Introduction
The theory of Public goods provides a rationale for the allocation function of Public policy. Public goods exhibit the features of non-excludability and non-rivalry. In the provision of Public goods, the private market fails to utilize resources efficiently.
Public goods are also closely associated with the ‘free-rider’ problem, in which people do not pay for the good and may continue to access it, which results in under-production, overconsumption and degraded goods and hence, government intervention is required.
The problem, then, is how the government should determine how much of such goods are to be produced and allocated.
The difficulty lies in deciding the type and quality of a public good that should be supplied and how much a particular consumer should be asked to pay.
In the case of private goods, consumers pay for the benefits received, but the problem in the case of public goods is how these benefits are valued. Individual consumers have no reason to reveal to the government how highly they value public goods.
To serve as an effective mechanism of preference revelation, a voting process on tax and expenditure decisions could be taken. Voters are confronted with a choice among budget proposals which carry a price tag in terms of their own tax contribution.
However, the political mechanism is imperfect and can only approximate what would be the optimal budget choice.
To explain preference revelation, there are two theories in Public Finance literature: the Ability theory and the Benefit theory (developed by Erik Lindahl). The Benefit theory has a modern variety, which is known as the “Voluntary Exchange” theory.
Benefit Theory or Voluntary Exchange Theory
Most governments collect funds from various sources to provide public goods or to finance transfer payments. The supreme source of revenue in mixed economies is taxation.
Under the Voluntary exchange model, tax levels are determined automatically because taxpayers pay proportionately for the government benefits they receive. Putting it another way, the individuals who benefit the most from public goods pay the most taxes.
For analyzing the Voluntary exchange or Benefit theory, two models have been discussed: the Lindahl model and the Bowen model.
Read in detail below:
Applications of Benefit Principle
The benefit principle may be applied as a guide to tax-structure design in the following ways-
● A General Benefit Tax- Under benefit taxation, each taxpayer would be taxed in line with his or her demand for public goods. Since preferences differ, no general tax formula could be applied to all people.
The government can ask how much various consumers are willing to pay for the same amount. Suppose that taxpayers have the same structure of tastes so that persons with the same income value the same amount equally.
Then, people with incomes of Rs 10,000 value a given level of public goods at suppose Rs 1000. With 1000 units supplied, they would be willing to pay Rs1 per unit. With incomes of Rs 20,000, they would be willing to pay a higher price of Rs 2.
The appropriate tax formula then depends on the income and price elasticity of demand for public goods. If income elasticity is high, the appropriate tax prices will rise rapidly with income, but if price elasticity is high, the increase will be dampened.
● Specific Benefit taxes- In this case, particular services are provided on a benefit basis, and consumers are asked to pay fees, user charges or tolls.
● Taxes in lieu of Charges- At times when impositions of direct charges are costly, a tax on a complimentary product may be used in lieu of charges. For e.g., automobile taxes may be used in lieu of tolls.
● Earmarking- This means allocating revenue collected from taxes.
Ability to Pay Approach
The ability-to-pay approach treats government revenue and expenditures separately. Taxes are based on taxpayers’ ability to pay; there is no quid pro quo. Taxes paid by the taxpayers are seen as a sacrifice, which raises the issues of how much the sacrifice of each taxpayer ought to be and how it should be measured:
- Equal Sacrifice: The total loss of utility because taxation ought to be equal for all taxpayers (the rich will be taxed more heavily than the poor).
- Equal Proportional Sacrifice: The proportional loss of utility because taxation ought to be equal for all taxpayers.
- Equal Marginal Sacrifice: The instantaneous loss of utility (as measured by the derivative of the utility function) because taxation should be equal for all taxpayers. This will involve the least aggregate sacrifice (the total sacrifice will be the least).
