Public Finance in Democratic Process: Fiscal Institutions and Individual Choice
By James M. Buchanan
- Ch. 1, Introduction
- Ch. 2, Individual Demand for Public Goods
- Ch. 3, Tax Institutions and Individual Fiscal Choice
- Ch. 4, Tax Institutions and Individual Fiscal Choice
- Ch. 5, Existing Institutions and Change
- Ch. 6, Earmarking Versus General-Fund Financing
- Ch. 7, The Bridge Between Tax and Expenditure in the Fiscal Decision Process
- Ch. 8, Fiscal Policy and Fiscal Choice
- Ch. 9, Individual Choice and the Indivisibility of Public Goods
- Ch. 10, The Fiscal Illusion
- Ch. 11, Simple Collective Decision Models
- Ch. 12, From Theory to the Real World
- Ch. 13, Some Preliminary Research Results
- Ch. 14, The Levels of Fiscal Choice
- Ch. 15, Income-Tax Progression
- Ch. 16, Specific Excise Taxation
- Ch. 17, The Institution of Public Debt
- Ch. 18, Fiscal Policy Constitutionally Considered
- Ch. 19, Fiscal Nihilism and Beyond
Individual Choice and the Indivisibility of Public Goods
The analytical models introduced in this book have embodied the central assumption that individual choice behavior in the fiscal process is in some sense analogous to market choice, at least to the extent that the latter may serve as an appropriate benchmark for comparative purposes. This assumption requires some defense, even at the expense of what may appear as a lengthy digression on the “pure theory of public goods.” Specifically, it seems necessary to demonstrate that individual choice behavior is amenable to scientific analysis and explanation despite the acknowledged
indivisibility of benefits from public goods and services among individuals, and, in consequence, the indivisibility of collective decisions regarding the supply and financing of such goods and services.
Does the very existence of indivisibility cause the individual to conceal his “true preferences,” to behave so as to thwart the attainment of mutually beneficial results in a community or group decision process? These questions assume especial relevance due to the importance of the “free rider” argument in the modern theory of public goods. If it could be shown that, by the mere fact of common benefit sharing over large numbers of persons, the single participant in fiscal choice does not behave in a manner analogous to market choice, the methodological framework upon which this whole study rests would be quite seriously undermined. Needless to say, I shall try to show that the problems raised by the “free rider” argument do not appear in the institutional context within which individual fiscal choice is analyzed in this study. This is not to say that the argument is erroneous; it remains fundamentally valid, but it becomes relevant only in a setting for choice different from that accepted here. However, I shall note that the mere fact of collective choice exerts an influence on individual behavior not unlike that predicted to arise from free rider elements.
The “Free Rider” Argument Summarized
Individuals are not likely to take actions that involve costs if they do not expect demonstrable benefits to result, these benefits being measured in terms of their own utility functions. If a person expects another person, or persons, to provide him with benefits in any case, he will not voluntarily initiate action on his own. Especially if the number of persons with whom he interacts is large, the individual is likely to consider that his own behavior in no way influences the behavior of others. In this situation, he simply reacts or adjusts to the behavior of “others” in a manner similar to his reaction to natural environment. Utility-maximizing behavior does not dictate that voluntary action toward common ends be independently or privately taken. The recognition of this fact is the basis for the “free rider” argument, one that has been discussed in connection with many of the theoretical and practical problems of group organization. As suggested, the argument has been central in the modern theory of public goods, arising out of the contributions of Samuelson and Musgrave.
