# Principles of Public Finance

Public Finance and a Review of Basic ConceptsThe Main Functions of the Public SectorResource AllocationRedistributionStabilizationDynamic OptimizationThe Failure of GovernmentA Review of Basic Analytical ConceptsConstrained MaximizationPareto OptimalityA Dual ApproachThe Public Sector in JapanIntergovernmental FinanceThe Budgetary SystemThe Budgetary Formula in JapanThe Budgetary ProcessThe Execution of the Budget and the Settlement of the AccountThe Content of the General Account in Japan The Category of BudgetGovernment ExpenditureTax RevenuePublic DebtOrganization of the Book Appendix: Japan's Fiscal ManagementReferencesThe Macroeconomic Theory of Fiscal Policy IThe Simple Keynesian Model The 45-degree ModelThe Fiscal MultiplierThe Multiplier with Tax RateThe Built-In StabilizerThe Balanced-Budget MultiplierThe IS/LM Analysis The Investment/Saving and Liquidity Preference/Money Supply Equilibrium ModelThe Size of the Multiplier in the IS/LM ModelExtreme Cases of the Zero Crowding-Out EffectDirect Crowding OutThe Crowding-In EffectThe Open Economy Extension to an Open Economy ModelThe Fixed Exchange SystemThe Flexible Exchange Rate System: The Effect of Fiscal PolicyThe Flexible Exchange Rate System: The Effect of Monetary PolicyZero Capital MovementThe Efficacy of Fiscal Policy and the Policymaker Three ViewpointsThe Lag of PolicyLag of Monetary PolicyLag of Fiscal PolicyLag and Automatic StabilizersRules Versus DiscretionAppendix: Public Investment in JapanA2 The Efficacy of Public Investment as a Counter-Cyclical MeasureA3 Fiscal Policy and the Optimal Size of Public InvestmentReferencesThe Macroeconomic Theory of Fiscal Policy IIThe Permanent Level of Fiscal VariablesDefinition of the Permanent Level of an Economic VariableThe Government's Budget ConstraintConsumption and Saving BehaviorOptimization Over TimeThe Permanent Income HypothesisThe Labor Market and Supply FunctionLabor Supply by HouseholdsLabor Demand by FirmsEquilibrium in the Labor MarketEquilibrium in the Goods MarketThe Effect of Fiscal Policy Three Cases of Fiscal ExpansionTemporary ExpansionPermanent Expansion APermanent Expansion BEvaluation of the Public SectorSubstitutabilityThe Multiplier Effect of Government SpendingEvaluation of Government SpendingAppendix: The Size of Government Spending and the Private Sector's EvaluationA2 Theoretical ConsiderationsA2.1 Evaluation of Government SpendingA2.2 Optimal Size of Government SpendingA2.3 Optimizing BehaviorA3 Empirical ResultsA4 ConclusionReferencesPublic DebtRicard's Neutrality TheoremA Two-Period ModelThe Implications of Public Debt IssuanceDebt Issuance in an Infinite Horizon EconomyThe Shift of the Burden to Future GenerationsA Two-Overlapping-Generations ModelThe Efficacy of Keynesian PolicyThe Shift of the BurdenBarro's NeutralityThe Inclusion of BequestsA Simple Model with BequestsBarro's Neutrality TheoremPolicy Implications of the Debt Neutrality TheoremPolicy ImplicationsTheoretical AssumptionsPerfect Capital MarketLump-Sum TaxesAnticipation of Future Tax IncreasesPlanning Period and Bequest MotiveEmpirical EvidenceThe Non-Keynesian Effect What Is the Non-Keynesian Effect?The Non-Keynesian Effect in the Real WorldSimple Theory of the Non-Keynesian EffectAppendix: Government Debt in an Overlapping-Generations ModelA2 The Basic Model of Overlapping GenerationsA2.1 The Consumer Within the Model of Overlapping GenerationsA2.2 Production Technology and Capital AccumulationA3 Government Debt and Intergenerational TransferA3.1 The Transfer ProgramA3.2 Some RemarksA3.3 The Burden of DebtA4 Debt Neutrality with Altruistic BequestsReferencesEconomic Growth and Fiscal PolicyA Simple Growth Model Long-Run Growth Rate in the Harrod-Domar ModelThe Effect of Fiscal PolicyThe Incorporation of