World Bank Reprint Series: Number 171 Jacob Meerman The Definition of Income in Studies of Budget Incidence and Income Distribution Do Empirical Studies of Budget Inlcidence Make Sense? Estimating Counterfactual Incomes in Studies of Budget Incidence (with Parthasarathi Shome) The Incidence of Sales and Excise Taxes, or Whlere Do We Put the Transfers? Reprinted with permission from Review of Income and Wealth, series 20 (December 1974), pp. 515-22; Public Finance, vol. 33, no. 3 (1978), pp. 295-313; Public Finance, vol. 35, no. 2 (1980), pp. 291-99; and Journal of Political Economy, vol. 88, no. 6 (1980), pp. 1242-48. Ntrvws \ND) NIFlNJORAN[)\ THE DEFINITION OF INCOME IN STUDIES OF BUDGET INCIDE)NCE ANI) INCOME I)ISTRIBUTION 's- JA('()B P. MI-11WAN International Bt3n;k for Reconstrueiotn tnt1d D)evel'opment INT RO )I) 1( I0N Interest in distribution has recently revived. In developed countries there is increasing explicit concern with the size-distribution of incomes, particularly with respect to their high and low extremes. In developing economies, growth of output as the overriding goal of public policy has been subordinated to concern with the distribution of the benefits from growth, and particularly with the persistence of deep low end poverty. Since governments directly allocate anywhere from an eighth to a third of total output. increasing concern with income distribution carries with it, logicallv. increasing concern with the ineidence of public aIctivity in the distribution of income. As a consequence the need to cstinmate sulchl incidence correctly is also increasing. Numerous resea1rchers have estimated aspects of budget incidence through allocation by incomne bracket of tax burden and, occasionally, expenditure benefit.' The logic of such allocationi requires that the techniques used have certain common elements. Thus, to determine tax-burden by income level, income per family before taxes must be estimated. There is no agreement on what income would be before government budget effects or after all such budget effects have been accounted for; i.e., after rcd.1cing, income by tax burdens and inicreasing them by benefits received from public expnClditurc.' Moreover studies whose focus is income distribution per se frequently, if not usually, ignore budget effects and define a concept of income which neither includes total taxes as a part of income nor in any way concerns itself with the benefits of government spending. Given the magnitude of public budgets, such cavalier treatment is a serious defect in much empirical work on income distribution. In some recent work, I approaclhed this topic from another (lirection: Hlow do those studying size distribution of income handle tiscail incidence'? In 1971. we received nmore than four dozen empirical distributions of income. Of this total, oniv 13 considereda .ins apect tf buidget incideilce. Nine of these 1t3 countries were in Latin America, and seven of these nine were primarily studies of public linances. The typical size distribution studv implicitly assumes neutral budget incidelLC. Ti is 1,0teW0rhilis lhall in many of the studies of income distribution, it was imlnpwiblc to determine how the concept of aggregate income was derivedl. -The focus is budget incidenice rather than general tiscal incidence. It assumes that the etTects of government budget activitv can be separated and analyzed independently of all the other effects of government policies on economic activity and hence the distribution of incomes. 'Ilhe continuing controversy on to what degree recerit empirical work on budget incidence and income distribution. both iatiisical and analytical, is necessarilV invalid because of a failure to generate a general equilibrium approach is not the subject of this paper. 'The presumnption i. ih:ii the actual approaches commonly used are Ntifficienil valid to make th.-m worthwhile. 5 15 TIhis confulsioni concerning the plroper (lelinlitio)i of inicOmiie is ti)viotisly undesirable. For example, the estimated distribuitioin of tax burden depends iII part on how aggregate incomiie is diefileL. Nevertheless, it is not an irtesolvable matter. This paper lproposes to rekindle an interest in it. I lopefullv it will help lead to colnsenstus on thie best (definitiotn of inicom iln SLuich work. Avcen it \se [ had suZclh eonsenlsus, the mutltifiariouis problemvs of tusilng actual data in estimiiating hotsellold and other incomes corresponding to the best (eftillitioTn nlOt to menCetionl the still more intIractable problurm of estimating the IOCUS of tax IuI'rdenS and e\xlpLelnditture benefits---would still be with tus. Nevertheless it would be a step forward if everyone at le.ast agreed on the basic conicept to be niafilpLlatc(l I use the phrasc iekind(lle interest since, as usual, the matter is n(ot withoLut antecedents. In the early I 900's, thlerec were two basic approaches in empirical studies of hbud(get inci(denice. TIhe "Adjtusted National Incomie App-iroach" [21,171 engaged in somettinrg of a debate uxith the "Net National Product Appni,ich-l'', [11[19] but thev did not arrive at anl agreement. In ;eneral however analysts studNillng tax or budtoet inCidLCIICe haVe used tthe invalid approach, tIlhat is diCtinIedl the ;tgre^;lte as national income, or used an even less defensible concept. TI he most systemiatic Utse of the Adjusted National Inicome n Appro,ach is that of the tTnited Natoios Statistical ( 'r-in nish, on which in 1972 publis,hed draft guidelinies for empirical country workr in compliling dati ) because C? Q Pi, depending upon the relative efficiency of government finance. Note that household income (Y2 ) is measured after all government effects have beeni considered, and that each household consumes all of G2. The existence of government means that household consumption plus saving is no longer identically equal to factor income. Spending per householdj from factor income in state 2 must equal n m w 2 P2i Q2i k- I R2k A2h h-) T2h where: 'Ph tax or negative tax, namely trans;er, (h = 1, 2 ... w). Consequently, we can rewrite relation (2) as m wn (2') Y2- k=1 R2k A2k - T2h + + G2 ' 2j k=12k k -h=1 2h+i~=yll Q2 BG22 In the typical empirical country studies of budget incidence, benefit incidence is n defined as BPQi A SgG; t;ax incidence as 1 7'h; and RPTO incidence as zero.9 One crucial consequence of the latter assumption is that factor incomes in DO EMPIRICAL STUDIES OF BUDGET INCIDENCE MAKE SENSE? 301 m State 2 ( .RkAk) are defined as equal to factor incomes in State 1. Since factor k = incomes in State 1 are defined as equaling household income (Ylj), this leger de main in turn permits comparing the change in incomes between the two states: Y m is simply assumed equal to - R2 But of course RPTO incidence is by no means zero and it is precisely the assumption - all too often implicit - that it is which results in some of the high level of controversy concerning the empirical country studies. What is clear is that because of RPTO effects, we can not have a very good idea of Ylj. It follows that empirical country studies of budget incidence as well as tax incidence alone, are invalid if they claim to be studies comparing our two states of the world. This conclusion is elaborated below, at first as concerns the effects of changing relative prices in the context of the Lindahl Solution; and then very briefly in terms of changes in techniques, output, and its composition. C. The Lindahl Solution If in State 2 we also have solely efficient benefit taxation, such that marginal value of benefit received = tax paid (a Lindahl Solution), then Relation (2) above is an equation for household j and for the economy as a whole: 0 n n Q Q = n (3) i: 1 P2j Q2ij + 2 2ijBQ2i;+ j=12 G R2kj A2ki And for each household j: w n (3') 2 h Is= BP + B2jG2 h=1 Th=i=1 2i Q2i+B2G The belief is widespread that a Lindahl Solution to the problem of financing public expenditure is necessarily Pareto superior,"1 that is the household utility corresponding to income in the second State (Y21) equals or exceeds that of income in the first State (Y1j). However, this belief is false because government taxing and expenditure affect relative prices, returns to assets, and/or asset endowments. It may be useful to belabor this point. Given a constant level of prices, in empirical work, we normally assume that the larger of two incomes is more desirable because household utility is assumed to be a positive function of income. However, if relative prices associated with the two incomes are radically different - say as the consequence of substantial changes in government taxes and expenditures - a given household may prefer the lesser income with the more favorable relative prices - as has been amply demonstrated by Hicks, Slutsky and others. For this reason even a successful comparison of measured incomes in two different states of government 302 JACOB MEERMAN activity does not necessarily give unambiguous results. In terms of our Lindahl Solution, the fact that all first order conditions in both private and public sectors are met for an optimum, which is to say inter alia that for all households marginal value of public output equals the tax price [Equation (3')] does not mean that all house- holds are necessarily as well off as in State 1. The Lindahl Solution is Pareto optimal, not Pareto superior. We can make this point symbolically by going behind income to household utility. 'That is: (4) U21 ( 11--. where U; utility corresponding to Y' and subscripts 1 and 2 refer to States 1 and 2. Pareto superiority implies U'2 - U11 a 0. But as noted, this is not a necessary con- sequence of (3). UT- U < 0 is also possible. T'he non-Pareto superiority of the Lindahl Solution by implication also rein- forces our earlier conclusion that meaningful comparison of incomes between States 1 and 2 is impossible: Even were it possible to dtinrmine the Ylj in some sort of deus ex machina fashion, we would not know what meaning to attach to it as concerns welfare (or "real income") because of the probably very subs .-tial change in relative prices.1 2 D. Subsidies in Production We can also develop equation (2') by assuming that the newly introduced government also provides subsidies in production (including completely free inputs) such as the cost of agricultural extension services or the subsidy element in loans at submarket interest rates. Thus, we revise equation (2') for household j as follows: mn h n 6) Y2 = '_ R2k A2k + k 2 -h=- T2h ' 2i +2* k5)=1 k2=1i'2 h-1 iZi 2 where we assume that there are r subsidies, Sf (f = 1, 2 ... r). Subsidies in production are analytically identical to taxes with opposite signs. Recall that in the case of perfect comnpetition, indirect taxes are passed forward to burden final output. In our model, which assumes perfect competition, so that all produc- tive subsidies are available to all firms, productive subsidies are therefore passed forward to final output as well. (It may also be well to recall here that the concept of factor returns (Ri) is net of indirect taxes and production subsidies. Thus, output price always equals total factor retlurns plus indirect taxes less subsidies.) In contrast to government financed private goods (BPQj) such as social services, note that the benefit incidenev of production subsidies - as in the case of taxes - is DO EMPIRICAL STUJDIES OF BUDGET INCIDIF,NC'E MAKE SENSE? 