TOPIC 13

Public goods, common

resources and designing
taxes

INTRODUCTION

• When a good does not have a price attached

to it, private markets cannot ensure that the
good is produced & consumed efficiently.

• Government policy can potentially remedy

the resulting market failure & raise economic
well-being.

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 INTRODUCTION
• Excludability
– A good is excludable if a person can be
prevented from using it. How?
• An ice-cream is excludable because you cannot
consume it without paying the price.
• Rivalry in consumption
– A good is rival in consumption if one person’s use
diminishes other people’s ability to use it.
• An ice-cream is rival in consumption because if one
person eats an ice-cream, another person cannot eat
the same ice-cream.

FOUR TYPES OF GOODS

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 PRIVATE GOODS
• Consider a good such as an
apple
– Apple is a private good as
• If you don’t pay the price to eat an
apple you don’t get to consume it.
It is an excludable good.
• If you consume the apple then
others cannot consume it. The
apple has rivalry in consumption.

– Most goods we consider in this

unit are private goods
• they are excludable & rival.

PUBLIC GOODS
• Now consider a good such
as national defence
– National defence is a public
good as
• Even if you don’t pay for it you
benefit from it – consumption is
not excludable.
• If you enjoy the benefits of
defence protection that does not
limit the ability of others to enjoy it
– consumption is non-rival.
– Many important goods in the
economy are public goods.

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 CLUB GOODS
• Now consider membership of
a golf club
– This is an example of a club
good since
• Membership is excludable – if you
don’t pay your membership fee
you cannot play golf.
• But membership is non-rival – the
fact that you are a member does
not limit the ability of others to
join.
– So, a club good is an
excludable & non-rival good.

COMMON RESOURCES
• Finally consider a congested
non-tolled road
– This is an example of a common
resource/common property
• Road Use is non-excludable – you
can use it without paying anything.
• Road use is rival – there are costs
associated in terms of increased
travel times when an extra motorist
uses the road.
– Common resources are goods
that are rival in consumption but
not excludable.

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 TYPES OF GOODS: SUMMARY
• Private goods
– both excludable & rival

• Public goods
– neither excludable nor rival

• Club goods
– excludable but not rival.

• Common property
– rival but not excludable

PUBLIC GOODS, COMMON

RESOURCES AND EXTERNALITIES
• If one person were to provide a public good,
such as defence
– other people would be better off without paying for
this benefit.
– Similar to positive externalities

• Similarly, if one person uses a common

resource, such as the fish in the ocean
– other people are worse off without being
compensated for this loss.
– Similar to negative externalities

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 FREE RIDER PROBLEM
• A free rider is a person who receives the
benefit of a good but avoids paying for it.

• Since public goods & common property are not

excludable free riders can consume them.
– This means private markets undersupply public
goods as firms don’t get rewarded by some users.
– And common resources are overused due to free
riding.

PROVISION OF PUBLIC GOODS

WITH FREE RIDERS
• The government can potentially remedy the
problem.
– If the government decides that the total benefits
exceed the costs, it can provide the public good and
– then forcing people to pay for the good via taxes.
• However, cost-benefit analysis in such situations is at best
a rough approximation since there is no information on
price available, unlike private goods.
• Also people in favour of the public good tend to exaggerate
the benefits and vice versa

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PRIVATE PROVISION OF PUBLIC
GOODS
• Consider search engines such as Google
and Bing, and video-sharing sites such as
YouTube and Vimeo. These are public goods
since
– Anyone with a computer and internet connection
can use these for free, and
– one user does not reduce the benefit other users
can derive from the same program.

• Yet private firms operate these websites as

for-profit businesses.

PRIVATE PROVISION OF PUBLIC

GOODS
• How can a firm generate revenue from a
product that consumers enjoy for free?
– These firms are funded by revenue from
advertisements displayed on their web pages.
– Advertisers want to reach a wide audience, so
they are willing to pay more as a website is visited
by more users
– This gives the firms an incentive to make their
websites popular with the users.
– In this sense, user demand drives the content on
websites.

