Assignment Code: MEC-006/AST/2021-22

Course Code: MEC-006

Assignment Name: Public Economics

Year: 2021-2022 (July 2021 and January 2022 Sessions)

Verification Status: Verified by Professor

Note: Answer all the questions. While questions in Section A carry 20 marks each (to be answered in about 500 words each) those in Section B carry 12 marks each (to be answered in about 300 words each). In the case of numerical questions word limits do not apply.

Section A

1) Discuss the relationship between Public Choice and Social Choice.

Ans) Public Choice delves deeper into issues such as why does the government engage in economic activity? If an activity has a lot of externality or spillover and involves a lot of people, it might be better for the government to do it. As David Hume famously observed, it is simple for two people to agree on the terms of draining a field that affects them, but it would be quite difficult for many people to agree on the terms of sharing the cost of drainage.

Who allows the government to do anything it wants? People in a democracy and the monarch/dictator in a monarchy/dictatorship could be the simple answer. However, neither a monarchy nor a dictator/despot/autocrat can function without the help of a coterie. Some people always participate in the decision-making process, consider the issues and implications, and reach a conclusion based on norms imposed from the outside (for example, the constitution) or determined during the process itself, which is a decision-making process. Public Choice is the study of how individual preferences are transformed into public decision-making on a public problem.

The Public Choice is concerned with who will participate and how the decision will be made. Whether the participants are motivated by social concerns or by personal interests, and what the consequences of different behaviours are. Whether the participants are citizens, elected representatives, and how they were elected, or members of the bureaucracy's handpicked employees. Whether it's a secret ballot election of representatives, a committee meeting with a no-dissent rule, or a board meeting with the chair as the final authority.

Social Choice is a closely related topic. Some people don't differentiate between the two, while others do. The link between individual preferences and societal choice is the focus of Social Choice Theory. Individual preferences have been attempted to be aggregated, but individual preferences refer to individuals' preferences from a social standpoint, which is why many analysts, including Arrow, have suggested the term individual values, which refers to individuals' social values, value judgments, or social views.

If we had to choose between the two, we'd call a Social Choice a collective choice that involves all individuals in decision-making that affects them all, and a Public Choice a collective choice that involves those individuals who represent the interests of all individuals in decision-making that affects all those who are represented by the participants. It means that public decisions are made through legislatures, parliaments, cabinets, committees, commissions, tribunals, and boards, while social decisions are made through referendums and popular elections. Some prefer to refer to such exercises as public choice dilemmas, while others prefer the opposite. Others have referred to both types of exercises as Collective Choice. According to Dennis Mueller, public choice is a collective option that is more positive in nature, whereas social choice is a collective choice that is more normative in nature. In truth, the phrase Public Choice was coined considerably later, and early writings on the subject used the word Social Choice to describe the types of decision-making procedures that are now known as Public Choice.

The study of government intervention through public choice theory is gaining popularity. It is described as an application of economics to the study of politics in a nutshell. It's the application of economics approach to the study of political institutions, procedures, phenomena, and processes, which includes government, bureaucracy, and the court. The most common technique used is one of the methodological individualisms, which embraces a contractarian rather than organic conception of state. In this field of research, the person being studied is egoist, logical, and utilitarian. Homo politicos is a hybrid of homo economicus and homo politicos. It primarily addresses voting behaviour, voting systems, and voting rules, as well as the possibility of logrolling and behavior-modifying strategies, the impact of pressure groups and party politics, and optimal majority questions in terms of associated costs. Many workers in this sub discipline have been intrigued by the use of game theoretic frameworks, transaction cost frameworks, and the probability of whether an individual's vote is essential in decision-making.

Where do the rules originate from, and why isn't there a single regulation for everything from revising the Constitution to building a rural road connecting a town to a highway? What are the activities that might need to be centralised? These are the issues that Public Choice addresses. Some scholars have raised concerns about the form, content, and method of constitution-making by free citizens, as well as the reasons and conditions of revolution.

2) Briefly explain the problems of ‘international policy coordination’.

Ans) Despite the potential welfare gains from such coordination there are several problems that need to be overcome before these gains are realised.

