PUBLIC CHOICE THEORY AND THE

ECONOMICS OF TAXATION

LECTURE NOTES

Revealing society’s preferences through majority voting is the way collective decisions are made in a
democracy.
A. Majority voting can lead to inefficient outcomes; that is, the majority can defeat a proposal that would have
provided greater benefits than costs and adopt one that costs more than the benefits it provides
1. Illustration of an inefficient “no” vote result: Suppose there are 3 voters who each will have to pay P300 in
tax if a proposal is adopted. It is worth P700 to one, P250 to the second and P200 to the third. The second
and third voters will vote “no” and defeat the proposal despite the fact that the total benefits (P1150) exceed
the P900 cost.
2. Illustration of an inefficient “yes” vote result: Take the same three voters as above and the same level of
taxation. Now the proposal is worth P100 to the first voter and P350 to each of the others. The vote will be 2
to 1 in favor of the proposal even though the total benefit of P800 is less than the P900 cost.
3. Conclusion: The problem is that the oneperson onevote rule does not measure intensity of preferences, so the
result may not be economically efficient.
B. Interest groups may improve the economic efficiency of results by registering intense feelings with elected
representatives or by organizing major efforts to get the vote to go their way.
C. Logrolling or vote trading may also secure favorable decisions for those who feel strongly about certain issues,
but it may also negate an efficient outcome in favor of a special interest group where the value of the benefits
received does not justify the cost. The efficiency of the outcome will depend on the circumstances.
D. The paradox of voting is that society may not be able to rank its preferences consistently through majority voting.
1. If three voters have expressed their rankings of three public projects; each has a different ranking. If voting is
done on pairs of projects, it can be shown that national defense will win over roads, and roads will win over
weather warning systems. But the logical conclusion that the community prefers national defense to weather
warning systems is not the case—they would each get the same number of points (if points were awarded for
a 1st, 2nd, and 3rd choice). In other words, if one choice must receive a majority of the votes, there will not
be a consistent outcome in this case unless somehow the strengths of the rankings can be measured.
2. Government might find it difficult to provide the “correct” public goods by acting in accordance with
majority voting.
E. The median-voter model suggests that under majority rule the median voter will in a sense determine the
outcomes of elections. The median voter is the person holding the middle position on an issue.
1. There are three voters deciding among three types of weather warning systems. The first is willing to spend
P400; the second, P800; the third, P300. The median-voter model suggests that the P400 proposal will win.
In a choice between the P400 and P800 proposal, the first and third will vote for the P400 type. In a choice
between the P400 and P300, the first and second will vote for the P400 type. In other words, both extreme
voters prefer the median choice rather than the other extreme, so the median voter will tend to predominate.
2. Real-world examples occur in political positions where candidates seem to aim their appeal at the median
voters within each party to get the nomination and later at the middle of the population in an effort to win the
election.
3. Implications of the median-voter model:
a. Many people will be dissatisfied by the extent of government involvement in the economy.
b. Some people may “vote with their feet” by moving into political jurisdictions where the median voter’s
preferences are closer to their own.
c. Median preferences can change over time.
Government failure can occur as well as market or private sector failure. The fact that the latter exist does not
mean that the public sector improves efficiency.
A. Special interests and “rent seeking” may promote the interests of a small group at the expense of society at large.
1. The special-interest effect refers to the situation where a small number of people will receive large gains at
the expense of a much larger number of people who individually suffer small losses. The small group will be
well informed and highly vocal on the issue and press politicians for approval. The large numbers who will
each suffer small losses will not have the incentive to be informed or feel strongly. The result is that the
politician will support the specialinterest program, whose supporters will notice the vote in their favor, and
ignore the majority who don’t feel strongly.
2. Pork-barrel politics is an example of the special-interest effect. In this case, the benefit goes to a single
political district and to the politician from that political district. The cost of the project is spread out to many
individuals who will never receive the benefits. Pork-barrel politics is often combined with logrolling.
3. Rent-seeking behavior occurs when a transfer of wealth at someone else’s or society’s expense occurs
through government action. Here the term “rent” means any payment to a resource supplier, business, or
other organization above that which would accrue under competitive market conditions. Examples include
tax loopholes that benefit only certain groups; public works projects that cost more than the benefits they
yield; and occupational licensing that requires more than is necessary to protect consumers.
B. Clear benefits, hidden costs (or the reverse, immediate costs and future more vague benefits) are another dilemma
for politicians trying to decide on public programs. Where the benefits are recognizable and popular, the