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 COMMON RESOURCES
• Common resources are not excludable.

• But they are rival goods because one person’s

use reduces other’s .

• Here the resources already exist so focus is

less on their under-provision than that they are
overused due to free riding.

TRAGEDY OF THE COMMONS

• The tragedy of the commons refers to the
overgrazing of communal land surrounding
medieval English villages.
– Overgrazing eventually damages the land’s ability to
replenish itself, destroying the common resource for
all families in the village.

• Land is overused since individuals are not

charged for usage.
– Similar to a negative externality – users don’t pay
the social costs of excess use.

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IMPORTANT COMMON RESOURCES
• Clean environment
– Greenhouse gasses emitted into the air in one
country spread around the world contributing to
climate change in every country.
• Oil deposits
– If owners of the properties decide individually how
many oil wells to drill, they will drill too many.
• Congested roads
– When one person drives on the road, it becomes
more crowded, and other people must drive more
slowly.

IMPORTANT COMMON RESOURCES

• Fish, whales and other wildlife
– Anyone can go to the ocean and catch whatever is
available. Each person has little incentive to
maintain the species for the next year.

• Notice that in all these cases we observe over

usage of the common resource

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 A GENERAL POINT: PROPERTY
RIGHTS ARE IMPORTANT
• Markets fail when property rights are not well
established
– when something of value does not have an owner
with the legal right to control use by pricing.

• Government solution can be to privatise

– e.g. to impose property rights through tolls on a
congested road so it becomes excludable.

• If a good is underprovided by markets (e.g.

defence) it can be publicly-provided.

DESIGNING A TAX SYSTEM

• Governments levy taxes
– to provide public goods and
– to regulate use of goods imposing externalities or
which are common resources.

• Two principles
– Taxes should impose as small a cost on society as
possible and
– the tax burden should be distributed fairly.

• Thus the tax system should be efficient &

equitable.

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 TAXES AND EFFICIENCY
• Costs of taxes include:
– tax payments by the taxpayers
– deadweight losses
– administrative burdens

• Deadweight loss
– We know that because taxes distort incentives, they
create DWLs and that
– DWL of a tax is the reduction in the economic
wellbeing of taxpayers in excess of the amount of
revenue raised by the government.

TAXES AND EFFICIENCY

• Administrative burden
– A third cost of taxation is the cost incurred
complying with the tax law.
– Taxpayers lose additional time & money
documenting, computing & avoiding taxes over and
above the actual taxes paid.
– These administrative burdens are part of any
inefficiency created.
• The resources devoted to complying with the tax laws are
a type of deadweight loss.

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 MARGINAL TAX RATES VERSUS
AVERAGE TAX RATES
• When discussing the efficiency and equity of
income taxes, economists distinguish between
two notions of the tax rate:
– The average tax rate is total taxes paid divided by
total income.
– The marginal tax rate is the extra taxes paid on an
additional dollar of income.

MARGINAL TAX RATES AND

INCENTIVES
• Rational people think at the margin.

• The marginal tax rate measures how much

the tax system discourages people from working.
– If you are thinking of working an extra hour, the
marginal tax rate determines how much the
government takes of your additional earnings.
– It’s the marginal tax rate, therefore, that determines the
deadweight loss of an income tax.

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 LUMP-SUM TAXES
• A lump-sum tax is a tax that is the same
regardless of earnings or any actions that the
person might take
– e.g. $100 per head regardless of who you are or what
you do.

• A lump-sum tax is the most efficient tax possible.

– Because a person’s decisions do not alter the amount
owed, the tax does not distort incentives and,
– therefore, does not cause deadweight losses.
• But inequitable.

TAXES AND EQUITY

• How should the burden of taxes be divided
among the population?