As this normative theory demonstrates, it is not difficult to state formally the necessary marginal conditions for Pareto optimality in a world that includes purely public or collective goods along with private goods. Difficulties arise, however, when attempts are made to translate these formal conditions into attainable results through plausibly workable institutions of individual choice. At this level, the private-goods world and the world of public goods are wholly different. In the former, market or exchange organization tends to produce results that meet the necessary marginal conditions, at least in some approximation and subject to explicitly definable side constraints. Individuals make their own choices, as consumers, as entrepreneurs, as sellers of productive services; these interact, one with another, in such a way that some point on the Paretian welfare surface is reached, at least conceptually. Once public goods are introduced, however, market organization “fails” in the sense that it no longer effectively channels individual or private choices in the direction of group or social optimality, as defined by the Pareto conditions. No longer are individuals, acting individually, led “as if” by an invisible hand.
The relevant question concerns whether or not the institutions within which individuals make decisions on public goods can be so organized as to eliminate the behavior that the free rider argument emphasizes. To accomplish this, institutions must present alternatives to the individual which embody definitive commitments on the part of others as well as himself, which make outcomes measurable in terms of his own utility dependent in some degree upon his own choice, and, finally, which reduce to some reasonable limits his own influence over the net “terms of trade.” Note that these are precisely the characteristics of the institutions of market choice. The problem becomes that of arranging or organizing the institutions of the “public-goods market” so as to insure that the individual behaves similarly in the two cases, or at least to the degree that the inherent differences in the nature of the choices allow.
The Wicksellian Proposals
Among fiscal theorists, Knut Wicksell holds the unique position of having carried his theoretical ideas through to an examination of the political structure within which fiscal decisions must be made and implemented.
*32 He proposed specific institutional reforms that would remove this element of individual behavior from its influence on fiscal outcomes. Wicksell proposed, first of all, that the bridge between tax and expenditure sides of the fiscal account be made explicit. When a specific expenditure project was presented, a whole array of possible distributions of the required tax bill was also to be presented, with each array estimated to produce revenues sufficient to cover the outlay. The expenditure project was then to be voted on in the legislature, along with each one of the tax allocations, and when one such combination secured the unanimous approval of the assembly, it was to be adopted. If no single combination received unanimous support, the expenditure project was not to be undertaken and no tax was to be levied.
Critics have been quick to look at the extreme restriction that any rule of unanimity imposes on group choice, and, generally, they have failed to see that Wicksell’s scheme provides a method of circumventing the free rider problem. Under the Wicksellian set of choice institutions, the individual (or his legislative representative) is presented with a series of alternative proposals, each one of which embodies not only a definite statement of the contribution to common cost that he must, individually, bear, but, also, the allocation of the remaining total tax liability among all other members of the political group. By voting for and against such proposals, the individual is put into a position of “trading” with his fellows. Bargaining in the standard sense is not absent from this essentially bilateral trade, and the individual will be motivated to try to get the best terms possible. However, if a genuinely beneficial inframarginal project is presented for a vote, there will be some net gains to be distributed, some pure “taxpayers’ surplus.” Because of the bargaining opportunities, an individual or group may be motivated to vote against some proposals that will, given his own tax share, actually yield to him net benefits. He may do so if he thinks that other proposals, more favorable to him, will be presented without too much delay in subsequent rounds of voting. However, this tendency to reject alternatives which, in the absence of bargaining possibilities, would prove advantageous, is not the same as “free rider” behavior. Under the Wicksellian rules, the individual knows that, unless he approves, the proposal cannot be adopted, and he must put up with the consequences of delay, along with all others. In the free rider situation, by contrast, the individual’s whole behavior is motivated by the idea that he can secure the benefits of a proposed spending project without agreeing to pay taxes.
The Wicksellian institutions of choice will not produce a unique “solution,” except in the case of purely marginal adjustments. If there are bargains to be made, the final location on the multidimensional contract locus will depend strictly on the outcome of the bargaining process. Another, and related, feature of the Wicksellian rules is that, in inframarginal cases, the final location will depend on the order that proposals are presented to the assembly for votes. Since there are many tax arrangements capable of securing unanimous approval, the first one presented will be more likely to be the one selected. The order of presentation itself becomes a bargaining weapon. These features, along with the more important one involving the undue costs of delay in reaching unanimity, make Wicksell’s institutional suggestions impractical, as he recognized. The point to be noted is, however, that these institutions would eliminate the “free rider” influence, as such, and that this feature of what we may call the Wicksellian “constitution” may be carried over into more practicable arrangements.
