Public economics in an age of austerity (the graz schumpeter lectures)

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Public Economics in an Age of Austerity

Governments all round the world are facing problems with their public
finances. At a time of austerity, how much should spending be cut and how
much should taxes be raised? Does the national debt represent a burden for
future generations? Should taxes on the rich be raised? This book examines
how the tools of public economics can be applied to answer such key questions
and to suggest alternatives to the austerity policies currently being pursued.
The fiscal problems faced are not simply the result of the post-2008
economic crisis but reflect a deep-seated fault line in modern economies.
There has to be fiscal consolidation to provide for an ageing population,
increased investment in education, and climate change. The book describes
how public economics can help us think about alternative ways of meeting
this challenge. It casts doubt on conventionally held views, such as those
concerned with top tax rates, the undesirability of taxing capital income, the
targeting of child benefits, and the merging of income tax and social security
contributions. The final part goes beyond national boundaries and considers
global public economics, focusing on the pressing problem of financing
development.
The conclusion of the book is that there are significant choices to be made.
Not all austerity packages are the same: there are alternatives. It would be
possible to raise taxes more and to cut spending less. It is important to consider the full range of possible policies. In considering these alternatives,
modern public economics provides a useful framework, but it has major limitations. Economists are too often prisoners within the theoretical walls they
have erected and fail to see that important considerations are missing.
Economists have paid too little attention to the ethical basis underlying their
policy recommendations.
A. B. Atkinson is a Fellow of Nuffield College, of which he was Warden from
1994 to 2005 and is currently Centennial Professor at the London School of

Economics. He was knighted on 2001 for services to economics, and is a
Chevalier de la Légion d’Honneur.

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The Graz Schumpeter Lectures

Previous titles in the series:
1. Evolutionary Economics and Creative Destruction
J. Stanley Metcalfe
2. Knowledge, Institutions and Evolution in Economics
Brian J. Loasby
3. Schumpeter and the Endogeneity of Technology
Some American Perspectives
Nathan Rosenberg
4. Consumption Takes Time
Implications for Economic Theory
Ian Steedman
5. Exchange Rates and International Finance Markets
An Asset-Theoretic Approach with Schumpeterian Perspective
Erich W. Streissler
6. An Unholy Trinity
Labor, Capital and Land in the New Economy
Duncan K. Foley
7. Politics and Economics in the History of the European Union
Alan S. Milward
8. The Dynamics of Industrial Capitalism
Schumpeter, Chandler, and the New Economy
Richard N. Langlois

9. Growth, Distribution and Innovations
Understanding Their Interrelations
Amit Bhaduri

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10.Complex Economics
Individual and Collective Rationality
Alan Kirman
11.Public Economics in an Age of Austerity
A. B. Atkinson
For more information, please visit the Graz Schumpeter Society’s website:
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Public Economics in an Age of
Austerity

A. B. Atkinson

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First published 2014
by Routledge
2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN
and by Routledge
711 Third Avenue, New York, NY 10017
Routledge is an imprint of the Taylor & Francis Group, an informa business
© 2014 A. B. Atkinson
The right of A. B. Atkinson to be identified as author of this work has been
asserted by him in accordance with the Copyright, Designs and Patent Act
1988.
All rights reserved. No part of this book may be reprinted or reproduced or
utilised in any form or by any electronic, mechanical, or other means, now
known or hereafter invented, including photocopying and recording, or in
any information storage or retrieval system, without permission in writing
from the publishers.
Trademark notice: Product or corporate names may be trademarks or
registered trademarks, and are used only for identification and explanation
without intent to infringe.
British Library Cataloguing in Publication Data
A catalogue record for this book is available from the British Library
Library of Congress Cataloging in Publication Data
Public economics in an age of austerity / A. B. Atkinson.
pages cm. – (The Graz Schumpeter lectures)
1. Finance, Public. 2. Taxation. 3. Social policy. I. Title.
HJ141.A747 2014
336–dc23
2013040860
ISBN: 978-1-138-01815-0 (hbk)
ISBN: 978-1-315-77988-1 (ebk)
Typeset in Times New Roman

by Taylor & Francis Books

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Contents

Illustrations
Preface

viii
ix

1

Public economics and austerity

2

Taxing the rich

18

3

Models can become prisons

37

4

Global public economics

59

5

Conclusions

83

Bibliography
Index

87
94

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1


Illustrations

Tables
1.1 Optimal indirect tax structure under different assumptions about
the possibilities for direct taxation
4.1 Distribution of income among world citizens 1992