303 defined as equal to the subsidy: A subsidy is assumed to always reduce the costs of production by the cost of the subsidy, just as an indirect tax has exactly the opposite effect. Consequently, the problem of value to consumers being different from costs, which is freqently so pressing with respect to publicly provided specific goods, does not arise in the case of production subsidies. All that has gone before concerning RPTO effects of taxes and expenditures is equally applicable to produe- tion subsidies. E. Effects on Techniques, Output, and Its Composition Thus far, the focus has been goods produced in both periods. In reality, taxes, public spending and other public activity affect saving decisions, occupational de- cisions, and the development of fundamental institutions. Consequently, not only do relative prices and outputs change, but also factor endowments, and techno- logical relations that is the "very nature" of production itself. Thus, once govern- ment exists, there may be production of things like battleships, public parks, and social security systems. On the other hand, certain outputs may be repressed such as unlicensed practice of medicine, or unlimited publication of newspapers. Which outputs are repressed and which produced of course depend on the type of govern- ment.13 In short, to compare the distribution of income in an economy with government to what it would be without government is a bit like comparing the locomotion of the adult frog with the progenitor tadpole. Making the equations more realistic by adding externalities in both private and public goods in no way alters this simile. The only empirical comparisons which it may be possible to make rigorously are (i) those involving small changes or (ii) those in which R, A, P, and Q are independ- ent of government budget activity. F. Small Changes: Differential Balanced Budget Incidencel 4 Define a Third State occuring after a new government specific expenditure (QC) is financed by an equivalent increase in a tax (Tc). To make things less complicated, define remaining tax incidence and benefits from other government financed out- puts as unchanged and asvsume that there is no effect on techniques. As a conse- quence, we generate two or more identities. The focus is total incidence, that is on the change in income in State 3 compared to State 2. For household j, this ii; stated as in (6). m m (6) A Y k = 1 A Rk A2k + _ R3 k -Ak Tc + BP& Q3c Or focusing on the spending side in the Third State gives 304 JACOB MEERMAN (7) AY = [l2 AfL3LQi+BPcQ3c (7) Yi= iA Pi Q2i + i=1 P3i Qi f 3c Concrete illustration is useful. Suppose the expenditure newly financed (QC) is hospital care for the poor. The short term effects may bp: (a) ARi, an increase in the wages of medical personnel and in the returns to other hospital factors, plus other possible changes in R. (b) AAi, an increase in employed medical personnel, plus other changes in employ- ed assets. (c) ATc, an increase in tax c equal in the aggregate to the total costs of Q3c- (d) "P Q3c' consumption of "free" hospital care (hitherto Qc, publicly financed, was non-existent.) (e) APi, an increase in price of medical outputs, plus other changes in relative prices. (f) AQi, an increase in the quantity of medical outputs (in addition to Q3d, plus other changes in outputs. Obviously, not all effects apply to all households. Although we assume an unchanged average price level, relative prices have changed. As a consequence for household j, although (6) and (7) measure the change in income at a constant price level, we cannot be certain that even where Yi is positive, that total utility has increased. The change in relative prices may make it possible for one household to attain a higher level of utility per dollar of private spending; while in spite of substitution another household perforce moves to a lower indifference curve for a given private budget constraint. Hence, unambiguous com- parison even in the case of differential balanced budget incidence is impossible. Many will argue that for small government programs, changes in factor endow- ments and relative prices are likely to be small, so that calculation of the change in money income is a good estimate of the change in total utility. I would take the same position. Nevertheless, if one wants to be rigorous, then the earlier conclusion holds. Note, however, that conceptually it is possible to measure not only total incid- ence AY1, but also to break out our three components. In identities (6) and (7), AY. is total incidence of the new tax/expenditure. The final term in both identities is benefit incidence. In identity (6), the third term on the right side is tax incidence. Finally, RPTO is most simply defined as a residual equal to AY; - (BP3c - ATc). G. Tax and Benefit Incidence Compared Using our definitions, the first and second terms on the right side of equation (6) encompass RPTO incidence. In other words, they measure the combined RPTO D)O EMPIRICAL STtJDIES OF BUI)GET INCIDENCE MAKE SIENSE?. 305 effects of both the increased tax (ATC) and the new publicly financed expenditure (Qc) In our example, we cannot separate out the RPTO effects of the tax from those of the expenditure. But one can devise examples in which the sole change is a compensating change in either expenditure or tax; e.g., replacing one tax with an equally-yielding alternative. Such cases would permit calculation of either the RPTO incidence of the change in taxes or in expenditure separately. In identity (6) the change in taxation affects relative prices of outputs and returns to factors and may have long-run effects on asset formation. None of these changes is assumed in studies of total tax incidence. See for example the recent study of Pechman and Okner 118] or Gillespie [61.15 Such tax studies measure solely the analogue of benefit incidence with respect to taxes. Yet this unmeasured RPTO incidence on the tax side is important. Obviously, effects of decreased and/or re-channeled private spendirng on relative prices, factor endowments, and even tech- nological change are significant. The failure to deal with these in tax studies probably means errors as grave as those on the spending side where similar effects are ignored.1 6 An implication of this reasoning is that, conceptually at least, we can also de- compose total incidence into two symmetrical pieces of two parts each: Tax incid- ence per se (defined as equal to the total tax) and the resulting RPTO incidenice. Benefit incidence per se and the RPTO incidence resulting from the expenditure. A certain conceptual symmetry results. We define tax and benefit incidences as reduc- ing and increasing incomes directly. Their RPTO incidences are more veiled, operat- ing through changes in relative prices in factor and product markets, as well as through changing quantity and composition of output. One additional conclusion is suggested by the above material. An attempt to assess even the differential incidence of an existing program is apt to be extremely complex, demanding research inputs which may not be at all commensurate with the expected research benefits. Empirical country studies of tax incidence although frequently criticized be- cause they ignore RPTO effects, are nevertheless widely accepted. Similar studies of expenditures, however, have been more seriously criticized, and have less widespread acceptance than those of taxation.17 Yet, one conclusion suggested by the sym- metry of incidence with respect to taxes and expenditures is that if it makes sense to study tax incidence ignoring RPTO effects, as is commonly the case, it should make equal sense to study benefit incidence in the same fashion, as is equally commonly the case. It is possible that the greater resistence to the expenditure studies may be due to confusion of I?PTO and benefit incidences. Just as it is possible to separate tax-incideniee per se from the associated RPTO effects, so it is possible in fact, thus far, inevitable - tzit study of henefif incidence occurs independently of RPTO analysis with respect to expenditure. 306 JACOB MEERMAN H. RPTO Incidence in the Short Run Our earlier conclusion was that the empirical country studies of budget in- cidence were seriously invalid if they claimed to compare the effects of budget activity between a state of the world with government and a state of the world without it. (Just what is claimed to be compared in such studies is frequently not clear.) Can we make an alternative and less defective interpretation? The answer is yes if we move from a general equilibrium to a partial eqtuilibrium framework. Most of the concern with incidence questions by both citizenry and decision- makers focuses on the effects of budget activity oni the returns to the existing distribution of factors of production. The vector of interest is therefore (R, P). And the relevant question is, to what degree does government budget activity so radically affect relative factor and product prices that for a given household endowment of factors, household utility corresponding to pre-tax factor returns in the two periods differ substantially. This question is unstudied. Presumably, it is an important component of incid- ence in many situations. For example, when government is the major employer of certain groups, it may also increase the returns to those groups substantially above what they would be if government did not exist. Additional examples come to mind. Clearly of importance is the size of government relative to the economy, and of government demandl for highly differentiated labor, or capital. By the same token, the incidence due to changes in relative prices would decline as an economy ifl- creases the diversity of production, as labor and capital increase their mobility, as production functions become increasingly variable on both the input and output sides. What these considerations suggest is that such incidence is apt to be higher in a highlv dual, developing country with a large government than in an advanced eco- nomy. Returning now to our question, the empirical country studies of budget incidence can be most usefully viewed ass "short-run backwards", in which factors of production and technology are constant. Their error lies in the assumption that R and P are independent of budget activity. We do not know when this error is serious and when it is trivial. L Measuring Benefit Incidence Another major source of discontent with country studies of benefit incidence is the assumption that total costs equal total value. As concerns public goods this frequently is i n t erpret e(d as follows: (8) B4gG = a-TC9 DO EMPIRICAL STUDIES OF BUDGET INCIDENCE MAKE SENSE? 