Economists are good in recognizing the indirect, hidden costs of many things that escape the attention of most non-economists. This is an important function of economists difficult to over-emphasise. However, most economists overestimate the costs (or underestimate the benefits) of public spending, especially on research and environmental protection. In combination with the global public good and long term nature of the fruits of research and environmental protection, this may make public spending on these items well below the optimal levels. The cost overestimation arises from the overestimation of the excess burden of taxation, the failure to take adequate account of burden-free taxes, relative-income effects, and the environmental disruption effects of most production and consumption and the failure of further private consumption in non-poor countries to increase happiness, making the happiness cost of public spending virtually zero. Accounting to these effects that the recent world-wide trend towards cuts in public spending may really be grossly inefficient despite some unavoidable inefficiency in public spending.

kwang.ng@buseco.monash.edu.au

OVERESTIMATION OF COSTS OF PUBLIC SPENDING ON RESEARCH AND ENVIRONMENTAL PROTECTION

Abstract

Public spending, especially on research and environmental protection, is likely well below optimal due to the long-term and global public-good nature and the overestimation of the costs of raising public revenue. This overestimation arises from 1. Economicsts' emphasis on the excess burden of taxation, ognoring that this is largely offset by the negative excess burden on the spending side; 2. The failure to take account of the environmental disruption effects of most production and consumption (which make taxes largely corrective than distortive), relative-income effects (which bias in favor of private consumption), and burden-free taxes on goods with diamond effects; 3. The failure to recognize the fact that, in non-poor countries, higher private consumption does not increase happiness at the social level, making the happiness cost of public spending virtually zero. Both reported happiness and indicators of quality of life have little positive association with economic growth but increase with scientific and technological breakthroughs at the global level.

Keywords: public spending, government, research, environment, costs, taxation.

Economists are good in recognising the indirect, hidden costs of many things that escape the attention of monst non-economists. This is an important function of economists difficult to over-emphasise. However, most economists overestimate the costs (or underestimate the benefits) of public spending, especially on research and environmental protection. In combination with the global public-good and long-term nature of the fruits of research and environmental protection, this may make public spending on these items well below the optimal levels. The cost overestimation arises from the overestimation of the excess burden of taxation (Section 1), the failure to take adequate account of burden-free taxes, relative-income effects, and the environmental disruption effects of most production and consumption (Section 2), and the failure of further private consumption in non-poor countries to increase happiness, making the happiness cost of public spending virtually zero (Section 3). Accounting for these effects suggests that the recent world-wide trend towards custs in public spending may really be grossly inefficient despite some unavoidable inefficiency in public spending.

1. Overestimating the Excess Burden of Taxation

For a dollor of public spending, non-economists typically cost it at one dollar. However, economists typically cost it at well in excess of one dollar. A recent estimate by a prominent economist at Harvard University (Feldstein 1997) puts it at $2.65. Such high estimates of the costs of public spending suggest that public projects should yeild very high benefits before they are worthwhile to undertake. This conception probably partly contributes to the world -wide trend towards custs in public spending.

The costs of public revenue include not only its direct cost (the amount of taxes imposed) but also the costs of administration, compliance, policing, and distortion. While the first three types of costs are substantial, they do not vary significantly with the tax revenue raised. Hence, concentrating on the marginal costs of public spending, economists emphasize the ditortionary costs or excess burden of taxation due to the fact that taxes distort the free choices of individuals, especially in discouraging work effort, i.e. the disincentive effects. At least since the time of Pigou (1928), economists have emphasized that the benefits of public goods must exceed their direct costs by an amount sufficient to outweigh the excess burden of taxation. An authoritative modern textbook (Stiglitz 1988, p.140) puts the Pigovian principle this way: "Since it becomes more costly to obtain public goods when taxation imposes distortions, normally this will imply that the efrficient level of public goods is smaller than it would have been with nondistortionary taxation". It is known that this general rule is subject to qualifications due to the presence of considerations like complementarity/substituarity between public and private goods. (See, e.g., Atkinson and Stiglitz 1980, King 1986, Batina 1990, Wilson 1991, Chang 1997). Specific cases or conditions under which the efficient level of public goods is not affected have also been identified (Christiansen 1981, Boadway and Keen 1993, Konishi 1995).