8

79

Figures
1.1 Gross disposable real income of households from 1999 to 2012,
compared with GDP, Euro area (17)
1.2 Alternative routes for austerity
1.3 A simple overlapping generations model
2.1 Shares of the top 1 per cent in the United Kingdom
2.2 The evolution of the proportion ‘rich’ in the United States since 1960
2.3 Top tax rates in the UK from 1909 to 2011
2.4 Transmitted wealth in the UK as percentage of total personal
income
2.5 Ratio of personal wealth to personal income in the UK
4.1 Tax/spending or differential incidence?
4.2 Fiscal architecture: national taxation
4.3 Possible global fiscal architecture
4.4 Different dimensions of redistribution
4.5 Alternative forms for the social marginal valuation of income

4
7
13
18
21
22
35
35
69
72
73

76
81

Boxes
1.1
2.1
2.2
2.3
4.1
4.2

The Atkinson–Stiglitz theorem
Determination of the optimal top tax rate
Optimal taxation in a tournament model
The copula function
Summary of Millennium Development Goals
The optimal provision of official development assistance (ODA)

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9
23
27
31
60
63


Preface

I am most grateful for the invitation to present the Graz Schumpeter Lectures
in October 2012. There are at least three reasons for being grateful. The first
is that it gave me the opportunity to visit Graz, where my wife and I were
most warmly welcomed. We should like to thank Richard Sturn, Heinz Kurz,
Christian Gehrke, their families and colleagues for making our stay so
enjoyable and interesting. Our thanks too to Johanna Pfeifer for making such
efficient arrangements. The second reason is that the preparation of the lectures gave me grounds for collecting my thoughts about both current austerity
policies and the underlying state of public economics. As noted below, I have
drawn on a number of earlier pieces of work, but the four lecture series challenged me to bring them together. It also led to my re-reading, or reading for
the first time, the writings of Joseph Schumpeter, many of which are highly
relevant to my subject, notably his remarkable 1918 essay on ‘Die Krise des
Steuerstaates’ (‘The crisis of the tax state’), republished in translation in
Schumpeter (1991). The third reason for gratitude is that the lecture attracted
a large student audience, who posed excellent questions, both inside and
outside the lecture room.
The Lectures build on a review article I have written on the work of the
UK team chaired by Sir James Mirrlees, published in the Journal of Economic
Literature (Atkinson, 2012). The Lectures draw also on material presented in
three earlier public lectures. In September 2011, I gave the first Amartya Sen
Lecture, with the title ‘Public economics after The idea of justice’, at the
annual conference of the Human Development and Capability Association in
the Hague. The Sen Lecture has been published in the Journal of Human
Development and Capabilities (Atkinson, 2012a). In January 2012, I gave the
fifth Sandmo Lecture, with the title ‘Public economics in an age of austerity’,
at the Norwegian School of Economics and Business Administration in
Bergen. Chapter 4 draws substantially on the Fourth Jelle Zijlstra Lecture
(Atkinson, 2005) given at the Free University, Amsterdam, on 12 December
2005, when I was a visiting fellow at the Netherlands Institute for Advanced
Studies.
Empirical aspects of the research reported in the Lectures draw on work

carried out in conjunction with a number of colleagues, whom I would like to

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x

Preface

thank most warmly. I have taken distributional data from the Chartbook of
Economic Inequality, available from the website of INET at the Oxford
Martin School, prepared together with Salvatore Morelli. I have cited results
on the joint distribution of earned and capital income from a project, initiated
with Emmanuel Saez, and now in progress with Rolf Aaberge of Statistics
Norway, Sebastian Königs, and Christoph Lakner. The findings on long-run
trends in inheritance in the UK are part of a multi-country project with
Facundo Alvaredo and Thomas Piketty, with whom I have also had the
pleasure of working on the World Top Incomes Database and associated
volumes. In Chapter 4, I have drawn extensively on joint work with Andrea
Brandolini, whose influence indeed runs through the book.
Going further back in time, my thinking on public economics has been
much inspired by a long period of collaboration with François Bourguignon,
who will recognize many of the issues with which we have grappled, and by
fruitful discussions over the years with Agnar Sandmo. The foundations for
much of my analysis were laid down in the twelve-year research programme
from 1978 to 1989, Taxation, Incentives and the Distribution of Income,
directed jointly with Mervyn King and Nick Stern. This was an intellectually
exciting time, and, although our weekly breakfasts are long in the past, I owe
them a great debt. A decade before that, I could not have had a better introduction to modern public economics than that provided by Peter Diamond
and Jim Mirrlees, and subsequently writing a graduate textbook with Joe