Public InvestmentOptimal Public Investment The Role of Public SpendingPublic Investment in the Market EconomyOptimal Allocation Between Two RegionsOptimal Size of Public InvestmentThe Discount Rate of Public InvestmentThe Solow ModelFormulation of the Solow ModelStability of the SystemThe Effect of Fiscal PolicyThe Endogenous Growth ModelThe Optimal Growth ModelThe AK ModelPublic Investment and Growth RateInequality and Economic GrowthIncome Redistribution and Tax RateExternality of Educational InvestmentAppendix A: Taxes on Capital Accumulation and Economic GrowthA1 IntroductionA2 The Endogenous Growth ModelA2.1 TechnologyA2.2 The Three-Period Overlapping-Generations ModelA2.3 The Altruistic Bequest MotiveA3 Economic Growth and Efficiency A3.1 The First Best SolutionA3.2 Optimizing Behavior in the Market EconomyA3.3 The Circumstance in Which Physical Bequests Are ZeroA3.4 The Circumstance in Which Physical Bequests Are OperativeA4 Taxes and Economic Growth A4.1 The Constrained EconomyA4.2 The Unconstrained CircumstanceA5 ConclusionAppendix B: The Supply-Side Effect of Public Investment in JapanB1 Earlier StudiesB2 Recent StudiesB3.1 Constraints in JapanB3.2 Public Investment Management ReformB3.3 Strengthening Wide-Ranging CoordinationB3.4 Cost-Benefit AnalysisB4 Public Investment Management ReformReferencesFiscal ManagementUnderstanding Fiscal Management The Problem of Public Debt IssuanceBalanced-Budget PolicyThe Efficacy of Keynesian PolicyThe Tax-Smoothing HypothesisCompensation PolicyThe Long-Run Argument for a Zero-Tax NationOverall Arguments on Fiscal DeficitsFiscal Bankruptcy The Possibility of Fiscal BankruptcyThe Government Budget ConstraintPrimary BalanceThe Dynamics of Government Budget ConstraintSome Special Casesg = tr = ng + rb — t = 0The Rate of Interest and Fiscal CrisisFiscal Consolidation Desirable Fiscal ConsolidationThe Optimal Target of Fiscal ConsolidationPolitically Weak GovernmentThe Legal Constraint of Fiscal ConsolidationThe EU and the EuroAppendix: Fiscal Deficits in a Growing EconomyA1 IntroductionA2 A Simple Growth ModelA2.1 Analytical FrameworkA2.2 The Government's ObjectiveA3 Optimal DeficitsA3.1 Phase DiagramA3.2 Optimal Deficit During TransitionA3.3 Macro IS BalanceA3.4 Comparative DynamicsA3.5 Optimal Deficit in the Long RunA3.6 Numerical ExampleA4 ConclusionA4.1 Deficits and GrowthA4.2 Deficit Ceilings and Fiscal PrivilegeA4.3 Hard Budget and Soft Budget OutcomesReferencesThe Public PensionJustification of the Public PensionThe Public Pension SystemJustificationIncome RedistributionThe Failure of Private PensionsPaternalismThe Efficiency of a Compulsory Public PensionEconomic Effect of the Public PensionThe Funded SystemThe Pay-AS-You GO SystemPublic Debt and the Public PensionThe Funded System and Public Debt Issuance Within the Same GenerationPay-AS-You-GO System and Public Debt Issuance Among GenerationsGenerational AccountingPublic Pension ReformThe Aging Population in JapanThe DB SystemThe Move from DB to DCA Fully Funded SystemIntergenerational ConflictsPrivatization of the Pay-AS-You-GO System A Simple ModelThe Gain in Economic Welfare Through PrivatizationAppendix A: Intergenerational Conflict in an Aging JapanA1 IntroductionA2 Medical InsuranceA2.1 Japan's Health Care SystemA2.2 The Retired and ElderlyA2.3 Issues of Medical InsuranceA3 The Pension SystemA3.1 Japan's Public Pension SystemA3.2 Pension Reform in an Aging JapanA3.3 Outline of the 2004 Pension Plan RevisionA3.4 Is the 2004 Reform Effective?Appendix B: Simulation Analysis in an Aging JapanB1 IntroductionB2 The ModelB3 Simulation Analysis in Ihori et al. (2005)B3.1 DemographyB3.2 Government DeficitsB3.3 The Social Security SystemB3.4 TaxesB3.5 Technological ProgressB3.6 Simulation ResultsB4 Simulation Analysis in Ihori et al. (2011)B4.1 