307 where: TC9 = total costs of producing G a1 = proportion of total income received by household i.. This of course gives the same relative results as the assumption that no one benefits directly from general goods - an assumption of some attraction given the character of most such expenditures as general overhead costs.18 These allocation techniques have no scientific basis in fact. They can be described as pseudo quantification of philosophical positions or a priori assumptions as to the arguments in utility func- tions.19 Yet the problems of allocating benefits from such goods may not be insur- mountable. For example, if one's interest is improving the long-term welfare of disadvantaged groups, it makes sense to disregard such expenditures since it is un- likely that even substantial changes in their magnitude and form will have much impact on absolute welfare of the poor.20 More problematic is the frequent assumption in such studies of allocative effic- iency for specific expenditure. In other words, mode of production and allocation of public outputs is such that for each household, assumed value received for any output equals corresponding cost of production. In terms of the model, this means for household i that (9) BSi = b where ZUb average and marginal cost of publicly financing i. It is obvious that the political process does not give such fine-tuned results. It is also usually impossible to empirically measure Bi: Even if households wanted to, it probably would be virtually impossible for them to consistently value - i.e., decide what they would be willing to pay for - a school year, or park-sojourn, or clinic visit. Moreover to the extent that expenditures redistribute from wealthy to say a poor family, it may be that BjS2 < C(7, because of the meager level of income of the poor relative to the magnitude of government programs. Nevertheless, this latter situation may be compatible with a net increase in utility for the community as a whole, to the extent that redistribution is income equalizing and marginal utility is a declining function of income. Under such circumstances, the likely associated pro- gressive tax could reduce utility less than the spending increases it.2 1 Such thinking leads some to assert that aggregate government spending on average and on the margin produces at least as m uch "welfare" or utility as the private spending for which it substitutes. In other words, the utility of the publicly provided Qi to the recipient household is seen as equal on average to the utility of the taxes to the household which pays for it. One conclusion from this line of reasoning is that charging the public costs of providing a benefit to a recipient, may give better results in terms of the underiying distribution of welfare across the 308 JACOB MEERMAN community than attempting to estimate the value to the recipient, as thus far assumed in the model. But one can make a third and still weaker assumption: (10) Jb- f(Qi) f' -0 where Up - total utility to the beneficiary of publicly financed good Qi. Since average costs per unit of output are fairly stable, it follows that utility and total costs are positively associated. If this is true, obviously, it continues funda- mental to know who benefits, and to identify beneficiaries by the amount spent on their behalf. This leads to the conclusion that study of benefit incidence should be redefined. It should not attempt the inmpossible, namely to estimate the value of all benefits to recipients, but rather to estimate the distribution of publicly financed outputs and corresponding public costs by beneficiary. In other words, the aim should not be to measure the value of benefits received, but t . measure the distribu- tion of the costs to the (cv:ninuniy of providing those benefits. Incidentally, this interpretation of "benefit incidence" although frequently eclipsed is not new. In 1941, Stauffacher'! concern with the discrepancy between public costs and subjectivf' evaluation of benefits led to an outcome similar to that suggested above. In his words: "'The benefit approach is ... primarily concerned with ... charging the cost of certain services provided by the government to the group(s) which they are intended to benefit"'.2 2 Because of the wav this paper is organized, the importance of measuring benefit incidence of existing programs - independently of the question of budget incidence or tax incidence - may not have been brought to the fore. More concretely, if the poor are to escape poverty through public expenditure then, mneasuring benefit incidence becomes a basic policy input: Intelligent activity to assist the poor re- quires knowledge of how well existing programs are functioning in terms of which reach the poor and which do not. Information concerning the distribution of public costs by beneficiary is a necessary first step in acquiring such knowledge. Conse- quently, whether or not we compare the actual with an ex ante hypothetical dis- tribution, knowledge concerning benefit incidence is valuable per se. Throughout this discussion we have assumed, unrealistically, either completely private or public goods. Usually it is argued that many publicly financed specific goods have positive externalities not capturable by the private producer. Hence, public finance is needed to increase output to the optimal level. Introduction of such considerations into the above argument would result in reinforcing the con- clusion that the assumption of costs of public production highly associated with benefits - which now distribute more diffusely - is usually valid. But such introduc- tion would also suggest the difficulties in treating even specific expenditures as DO EMPIRICAL STUJDIES OF BITDGET INCIDENCE MAKE SENSE? 309 completely private goods. Yet, at the same time, it would reinforce the desirability of estimating on whose behalf and in what magnitude public spending proceeds. More specifically, if utility functions are interdependent, so that on average house- hold k derives utility from the publicly financed "merit goods" consumed by household j, it is of value to be able to state clearly what the cost to the community is of providing the goods toj. Such information is a necessary condition for rational planning of public expenditures. III. MAIN POINTS (1) Estimating budget incidence in terms of an economy with governmelnt and that same economy without government or minimum government is impossible. (2) Scientific measurement of differential balanced budget incidence is im- possible. Even approximate measurement is extremely difficult if RPTO incidence is substantial. (3) Although it is impossible to measure benefit incidence, in general, benefit incidence and community costs will be closely associated. Consequently, we take costs, which we can measure, as a proxy for benefits. This procedure brings a useful by-product, identification of the costs incurred by the community in providing benefits to different groups. This is a necessary first step in many types of policy analysis. (4) It is possible and worthwhile to study both tax and benefit incidence inde- pendently of RPTOincidence. (5) Study of RPTO incidence per se is desirable. It would be useful to gauge its importance relative to that of benefit incidence. (6) Country studies of general tax and/or public spending incidence would be improved if they discussed explicitly two necessary limitations: (i) the usual assump- tion that relative prices, asset endowments, and production functions are independ- ent of budget activity; and (ii) their usual failure to consider RPTO incidence. It may be best to regard such studies as being of the short run "backwards" with asset endowments, production functions, and relative prices fixed. (7) Thinking about the incidence of both taxes and public expenditures would be improved if the symmetry of the two were recognized: tax incidence, in con- ventional definition is analogous to benefit incidence; RPTO incidence with respect to taxes (largely ignored in country studies) is analogous to RPTO incidence with respect to expenditure (largely ignored in country studies). (8) Because marginal utility declines with income, in many situations charging costs to recipients may be a better measure of the overall impact of budget activity on welfare than attempts to measure benefits in value terms: Even if a dollar of tax 310 JACOB MEERMAN produces a quarter of benefits, total welfare may be increased if the tax-payer is wealthy and the beneficiary poor. NOTES * In this paper I speak solely for myself, and not for rny employer. ** The author is an employee of the World Bank, Washington, D.C. 1 This is still a very narrow perspective. Government affects income distribution fundamentally by supporting basic institutions and attendant legislation, e.g., a constitution, and less fundament- ally by affecting numerous variables which in turn affect income distribution; e.g., foreign ex- change rates, interest rates, treatment of business, wage and migration policy, and rate of inflation. Budget incidence, therefore, can only measure a small part of government impact on the distribu- tion of income. 2 For a review and critique of country studies of budget incidence see Bird and de Wulf [2], McLure [11], Meerman [12], de Wulf [25]. An early critique of TUnited Kingdom measures of budget incidence wvas led by Peacock and Shannon [17]. Alan Prest [201 continued this attack on the IJ.K. measures in part by stressing the contradictory nature of the ' traditional" assumptions concerning tax incidence as also discussed in his 1955 paper. The frustrating question of the incidence of public goods has been discussed at length in Aaron and McGuire [1] and Brennan's cGinment plus rejoinders [4. ] 3 The focus is solely effects from taxing and spending. Concomitant changes in the institution- al framework and their impact on distribution are not considered, e.g., licensing requirements. 4 | l 1, p.7 1. McLure states that the concepts and terms expenditure and benefit incidence are from Musgrave [ 14, pp. 2 1 * - I5 ]. McLure is correct in this, although it is interesting that nowhere else (including the index) does Musgrave use such language, nor does he make a distinction between expenditure and benefit incidence as such in his 1973 text. Rather he defines expenditure incidence as encompassing both benefit and Mc(Clurian expenditure incidence. See Musgrave and Musgrave [Li., pp. 360-61 ]. 6 Slavery presents a real world example of this assumption. 6 A world without government is an idealization. More realistically, define it as minimal government spending compatible with maintenance of sufficient order and security to permit modern economic life. Depending on circumstances, this would probably lie between 1 and 3 percent of GNP for most countries. This is close enough to zero to permit such idealization without seriously biasing analytical results. 