Balancing public good benefits and taxation

Cadets

General service officers and graduate cadets during commissioning in Lanet, Nakuru County on March 10, 2023: Security is one of the public goods.

Photo credit: John Njoroge | Nation Media Group

Security, infrastructure, environment, and health are among the first of many examples of public goods. Governments plan for most of the expenses and the provisioning of these public goods, mostly funded by tax revenues.

Public goods are designed to be available and have specific merits that prevent individuals, citizens or residents from being unable to access them.

The theory of public goods provides a rationale for the allocation function of public policy. These goods exhibit the features of non-excludability and non-rivalry. They are closely associated with the free rider problem in which people do not pay for them and many continue to access them, which can lead to underproduction, overconsumption, and degraded goods, and hence government intervention is required.

In Kenya, for example, the supply of water, which can be both a public or private good, now seems to be moving more towards exclusivity during drought since many individuals resort to private sources.

If we consider the theory of public goods, and water being a necessity, perhaps there should be a greater allocation function of resources to develop the solutions for this challenge.

The question is how the government determines how much such goods will be produced and allocated. The difficulty lies in deciding the quality of public goods that should be supplied and how much a consumer should pay.

For private goods, consumers pay for the benefits received. Still, the problem in the case of public goods is how these benefits are valued.

Public goods

Individual consumers have no reason to reveal to the government how highly they value public goods. To serve as an effective mechanism of preference revelation, a voting process on tax and expenditure decisions could be taken. Voters are confronted with the choice among budget proposals with price tags in terms of their own tax contribution.

However, the political mechanism is imperfect, and can only approximate what would be the optimal budget choice. To explain the preference revelation there are two theories in public finance: The Ability Theory or the ability to pay principle of taxation developed by Erik Lindahl and the Benefit Theory or voluntary exchange theory developed by Bowen.

Most governments collect funds from various sources to provide public goods or to finance transfer payments. The supreme source of revenue in mixed economies across the globe is taxation.

Under the voluntary exchange model, tax levels are determined automatically, because taxpayers pay proportionately for the government benefits they receive.

Another way, the individuals who benefit the most from public goods, pay the most taxes. For analysing the voluntary exchange or benefits theory two models are usually discussed, namely the Lindahl model and the Bowens Model.

Erik Lindahl was a Swedish economist who served as an adviser to the government of Sweden and the Swedish Central Bank. Lindahl's model focuses on financing public goods in harmony with individual benefits. The quantity of public goods satisfies the requirement that the total marginal benefit equals the marginal cost of providing the public good.

As people are different in nature, their preferences also differ and the consensus requires each individual to be a somewhat different tax for every service, or good that he consumes. If each individual's tax price is set equivalent to the marginal benefit received, then each individual is made better off by the provision of public goods, and thus may accordingly agree to have that service level provided.

A Lindahl tax is a system of taxation in which individuals pay for the provision of a public good in accordance to their marginal benefits. The theory tries to solve the following three problems: extent of State activity, allocation of the total expenditure among various goods and services, and allocation of the tax burden.

If we take the example of public transport facilities, although not a pure public good as there are charges, the government of certain nations such as the UK allocate some public transport benefits or even some exemptions to individuals who meet certain criteria and discriminatory pricing strategies to cater to their costs while providing service to all.

Kenya has the infrastructure works in place enhancing road use, however, Kenya could certainly benefit from having a better public transportation system. Theories like Lindahl’s suggestion of allocation of resources could come in use here.

Why do economies have difficulty in applying this theory? That is because Lindahl pricing and taxation require the knowledge of demand functions for each individual for all private and public goods. When information about marginal benefits is available only from the individuals themselves, they tend to underreport the evaluation of a particular good.

Revolution

This gives rise to a preference revolution problem. Each individual can lower his tax cost by underreporting his benefits derived from public goods or services. This informational problem shows that survey-based Lindahl taxation is not incentive compatible.

There are certain limitations of Lindahls model. First, individual demand curves and individual preferences are not easily known. Due to the free rider problem, people have the incentive to hide their true preferences and, thus, their marginal valuation.

Then comes the Bowen model. Bowen's model has more functioning significance since it establishes that when the public or social goods are produced under conditions of increasing cost the opportunity cost of the private good is forborne.

Bowen's model or voluntary exchange model takes into consideration the direct correlation between revenue and expenditure in the budget. It explains the role of the market in the allocation procedure of the public sector. However, although simple in its application, the model has various difficulties. It limits the scope of government activities. It is applicable only when beneficiaries can be observed directly, which is impossible for most public goods.

Taxation in accordance with the benefit principle would leave the distribution of real incomes unchanged.

Economists have displayed a growing interest in the problem identified to inappropriate allocation of public goods. The fact that the public budget has grown considerably during the period has added to the attractiveness of the problem. Individuals have different preferences based on their nature, personal choices, and more.

Lindahl taxation is a solution to this issue by simultaneous determination of the extent of public activity and distribution of the corresponding tax burden.

In spite of the shortcomings of Lindahl's model, it has proven to be an important impetus for the development of the theory of public goods.

Barot is a business and financial analyst; [email protected]