AssumptionsB4.2 Simulation ResultsB5 ConclusionReferencesThe Theory of TaxationTaxation and Labor Supply A Model of Labor SupplySubstitution Effect and Income EffectThe Cobb-Douglas Utility FunctionThe Efficiency of TaxationA Comparison with Lump Sum TaxThe Size of the Excess BurdenThe Excess Burden and the Substitution EffectInterest Income Tax and Saving The Life Cycle Saving HypothesisThe Effect of Interest Income Tax: The Substitution Effect and the Income EffectThe Cobb-Douglas Utility FunctionThe Human Capital EffectThe Cobb-Douglas Utility Function RevisitedInvestment and TaxThe Classical ViewCorporate Tax and Borrowing FundsCorporate Tax and Retained EarningsThe Cost of CapitalDepreciationThe Incidence of Corporate Income Tax in JapanConsumption TaxShift of the Tax Burden and Price DeterminationThe Consumer as the Legal TaxpayerThe Burden of Tax and IncidenceAppendix: The Savings Elasticity Controversy A1 Boskin (1978)A2 Summers (1981)ReferencesTax ReformLabor Income Tax and Interest Income TaxExogenous Labor SupplyComprehensive Income TaxExpenditure TaxEndogenous Labor SupplyThe Negative Incentive Effect and Optimal TaxationThe Theory of Optimal TaxationTheoretical FrameworkThe Ramsey RuleThe Inverse Elasticity PropositionThe Uniform Tax Rate PropositionMathematical FormulationHeterogeneous HouseholdsThe Theory of Tax ReformOptimal Taxation and the Theory of Tax ReformThe Fundamental Rule of Tax ReformApplication to Some ExamplesEnlarging the Tax BaseUnifying Tax RatesGeneral Consumption Tax and Labor Income TaxThe Equivalence TheoremA One-Period ModelSome RemarksThe Timing Effect of TaxationThe Overlapping-Generations ModelThe Incidence of Tax ReformTransitional GenerationsThe Effect on Saving and Economic GrowthSimulation Analysis of Tax ReformMulti-Period Overlapping-Generations Growth ModelComments by Evans (1983)Appendix A: Optimal Taxation in an Overlapping-Generations EconomyA1 The Optimal Tax Rule A1.1 Overlapping-Generations Growth ModelA1.2 Dual ApproachA2 The First Best SolutionA3 Second Best SolutionA4 Optimal Taxation in the Second Best CaseA4.1 The Modified Ramsey RuleA4.2 The Elasticity TermA4.3 The Implicit Separability ConditionA4.4 Two Objectives and Intertemporal EfficiencyA4.5 The Lagrange MultiplierA5 Heterogeneous Individuals and Distributional ObjectivesAppendix B: Tax Reform Within Lump Sum TaxesB1 IntroductionB2 Analytical FrameworkB3 Lump Sum Tax ReformB3.1 The Tax Postponement EffectB3.2 The Effect on SavingsB3.3 The Welfare Effect of Tax ReformB4 The Tax Timing EffectB4.1 The Welfare Implication of the Tax Timing EffectB4.2 SummaryB5 Some RemarksReferencesIncome RedistributionProgressive Income TaxIncome Redistribution PolicyA Two-Person Model with Income InequalityThe Social Welfare FunctionThe Socially Optimal PointThe Optimal Income Tax SchedulePerfect Equality When Income Is UncertainEndogenous Labor SupplyThe Detrimental Outcome of Perfect EqualityEndogenous Labor SupplyA Linear Income Tax ScheduleThe Tax Possibility CurveThe Optimal Income TaxThe Rawls JudgmentThe Bentham CriterionOptimal RedistributionNonlinear Income TaxThe First BestSelf-Selection ConstraintThe Optimal Marginal Tax RateA Differentiated Linear Tax ScheduleThe Recent Approach to the Optimal Marginal Tax RateEconomic Constraint and RedistributionCredibilityThe Crowding-Out EffectExpectationAsymmetric InformationStigmaCommitmentAppendix: Optimal Linear Income TaxA1 IntroductionA2 The ModelA3 Shift of the Social Welfare FunctionA4 Shift of the Tax Possibility FrontierA4.1 The Maximin CaseA4.2 The Utilitarian CaseA5 ConclusionReferencesThe Theory of Public GoodsPublic Goods 1.1 Public Goods and Private GoodsFormulation of Public GoodsPublic Goods and Actual Government SpendingOptimal Provision of Public Goods: The Samuelson RuleThe Samuelson