7 The restriction to private consumption or investment goods directly to households is unreali- stic. It is eliminated below where the methodology is developed for considering subsidies in the form of production inputs. Public good is defined as a good "which all enjoy in common in the sense that each individual's consumption of such good leads to no subtraction from any other individual's consumption of that good" [21, Samuelson, p. 387 1. 8 [11, McLure, p. 521. See also Maital [p. 562], Aaron and McGuire [1, p. 9091 all of whom accept this approach. 9 For two good recent examples, see Gillespie [71 and Musgrave and Musgrave (15, pp. `:i5- i7]. 10 Equation (3) could have been written in national accounts terms; assuming that total final output equals total factor-incomes is consistent with a Lindahl equilibrium, 11 Pareto superiority exists when in moving from equilibrium State I to equilibrium State 2, no household's total utility diminishes and at least one increases. DO EMPIRICAL STUDIES OF BUDGET INCIDENCE MAKE SENSE? 311 12 In other perspective, we have here a version of the Index Number Problem in which solely relative prices change. Use of a Laspeyre index defines the maximum amount "real" income could have fallen for any household in State 2 relative to State 1. Note that the comparison is between an actual and a hypothetical given income distribution. Whether State 2 co,:ld be Pareto superior, given the range of possible income distributions in State 2 is another issue. But even an actual or possible Pareto superior sitation for State 2 does not mean that State 2 is inambiguously better. It may have been possible to achieve an income distribution in State 1 preferred by all to the actual :Dr possible distribution in State 2. See Scitovsky [22]. The debate between Aaron and McGuire [1] and Brennan [4] revolved around whether, on introducing public goods, a Lindahl solution is "distributionally neutral", The outcome came close to the position presented here, namely the necessary ambiguity in comparing incomes in two states with different relative prices, even though incomes in terms of the standard numeraire remain constant. 13 In terms of the model only a subset of the n possible Qi will be produced in any given state. 14 Defined as the combined incidence of a tax and the expenditure it finances. 15 The Pechman/Okner study is also of interest in avoiding many of the problems discussed above. They did this by eschewing comparison of the status quo with a hypothetical zero govern- ment but used as their "counterfactual" a hypothetical proportional income tax equal to total taxes. 16 Although RPTO effects are always neglected in the empirical country studies, in a wide variety of othir work they are the focus of attention. See Break [3]. But the results of such work have not been of a kind to permit their application in the ceuntry studies. 17 See the references to the general critiques in note 2. 18 For an analyis of some of the problems in allocating benefits from general goods see Shoup [23, pp. 66ff] Aaron and McGuire [1], Brennan 14], M5eerman [131. 19 See Aaron and McGuire [1]. 20 Another alternative is to regard the services from outlays for internal and external security as a peculiar general intermediate good whose benefits cannot be allocated by households. See Kuznets [9, p. 156] where he argues 'that such goods are "the cost of membership in our business civilization". 21 As illustrated by the case in which the poor family prefers a block grant equal to the cost of the government service received, e.g., subsidized housing. Such subsidized housing need not be inferior to the ex-ante situation. To give a new twist to the Kaldor compensation criterion, in the above example if the poor could transfer utility, they might be more than willing to fully compensate the loss of utility to those who finance the housing subsidy. 22 See also the discussion in Cartter [5, pp. 11-131, Musgrave et al [16, pp. 282-84] and the cryptic remark of Gillespie [6, p. 1761. REFERENCES [11 Aaron, Henry, and McGuire, Martin, "Public Goods and Income Distribution", Econometrica,Vol. 38 (1970), pp. 907--2Q. [2] Bird, Richard M. and de Wuilf, Luc H., "Taxation and Income Distribution in Latin America, A Critical Review of Empirical Studies", International Monetary Fund Staff Papers, Vol. 20, No. 4/1973, pp. 639-82. [3] Break, George F., "The Incidence and Economic Effects v f Taxation", in The Economics of Public Finance (Washington, D.C., The Brookings Institution, 1974), pp. 119-240. 312 JACOB MEERMAN [41 Brennan, Geoffrey, "The Distributional Implications of Public Goods", Econometrica, Vol. 44, No. 2 (March 1976). [5] Cartter, Allan M., The Redistribution of Income in Postwar Britain (New Haven, Yale University Press, 1955). [6] Gillespie, W.I., "Effects of Public Expenditure on the Distribution of Income", in Musgrave, Ridl *d A., ed., Essays in Fiscal Federalism (Washington, D.C., Brookings Institution, 1965). [71 Gillespie, W.I., "On the Redistribution of Income in Canada", Canadian Tax Journal, Vol. XXIV, No. 4/1976, pp. 419-50. [81 Hotelling, Harold, "The General Welfare in Relation to Problems of Taxation and of Railway and Utility Rates", Econometrica, Vol. 6 (July 1938), pp. 242-69. 191 Kuznets, Simon, "National Income, a New Version", Review of Economics and Statistics, Vol. 30 (1948), pp. 151-79. [ 10] McLure, Charles, E., Jr., "The Theory of Expenditure Incidence", Finanzarchit', Vol.30, No. 3/1972, pp. 432-53. [ 1]iMcLure, Charles, E., Jr., "On the Theory and Methodology of Estimating Benefit and Expenditure Incidence", Paper presented at the WYorkshop on Income Distribution and its Role in Development (Houston, Texas, William Marsh Rice University, 1974). [12] Meerman, Jacob, "Fiscal Incidence in Empirical Studies in Income Distribution in Poor Countries", UT.S. Agency for International Development, Discussion Paper No. 25 (Washington, June 1972). [13] Meerman, Jacob, "Income Redistribution in West Malaysia and Recent Empirical Work on Budget Incidence: A Comment", Public Finance/Finances Publiques, Vol. XXX, No. P11975, pp. 131-35. [141 Musgrave, Richard A., Tlhe Thieory of Public Finance (New York, McGraw Hill, 1959). [151 Musgrave, Richard A., and Musgrave, Peggy B., Public Finance in Theory and Practice (New York, McGraw Hill, 1973). [161 Musgrave, Richard A., et al., "The Distribution of Fiscal Burdens and Benefits", Public Finance Quarterly, Vol. 2, No. 3 (July 1974). [17] Peacock, Alan and Shannon, Robin, "The Welfare State and the Redistribution of Income", Westminster Bank Review Quarterly (August 1968). [181 Pechman, Joseph A. and Okner, Benjamin A., Who Bears the Tax Burden? (Washington, D.C., Brookings Institution, 1974). [191 Prest, Alan R., "Statistical Calculations of Tax Burdens", Economica, Vol. XXII, No. 87 (August 1955). [201 Prest, Alan R., "The Budget and Interpersonal Distribution", Public Finan7ce/Finances Publiques, Vol. XXIII, No. 1-2/1968, pp. 80-98. [21 ] Samuelson, Paul, "The Pure Theory of Public Expenditures", Revieu of Economics and Statistics, Vol. 36 (1954), pp. 387-89. [22] Scitovsky, Tibor, "A Note on Welfare Propositions in Economics", The Review of Economic Studies, Vol. 9 (1941), pp. 77-88. [23] Shoup, Carl S., Public Finance (Chicago, Aldine Publishing Company, 1969). [24] Stauffacher, Charles, "The Effect of Govemmental Expenditures and Tax Withdrawals upon Income Distribution, 1930-1939", Public Policy, No. 2 (1941), pp. 232-61. [251 de Wulf, Luc H., "Fiscal Incidence Studies in Developing Counitries: Survey and Critique", International Monetary Fund Staff Papers, Vol. 22, :', ). 1/1975. Summary: Do Fmpirical Studies of Budget Incidence Make Sense? - This paper attempts to rcduce the controversy concerning statistical studies of the incidence of taxes and public expenditure. The analysis is based on an algebraic formulation of the household budget constraint permitting comparisons under various states of the world. Incidence is so defined as to include general equilibrium effects of taxes and expenditures, namely changes in relative prices, technological change, and the outputs of various goods and services, (RPTO incidence). The paper shows that the DO EMPIRICAL STUDIES OF BUDGET INCIDENCE MAKE SENSE? 313 empirical country studies wrongly assume that RPTO incidence is zero. Economists have been more willing to ignorc RPTO incidence in aggregate tax studies than in the analysis of incidence of public expenditures notwithstanding the symmetry between the two: The statistical studies exclude RPTO considerations, in analyzing both tax and benefit incidence but should ;nclude them in both cases. In fact, such studies are really "short run backwards." in that RPTO incidence is implicitly assumed constant in the backwa:ds comparison of the actual distribution of tax burdens and expenditure benefits among households with the hypothetical situation of zero government. The paper also shows that a Lindahl solution to production of public goods although Pareto optimal may not be Pareto superior. The paper also considers the assumptions used to distribute benefits of public expenditures across households. 'The studies inevitably assume that the recipient's valuation of such benefits equals their public costs. This is improbable, for example, where the cost is high and thie recipicnt's income is low as may be the case with poor children in secondary schools. However we can make a virtue of necessity. The researcher should drop all pretense of measuring benefits and allocate costs to beneficiaries. TIhis will be useful to policy makers whso need to know where the spending goes. It may also give a better measure of the overall impact of budget activity on welfare than attempts to measure the value of benefits. RWsunmr: Les etudes empiriques de l'incidence budgetoire ont-elles un sens? - Cet article tente d'apaiser la controverse sur les etudes statistiques relatives A l'incidence des impots et des depenses publiques. L'analyse est fondee sur tine formulation algebrique de la contrainte relative A la gestion budgetaire permettant des comparaisons en differents pays dans le monde. L'incidence est definie de facon A inclure les effets d' equilibre g6n6ral des imn,ts et des d6penses, A savoir modifications dans les prix relatifs, evolution technologique et productions de divers biens et services (incidence RPTO). L'article montre que les recherches empiriques par pays posent A tort comme hypothese que l'incidence RPTO est nulle. Les economistes ont eu davantage tendance A ignorer l'incidence RPTO dans les recherches en matiere d'imp6ts que dans l'analyse de l'incidence des d6penses publiques, malgre la symetrie entre les deux: les etudes statistiques negligent le RPTO en analysant l'incidence A la fois des imp6ts et des avantages, alors qti'elles devraient les inclure dans les deux cas. En fait, de telles etudes sont r6ellement "en arri4re A court terme", en cc sens que l'incidencc RPTO est implicitement supposee constante dans la comparaison "enarrier" de la