Welfare Economics & Fiscal Illusion: Key Economic Theories
Welfare Economics: Foundations & Concepts
Welfare economics aims to move beyond purely ethical judgments (e.g., “more is better than less”) to achieve a universally accepted supreme goal: maximizing social welfare. It represents a monistic approach to economic well-being.
Classical Welfare Economics
Developed by economists like Alfred Marshall and Arthur Pigou. Marshall defined production and economic well-being in terms of happiness, focusing on identifying the economic policy factors that contribute to this happiness. Pigou, in turn, conceptualized economic welfare as the sum of satisfactions that could be expressed in monetary terms. He proposed two basic aims for economic policy: the growth and distribution of the national dividend. Pigou argued that transferring income to satisfy more intense desires at the expense of less intense ones helps increase overall social welfare. Vilfredo Pareto later introduced the Principle of Unanimity, a cornerstone of welfare economics based on consumer sovereignty and individualism in social choice. This principle asserts that individuals are the best judges of their own welfare.
Principle of Compensation
This principle was set forth by Nicholas Kaldor and John Hicks. It states that a situation II is considered better than situation I if, in moving from I to II, at least one person gains and no one loses, or if the winners could hypothetically compensate the losers, making everyone at least as well off as before.
The Social Welfare Function
Economists like Abram Bergson and Paul Samuelson developed the concept of a social welfare function. This function attempts to combine variables that influence individual welfare, such as economic growth, employment levels, price stability, balance of payments, and income distribution. Another approach is to base the social welfare function on the aggregation of all individual utilities. A significant critique of this idea is Arrow’s Impossibility Theorem, which highlights the difficulty of establishing a universal social ordering rule without making interpersonal comparisons of utility.
Cost-Benefit Analysis
This approach represents a new conception stemming from the Principle of Compensation. Based on the existence of social costs and benefits, it aims to assign prices to elements that typically lack market prices. These new prices, known as shadow prices, are intended to reflect the true social value of goods and services. It’s important to note that the economic viability of a project (often measured by its Net Present Value, NPV) does not necessarily align with its social cost (which would incorporate shadow prices into the analysis). Therefore, an economically viable project could potentially lead to a worse social situation than the baseline.
Theory of Fiscal Illusion
Developed by Amilcare Puviani, this theory posits that governments seek to maximize the perceived difference between the benefits of public services and the costs of taxation. The goal is to make citizens believe that government spending effectively solves problems, even when it doesn’t, and to make the associated costs (their tax payments) less visible. The main strategies to achieve this include:
- Relying on Indirect Taxes: Taxes on goods and services are often less visible to the taxpayer than direct income taxes.
- Minimizing Changes in Tax Rates: The objective is to create a perception of stability among citizens, even if the real tax burden changes through other means.
- Introducing Seemingly Temporary Taxes: Governments may present taxes as temporary measures, only for them to become consolidated and permanent.
- Launching Spending Programs During Low-Cost Periods: Initiating programs when their costs are low (e.g., increasing unemployment benefits when the unemployment rate is already low) can be done for purely propaganda purposes, making the benefits seem greater relative to the perceived cost.
Forms of the State: The Italian School Perspective
Moreover, the Italian school of public finance identifies three possible forms the state can take:
- Monopoly (Predatory) State: In this model, a specific group or political party controls the government and aims to maximize the welfare of its members through means like securing jobs, directing regional investments, and employing fiscal illusion.
- Individualist State: Here, the state exists to serve individual welfare, and public welfare is seen as the aggregation of the well-being of individual agents. This model emphasizes the importance of properly informing citizens about the benefits and costs of state actions.
- Paternalistic State: In this view, fiscal illusion should be deliberately exploited by the government for the perceived benefit of the people, assuming the state knows what is best for its citizens.