[SOUND] Welcome back. In this lecture we will talk about taxes. Taxes are quintessential for governments' presence in economies. And it's no surprise that theory of taxation is a central part of the public economics theory. Let's first recall what we learned last time. The role of government was defined as one that fixes market failures. Markets do miracles but beyond the limits where they are efficient markets fail. And such failures can be very costly economically and very painful socially. If markets failures are left unattended, then societies according to the famous metaphor of Thomas Hobbes would be in their nature states. And again, by using the formulation of Thomas Hobbes, life in such societies would be poorer, nasty, brutal, and short. Governments come to rescue, and they offer an alternative mechanism of resource allocation which supplements markets, augments markets, and in a more general way is combined with markets to ensure proper coordination of individual activities and efficient allocation of resources in cases where markets alone can not do this job. Therefore, the role of governments, as we agreed, is to prevent market failures. This definition, of course, is way too general although it gives us a good idea as to what government should be doing in economies, implementations of these general ideas, interpretations of these ideas could be very different from each other depending on social, economic, and political context. And, therefore, it should come as no surprise that governments around the world and across periods of history are very different from each other. They can differ in sizes, they can differ in scopes, they can differ in what they do, they can differ in how they do. We observe a huge variety of governments in modern world and across history. One way to explain this variety is to assume that societies optimally select governments to serve their needs. However, as in every optimal choice problem, we have to deal with preferences and constraints. So, one way to explain goverments' variations across the world and across history is to assume that our preferences are very different. For example, some societies could prefer big governments. Some societies have stronger aversion to inequality, stronger sense of solidarity, and, therefore, they would task their governments, trust their governments with extensive redistribution of resources. Other societies are more minimalist, they value freedoms, they value market forces, and as a result they keep their governments minimal. Apart from preferences, societies could be different from each other in the constraints which governments face when they operate. Such constraints can be different in their nature, and we'll discuss those at great length later in this lecture. But just to give an idea, one constraint that governments have to deal with is the informational constraint. As we all know, informational asymmetry is a fundamental feature of economies. And markets fail oftentimes precisely because of informational asymmetry. You know very well, or I assume you know or might have heard about the so-called lemon problem whereby if I want to sell you a used car you might be uncertain about the quality of this car. And this uncertainty could preclude us from concluding a transaction that otherwise would have been quite beneficial for both of us. Therefore again, informational asymmetry is a source of market failures but at the same time informational asymmetry constrains governments as potential remedies of market failures. To properly implement their functions, governments need to have a lot of information about markets, economy, firms, individuals, taxpayers, so on and so forth. Much of this information is privately held. And it would be unrealistic to assume that governments can collect this information fully and accurately. Therefore, information constraints is something that we have to deal with when we try to visualize the role of government. Another constraint that might be quite relevant is the government's capacity. We can imagine some governments are staffed with highly competent, well trained, highly motivated, non-corrupt public servants that have access to necessary tools, mechanisms, data systems, so on and so forth. In other circumstances, governments might not have enough funds to support a strong cadre of public servants. These public servants might lack the incentives, might lack the training, the skills, and many other things. And, as a result, these governments will not be able to do as much as more capable governments can do. Nonetheless, it's still possible to think of societies choosing their government, so that under the constraints that governments are faced with, the societies select governments to do as well as possible their jobs. And, as a result, as I said before, if we assume this optimal design government position, then the variation of governments across the world can be explained by simply the variation of societal needs, preferences, and constraints that they have to deal with while choosing their government system. Normative view in economics is basically about how best to organize certain types of economic activities. And normative views in public economics is about how best to organize governments. Well, of course, in real world societies are very rarely sufficiently unanimous. And public choice of governments institutions, ways and means government function is rarely a single person's decision. Therefore, applying normative views to explaining real life government performance might not be entirely realistic. And what might be an alternative, would be what is called positive view. When economists assume positive view, they're not trying to tell how to best organize certain activities but instead are trying to explain what is happening in certain areas given the interests, given the preferences, given the incentives, so on and so forth. And, therefore, when we study governments, we should try to combine normative and positive approach. However, normative view is still quite