Assignment Code: MEC-006/TMA/2022-23

Course Code: MEC-006

Assignment Name: Public Economics

Year: 2022-2023

Verification Status: Verified by Professor

Answer all the questions.

SECTION A

Answer the following questions in about 700 words each. 20x2

Q1) Explain the Tiebout Model (voting with your feet) in context of the provision of local public goods. What are the problems associated with this model?

Ans) According to Tiebout, people should choose the neighbourhood whose provision of local public amenities and tax rates best matches their desires. He suggested that people would communicate their preferences in a local community setting by relocating to the area that best reflected their interests and gave the preferred tax benefit combination. However, he believed that this human mobility was largely free. Thus, people "vote with their feet" to express their views.

The Tiebout Model

Assumptions:

1. "Consumer-voters" will relocate to regions that accommodate their specific tastes.

2. It is expected that they are fully informed about the local taxes and services offered by the local government.

3. They will be sought by jurisdictions that don't have the right number of residents for their preferred spending pattern.

4. In the sense that the costs of transportation, job searching, and other expenses are negligibly little in comparison to the benefits of migration, there is costless mobility.

5. The movement of people from one place to another shouldn't have a harmful effect on others' utility in the destination area by adding to existing congestion.

Mechanism:

The Tiebout mechanism must provide a condition in which it is impossible for any individual to enhance utility as a result of shifting communities for an equilibrium to maximise welfare.

Consider the possibility that people move around until the advantages of living in one place are equal to the advantages of living in another. Individual equilibrium occurs where, if the marginal benefit or utility from entering locale X is indicated by MBx and the marginal benefit from entering locality Y is MBy, then, MBx=MBy

There is no more movement between the places of X and Y as soon as this criterion is achieved. Consequently, societal stability also exists.

However, when someone relocates, "congestion charges" could be added to the already overcrowded facilities. Individual welfare maximum requires that net individual benefits even after mobility across the two regions are identical if MCx and MCy reflect marginal congestion costs of adding one more person to regions X and Y, respectively.

MBx–MCx=MBy–MCy

Here, it is believed that a person will move from region Y to region X, causing congestion to be more severe in X and less severe in Y. The ideal is attained via internalisation of these externalities.

Problems with the Tiebout Model

Economies of Scale: There would need to be a very large number of small communities to create an equilibrium when there are different preferences for public goods. This may indicate a lot of small villages, which would prevent them from benefiting from potential economies of scale in the creation of local produce.

Benefit Spillover: In the analysis above, it was assumed that everyone who lived in the area benefited from everything. One locality's advantages may transfer to another's jurisdiction. These spillovers may be "internalised" by the two localities through a process of direct bargaining. As an alternative, a central government might have a role. The analyses described will be altered in either case.

Non-Static Preferences: There are additional challenges for the Tiebout mechanism if preferences for local public services vary throughout the course of the life cycle. People prioritise facilities for children's education at various ages; later, they become more concerned with amenities for elderly seniors. The inference is that either local communities are made up of individual homes whose demands vary at the same time, or households relocate as circumstances change.

Q2) “The structural interdependence forms the basis for the policy maker’s choice behaviour for policy”. In the light of this statement explain the structural interdependence and policy coordination.

Ans) The choice behaviour of the policy maker for a policy or policy mix is actually based on the structural interdependence. The spectrum created by different policy combinations depends on the degree of agent coordination. In 1943, Paul Rosenstein-Rodan said that economic development could be viewed as a gigantic coordination failure, in which some investments are not made because complementary investments are not made, and there are other investments that are not made because the initial ones are absent.

This offers a potential justification for why similar policy tools behave differently and produce different or divergent policy results in similar economic contexts. It actually depends on the type of expectations and beliefs that agents in various sectors have about one another's behaviour.

Nature of Coordination Problems

The modelling of the dynamic process of institutional change has made only little progress, which has constrained the available alternatives for policy. It has been established that innovation, integrity, investment, training for the labour force, and saving can result in externalities that are mediated by:

1. Information on belief change.

2. Effects of the various agents on technology.

3. Modifications to the existing market set.

4. Alterations in market size.

5. Cost variations for searches.

Spillovers, Bureaucrats, Rent-seekers, and Collectivist Enforcement

The coordination issue affects not only the levels of economic activity, such as investment, research, and development, but also the actions of the institutions that make up the economy. The ranking of various courses of behaviour can be influenced by externalities. The equilibrium to which the economy eventually converges in evolutionary contexts depends on its past. Thus, opening a nation to foreign competition that "hurts" bureaucratic enterprises in the economy differently may cause the economy to shift from one equilibrium to another, which would then have an impact on the advancement of linguistic technology.

