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The Three Branches Revisited


It is now over three decades that I first discuss policy failure, be it in the private or
viewed fiscal theory in the context of a three- the public sector. The following observa-
branch model, distinguishing between its tions, therefore, remain within the normative
allocation, distribution, and stabilization frame.
functions [Musgrave, 1957; 1959]. The idea
was two-fold. On the one hand, there was the Allocation
fact that budget policy must address a I begin with the allocation branch and its
variety of problems with quite distinct central role in the fiscal system. The
analytical underpinnings and objectives. All allocation function, as I defined it, deals with
of these were based on what might be called the provision for social or public goods, that
market failures, but failures of quite different is, goods the benefits of which are external
sorts. A general theory of fiscal economics and thus consumed jointly. A's partaking is
seemed thus an inappropriate and impossible non-rival to that of B. Social goods thus
target. On the other hand, it was evident that differ from private goods, the consumption
the budget in its final formulation must of which is rival. In the real world, there are
account for each of these objectives and their to be sure many instances where both private
interaction. Hence, the need for a coordinat- and social good features appear in the same
ing framework. product or service. Externalities abound and
These still seem sensible observations, but pure cases of totally external or internal
much water has flowed over the dam since benefits are scarce. Nevertheless, the differ-
then. The three-branch division has become ential between the two categories comes out
a widely accepted textbook pattern, but has most clearly if they are compared in pure
also met with criticism and found little form.
response in actual policy design. This lecture Two approaches to the provision of social
therefore seemed a good occasion to recon- goods may be followed. One, taking the
sider the model, whether and how it should theorist's high road, shows allocation and
be amended. distribution to be inherently inderdependent,
To begin with, let me note that my intent determined simultaneously in a general
was to design a normative framework for equilibrium system; and the other, desiring
c o r r e c t policy determination. This is worth to be useful, insists on separation, needed
noting, since the discussion of recent years since the allocation function becomes
has shifted to stressing problems of public solvable only after distribution is deter-
sector failure--seeking revenge, as it were, mined. Both make sense but view the
for my generation's emphasis on market problem at different levels of abstraction.
failure. Policy like market failure, of course, The theorist's model applies the concept of
does exist and needs to be understood so that Pareto-optimal resource use to a setting
it can be checked; but this does not obviate which includes both private and social
the need for understanding what constitutes goods. As Samuelson demonstrated in his
correct policy design. Without knowing what papers of 1954 and 1955--that pinnacle in
is the correct solution, it makes little sense to the history of fiscal theory--the efficiency
rule differs for the two types of goods
*H. H. Burbank, Professor of Political Economy, [Samuelson, 1954; 1955]. For private goods,
Emeritus, Harvard University,and AdjunctProfessor,
University of California at Santa Cruz. Presidential efficiency requires that marginal cost equals
Addressat the Twenty-SixthAtlanticEconomicSociety price and thereby the marginal utility for
Conference, October 6-9, 1988, Philadelphia,Pennsyl- each consumer.
2 AEJ: MARCH 1989, VOL. XVII, NO. 1