Sustainability

One of the major problems identified for international policy coordination is whether the agreed outcome is sustainable. As can be seen from the previous Hamada diagrams all points on the contract curve, except at the Bliss points, lie off both country’s reaction curves. Indeed, any agreement that coordinates monetary policy on a point other than the Nash equilibrium necessarily implies that at least one country has an incentive. Once it is realised that countries have an incentive to renege upon the agreement no country will enter policy coordination. This problem of sustainability is also relevant to dynamic games. In this context the problem is that of time inconsistency which arises when a government has the short run incentive to deviate from its long run optimal policy.

The government’s optimal long run policy is associated with policy coordination at point C. However, as in the static model, governments may have a short run incentive to deviate from this outcome. This problem is particularly severe when the game is known to be played only a finite number of times. In this situation backward induction predicts that all countries will pursue the Nash equilibrium every time period. This prediction appears to rule out the possibility of effective policy coordination. Fortunately, several ways have been suggested for how government might overcome this problem of sustainability. Most of these proposals these include the importance of precommitment, an effective punishment strategy against countries that break international agreements (implemented either by other governments or the private sector), and countries being concerned with maintaining a favourable reputation for cooperation. In the context of international monetary policy one type of precommitment has received considerable attention. In this situation one country acts as the leader and then other countries follow its lead. Figure 1 illustrates the outcome of this model for the example of recessionary bias discussed in the previous section. In this example both countries maintain a fixed exchange rate and desire a balance of payments surplus.

                                 Figure 1

As illustrated in Figure 1 the leader will be made better off compared to the Nash equilibrium. The follower, however, may be made better or worse off depending on the structure of the model. Even if the follower is made better off the gains from such an arrangement are unlikely to be equally divided. As a result, there will, in general, be some conflict over who should be the leader, which may cause this equilibrium to be unsustainable. Even if this equilibrium is maintained it is only a partial solution to the problem of time inconsistency, as it still yields a Pareto inefficient outcome.

Inflationary Bias

Another potential problem with the coordination of monetary policy is that it can worsen the inflationary bias within each country. If the costs associated with this increased domestic inflation outweigh the gains due to policy coordination countries will prefer to go without coordination. A country can experience inflationary bias if its optimal long run monetary policy is time inconsistent. Policy coordination may increase the government’s incentive to deviate from its optimal monetary policy. If this is perceived by the private sector it will increase its inflationary expectations resulting in an increased level of equilibrium inflation. Government may be tempted for a greater incentive to deviate from its long run optimal policy because such coordination can improve the trade-off facing the government over inflation and unemployment. Diagrammatically the short-run Phillips curve becomes flatter under coordination as opposed to no coordination. If one country expands its money supply in isolation then its exchange rate will depreciate causing the cost of imports to rise, and this stimulates inflation. If, however, monetary policy is coordinated, and all countries expand their money supplies simultaneously, then the exchange rate effects are less severe and so inflation is tempered. The costs of expansionary monetary policy caused by higher inflation are less for a coordinated expansion of monetary policy, than for an isolated expansion of monetary policy by one country. Growth rate of money supply in foreign country

                    Figure 2

As the costs are lower, there is a greater incentive for the government to expand the money supply. Agents perceive this and so anticipate a faster growth rate of the money supply, and hence expect higher inflation. The optimal response for the government is then to produce this higher level of inflation. In equilibrium there is now a greater level of inflationary bias in the economy. This outcome is illustrated in Figure 2.

With no policy coordination the Nash equilibrium is at point A with inflation equal to IA. Under policy coordination the short run Phillips curve is less steep and so the new Nash equilibrium is at point B with inflation equal to IB Inflationary Bias under Policy Coordination.

Uncertainty

We know that uncertainty is one of main influencing factor in policy process and especially in coordination of economic policies. With government’s using different models they may be unable to agree on the most appropriate agreement, and negotiations may break down. This may involve two separate aspects. First, governments may view all the available models as being essentially plausible, and so base their policy proposals on some weighted average of their forecasts. Second, they may actively seek to learn which model, if any is true. This will involve governments updating their beliefs about the true economic model using their observations of macroeconomic variables. Given these responses to model uncertainty the performance of economies with coordinated, rather than uncoordinated, policies improve substantially. Indeed, such arguments may reverse Frenkel and Rockett’s conclusions and suggest that the case of cooperation is strengthened given the presence of model uncertainty.