Rent Seekers versus Producers

This particular coordination problem strives to explain why some nations struggle to develop when the insecurity of property rights is caused by both public and private rent seeking. One explanation is that rent seeking, particularly by government officials, is likely to hinder innovative activities when rent seeking yields are higher than those from innovation. There can be several equilibria as a result. When this happens, one equilibrium has a low proportion of returns on innovations and a high fraction of rent seekers. However, there is another equilibrium present at the same time where the opposite is true.

‘Collectivist’ versus ‘Individualistic’ Enforcement

Most policy and development economists agree that the institutions that support contract enforcement are among the most crucial groups in an economy. Grief (1994) uses two different actor types to depict it: merchants and agents. Foreign trade is conducted on behalf of merchants by agents. A merchant can decide whether to pursue his contracts with agents collectively or individually. The collectivistic enforcement comprises punishing an agent who is known to have defrauded a merchant in a collective group by refusing to recruit them. Individualistic enforcement calls for a merchant to exclusively punish agents who have defrauded him.

Policy for Interventions to Solve Coordination Problem

Different interventions can have an impact on results. The most significant ones are those that modify the dynamics of the political process, address coordination problems, change income distribution, and use information as an intervention. It cannot be assumed that political process can be a good option to achieve essential changes because the equilibrium set of behaviours in a decentralised economy may not be Pareto efficient. The research of Adersa and Ray also demonstrates the possible role of policy in a range of situations. Here, we simply take a few of the most significant potential policy changes into consideration.

Affirmative Action and Anticorruption Programme: If a modification in the law results in a new equilibrium that implies a revised belief that supports the equilibrium, then the equilibrium may be forced. Tirole created a model to analyse group reputation and showed that an anticorruption campaign of sufficient length and rigour can contribute to the transformation of an economy from one with high levels of corruption and sustained belief in it to one with lower levels of corruption and sustained belief in it. This change has a significant impact on almost all economic sectors.

SECTION B

Answer the following questions in about 400 words each. 12x5

Q1) Enlist the canons of taxation. Explain the approaches to tax equity.

Ans) A good tax system should possess the following characteristics:

1. Revenue Adequacy: Governments levy taxes to finance their expenditures. Therefore, a good tax system should generate adequate revenue for the government.

2. Equity: The tax burden should be distributed in an equitable manner.

3. Efficiency: The tax system should not interfere with the efficient allocation of resources.

4. Administrative Simplicity: The tax structure should be simple to administer. Also, the cost of collection should be the minimum. Simplicity of the tax structure would also help in checking evasion.

5. Transparency: The levying of taxes and the spending of tax proceeds should be done in a transparent manner. The tax structure should be such that its incidence should be clear.

Approaches to Tax Equity

Benefits Received Approach

A major motive for collecting taxes is to finance the provision of public services. Therefore, the proponents of Benefits Received Approach argue that the individuals should contribute to government revenue according to the benefits they receive from public services. So, it provides a clear link between the benefits received by the people from the services and their contribution towards their provision. It also solves the problem of determination of the quantity and form of public services. However, there are certain drawbacks to this approach. It cannot be applied when taxes are levied for redistributive purposes. Ideally this principle should apply only to those taxes which are used to finance public services. But in practice, such a separation of taxation for public services and taxation for other purposes is rarely done. This approach is not much applicable for direct taxes.

Ability to Pay Approach

The ability to pay approach is more relevant for direct taxes. It states that individuals should contribute towards government revenue according to their ability to pay. Income, consumption, wealth etc., could be used as the indicators of the ability to pay of individuals. A tax system, which follows this approach, should adhere to two principles of equity Horizontal Equity and Vertical Equity. The former states that individuals with equal ability to pay should pay equal taxes whereas according to the latter principle those who are in a position to pay higher taxes i.e., those with higher ability to pay should pay more than those with lower ability to pay. Taking income as the index of ability to pay, this means that individuals with higher income should pay more taxes than those with lower incomes.

