Public Provision of Private Goods and Nondistortionary Marginal Tax Rates

The incidence and efficiency losses of taxes have usually been analysed in isolation from public expenditures. This negligence of the expenditure side may imply a serious misperception of the effects of marginal tax rates. The reason is that part of the marginal tax may in fact be payment for publicly provided commodities and reflect a cost that the consumers should bear in order to face the right incentives. Hence, part of the marginal tax serves the same role as a market price in the sense that it conveys information about a real social marginal cost of working more hours. We develop this idea formally by studying an optimal income tax model in combination with a type of public provision scheme not analyzed before; the provision level is individualized and positively associated with the individuals’ labour supply. As examples we discuss day care, elderly care, primary education and health care. We show that there is a gain in efficiency if public provision of such a service replaces market purchases. We also show that it is necessary for efficiency that marginal income tax rates are higher than in economies where the services are purchased in the market. This is because the optimal tax should be designed so as to face the taxpayers with the real cost of providing the services. Hence, it might very well be that economies with higher marginal tax rates have less severe distortions than economies with lower marginal tax rates. We also explore whether an efficiency gain is achievable by alternatively making day care expenses tax deductible and derive a negative conclusion