The Policy Elasticity

This paper provides a general framework for evaluating the welfare impact of government policy changes towards taxes, transfers, and publicly provided goods. The results show that the behavioral response required for welfare measurement is the causal impact of each agent’s response to the policy on the government’s budget. A decomposition of this response into income and substitution effects is not required. Because these desired elasticities vary with the policy in question, I term them policy elasticities. I also provide an additivity condition that yields a natural definition of the marginal costs of public funds as welfare impact of a policy per dollar of its cost to the government budget. Finally, I use the model, along with causal estimates from previous literature, to study the welfare impact of additional redistribution by increasing the generosity of the earned income tax credit financed by an increase in the top marginal income tax rate. I show existing causal estimates suggest additional redistribution is desirable if and only if providing an additional $0.44 to an EITC-eligible single mother (earning less than $40,000) is preferred to providing an additional $1 to a person subject to the top marginal tax rate (earning more than $400,000).