Stiglitz was an unforgettable experience.
This book is based on four lectures and covers only a selection of issues in
public economics. I am very conscious that I have failed to survey many
important and interesting topics. I should therefore refer the reader to the
much more exhaustive treatments provided in the Background Papers for the
Mirrlees Review (Mirrlees, 2010) and in the excellent survey of the field by
Robin Boadway (2012).
Preparing these lectures has led me to reflect on my approach to public
economics and to economics in general. As a student in Cambridge, England,
in the early 1960s, I was taught by a number of people who held strong views,
views that they expressed with great fervour and a combative style. Perhaps as a
reaction, perhaps as a matter of personal temperament, I have always
regarded my views about economics – in contrast to my moral principles – as
tentative and open to revision as I learned more and acquired more evidence.
In this process, criticism is to be listened to, not simply combated or dismissed. Perspectives different from one’s own can yield new insights or reveal
aspects that need to be re-addressed. I stress the need for open-mindedness,
since economics today seems to have become less open-minded. The needs of
modern media communication mean that it is dominated by those that have a
strong message to deliver. In academic life there is increasing sub-division into
specialist groups with heavy emphasis on an agreed set of positions and
approach to economics. This makes me uneasy.


Preface xi
At the same time, I remain optimistic about the future of the subject of
economics. There are many who share my concerns, and I have had the
pleasure of working with a great set of co-authors. In recent years, I have had
wonderful students and post-doctoral fellows. To all of them this book is
dedicated.
Tony Atkinson

September 2013



1

Public economics and austerity

1.1

Public economics and public debate

The subject matter of my lectures is public economics. I hope that this is an
appropriate topic for the Graz Schumpeter Lectures, since Joseph Schumpeter
was both a professor of public finance and – rather briefly – an active policymaker, as Austrian Minister of Finance in 1919. Wikipedia, with studied
ambiguity, describes him as serving ‘with some success’. Schumpeter himself
said that ‘it was no pleasure’ (Swedberg, 1991, page 60). There can be no
doubt that it was a difficult task, and would have defeated even a person with
greater diplomatic skills.
Today too Finance Ministers face a difficult task. For this reason, I have
chosen to focus on public economics in an age of austerity. This is certainly
topical. In 2010, Merriam-Webster’s Dictionary named the word ‘austerity’ as
its ‘Word of the Year’ based on the number of web searches this word generated.
All around the world, there are governments adopting or are being required to
adopt ‘austerity programmes’. But these programmes are highly controversial.
They divide politicians, they divide countries, and they divide governments
from many of their citizens, as shown by riots and demonstrations in the street.
In focusing on austerity programmes and longer-term fiscal problems, I
am – in the spirit of Schumpeter – concerned both with the substantive issue
and with the state of public economics. I shall ask – what are the lessons of

public economics for the debate about austerity programmes? But also I shall
ask – what are the strengths and weaknesses of modern public economics?
The interplay between academic research and public policy is of central
importance to the discipline of public economics. In preparing this lecture, I
looked back at the first issue of Journal of Public Economics that was founded
some forty years ago. I was struck by the extent to which the authors in that
first issue have consistently been concerned with the application of their analysis to the pressing problems of current policy. The authors included one
future chair of the US Council of Economic Advisers and one future Governor of the Bank of England. Since then, there has been much progress in our
understanding. At the same time, there remains a gulf – a gulf that is
particularly apparent in recent debates about austerity programmes.


2

A. B. Atkinson

In these debates, one hears a great deal from macro-economists and from
economists specializing in financial markets. Yet one hears relatively little
from experts in public economics. This seems to me surprising. Is not public
economics concerned with deficits and taxes and government spending? Is not
the national debt one of the essential topics in any course on public finance?
Should not students therefore be taking courses in public economics? To take
just some examples, cannot public economics help us think about the following
questions?
 The balance between tax increases and spending cuts is typically of the
order of 25%/75%. Are these the right proportions?
 Tax rises in a number of countries take the form of raising VAT rates.
Should we also consider broadening the VAT tax base?
 Past fiscal consolidations have fallen disproportionately on cutting
government capital investment. Does this simply pass on the burden to the

next generations in a different form?
 Should we cut back on personal services for the elderly or on youth services?
 Should we raise taxes on capital?
And there are many more.
These lectures are concerned with the contribution of public economics to
the kind of issues just listed. The first chapter covers the field more generally,
and provides an introduction to the key points. The next three chapters go
into greater depth, taking a number of case studies. The first (Chapter 2)
treats a much debated topic. How should we tax the rich? What should be the
top tax rate? Should we tax inherited wealth? The title of Chapter 3 (‘Models
can become prisons’) may appear a little mysterious. When I explain that it
concerns the way in which the recommendations by economists can be driven
as much by their modelling as by economic reality, then it may appear rather
dry. However, I explore the role of economic models in the context of
important real-world issues: taxing capital income, child benefits, and the
merging of income tax and social security contributions. These policy issues
are discussed in Chapters 1 to 3 in a largely national perspective, but they
have an important global dimension, and Chapter 4 sets out an agenda for
global public economics. Why for example do national governments make
transfers to other countries, notably in the form of official development
assistance? Should we have international co-operation in taxation and global
taxes? Should there be a World Tax Authority?
As I have stressed, I am concerned with the application of public economics
to policy-making, and for this reason I shall be referring at a number of
junctures to the recent major review of taxation in the United Kingdom (UK)
carried out by a team chaired by Sir James Mirrlees. This was not an official
body but one established by the Institute for Fiscal Studies. (It was a successor review to that carried out by the Meade Committee in the 1970s (Meade,
1978).) The report of the Mirrlees Review (Mirrlees, 2011), Tax by design,

