Lindahl tax

A Lindahl tax is a form of taxation in which individuals pay for the provision of a public good according to their marginal benefits. So each individual pays according to his/her marginal benefit derived from the public good. e.g. If A loves scenic beauty and likes to be close to nature he might be ready to pay 5 dollars per day for sitting in a park, whereas a housewife who does not visit the park very often will not be ready to pay so much, but might agree to pay 1 dollar. So a person who values the good more pays more. Lindahl taxes are sometimes known as benefit taxes. A Lindahl equilibrium is a state of economic equilibrium under such a tax. Individuals in a society have different preferences based on their nature, personal choice etc. So an individual's willingness to pay for a public good is a function of many factors, like income, preference etc. So a student will want to pay just 1 dollar for entering a museum but a business man will be ready to pay 10 dollars for the same museum. So in such cases the problem of supply of the public good, at optimal levels arises. Lindahl taxation is a solution for this problem. [1]

Definition
A Lindahl tax is an individual share of the collective tax burden of an economy.[2] The optimal level of a public good is that quantity at which the willingness to pay for one more unit of the good, taken in totality for all the individuals is equal to the marginal cost of supplying that good. Lindahl tax is the optimal quantity times the willingness to pay for one more unit of that good at this quantity.[3]

Lindahl equilibrium
A Lindahl equilibrium is a method for finding the optimum level for the supply of public goods or services.This idea was given by Erik Lindahl in 1919. The Lindahl equilibrium happens when the total per-unit price paid by each individual equals the total per unit cost of the public good. The Lindahl equilibrium is Pareto efficient and it can be proved that an equilibrium exists for different environments.[4] Lindahl equilibrium describes how efficiency can be sustained in an economy with personalised prices. Johansen (1963) gave the complete interpretation of the concept of "Lindahl Equilibrium." The basic assumption of this concept is that every household's consumption decision is based on the share of the cost they must provide for the supply of the particular public good.[5] The importance of Lindahl Equilibrium is that it fulfills the Samuelson rule and is therefore said to be pareto efficient, despite the existence of public goods. It also demonstrates how efficiency can be reached in an economy with public goods by the use of personalised prices. The personalised prices equate the individual valuation for a public good to the cost of the public good.[6]

Background

Erik Lindahl was deeply influenced by his professor and mentor Knut Wicksell and proposed a method for financing public goods in order to show that consensus politics is possible. As people are different in nature, their preferences are different, and consensus requires each individual to pay a somewhat different tax for every service, or good that he consumes. If each person's tax price is set equal to the marginal benefits received at the ideal service level, each person is made better off by provision of the public good and may accordingly agree to have that service level provided.

Problem with Lindahl taxation

Lindahl pricing and taxation requires the knowledge of the demand functions for each individual for all private and public goods.When information about marginal benefits is available only from the individuals themselves, they tend to under report their valuation for a particular good, this gives rise to a "preference revelation problem." Each individual can lower his tax cost by under reporting his benefits derived from the public good or service. This informational problem shows that survey-based Lindahl taxation is not incentive compatible. Incentives to understate or under report one's true benefits under Lindahl taxation resemble those of a Prisoner's dilemma, and people will be inclined to under report their demands for the public goods or service. Preference revelation mechanisms can be used to solve that problem, although none of these have been shown to completely address the problem. Among others the VickreyClarkeGroves mechanism is an example of this, ensuring true values are revealed and that a public good is provided only when it should be.[7] The allocation of cost is taken as given and the consumers will report their net benefits (benefits-cost). The public good will be provided if the sum of the net benefits of all consumers is positive. If the public good is provided side payments will be made reflecting the fact that truth telling is costly. The side payments internalize the net benefit of the public good to other players. The side payments must be financed from outside the mechanism. In reality these preference revelation mechanisms are difficult to implement as the size of the population makes it costly both in terms of money and time.[8]

Demand Revelation
The concept of demand revelation was developed by Edward Clarke, and further by Nicolaus Tideman and Gordon Tullock. It uses economics principles to make efficient social choices. Individuals who manipulate their outcomes, create a social cost:

by creating a situation in which the people have to pay more than what they want, or by not having the supply of a good that they are willing to pay more for. By paying this social cost, they compensate society for getting their way.[9]

The Demand Revelation theory uses the Clarke tax or pivot mechanism, to ensure that individuals will consider the fact that their choices have a social cost on the social outcome, thus ensuring that they truthfully reveal their preferences,and hence overcoming the free rider problem of public goods provisioning. [10]

