Alternative measures of the marginal cost of funds

LIQUN LIU [*] This article reconciles the use of two different marginal cost-of-funds (MCF) measures by resorting to alternative marginal benefit measures. It demonstrates how the alternative MCF measures can be properly applied to two classic problems in expenditure analysis: local cost-benefit project evaluation and the second-best public good level question. Relative strengths of the two MCF approaches in addressing the two problems are identified. (JEL H21, H43) 1. INTRODUCTION It is widely appreciated that the welfare cost of taxation should play a role in the normative analysis of government expenditures. Efficiency in government spending involves balancing the marginal benefits and marginal costs of expenditures. The marginal cost of spending in part depends on the welfare costs (also known as excess burdens or deadweight losses--we will use the term welfare costs) that result from raising the revenue that finances the expenditures. To determine the marginal cost of government spending, we multiply the direct resource cost of the expenditure by a term generally referred to as the marginal cost of funds (MCF). The MCF is the cost of raising an additional dollar of revenue, which includes the direct cost (the dollar of revenue actually raised) plus any additional welfare costs resulting from the change in the tax structure. Martin Feldstein emphasized the importance of MCF in a recent paper appropriately titled "How Big Should Government Be?" (Feldstein [1997]). He correctly stresses that the answer to this question involves comparing the benefits of incremental government spending with the MCF and concludes that the economics profession should devote more attention to informing policy makers of the importance of MCF and providing estimates of its magnitude. Feldstein's own estimate of MCF is $2.65 (Feldstein [1999]), implying that the distortionary cost of raising revenue is amazingly high--raising an additional dollar of revenue carries with it an efficiency loss that is more than one and a half times (1.65) as large. In sharp contrast, there are a number of estimates in the literature on MCF that are strikingly lower, so low as to suggest that MCF should play a minor role in the evaluation of government spending programs. For example, Stuart [1984] reports an estimate of $1.07, and Ballard and Fullerton [1992] suggest that i n a variety of cases MCF is less than $1.10. These disparate estimates of the magnitude of MCF are worrisome because they have contradictory implications regarding the importance of the distortionary cost of taxation. But a major reason for the differences in these estimates is simply definitional (Fullerton [1991] and Ballard and Fullerton [1992]): Feldstein is using a definition of MCF that depends primarily on the compensated effects of taxation, whereas the other estimates use a definition of MCF that depends primarily on uncompensated effects. The definition based on compensated effects always yields a larger estimate of MCF. [1] This raises the obvious question: Which definition is the appropriate one to use in the evaluation of government expenditures? That is the subject of the present paper. In this paper we investigate the appropriate measure of MCF for a special case that has been widely discussed in the literature--when the government expenditure is to finance the provision of a public good that enters consumers' utility functions in a separable fashion from private goods and leisure. (That the appropriate definition of MCF depends on exactly how the expenditure affects consumer utility was emphasized by Wildasin [1984] and Ballard and Fullerton [1992].) Recent papers that help clarify the role of the separability assumption include Mayshar [1991], Snow and Warren [1996], and Ahmed and Croushore [1996]. Furthermore, we restrict our attention to the case in which the public good is financed by a tax on wage income. In this case, much of the literature on MCF emphasizes that the definition of MCF should be based on the uncompensated wage elasticity of labor supply, in contrast to Feldstein's measure. …