Rule: Diagramed DerivationThe Samuelson Rule: Mathematical DerivationThe Samuelson Rule: Simple DerivationNumerical Example: A Two-Person Model of Public GoodsThe Theory of Public Good Provision: The Nash Equilibrium ApproachThe Nash Equilibrium Approach of Private ProvisionA Two-Person ModelEfficiency of the Nash EquilibriumExamples: ComparisonCriticism of the Nash Equilibrium ApproachThe Theoretical Analysis of Public Goods: The Lindahl EquilibriumThe Lindahl EquilibriumEfficiency of the Lindahl EquilibriumThe Free Rider ProblemPublic Goods and the Free Rider ProblemPossibility of the Free Ride ProblemGame Theory Approach to the Free Rider ProblemThe Clarke TaxThe Clarke Tax and a Balanced BudgetThe Neutrality Theorem of Public GoodsThe Neutrality TheoremThe Model of Neutrality ResultPerfect Crowding OutPlausibility of the Neutrality TheoremConcluding RemarksAppendix: Public Bads, Growth, and WelfareA1 IntroductionA2 Analytical FrameworkA3 Wealth DifferentialsA3.1 The Neutrality ResultA3.2 Analytical ResultA4 Immiserizing GrowthA5 ConclusionReferencesPublic Spending and the Political ProcessThe Failure of GovernmentGovernment InterventionThe Theory of Public ChoiceSmall GovernmentThe Voting Model Inequality and the Demand for Public GoodsAnalytical FrameworkThe Median Voter TheoremThe Voting Model and RealityThe Paradox of VotingProblems with the Median Voter HypothesisInterest GroupsPolitical Parties and Fiscal PolicyThe Objective of PartiesThe Convergence TheoremFurther Analysis of the Convergence TheoremExtensions and VotingThe Political Business CycleThe Partisan Business CycleTheoretical Model of the Partisan Business CycleThe Macroeconomic ModelThe Behavior of Two PartiesThe Effect of the ElectionThe Probability of Winning the ElectionFurther CommentsChange of GovernmentThe Evaluation of Public SpendingAppendix A: Fiscal Privileges, Consolidation Attempts, and Pigouvian TaxesA2 The Basic ModelA3 The Model Without Consolidation Attempts A3.1 The Competitive SolutionA3.2 Pigouvian TaxA4 The Model with Consolidation AttemptsA4.1 The Competitive SolutionA4.2 Pigouvian TaxA4.3 The Consumption TaxA5 ConclusionAppendix B: Political Factors and Public Investment Policy in JapanB1 Political Pressures from Local Interest GroupsB2 Intergovernmental Transfers in JapanB3 The Impact of Interregional TransfersB4 Efficient and Effective Public Investment ManagementReferencesLocal Public FinanceIntergovernmental FinanceDecentralization and Local FinanceThe Decision System of Intergovernmental FinanceThe Centralized SystemThe Decentralized SystemIntergovernmental FinanceThe Supply of Local Public GoodsLocal Public GoodsThe Optimal Provision of Local Public GoodsVoting with Their Feet: The Tiebout HypothesisPlausibility of the Tiebout HypothesisTax CompetitionThe Competition for a Mobile Tax BaseTaxing Mobile CapitalThe Time Consistency of a Tax PolicyThe Time Consistency ProblemA Simple ModelThe Principle of Local TaxThe Overlapping Tax BaseThe Soft Budget ProblemThe Benefit-to-Pay PrincipleThe Fixed Asset TaxThe Inhabitant TaxThe Consumption TaxBasic Principles of a Local Tax SystemRedistribution among Local GovernmentsRegional Diversity of Local TaxThe Three-Person Model of Regional RedistributionEfficiencyFurther Issues on Intergovernmental FinanceLocal Public DebtA Decentralized Fiscal SystemAppendix: An Analytical Model of Central and Local Governments in Japan A1 The Local Allocation Tax in JapanA2 An Analytical Model of Central and Local GovernmentsA2.1 The Soft Budget ConstraintA2.2 An Analytical FrameworkA2.3 The Pareto Efficient SolutionA3 The Hard Budget GameA3.1 The Second StageA3.2 The First StageA3.3 OutcomeA4 The Soft-Budget GameA4.1 CG's Ex Post Transfer: The Second StageA4.2 LG's Behavior: The First StageA5 Welfare ImplicationsReferences