distribution reelle des charges fiscales et des avantages des depenses entre les menages, avec une situation hypothetique d'un gouvernement inexistant. L'etude montre aussi qu'une solution de I indahl pour la production de biens publics, bien que respectant l'optimum paretien, n'est pas superieure A celle de Pareto. LI'article traite egalement les hypotheses relatives A la distribution des avantages des depenses publiques entre les menages. Les etudes posent in6vitablement en hypothese que la valeur de tels avantages potir qui les recoit &quivaut A leurs coats publics. Or, ceci est improbable, par exemple quand le cott est 6lcvc et que le revenu du b6n6ficiaire est bas, comme c'est le cas pour les enfants pauvres dans les ecoles secondaires. Cependant, on peut faire d'une necessit6 une vertu. Le chercheur devrait renoncer A la pretention de mesurer les avantages et de repartir les coats entre les ben6ficiaires. Ce serait pourtant utile pour les d6cideurs politiques qui ont besoin de savoir la destination des depenses. Cela peut aussi donner une meilleure evaluation de l'effet global de l'activite budgetaire sur le bien-etre que les tentatives faites pour mesurer la valeur des avantages. Zusammenfassung: Sind empirische Studien iTber Budgetinzidenz sinnvoll? - Dieser Artikel versucht, die Kontroverse um statistische Untersuchungen der Inzidenz von Steuern und dffentlichen Ausgaben abzubauen. Die Analyse basiert auif einer algebraischen Formuliening der Budgetnebenbedingung, die Vergleiche zwischen verschiedenen Staaten der Welt zulaBt. Die Inzidenz ist so definiert, daB sie allgemeine Gleichgewichtseffekte von Steuern und Ausgaben, insbesondere Anderungen der relativen Preise, technologische Veranderungen und die Produktion verschiedener Giiter und Dienst- leistungen (RFTO-Inzidenz) einschlieBt. Der Artil.el zeigt, daB die empirischen Landerstudien f'alschlicherweise eine RPTO-Inzidenz von Null annehmen. Wirtschaftswissenschaftler sind eher bereit, die RP'tO-tnzidenz in Steuerunter- suchungen unberilcksichtigt zu lassen als bei Analysen der Inzidenz offentlicher Ausgaben ungeachtet der Symmetrie zwischen den beiden: Statistische Untersuchungen schlieBen RPTO bei der Analyse der Steuer- tind Nutzeninzidenz aus, sollten sie jedoch in beiden Fallen beracksichtigen, Tatsachlich sind solche Untersuchungen wirklich 'kurzfristig riuckwarts gewandt", insofern als die RPTO-Inzidenz implizit als konstant in dem "rtickwirts" orientierten Vergleich der gegenwartigen Distribution von Stcuerlasten und Ausgabennutzen zwischen Haushalten unter der hypothetischen Situation einer Null-Regierung. Der Artikel zeigt ebenfalls, daB eine Lindahl-Lbsung fUir die Produktion offentlicher (,uiter, auch wenn sie Pareto-optimal ist, nicht unbedingt der Paretos-Losung tlberlegen ist.Darilberhinaus werden die Annahmen untersucht, unter denen die Nutzen offentlicher Ausgaben auf die Haushalte verteilt werden. Die LUnter- suchungen gehen zwangslaufig davon aus, daB die Bewertung des Empfangers solcher Nutzen mit den offentlichen Kosten gleichzusetzen ist. Dies ist z.B. dort unwahrscheinlich, wo die Kosten hoch und die Empftingcreinkommen nied- rig sind, wic es bei armen Kindern in hoheren Schulen der Fall scin kann. Aus der Notwendigkeit lait sich jedoch eine Tugend machen. Der Wissenschaftler sollte auf eine Messung der Nutzen verzichten und die Kosten unter den Be- gilnstigten aufteilen. Dies ware filr die Politiker voni Nutzen, die iiber die Venvendung der ielder informiert sein mulssen. Dies lieBe auch cine bessere Bewertung der Gesamtwirkung budgetairer MaBnahmen auf die Wohlfahrt zu als Versuche, Nutzen zu bewerten. ESTIMATING COUNTERFACTUAL INCOMES IN STUDIES OF BUDGET INCIDENCE by JACOB MEERMAN AND PARTHASARATHI SHOME* I. INTRODUCTION In a recent issue of this journal Meerman asks, "Do Empirical Studies of Budget Incidence Make Sense?" He answers that although sensible, their usefulness is much constrained because they are short run "backwards" in that they implicitly assume ceteris paribus conditions for relative prices, technology, labor supply, level of unemployment, savings, and investment in making the incidence estimates [9, p. 298]. Meerman sums these together under the heading of RPTO incidence (relative prices, technology, output). Perhaps the most serious and most vitiating of these ceteris paribus conditions is that for relative prices.1 In addition, the failure of these studies to, in any way, indicate the effects of government budget activity on savings and investment is also a very serious limitation. It is noteworthy that these problems are to some degree dealt with in the Harberger Model [7] and in its development.2 In what follows we wish first to show how results from the Harberger Model can be used in conjunction with the Meerman approach to suggest some of the error in the comprehensive statistical studies because of assuming fixed relative prices. In other words, Meerman somewhat overstates his case. To some degree relative price changes for factors of production - principally capital and labor - can be taken into consideration in the comprehensive statistical studies. Second, by correcting and elaborating on Meerman's model, we wish to point out two additional errors in the comprehensive statistical studies because of the fact that if taxes are in part (or in total) indirect, total factor incomes (or in Meerman's model the household budget constraints) necessarily sum to less than total output. II. IMPLICATIONS OF THE HARBERGER MODEL In Section II(B) of his paper, Meerman points out that in the comprehensive Public Finance / Finances Publiques No. 2/1980 Vol. XXXV/XXXVbme Ann6e 292 JACOB MEERMAN AND PARTHASARATHlI SHOME statistical studies of incidence, a "counterfactual" or a hypothetical, before-tax position (state 1) is defined and then compared with the observed post-tax position (state 2), to obtain a measure of incidence. He goes on to show how RPTO incidence is implicitly assumed to be zero in these short run studies and how the counterfactual household income, Yl, is simply taken to be equal to the observed m value of the total factor incomes, X R2k A2k, where Rk is the per unit return to k=l the k factor, and Ak is its quantity. In his orginal article Harberger used as the counterfactual - Meerman's state 1 -a perfectly competive US economy with Cobb-Douglas production funtions, fixed technology, fixed supply of factors and no corporate income tax. He also assumed expenditure neutrality: Government expenditure from the tax was to exactly mimic the former expenditure of the private resources now taxed away. Harberger compared labor and capital incomes in counterfactual state I with what they were in actual state 2, principally by permitting relative factor prices to vary. A sufficiently long run analysis allowing for intersectoral factor movements to be completed, together with the assumption of perfect competition, implies that capital earns the same net return in all uses. Consequently Harberger's state 2 had a higher gross rate of return per unit of capital in the more highly taxed corporate sector than in the non-corporate sector. We illustrate Harberger's case by the following example using Meerman's notation. Let us focus only on the returns (RK) a.nd c1uantities (AK) of capital in the corpora e and non-corporate sectors. Then let RgKAgK be the net inconl1e of capital in the l sector (i = corporate, C; and non-corporate, NC) for the g state (g = before-ta K, 1; and after-tax, 2). Then C C NC NC (1) RJKAl K +RIK Al K = RIK AlK After the tax is imposed and equilibrium has been achieved in state 2, the gross income of total capital can be defined as NC NC C C (2) R2K A2K + S = RKA2K+R2 K A2K +S NC NC' C C where R2 K A2 K is the post-tax income of non-corporate capital, and (R2 K A2 K + S) is the gross income of corporate capital, of which S is the tax on corporate capital. In the unsophisticated approach to corporate tax incidence it is assumed that (3) RIK AIK - R2K A2K = S that is, the entire tax appears to be "borne" by corporate capital. But, as explained ESTIMATING COtJNTERFACTUAL INCOMES 293 below in the simple Harbergerian example elaborated in Table 1, in reality the net per unit return to capiial in both sectors is depressed. It is in the nature of Cobb-Douglas production functions that factor shares of total income remain constant at all input prices. In our example, constant composition and price of final output is implicitly assumed. Consequently - as illustrated in Table 1 - aggregate gross returns to non-corporate and corporate capital remain constant at 400 and 200 respectively. In Table 1, the tax on income from corporate capital is 25%. Since the gross return remains 400, the net return must fall to 300, with the proceeds from the tax equaling 100. We now have clearly in mind what is needed to calculate the post-tax positions shown in Table 1. (Table 1 refers to capital income only since labor incomes in both sectors will remain the same in pro-tax and post-tax_positions.) In the posttax situation, R2 K is taken as the net price of capital and A2 K is the quantity of capital in the corporate sector. r'hen net income in the corporate sector must be equal to 300, or C C (4) R2K A2K =300 Given that the total amount of capital is 600, we can write (600 - A2' as the C amount of capital in the non-corporate sector. For equilibrium, R2 K has to be the net price of capital in both sectors. Thus, since the income of capital in the non- corporate sector is 200, we have C C (5) R2 K(600 - A2 K) 200 C C Solving equations (4) and (5) we have R2 K = 5/6 and A2 K = 360. The post-tax quantity of capital in the non-corporate sector is then (600-360) = 240. And the C gross return per unit of capital in the corporate sector R)K where t is the tax rate (25%). Thus it is equal to 1-625 10/9. It is now obvious that in economies similar to that assumed here, in order to get to the counterfactual capital income, RIKAIK, that is (400 f200), one should simply add the gross income of capital in the corporate sector (400) to the income of capital in the non-corporate sector (200). Labor income in state 2 can be simply added on to this since it is not affected by the tax, and thus the total income for counterfactual, RI Al, is obtained.3 This outcome has implhrawtions for the comprehensive statistical studies (CSS). Consider two households in state 2 (from the world of Table 1). HouseholdA has income from corporate capital only. Household B has income from non-corporate 294 JACOB MEERMAN AND PARTHASARATHI SHOME TABLE I Capital Income, Quantity And Price In Pre-Tax And Post-Tax Positions State I (Before Tax) Income Quantity Price RIK AJK-400 AIK =400 AIK= NC NC NC NC RIK AIK = 200 AK =200 RJK= I State 2 (After Tax) (Assuming Cobb-Douglas Production Functions, and a 25% Tax on Corporate Capital Income, Equal to 100) Income Quantity Price R2K A2K +S=400 (gross) A2K = 360 R2K C 109 (gross) R2K A2K = 300 (net) R2K = 5/6 (net) NCNCNC NC R2KA2K = 200 A2K = 240 RNK 516 capital