Wicksell recognized that unanimity would be difficult, if not impossible, to achieve, and he did modify this requirement to one of “relative unanimity” when he came to discuss implementation of his schemes. He did not, however, abandon his basic notion, which is surely correct, that unanimity provides the only criterion to insure that expenditure proposals are really worth making, “worth” being measured in terms of individual evaluations.
The ultimate validity of the unanimity criterion can be accepted without the implication that either full or relative unanimity should be the rule for the making of day-to-day fiscal choices. At the level of “constitutional” decision, where the alternatives are the various possible rules for making ordinary decisions for the group, it may be recognized and predicted that the costs of reaching each separate decision through a unanimity rule may be intolerably high and that some acceptance of “inefficient” results in particular instances seems warranted. The costs of reaching agreement, of higgling and bargaining, of delay, of holding out for better terms, all of these involve resource commitments and produce waste just as effectively as the making of “wrong” decisions under less perfect rules. The constitutional decision process, therefore, must weigh the advantages and disadvantages, the benefits along with the costs, of all possible rules for the making of collective fiscal choices. And, conceptually, the constitutional decision process should produce some consensus on an “optimal” set of rules. Such rules may be many and varied, with particular rules applied to particular situations. Since this whole approach has been discussed in some detail in other works, it need not be elaborated here.
What is of relevance to the question posed for this chapter is that, once a constitutional decision on the rule for making fiscal choices has been adopted by the community and remains in force, individual behavior of the “free rider” sort is no longer likely to occur. The adoption of
any rule for making collective choices accomplishes in this respect precisely what Wicksell’s unanimity rule does, and even more effectively. For purposes of both simplicity and realism in demonstrating this, let us suppose that the constitution dictates that fiscal choices are to be made by simple majority voting.
The individual is now asked to participate in a collective fiscal decision. Suppose that a spending proposal is under consideration, and he estimates that this will yield to him benefits that he values at $10. The proposal is accompanied by a tax levy which he estimates will embody a personal liability of $8. Will the individual be led, by “free rider” elements, to vote against this fiscal combination, even though it yields to him net benefits, or will he vote straightforwardly on the basis of net benefits? In the first place, the individual will recognize that his own vote will not necessarily be determining, and this alone may affect his behavior. We return to this consideration later, but assume that the individual will vote, one way or the other. He may recognize the possibility that other proposals alternative to the one actually confronted may arise and that some of these may involve a more favorable distribution of the tax load. Because of this, elements of bargaining strategy remain in his behavior. Suppose, for example, that the tax proposed is a proportional income tax, and that the individual has a higher than median income. He may sense that, should the particular proposal be defeated, some alternative scheme might emerge, say, a poll tax, which would produce for him $4 in “taxpayers’ surplus” instead of the $2 now promised. On the basis of such considerations, he may vote against the proposal. Nevertheless, there is much less likelihood that he will do so here than in the Wicksellian unanimity case. In the situation described here, the individual stands to gain $2 if a favorable vote results. Alternative tax schemes may yield him more than this, as suggested, but still other alternatives may yield him
less, and these may eliminate or even make negative his own share in “taxpayers’ surplus.” For example, if he helps to defeat the proposed expenditure-tax combination, the effective alternative may be, not the poll tax, but a progressive income tax, under which he may be subjected to a net loss. It is precisely this threat of less favorable terms of trade, imposed by some majority coalition of which he is
not a member, that will cause the individual to bargain much less strongly here than under unanimity rule. By and large, under the operation of less-than-unanimity rules for choice the individual will tend to vote in accordance with his own best estimates of benefits and costs.
