Bev Dahlby

The Marginal Cost of Public Funds: Theory and Applications

The marginal cost of public funds (MCF) measures the loss incurred by society in raising additional revenues to finance government spending. The MCF has emerged as one of the most important concepts in public economics; it is a key component in evaluations of tax reforms, public expenditure programs, and other public policies. The Marginal Cost of Public Funds provides a unified treatment of the MCF, carefully developing its theoretical foundations in a variety of contexts and describing its application to a wide range of policies--from excise taxes in Thailand to public sector borrowing in Canada and the United States. The Marginal Cost of Public Funds develops the basic theory of the MCF within the framework of public economics and shows how it is related to the traditional measures of the efficiency loss from distortionary taxation. The MCF concept is then applied to the major sources of revenues for governments--sales and excise taxes, taxes on labor income, taxes on the return to capital, public sector borrowing, and intergovernmental grants. This book will be an essential reference for economists and public policy analysts both in and out of government. Exercises and recommendations for further reading at the end of each main chapter highlight its usefulness as a supplementary text in advanced undergraduate or graduate courses in public economics.

Vertical fiscal externalities in a federation

Abstract We examine vertical fiscal externalities in a model where a state government provides a productivity-enhancing public input and both the state and the central government tax wages and profits. Previous literature has emphasized the negative tax externality that occurs when two levels of government impose distortionary taxes on the same tax base. We show that an increase in the state government’s tax rate on wage income can increase federal revenues if the federal government imposes an ad valorem tax on employees’ wages and the demand for labour is inelastic. We also show that an increase in the provision of the public input can either increase or reduce federal tax revenues, leading to either under- or over-provision of the public input by the state government.

ADVERSE SELECTION AND STATISTICAL DISCRIMINATION An analysis of Canadian automobile insurance

Abstract Statistical discrimination occurs when a characteristic, such as sex, is used as an indicator of the risk group of an individual. The theory of adverse selection is used to explain the occurrence of statistical discrimination. A model of the market for collision insurance, which is based on the theory of adverse selection, is estimated on Canadian data. The results suggest that adverse selection occurs in this market. Simulations of the effect of prohibiting sexual discrimination in the 21–24 age group indicate that the premiums for single females would increase substantially and that a significant proportion would no longer purchase collision insurance.

Fiscal Capacity, Tax Effort, and Optimal Equalization Grants

In this paper, the authors address the question of how the tax burden in a federation should be distributed across the different jurisdictions so that the social cost of providing government services is minimized. Using optimal tax theory, they derive formulas for the optimal equalization grants that equalize the social marginal cost of raising revenue across all provinces. The authors show how the optimal equalization grants are related to a measure of tax effort based on the marginal cost of public funds and a measure of fiscal capacity that takes into account the elasticity of the tax base and its substitutability with other tax bases.

Testing for Asymmetric Information in Canadian Automobile Insurance

An increase in an insurance policy’s premium, holding the deductible constant, should increase the average claim frequency for the policy if the insurance market is subject to an adverse selection process. A model of adverse selection is developed to test this proposition using data on collision insurance in Canada over the period 1974–1986. The equations for the demand for collision insurance and for the average claim frequency for the policy are derived assuming that consumers have a constant absolute risk aversion utility function and that the underlying distribution function for the probability of loss is a member of the gamma distribution. The parameters of the models are estimated using a nonlinear estimation procedure, and a linear version of the model is also estimated. In general, the results are consistent with the presence of adverse selection in the market.

Price Adjustment in an Automobile Insurance Market: A Test of the Sheshinski-Weiss Model

Nominal price rigidity is explained in the Sheshinski-Weiss (SW) model by costly price adjustment. The predictions of the SW model, which describe a firms optimal forward-looking price adjustment strategy, were derived and tested using microdata on the timing and the magnitude of premium changes by sixty-nine firms in the Alberta automobile insurance market over the period 1974-82. The model was tested by estimating the structural equations of the model, probit equations for premium changes, and reduced-form equations for the firms new premium and its old premium. The overall conclusion is that the SW model does not explain the price adjustments observed in the Alberta automobile insurance market.

Adverse Selection and Statistical Discrimination

Statistical discrimination occurs when a characteristic, such as sex, is used as an indicator of the risk group of an individual. The theory of adverse selection is used to explain the occurrence of statistical discrimination. A model of the market for collision insurance, which is based on the theory of adverse selection, is estimated on Canadian data. The results suggest that adverse selection occurs in this market. Simulations of the effect of prohibiting sexual discrimination in the 21–24 age group indicate that the premiums for single females would increase substantially and that a significant proportion would no longer purchase collision insurance.

What Does it Cost Society to Raise a Dollar of Tax Revenue? The Marginal Cost of Public Funds

The marginal cost of public funds measures the welfare loss a society incurs in raising an additional dollar of tax revenue. Tax increases distort economic decisions and erode tax bases because of tax avoidance and tax evasion by taxpayers. This Commentary uses econometric estimates of the effects of higher provincial tax rates on the provinces’ corporate income tax, personal income tax, and sales tax bases to calculate the marginal cost of public funds (MCF) for these taxes. The results indicate that the cost of increasing provincial tax revenues through a corporate tax rate increase is very high, and in some provinces, corporate tax rate reductions in 2006 would have increased the present value of the provincial government’s total tax revenues. The results also suggest that significant welfare gains would accrue from reducing provincial corporate income tax rates. As well, increasing provincial corporate and personal income tax rates can cause significant reductions in federal tax revenues because the federal and provincial governments levy taxes on the same tax bases. Finally, Canada’s system of the equalization grants might reduce the perceived MCF of recipient provinces.

A Framework for Evaluating Provincial R&D Tax Subsidies

The spillover effects from a firms research and development (R&D) activities provide a rationale for R&D tax incentives. This paper provides a framework for incorporating the external rate of return on R&D, the tax sensitivity of R&D spending, and the governments marginal cost of public funds in the evaluation of provincial R&D incentive programs. Using this framework, we find that an additional dollar of tax incentive has to generate close to

A Cost-Benefit Analysis of the Thailand Taxpayer Survey

2.00 of additional R&D and the external rate of return has to be very close to 30 percent in order to justify a provincial tax subsidy for R&D if the provincial governments marginal cost of funds is