In contrast to minor qualifications and special cases, a whole scale onslaught on the Pigou principle is presented by Kaplow. He argues that public goods can be financed without additional distortion by using an adjustment to the income tax that offsets the benefits of the public good. The 'preexisting income tax schedule is adjusted so that, at each income level, the tax change just offsets the benefits from the public good. By construction, an individual's net reward from any level of work effort will be unaltered; any reduction in disposal income due to the tax adjustment is balanced by the benefits from the public good. Because an individuals' after-tax adjustment is balanced by the benefits from the public good. Because an individual's after-tax utility as a function of his work effort will thus be unchanged, his choice of work-effort - and utility level - will also be unaffected' (Kaplow 1996, p.514).

For example, if the benefit of a public good is proportional to the income level of the taxpayers, it may be financed by a (or an increase in) proportional income tax. The proportional income tax itself may involve a disincentive effect. However, the tax plus the public good together involve no disincentive effect. For example, suppose the benefit of police protection of properties is proportional to the income level of the taxpayers. With a higher degree of police protection financed by a higher proportional income tax, a person benefits more (in comparison to a lower degree of protection and lower tax) and pay more by the same amount if she earns more, leaving the incentive structure unaffected.

While Kaplow's argument has to be qualified in the presence of tax evasion, heterogeneity of individuals at the same income level, benefits from public goods relating to ability than to income, etc., its main thrust is valid, as argued in more detail in Ng (forthcoming). How do we reconcile then with the orthodox position of the high costs of public spending? First, Feldstein (1997) obtains his high estimate of $2.65 by including policy-intended effects as unwanted distortions. He emphasises that higher tax rates may not only reduce the supply of labour and capital, but also changes the forms in which individuals take their compensation, including more on things that are tax deductible. However, while correctly including tax-induced expenditures on luxurious working conditions, he also includes other tax-deductible items like 'charitable gifts, and health care' as involving distortions. However, these items are what the society/government want to encourage either on the grounds of external benefits (e.g. the prevention of communicable diseases), poverty reduction, and possibly merit wants (though the last ground is more controversial). Provided the extent of tax-deductibility is not excessive, no net distortion is created. Or, the extent of the distortion is offset by the benefits, as demonstrated more formally in Ng (forthcoming).

Secondly, Feldstein's high estimate ignores the argument of Kaplow. Alternatively stated, while the cost of a dollar of public spending on the revenue side may be much higher than $1, the excess may be largely offset by the positive incentive (or negative disincentive) effects of the spending side. If the benefits of the public spending are not positively correlated with ncome such that there is no positive incentive effects on the spending side but only disincentive effects on the revenue side, there is a distributional benefit since the rich pay more and the poor pay less, as shown in more detail in Kaplow (1996) and Ng (forthcoming).

Since high tax rates also encourage tax avoidance and evasion and since some higher benefits of public goods are related to unobservable earning ability than observable income levels, the positive incentive effects on the spending side generally do not completely offset the distortive effects on the revenue side, making a dollar of public spending still in excess of a dollar taking both sides into account. However, as argued below, there are other considerations suggesting either that the cost of a dollar of public spending should be significantly reduced (possibly to below one dollar) or that the benefits of pbulic spending should be significantly increased from those normally estimated by economists.

2. Environmental Effects, Relative-income Effects, and Burden-free Taxes

Even before we take account of Kaplow's argument discussed above, the costs of public spending are overestimated due to the failure to take adequate account of the environmental effects, relative-income effects, and burden-free taxes.

Environmental Effects

The production and consumption of most goods and services impose significant disruption on the environment either directly or indirectly (through input usage), including various forms of pollution, congestion, deforestation, etc. Ideally, taxes should be imposed in accordance to the estimated costs on the society of these environmental disruption effects. However, largely speaking, this has not happened. Thus, the general taxes on income and consumption, though designed mainly for the purpose of revenue raising, may in fact serve as rough counteracting measures to the disruption effects involved. Thus, far from being distortive, taxation may be corrective; instead of imposing positive excess burdens or distortionary costs, taxation may impose serve ti improve efficiency. Given that tax rates are around 30% in most countries and the severity of the environmental effects, such may well be the case, especially if a global and long-term view is taken. At the very least, the distortive costs of taxation are far less than estimates that fail to account for the environmental effects. Most such estimates (e.g. the one by Feldstein mentioned above) do not consider the environmental effects.

