Name: Muroza Pride T

Reg Number: R214496U

Program: HFET

FET401 Assignment

Question

In public policy, equity and efficiency often stand in opposition. Discuss the tensions
between these two principles in the context of a specific public finance issue, such as tax
policy or public goods provision. [20 marks]
In public policy, the principles of equity and efficiency often stand in opposition. Equity
refers to the fairness of the distribution of resources and benefits among individuals in
society, while efficiency pertains to the optimal allocation of resources to maximize overall
welfare. However, this essay discusses the tensions between these two principles in the
context of tax policy and within the public goods framework as well as illustrates how efforts
to achieve equity can lead to inefficiencies.

Firstly, equity in tax policy emphasizes the fair distribution of tax burdens and benefits. To
achieve vertical equity, higher-income individuals should pay a larger proportion of their
income in taxes compared to lower-income individuals, reflecting their greater ability to pay
(Musgrave 1984). Horizontal equity, on the other hand, demands that individuals with similar
ability to pay should contribute equally to tax revenues (Stiglitz 1988). For example,
progressive tax systems, where tax rates increase with income, are designed to enhance
vertical equity by ensuring that high-income earners contribute a larger share of their income
compared to lower-income earners. These systems are seen as more equitable because they
redistribute income and help fund public services that benefit society.

However, efficient tax systems aim to minimize distortions in individual and business
behaviours while maximizing revenue (Buchanan 1963). According to the efficiency
principle, taxes should be levied in a way that they do not discourage productive activities or
lead to economic inefficiencies. For example, high marginal tax rates can disincentive work
effort, savings, and investment, thus potentially leading to lower economic growth (Feldstein
1995). Supportively, efficiency suggests that a flat tax or a consumption-based tax could be
more conducive to economic growth because they minimize the behavioural distortions
caused by higher tax rates on income. However, such systems may exacerbate issues of
equity as they often place a heavier relative burden on lower-income earners who use a
greater percentage of their income on consumption (Piketty, Saez, and Zucman, 2018).

Elaborately, the fundamental tension between equity and efficiency arises when efforts to
enhance equity lead to inefficiencies. For instance, while a progressive tax system may
promote equity by redistributing wealth, it can also create disincentives for higher earners to
invest, innovate, or work extra hours. Subsequently, this can result in slower overall
economic growth and may deter investment that could have been utilized to generate
employment and improve societal welfare. More so, implementing complex tax systems
designed to enhance equity often leads to increased compliance costs and administrative
burdens. The complexity can create loopholes that wealthy individuals exploit, undermining
the fairness that progressive taxation intends to achieve (Hassett and Mathur 2015).

Furthermore, within the framework of public goods, equity refers to the fair distribution of
outcomes among individuals in society. It can be further classified into vertical equity which
posits that individuals with different abilities to pay should contribute differently and
horizontal equity which holds that individuals with similar abilities should contribute
similarly (Musgrave 1984). In the context of public goods, equity concerns often revolve
around who receives the benefits of these goods and how the costs are shared. On the other
hand, efficiency refers to the optimal allocation of resources to maximize total welfare, often
defined in terms of Pareto efficiency where it is impossible to make one individual better off
without making another worse off (Marshall 1890). In public goods provision, efficiency is
concerned with achieving the right level of provision while minimizing waste (Samuelson
1954).

Public goods are characterized by non-excludability and non-rivalry. Non-excludability

implies that it is impossible to prevent anyone from using the good while non-rivalry implies
that the use of a good by one person does not reduce another's opportunity to use the same
good (Samuelson 1954). Classic examples of public goods include national defense, public
parks, public roads, clean air and street lights. There is an issue of cost sharing which arises
when public goods are provided. A tax system that seeks to distribute tax burdens equitably
can inadvertently lead to inefficiencies. For example, funding public goods through
progressive taxation aims to enhance equity by requiring wealthier individuals to pay a larger
share. Resultantly, higher taxes may discourage investment and economic activity among
high-income earners thereby causing a reduction of overall resources available for public
goods (Feldstein 1995).

More so, the free-rider problem is also a classic challenge associated with public goods.
Individuals may benefit from public goods without contributing to their cost and this may
lead to under-provision. While a focus on equity might advocate for free access to public
goods for everyone, this can result in insufficient funding and maintenance of these goods. If
the provision of public goods is perceived as inequitable for example wealthier individuals
benefiting disproportionately, there may be pressure to raise taxes, further exacerbating
inefficiencies in the allocation of resources (Olson 1965).
In conclusion, such tensions between equity and efficiency in tax policy and the provision of
public goods demonstrate the complexity that policymakers face. While striving for equity is
important for social cohesion and justice, it is equally crucial to consider the potential adverse
effects on economic efficiency. Ideally, a balance has to be reached which allows a tax
system to encourage both fair distribution and economic growth. This calls for very careful
balance in the design of policies that will enhance both equity and efficiency toward a more
sustainable and just approach in the provision of public goods. The tension between these two
principles will continue also to be brought to the fore by debates over tax reforms around the
world.
References

Buchanan, J. M. (1963). "Public Finance in Democratic Process: Fiscal Institutions and

Individual Choice." University of North Carolina Press.

Feldstein, M. (1995). "The Effect of Taxes on Economic Behavior." The American Economic
Review, 85(2), 170-174.

Musgrave, R. A., & Musgrave, P. B. (1984). "Public Finance in Theory and Practice."
McGraw-Hill.

Stiglitz, J. E. (1988). "Economic Analysis of Public Policy." The American Economic

Review, 78(2), 425-430.

Feldstein, M. (1995). "The Effect of Taxes on Economic Behavior."

Marshall, A. (1890). Principles of Economics. Macmillan.

Musgrave, R. A. (1984). Public Finance in Theory and Practice. McGraw-Hill.

Olson, M. (1965). The Logic of Collective Action: Public Goods and the Theory of Groups.
Harvard University Press.

Samuelson, P. A. (1954). "The Pure Theory of Public Expenditure." The Review of

Economics and Statistics, 36(4), 387-389.