In the case of social goods, the rule the early efforts at modeling a public sector
requires that marginal cost be equal to the theory based on known preferences, pro-
sum of the marginal utilities derived by all ceeding directly to what might be done to
consumers. From this is derived an efficiency design a formulation which would be useful
frontier, defining the optimal mix of outputs at the practical level.
for different patterns of welfare distribution With a market mechanism inapplicable,
among consumers. The preferred point on reliance had to be placed on a voting process,
that frontier is then chosen by applying a calling for a choice among tax-expenditure
hypothetical social welfare function. In this patterns. Thereby, consumers qua voters
fashion, the allocation problem, the decision would be forced to reveal their preferences.
of what is to be produced, is determined What was needed, so we may put it, was a
simultaneously with that of distribution. The voting model for a system of benefit taxa-
latter is seen in welfare terms, including that tion. He then proceeded to examine voting
derived from the consumption of social as rules, suggesting a solution of "approximate
well as of private goods. unanimity," a somewhat primitive formula
The model thus offers a simultaneous in view of modern choice theory but never-
solution of: (1) The division of output theless an important step in that direction.
between private and social goods with the The hoped for outcome is that of pricing
latter available to all; and (2) The distribu- in line with marginal costs and benefits to the
tion of private goods among consumers. The consumer, as developed later by Eric Lin-
Walrasian spirit of simultaneous solution dahl. In that model, demand curves for
reigns supreme, be it in a world of private social goods are added vertically rather than
goods only or for a mix of private and of horizontally, output is determined at the
social goods. intersection of supply and aggregate de-
First attempts to grope towards such a mand, with each consumer contributing in
solution were made in the 1880's by Sax and line with the level of price offered by his or
Mazzola [Musgrave and Peacock, 1958]. her demand curve at the equilibrium output
Impatient to move towards a more practica- [Lindahl, 1919].
ble solution, Wicksell [1896] pointed to a This view of the fiscal process is in sharp
fatal shortcoming of that model. This was its contrast to actual practice, where benefit
reliance on an omniscient referee to whom taxes play only a very minor part and the
all preferences are known. Such a referee revenue independent of source is then used
could then proceed in the above fashion, to finance total expenditures, be it to meet
planning for the efficient provision of social allocation or distribution objectives. This
goods. But so Wicksell noted, no such practice, in turn, reflects an old tradition in
referee exists. Preferences for social goods fiscal theory, basing revenue design on a
are not known and must be determined concept of ability to pay, without relation to
before the budget can be set. As distinct from benefits received. While Adam Smith noted
the case of private goods, this determination both benefits received and ability to pay in
cannot be left to bidding in the market. his famous maxim, the emphasis from John
Since consumption of social goods is non- Stuart Mill on, extending over Edgeworth to
rival, people will not reveal their preferences. Pigou, has been entirely on the latter,
The free-rider problem (as it came to be viewing the problem of tax design indepen-
called later) has to be faced. Surprisingly, dent of the expenditures that are to be
this fact had already been noticed by David financed [Pigou, 1928].
Hume [1740] a hundred years earlier, but While this difficulty does not arise for the
had been overlooked for a century thereaf- distribution branch where expenditures in
ter. Facing this reality, Wicksell passed over the form of transfers are but negative taxes,

it leaves the theory of the allocation branch patterns of distribution, levels of output, or
unresolved. Following the Pigouvian tradi- rates of growth, thus establishing a multi-
tion, this basic flaw is continued in the more dimensional possibility frontier. But eco-
recent doctrine of optimal taxation. With nomics does not tell us how to choose the
taxation viewed as taking, independent of best point thereon. There are, to be sure,
benefits received, the problem simply is how moves which will permit A to gain without
to minimize the resulting burden, including B's losing, and hence to be preferred,
that of dead-weight loss. provided only that envy is disallowed.
Economics helps, if only to avoid stupidity.
Distribution But there is no single solution at which
The Wicksellian model of the allocation each member of the community will be better
branch, while linking both sides of the off. Considerations of rights, as distinct from
budget, remains incomplete as it simply gains by trade, must be faced. On one end of
assumes the existence of an initial distribu- the scale is the proposition that a person is
tion of income. Consumers qua voters entitled to the fruits of his or her labor, the
cannot decide how to bid for social goods Lockean vision of property rights as based
until their income is known. Two budgets on natural or divine law [Locke, 1960]. On
will be needed. The first must implement a the other end is the notion of a common
tax-transfer process, i.e., a negative income pool, to be distributed in line with some rule
tax so as to establish the desired state of of fairness.
distribution. On that basis, people then vote Difficulties arise in either case. Lockean
for the second, determining public services entitlement clearly applies to returns to labor
and benefit charges (Lindahl prices) to but not from natural resources, as symbol-
defray their cost. ized in Henry George's [1880] doctrine of a
Good and well, but this leaves open the single tax. Moreover, is entitlement limited
question of what pattern of distribution the to returns in a competitive market thus
distribution branch is to establish. Wicksell, linking both efficiency and justice, or are
not only economic theorist but social monopolistic returns acceptable as well?
philosopher as well, faced up to that Finally, it remains to be decided how
disturbing question. If the voting solution to bequests are to be treated under the entitle-
preference revelation is to be just as well as ment doctrine.
efficient, so he argued, a just distribution of The common pool approach, as well,
income must pre-exist that vote [Wicksell, permits multiple interpretations. Fairness
1896]. may be defined in various ways. Proceeding
It is not surprising, therefore, that Wick- from the premise that the rational individual
sell presented his model as "A New Principle seeks to maximize happiness or satisfaction,
of Just Taxation," and that Lindahl entitled and the moral dictum that the happiness of
his treatise "The Theory of Just Taxation." each person be given equal weight, Ben-
History, as well as the current scene, both tell tham's [1978] utilitarian doctrine then asked
us that the distribution of output, as well as for total satisfaction to be maximized.
its efficient provision, is an important part of Assuming that marginal income utility falls
the problem. Economics short of social as income rises and holding total output
philosophy and vice versa is but half the constant, he thus arrived at a case for equal
story. distribution. This conclusion, however, is
Such is the case, even though the issue of promptly qualified by allowance for detri-
just distribution is not resolvable by the tools mental effects on output and the stability of
of economic analysis. These tools do permit the social order. In the end, the outcome
us to explore the interaction between differs little from that of the Lockean
4 AEJ: MARCH 1989, VOL. XVII, NO. 1