Relative-income effects

The importance of relative incomes (one's income relative to those of others) is beyond doubt and has been discussed by economists as early as Rae (1834). However, its relevance for the costs of public spending has been ignored. Ignoring the possible concern for the poor, most people (with the exception of those at starvatin level) typically would not like a situation where the income of everyone is doubled while her income increases only by 5%.

For a single person, an increase in income increases both her absolute and relative incomes. It is thus perceived to be very important. If the friends/school-mates of your child all receive expensive birthday gifts, you also have to give your child an expensive one. If your friends all have luxurious cars, you may feel less satisfied with your standard one. However, since public goods are simultaneously consumed by all individuals, no such relative pressures are present. This causes a bias in favour of private spending or against public spending. The benefits of public spending are underestimated (effectively equivalent to an overestimation of the costs). In most estimates, the marginal benefit of private expenditure is likely to be taken to include the absolute-income or intrinsic consumption effects plus the internal or direct relative income effect (as these two taken together constitute the worth of private consumption as it appears to each individual), but not to include the negative external or indirect relative income effects. This creates an over-emphasis in favour of private expenditure, leading to a sub-optimal level of public spending, as demonstrated more formally in Ng (1987a).

Burden-free Taxes

Economists regard a tax of $1m as generally imposing a burden in excess of $1m, say $1.35m on the economy. (The $2.65m figure estimated by Feldstein is a remarkably high fiture; $1.35m is about the average estimate). The $1m is the burden that is exactly offset by the tax reveue. The $0.35m is the excess burden that is a deadweight loss created by the taxation distortion of choice. While most economists realize that corrective taxes on say pollution involve negative excess burden or positive efficiency gain, burden-free taxes are regarded as existent only in fairyland. However, there are goods taxes on which create not only no excess burden (the $0.35m) but no burden ($1m) at all. These are pure diamond goods or goods valuded for their values rather their intrinsic consumption effects. People consume or hold these goods to show off their wealth, to use them as stores of value or gifts of value. Cubic zirconia looks exactly like top quality diamond but costs only a tiny fraction of true diamond. But no one gives his fiancee an engagement ring of cubic zirconia. For such goods, it is the value (price times quantity) that enters the utility function of the consumer rather than the quantity, as posted in economic analysis. As prices increase due to higher taxes on these goods, consumers may just spend the same amounts to buy the same values without real losses. The revenues raised are pure gains, suggesting arbitrarily high taxes on them (Ng 1987a). While many goods (most precious metals and stones, top brands of most goods especially conspicuous items like cars and wines) possess various degrees of diamond effect, few if any good is a pure diamond good. Nevertheless, very high taxes on mixed diamond goods are still efficient. Moreover, as consumers may wish to consume the value (pure diamond) aspect of the mixed good so much (such as to show off their wealth) as to incur negative utility on the intrinsic consumption aspect (such as health-threatening excessive drinking), taxes on such mixed diamond goods may actually make consumers better off (being able to show off to the same extent without drinking to excess), as shown in Ng 1993.

1. The Failure of Private Consumption to Increase Happiness

When one is starving, increase consumption is essential. However, after the satisfaction of basic biological needs, there is increasing evidence that increases in private consumption fail to increase happiness at the social level. Individuals still engage in the rat race for making more money and consume more mainly due to the competitive aspect related to the relative-income, relative-consumption effects discussed above. It is true that happiness is difficult to measure and compare objectively. However, conceptually, it is cardinally measurable (Ng 1997). A practical method has also been developed and used to measure happiness cardinally and interpersonally comparably (Ng 1996a). Though most existing measures of happiness have more problems with their comparability, they are not completely useless. Different researchers come up with largely consistent results which also corespond with alternative measures like the opinions of friends. (See Veenhoven 1984, 1993). If one wants to be pedantic in insisting on perfect accuracy, even the measurement GDP is open to query on its accuracy and comparability.

