PUBLIC FINANCE IN THEORY AND PRACTICE j j j j j j j j j j j . j j j j j j j j j j j j j j j j j j j j j j j PUBLIC FINANCE IN THEORY AND PRACTICE Fifth Edition Richard A. Musgrave H. H. Burbank Professor of Political Economy, Emeritus Harvard University Adjunct Professor of Economics University of California at Santa Cruz Peggy B. Musgrave Professor of Economics University of California at Santa Cruz McGRAW-HILL BOOK COMPANY New York St. louis San Francisco Auckland Bogota Caracas Colorado Springs Hamburg Usbon london Madrid Mexico Milan Montreal New Delhi Oklahoma City Panama Paris San Juan sao Paulo Singapore Sydney Tokyo Toronto PUBLIC FINANCE IN THEORY AND PRACTICE INTERNATIONAL EDITION 1989 Exclusive rights by McGraw-Hill Book Co- Singapore for manufacture and export. This book cannot be re-exported from the country to which it is consigned by McGraw-Hill. Copyright© 1989, 1984, 1980, 1976, 1973 by McGraw-Hill, Inc. All rights reserved. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a data base or retrieval system, without the prior written permission of the publisher. 6 7 8 9 20 MPM 20 9 8 7 6 5 4 This book was set in Times Roman by the College Composition Unit in cooperation with Arcata Graphics/Kingsport. The editor was Scott D. Stratford; the designer was Rafael Hernandez; Project supervision was done by The Total Book. New drawings were done by Fine Line Illustrations, Inc. Library of Congress Cataloging-in-Publication Data Musgrave, Richard Abel, (date). Public finance in theory and practice I Richard A. Musgrave, Peggy B. Musgrave.- 5th ed. p. em. Bibliography: p. Includes index. ISBN 0-07-044127-8 ISBN 0-07-044128-6 (pbk.) 1. Finance, Public-United States. I. Musgrave, Peggy B. II. Title. HJ257 .2.M87 1989 88-13317 336.73-dc19 When ordering this title use ISBN 0-07-1 00227-8 Printed in Singapore About the Authors Richard A. Musgrave is H. H. Burbank Professor, Emeritus, at Harvard Univer- sity and adjunct professor of economics at the University of California, Santa Cruz. After undergraduate work at Heidelberg University, he came to the United States in 1933 and received his Ph.D. from Harvard University. Having served at the Fed- eral Reserve Board during the 1940s, he taught at the University of Michigan, Johns Hopkins, and Princeton before returning to Harvard in 1964. Professor Musgrave has authored numerous volumes and papers in the fields of public fi- nance and fiscal policy. Named Distinguished Fellow of the American Economic Association and Honorary President of the International Institute of Public Finance, he has been elected to the National Academy of Science, and has been a recipient of the Frank A. Seidman Distinguished Award in Political Economics and of hon- orary doctorate degrees. Peggy B. Musgrave is a professor of economics at the University of California, Santa Cruz. She received her undergraduate training at Cambridge University, a Master's degree at American University, and a Ph.D. at Johns Hopkins University, specializing in international aspects of public finance. Professor Musgrave has worked with the International Tax Program of Harvard Law School and has con- sulted with the World Bank, the U.S. Treasury Department, the Senate Foreign Relations Committee, and the United Nations. She is the author of many books and journal articles dealing with various international aspects of public finance. Her current teaching interests include public finance, cost-benefit analysis, law and economics, and women in the economy. Dr. Musgrave is currently involved in re- search and writing on international tax coordination. v Contents Preface to the Fifth Edition XV Excerpt from the Preface to the First Edition xvii PART ONE WHAT THE PUBLIC SECTOR IS ABOUT Chapter 1 Fiscal Functions: An Overview 3 A Introduction 3 B The Allocation Function 7 c The Distribution Function 9 D The Stabilization Function 11 E Coordination of Budget Functions 13 F Summary 14 Chapter 2 Public Sector in the Economic Accounts 15 A Public Sector in the Circular Flow 15 B Public Sector in the National Income Accounts 17 Chapter 3 Fiscal Institutions 21 A Survey of United States Fiscal Structure 21 B The Constitutional Framework 23 c Implementation of Expenditure Policy 31 D Implementation of Tax Policy 33 E Other Aspects of Implementation 35 F Summary 37 vii viii CONTENTS PART TWO ALLOCATION, DISTRIBUTION, AND PUBLIC CHOICE Chapter 4 Public Provision for Social Goods 41 A Social Goods and Market Failure 42 B Provision for Social Goods 45 C Mixed Goods 49 D Giving as a Social Good 55 E Merit Goods 55 F Summary 58 Chapter 5 Social Goods Considered Further 59 A Meaning of Efficiency 60 B Efficient Provision of Private Goods 60 C Efficient Provision of Social Goods 65 D Social-Goods Allocation in the Budget 68 E Allocation or Distribution: Which Comes First? 71 F Summary 71 Chapter 6 Equity in Distribution 73 A Does Equity Belong in Economics? 74 B Approaches to Distributive Justice 76 C Limits to Redistribution 82 D Summary 85 Chapter 7 Public Choice and Fiscal Politics 87 A Direct Democracy 88 B Representative Democracy 96 C The Leviathan Hypothesis 99 D Classes and Interest Groups 106 E Summary 108 PART THREE EXPENDITURE STRUCTURE AND POLICY Chapter 8 Public Expenditures: Structure and Growth 113 A Public Expenditure Growth 114 B Growth by Type of Expenditure 116 C International Comparison 119 D Causes of Expenditure Growth 119 E Summary 128 CONTENTS lx Chapter 9 Expenditure Evaluation: Principles 130 A Decision Rules 131 B Fundamentals of Project Evaluation 135 c Types of Benefits and Costs 137 D Measurement of Benefits and Costs 139 E Assigning Weights in Project Selection 143 F Efficiency and Equity Once More 147 G Discounting and the Cost of Capital 150 H Risk and Economic Change 160 Summary 161 Chapter 10 Case Studies in Expenditure Policy: ( 1) Public Services 164 A National Defense 164 B Highways 167 c Outdoor Recreation 177 D Education 180 E Summary 185 Chapter 11 Case Studies in Expenditure Policy: (2) Low-Income Support and Social Insurance 187 A Low Income Support Programs 188 B Effects on Work Incentives 190 c Social Insurance Programs 195 D Issues in OASI 199 E Summary 206 PART FOUR PRINCIPLES OF TAXATION Chapter 12 Introduction to Taxation 211 A Categories of Revenue 211 B Requirements for a "'Good'' Tax Structure 216 c Summary 217 Chapter 13 Approaches to Tax Equity 218 A Application of Benefit Principle 219 B Ability to Pay: (I) Horizontal Equity and Choice of Tax Base 223 c Ability to Pay: (2) Vertical Equity and Rate Structure 228 D Summary 231