The advances in the economics of the public sector during the past quarter century have been as pronounced as in any field within economics. Public finance has become a rigorous branch of applied microeconomics, incorporating the best thinking and most advanced tools of both theoretical economics and econometrics. In the remarks below, I will focus on a few key areas in applied and theoretical tax and expenditure policy, drawing both upon the academic work of myself and others, and my experiences in the policy arena, both as Chairman of the Council of Economic Advisers and as Chief Economist of the World Bank. I shall address both the questions of what we have learned in the past few decades as well as the questions where further research is needed.
One of the most significant insights — obvious from current perspectives — was the recognition that all taxes induce distortions, but that the total dead weight loss of the tax system was not minimized by minimizing the number of distortions.1 Perhaps the second most significant insight — again obvious from current perspectives — was that one could approach efficient taxation using the same concepts that economists had long used in analyzing efficient allocative mechanisms, that is pareto efficient tax structures were those such that no one could be made better off, given the technological and other constraints, without making someone else worse off. With a specified social welfare function, one could choose which among these Pareto efficient tax structures maximized social welfare.2 The third important insight was the recognition of the key role played by these constraints, especially the informational constraints. Lump sum taxation was clearly Pareto efficient, if the government had all the information about each individual and could tax each differentially. However, if, for instance, government could not observe each individual’s ability, but could observe his income and expenditures on particular commodities, then taxes had to be based on those variables. But in that case, it turned out Pareto efficient commodity tax structures did not look anything like those that Ramsey had characterized; for instance, if there was separability between leisure and consumption, then there should be no commodity taxation at all. Ramsey’s analysis (and that of Diamond and Mirrlees) had an additional implicit and unrealistic constraint: that income could not be taxed.
At one level, there has been enormous progress and change in thinking about the role of the state in the economy. Today, everyone recognizes the importance of market failure and the need for collective action. At the same time, there is a consensus about the central place of the market in the economy. In a sense, there has emerged a consensus behind the ‘Third Way,’ between socialism and laissez faire. But within those wide bounds, debate continues: there is a major difference between Bush’s compassionate conservatism or Clinton’s New Democrats, and within Europe, differences are every bit as large.
Differences of view arise partly out of differences in models of the economy and models of the government: how large are the market failures? How large are the public failures? How easy is it to rectify the market failures? To rectify the public failures? Sometimes, differences in views seem designed to justify particular special interests (or at least have that effect): Certainly, part of the incentive for privatization of social security in the United States, with its efficient social security administration, is the extra revenues that would be derived by the financial community; what would appear as higher transactions costs (an adverse consequence to most public policy analysts) appears as higher incomes to those marketing the new products (a positive consequence to most in the financial community.)47
Advances in the economics of the public sector should have shifted the balance: we now know how to design better tax systems, that reduce the dead weight loss, for any given amount of revenue raised or redistribution. We now know better how to use market mechanisms in the public sector to improve its efficiency and efficacy. Similarly, we are now more aware of the pervasiveness of market failures, and of the possible complementary relationships between the public and private sector, especially in areas like finance, where information problems are important and where market failures have repeatedly had large systemic consequences. Yet, at least in the United States, the balance of public sentiment seems to have shifted in the opposite direction. There is an interesting question — perhaps more a matter of the sociology of political activity than of conventional economics — of why that is the case.
As always, though, in matters of public policy, part of the differences in views arise from differences in values, in the relative weighting put on equity, and on alternative conceptions of equity. The latter represents one of the more important changes in public policy thinking over the past quarter of century: an evaluation of economic systems not just in terms of final outcomes (e.g. the steady state equilibrium distribution of income), but in terms of dynamics and process — we evaluate systems in terms of the equality of opportunity, in the seeming fairness of the system. Here too, practice may have outpaced theory: there has been only limited progress in welfare economics in developing the conceptual frameworks and analytic tools.48 This too remains one of the important challenges for the coming decades.
