in our societies. Behavioural
economics will undoubtedly come to play an important role in our understanding of
political economy. As we noted, the standard economic model has individuals with
well-defined utility functions (preferences). Advertisers do more than just provide in­­
formation: they attempt to shape preferences and beliefs. So too do political parties and
politicians. Marketing research and behavioural economics have given us some insights into how and the extent to which this can be done. But these insights have yet
to be widely integrated into political economy analysis.

One topic that has come to play a central role in political economy in recent years
is corruption. Imperfections of information (see below) are, of course, essential to
understanding corruption: if corruption could be costlessly observed, presumably it
would not occur. Corruption can, in part, be understood as a breakdown in wellfunctioning principal agent relationships, where one party is supposed to act on behalf of another. Public corruption is associated with a public official acting to serve
his or her own self-interest, rather than the public that he or she is supposed to serve.
Such failures to fulfill fiduciary duties also arise, of course, within the private sector.
Some policies, it is argued, are better than others on the basis that they are more corruption resistant.7 Closely related is the literature on rent-seeking, surveyed recently
by Ignacio Del Rosal (2011).
We emphasize throughout the Lectures the distributive consequences of policies. The fact that different policies affect different groups differently is a core part
4  
On the other hand, Diamond and Saez (2011) use the standard model to argue strongly that the top
marginal tax rate should be 80 per cent (in the case of the United States, taking into account other taxes,
the top federal income tax rate should be between 48 per cent and 76 per cent).
5  
For a discussion of some of the recent advances in social choice theory, see Maskin and Sen (2014).
6  
Since then, one of us (JES) has spent considerable time working in the US government and for the
World Bank. This has only deepened these concerns. Stiglitz (1997, 1998a) provides some alternative interpretations of these experiences, focusing on how different policies affect the political dynamics through
information flows and helping create bargaining coalitions.
7  
There has been a particular focus on corruption-resistant tax structures in developing countries. See
Stiglitz (2010).


Introduction  

•

  xvii

of the “political economy”. Political leaders attempt to put forward proposals that
can muster sufficient support, a winning coalition of beneficiaries of the policies. But
political debates often also center around differences in perceptions concerning the
effects of these policies. Evidently our theoretical and empirical understandings of
the economy are sufficiently uncertain that economists disagree among themselves;
even when there is widespread agreement among economists, politicians can attempt
to persuade voters of an alternative reality. We noted earlier the important role of
“culture”. Subgroups within a population can come to beliefs that are not based on
evidence, exemplified in the United States by attitudes about climate change. The fact
that government policies can affect the distribution of income has further consequences for the political equilibrium, if economic inequality translates into political
inequality (as it typically does in practice). There can be an economic-cum-political
equilibrium with a low level of inequality, with the political process leading to rules
of the game (including tax laws) that support this low level of inequality; and there
can be another equilibrium with a high level of inequality.8
An important strand in modern political economy focuses on commitment—on
the realization that with democratic processes policies can change. While traditional
discussions of tax policy contrasted temporary vs. permanent changes, there is in fact
no such thing as a permanent policy change, and especially so in democracies, where
elections are typically about changing policies. In a world with incomplete contracting
(and imperfect information), the ability of governments to commit themselves to unchanging policies has important consequences. When firms make long-term investments, what matters is not just the tax rate today, but tax rates in the future. While the
current government in a democracy cannot control what future governments might
do, it can change the transactions costs and alter, in other ways, the consequences of
a changed policy. In so doing, it can affect the likelihood that future governments will
change their actions and alter the behaviour of market participants.9 Institutional arrangements can also affect perceptions about the government’s commitment.10
The dynamic interactions among parties may sometimes lead to surprising results.
Consider a two-party model, with one party being more pro-business than the other.
If the first party lowers the tax on dividends, market participants will know, should
the other party come into office, that they will raise the tax. But that means that firms
will distribute profits during the low-tax regime, and the lower level of retained earnings will result in less investment—firms may not have the requisite finance when a
good project comes along. On the other hand, when the other party comes into office,