Lindahl tax and Pareto optimality

A very important question is that whether a Lindahl tax is a Pareto Optimal equilibrium? A Pareto Optimal allocation happens with public goods when the total of the marginal rates of substitution (MRS) equals the marginal rate of transformation (MRT). So if it can be shown that this holds true in a Lindahl equilibrium, it can be conveniently said that it is Pareto Optimal. This can be shown by following the following steps:

X's demand curve We take a demand curve for a public good. The less the price of the public good, the more will X want to consume. Let the horizontal line (dashed) be the full price of the public good. Now here, the demand curve implies that X will demand very less. But what if instead of the price decreasing, the percentage of the price X has to pay decreases? Now X sees the price going down, so his demand for the good increases. Now lets consider the demand curve of another person, lets say Y. Y sees the vertical axis turned the other way around, with the full price on the bottom and percentage decreasing as you move upwards. Like X, Y will also demand more as his observed price goes down. [15]

Y's demand curve

Now as Y observes the price going down it also means that we move further up the vertical axis. Equilibrium is when both X and Y demand the equal amount of the good. This is possible only when the demand curves of both X and Y intersect each other. If a line is drawn over the price axis from that point of intersection, we get the percentage share for each person that is required to get that price. [15] In the Lindahl tax scheme it is essential that the system should provide for a pareto optimal output of the public good. The other important condition is that the Lindahl tax scheme should connect the tax paid by an individual to the benefits he derives. This system kind of promotes justice. If the individual's tax payment is equivalent to the benefits received by him, and if this linkage is good enough then it leads to Pareto Optimality.[16]

Public good
In economics, a public good is a good that is non-rivalrous and non-excludable. Non-rivalry means that consumption of the good by one individual does not reduce availability of the good for consumption by others; and non-excludability means that no one can be excluded effectively from using the good.[1] In the real world, there may be no such thing as an absolutely nonrivalrous and non-excludable good; but economists think that some goods approximate the concept closely enough for the analysis to be economically useful. Public goods have two distinct aspects: nonexcludability and nonrivalrous consumption. Nonexcludability means that the cost of keeping nonpayers from enjoying the benefits of the good or service is prohibitive. If an entrepreneur stages a fireworks show, for example, people can watch the show from their windows or backyards. Because the entrepreneur cannot charge a fee for consumption, the fireworks show may go unproduced, even if demand for the show is strong. For example, if one individual visits a doctor there is one fewer doctor's visit for everyone else, and it is possible to exclude others from visiting the doctor. This makes doctor visits a rivaled and excludable private good. Conversely, breathing air does not significantly reduce the amount of air available to others, and people cannot be effectively excluded from using the air. This makes air a public good, albeit one that is economically trivial, since air is a free good. A less straightforward example is the exchange of MP3 music files on the internet: the use of these files by any one person does not restrict the use by anyone else and there is little effective control over the exchange of these music files and photo files. Non-rivalness and non-excludability may cause problems for the production of such goods. Uncoordinated markets driven by self-interested parties may be unable to provide these goods in optimal quantities, if at all. There is a good deal of debate and literature on how to measure the significance of public goods problems in an economy, and to identify the best remedies. These debates are highly relevant to political arguments about the role of markets in the economy. While it does not follow that because markets will not spontaneously provide pure public goods, the state should do so, it may well be that if some public agency does not provide them, they will simply not be provided at all, notwithstanding effective demand for them. Public goods problems are also closely related to externalitiescomplex multilateral externalities are typically accompanied by the same "free-rider" problem that occurs with non-rival, non-excludable goods and services.

Aggregate demand (MB) is the sum of individual demands (MBi)

Graphically, non-rivalry means that if each of several individuals has a demand curve for a public good, then the individual demand curves are summed vertically to get the aggregate demand curve for the public good . This is in contrast to the procedure for deriving the aggregate demand for a private good, where individual demands are summed horizontally.

Terminology, and types of goods

Paul A. Samuelson is usually credited as the first economist to develop the theory of public goods. In his classic 1954 paper The Pure Theory of Public Expenditure,[2] he defined a public good, or as he called it in the paper a "collective consumption good", as follows: ...[goods] which all enjoy in common in the sense that each individual's consumption of such a good leads to no subtractions from any other individual's consumption of that good... This is the property that has become known as Non-rivalry. In addition a pure public good exhibits a second property called Non-excludability: that is, it is impossible to exclude any individuals from consuming the good. The opposite of a public good is a private good, which does not possess these properties. A loaf of bread, for example, is a private good: its owner can exclude others from using it, and once it has been consumed, it cannot be used again. A good which is rivalrous but non-excludable is sometimes called a common pool resource. Such goods raise similar issues to public goods: the mirror to the public goods problem for this case is sometimes called the tragedy of the commons. For example, it is so difficult to enforce restrictions on deep sea fishing that the world's fish stocks can be seen as a non-excludable resource, but one which is finite and diminishing. Excludable Non-excludable