Public economics and austerity

3

took a long-term view of ‘a good tax system for the 21st century’. It was
accompanied by a set of background papers, Dimensions of tax design, published in 2010. The 1,880 pages, written by sixty-three authors from many
countries, represent a major contribution and a rich source of new ideas for
policy-makers around the world. It also provides a convenient vehicle to
assess the current state of public economics.

1.2

Public economics, austerity, and macro-economics

I referred just now to macro-economists, and I begin with the relation
between public economics and macro-economics. A theme running through
this book is my view that economists have become over-specialized. In particular, public economics has become too divorced from other fields, notably
macro-economics. This is a loss to both sides, as was gracefully recognized
some years ago by Robert Lucas: ‘as a practising macroeconomist, I must say
that I have greatly enjoyed this excursion into public finance. … How
refreshing it is to spend some time in the company of a group of applied
economists who simply take for granted the desirability of using (and
extending) the powerful methods of dynamic general equilibrium theory to
gain a deeper understanding of policy issues’ (1990, page 314).
The divorce between public economics and macro-economics is relatively
recent. In the 1950s, Richard Musgrave devoted a third of his celebrated The
theory of public finance to stabilization policy. As he says, ‘an effort is made to
view the stabilization function in the broader context of efficient budget
policy. This policy must account for the provision of social services and distributional adjustments as well as stabilization’ (1959, page viii). Even if
Musgrave conducted his analysis of the public household in terms of the

celebrated three branches (Allocation, Distribution, and Stabilization), he saw
that they needed to be carefully co-ordinated. The tools considered by Musgrave included automatic stabilizers, whose role has been under-played in
recent analyses of the economic crisis. One reason for the under-emphasis is
that we remain fixated on what is happening to Gross Domestic Product
(GDP), rather than consider the macro-economic variable of greater concern
to most people – what is happening to Household Disposable Income (HDI).
Every quarter we are bombarded with statements as to whether the economy
is growing or in recession. But these statements are almost entirely focused on
what is happening to GDP. But what does GDP mean to our citizens? It is a
measure of economic activity, but not one that is directly related to their
living standards.
For this reason, it seems to me better to headline the impact of economic
performance on household living standards. And this shows a different story.
If we compare the evolution of GDP and HDI over the period from 1999 to
2012 in the seventeen-country Euro zone, then we see (Figure 1.1) that in the
first part of the period, up to the onset of the crisis in 2007, household disposable income rose less than GDP. Both are expressed in real terms: that is,


4

A. B. Atkinson

adjusted for the rise that has taken place in prices. Then, when GDP fell
sharply in 2008 and 2009 – a fall of 5.7 per cent – household disposable
incomes were broadly maintained, at least until the end of 2010. The automatic stabilizers and the discretionary stimulus measures worked. This is a
remarkable, and little heralded, success. I find it surprising that the political
leaders at the time have not made more of this. Less surprising is the focus by
politicians on GDP as a measure of recovery, but they have to recognize that
this will not be perceived by their electorates until this feeds into
improvements in household disposable incomes.

The conclusion I draw is that we should not lose confidence in the
effectiveness of short-term stabilization policy. We need to retain automatic
stabilizers and to use discretionary policy. As argued by Peter Diamond,
in today’s economic environment of high unemployment in many countries and high vulnerability to the risk of significant further shocks,
shocks that have sizable probabilities, fiscal policy has a far more important role to fill than in the earlier post-war US recessions. Indeed, the
failure to take further fiscal steps to help the recovery is viewed as a
major political shortcoming in the eyes of many analysts, including me.
(Diamond, 2012, page 2).

125

Index 1999 Q1 = 100

120

115

110
Household disposable income
GDP

105

100
Q1Q2p3Q4 Q1Q2p3Q4 Q1Q2p3p4 Qi |q 203|q 4 Qip2Q3Q4 Q1Q2p3Q4 Q ip2Q3p4 Q1Q2Q3p4 Q1Q2Q3Q4 Q1Q2Q3Q4 Q1Q2Q3Q4 Ql|Q2Q3Q4 Qip2|Q3|Q4 Q1 Q1

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

O
CM

1999

10 12

Figure 1.1 Gross disposable real income of households from 1999 to 2012, compared
with GDP, Euro area (17)
Source: Eurostat website, series namq_gdp and sector accounts.

