Evaluating Public Expenditures When Governments Must Rely on Distortionary Taxation

The evaluation of public expenditures is a central concern of development economics-and a concern highlighted by the increasingly stringent budget constraints in both developing and developed countries. This task has also become increasingly difficult as governments have moved their focus away from providing private, tradable, goods towards public goods that are provided either without charge, or at a charge considerably below their value to consumers. Until recently, it was widely believed that government projects could be evaluated without reference to the costs of raising tax revenues. The classic border price rule provided a simple and apparently robust procedure for project evaluation. Anderson and Martin use a rigorous formal model to explore the welfare consequences of government provision of different types of goods in economies in which governments must rely on distortionary taxation. They show that the border price rule is accurate only in the rather special case where the project outputs are sold at their full value to consumers-something that is difficult to do for a public good such as a lighthouse or a functioning judicial system. Whenever a publicly provided good is sold for less than its full value to consumers, Anderson and Martin show that the implications of public good provision for government revenues needs to be taken into account. They provide simple rules for project evaluation that depend on only one additional parameter, the compensated Marginal Cost of Funds for the taxes on which the government relies. With an estimate of this additional parameter, analysts are able to prepare unbiased evaluations of the particular types of government projects. The rules suggested involve adjusting the fiscal revenues generated (or destroyed) by the project by the marginal cost of funds before comparing them with the assessed benefits to producers and/or consumers of the project. In the case of a protected, but tradable, good provided by the government, this results in a shadow price that is below the world market price. Where projects produce output that is sold without charge, the costs of the project inputs must also be adjusted using the MCF. In intermediate cases, where the government levies user charges that fall below the full value of the goods to the private sector, the revenue shortfall from the project must be adjusted by the MCF. After presenting their key results, the authors compare them with the results presented in the literature for cases where governments must rely on distortionary taxation. The border price rule for traded goods has almost invariably been invoked except in recent papers by Devarajan, Squire and Suthiwart-Narueput, and by Harberger. Anderson and Martin show that most studies have based their support for the border price rule on the rather special case where governments sell their project outputs at full market prices. The valuation principles presented in this paper appear to provide a practical basis for evaluation of government expenditure projects. While more complex than the border price rule, they do not appear to be unmanageably so, as long as estimates of the compensated marginal cost of funds are available to the analyst. Evaluating Public Expenditures: A Simple General Framework Governments and international lending organizations need simple, robust frameworks for evaluating project proposals in distorted economies. The border pricing rule for traded goods (see, for example, Squire 1989; Drèze and Stern 1987) provides an attractively simple basis for project evaluation: regardless of distortions, governments should evaluate the tradable goods they provide at border prices. Unfortunately, the border price rule needs modification when projects are not revenue neutral and when governments must rely on distortionary taxation to fund their projects. Government sale of goods below their market price creates a revenue need which must be met from distortionary taxation. The purpose of this paper is to provide rigorously derived guidelines for evaluating government projects in this situation. The rule we obtain is operational with an additional ‘parameter’, the Marginal Cost of Funds, which is frequently available. The literature on project evaluation has focused heavily on projects in which governments produce goods that are sold to the private sector at their market price (see, for example, Squire 1989; Blitzer, Dasgupta and Stiglitz 1981). This formulation may have been reasonably appropriate in an era where attention focused primarily on industrial projects but, as Devarajan, Squire and Suthiwart-Narueput (1997) point out, is of limited relevance now that the concerns of governments and international organizations have shifted so strongly to the provision of an enabling environment for private sector development. Charging a price that equals the marginal valuation of project output to the private sector is impossible in government projects that provide Samuelsonian public