“Public goods, labor supply and benefit taxation”

A benefit tax is a tax whose amount is determined in accordance with the benefits received. It is well-known that an increase in the tax burden reduces individual welfare due to its negative effect on private consumption, but the public finance literature commonly disregards the positive effects that an increase in public goods provision (that follow the increase in taxes) can have on taxpayers’ welfare. This paper first considers an economy in which a proportional labor-income tax is used to finance the provision of (pure) public goods, and describes a “second-best benefit” tax solution to the tax-expenditure problem that is efficient and satisfies the benefit principle of taxation. The analogous “first-best benefit” tax solution can be obtained with the same procedure under lump-sum taxation. The tax burdens under these solutions are set individually to maximize each taxpayer’s surplus given the contributions of all taxpayers and no free riding. The solutions provide natural benchmarks to separate the problems of efficiency and redistribution.