Public economics and austerity

5

I fully share his view, but I will not say more about this. Rather, I want to
look ahead to the medium- and longer-term fiscal problem. While the title of
my lectures refers to ‘austerity’, I believe that the fiscal problems that we
are facing are not simply the consequence of the crisis, but reflect more
deep-seated fault lines in modern economies. Indeed, Figure 1.1 contains a
warning in this regard. Over the longer-term, household disposable income
cannot be expected to grow in line with GDP. The annual growth rate
from 1999 to 2007 was 2.5 per cent for GDP, but only 1.9 per cent for
household disposable income. In the future, the growth rate of household disposable income may well be lower. We may indeed be flat-lining, particularly
when account is taken of population growth, not allowed for in the chart.
In emphasizing the longer-term fiscal problem, rather than the immediate
crisis, I am following in the footsteps of Joseph Schumpeter in his essay ‘Die
Krise des Steuerstaates’ (‘The crisis of the tax state’). Writing at the end of the
First World War, he argued that it was not the case that ‘an otherwise perfectly healthy tax state had suddenly become impossible owing to the world
war and its aftermath’ (1991, page 101). He goes on to refer to ‘a much more
basic inadequacy of the particular society whose fiscal expression the tax state is’
(page 101). What is the source of this more basic inadequacy? As I have
argued, household disposable incomes cannot be expected to continue to rise
in line with GDP. This is the case for well-known reasons. In part this arises
for life-cycle reasons – at both ends of the age spectrum. Resources are
required to meet the ageing of the population, where, even with longer
working lives, there is going to be a larger dependent population. Resources
are essential for investment in education for young people. At the same time,
there is the need for expenditure in facing the challenge of climate change and
environmental degradation – either now or soon. And, perhaps less widely
recognized, we need to build up social net worth. In recent decades, the state,

at least in the UK, has financed its tax cuts by running down the net worth of
the state. This can no longer be continued, and indeed I believe that the state
needs once more to establish a positive net worth position.
All of these claims on our resources need to be taken into account in
designing austerity programmes – and medium-term fiscal policy. How does
public economics help us think about these issues? What are the lessons that
may be drawn? Can one indeed learn anything? Some people – like the Spanish
football manager, Vicente del Bosque, do not believe that economists have
anything useful to say. According to him, ‘no one knows anything about economics. It’s the great lie of the economists. By contrast in football people might
have contrasting opinions, each of which has some validity. But the economists
always speak in conditionals – what a mess’ (interview in the Guardian, 8 September 2012). I hesitate to take issue with a celebrated football manager, but I
believe that he is wrong with regard to economics. As I have already explained
in the Preface, I believe in a more modest role for economists. Conditionals are
precisely what economists should be offering; they should not be making
decisions but spelling out the alternatives. And there are alternatives.


6

A. B. Atkinson

1.3 There are alternatives
The first lesson is that there are choices to be made. Austerity programmes
are often presented as though there is no substitute. Mrs Thatcher in Britain
famously used the phrase ‘there is no alternative’, and this has been much
echoed in recent years by politicians in many countries. But the function of
economists, in my view, is to make clear that there are alternatives.
Of course, our choices are limited. The government is constrained by its
budget constraint. Revenues have to cover the cost of government spending
and the excess of debt interest over the increase in the debt. On account of the

economic crisis, the choices have become more limited. The automatic stabilization has come at a price in terms of the government budget, leading to
lower revenues and to increased transfer payments. The rescue of banks was
financed by an increase in public debt. Slower growth rate meant that less
new debt could be issued without raising the debt to GDP ratio. The most
straightforward argument for austerity programmes is therefore that the government’s budgetary position has worsened. This is an age-old argument. In
what used to be the standard UK public finance textbook, Pigou said that,
after a war, ‘certain government expenditures, which it used to be worthwhile
to undertake, a country may no longer be able to “afford”’ (1947, page 32).
This is a genuine ‘austerity’ argument for cuts in public spending.
What though does austerity imply? The most obvious answer is that we
have to reverse some of the increases that took place as the economy grew in
the past. The revenue constraint becoming tighter implies a combination of
tax rises (reducing private spending) and government spending cuts. ‘Affordability’ would imply returning along the previous expansion path, as illustrated in Figure 1.2 by the dashed arrow. This would involve something like
the 45/55 ratio shown in the figure, where 45 per cent of the cut would fall on
government spending and 55 per cent on private consumption (via increased
taxes on incomes and spending). However, the austerity packages introduced
in many countries have usually focused more on reducing government spending
than on reducing private spending. The typical response in OECD countries has
been more like 75 per cent public spending cuts and 25 per cent tax rises. This is
illustrated in Figure 1.2 by the heavy arrow. The path chosen by the UK is particularly steep, with the fiscal adjustment loaded on cuts in public spending. The
Office for Budget Responsibility (2013) forecasts in 2013 showed the ratio of
taxes to GDP as broadly constant for the period 2011 to 2017 but the ratio of
managed public spending to GDP as falling by some 5 percentage points.
Why has an adjustment path been chosen that loads the austerity measures
heavily on the side of cuts in government spending? One can understand that
there may be short-term reasons why it is easier to make urgent adjustments
to spending and that some stability in taxation is desirable. There has been
a – much debated – macro-economic proposition that spending cuts are more
effective in securing fiscal re-adjustment. But we are talking here about
medium-term policies – over some five years or more. Why not simply move