dividend taxes are raised, and firms, knowing that taxes are likely to be subsequently
reduced, are induced to retain earnings, so that when a good project comes along,
they can make the investment. Thus, the level of investment will be higher in the
high-tax regime than in the low-tax regime, and the pro-business party curtails the
extent to which it cuts taxes, given its awareness of these effects (see Korinek and
Stiglitz, 2009).
There are important normative questions in the design of the optimal commitment policies on the part of government. In the macroeconomic literature, for
8  
The multiplicity of political-cum-economic equilibria has been noted in other contexts. In the absence
of a rule of law, those who take advantage of such situations thrive, and they support a political equilibrium
with a weak rule of law. But there can be another equilibrium with a strong rule of law. See Hoff and Stiglitz
(2004a, 2004b, 2008).
9  
The general theory of equilibrium in contestable democracies is set forth in Korinek and Stiglitz (2008).
10  
Thus, in monetary theory, some argue that independent central banks, dominated by those from
financial markets, can serve as an important commitment device that the central bank will take an antiinflationary stance.


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instance, policies with strong government commitments are often advocated within
models that assume that the structure of the economy is known and not changing.
But policies that work in one environment may be inappropriate in another. If a government’s commitments are too strong, it will not be able to adapt to the changing
circumstances.
Within the public sector, the design of the structure of decision-making affects
the decisions being made and what the public sector does. There are two aspects of

this. One, the study of bureaucracy, has traditionally been the provenance of public
administration. And yet the constraints imposed on bureaucracy (e.g., concerning pro­­
curement, hiring and dismissal of public employees, and so on) are among the reasons that government is often accused of being less efficient than the private sector. In
assessing the relative merits of public and private production, account has to be taken
of the reasons that such constraints are imposed on the public sector, and whether
there are alternative rules that might provide the desired protections at less cost.
The other relates to fiscal federalism, the level of government at which different
decisions are made (see Oates, 1999, and Faguet and Pöschl, forthcoming). There has
been a widespread movement to put government closer to citizens, in the hope that
this will make government more accountable. But such efforts at decentralization
have not been totally successful, and often for political economy reasons. In some
cases, local government seems more controlled by local elites. The theory of local
public goods (Lecture 17), moreover, explains how competition among communities
may limit the degree of redistribution that can occur. These issues may be playing out
in important ways in the European Union.

Leaving the World of Competitive General Equilibrium
The analysis of public policy can be no better than the understanding of the economy on which the analysis is based, as we warned the reader in the Introduction
to Lectures on Public Economics. We went on to emphasize that the model underlying much of the Lectures—and much of public economics—was the Arrow-Debreu
model of competitive general equilibrium. Looking back a third of a century later, we
are struck that little seems to have changed in this respect. Even then, we were stressing the breakdown of the assumption of perfect competition, the absence of markets,
and the role of imperfect information (see Lecture 11). In an earnest of taking these
seriously, we set out in Lecture 7 a model of general equilibrium tax incidence with
monopolistic competition à la Dixit-Stiglitz. With some notable exceptions, this attempt at bridging the public economics and industrial organization literatures has
not been followed—in contrast to international trade theory, where “the theory of
monopolistic competition has had a huge impact on modern trade theory” (Neary,
2001, 2).
More troubling, since Lectures was published there have been significant advances
in the development of the basic theory of the economics of imperfect information,
and even considerable empirical research; but many strands of this work have not

been adequately incorporated into modern public economics. To mention but two
examples: in the presence of information asymmetries and incomplete markets, there
are pervasive pecuniary externalities, providing scope for corrective taxation.11 And
markets where information asymmetries are important may not “clear”: there can
See Greenwald and Stiglitz (1986), and Arnott and Stiglitz (1986).