• How do we evaluate whether a tax system is

fair?

• There are two equity principles of taxation:

– benefits principle
– ability-to-pay principle.

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 THE BENEFITS PRINCIPLE
• People should pay taxes based on the benefits
they receive from government.
– e.g. a petrol tax:
• Tax revenues fund our roads network.
• People who drive most pay most.

• It seems fair that a person who gets greater

benefit from a public good should pay more for
it than a person who gets little benefit.
– Wealthy citizens should pay higher taxes than poorer
ones as they have much to protect and hence get
greater benefit from police, fire brigades, etc.

THE ABILITY-TO-PAY PRINCIPLE

• Taxes should be levied on a person according
to how well that person can shoulder the
burden.

• This leads to two notions of equity:

– vertical equity
– horizontal equity

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 VERTICAL EQUITY
• The idea that taxpayers with a greater ability-to-
pay taxes should pay most.
– For example, people with higher incomes should pay
more than people with lower incomes.

• A proportional tax – high-income & low-income

taxpayers pay the same fraction of income.

• A regressive tax – high-income taxpayers pay a smaller

fraction of their income than low-income taxpayers.

• A progressive tax - high-income taxpayers pay a larger

fraction of their income than do low-income taxpayers.

HORIZONTAL EQUITY
• The idea that taxpayers with similar abilities to
pay taxes should pay the same amounts.
– e.g. two families with the same number of
dependents & the same income living in different
parts of the country should pay the same taxes.

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 CASE STUDY: WHO SHOULD PAY
FOR HIGHER EDUCATION
• Gough Whitlam’s Labour government in
Australia was elected in 1972

• One policy was to remove university fees.

– If there are private benefits from education, this
imposes DWLs
– Supporters of state-paid university education argued
that it would help the disadvantaged.
– Opponents argued that most students going to
university are from relatively well-off families.

CASE STUDY: WHO SHOULD PAY

FOR HIGHER EDUCATION
• What you want is
– a scheme which involves some payment by students
to reflect private benefits.
– a scheme that does not prevent those with limited
access to capital markets from pursuing an
education.

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 CASE STUDY: WHO SHOULD PAY
FOR HIGHER EDUCATION
• In 1989, Bob Hawke’s Labour government
introduced a program to share the costs of
university education between
– the student and
– the taxpayer
called the Higher Education Contribution
Scheme (HECS).

CASE STUDY: WHO SHOULD PAY

FOR HIGHER EDUCATION
• To avoid disadvantaging poor students, no
student would have to pay fees before finishing
university.
– Instead, the government would ‘lend’ the student the
money.
– Repayments would be based on income that
students earn after completing studies.
– The success of HECS scheme has led to its imitation
in other countries.

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 TAX INCIDENCE AND TAX EQUITY
• We know that the person who bears the burden
of a tax is not always the person who gets the
tax bill from the government.
– Taxes affect people beyond those who actually pay
the tax.

• Since the study of who bears the burden of taxes

(tax incidence) is central to evaluating tax equity
– when evaluating the vertical and horizontal equity of
any tax, it is important to take account of these effects.

TAX INCIDENCE AND TAX EQUITY

• Consider a tax on sports cars.
– This tax may seems to target the wealthy buyers of
sports cars.

• Yet if buyers substitute sports cars with other

luxuries, then the sale of these cars will fall
substantially.
– In the end, the burden of the tax will fall more on
workers who make and sell sports cars.

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 SUMMARY
• Equity & efficiency are important goals of tax
policy.

• The efficiency of a tax system refers to the

costs it imposes on taxpayers.

• The equity of a tax system concerns whether

the tax burden is distributed ‘fairly ‘among the
population.

SUMMARY
• According to the benefits principle, it is fair for
people to pay taxes based on the benefits they
receive.

• According to ability-to-pay principle, it is fair for

people to pay taxes on their capability to
handle the financial burden.

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