Benefit Theory or Voluntary Exchange Theory

Introduction

The theory of Public goods provides a rationale for the allocation function of Public policy. Public goods exhibit the features of non-excludability and non-rivalry. In the provision of Public goods, the private market fails to utilize resources efficiently.

Public goods are also closely associated with the ‘free-rider’ problem, in which people do not pay for the good and may continue to access it, which results in under-production, overconsumption and degraded goods and hence, government intervention is required.

The problem, then, is how the government should determine how much of such goods are to be produced and allocated.

The difficulty lies in deciding the type and quality of a public good that should be supplied and how much a particular consumer should be asked to pay.

In the case of private goods, consumers pay for the benefits received, but the problem in the case of public goods is how these benefits are valued. Individual consumers have no reason to reveal to the government how highly they value public goods.

To serve as an effective mechanism of preference revelation, a voting process on tax and expenditure decisions could be taken. Voters are confronted with a choice among budget proposals which carry a price tag in terms of their own tax contribution.

However, the political mechanism is imperfect and can only approximate what would be the optimal budget choice.

To explain preference revelation, there are two theories in Public Finance literature: the Ability theory and the Benefit theory (developed by Erik Lindahl). The Benefit theory has a modern variety, which is known as the “Voluntary Exchange” theory.

Benefit Theory or Voluntary Exchange Theory

Most governments collect funds from various sources to provide public goods or to finance transfer payments. The supreme source of revenue in mixed economies is taxation.

Under the Voluntary exchange model, tax levels are determined automatically because taxpayers pay proportionately for the government benefits they receive. Putting it another way, the individuals who benefit the most from public goods pay the most taxes.

For analyzing the Voluntary exchange or Benefit theory, two models have been discussed: the Lindahl model and the Bowen model.

Read in detail below:

• Lindahl Model
• Bowen Model

Applications of Benefit Principle

The benefit principle may be applied as a guide to tax-structure design in the following ways-

● A General Benefit Tax- Under benefit taxation, each taxpayer would be taxed in line with his or her demand for public goods. Since preferences differ, no general tax formula could be applied to all people.

The government can ask how much various consumers are willing to pay for the same amount. Suppose that taxpayers have the same structure of tastes so that persons with the same income value the same amount equally.

Then, people with incomes of Rs 10,000 value a given level of public goods at suppose Rs 1000. With 1000 units supplied, they would be willing to pay Rs1 per unit. With incomes of Rs 20,000, they would be willing to pay a higher price of Rs 2.

The appropriate tax formula then depends on the income and price elasticity of demand for public goods. If income elasticity is high, the appropriate tax prices will rise rapidly with income, but if price elasticity is high, the increase will be dampened.

● Specific Benefit taxes- In this case, particular services are provided on a benefit basis, and consumers are asked to pay fees, user charges or tolls.

● Taxes in lieu of Charges- At times when impositions of direct charges are costly, a tax on a complimentary product may be used in lieu of charges. For e.g., automobile taxes may be used in lieu of tolls.

● Earmarking- This means allocating revenue collected from taxes.

Ability to Pay Approach

The ability-to-pay approach treats government revenue and expenditures separately. Taxes are based on taxpayers’ ability to pay; there is no quid pro quo. Taxes paid by the taxpayers are seen as a sacrifice, which raises the issues of how much the sacrifice of each taxpayer ought to be and how it should be measured:

• Equal Sacrifice: The total loss of utility because taxation ought to be equal for all taxpayers (the rich will be taxed more heavily than the poor).
• Equal Proportional Sacrifice: The proportional loss of utility because taxation ought to be equal for all taxpayers.
• Equal Marginal Sacrifice: The instantaneous loss of utility (as measured by the derivative of the utility function) because taxation should be equal for all taxpayers. This will involve the least aggregate sacrifice (the total sacrifice will be the least).