Public economics and austerity

7

Government
spending

Typical 45/55 overall ratio

Expansion path

75/25 ratio for cuts via
austerity programmes

Private spending

Figure 1.2 Alternative routes for austerity

back down the expansion path? The point I wish to stress there is that this is
a choice. A variety of arrows can be followed in Figure 1.2, as illustrated by
the lighter lines. The choice of austerity programmes concentrated on spending reductions must reflect other reasons. Has there, for example, been a shift
in preferences against public spending? Are austerity programmes being used
as a means for scaling back the size of the state? Or is government spending
seen as redistributive and there has been a shift against redistribution? Whatever
the underlying agenda, it needs to be made explicit. We need a reasoned case.
What is more, there are evident choices within the categories of spending
and taxation. We can cut current spending or we can cut government capital
investment. We can cut spending on goods and services or can cut transfers. If

it is spending on goods and services, then there are many acute choices.
Should we scale back services for the elderly, like home help, or services for
the young, like youth training? On the tax side too there are many options,
and it is to these that I now turn.

1.4 Choices for taxes
Just as there is a choice regarding the balance between spending cuts and tax
rises, so too the form of taxation offers a range of possibilities. Public

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A. B. Atkinson

economic analysis can help us in considering the options, but it is essential to
recognize that the answers obtained depend crucially on (1) the range of
instruments considered and (2) the underlying model of the economy and the
(often implicit) economic assumptions. These two points are the principal
subject of this section.
Range of instruments
In order to illustrate the way in which the choice of taxes depends on the
range of instruments, I take the example of the age-old question of the balance between direct and indirect taxation. This is a much discussed issue in
public finance, although you may wonder why. After all, it makes little difference whether the government reduces your take-home pay through an
income tax or reduces what you get for it through a value added tax. There
are, however, two differences. The first is that the income tax can be made
progressive, so that better-paid people pay more on an extra €1,000 than less
well-paid people, whereas a shopkeeper does not ask you about your income
before deciding what rate of VAT to charge. The second is that the income

tax is the same however you spend your income, whereas VAT can be levied
at different rates, so it can be set to zero on food or children’s clothing. Does
this mean that income taxes should be directed at equity goals and indirect
taxes at raising revenue efficiently? The answer is ‘no’, as we can see by considering the optimal role of indirect taxes under different assumptions about
the scope for direct taxes – see Table 1.1.
To begin with, let us consider the situation where no income tax is possible
and indirect taxes are expected to do all the work. Then the design of the tax
structure has to balance both equity and efficiency objectives. In loose terms,
one wants on equity grounds to tax more heavily goods and services that are
luxuries, and on efficiency grounds to tax more heavily goods and services
that do not respond much to taxation (their demand is inelastic). These may
point in opposite directions and a balance has to be struck.
But if one allows the simplest direct tax, which is a uniform poll tax, then
the role of indirect taxes changes. Apart from migration in and out of the
country, the poll tax does not affect behaviour – it is purely lump sum. From
Table 1.1 Optimal indirect tax structure under di erent
ff assumptions about the
possibilities for direct taxation
Assumption about direct taxes

Optimal indirect tax

1. No direct taxes
2. Uniform poll tax

Balances efficiency and equity
Ensure equity (e.g. exempt food), since poll
tax = most efficient way to raise revenue
(leaving aside externalities)
Under certain conditions of separability,

and absence of externalities, uniform
indirect tax, since equity ensured by direct tax

