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

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82 Volume13 N°1 2008 EIB PAPERS ABSTRACT This paper discusses alternative ways of defining and measuring the marginal economic cost of public funds and reviews empirical cost estimates – including estimates for EU countries. Moreover, it illustrates how the economic cost of public funds should be accounted for in cost-benefit analyses of government expenditure, notably on public infrastructure, and how the cost-benefit assessment changes if user fees contribute to the financing of infrastructure services. The paper also clarifies why the economic cost of public funds must not be confused with the social discount rate, social opportunity cost, and the interest rate on government debt. In this context, the paper discusses how government borrowing – that is, taxing later in lieu of taxing now – affects the cost-benefit assessment. Armin Riess (a.riess@eib.org) is Deputy Head of the Economic and Financial Studies Division of the EIB. The paper has benefited greatly from comments by Atanas Kolev, Eric Perée, Hubert Strauss, and Timo Välilä. The views expressed are strictly personal.
The economic cost of public funds in infrastructure investment The art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest amount of hissing. Jean Baptiste Colbert 1. Introduction To finance their expenditures, governments must raise taxes now – or later in case they borrow to pre-finance expenditures. Each euro raised imposes a burden of one euro on taxpayers as their opportunities to spend are cut by one euro. This burden constitutes an opportunity cost – a concept at the heart of economics, categorically expressed by Nobel laureate Kenneth Arrow (1974, p. 17) as “… this or that, not both. You can’t do both.” But when funds are withdrawn from the private sector through taxation, there is more to consider than merely a one-to-one opportunity cost. Virtually all taxes – taxes on wage income, interest income, and consumption, for instance – are distortionary in the sense that they drive a wedge between the prices relevant for the supply side of markets and those relevant for the demand side. As a result, economic activity falls below the level that would materialize in the absence of distortionary taxation. This decline in activity constitutes an excess burden that comes on top of the burden of taxation, implying that the economic cost of raising one euro is larger than one euro. This has considerable implications for the cost-benefit comparison of government expenditure, effectively making less expenditure worthwhile compared to a situation without excess burden. That said, spending tax revenue might have effects that work against this negative impact on government expenditure. To be clear, one should not think of effects related to the direct expenditure benefits. As for them, an intuitively reasonable expectation is that they should amount to at least one euro for each euro of tax revenue raised. Rather, government expenditure could have effects that essentially counterbalance the excess burden of taxation, that is, the reason why the economic cost of public funds is larger than one in the first place. More specifically, given the nature of the excess burden, one needs to think of effects that boost the economic activity hampered by distortionary taxes. For instance, consider an increase in wage taxes to raise finance for transport infrastructure. Better infrastructure might increase the supply of labour. If it does, it counters the decline in supply caused by an increase in distortionary wage taxes. Or, imagine a specific tax on TV sets is increased to finance a new public TV channel. The availability of an additional – presumably high-quality – channel might increase the demand for taxed TV sets, thereby boosting the production of TV sets – an activity curbed by the specific tax. There are thus two opposing forces. On the one hand, distortionary taxes create an excess burden, raising the economic cost of public funds above the forgone opportunities due to transferring one euro from taxpayers to the government. Costs understood in this way depend on the type of tax since the excess burden is unlikely to be same for all taxes. On the other hand, the expenditure made possible by tax revenue might, in addition to generating direct benefits, boost activities that taxation reduces. One could consider this simply an indirect benefit that cost-benefit analyses of government expenditure need to account for. Alternatively, one could see this as a reason for redefining the economic cost of public funds. In this case, the economic cost of funds would depend not only on the type of tax imposed but on the type of expenditure, too, making the cost of funds expenditure specific – as the reference to infrastructure investment in the title of this paper suggests. Obviously, alternative ways of defining the economic cost of public funds do not change the economics of the expenditure examined. Yet, for applied expenditure and project appraisal there is a challenge: Analysts need to know whether the empirical estimate of the economic cost of public funds they use rests on the first (conventional) definition, considering just the excess burden of taxation, or the Armin Riess EIB PAPERS Volume13 N°1 2008 83
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Preface This year the European Inve
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Infrastructure investment, growth a
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Government investment is not the sa
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Different types of government inves
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Infrastructure accounts for one-thi
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Page 130 and 131: Despite progress, infrastructure de
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EU funds provide additional resourc
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Various empirical studies confirm t
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In some new member states there is
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PPPs offer new opportunities to fin
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Strong legal and institutional fram
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Additional fiscal reporting - even
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Fiscal adjustment and reforms need
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EIB Papers Volume 13. n°1/2008 - European Investment Bank

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