Reaction of Other Countries

A final problem associated with the policy coordination is that countries not involved in the policy agreement may react in such a way as to offset the gains from such an initiative. In fact, countries cannot determine their optimal policies without determining how other countries will react. This complicates the policy process for deciding on which optimal policy combination to pursue, and may cause countries to act unilaterally i.e., uncoordinated.

Section B

3) Explain the different roles of the state on which the economic rationale of the state is based.

Ans) The economic rationale of the State is explained through specifying different roles of the state from an economic perspective such as: (i) Allocative role, (ii) Distributive role, (iii) Stabilization role, (iv) Regulatory role for the state.

Allocative Role

In a welfare state, the government's fiscal responsibility leads to the maximisation of social welfare by allocating public spending to the manufacture or provision of socio-economic infrastructure, which is the building of social overhead capital. It explains the following three stages:

1. Given the resource restriction, efficient resource allocation between the public and private sectors in a mixed economy. In this context, Samuelson's "Pure Theory of Public Expenditure" provides a solution based on the General Equilibrium Approach.

2. Using the principle of Maximum Social Advantage, determine the budget's optimal size.

3. Prioritization of various public goods and services for production or provision, taking into account public choice via the translation of individual preferences into collective choice. In a democratic country where the ruling party relies on citizens' votes to stay in power, the budgetary policy of allocating the government's available and potential resources for those public goods and services that conform to the public choice and satisfy the greatest number of people tries to gain public support.

Distributive Role: The government of a state is also responsible for promoting equity and ensuring social justice. Budgetary policy is required to eliminate inequity between the rich and the poor in a society and to ensure regional development balance.

Role of Stabilization: It refers to fine-tuning the economy and strengthening the state's economic fundamentals. It adheres to cautious fiscal policy by thoroughly examining the state's resources mobilisation and spending management options. It discusses fiscal responsibility and budget management in terms of reducing deficits, making debt more manageable, and achieving maximum economic growth.

Regulatory Role: Formation of economic policies and their effective implementation to fulfil the objectives of the state speaks about better administration and effective governance. Rules, regulation, norms and guidelines to materialize state’s aspiration usually refer to its regulatory role.

4) Write a note on the concept of ‘multiple equilibria’.

Ans) For the most part, economic equilibria are studied through the development, analysis, and application of mathematical models. The values of interest are solutions of systems of equations and inequalities. Economists distinguish between general and partial equilibrium theory. Partial equilibrium theory differs from general equilibrium theory by having a specific set of variables held constant for the analysis. The French economist Léon Walras (1834–1910) is credited with being the father of general equilibrium theory. His great seminal work, Elements of Pure Economics (1874), sets forth his conception of the subject in increasing levels of completeness and detail. In dealing with a pure exchange economy with multiple markets, he developed a mathematical model in the form of a system of simultaneous equations having exactly as many unknowns as equations; a solution of the system would presumably yield an equilibrium. As it happens, neither the existence nor the uniqueness of a solution to the formulated system is guaranteed on the grounds of having as many equations as variables. Moreover, even if a solution exists, there is no guarantee it will be nonnegative (or even real).

A brief theoretical conceptualization that could serve as a foundation for selecting an agenda or formulating a policy proposal Multiple equilibria is an issue in which there are too many solutions to a problem, some of which are complementary to each other and others which are sharply contradicting. When there are numerous equilibria, all agents must work together to implement the policy, which may reflect one or a compromise combination of several equilibria. As theory appears to have little predictive capacity, it affects the creation of expectations in both voters and incumbent or prospective policymakers. There are two techniques to eliminate the multiplicity of equilibria in game theory. One such example is equilibrium selection. There is a lot of literature on the subject, and there are a lot of debates about whether the solution is satisfactory.

The approach of equilibrium refinements tries to improve the definition of equilibrium in order to eliminate other equilibria as possibilities. This is accomplished by restricting how beliefs are formed. As a result, agents are barred from making outrageous policy claims.

