Welfare Analysis of Tax and Expenditure Reform

Abstract

The motivation of the present paper originates from the current debt crisis of so many developed countries and analyzes, within a simplified model with a single representative consumer, the welfare effect of a combined reduction in indirect taxes and public expenditure. As already demonstrated by a pioneering work by Guesnerie (Econometrica 47:393–421, 1977) and subsequent literature, the bulk of information needed to be sure to get a welfare gain from this reform is heavy; under this respect a feature of the paper, to which less attention was paid, is a more detailed description on the side of public expenditure where multiple expenditure categories are allowed: this feature can be exploited to properly tailor expenditure and tax cuts. The main policy prescription arising from the paper is to concentrate expenditure cuts on categories with close private substitutes and a low marginal willingness to pay for them, and tax decreases on private goods with larger own price effects, weak relations with other private goods and complementary to labour. An important implication is that marginal willingness to pay could be the rationale for a new, or parallel, classification of public expenditure categories carrying incentives toward quality and efficiency.