Evaluating public expenditures when governments must rely on distortionary taxation

Anderson and Martin provide simple, robust rules for evaluating public spending in distorted economies. Their analysis integrates, within a clean unified framework, previous treatments of project evaluation as special cases. In this paper, the authors use a general system of fiscal accounting for marginal changes in the provision of public that allows them to account for various approaches to the funding of government projects. They obtain two key results that seem likely to be useful for project evaluation. Firstly, the shadow prices of traded (as well as non-traded) goods are not generally equal to their world prices, but differ from world prices by an amount that depends upon the impact of the project on government revenues and on the Marginal Cost of Funds (MCF). Secondly, the costs of a government project need to be adjusted by the Marginal Cost of Funds before being compared with the benefits accruing from the project. The analysis leads to operational rules for project evaluation that are only slightly more complex than the border pricing rule. To conduct the analysis, the authors utilize a framework that makes explicit the role of government in providing public goods and services subject to a budget constraint. They consider first in Section 1 a general welfare analysis of the provision of a public good which is purchased from the rest of the world and paid for out of distortionary tax revenue. In Section 2 they consider the nature of the resulting shadow prices in more detail. In Section 3 the authors consider the role of the MCF in evaluating the cost of project inputs. Section 4 deals with user charges for public goods, which are of course only feasible when such goods are excludable. Section 5 places the results in the context of the earlier literature in order to clarify the relationship between their results and those obtained by earlier authors. Section 6 provides some simple numerical examples to highlight the potential importance allowing for the costs of raising funds.