The equilibrium selection approach to solving multiple equilibria problems seeks to keep the definition of equilibrium while accepting the fact that there are several equilibria and delegating the duty for choosing between them to the agents. Sheathing established the most influential selection criterion of 'focal point' (1960). If there are numerous equilibria, one will be chosen because it has a 'natural', 'obvious', and 'conspicuous' property that causes agents to form on it. Absence of coordination and communication does not pose an issue as long as actors are focused on achieving a specific equilibrium.

5) Do you agree that ‘fiscal competition’ could result in inefficiency? Discuss.

Ans) While 'cooperative federalism' has received increasing attention in the fiscal federalism literature, it is important to remember that the relationship between government units is fundamentally competitive. Cooperation entails adherence to a centralised policy framework, which could lead to the abolition of the notion of federalism entirely.

Fiscal rivalry has been deemed inefficient and distortive, despite the fact that some undesired acts are made to increase the tax base. Taxpayers have significant compliance costs as a result of fiscal competitiveness that results in multiple tax rates. When competing jurisdictions cut their tax rates to keep their tax bases, this is referred to as fiscal warfare or 'races to the bottom.' The rationale for interfering jurisdictional fiscal competition is that states compete to attract businesses to their territories in order to generate economic activity, which can lead to increased tax revenues and expenditures, which can be used to improve people's quality of life. This is predicated on the assumption that tax rates have an impact on business decisions and, as a result, on economic growth.

The employment of tax instruments to encourage commerce and industry can affect the pattern of resource allocation by altering relative pricing in unanticipated ways and introducing various forms of barriers – fiscal as well as physical – to the free flow of factors and goods. Because jurisdictions differ in their ability to attract trade and business, the ability to attract trade and business will vary. It has the potential to lead to the powerful exploiting the weak.

Inter-state disparities in the degrees of development are apparent in emerging country federations. Where the costs and benefits of governmental actions are not clearly comprehended, there is no link between tax and expenditure decisions. When states engage in fiscal competition by shifting the responsibility of supporting public services to other states, the system becomes inefficient.

Consumption taxes account up the majority of revenue in most developing countries. Because the administrative infrastructure in these nations is typically lacking, origin-based indirect taxes are frequently employed as a soft alternative for obtaining revenue rather than destination-based indirect taxes. The tax system is opaque, and a cascading tax structure has been implemented, with inputs and capital goods being taxed, cross-border purchases being taxed at low rates to encourage business, and exports to other jurisdictions being taxed at the greatest rate possible. The following are the consequences of such a policy:

1. Choosing separate tax rates for residents and non-residents is a method that increases rate differentiation.

2. Tax exporting and the use of tax incentives to entice capital complicate the tax system and render it vulnerable to abuse.

3. Tax competition has the potential to have a considerable negative impact on equity and efficiency.

As a result, the benefits of having the freedom to choose their preferred public services and tax rates may conflict with the welfare loss resulting from inter-state fiscal rivalry. It has the potential to exacerbate regional disparities and, in some cases, jeopardise the public sector's long-term viability. This issue can be addressed by a tax harmonisation programme that entails collaboration between jurisdictions and the federal government.

6) Bring out the ‘efficiency and equity’ dimensions of direct taxation.

Ans) Efficiency Dimensions:

A Pareto efficient resource allocation is one in which no economic agent benefits while another in the economy suffers. According to mainstream economic theory, free market forces would lead to a Pareto efficient allocation in a system where each economic agent maximises its objective function subject to constraints (e.g., individuals maximise their utility subject to their budget constraint and firms maximise their profits) and given certain other assumptions.

In such a system, imposing a tax would change the relative prices. The pricing signals would be corrupted, influencing economic agents' decisions and changing resource allocation. For example, when a sales tax is imposed, the slope of the consumer's budget line changes, as does his equilibrium position. The economic agent would endeavour to reduce the consumption of the taxed commodity in order to reduce the tax payment. As a result, the relative importance of various goods in a consumer's consumption basket is altered.

When it comes to indirect taxes, the distortionary effect is obvious. Direct taxes have a less pronounced distortionary effect than indirect taxes. Consider the impact of income taxes. An income tax has no effect on the relative prices of commodities, but it does influence the individual's decision between income and leisure.

