THE OPTIMAL SUPPLY OF PUBLIC GOODS AND THE DISTORTIONARY COST OF TAXATION

TLDR

Economists traditionally consider distortionary tax costs when determining the optimal supply of public goods, and this analysis also applies to setting optimal environmental taxes. The study shows that a tax adjustment can finance a public good without increasing distortion. This is achieved by adjusting the income tax to offset the public good’s benefits, thereby eliminating distortion. When the simple cost‑benefit test is met, the public good should be supplied; if a different tax adjustment is used, the outcome changes only in redistribution, so the cost‑benefit test must incorporate both distortionary and redistributive effects.

Abstract

The conventional view of economists is that the optimal supply of public goods must directly take into account the cost of financing them with distortionary taxes, notably the income tax. However, this article demonstrates, under standard simplifying assumptions, that it is possible to finance a public good in a manner that results in no additional distortion, by using an adjustment to the income tax that offsets the benefits of the public good. In this case, it is optimal to supply the public good whenever the simple costbenefit test is satisfied. The article also shows that if a different tax adjustment is made, the difference in outcome will be purely redistributive; thus, any change in distortionary costs will be accompanied by an opposing change in redistributive benefits. In this case, the cost-benefit test should be modified to reflect both of these changes. Finally, it is explained that the present analysis is fully applicable to determining the optimal level of environmental taxes.