entitlement rule. we begin with an existing state of

In its modern form, utilitarian doctrine distribution as results from the operation of
defines satisfaction in terms of expected market forces, including market imperfec-
utility. With fairness viewed as requiring tions, status, inheritance, and so forth. Given
impartial choice, each individual is to choose this initial state, the issue is then seen in
among states of distribution, not knowing terms of redistribution only. This involves
what his or her position in the resulting both giving and taking.
outcome will be [Harsanyi, 1976]. With Giving in the form of charitable contribu-
individuals thus maximizing their expected tions may be seen in terms of doing good
utility from behind a veil, the solution once deeds or in terms of his or her satisfaction
more calls for an equal distribution if total derived from improving the welfare of the
outcome is fixed, but not so once disincen- donee. Such redistribution is quite compati-
tive effects are allowed for. ble with the Lockean concept of primary
Rawls [1971] similarly defines fairness as entitlement by market earnings.
choice behind a veil, but then arrives at a Taking is a different matter. Operating
solution which maximizes the position of the within constitutional constraints, this does
lowest. Interpreted as maximizing expected not permit robbery but does provide for
utility, this implies the rather extreme redistributive legislation based on majority
assumption of infinite risk aversion. If rule. Progressive taxation and transfer
interpreted as a moral rule p e r se, the payments are thus within constitutional
utilitarian concept of maximizing aggregate bounds, provided a majority supports the
satisfaction is discarded in favor of exclusive measure.
concern with the lower end of the scale. This severely qualifies the Lockean rule,
Philosophers thus have left us with a wide but it does not go all the way: Voting on
range of models, and more than one is redistribution differs from what would be
consistent with the golden rule as appears in voting on primary distribution since it
biblical sources or, for that matter, as called proceeds from a market-determined initial
for by Kant's categorical imperative. Their state. Nevertheless, attitudes towards pat-
performance in an uncertain world has to be terns of primary distribution enter. The
considered, but even then the final choice voter's choice will be determined not only by
cannot be based on scientific reasoning only. consideration of interpersonal utility, but
In the end, it reduces to a choice of iru'st will also reflect impartial value judgment
principle, and thereon people may disagree. regarding primary distribution.
Compromise is needed to make society
function. Linkage of Functions
In line with this, solutions may be found As noted earlier, the general equilibrium
which fall in between the two poles of approach, as formulated in Samuelson's
entitlement and common pool. Various model, provides for a simultaneous solution
combinations may prevail. The Lockean rule of the allocation and distribution functions.
may be qualified by calling for support of The Wicksellian tradition, on the contrary,
those whose innate ability is so low as to fall calls for separation and takes the distribu-
short of yielding an acceptable minimum. tion function to be performed as a first step.
Common pool rules may be qualified by While superior in pointing towards a
granting some entitlement rights, as in fact workable approach, this procedure also has
comes about by allowing for output effects. its flaws. These become apparent when
Nor is the policy choice made in a de novo viewed in the context of a general equilib-
setting where the philosopher's pattern of rium model.
primary distribution is determined. Rather, The difficulty arises because distribution