and no other source. Both households own 40 units of capital. They live in our simple Harbergerian Cobb-Douglas world, where legally "only" corporate income is taxed and at 25 percent. We indicate their state I and state 2 incomes in Table 2 below. TABLE 2 Incomes of Two Households in State 1 and State 2 Source of Household Capital Quantity Income Gross Net State 2 State I A Corporate capital 40 (10/9)(40) (5/6)(40) 33.33 40 = 44.44 = 33.33 B Non-corporate capital 40 (5/6)(40) (5/6)(40) 33.33 40 = 33.33 = 33.33 FSTIMATING COUNTERFACTIAL, INCOMES 295 TIhie Harberger Cobb-Douglas approach makes the proper measure of income in state 1 and state 2 obvious - under competitive assumptions. Yet in many of the CSS. the approach used appears to have been defective. Such studies frequently answer the question, what would incomes be in state 1, that is were there no government, by simplv taking gross factor incomes as they are in state 2, even though the studies assume that taxes on part of capital actually burden all capital in part or in total. In terms of the example above, this means taking total income for hotusehold A in state 1 as 44,44, since at first glance this is what factor income would be were there no government. Consequently, this approach exaggerates couinterfactuial income of corporate capital owners, if corporate taxes are above thle :i\erage of capital taxation.4 In addition relative tax burden of the corporate capitalists is estimated as somewhat too low; couinterfactual incomes are too low for capitalist households with low corporate income, while their estimated burdens ronm capital taxes are too high. Peehmiran and Okner [It] - we believe - avoid this error, although it is not corrplet(1y clear that this is the case, since they do not provide detail on just how they "-retore" corporate income taxes to houLseholds. Musgrave et al [10] may have added the enitire corporate income tax back to corporate capital shareholders in huildling their countertactual for a US study of budget incidence for 1968. To wit: p1. p op)er treattment of the corporation tax calls for imputation of total corporate source income to sharcholdlcir (MNwsgrave et al [ 10, p. 301 1). If they did do this it would noit be consistent with their six tax shifting assumptions for the corporate income tax, none of which assumes that the tax burdens solely owners of corporate shares. In general in most studies no attempt is made to adjust counterfactual income to be consistent with incidence asstirnptions.5 We should also emphasize that some investigators are very much aware of the efTect'. of government tax and expenditures ofn relative prices.6 But it has hitherto been widely believed that it is impossible to in any way come to grips with the problem. This is not completely the case, as suggested by the work on the Harberger model as well as the discussion on indirect taxation below. We do have a beginning in dealinig with the more general issues of the impact of taxes on counterfactual incomnes. But the spendJing side is, alas, largely terra incognita. ILl. I IlT 1LI I 1 CTS O F INDIRECT TISA.X;I In s'ection II(C) of his paper, Meerman miakes an implicit aind uniwarranted . '.Aulptip wi to the effect that all taxes are direct. He states the L.indahl solition. his equation (3), as total output equals total flactor income, or n / n / / I / (6) 2 Ji; Qij t E- ' 1i Q:j + 2 G2 2 -' R2ki A2kj hi 1 1i j- 14 k4 ji 296 JACOB MEERMAN AND PARTHASARATHI SHOME where P2JU and Q2y are the pr ce and quantity respectively, in state 2, of the X commodity purchased by thej household, i2ij is the marginal value to recipient household j of the private commodity i, in state 2, provided through government provision; Bgj is the corresponding marginal value of the public good (G); G2 is the m I amount of the public good, and E X R2kj A2kj is total factor income. This equality will hold only if all taxes are direct. For if taxes are in part or in total indirect, the left-hand-side of the equation (total output) must be greater than the right-hand-side (total factor income) by the amount of indirect taxes. Thus the above statement of the Lindahl solution is valid if and only if all taxes are direct so that there is no wedge between total output and total factor incomes. Of course whether or not indirect taxes exist, in no way affects Meerman's conclusion that a Lindahl solution is not necessarily Pareto superior. This failure to be explicit about the directness or indirectness of taxation suggests another aspect of the problem of what is the proper concept of total household income for state 1. As noted, if in state 2 all taxes are indirect, then, even ignoring RPTO incidence, for all households combined, the sum of factor incomes is less than total output ov NNP by the amount of indirect taxes. In other words if Y2/ is the income of the . houisehold in state 2, A' is the average indirect tax per private good, and the variance in ' is independent of the distribution of incomes, then if we have a Lindahl solution or we take a national accounts perspective we have the following for each household j: m n (7) Y2j= v R2k A2k + X( Q2 ) k=l i-l Under these circumstances to get a proper measure of Ylj we need to impute- somehow - to each household its change in income on the assumption of complete remission of indirect taxes. (The resources corresponding to the sum of all such n / changes will necessarily be (X) X' X Q2iq)- Many researchers have ignored i=1 1-1 this problem and taken as their counterfactual simple factor incomes in economies with considerable indirect taxation. Even the more sophisticated researchers, who put these resources into the indirect taxes would be distributed in state I in proportion to the distribution of factor incomes and that changes in relative product prices are neutral (Pechman and Okner [1 1 ]; Musgrave [ 10], and Browning [3]). In brief, the CSS ignore RPTO incidence, and they also fail to consider the most obvious aspect of RPTO incidence, namely how to adjust household incomes DO EMPIRICAL SrtIDIES OF BUD)GET INC![DNCE MAKE S[NSE? 297 private incomes) and benefit incidence (who receives the benefits of government services)" [11, McLure, p.2l. In McLure's thinking, total incidence can therefore be decomposed into: "The burden (and benefits) of taxes used to finance public activ- ity, the benefits of public services, and the redistribution of income resulting from changes in relative factor rewards and product prices induced by the shift of purchasing power from the private to the public sector. For converiience, we can refer to these three effects as tax, benefit and expenditure incidence, respectively"' Earlier versions of this paper attempt to use both this basic tripartite decompos- ition of incidence as well as the terms benefit and expenditure incidence. Although logically there was no problem, the result was continuing confusion of readers not to mention in.ind&ary red herrings. Three difficulties were basic: (1) The distinction is made between expenditure incidence as consisting of impacts on private incomes - in Musgrave's language "changes in the distribution of income disposable for private use" 114, Musgrave, p. 214] - and benefit incidence as "the benefits derived from public services". Clearly, however, the benefits from public services have private income equivalents. In a common definition of income, transfer payments, rent allowances, and public medical care received free or at subsidy can be regarded as private income by their recipients. Musgrave and McLure really define income rather rigorously as solely returns to factors of production and on the spending side solely the goods and services which those returns can purchase. (2) It is very common, among economists, to use "expenditure incidence" to refer to benefit incidence alone or to benefit incidence plus McLure / Musgravian expenditure incidence. And it is difficult to fault people for using the terms in such an apparently straightforward and common sense fashion. But it does lead to un- necessarv conftusion, and a great deal of explanation. (3) Finally, because of the common definition of tax incidence as equal to the anmount of the tax, the phrase "expenditure incidence" as used by Musgrave and McLure may carry something of an implication that only an expenditure has effects on relative prices, on techniques, and on the volume of output. We realize, of course, that taxes have similar effects. More g2nerally, we realize that by and large increases in taxes and expenditures go hand in hand, i.e., over the long run budgets have to be (nearly) balanced. Consequently, it is probably useful to think of incremental taxes and their associated incremental expenditures together making explicit the fact that the resulting effects on tax/expenditure on relative product and factoi prices as well as the volume and composition of output are closely associated. Where this leads us for the analysis at hand is to (i) development of a model in terms of balanced budget incidence, as the situation which most correspon(is to the real world; (ii) to keeping the McLuIIre Mlusgrave tripartite decomposition of in- cidence but to putting it into new bottles. Specifically, we define benefit incidence 298 JACOB MEERMAN AND PARTHASARATHI SHOME REFFERENCES [1] Andic, Fuat M., "Poverty and Tax Incidence in West Malaysia", Public Finance Quarterly, Vol. 5, No. 3/1977, pp. 329-370. [2] Ballentine, J.G. and I. Eris, "On the General Equilibrium Analysis of Tax Incidence", Journal of Political Economy, Vol. 83 (1975), pp. 633-644. [3] Browning, E.K., "The Burden of Taxation", Journal of Political Economty, Vol. 86 (August 1978), pp. 649-671. [4] Dodge, David A., "Impact of Tax, Transfer, and Expenditure Policies of Government of the Distribution of Personal Income in Canada", Review of Income and Wealth, Series 21, No. I (March 1975), pp. 1-52. [5] Franzen, Thomas, Lovgren, Kerstin and Rosenberg, Irma, "Redistributional Effects ofTaxes and Public Expenditures in Sweden", Swedish Journal of Econonmics, Vol. 77, No. 1/1975, pp. 31-55. [6] Gillespie, Irwin W., "Effect of Public Expenditures on the Distribution of Income", in Essays in Fiscal Federalism (Washington, D.C., Brookings Institution, 1965) pp. 122-186. [7] Harberger, A.C., "The Incidence of the Corporation Income Tax",Journal ofPoliticalEconomY, Vol. 70 (1962), pp. 215-240, reprinted in Taxation and Welfare (Boston, Little, Brown and Company, 1974). [8] McLure, C.E., Jr., and W.R. Thirsk, "A Simplified Exposition of the Harberger Model, Il: Expenditure Incidence", National Tax Journal, Vol. 28 (1975), pp. 195-207. [9] Meerman, J., "Do Empirical Studies of Budget Incidence Make Sense," Public F'inance/F'nances Publiques, Vol. 33, No. 3/1978, pp. 295-312. [10] Musgrave, R.A. et al., "The Distribution of Fiscal Burdens and Benefits", Public Finance Quarterly, Vol. 2, No. 3/1974. [11] Pechman, J. and B.A. Okner, Whlo Bears the Tax Burden (Washington, D.C., Brookings Institution, 1974). [12] Ratti, R.A. and