A Constitutional Approach to Tax Institutions
This conclusion is strongly reinforced when it is recognized that the organization of separate tax-expenditure proposals is costly, and that once a proposal is defeated it is not likely to be presented again under any alternative scheme for financing. Real-world political structures as they operate allow considerably less room for strategic bargaining than even this simple majority-rule model suggests. As noted earlier, spending proposals are not normally considered simultaneously with tax proposals. A “tax structure” or “tax system” is chosen quite independently of the particular allocation of benefits in specific instances, and expenditures are voted in the knowledge that taxes will, in fact, be distributed among individuals in accordance with the tax institutions in being. This implies that the institutions of payment, of taxation, are also chosen “constitutionally,” in the sense that, once chosen, they will remain in being over a whole set or sequence of possible and unpredictable spending projects.
In Part II, problems of individual choice at the level of “constitutional” alternatives will be discussed. If tax institutions are selected in some such fashion, significant departures from the satisfaction of the necessary marginal conditions for Pareto optimality in the public-goods sector must be anticipated. Even for a single and purely collective good, individual marginal evaluations differ, and the meeting of these conditions would require that each and every person in the group confront possibly differing tax-prices. Samuelson and Musgrave, and others, have stressed the point that, in fiscal choice, individuals will not voluntarily “reveal their true preferences” for public goods. This is valid, however, only if individual tax-prices are directly dependent on their revealed evaluations. In other words, only if some attempt is made to “price” public goods optimally will the individual be motivated to behave strategically. If, however, tax institutions are selected constitutionally, it is clear that individual evaluations for public goods do not directly determine tax-prices. These evaluations do determine the manner in which an individual will vote on extensions or contractions in outlay that may be proposed, but they cannot directly affect the tax-price per unit at which the public good is being made available to him. Under these considerations, the individual has no incentive at all to conceal his preferences for the public good when he participates, directly or indirectly, in fiscal decisions. Even for inframarginal choices, where there may be significant “taxpayers’ surplus” to be distributed among members of the group, no explicit bargaining takes place. The division of this available “taxpayers’ surplus” will be predetermined in the selection of the tax institution, which takes place prior to and independently of the selection of particular spending projects. In other words, the constitutional approval of a tax institution provides a means of determining, externally and arbitrarily, the distribution of the “gains from trade” among individuals in subsequent fiscal choices.
Because of its effect on the individual decision calculus, this procedure results in greater “efficiency” in collective choice-making, as such, and these gains may be more than enough to offset the losses that must be present in the purely allocative sense. On balance, therefore, the fiscal structure which makes some separation between the “constitutional” selection of its basic institutions and the choosing of the public goods-private goods mix within the operation of these institutions may provide the most “efficient” outcomes, considered over the long run.
It is upon the basis of such a structure that we have examined various fiscal institutions in previous chapters. We have analyzed the behavior of the individual as he confronts an expenditure decision or a tax decision under the assumption that the institution of taxation has been externally determined. In other words, when we examined whether or not an individual would “vote for” or “vote against” a proposed spending project under the personal income tax, we noted that his vote, positive or negative, would not, directly, affect the final distribution of the tax load among all members of the group. This was presumed to have been settled by some “constitutional” decision that was made before the choice examined in our study of the individual calculus. Under the personal income tax, for example, the pattern of tax-prices among persons is a function of the taxable income distribution. The discrimination in tax-prices that results is in no manner related directly to the marginal evaluations for the public services voted upon by the individual, although there exists the normal relationship via the income elasticity of demand. Under such conditions, the individual has no incentive to behave as a “free rider”; rational behavior dictates that he support spending projects, the personal benefits from which he estimates will exceed tax-costs. The indivisibility or the generality of these benefits exerts no influence on this choosing behavior, except insofar as this indivisibility requires collective not individual outcomes, thus preventing independent quantity adjustments.