Read More in: Theory of Public Finance
- Public Finance: Meaning, Nature & Scope
- Role of Government in Economy
- Role of Government in Mixed Economy: Public & Private Sector
- Role of Government under Cooperation and Competition
- Role of Government in Economic Development and Planning
- Concept of Public Goods, Private Goods, and Merit Goods
- Concept of Market Failure and Functions of Government
- Market Failure and Functions of Government: Decreasing Costs
- Market Failure and Functions of Government: Externalities
- Market Failure and Functions of Government: Public Goods
- Future Market: Meaning, Role & Uncertainty
- Concept of Information Asymmetry
- Theory of Second Best: Concept & Explanation
- Problem of Allocation of Resources: Public & Private Mechanisms
- Preferences: Meaning, Types & Problems of Preference Revelation
- Preference Aggregation & Its Mechanism
- Voting Systems, Direct Democracy, Representative Democracy, Leviathan Hypothesis & Arrow’s Impossibility Theorem
- Economic Theory of Democracy: Concept & Explanation
- Politico Eco Bureaucracy: Concept & Explanation
- Rent-Seeking and Directly Unproductive Profit-Seeking Activities
- Rationale for Public Goods: Concept & Explanation
- Benefit Theory or Voluntary Exchange Theory
- Lindahl Model: Concept, Equilibrium & Limitations
- Bowen Model: Concept, Advantages & Limitations
- Samuelson’s Model of Public Expenditure
- Musgrave’s Model of Public Expenditures
- Demand Revealing Schemes for Public Goods
- Vickery-Clarke-Groves Mechanism
- Groves-Ledyard Mechanism
- Tiebout Model: Concept, Assumptions Equilibrium & Simple Tiebout Model
- Theory of Club Goods
- Keynesian Principles of Stabilization Policy
- Difference Between Keynesian Economic Thought and Others
- Role of Expectations and Uncertainty in Formulating Stabilization Policy
- Intertemporal Markets Efficiency & Failure
- Liquidity Preference Theory
- Diamond-Dybvig Banking Model
- Preference Shocks, Adverse Selection & Central Bank
- Equilibrium Deposit Contract
- Social Goods and Its Effect on Stabilization Policy
- Effect of Infrastructural Facilities on Stabilization Policy
- Effect of Distributional Inequality on Stabilization Policy
- Effect of Regional Imbalances on Stabilization Policy
- Wagner’s Law of Increasing State Activities: Explanation, Graph & Criticism
- Peacock-Wiseman Hypothesis: Explanation, Graph & Criticism
- Public Expenditure: Concept, Objectives, & Public vs Private Expenditure
- Pure Theory of Public Expenditure
- Structure & Growth of Public Expenditure in India
- Trends, Lessons & Priorities in Public Expenditure in India
- Social Cost-Benefit Analysis: Project Evaluation, Estimation of Costs & Discount Rate
- Performance Based Budgeting and Zero Based Budgeting
- Theories of Tax Incidence: Concentration Theory, Diffusion Theory & Modern Theory
- Tax System and Its Principles
- Equity Principle and Efficiency Principle of Taxation: Meaning, Explanation & Examples
- Ability to Pay and Benefits Received Principle of Taxation
- Theory of Optimal Taxation: Excess Burden & Distortions of Taxation
- Deadweight Loss of Taxation: Causes, Measurement & Example
- Concept of Equity & Efficiency in Economics
- Trade-Off Between Equity and Efficiency: Meaning & Example
- Theory of Measurement of Dead Weight Loss
- Double Taxation: Meaning, Desirability, Forms & Solution
- Solution to Problem of Double Taxation: Intra-Country & International
- Double Taxation Avoidance Agreement (DTAA) and Indian Policy
- Classical View on Public Debt
- Compensatory Aspect of Public Debt Policy
- Public Debt or Borrowings: Concept, Need, Sources & Types
- Concept of Public Debt or Public Borrowings
- Need for Public Debt or Public Borrowing
- Sources of Public Debt
- Classification of Public Debt
- Burden of Public Debt: Meaning, Types & Explanation
- Debt Through Created Money or Deficit Financing
- Public Debt (Public Borrowings) and Inflation (Price Level)
- Crowding Out of Private Investment and Activity
- Principle of Public Debt Management and Debt Repayment