Read More in: Theory of Public Finance

1. Public Finance: Meaning, Nature & Scope
2. Role of Government in Economy
3. Role of Government in Mixed Economy: Public & Private Sector
4. Role of Government under Cooperation and Competition
5. Role of Government in Economic Development and Planning
6. Concept of Public Goods, Private Goods, and Merit Goods
7. Concept of Market Failure and Functions of Government
8. Market Failure and Functions of Government: Decreasing Costs
9. Market Failure and Functions of Government: Externalities
10. Market Failure and Functions of Government: Public Goods
11. Future Market: Meaning, Role & Uncertainty
12. Concept of Information Asymmetry
13. Theory of Second Best: Concept & Explanation
14. Problem of Allocation of Resources: Public & Private Mechanisms
15. Preferences: Meaning, Types & Problems of Preference Revelation
16. Preference Aggregation & Its Mechanism
17. Voting Systems, Direct Democracy, Representative Democracy, Leviathan Hypothesis & Arrow’s Impossibility Theorem
18. Economic Theory of Democracy: Concept & Explanation
19. Politico Eco Bureaucracy: Concept & Explanation
20. Rent-Seeking and Directly Unproductive Profit-Seeking Activities
21. Rationale for Public Goods: Concept & Explanation
22. Benefit Theory or Voluntary Exchange Theory
23. Lindahl Model: Concept, Equilibrium & Limitations
24. Bowen Model: Concept, Advantages & Limitations
25. Samuelson’s Model of Public Expenditure
26. Musgrave’s Model of Public Expenditures
27. Demand Revealing Schemes for Public Goods
28. Vickery-Clarke-Groves Mechanism
29. Groves-Ledyard Mechanism
30. Tiebout Model: Concept, Assumptions Equilibrium & Simple Tiebout Model
31. Theory of Club Goods
32. Keynesian Principles of Stabilization Policy
33. Difference Between Keynesian Economic Thought and Others
34. Role of Expectations and Uncertainty in Formulating Stabilization Policy
35. Intertemporal Markets Efficiency & Failure
36. Liquidity Preference Theory
37. Diamond-Dybvig Banking Model
38. Preference Shocks, Adverse Selection & Central Bank
39. Equilibrium Deposit Contract
40. Social Goods and Its Effect on Stabilization Policy
41. Effect of Infrastructural Facilities on Stabilization Policy
42. Effect of Distributional Inequality on Stabilization Policy
43. Effect of Regional Imbalances on Stabilization Policy
44. Wagner’s Law of Increasing State Activities: Explanation, Graph & Criticism
45. Peacock-Wiseman Hypothesis: Explanation, Graph & Criticism
46. Public Expenditure: Concept, Objectives, & Public vs Private Expenditure
47. Pure Theory of Public Expenditure
48. Structure & Growth of Public Expenditure in India
49. Trends, Lessons & Priorities in Public Expenditure in India
50. Social Cost-Benefit Analysis: Project Evaluation, Estimation of Costs & Discount Rate
51. Performance Based Budgeting and Zero Based Budgeting
52. Theories of Tax Incidence: Concentration Theory, Diffusion Theory & Modern Theory
53. Tax System and Its Principles
54. Equity Principle and Efficiency Principle of Taxation: Meaning, Explanation & Examples
55. Ability to Pay and Benefits Received Principle of Taxation
56. Theory of Optimal Taxation: Excess Burden & Distortions of Taxation
57. Deadweight Loss of Taxation: Causes, Measurement & Example
58. Concept of Equity & Efficiency in Economics
59. Trade-Off Between Equity and Efficiency: Meaning & Example
60. Theory of Measurement of Dead Weight Loss
61. Double Taxation: Meaning, Desirability, Forms & Solution
62. Solution to Problem of Double Taxation: Intra-Country & International
63. Double Taxation Avoidance Agreement (DTAA) and Indian Policy
64. Classical View on Public Debt
65. Compensatory Aspect of Public Debt Policy
66. Public Debt or Borrowings: Concept, Need, Sources & Types
67. Concept of Public Debt or Public Borrowings
68. Need for Public Debt or Public Borrowing
69. Sources of Public Debt
70. Classification of Public Debt
71. Burden of Public Debt: Meaning, Types & Explanation
72. Debt Through Created Money or Deficit Financing
73. Public Debt (Public Borrowings) and Inflation (Price Level)
74. Crowding Out of Private Investment and Activity
75. Principle of Public Debt Management and Debt Repayment