3. Fully variable non-linear direct tax


Public economics and austerity

9

an efficiency point of view, this is how revenue should be raised. A government concerned solely with efficiency should not employ indirect taxes but
use the simplest of direct taxes. As was recognized by Adam Smith, ‘in
countries where the ease, comfort and security of the inferior ranks of people
are little attended to, capitation taxes are very common’ (Smith, 1904 (1776),
page 482). It is only if the government is concerned about equity that it
should use indirect taxes, which have a higher efficiency cost, since they distort consumer choices. By raising revenue from indirect taxes on luxuries and
reducing the poll tax, the government is benefitting the poorer households, as
it will if it sets a zero rate for goods that they consume more than proportionately. It is distributional concerns that are central. In many areas of
economics it is assumed that all consumers are identical – much of macroeconomic theory is based on the assumption of identical representative
agents – but such an assumption would make no sense in public finance. The key
issues in public finance arise only when we allow for the fact that people have
different capacities to pay, as is assumed here.
If we go further, and allow for a general non-linear income tax, with rates
that vary over different tranches of income, then this allows us to achieve
more redistribution. Indeed, under certain conditions (set out in Atkinson and
Stiglitz, 1976 – see Box 1.1), it allows us to achieve all the desired redistribution, and there is no need to use indirect taxes for equity objectives. The earlier result is over-turned: a uniform rate of indirect tax is optimal. One caveat
which is entered is that efficiency may require taxes to be levied, or subsidies
paid, on goods and services that are socially costly or beneficial – or so-called
externalities. This matters and the notion of externalities has a wider
pertinence to which I return.

Box 1.1 The Atkinson–Stiglitz theorem
Individuals are assumed to differ only in their wage rate per hour. They
maximize utility derived from the consumption of n goods (x1, … xn) and
leisure, denoted by x0. There are no external effects. The government
observes individual incomes and can apply a non-linear income tax, in
addition to indirect taxes. The government maximizes an additive function of
individual utilities subject to raising a specified revenue. The AtkinsonStiglitz theorem (Atkinson and Stiglitz, 1976) states that if the utility function
is weakly separable in leisure and goods (so that it may be written as U[f(x1,
… xn), x0]), then optimal commodity taxes should be uniform regardless of
the form of the function f().
As has been shown by Konishi (1995), Laroque (2005), and Kaplow (2006),
the result can be extended in an important direction. They have shown that,
even if the non-linear income tax is not optimally chosen, a move from a
differentiated to a uniform indirect tax can be Pareto-improving if accompanied
by a suitable adjustment of the income tax schedule.


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A. B. Atkinson

The result shown in the bottom right hand corner of Table 1.1 is one of the
considerations that underpin the proposal to move to a broader base for the
VAT and, in particular, to do away for zero rates of tax, such as those for
food. In the UK, VAT is not paid at present on food, children’s clothing, and
other items such as books. (In Austria, there is a reduced rate at 10 per cent
for food and books.) This has led the recent review of UK taxation – the
Mirrlees Review – to propose bringing these within the tax net. Since the
immediate response is that this will hit those on low incomes, they plan to

use more than half the revenue to raise the income tax threshold and to
increase income-tested transfers (and adjust tax rates). The Mirrlees Review
concludes that the overall package would be both redistributive and raise an
additional £10 billion (0.7 per cent of GDP), or to double the contribution of
increased taxation to deficit reduction. The package would shift the balance
back towards taxes. The report presents evidence showing that the bottom
four decile groups would gain in terms of real income and that the top six
groups would lose (Mirrlees, 2011, Figure 9.5).
Underlying economic assumptions
There are, however, serious questions to be asked about this application of
economic analysis and its empirical implementation. Most importantly, it
assumes that the effect of the imposition of VAT at 20 per cent is to raise
prices by 20 per cent. The Mirrlees Review states explicitly (although only in
a footnote) that ‘it is assumed that the incidence of the VAT reform is fully on
retail prices’ (2010, page 301n). Such an assumption is valid where there is
perfect competition and constant costs of production, but ceases to be so
when these conditions do not hold. Whether the tax is fully passed on to
the consumer – no more, no less – depends on the decisions of retailers,
wholesalers, and manufacturers. Here one must question the underlying view
of the economy. The analysis assumes a competitive exchange (Arrow–
Debreu economy), where everyone is a price-taker. In reality, many markets
are imperfectly competitive, and much of the economics of industrial
organization is concerned with price-setting rather than price-taking behaviour.
Imperfect competition may be associated with either under- or over-shifting
of the tax, and in the latter case it is possible that profits may actually
increase with the tax rate, as has been shown by Seade (1985). (For further
references, see Myles (1995, pages 361–63).) Indeed, there are some reasons to
suppose that oligopolistic firms will raise their price by more than the tax.
Certainly, the extension of VAT to food may serve as a signal for a co-ordinated
round of margin increases, in which case the loss to poorer consumers may be

larger than assumed in the calculations cited above. It is also the case that the
existence of imperfect competition affects the optimum tax analysis. This has
been demonstrated by, among others, one of the authors of the Mirrlees
Review, Gareth Myles. He showed (Myles, 1989) that the conditions for
optimal indirect taxation now include terms which depend on the degree of