Rivalrous

Private goods food, clothing, cars, personal electronics Club goods cinemas, private parks, satellite television

Common goods (Common-pool resources) fish stocks, timber, coal Public goods free-to-air television, air, national defense

Non-rivalrous

The definition of non-excludability states that it is impossible to exclude individuals from consumption. Technology now allows radio or TV broadcasts to be encrypted such that persons without a special decoder are excluded from the broadcast. Many forms of information goods have characteristics of public goods. For example, a poem can be read by many people without

reducing the consumption of that good by others; in this sense, it is non-rivalrous. Similarly, the information in most patents can be used by any party without reducing consumption of that good by others. Creative works may be excludable in some circumstances, however: the individual who wrote the poem may decline to share it with others by not publishing it. Copyrights and patents both encourage and inhibit the creation of such non-rival goods by providing temporary monopolies, or, in the terminology of public goods, providing a legal mechanism to enforce excludability for a limited period of time. For public goods, the "lost revenue" of the producer of the good is not part of the definition: a public good is a good whose consumption does not reduce any other's consumption of that good.[3]

Debate has been generated among economists whether such a category of "public goods" exists. Steven Shavell has suggested the following: ...when professional economists talk about public goods they do not mean that there are a general category of goods that share the same economic characteristics, manifest the same dysfunctions, and that may thus benefit from pretty similar corrective solutions...there is merely an infinite series of particular problems (some of overproduction, some of underproduction, and so on), each with a particular solution that cannot be deduced from the theory, but that instead would depend on local empirical factors.
[4]

The economic concept of public goods should not be confused with the expression "the public good", which is usually an application of a collective ethical notion of "the good" in political decision-making. Another common confusion is that public goods are goods provided by the public sector. Although it is often the case that Government is involved in producing public goods, this is not necessarily the case. Public goods may be naturally available. They may be produced by private individuals and firms, by non-state collective action, or they may not be produced at all.[citation needed] The theoretical concept of public goods does not distinguish with regard to the geographical region in which a good may be produced or consumed. However, some theorists (such as Inge Kaul) use the term global public good to mean a public good which is non-rival and nonexcludable throughout the whole world, as opposed to a public good which exists in just one national area. Knowledge has been held to be an example of a global public good.[5]

Social goods
Social goods are defined[by whom?] as public goods that could be delivered as private goods, but are usually delivered by the government for various reasons, including social policy, and funded via public funds like taxes. Note: Some writers have used the term public good to refer only to non-excludable pure public goods. They may then call excludable public goods club goods.[6]

Examples

Common examples of public goods include: defense, public fireworks, lighthouses, clean air and other environmental goods, and information goods, such as software development, authorship, and invention. Some goods (such as orphan drugs) require special governmental incentives to be produced, but can't be classified as public goods since they don't fulfill the above requirements (Non-excludable and non-rivalrous.) Law enforcement, streets, libraries, museums, and education are commonly misclassified as public goods, but they are technically classified in economic terms as quasi-public goods because excludability is possible, but they do still fit some of the characteristics of public goods.[7] The provision of a lighthouse has often been used as the standard example of a public good, since it is difficult to exclude ships from using its services. No ship's use detracts from that of others, but since most of the benefit of a lighthouse accrues to ships using particular ports, lighthouse maintenance fees can often profitably be bundled with port fees (Ronald Coase, The Lighthouse in Economics 1974). This has been sufficient to fund actual lighthouses. Technological progress can create new public goods. The most simple examples are street lights, which are relatively recent inventions (by historical standards). One person's enjoyment of them does not detract from other persons' enjoyment, and it currently would be prohibitively expensive to charge individuals separately for the amount of light they presumably use. On the other hand, a public good's status may change over time. Technological progress can significantly impact excludability of traditional public goods: encryption allows broadcasters to sell individual access to their programming. The costs for electronic road pricing have fallen dramatically, paving the way for detailed billing based on actual use. There is some question as to whether defense is a public good. Murray Rothbard argues, "'national defense' is surely not an absolute good with only one unit of supply. It consists of specific resources committed in certain definite and concrete waysand these resources are necessarily scarce. A ring of defense bases around New York, for example, cuts down the amount possibly available around San Francisco."[8] Jeffrey Rogers Hummel and Don Lavoie note, "Americans in Alaska and Hawaii could very easily be excluded from the U.S. government's defense perimeter, and doing so might enhance the military value of at least conventional U.S. forces to Americans in the other forty-eight states. But, in general, an additional ICBM in the U.S. arsenal can simultaneously protect everyone within the country without diminishing its services."[9]