Q2) Explain the debt obligation of the central government for internal debt, external debt, and other liabilities.

Ans) Public debt refers to borrowings made by the federal and state governments. The three main categories of debt held by the Central government are as follows:

Internal Debt

This includes:

1. Market Loans: These typically bear interest and have a 12-month or longer maturity duration at the time of issue. These loans are nearly always provided by the government. These loans are funded through the selling of securities or another method on the open market.

2. Bonds: This category includes 1998 gold bonds, compensation bonds, and other bonds like capital investment bonds and national rural development bonds.

3. Treasury Bills: The government has relied largely on treasury bills as short-term liquidity to close the budget imbalance. Every Friday, 91, 182, or 364-day bonds are issued. Treasury bills are issued to the RBI, state-owned banks, and others.

4. Special Floating and Other Loans: Special floating and other loans are India's contribution to IMF, IBRD, and IDA capital. These are non-negotiable, non-interest-bearing securities, and the Indian government must pay on demand.

5. Special Securities Issued to RBI: The government borrows from the Reserve Bank and issues non-negotiable, interest-free securities. Such borrowing are short-term loans.

6. Ways and Means Advances: The Indian government obtains short-term advances from the Reserve Bank of India. Temporary debts are usually repaid within three months.

7. Securities Against Small Savings: Under the new accounting method of the national small savings fund, a large part of small savings were converted into Central government securities in 1999-2000. End-March 2003 small savings securities totalled Rs. 2.02 billion.

8. Small Savings: Due to rising earnings and innovative government initiatives, small savings have expanded in recent years. Some scams offered enticing tax breaks, so people funnelled large quantities of money via them.

9. Provident Funds: State and public provident funds exist. The Public Provident Fund Act of 1968 created the public fund. After 15 years, PPF deposits are repaid. Available loans and withdrawals.

10. Other Accounts: Postal Insurance and Life Annuity Fund, Hindu Family Annuity Fund, Compulsory Deposits and Income-Tax Annuity Deposits, and Non-Government Provident Fund Special Deposits.

11. Reserve Funds and Deposits: Reserve money and deposits are separated into two groups: interest-bearing and non-interest-bearing categories. They include civil deposits, departmental and judicial deposits, depreciation and Reserve Funds of the Department of Posts, Department of Telecommunications, and the Railways, as well as local fund deposits.

External Debt

The majority of external debt is often issued in foreign currencies, and a sizeable portion of it is also repaid in foreign currencies. The Government of India has obtained foreign loans from several nations, including the USA, UK, France, former USSR, Germany, Japan, and others, as well as from global financial organisations like the IMF, IBRD, and IDA, among others.

Q3) What are public goods? Explain their features. How are public goods responsible for market failure?

Ans) Therefore, public goods have the dual properties of being non-rival in the concurrent consumption by two or more consumers and being non-excludable by any consumer for any reason. It is preferable to utilise those resources in higher provision rather than to prevent consumption, some may argue, as excludability is an issue of cost or non-excludability may be a costly proposal.

A pure public good is one whose consumption does not affect the amount made available to other people, or one whose consumption is not competitive. Everyone can enjoy the benefits without any interruption from one another. Thus, everyone in the community has access to supplies of these items. A public good need not always be something that the government provides. Instead, it describes a product with the following two features:

1. Non-Rival Consumption: When, with a certain level of output, consumption by one individual does not have to reduce consumption by anyone else, the good is non-rival in consumption. In other words, several persons may consume the same good at once. Giving the good or service to another person has no financial cost. In other words, there are no additional marginal costs.

2. Non-Exclusion: The inability to exclude anyone from the advantages of the good is known as non-exclusion. In other words, no one can be prevented from taking advantage of a public good. Whether or whether a person pays for the good, they will still profit from its manufacture. Nobody can voluntarily refuse to carry out their mandate or contribute to covering its costs.

Public Goods and Market Failure

It is commonplace in political and economic theory to assert that the existence of public goods justifies the necessity of government. These are the products that everyone wants. However, no one wants to foot the bill for supply. The issue with free riders is this. Sometimes the private sector provides public goods, and the public sector provides private products. The argument persists that the market economy ensures the effective use of resources while supplying private products. Free riders make it difficult or impossible for the market to efficiently offer public goods. In this situation, private agreements are typically ineffectual, and if the public benefit is to be created effectively, government subsidies or provision is required.