P. Shome, "The Incidence ofthe Corporation IncomeTax: A Long Run, Specific Factor Model", Southern Economic Journal, Vol. 44, No. 1/1977, pp. 85-98. [13] Ratti, R.A. and P. Shome, "On the Separability of the Incidence and Efficiency Effects of the Corporation Income Tax", Public Finance/Finances Publiques, Vol. 32, No. 3/1977, pp. 348-353. [14] Vandendorpe, A.L. and A.F. Friedlaender, "Differential Incidence in the Presence of Initial Distorting Taxes", Journal o Public Economics, Vol. 6 (1976), pp. 205-229. Summary: Estimating Counterfactual Inconmes in Studies of Budget Incidence. - In his article "Do Empirical Studies of Budget Incidence Make Sense?" [91 Jacob Meerman argued that one of the most serious shortcomings in such studies was the failure to in any way consider the effects of government activity on relative factor and output prices. But Meerman overstated his case. This paper shows how the effect of the corporate income tax on relative returns to factor incomes is dealt with in the Harberger Model. In the process the paper shows how use of the Harberger Model could deal with some common errors in the empirical statistical studies. The paper also deals with a minor error in Meerman's article: His demonstration that a Lindahl-solution to taxes and public production is Pareto optimal but not necessarily Pareto superior, implicitly involved the notion that all taxation is direct. It is obvious, however, that the conclusion also holds in economies with indirect taxation. The paper then takes off from this point to discuss some rarely considered prohlenriL ariiing from the fact that in economies with indirect taxes, total factor incomes are less than total incomes. Many studies simply err in generating the ESTIMATING COUNTERFACTUAI, INCOMES 299 counterfactual incomes of a before-government world without including indirect taxes. Those few studies that do incorporate the wedge of indirect taxes, back into factor incomes, do so in an unsatisfactory manner. Resume: Estimation tit, revenus "counterflctual" ilanIs ltv trles (fincidence btudgtaire. - Dans son article "Do Ermpirical Studies of Budget Incidence Make Sense?"[9 ], Jacob Meerman affirme que I'uLne des deficiences les plus importantes de ces etudies est l'absence de prise en considfration des ef'fets de l'activiti~ gousernementale sur les prix relatif:s des facteurs et de l'output. Matis Meerman a exag6r6 son cas. C'et article montre comment l'effet de l'impot sur les soci6t&s sur les rendements relatifs de revenus des facteurs est traite dans le mod&le de fHarberger. Au cours de cet article, nous montrons comment l'utilisation du modtle de Harberger pourrait eviter certaines erreurs communes dans les &udes statistitques empiriques. P.'article present traite egalement d'une erreur mineure dans l'article de Meerman: sa denmonstration qu'une solution du type lindahl aux problemes des taxes et de la production publique est optimale au sens de Pareto, mais pas n6cessairement superieure au sens de Pareto, fait appel implicitement a la notion que toute taxation est directe. 11 est cependant evident que cette conclusion vaut egalement pour des economies avec taxation indirecte. L'article present part ensn'te de cette conclusion pour discuter certains problemes, rarement considerfs, resultant du fait que dans de, economies avec taxes indirectes, les revenus des facteurs totaux sont moindres que les revenus totaux. De nombreuses e.udes s'igarent en engendrant les revenus "counterfactual" d'un monde d'avant-gouvLrnement sans inclure les imp6ts indirect%. Les qtuelques etudes qui incorporent la part des taxes indirectes dans les revenus de facteurs, le font de maniere peu satisfaisante. Zusammenfassung: Eine Schdtzung der ,,counterfactuial"-Eitnkornnen in Ut.zit'rsuchunqcnm Uber die Budget- inzidenz. - In seinem Artikel "Do Empirical Studies of Budget Incidence Mlake Sense?" [9] argumen- tierte .lacob Meerrman. daB einer derschwerv; legendLenl l Ntingel '.olcher llntersuchtungen darin bestehe. dal3 die Effekte von StaN,ttsdtii imaten auf relative Faktor- und Outputpreise unberuicksichtigt bleiben. Aber Meerman uberbewertete seine Argumentation. Dieser Artikel zeigt, wie die Effekte einer Kbrper- schaftschaftssteuer auf relative Faktorertriige im Harberger-Modell abgehandelt werden. Im weitereni Verlauf wird gezeigt, wie man bei Anwendung des Harberger-Modells mit einigen al!gemeinen Fehlern bei empirischen statistischen UIntersuchungen fertig werden kbrnnte. IDiese Ulntersuchunig befal3t sich ebenfalls mit einem geringfiigigen Iehler in Meermans Artikel: Sein Nachweis, da8 eine Lindahl-L.6sung fiur Steuern und 6ffentfiche Produktion pareto-optimal, aber nicht unbedingt pareto-superior sei, impliziert die Bedingting. daB jede Besteuerung direkt sei. Diese Schlulfolgerung ist offenkundig in Wirtschaften mit indirekter Besteuerung giiltig. Der Artikel nimmt dies zum AnlaB, einige kaum beachtete Probleme zu diskutieren, die sich daraus ergeben, daB3 in Wirtschtften mit indirekten Steuern die gesamten Faktoreinkommen geringer sind als die Gesamteinkommen. Viele Untersuchungen gehen einfach fehl, wenn sie "counterfactual"-Einkommen ,n einer Volkswirtschaft ohne Staatssektor berech- nen, ohne indirekte Steuern einzubcziehen. In den wenigen IJntersuchungen, in denen die Wirkungen indirekter Steuern aufFaktoreinkommen einbezogen werden, geschieht dies auf unbefriedigende Weise. Confirmations and Contradictions The Incidence of Sales and Excise Taxes, or Where Do We Put the Transfers? Jacob Meerman World Bnnk Whether sales and excise taxes are regressive or progressive depeiids orn howv the question is askecl. If tax incidence is measured in the conltext of a cmo-ipl'cht ctisive studyiv of both taxes and benefits, thev are likely to be regressive. If otne uises diffcrential incidence analysis in the maniner of Edgar Browning (1978), tlhey ar'e likely to be progres- sive. As dlkciis,ed below, of crucial nipmi'riMce ill stclh ani analysis is the irmplicit or explicit dlefimitiioii of wliat incomes WOul]d be were there Ino taxei. So-cailled cointerlf'Nctuil inicomIIe is the crux of the problem. The measurement of tax incidence involves an estimate of what incomnes would l)e wvere there no taxes to compare againist actual incomes, after taxes have been paid. Such estimationl imrnediately runis tup against the difficulty that taxes finrance public spein(inlg wvhic(h also affects the distribtutioni of inconmes in nmany waxs. Var'iouIs tech- niq(utes have beeni developed to cleail withl this (ificdltlly. One of'tlhese has beeni the nietrti alitv assumption, whlicti in its earlliest fo'rII simply provide(d a way; to ignore public spen(ling by assiming that the gov- ernmient spenlt in the same wvav as those wvho paidI the taxes wouLl(d have spent (Har'berger 1962, p. 224 ). 'I'he assumption has undlergonie a certain dleveloptnieiit, but it i'emains essentially as it was in the hegimikicg (Peclimian and 0kner 197-4, p). 29). In contrast, stiulies of budget iici(ld'mice which iticcii ipt to estimate b)oth tax incidlenice and(l the dli(lriiltioni of b)enefits fromil publi( spending do Inot have this problem. In such stu(lie's the atlemilpl is, or In tfiis paper I spe.ak snholih ftio imseln iidot foun t n% eniplovex. tche Worl(d Baik. I wotul(d like tO thaink Ch,li. (lipt (.oi'e for llplf)hil (Onim11ents oni a pirevious (draift. Il-u-'ial of PF111al Ewton f lo v 80, "X i ,I no 6) c 14l1M) In I he l i'Nrsc of ( 1li tago (0(022i 38X)08,80. 84) t,A1RI3Si)1 5 12.42 CONFIRNIATIONS ANI) CONTRAD)IC IONS I 243 sho,Ad be, to estimiiate whhat household incomies wvoul(d be wvere there neitlier taxes nior public speridiig. Such tom eti i fo. tual pi-illarv ill- comes are then re(duce(d by taxes and( increased bx I)enefits to arrive at a postgovernmiietnt (listril)utionLi An)otlhev soluti)on to tie probleni pres.n1tedl y pub)lic speiiding is to definle incomes as they woul(l he were guv(er imw r t spendling Ull- chaiiged buit financed tlhrotugh a pit)portional inconie tax, in oilier wvor-ds, a comlprehensive differentilal in( idtnte approacht Pechmnanl and Okner (19714, p. 29j uIse(1 this ippi ;ithIi, %Jixoh they dles(ribed thus: "'Ie (luestiori it [the Studi] attemp1)ts to arl swci is-1ow dloes the distribution of disposable intcomiles of households undl(ler the present tax systenm (liffeir fIromii what it woUld be if the . . . taxes theiy pay were collected through at proportional inconie talx withi the samnce vield?" This proportional imcollie tax approach inl tax incicl(ice studies deals with the problem of thte incidence Of pic)U1C Spending inI a superior wvay, because it assumes ceh'ris paxrilbw conldition"s for every- thing on the spenidinig side and aSSUIm'eS that a "nieutital" counterfac- tual tax system is substu. ited for the actuial onle.2 In using this approach., Pechmlan anid( OknIeri include ini their in- come base certaini cash transfers to hotuseholdls. Iherefore, these are necessarily inicltulded in the Cointer(Tbo untal which they use, i sipliui itl> as the basis for comparing household incomies. In brief, certain cash transfers are included as part ot houtsehold incomes both in the before-governiiiient-exists situation (tie coinrTle rct tcrall) arid the after-ta!.es-are-paid sittuationi (actual). It is itnl)ortant to niote that in comprehensive couintrv sta listical studies of buidget incidence-which estimate both tax an(i bernefit incidence-such aii inclusion of certain cash transfers as part of couniterf'acttual income wvoutld niot be correct.3 In such studies cash tranisfers are a benefit and,t thierefore, are in- cluded solelv as part of income after government beniefits zire added to it. Pechman and Okner- are cuitting iito) the income sircarus to take their measuremenit and develop a coutnierf actual at a poinit that gives One of the major adjustriients to actual inconmes is to increase them by the amount of indirect taxes. Were governments elirsssna-ed, their "bleeding" of thle incomle stream through indirect taxes wouldl cease, ani( real incomes woul(d increase fromn the total national income to net tiationial produi(t. 2 Each tax is examined1 arn(d contrasted with the equivalent proportional income tax. The results are summned to give the inc idlen( e of' all taxes corntbiined. Te couniterfactual comes closest to netutralitv in the short rutt iin whii(i factor supplies are inela,tic. But even short-run neutrality is not attaine(d insofai as the (demand({ for leisure is a function of wages. Nfusgrave and iothers first used this technique irs 1951, i( ording to Pe(hman and Okner (1974, p. 24, D. 14). 3 IThis point is discussed below. FIo a TevieW and critique of so Ii stud(ies see M o.ure (1972), de Wulf (1975), antI Meernmani (1978). A fiodiiig conirnion to sot ii std(lies, and of relevance to this paper, is that ustually govei iitnClet expenditure-includling transfers-redistributes far monre in favot of the poor thati tax systems. 