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

and Teal (1996), for instance. In fact, a cost-benefit analysis of a public project in such an environment
would show that its cost exceeds its benefit.
Moving on to a more pertinent benchmark, let us introduce public goods, that is, goods and services
the market fails to supply or supplies in insufficient quantities. In these circumstances, markets
do not allocate resources efficiently, and government provision of public goods can make society
better off. More specifically, increasing the supply of public goods enhances welfare as long as their
marginal benefits exceed their marginal costs. Assuming that marginal benefits fall with an increase
in public goods (and/or that marginal costs rise), the optimal level of spending on public goods is
found when marginal benefits equal marginal costs. In the absence of market failures other than the
public-goods market failure and with lump-sum taxes financing the provision of public goods, the
condition for the optimal provision of public goods is
(3) B = C,
with B indicating the direct marginal benefits of public goods and C the marginal costs of producing
them. 3 As in Section 2, a road-safety improvement project is used from here on as an example for
the provision of a public good, with B and C indicating the project’s direct benefits and its costs,
respectively.
How does the cost-benefit comparison change relative to benchmark (3) if the real-world situation
differs from the perfectly competitive setting not only because of the public-goods market failure
but because distortionary taxes are used to finance the project? The conventional approach to the
economic cost of public funds suggests that project costs need to be scaled up by the factor α C > 1
because the economic cost of one euro raised with distorting taxes is larger than one euro. This
changes the cost-benefit rule to
(4) B = α C C with α C = 1 + β C and β C ≥ 0.
Thus, due to the excess burden of taxation (β C > 0), the economic cost of the project becomes α C C > C.
It follows that the cost-benefit rule (4) requires B > C, that is, for a project to be economically viable its
direct benefit must be larger than its cost to make good for the excess burden of taxation.
To illustrate, for α C = 1.2, direct project benefits must exceed direct costs by 20 percent to ensure the
economic viability of the project. To put it differently, a road-safety improvement project costing
EUR 100 million would need to generate direct benefits of EUR 120 million. Section 4 will review
empirical estimates of the parameter α C .
Let us then consider indirect project benefits, more specifically, spending effects that boost
economic activity hampered by distorting taxes. For the wage tax and the road-safety improvement
project, the spending effect increases the supply of labour, output, and wage tax revenue. Induced
tax revenues, which measure the welfare impact of the spending effect, accrue to the government
and reduce the financing requirement for the project to C − R, with R representing the extra tax
revenue due to the spending effect. As a result, the scaling factor α C needs to be applied to project
cost and induced tax revenue, that is, the net budgetary impact of the project. The optimality
condition then becomes:
3 In essence, (3) is the Samuelson condition for the optimal provision of a public good, with B representing the aggregate
marginal willingness to pay for the public good and C representing its marginal production costs.
The conventional
approach to the
economic cost of public
funds suggests that
for a project to be
economically viable its
direct benefits must be
larger than its direct
costs.
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