itself is affected by the allocation branch. the major task of budget policy. The great
Earnings and relative prices of private goods depression of the 1930's left the economy
will depend on what public services are with massive unemployment and the rise of
provided through the allocation branch. Keynesian economics pointed to lack of
Similarly, the gains (in terms of consumer demand as the villain. Given an inelastic I
surplus) which are derived from such and infinitely elastic L M schedule, budget
provision enter into the final pattern of deficits based on a higher level of public
welfare distribution. This being the case, it spending seemed the way out.
becomes impossible to implement the just Since then, the scene has changed consid-
state of distribution ahead of rather than by erably. The unemployment of the great
simultaneous determination with the alloca- depression was wiped out by the economic
tion branch. expansion of World War II. Monetary
We are thus left with a choice between a policy was reinstated in the Federal Reserve-
correct but unworkable model and one Treasury Accord of 1951 as an equal (or
which can be applied but is theoretically eventually more so) partner.
flawed by disregarding allocation branch By the mid-1960's, the problem of macro
effects on distribution. As I see it, the best we policy had become one of walking the tight-
can do is to follow the latter course, keeping rope between maintaining high employment
in mind its defect; or, it might be argued, and avoiding inflation. Concern then shifted
moving towards a correct solution by to establishing a proper mix of fiscal and
successive trials and revisions of the distribu- monetary policy, designed not only to
tion budget. maintain stability (i.e., high employment
A further though more readily resolved without inflation), but also to achieve a
overlap between the two functions should be desirable rate of growth.
noted. It results because redistribution More recently, focus has been on the
proceeds not only in cash but may also be in supply side effects of tax policy rather than
kind. Charitable donors may prefer to give in on the level of revenue, and now on the trade
kind, since they derive more satisfaction implications of policy mix. In short, the role
from certain uses by the donee than from of budget policy--the level of deficit and the
others. Similarly, voters as payees may be design of tax structure--came to be viewed
more supportive of in-kind programs than of in more sophisticated terms, but budget
cash transfers, even though voters as recip- policy continued to remain an~ important
ients may prefer a larger in-kind transfer to a variable in macro policy.
smaller one in cash. While such has been the case at the level of
Initial separation of allocation and distri- policy thinking, a fundamental challenge has
bution, with the latter in cash terms, may been advanced at the theoretical level. The
thus be followed by redistribution with in- size of deficit or surplus, so it has been
kind elements. Indeed, the argument might argued, does not matter. The rational
be carried further, viewing even primary taxpayer will discoum future net income to
distribution in in-kind terms. Primary adjust for debt service, finding its current
entitlement may then be seen as calling for value to be the same as that of current tax
provision with food and shelter, but not to finance. This reasoning was already ad-
income if put to trivial uses. vanced by David Ricardo who, correctly I
think, then proceeded to discard it as
Adding Stabilization unrealistic. Taxpayer horizons are not that
It remains to consider briefly the third long, tax laws may change, and the economic
corner of my triangle, that of stabilization. future is not that predictable.
There was a time when this almost seemed Fiscal variables, therefore, remain of
6 AEJ: MARCH 1989, VOL. XVII, NO. 1