The free rider problem

Public goods provide a very important example of market failure, in which market-like behavior of individual gain-seeking does not produce efficient results. The production of public goods results in positive externalities which are not remunerated. If private organizations don't reap all the benefits of a public good which they have produced, their incentives to produce it voluntarily might be insufficient. Consumers can take advantage of public goods without contributing sufficiently to their creation. This is called the free rider problem, or occasionally, the "easy rider problem" (because consumers' contributions will be small but non-zero). If too many consumers decide to 'free-ride', private costs exceed private benefits and the incentive to provide the good or service through the market disappears. The market thus fails to provide a good or service for which there is a need.[10]

The free rider problem depends on a conception of the human being as homo economicus: purely rational and also purely selfishextremely individualistic, considering only those benefits and costs that directly affect him or her. Public goods give such a person an incentive to be a free rider. For example, consider national defense, a standard example of a pure public good. Suppose homo economicus thinks about exerting some extra effort to defend the nation. The benefits to the individual of this effort would be very low, since the benefits would be distributed among all of the millions of other people in the country. There is also a very high possibility that he or she could get injured or killed during the course of his or her military service. On the other hand, the free rider knows that he or she cannot be excluded from the benefits of national defense, regardless of whether he or she contributes to it. There is also no way that these benefits can be split up and distributed as individual parcels to people. The free rider would not voluntarily exert any extra effort, unless there is some inherent pleasure or material reward for doing so (for example, money paid by the government, as with an all-volunteer army or mercenaries). The free riding problem is even more complicated than it was thought to be until recently. Any time non-excludability results in failure to pay the true marginal value (often called the "demand revelation problem"), it will also result in failure to generate proper income levels, since households will not give up valuable leisure if they cannot individually increment a good[11]. This implies that, for public goods without strong special interest support, underprovision is likely since benefit-cost analyses are being conducted at the wrong income levels, and all of the ungenerated income would have been spent on the public good, apart from general equilibrium considerations. In the case of information goods, an inventor of a new product may benefit all of society, but hardly anyone is willing to pay for the invention if they can benefit from it for free. In the case of an information good, however, because of its characteristics of non-excludability and also because of almost zero reproduction costs, commoditization is difficult and not always efficient even from a neoclassical economic point of view.[12]

A budget is a financial plan for the future concerning the revenues and costs of a business. However, a budget is about much more than just financial numbers.

Wagner's law
Wagner's law, also known as the law of increasing state spending, is a principle named after the German economist Adolph Wagner (18351917).[1] He first observed it for his own country and then for other countries. For any country the public expenditure rises constantly. It shows an upward sloping trend. The law predicts that the development of an industrial economy will be accompanied by an increased share of public expenditure in gross national product:

The advent of modern industrial society will result in increasing political pressure for social progress and increased allowance for social consideration by industry.

Wagner's law suggests that a welfare state evolves from free market capitalism due to the population voting for ever-increasing social services. Neo-Keynesians and socialists often urge governments to emulate modern welfare states like Sweden. In spite of some ambiguity, Wagner's statement in formal terms has been interpreted by Richard Musgrave as follows: As progressive nations industrialize, the share of the public sector in the national economy grows continually. The increase in State Expenditure is needed because of three main reasons. Wagner himself identified these as (i) social activities of the state, (ii) administrative and protective actions, and (iii) welfare functions. The material below is an apparently much more generous interpretation of Wagner's original premise.

Socio-political, i.e., the state social functions expand over time: retirement insurance, natural disaster aid (either internal or external), environmental protection programs, etc. Economic: science and technology advance, consequently there is an increase of state assignments into the sciences, technology and various investment projects, etc. Historical: the state resorts to government loans for covering contingencies, and thus the sum of government debt and interest amount grow; i.e., it is an increase in debt service expenditure.

Graph showing kink in increasing public expenditure in The "Peacock-Wiseman Hypothesis".[2]

The Peacock-Wiseman Hypothesis

As per the study on public expenditure for the period 1891-1955[3] in U.K. conducted by Peacock and Wiseman based on Wagners Law, it was found to be still applicable. It was further stated that:

There has been considerable increase in revenue to the governments due to the economic developments over the years, there by leading to a boost in public expenditure. The government can simply not ignore the demands that people make regarding various services, especially, when there is an increase in revenue collection at a constant rate of taxation. Further it stated that during the times of war the tax rates are increased by the government to generate more funds to meet the increase in defense expenditure. This is known as displacement effect.[4] Such 'displacement effect' is created when the earlier lower tax and expenditure levels are displaced by new and higher budgetary levels. But it remains the same even after the war as people become habituated to it. Such an increase in revenue therefore gives rise to government expenditure