Individual Interest in Collective Choice
The very fact that the individual must choose in the context of a
collective decision process is, itself, important in influencing his behavior, and in a manner not unlike that discussed in connection with the so-called “free rider” motivation. This effect stems, not from the indivisibility of the benefits from public goods and services, but from the nature of the decision process when collective outcomes are settled by less-than-unanimity rules. The single person, as he participates in collective choice, will recognize that his own preferences, as expressed by his vote in the simple direct-democracy model, will not be decisive except in a certain finite number of possible configurations of preferences among other members of the political group. He will be faced with the probability that his own vote simply “does not matter.” This probability becomes larger as the size of the electorate increases, given any established voting rule. This probability may lead the individual to abstain from participating in the choosing process.
If participation in the collective choice process is genuinely costless, the individual should rationally participate and he should express his “true” preferences under the institutions that we have outlined. If, however, voting itself involves some cost, rational behavior may dictate abstention, even though net benefits may remain from favorable outcomes. This point may be illustrated by a very simple three-person model. Suppose that the individual expects benefits from a proposal amounting to one-third, if the collective decision is favorable to him whom we call A. He does not, however, know the preferences of B and C. Assume that the cost of voting to A will be one-fourth. If a unanimous vote is required, or if he is appointed chooser for the group, he will clearly vote since net benefits exceed the costs of participation. However, what will he do if majority rule is in effect? Here he must estimate the probabilities of his being influential in determining the outcome. If both B and C are against the proposal, there is no point in A’s participating in the process. Similarly, if B and C are in favor of the proposal, there is nothing to be gained from participating. Only if B and C are split on the issue can A’s vote be critical. Since they can be split in two different ways, we have a total of four possible configurations of B’s and C’s preferences, of which A’s vote will be controlling in only two. For A, the probability is one-half that he will be the critical decision-maker for the group. Applying this probability calculus, we see that A’s personal “expected benefit” from voting, not from a favorable decision, is only one-sixth, less than the cost of voting, which we assumed to be one-fourth. The result is that, under such conditions, A will not participate in the “election,” and the outcome will be determined by those more interested or whose costs of voting are less.
Although this example greatly exaggerates the costs of participating, it demonstrates the point to be made, and it should be noted that as the group becomes large, similar results will follow even if costs are reduced to very low levels. Note that, through his rational abstention under such conditions, the individual is not “giving false signals” or “failing to reveal his true preferences.” Given the situation that he confronts, he is fully expressing his preferences by abstaining from voting.
How will the individual make the decision whether or not to vote? In our simple example, we assumed an estimate of the net benefits (benefits minus costs) of a favorable outcome. However, as earlier chapters have shown, the securing of information about expected benefits and expected costs is itself costly, and there exists some “optimal” level of investment in the gathering of such information in each particular instance. In addition to this ignorance factor, there remain inherent uncertainties in any collective decision. That is to say, even if the individual knows that his own vote will determine the outcome, and even if he has the most complete access to information concerning expected benefits and costs, under most tax institutions that exist in the real world additional uncertainty will remain due to the freedom of all taxpayers to modify the tax base through their behavior on private market choices. In any practical situation, therefore, the individual must act on the knowledge that all three of these elements are operative. He cannot know with accuracy what his fellows are going to do with respect to modifying the aggregate tax base; he cannot invest the effort required to translate alternative collective outcomes accurately into private or personalized benefits and costs; and he cannot predict with accuracy the preferences of his fellows for and against particular proposals. Facing this set of circumstances, the individual may behave quite rationally, and yet his observed behavior may only remotely resemble rational behavior in market choices. The three difficulties compound one another. Knowing that his own vote will be determining in only a certain number of possible configurations of preferences of his fellows, the individual will be led to invest less effort in securing information about alternatives than he otherwise would do. And, conversely, knowing that he has less than perfect information, and that inherent uncertainty remains as to the effects of alternative outcomes, he will tend to abstain from voting when, if he knew the actual effects, participation might prove rational.