11  


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  xix

be unemployment and credit rationing (Stiglitz and Weiss, 1981, and Shapiro and
Stiglitz, 1984). If that is the case, among the first-order effects of any policy change
(such as taxes) are those on the unemployment rate or the availability of capital. Macro­­
economics has belatedly taken these ideas on board, with a major thrust focusing on
macroeconomic externalities, including the role that corrective taxes can play in dealing with such externalities. For instance, Olivier Jeanne and Anton Korinek (2010)
explain that when firms borrow in foreign exchange, they do not take into account the
general equilibrium consequences that might arise in the case of an adverse shock, so
there is excessive foreign exchange denominated indebtedness. They propose a corrective tax to deal with the externality.
These and other models incorporating macroeconomic externalities, information
imperfections, and other rigidities can help explain the equilibrium level of unemployment (or, more generally, the probability distribution of unemployment and the
shortfall between actual and potential output), and tax policies can have significant
effects on the equilibrium. If that is the case, then tax policies may not only have the
microeconomic effects upon which public finance has focused, but also even more
important macroeconomic impacts.12
Imperfect information helps explain why corporate governance is so important—

and why the standard model of the firm (in which the firm maximizes its profits or
stock market value) almost surely provides an inadequate theory of firm behaviour.
An important part of traditional public finance analyses firm responses to taxes imposed on it (on the labor it hires, on its profits, and on the goods it sells), and if firms
do not behave according to the standard competitive theory, our predictions of firms’
responses may be incorrect, and so accordingly will our analysis of the consequences
of taxes.13 And this is even more the case if firms are credit or equity constrained.14
These are not just matters of theoretical niceties: they have important policy implications. If, for instance, firms are credit constrained, then average tax rates (which determine the amount of cash a firm has available to invest) matter as much as marginal
tax rates. The standard theory cannot explain why firms pay dividends rather than
buy back shares. But were firms to replace dividends with share buybacks on a more
significant scale than is already the case, government revenue would be substantially
reduced.
Finally, imperfections of information play a central role in determining the set of
feasible taxes: one can only impose taxes on things that can be observed; and as we
pointed out in the Lectures, the set of feasible taxes are critical for understanding the
structure of optimal taxes—even for determining whether it is desirable to have differential indirect taxation.
12  
The latter may be an order of magnitude larger than the former—typically Harberger triangles
are small relative to the losses associated with the economy operating for extended periods below full
employment.
13  
Before our book was published, there was a large literature on managerial capitalism (e.g., Marris,
1964). But this work was largely dismissed by the mainstream. With the advent of the economics of in­
formation, the extent of managerial discretion has increasingly become recognized, and there is a bur­
geoning literature attempting to take this into account in the analysis of firm behaviour. But the implications
for public finance have yet to be fully explored.
14  
Equity-constrained firms cannot raise additional equity, or can do so only at high costs, and they
will act in a risk-averse manner (Greenwald and Stiglitz, 1990). While an earlier literature (Domar and
Musgrave, 1944) attempted to take this into account—suggesting that a profits tax would lead to more
risk-taking, since the government is a “silent partner” in the firm—most of the literature over the past

50 years has paid little attention, focusing more on risk-neutral firms in the context of well-functioning
financial markets.


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Inequality and Redistribution
Central to Lectures on Public Economics is the distribution and redistribution of income. In the years following its publication this may have seemed strange to some
readers, as macroeconomics took a turn towards the assumption of representative
agents with identical endowments and tastes. Indeed, there were influential mainstream economists who claimed that distributional concerns had no place in “sound
economics”. However, public economics restricted to efficiency considerations in a
world of identical agents would fail to address the key questions of public policy.
Distributional concerns are central to public economics. The disputed issues in public
finance—those on which economists are asked to contribute to the public debate—
arise because people have different capacities to pay and different preferences. These
differences among people are of first-order importance. We cannot put it better than
Robert Solow: “Heterogeneity is the essence of a modern economy. In real life we
worry about the relations between managers and shareowners, between banks and
their borrowers, between workers and employers, between venture capitalists and
entrepreneurs, you name it. . . . We know for a fact that heterogeneous agents have
different and sometimes conflicting goals, different information, different capacities
to process it, different expectations, different beliefs about how the economy works.
Representative-agent models exclude all this landscape” (2003, 1).
The assumption that everyone is identical is a powerful simplification, and were
it true, public finance might be a simple matter: just impose lump-sum taxes on everyone. In fact, the analysis of public policy within models where people differ is a
challenge, as is illustrated by the discussion in Lecture 13 of the way in which James

