Public Finance Myopia? Fiscal Incidence to the Rescue

February 24, 2015

Let’s not forget to remember that net fiscal incidence is the key measure to evaluate the distributive effect of government policy; that is, the total distribution of spending and taxes. The significance of net fiscal incidence is obvious, yet there is a tendency for spending and tax incidence to be viewed in isolation. This can lead to a counterproductive, myopic view on government policy.

If I take a dollar from you but then give you two back in return, what is the outcome? Assuming this happens simultaneously, a reasonable person would say that you have gained a dollar.

This example provides a framework for how to think about the distribution of public expenditures and how funding for such expenditures are raised.

The idea of net fiscal incidence is to capture how costs and benefits of government are distributed across income strata. Assume, in your income bracket, that the tax burden is one dollar. Postulate further that the benefits you receive from public goods and government services equate to two dollars. In theory, the net fiscal incidence is a positive one dollar; meaning, you have gained more than you paid for in taxes. As this measure readily demonstrates, both sides of the government equation matter and a myopic view of either the spending side or the tax side is merely a disservice.

Granted, estimating the incidence of spending and taxation entails uncertainties. The “benefit” of government programs and public goods is generally complex to gauge. To a degree, this also applies to determining tax burdens. However, this does not, of course, preclude usage of the concept. On the contrary, more focus and emphasis on this fundamental measure of public finance is warranted.

Studies empirically addressing net fiscal incidence have been conducted worldwide throughout the 20th century. This type of research has been performed to inform policymakers in both developing and developed countries about, for example, the regressivity and progressivity of spending and revenue raising systems—and how these add up. The Tax Foundation has performed related studies on this topic, in the U.S., prior to the 1960s. Our most recent, in-depth report of fiscal incidence can be found here.

A holistic understanding of the distributive effect of government policy is critical. Nonetheless, integrated spending and tax incidence thinking, as an analytical tool, may be relatively undervalued. Let’s remember the net fiscal incidence measure and promote a more integrated thinking of public finance.

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