Should Governments Create Production Inefficiency?

Knud Munk

No 98-20, EPRU Working Paper Series from Economic Policy Research Unit (EPRU), University of Copenhagen. Department of Economics

Abstract: The paper extends the standard second best theory of optimal taxation to take into account the existence of differences in administrative costs associated with different tax-transfer systems providing a more realistic framework for the analysis of the trade-offs between equity and efficiency considerations inherent in many concrete policy issues. Policy recommendations with respect to reform of the Welfare State and other changes in government policy often seem to take for granted that production efficiency is desirable. However, based on the analysis in this paper it may be argued that it is, in fact, more reasonable to expect social welfare maximising government policies to result in significant production inefficiencies, especially if the government is strongly adverse to inequality.

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