Equity Dimensions:

Any tax system should have equity or fairness as a core element. The burden of taxes should be divided equitably, according to most people. However, the concept of equity must be adequately defined before a tax structure can be designed. There are two ways that are commonly used:

Approach to Receiving Benefits

The provision of public services is a primary motivation for tax collection. As a result, supporters of the Benefits Received Approach say that individuals should contribute to government revenue based on the benefits they obtain from government services. As a result, it establishes a clear link between the services' benefits and the people's contribution to their provision. It also resolves the issue of determining the number and nature of government services. However, there are several disadvantages to this strategy. When taxes are imposed for redistributive objectives, it cannot be used. In an ideal world, this principle would only apply to taxes intended to fund public services. In practise, however, such a distinction between taxes for public services and taxes for other purposes is rarely made. For direct taxes, this strategy isn't very useful.

Approach based on Financial Capability

For direct taxes, the ability to pay approach is more relevant. Individuals should contribute to government revenue based on their ability to pay, according to the law. Individuals' ability to pay can be measured by their income, consumption, wealth, and other factors.

A tax system based on this approach should obey two equity principles: horizontal equity and vertical equity. Individuals with equal ability to pay should pay equal taxes, whereas those in a position to pay higher taxes, i.e. those with higher ability to pay, should pay more than those with lesser ability to pay, according to the latter premise. Individuals with greater earnings should pay more taxes than those with lower incomes, if income is used as a measure of ability to pay.

The ability to pay approach lays out the groundwork for constructing a fair tax system. But, in order to conform to the idea of vertical fairness, how much should people of various income levels pay? Individuals should sacrifice equivalent amounts of their welfare as a result of tax payments, it is maintained. This notion of "equal sacrifice" has three rules.

7) Explain the impact of ‘internal public debt’ on production and distribution.

Ans) Private investment is harmed when people acquire government securities by withdrawing money from industrial companies or selling debentures and shares of industrial concerns. The net effect on investment will be determined by the government's use of the funds. If the government spends this money on public projects, the total amount of money available for production may not be harmed, but if it is spent on non-productive projects, the total amount of money available for production may be harmed.

Private investment is unaffected if people buy government assets with idle funds; however, if they buy with bank deposits, private investment may be harmed because the bank's lending capacity may be lowered due to lower deposits.

In general, a bank's lending capability is elastic. The ability of a bank to generate loans is determined by the country's central bank policies. When the latter stimulates the development of credit, the chances of credit growth skyrocket. It has the ability to increase credit based on the strength of ad hoc or newly produced securities. As a result, government borrowings may not affect private sector investment if there are sufficient cash for constructive objectives. Furthermore, the government will use the loan profits to pay contractors for products and materials acquired, as well as to pay employees' salaries. This will raise purchasing power and bank deposits, both of which can be used to lend to the private sector. As a result, government borrowing from banks may have little impact on private sector investment.

If the government borrows money for non-productive purposes, it can only be returned by increased taxes in the future, which may have an impact on consumption. Those who are employed in welfare schemes improve the efficiency of the workforce as well as the efficiency of production. When productivity rises, the community's income rises as well, and so, additional taxation may have no impact on consumption. If the loans are directly used for productive purposes, they improve the community's income. As a result, consumption is unaffected, but it rises. Furthermore, extra income can be used to pay both the interest and the principal.

Government securities are generally purchased by the wealthy in the community, but the weight of taxes levied to cover interest payments falls on the poorer classes as well. As a result, public debt has the potential to exacerbate wealth disparities. As a result, the public debt may not have the desired distributional effects. If the bondholders and the tax are the same, there will be no income distribution. As a result, income disparities will not widen, but this is not always the case. As a result, some income redistribution will occur as long as taxpayers and bondholders belong to different groups, and as previously stated, economic inequalities may increase.

If public debt is used to provide more economic welfare to lower-income groups, income inequalities will decrease and a more equal distribution of income between different sections of the community will occur. However, if the loan financing causes inflation, some of the positive effects on income distribution may be offset by price increases. As a result, if the loan revenues are used to fund welfare programmes, the distributional implications are significant.