politician may vote for the program even if the costs exceed these benefits if the costs are diffuse or hidden.
C. Limited and bundled choice is another problem with public goods. The voter must choose between a few
candidates who will have the power to select the public goods and services to be financed by the voter’s tax
money. The choices are “bundled” in that the limited set of candidates will govern over a variety of issues, and
the voter’s preferences may not perfectly align with any candidate. In the private sector, the consumer has a
multitude of choices available, and can generally separate out those goods and services not desired.
D. Bureaucracy and inefficiency can be another problem in the public sector because there is not the profit motive or
competitive pressure to perform efficiently. Ironically, the typical response of government to a program’s failure
may be to increase its budget and staff.
1. Government employees, together with the special-interest groups they serve, often have the political clout to
block attempts to pare down or eliminate their agencies.
2. There is a tendency for government bureaucracy to justify continued employment by looking for and
eventually finding new problems to solve.
E. Imperfect institutions exist in both the public and private sectors, which often makes it difficult to decide which
institutions would perform best in the production of certain goods and services.
Apportioning the tax burden and deciding how the public sector should be financed is also a complex question.
A. Benefits received vs. ability to pay principle of taxation.
1. The benefitsreceived principle asserts that households and businesses should be taxed in relationship to the
services they receive. For example, gasoline taxes are earmarked for highway construction and maintenance.
a. How can the government decide which citizens receive how much benefit from less divisible public
goods like national defense?
b. Government efforts to redistribute income would be selfdefeating if the benefitsreceived principle of
taxation were applied universally—welfare recipients would have to pay for their welfare at the extreme
version of this.
2. The ability-to-pay principle asserts that the tax burden should rest more heavily on those with greater income
and wealth. The rationale is that those people with much income or wealth will value their marginal dollars
less than those with low incomes, where each dollar is very meaningful.
B. Progressive, proportional, and regressive taxation systems relate to the above issues.
1. A tax is progressive if its average rate increases as income increases; the tax grows absolutely with income
and also proportionately.
 2. A tax is proportional if its average rate remains the same; the tax payment grows absolutely with income but
remains the same proportionate to income.
3. A tax is regressive if its average rate declines as income increases; the tax may or may not increase in the
absolute amount, but it declines in proportion to income.
C. Applications in existing tax structure:
1. Sales taxes are not as proportional as they seem if they are on all goods. A general sales tax is regressive
because, although everyone pays the same percent on expenditures, the rich tend to spend a much smaller
fraction of their incomes, while the poor may spend all of their incomes. Therefore, the rich will pay a
smaller overall proportion of their income in sales taxes.
2. The corporate income tax is essentially a flat-rate tax with a set rate, but if it is passed on to consumers in the
form of higher prices it may actually be regressive in its impact.
3. Property taxes tend to be regressive because landlords pass along this cost to tenants who have lower
incomes; housing costs are a larger proportion of income for the poor than for the rich, so economists estimate
that the property tax on that housing would end up being a greater proportion of low incomes than of high
incomes.
Tax Incidence and Efficiency Loss
A. Tax incidence refers to who actually bears the economic burden of a tax
1. The division of the burden is not obvious. the impact of a P2 per-bottle tax on wine that was priced at P8 per
bottle before the tax.
2. The new equilibrium price rises to P9, not P10 as one might expect with the P2 tax.
a. Consumers pay P1 more per bottle.
b. Producers receive P1 less per bottle.
3. In this example, consumers and producers share the burden of the tax equally. The incidence is not
completely on either one.
B. Elasticities of demand and supply explain the incidence of an excise or sales tax.
1. Given supply, the more inelastic the demand for the product, the larger the portion of the tax is shifted
forward to consumers.
2. Given demand, the more inelastic the supply, the larger the portion of the tax borne by producers or sellers.
C. Probable incidence of taxes is estimated for various taxes.
1. The personal income tax generally falls on the individual except for those who can control the price of their
labor services and pass on the cost of the tax through higher fees.
2. The incidence of the corporate income tax is uncertain. Some corporations may be able to shift the burden by
charging higher prices; others may find there is decreased profitability and the burden is then borne by
stockholders.
3. Excise taxes can be shifted to the consumer where demand is inelastic. This is true generally with the small
range of products on which excise taxes are levied (gasoline, cigarettes, and alcoholic beverages). However,
because sales taxes cover such a wide range of products, the incidence of sales taxes is just as likely to fall on
the seller—it depends on the respective elasticities of demand and supply for the product.
4. The incidence of property taxes may fall on the property owner, or in the case of rental and business property,
the tax would be largely shifted onto the tenant or the customer.