1244 JOURNAI. OF POLITICAL ECONONIY neither incomies as thev would be were there no government nor incomes as thev are after all government effects are taken into con- sideration. But there is nothirng wronig with this approach given their basic point of departure and their approach based on differential incidence. In a recent article in the joturnal 1/ Po/lilied Econo)my, Browning (1978) took the Pechlniain an(d Okier approach and data to develop an analysis which reverses the c ()iv eiitioc mal wisdomi c( i Icernig I the inci- dence of in(lirect taxes. Browning was able to conclude that excise and sales taxes are progressive un(ler the very reasonable assumption that transfer paymiernts are indepein(leilt of such taxes.4 He reasoned that, since excise and(l sales taxes force a wedIge between finial output prices an(d factor costs, theY redtiuc factor payrnicnis by the amiount of the wvedge which becomes governmernt resources. Real transfer income in effect escapes such taxes. with or without inflation.5 Since transfer income is a negative functioin of factor incomiies and accounts for a substantial part of total inlmcs., the outconie is highlv progressive excise and( sales taxes. This coniclusioni is wvarranted as loing as the discussion is in the context of (liffeienitial tax incidence and incomes are as definedI b1 Pechmian and(l Okner (1974) in their study (ancd Browning's). Under such terniis Browning's .as.r lcrion that the entire U.S. tax system is nmtre progressive thanl Pechnian and 0kner coin- clude can be conisidered valid. But Browning's outc()nre is veiNy (4ep)ei11CleIIt (onI the pattel-rn of gov- ernmenit spenlding. If tran.sfer paymenits distribute in proportionI to what pretax income wouild be, the conventional wis(lom of regressive excise and sales taxes holds even if transfers are included in the income base. MNore generally, if we use the Browning approach, the regressivitv or progressivitv of in(lirect taxes depen(Is on iow the goverinmenit spends the resources it collects. This conclusioin is illustreate(d in table 1. Assume a world( with onie rich household and(1 onre poor one. In :ittiation A, there are nio taxes and NNP (net national product) e(luals NI (natioilal income). In situationi B, excise and sales taxes re(luce factor incomes by a ninth. (Th1ere is no inflation.) Thle taxes finance solely transfers which distrib- ute in proportion to factor incomie. TIhus the incidence of sales taxes arnd excises is proportional. Since the income balse is factor incomes plus traiisfers, the tax burden for all is 10 percent. Not uintil situationl C do wve get the Browninig miit(onic, in which the taIxes ar'e stron glx' pn )riessike. In C( all the taxes collc( ed are ia ii sfreLlld to the poorx 4E.g., if similar taxes Nvert, increased substanrialks, salV a value-added tax ini- plemnented, Congress wot l1( increase welfare palimnerits to offset their effects. I In c(ontra1st, Pechiari andt (kner (1974) had the (ash tran.sfters bear a proportionial share of thie burdern of excise anidl sales taxes. TABLE I COMPARATIVE TAX BURDENS USING BROWNING'S APPROACH IN A TWO-HOUSEHOLD WORLD RICH HOUSEHOLD POOR HOUSEHOLD to -BROWNING S A Factor Tax Factor Tax INCOME U SITUATION Income Transfers Taxes Ratio* Income Transfers Taxes Ratio* NNP NI AGGREGATE A 90 ... ... ... 18 ..- ,- ... 108 108 108 B 80 10 10 .10 16 2 2 .10 108 96 120 C 80 ... 10 .111 16 12 2 .067 108 96 120 * Income base is pregovernment factor income plus transfers. 1246 JOURNAL OF POLITICAL ECONOMY TABIE 2 FISCAL IN(:IDEN(CE USING CO.MPR IIENSIVE APPROACH IN A TvO--HoLTSEHLDO WORLI) Income Aggregate Rich Poor sNI or NNP Income, pregovernment S(M 18 1(8 108 Income after tax paviment 8( lfi ... ... Tax burden 11 11 Income after receipt 80 28 96 108 of benefits (transfers) Net fiscal incidence -11% 56%c ... ... Net benefit incidence nc 67% ... ... Since ai la Browining these transfers are includ(le(d in the income base, while the indirect taxes burdein solely factor income, the outconie is a tax ratio for the rich of 11.1 percent and 6.7 percent for the poor. In the conmprehlenisive stu(lies '.. budget inci(lenice, transfers wvould be move(d to the postgOvernnlent distributioni, and incomes wvould total to NNP. Conse(quentlv the outcome wvould be as slhoNvn in table 2. In table 1, there is lo prob)lem in findin1g oUt wlhat incoines woul](I be in the pregovernment oouilterfactual (situation A). In acttual inci- dence work, what inconmes would settle down to-that is, counter- factual incomes-were sales and excises eliminated is unlknown. Browninig's solutioni was to increase all factor incomes in equial pro- portion so that the aggregate increase would equal the total value of excise and sales taxes. 'I'his is the approach used in table 1. To get to the counterfactual situLation A fromi situation C it was necessary to increase all factor incomies by onie-eighlth, that is, by total taxes, to arrive at the aggregate e(qual to NNP. TIhlis illustrates thie fact that counteifacttual or pregovernnment inicoIIIe itself dlepend(s on the incidence assumiptions.6 A basic implication of the comprehenisive approach is that the incidei,ce of excise a(li sales taxes maiy or imay not b1e regressive. They bur(lenI factor ilncomeS, which are made to sumi to total inconmes in generating the counterfiactual pi)egove lye'11emt hicomne tused in the complcr(hici'%ive statistical sttidies. Btut theV alSo bunl'(ell incotmes ac- cor(inlg to the (legree of ptllrchase of itellms taxed alld the cl ii ge 1 relative product prices of those itesis dtue to the taxes. 'Ilie comllcdled 6 InI Pechriian and Miter (1974), ias wvell .1s the work on the corporation incomne tiiX inspired l)N the I Lat bergel mnodtel. pregover l tent it(omiies (lo indeed varv accor(ling 1l inci(lence assuminptionis. 'Most statistical stu(ties, however, err on this point (see NMeer- man 1974, pp). 52 1-22). (C)ONFIRMATIONS ANI) (C()NTRADIiC:TIi ONS 1 247 effect of produtctionr and consumption buriens is niot clear. Brown- in1g, for exaim1ple, makes the uinusual argtimierit that the "Tiet effects on real income resultiiig fromii ch}1aniges inl relative prices" are close to 7ero (1978, pp. 660-65). Inl the comiiprehenisive stud(lies (if the BroNming approach is tisec, inl which all factoi iniconmes are in creased ill equal prop)ortioni hb an amn()uiit etlual to the t(ital value of excise and sales taxes), this outcome wNould( imteanl that sales and excise ta}xes are proportiornal, A fundamental consequenice of thle Biowninhg approa,Ich is anl ill- comiie aggregate which may dlepart tl)slarfli,!ll\ fromii NNP. (In tal)le 1, the Br owniing inicomjie aggregate exc;((le(e NNI bh I 1.1 pet'ceit.) PechinaI anIId 0kner icluded(l onlv cash tianisfteirs in inicomes. These accounted for less thani 5 pelent of the al greglate. Birownlilng hroadens the contcept of tralnsfers to tranisfers itn kinid, suclh as benefits froml educationi and medical care. TIhlese account for 20 percent of his inicome aggregate.7 Consequently he end(s wsith veyt ; )IgrCssive sales anid excise taxes becauise, as niote(I earlier, tranisfer in(come is a n;ega- tive Iuinction of factor inicoimie. Brownfing also ends with aln illncome total wshich necessarilv far excee(ds total output (NNP). Ini terms of the comprelhenisive hldget Stuldlies, Ilis illcillne concept is ll1is(44lt'frrled: Benefits are part of' po ,igo\ em -c-mu illom e, nlot tlie piegm- rimuelnt counterf'actual. One could, therefore, criticiz.e B Osiirng by assertinig thla{t tile ill- coiime coiicept is inlvalid. The logic of national iIiwomle accouritinlg re(]llires that holusehiol(I incoIIIes sUmII to aggregate otutp)ut. Hltilerto inicomes e(lual to NNP (or nationral inicome) have alwavs heen asstnimed in tax inicidence wvork. In moving otut of the national accounts framiiework, Browninig has made a radical departure from earlier wvork. Yet it is also tIrue tlhait if' one is iiiterested in dlifTerential ici- (lence analysis, as is ofteni the case ini policy (dismrssioil. Brownlings appioach is tiseful. Betiefits are part of household inicomes, andI (cash benefits, at least, are taxed when spent. I o conclude, the ilncidelnce of excise anid sales taxes depentds oIn how you ask the q.oestion.9 7Browning implicitly asrumnes that household re6ipierits value b)enefits in kind at their resource (osts. 01rcourse, thev (do niot. He is, thieref ore, aggregatinig rtesource costs and in'conies His aggregate wouldl be ctter (escribed as (uasi inicme. B'owning has all the elenments neededl for a comprehensive budget incidence analvsis of the Inited States for 1977. 1 used his data to (do iust thlis ain e nd{ed swith thie lowvest incomiie (luintile increasing its incotme In 53 peremt as the cotihinedl result of' taxes anid public spendirng. TIhe highest (uinitile's income wNas rt'doced 1)5 15 percent. Details available on re(quest. 9 Charles mcI.ure (1979, p. 114) expressed a simiilar conotlusion in his ()nlirtlent onl Browning's paper: " . . . perhaps we should onisi(der his [Biowtniing'sl estimates to he reasonable alternatives to the conventionial estimates rathler thiani tili(ntie replacemients.' 1248 JOURNAL OF POLITICAL ECONOMY References Browning, Edgar K. "The Burden of Taxation." J.P.E. 86, no. 4 (August 1978): 649-71. de Wulf, Luc H. "Fiscal Incidence Studies in Developing Countries: Survey and Critique." Internat. Mlonetary Fund Staff Papers 22, no. 1 (Mfarch 1975): 61-131. Harberger, Arnold C. "The Incidence of the Corporatiorn Incomie Tax." J.P.E. 70, no. 3 Utine 1962): 215-40. NIcLure, Charles E., Jr. "On the Theory and M\ethodology of Estimating Benefit and Expendliture Incidence." Paper presented at the Workshop on Income Distribution and Its Role in Development, William Mlarslh Rice Univ., Houston, 1972. . "Commenitarv" (on Browvning's paper). In Inicome Inequality, Trendsi and International Compa7isons, edited by John R. Moroney. Lexington, Mass.: Heath, 1979. Meermanj, acob P. "'I'he Definition of Income in Studies of Budget Incidenice and Income Distribution." Rev. Income and WVealth 20, no. 4 (December 1974): 515-22. "Do Empirical Studies of Budget Incidence Make Sense?v" Puiblic Finanice 33. no. 3 (1978): 295-313. IlInsgrave, Richard A.; Carroll, John J.; Cook, Lorne D.; and Frane, Lenore. "Distribution of Tax Paynmenits by Income Groups: A Case Studv for 1948." ;Ant. TaxJ. 4 (March 1951): 1-53. Pechnian, Joseph A., and Okner, Benjamin A. It'hlo Bears the Tax Burden 9 Washingtoni: Brookings Inst., 1974. THE WORLD BANK Headquarters: 1818 H Street, N.W. U Washington, D.C. 20433, U.S.A. European Office: 66, avenue d'Iena 75116 Paris, France Tokyo Office: Kokusai Building, 1-1 Marunouchi 3-chome Chiyoda-ku, Tokyo 100, Japan The full range of World Bank publications, both free and for sale, is described in the World Bank Catalog of Publications, and of the continuing research program of the World Bank, in World Bank Research Program: A- stracts of Current Studies. The most recent edition of each is available with- out charge from: PUBLICATIONS UNIT THE WORLD BANK 1818 H STREET, N.W. WASHINGTON, D.C. 20433 U.S.A.