macro importance and to void the fiscal more efficient choice. High or low preferen-
equation is as premature as was that of ces regarding public services need not be
neglecting the monetary one a generation associated with high or low preferences
ago. A deficit remains expansionary and a regarding the desirable degree of redistribu-
surplus contractive, whether the result be tion, While the latter requires a progressive
reflected in changing employment or prices. tax-transfer scheme, benefit taxation in the
A change in policy mix from fiscal finance of public services calls for a tax
restriction to monetary tightness remains schedule related to income elasticities of
adverse to growth, with a growth-inducing demand, rather than to distributional goals.
effect produced by shifting to monetary ease Similar considerations apply, and with
and fiscal tightness. A trade deficit offsets special force, to the conduct of stabilization
the expansionary effect of a budget deficit; policy. Expansionary action may be imple-
but a budget deficit, by calling for higher mented by tax reduction and does not
interest rates, will attract foreign capital, require expenditure increase, just as restric-
thereby strengthening the exchange rate and tive action may be taken by tax increase
deepening the trade deficit. U.S. macro rather than expenditure cuts.
policy has gone astray not because tradi- Failure to break this linkage has been a
tional insights were mistaken, but because major cause of mismanaged macro policy
they have not been followed. during the 1980's. A needed tax increase was
blocked by proponents of budget cuts
Coordination of Functions because this might permit a higher level of
We have seen that budget policy must expenditures or reduce pressure for reduc-
serve distinct objectives, with each to be met tion. The result was to force excessive
without interfering with the others. The reliance on monetary restriction, with
distinction between budget functions must detrimental effects on growth, the balance of
be recognized so as to dampen policy failure. payment, and the piling up of foreign-held
To begin with, consider the proposition debt.
advanced by critics of the public sector, that
the political process generates excess Conclusion
budgets. Perhaps so, but a reverse bias may In presenting my three-branch scheme, I
also result. The preference of the median do not mean to recommend that there be
voter may fall short of, rather than exceed, three different Bureaus of Internal Revenue,
the efficient solution; and though the budget requiring the taxpayer to engage in three
share in GNP has risen, this is not proof of distinct transactions, tax payments, or
excessive growth. Needs, preferences, and transfer receipts. Even if the scheme were to
capacities may change. be implemented in full, payments due to and
The proper approach, therefore, is not to from the various branches would be netted
arbitrarily limit the budget, but to offer a out, presenting the taxpayer with one bill
better framework for arriving at its correct only. But even this is not suggested. It would
level. Tax and expenditure choices need be be unreasonable to expect such a scheme to
linked, showing that public services are not be followed in detail. Rather, it is meant as a
obtained free and that taxes are not paid framework, designed to draw attention to
without return. This much fair observers the distinct goals involved and, following the
should agree upon, even though they will insight thus gained, to take feasible steps
differ regarding the desirable size of the towards avoiding conflict and a more
budget. efficient fiscal process.
Separation of the public service budget The question then remains of what might
from redistribution similarly would permit a be done at a more practical level to meet this

need. Has fiscal theory gone astray ever since basic issues of tax structure design?
Adam Smith rejected earmarked (or benefit) These obviously are tough questions and I
taxes in favor of broad-based, ability-to-pay will not attempt to answer them here.
type taxes7 Could we have a defense tax, a Rather, let me conclude by suggesting that
social programs tax, and a "rest of the moving towards a more rational fiscal
budget" tax, voted upon by Congress in framework, though difficult, is not alto-
conjunction with such appropriations? What gether hopeless. When advancing in age, so I
gains could there be had from dividing the am told, one is to become increasingly
budget into a current and a capital part, with pessimistic, but I beg to depart from that
tax finance of the former, so as to prevent pattern. The public sector, in meeting its
burdening of future generations? Are there various tasks, is an essential component of a
not better ways to secure fiscal discipline functioning society. Going a step further, I
without applying the restraint of a balanced find it fortunate that, by the nature of social
budget amendment, thereby stifling macro relations, such is the case: a Democratic
policy when a flexible budget is needed? society is more likely to flourish in a mixed
How could expansionary or restrictive tax economy, one where a public sector is
policies be implemented without raising the needed to supplement the market.


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Appleton, 1880. 1928.
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