Public economics and austerity

11

shifting, and how it varies across industries, and on the extent to which profits
are taxed. As had been pointed out by Austin and Joan Robinson at the time
of the monopolistic competition revolution (Robinson, 1933), the tendency
for imperfectly competitive firms to charge more than marginal cost creates a
distortion that leads to households consuming less than they otherwise would.
This distortion can be corrected by a subsidy – that is, taxing the good less.
The situation is just like that of an externality, which is why I highlighted this
aspect earlier. As explained by Auerbach and Hines, the condition for an
optimal tax on an imperfectly competitive industry ‘carries precisely the
interpretation offered by Sandmo for the [optimal] tax conditions in the presence of externalities. Intuitively, the “externality” in the case of imperfect
competition is the outcome of the oligopolistic output selection, resulting in
the extra mark-up’ (2003, page 15). (The reference is to Sandmo, 1975.) The
necessary corrective terms have been derived in a model of monopolistic
competition by Reinhorn, who notes that ‘major policy errors could occur if
one uses the familiar tax rule for the perfectly competitive case when the
economy is actually imperfectly competitive’ (2012, page 225).
Seen this way, externalities are much more widespread than the case of the
excises on alcohol, tobacco, and petrol. In the real world, they arise, to differing degrees, across many industries. In the Mirrlees Review, the issue is
mentioned only in a footnote on page 156 of the Report, to be dismissed. In

my view, this is too hasty. Imperfect competition seems particularly relevant
to the case of one of the industries most affected by the expansion of the VAT
base, which is the food industry. As is well known, food retailing is dominated
by a small number of giant supermarket chains. In the UK in July 2013, the
percentage market shares were 30.1 (Tesco), 17.0 (Asda), 16.5 (Sainsbury’s),
and 11.7 (Morrisons) (website of Grocery News, September 2013). Threequarters of the market is supplied by four firms. This means that we need a
model of tax incidence with imperfect competition. It is also possible that the
increase in tax may be shifted backward. Supermarkets are well known for
driving a hard bargain with their suppliers, and it is possible the pressure will
be increased, reducing incomes. What is more, there may be “waterbed
effects”. Where the supermarkets put more pressure on their suppliers, the
suppliers in turn may seek to recoup some of the loss by raising the price that
they charge to independent retailers. This in turn may drive out some of the
few remaining independent shops, hence increasing still further the degree of
market concentration.
For these reasons, the extension of VAT to food may not be so evidently a
good way forward. How then could we raise revenue? One possibility that has
been canvassed is a luxury rate of VAT. In addition to the current UK standard rate of 20 per cent, we could levy a luxury rate at 30 per cent on certain
items. This appears to fly in the face of the theoretical results cited earlier
(Table 1.1), since it would increase the degree of differentiation of the VAT. It
moves in the opposite direction from the view that equity can be achieved by
direct taxes. However, we have just seen that we need to take account of


12

A. B. Atkinson

imperfect competition and of the additional terms that this introduces into
the optimal tax equations. Moreover, there is a further limitation of the

underlying analysis, which is that it focuses on just one dimension of distributional difference – earning power. There are other sources of inequality
such as inherited wealth. These will be discussed further in Chapter 2, but
they mean that we have to consider whether luxury rates of VAT may be
necessary on distributional grounds to catch the inequality resulting from
consumption financed from inherited wealth. This was indeed one of the key
arguments for a progressive expenditure tax advanced by Nicholas Kaldor in
his well-known polemic: ‘the real inequities of the system arise not so much
from the failure to exempt savings out of “income”, but the failure to tax as
“income” the spending power that is exercised through “dissavings” (or
spending out of capital)’ (Kaldor 1955, page 14).
Taxes are one side of the government budget, and I have argued that we
need to re-assess the possibilities of seeking additional revenue to meet the
medium-term fiscal challenge. But what about debt and spending?

1.5

Debt and spending: inter-generational choices

Much of the rhetoric of fiscal consolidation is concerned with the national
debt as a burden on future generations. Austerity programmes are defended
on the grounds that we need to reduce the debt passed on to the future. Many
years ago, President Eisenhower said that ‘I do not feel that any amount can
be properly called a “surplus” as long as the nation is in debt. I prefer to
think of such an item as “reduction on our children’s inherited mortgage”’
(State of the Union Message, January 1960). President Eisenhower was right
in one respect, even if he was wrong in another.
Where he was wrong is in focusing solely on the national debt. Just as I
have argued in the case of taxes, we have to consider the whole range of
instruments. In addition to the national debt, we also pass on to our children:







Pension liabilities
Public financial assets
Public infrastructure and real wealth
Private wealth
The state of environment and stocks of natural resources.

This was indeed well illustrated by President Eisenhower himself when, in his
next, and last, State of the Union Message in 1961, he recorded proudly that
he had been responsible for the ‘largest public construction programme in
history’ (the Interstate Highway System) and many other major public
investments. The children and grandchildren are driving along those roads
today. Indeed, one could argue that it is the real values – the roads, schools,
and stocks of minerals – that matter, and that the national debt is simply an