The recognition of these difficulties makes “theorizing” about individual behavior in fiscal choice complex, even within extremely simplified models. It is one thing, however, to acknowledge the difficulties of “theorizing”; it is another thing to refuse to make the attempt. We should try to make as much sense as is possible out of collective choice processes in democratic political organization. Whether or not suitable models can be developed, we know that, directly or indirectly, individuals do participate in fiscal choice. They make decisions; they elect representatives who make promises on fiscal matters; they occasionally vote in referenda; they support one political party or another; they join pressure groups; they write letters to their congressmen or to their newspapers; they write speeches; they write books; they talk to their neighbors. If this is acknowledged, then the influence of institutions on their behavior can scarcely be denied. Different institutions will tend to produce differing patterns of response.
The simple models are essential for the clarification of ideas, but these make both the positive results and the weaknesses of theory appear exaggerated. The three difficulties mentioned above need not serve as the major barriers to individual behavior that they seem. The uncertainties in fiscal choice are great, but these are circumscribed within limits; and there are means of reducing the costs of securing information; and individuals do have some idea as to the patterns of preferences among others.
This chapter has a methodological purpose, which is that of showing how the very fact of indivisibility, associated with public goods and services, does not negate all attempts to reduce collective choice-making to an individual-behavior calculus. In other words, this chapter represents a defense, as it were, of the approach taken in the whole study. I have shown that the “free rider” argument, while valid in the context of independent voluntary behavior, loses its relevance when the rules or institutions for choices are laid down in advance, whether these rules be those for Wicksellian unanimity or near-unanimity, or any other, including simple majority voting. Bargaining elements remain in individual behavior, but these are largely eliminated in fiscal choice because of the fact that tax institutions are “constitutionally” selected and are not normally adjustable to specific spending proposals. Confronted with alternatives for choice under this set of circumstances, the individual has no incentive to conceal his “true” preferences for public goods. The fact of indivisibility of benefits among separate individuals does nothing to modify this conclusion.
The outcomes of collective choice must apply to all alike, and not individually, and this tends to influence individual behavior in a manner not unlike that discussed under the “free rider” argument. The individual need not participate in collective choice, and only in some positive proportion of instances will his own vote be critical or decisive. Recognizing this, he may abstain on occasions, even when net benefits are expected to result from favorable outcomes, or net costs from unfavorable outcomes. Such abstention is, itself, “behavior.” But all this makes individual behavior in collective choice less amenable to analytical treatment than that in market choice.
Review of Economics and Statistics, XXVI (November, 1954), 387-89; “Diagrammatic Exposition of a Pure Theory of Public Expenditures,” XXXVII (November, 1955), 350-55. R. A. Musgrave,
The Theory of Public Finance (New York: McGraw-Hill, 1959), especially Chapters 4 and 6.
For works that are specifically concentrated on the “free rider” problem, see Otto A. Davis and Andrew Whinston, “Some Foundations of Public Expenditure Theory” (Mimeographed manuscript, Carnegie Institute of Technology, November, 1961), and Mancur Olson, Jr.,
The Logic of Collective Action (Cambridge: Harvard University Press, 1965).
An early and important recognition of the problem is found in Knut Wicksell,
Finanztheoretische Untersuchungen (Jena: Gustav Fischer, 1896).
For an application to ethics, see my “Ethical Rules, Expected Values, and Large Numbers,”
Ethics, LXXVI (October, 1965), 1-13.
Finanztheoretische Untersuchungen. The important portions of this work are translated as “A New Principle of Just Taxation,” in
Classics in the Theory of Public Finance, ed. R. A. Musgrave and A. T. Peacock (London: Macmillan, 1958), pp. 72-118.
The Calculus of Consent (Ann Arbor: University of Michigan Press, 1962).
An Economic Theory of Democracy (New York: Harper, 1957), especially Chapter 14.