EIB Papers Volume 13. n°1/2008 - European Investment Bank

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As the economic cost of public funds depends on country-specific circumstances, such as the tax regime, it is bound to vary across countries… 98 Volume13 N°1 2008 EIB PAPERS excess burden and thus increases the cost of public funds. All other things being equal, the direct benefits of a project need to be higher to ensure its economic profitability. Finally, since the economic cost of funds (whether α C or α M ) is a cost-scaling factor, it is relevant only for cost-benefit analyses, but not for cost-effectiveness analyses. Clearly, a cost-based ranking of project alternatives, meant to generate the same non-monetized benefits, does not change if all costs are scaled by the same factor. 4. Estimates of the economic cost of public funds The previous sections suggest that the economic cost of public funds is “a potentially confusing concept” (Jones 2005, p.156). Along the same lines, Håkonsen (1998, p.229) emphasizes “The literature on the marginal cost of public funds (MCF) and the excess burden is presently a very rich one. A problem with this literature is that several different measures are interpreted as MCF.” Indeed, a number of authors have tried to reconcile different estimates of the cost of public funds (Fullerton 1991; Mayshar 1990, 1991; Snow and Warren 1996; Håkonsen 1998; and Jones 2005). Against this background, the purpose of this section is threefold: First, to present Jones’ (2005) review of differences between ‘conventional’ and ‘modified’ estimates; second, to explain why estimates of the conventional cost of public funds are bound to differ across countries; and third, to report on recent estimates of the conventional cost of public funds for pre-enlargement EU countries. The review of Jones (2005) for wage taxes is reproduced in Table 1, showing that estimates range considerably, from 1 (Fullerton) to 1.57 (Stuart). That said, estimates for the United States suggest no striking difference between conventional and modified estimates. In any event, differences across countries might not be surprising for two reasons. Tax regimes and labour-market conditions vary across countries. As will be explained below, both features affect the distortionary impact of taxation. And then, the spending effect, which affects the modified cost of funds, depends, too, on labour-market conditions – more specifically the labour-supply response to public spending. As this response is probably country specific, estimates of the modified cost of funds are likely to differ from country to country. More fundamentally, commenting on the estimates of the modified cost of funds, Jones notes that “it is difficult to know the importance of the spending effect in each of them” (Jones 2005, p.170) – a lack of knowledge that seriously impairs the value of such estimates for the appraisal of specific public investment projects. Turning to reasons why the cost of public funds is likely to differ across countries, differences in tax and welfare regimes are bound to be decisive, notably differences in average tax rates, marginal tax rates, progressivity of the tax system, and unemployment benefit schemes. Differences in tax regimes combine with differences in the wage elasticity of labour supply. The excess burden of taxation and, by extension, the economic cost of public funds, is the higher the more the supply of labour reacts to a change in after-tax wages – a fact illustrated and discussed in Box 3. All other things being equal, countries with an elastic labour supply will have higher economic cost of public funds than countries with an inelastic supply. In fact, if the supply of labour is completely inelastic, an increase in the wage tax does not change labour supply and, thus, output. In this case, the conventional excess burden is zero (β C = 0) and the conventional economic cost of public funds is one (α C = 1). It follows that the modified excess burden is negative (β M < 0) and the modified economic cost of public funds is smaller than one (α M < 1) if the spending effect of the underlying government expenditure is positive, that is, boosts the supply of labour regardless of the after-tax wage.
Table 1. Estimates of the economic cost of public funds for wage taxes Conventional α C Modified α M Source: Jones (2005) Country Study Estimate United States Fullerton (1991) 1 – 1.25 Browning (1976,1987) 1.32 – 1.47 Canada Campbell (1975) 1.25 Dahlby (1994) 1.38 New Zealand Diewert and Lawrence (1996) 1.18 Australia Campbell and Bond (1997) 1.19 – 1.24 Findlay and Jones (1982) 1.275 – 1.55 United States Ballard and Fullerton (1992) 1.047 – 1.315 Ballard et al. (1985) 1.16 – 1.31 Stuart (1984) 1.07 – 1.57 There is another reason why estimates of the economic cost of public funds vary – a reason more fundamental and unrelated to differences between countries. Two types of labour-supply curves have been used to measure and estimate the excess burden. One is the so-called uncompensated, or ordinary, supply curve. It shows the actual response of households to a wage change. The other is the so-called compensated supply curve. It represents a hypothetical response, capturing only the fact that lower wages make work less attractive but ignoring that they reduce income and, thus, increase the necessity to work. Box 3 sets out in more detail the difference between both concepts and why they affect empirical estimates of the economic cost of public funds. Suffice it to emphasize here that compensated labour-supply curves are more elastic than uncompensated ones and that cost-of-funds estimates based on the former are higher than those based on the latter. 6 Knowing the essence of uncompensated labour-supply responses and elasticities, we are well prepared to review a study by Kleven and Kreiner (2006) that estimates the conventional cost of public funds for EU-15 countries. A salient feature of this study – setting it apart from most others – is that it explicitly distinguishes between two components of the aggregate labour-supply response. One reflects how employed people adjust the hours they work to a wage change; this is the intensive labour-supply response and the parameter measuring it is the uncompensated intensive supply elasticity. The other component reflects the entry and exit of people into the labour market due to a wage change; this is the extensive labour-supply response and the parameter measuring it is the participation elasticity or extensive supply elasticity. 6 Obviously, this statement applies to a wage tax. For a consumption tax, for instance, one needs to distinguish between compensated and uncompensated demand curves. The excess burden associated with the former is higher than that associated with the latter. … but differences in cost-of-funds estimates also reflect differences in definition and measurement. EIB PAPERS Volume13 N°1 2008 99
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Preface This year the European Inve
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The share of transport in governmen
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The shares of infrastructure and ho
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There have been marked differences
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