useful and valuable for a variety of reasons one of which would be that normative view gives us a benchmark. We can compare the performance of governments in real life against normative predictions and, as a result, we will be able to see to what extent the governments are doing or not doing their best in serving the needs of society. Second reason to keep in mind is that oftentimes normative prescriptions are observed in real life despite of the fact that no single person, no single decision maker selects a government, and, as I said, governments are outcomes of a complex political processes and public choices. I can mention at least a couple of explanations as to why in real life governments are close to what normative theory predicts, or could be close to what normative theory predicts. One reason is that the interest that dominates public choice, that prevail in shaping governments, this interest might be quite consistent with the interests of society. Some interests group might be just representing the interests of society, if you will, by coincidence. For example, if governments are under very strong influenced of business interests lobbies, sometimes business interests lobbies press for competitive markets, for efficient regulation, and for other things that government, that society wants from their governments. The second reason is that institutions including governments in modern world are oftentimes subject to competitive selection process. They experience evolutionary pressure just like species in nature experience evolutionary pressure. And, therefore, if some societies, for whatever reasons, selected bad institutions have improperly functioning governments, then sooner or later international competitive pressure upon these societies will force them to improve their governments and to bring their performance closer to what the normative theory predicts. Of course, you can not rely on these two mechanisms alone to ensure that governments are efficient. You see so many examples of government failures, corruption, capture, so on and so forth. Efficient governments are not a foregone conclusion. But for the reasons I just explained, it's still quite important to see what efficient governments are all about. And when we discuss efficient governments we are trying basically to answer a number of very important questions. The first one is what government should be doing. The general dictum that government should be fixing market failures gives us some guidance. But, in and of itself, it's not sufficient to describe the scope of governments. In other words, to decide what functions in economy a government would assume upon itself. Just to give a simple example, we'll agree that governments have to provide public goods. There is a variety of public goods in economies. And some goods are public only to a certain extent. And, therefore, we cannot expect that if there is some presence of publicness in a certain good, the government has to be involved. In some countries, in some nations, governments take care of a large array of public goods. In some others, they take care of the most vital public goods such as environmental protection, national defense, law and order, and so forth. Whereas the rest of public or quasi public goods such as, perhaps, education, healthcare, and examples like that are left at least partly in private hands or left to what is known as public/private partnerships where governments and public sector and private sector firms cooperate with each other in providing these public goods. Some example of regulations, some governments assume very broad regulatory prerogatives that regulate very many aspects of economies and social life. They legislate and sometimes criminalize certain activities whereas elsewhere governments refrain from being involved in these areas. So, the scope of government is a very important decision variable when we decide what government should and should not be doing. The second very important question is the size of government. It's about the volume of resources that the government controls. It's about the size of the public sector. It's about the level of taxation. It's about public expenditure programs, social services, and so forth. And here again, we observe a very broad range, for example, on one extreme we will see what is known as the welfare state whereby the government collects vast resources and use these resources to fund very generous, encompassing, very enabling social services and safety nets. And on the other, and on the other end of this spectrum, we'll see minimal government, where public expenditures are very severely restricted and cut. Last but not least, an important issue is what tools, taxes, laws, regulations, expenditure programs the government deploys to implement its functions. And here again, we observe a variety of choices. Let's talk about taxation for a second. This is something we'll be doing extensively for the rest of this lecture. Governments can collect revenues by using multiple taxes. They can tax income. They can tax sale. They can tax property, so on and so forth. So, how and why different taxes have to be combined with each other? Let's talk about externalities. Sometimes governments can address externalities by using direct regulations, by prescribing economic agents certain course of actions, or by using legal restrictions that economic agents would be prohibited to violate. In other instances, governments prefer to deal with such externalities through courts. Again, don't forget that courts are parts of government, so you can, for example, combine regulations and courts as means to prevent or control externalities. This is another example of decision variables. So, degrees of freedom that societies have when they try to chose their governments as best as they can. So, for the rest of this lecture I'm going to discuss with you how a particular area of government activities, that is taxation, should be chosen given preferences and constraints to best serve the society's needs. [SOUND] [MUSIC]