The relationship between happiness and income level intertemporarily within the same country (at least for the advanced countries which have such data) does not have a positive relationship. For example from the 1940's to 1994, the real income per capita of the US nearly trebled. However, the percentage of people who regard themselves as very happy fluctated around 30%, without showing an upward trend; another measure of average happiness fluctuated around 72%. Over the period 1958-88, the per-capita real income level in Japan increased by more than five times (Summers & Heston 1991). However, its average happiness measured fluctuated around 59%, also without an upward trend. (See Diener and Suh 1997; Myers 1996, p.445; Frank 1997; Veenhovern 1993.) In fact, 'if there is a casual relationship in rich countries, it appears to run from happiness to growth, not vice-versa' (Kenny 1999, p.19). Also, recent research suggests that individuals who strongly value extrinsic goals (e.g. fame, wealth, image) relative to intrinsic goals (e.g. personal develoopment, relatedness, community) have less happiness (Ryan, et al., forthcoming).

Kenny (1999, pp.4-5) also puts the point of fast diminishing marginal utility of income in more objective terms thus: 'Compare Mozambique, China and the USA. In turn, the countries' GNPs per capita in 1992 were $80, $470 and $24,740. Infant mortalities were 145.6, 30.5 and 8.6 per 1,000 live births, respectively. Life expectancies were 47, 69 and 76 years. Thus, going 1.6 percent of the distance between Mozambique and the United States in terms of wealth, so reaching China's income, we move 84 percent of the distance in terms of infant mortality and 76 percent of the distance in terms of life expectancy.'

On the other hand, there are factors that affect or at least correlate with happiness much more significantly than income, including being married or single (Myers 1996, p.510), being employed or not (Winkelmann and Winkelmann 1998), and having a religious belief and church attendance.

For those who do not trust the more subjective measure of happiness and opt to use more objective indicators of the quality of life, the picture is not much different. Analyzing a panel dataset of 95 quality-of-life indicators (covering education, health, transport, inequality, pollution, democracy, political stability) covering 1960 - 1990, Easterly (1997) reaches some remarkable results:

1. While virtually all of these indicators show quality of life across nations to be positively associated with per capital income, when country effects are removed using either fixed effects or an estimator in first differences, the effects of economic growth on the quality of life are uneven and often nonexistent. "For the fixed effects estimator applied to 95 indicators, the coefficent of income was significant at the 5% level for 40 indicators. This is not so bad, except that only 23 of these 40 show improvement in the quality of life associated with rising income. It is distressing that almost as many indicators show significant deterioration in quality of life" (Easterly 1997, p. 18).

2. Most of the exogenous time shifts (69 out of 95 indicators) improve the quality of life and time shifts are more important than growth effects in the majority (62% of the 79 available indicators) of indicators. Even for the only 22 out of the 95 indicators with a significantly positive relationship with income under fixed effects, time improved 10 out of these 22 more than income did.

The surprising results are not due to the worsening income distribution (there is some evidence that the share of the poor gets better with growth). Rather, the quality of life of any country depends less on its own economic growth or income level but more on the scientific, technological, and other breakthroughs at the world level. These depend more on public spending than private consumption.

If private consumption does not increase happiness (at the social level), public spending that reducesw private consumption may be costly in dollar terms but not in happiness terms. Since money is not our ultimate objective while happiness is, reckoning in dollar instead of happiness terms overestimate the ultimate cost of public spending.

1. Concluding Remarks

From the various factors discussed above, the costs of public spending have ben grossly overestimated. While it is desirable to do away with the inefficiencies in public spending if possible, it increases in public spending, especially in research and environmental protection, that can really increase our welfare. The recent trend to check the growth in public spending may be grossly inefficient. In fact, Ng and Ng (forthcoming) shows that economic growth increases the optimal share of public spending and that, without directly dealing with environmental disruption, economic growth may reduce welfare even if the shares of public spending and environmental protection are being optimized.

In addition to the above considerations, public spending on reseach and environmental protection is also likely to be grossly sub-optimal due to its long-term and global public-good nature. Scientific advances and a cleaner environment benefit the whole world for generations to come. Decisions taken by national governments with relatively short time horizons results in sub-optimal spending in these areas even before we consider the factors accounting for the overestimation of the costs of public spending discussed above.

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