Mirrlees, and before him William Vickrey, tackled the design of the optimal income
tax schedule where people differ in their earning power. The individual utility maximization problem has to be embedded within the social welfare maximization by the
government.
Since then, there has been an important generalization of the basic optimal tax
model in allowing people to differ in more than one dimension. Here we may distinguish between multi-dimensional treatments of the joint distribution of endowments
and tastes, on the one hand, and those concerned with the joint distribution of two
different dimensions of endowments on the other. The former raises issues about the
way in which taste differences enter the social welfare function.15 The latter is par­­
ticularly relevant to recent developments in the explanation of inequality. For much
of the past 30 years, attention has focused on the determinants of earned income,
privileging such factors as skill-biased technological change. That research has highlighted that relative wages can be affected by government policy (both taxation and
expenditures). Most of the earlier work (discussed in Lectures) assumed that the
before-tax relative income of, say, high- and low-productivity workers is fixed. But
there have been large changes in the relative wages of skilled and unskilled workers, and government policy can affect those wages. If the before-tax distribution is
less unequal, less of a burden is imposed on distortionary redistributive policies. Tax
policy needs to take this into account.16
However, we have both had a long-standing interest in the distribution of capital income, and this has now come to the forefront of public discussion, with wider
recognition of the role played by differences in inherited wealth. This in turn raises
interesting issues regarding how the design of taxation can affect inherited wealth.
Much of the work in this area was anticipated by Mirrlees (1976).
For an attempt to do so, see Stiglitz (1998b).

15  
16  


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  xxi

Thomas Piketty and Emmanuel Saez (2013), for example, have investigated the optimal taxation of inheritance in a model where people differ in earning capacity and in
bequest preferences that translate into unequal endowments in subsequent generations. The bi-variate composition of income more generally introduces the question
as to how the optimal design of taxation depends on the degree of correlation of different income sources. If we are moving from a situation where different people are at
the top of the distributions of earnings and the distribution of capital income (a “class
model”—see page 72) to a situation where it is the same people at the top of both
distributions, does this mean that there is a stronger case for higher taxes at the top?
Further analyses of the design of optimal taxation will require further developments in the theory of the distribution of income and wealth. For instance, even if
the stochastic process describing the evolution of wages is the same for all families,
and even if all families have the same preferences for bequests, there will be rich and
poor families, depending on particular experiences (luck). Even if government only
cared about the utility of dynastic families, it would want to engage in redistributive
taxation (including through the imposition of inheritance taxes), and even more so
if social welfare depends on the well-being of individuals, not just dynastic families.17
Moreover, individuals differ in their ability to obtain returns on capital. One might
treat the superior returns to capital as really a return to labor—to the individual’s productive abilities in managing capital—but our tax laws do not, and for good reason: it
is impossible to identify such returns, and to distinguish them from high returns that
are, for instance, a result of risk-taking.
One of the striking—and disquieting—results of Atkinson and Stiglitz (1976) using a standard model (with utility functions that were separable between leisure and
goods) was that there should be no taxation of capital. But once one recognizes these
differences in the ability to obtain returns on capital, this result no longer holds.18
(There are other reasons, related to the fact that the competitive model does not provide a good description of the economy, discussed in earlier sections of this Introduction. For instance, if some of what is recorded as a return to capital is in fact a
monopoly rent, or even the return to land or some other inelastically supplied factor,
it should be taxed—and indeed taxed at a very high rate.)
We noted earlier that the structure of optimal taxes depends on the set of feasible
taxes. So too the burden on taxes for redistribution depends on the extent to which
other instruments—in particular, expenditure policy—can be used. Often expenditure policy is essential—not just the provision of education and health, but also the
provision of public transportation, enabling poor individuals to have better access
to jobs.19 This analysis is related to another strand of advances: putting the theory