Q4) Discuss the impact of direct taxes and indirect taxes on factors of production.

Ans) The impact of direct taxes and indirect taxes on factors of production are:

Effects on Ability to Work

Taxes reduce available money. As a result, there is a reduction in purchasing power and consumption spending. These lead to a decline in the quality of life. As a result, productivity and capacity to work are negatively impacted. People from the low-income category experience this. Taxation has less of an impact on the ability to work for the wealthy, though. It is imperative to provide income tax exemption limitations for the benefit of low- and middle-income groups in order to minimise the negative consequences of taxation.

Effect on the Ability to Save

Taxes always have a negative impact on a person's ability to save money. Taxation negatively affects one's capacity to save because it is a function of disposable income, which is taxed as income. Savings typically decrease when disposable income does. Although taxes are typically levied on excess income, doing so will negatively affect the marginal propensity to save by reducing the surplus income from which saving is created. As a result, the ability to save will be proportionally reduced to the amount of taxes.

Effect on Ability to Invest

Evidently, the lower ability to save brought on by the tax levy reduces the capacity to invest in the private sector. Therefore, any tax has the immediate result of lowering the quantity of resources available for private sector investment. In fact, taxes create a vicious cycle because when they are implemented, people's capacity for saving is lowered, which leaves less money available for private sector capital formation.

This decrease in capital will then result in decreased output and income, which will further reduce people's capacity for saving. Therefore, it should be emphasised that it is crucial to prevent taxation from discouraging savings in order to sustain and develop the investment function in a free economy.

Q5) Write short notes on the following: (4x3=12)

(i) Buchanan’s Contractual Theory

Ans) Buchanan doesn't trust in the political process to achieve just income distribution since it involves pressure groups trying to strengthen their own economic position at the expense of others. To reach an end-state, income must be redistributed in society. Buchanan says choice, luck, effort, and birth explain income variations. The fourth factor, birth, is beyond a person's control and affects their endowments.

Buchanan prescribes different institutions to legitimise the state's involvement in addressing unequal endowment distribution and income distribution. They are:

1. Intergenerational financial transfers being taxed.

2. System of public funding for education.

3. A set of guidelines intended to stop or prevent discrimination in the distribution of employment opportunities.

From birth, a baby experiences unfairness in society depending on the socioeconomic background of different households or families and their endowments. In this sense, the accumulated wealth of the prior generation in a family is also essential, as the current generation becomes rich by inheritance, not their own income.

(ii) Arrow’s Impossibility Theorem

Ans) A social choice dilemma known as Arrow's impossibility theorem highlights the drawbacks of ranked voting systems. It claims that following the necessary rules of fair voting procedures will prevent a clear order of preferences from being established. The broad impossibility theorem is another term for Arrow's impossibility theorem, which bears Kenneth J. Arrow's name as an economist.

In all situations where preferences are ranked, it is impossible to create a social ordering without disobeying one of the following rules, according to Arrow's impossibility theorem:

1. Non-Dictatorship: Multiple voters' preferences should be taken into account.

2. Pareto Efficiency: Individual choices must be respected even when they are unanimous: If candidate A is preferred by every voter over candidate B, candidate A should prevail.

3. Independence of Irrelevant Alternatives: If one option is eliminated, the order of the remaining options shouldn't change: Even if a third contender, candidate C, is disqualified from the competition, candidate A should still come out on top if candidate B comes in second.

4. Unrestricted Domain: All individual preferences must be taken into account before voting.

5. Social Ordering: Each person should be allowed to rank the options whatever they choose and flag ties.

(iii) Role of government in a mixed economy

Ans) A new wind, similar to one that began in the wake of the Second Planet War, has been blowing throughout the world since the middle of the previous century. A further boost to private sector activity and a decisive blow to state sector participation became evident with the disintegration of Soviet Russia in the late 1980s. On the one hand, fiscal mismanagement spread like wildfire, gobbling up more than it could chew, while on the other, the pressure that prompted the implementation of welfare measures was no longer present.

Direct intervention began to give way to indirect intervention, and efforts were made to scale back indirect intervention as well as lower tax rates and eliminate subsidies. The following was the ethos. The government should be in charge of supply rather than production and should be in charge of regulation rather than production. Public intervention must pass a two-part test if the market is unable to complete a task efficiently.