Question

Can economic analysis precisely determine the proper levels of government spending and taxation?  In your answer explain the problems in using cost-benefit analysis.

Answer 1

It is theoretically possible to determine the proper amount of government spending and the optimal quantity of a public good. In theory, the demand for a public good can be found by adding the prices that people collectively are willing to pay for the last unit of the public good at each particular quantity. Then, the quantity and price at which the collective amount demanded matches the amount supplied will be the equilibrium or “optimal” output level.

In terms of cost-benefit analysis, this means that the public is equating the marginal benefit received from government spending to its marginal cost. Cost-benefit analysis aids in clear thinking about the public sector, but both benefits and costs of public goods are partially spillovers or externalities that are hard to measure. The text’s example of the potential benefits and costs associated with a new highway in an urban area provides a good illustration of the practical difficulties involved in determining the optimal level of spending. Of course, the other difficulty results from our system of representative democracy. Individuals do not vote on every single project even if the collective benefits and costs could be accurately measured. The second part of the first question asks about the proper level of taxation. This would be impossible to determine because the criteria used to determine the best level of taxation actually are often contradictory and so in the end, “proper” or “optimal” is a normative judgment. If “proper” meant that taxes should be based only on benefits received, it could be possible to achieve such a level using economic analysis although there would still be significant measurement problems. However, economists also believe that taxes should be based to some extent on “ability-to-pay” which rarely conforms to the benefits received criteria of taxation. Therefore, while theoretically it is possible to determine the optimal level of spending based on benefits received, it would not be possible to determine the combination of “proper” or “optimal” taxation necessary to finance the spending.

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