17  
The analysis of the equilibrium wealth and income distribution even in simple specifications is rather
complicated. See, e.g., Stiglitz (1969); Bevan and Stiglitz (1979); Becker and Tomes (1986); Kotlikoff (1988).
Note that in models with strong dynastic utility functions, those who are lucky in having high incomes
share their wealth with future generations. The result is that high inheritance taxes (in the absence of
offsetting progressive income taxes) may actually result in greater inequality of consumption/individual
utilities (Stiglitz, 1976). But even in these circumstances, the societal consequences of inherited in­­
equalities may make inheritance taxation desirable, suggesting limitations in the usual formulation of (even
inequality-averse) social welfare functions. Other models of inheritance attribute differences in inheritance
to the lack of efficient annuity problems (partially associated with problems of asymmetric information),
the consequence of which is that some individuals inherit more wealth because their parents died earlier.
See Stiglitz (1978b).
18  
We were aware of these limitations on our theorem even at the time we published our original paper;
we should perhaps have given them more attention. See, e.g., Stiglitz (1985).
19  
For a discussion of some aspects of this interplay between redistributive taxes and government ex­
penditures, see Stiglitz (1998b).


xxii 

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 introduction
into a general equilibrium context. There are four ways of going about changing the
final distribution of income and well-being: changing endowments, changing before
tax-and-transfer prices/wages, engaging in progressive taxation and transfers, and
engaging in distribution-sensitive public expenditures. Optimal tax-and-expenditure
policy entails coordinating all the relevant instruments.

The optimal design of taxation and spending may also change if the social welfare
function ceases to be exclusively determined by individual utilities or if these utilities are replaced by other indicators of individual well-being. Such a movement has a
long history in public economics. Richard Musgrave (1959) defined as “merit wants”
those where the state decides that the consumption of certain goods is to be encouraged (e.g., education). Or it could be that the government would strike out from the
individual utility functions the elements corresponding to demerit goods that should
be discouraged (e.g., tobacco). On the positive side, governments may attach greater
weight than individuals to expanding employment (see, for example, Kanbur, Keen,
and Tuomala, 1994) or to global warming or to the promotion of social trust or altruism.20 Governments may care about income and wealth inequality, and not just
because of the impact on an inequality-averse social welfare function. Democratic
processes may not work well when a society is too divided.

Finally: The Over-Specialization of Economics
As we emphasized at the outset, we believe that public economics should be situated
in the wider context of economics as a whole. In our view there is a risk that economics is becoming too specialized. The depth of specialization today has brought
impressive results, and we fully agree that people should establish their reputations
as x-economists. But at the same time they should retain an appreciation of what is
being achieved in other fields. In this respect, we belong to an older generation. One
of us (JES) defies classification: he could be a microeconomist or a macroeconomist,
or a labour economist, or an IO specialist, or a development economist. He has lectured in all these fields. The other (ABA) has, over a teaching career from 1967 to
2013, taught—apart from public economics—microeconomics, applied economics
(including macro), economic statistics, comparative economic systems, health economics, labour economics, and the economics of inequality. We hope that the republication of our textbook will contribute to a wider knowledge of public economics.
A B Atkinson
Nuffield College,
Oxford, INET at
the Oxford Martin
School, and London
School of Economics
J E Stiglitz
Columbia University

20  
There are externalities associated, say, with global warming, and the analysis of these externalities
has been a standard part of the analysis of public economics. But what if many individuals simply do not
believe that climate change is real, in spite of the scientific evidence? Should we maximize their ex ante
utility function, using their (misguided) beliefs? The questions raised here are analogous to those posed
earlier in this Introduction.


introduction  

•

  xxiii

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