The Transformation of Public Economics Research: 1970-2000The Transformation of
Public Economics Research: 1970-2000
Martin Feldstein (1)

The nature and content of research and teaching in public economics have changed
enormously during the past three decades. The field is more theoretically
rigorous, more empirical, more focused on real policy issues, and more concerned
with government spending as well as with taxation. For me, it has been an
exciting time to be a public finance economist and to contribute to this
intellectual transformation.
Theoretical Beginnings
When I began studying public finance as a graduate student in England in the
early 1960s, the bible of the field was Richard Musgrave's The Theory of Public
Finance (1959). Unlike earlier books by authors like Pigou (1947) which were
characterized by prose unencumbered by diagrams and algebra, most of the
Musgrave volume looked like a standard price theory book with graphs and algebra
showing the partial equilibrium effects of taxes on prices and quantities and
the associated effects on deadweight losses. The Musgrave book was about the
core issues of incidence and efficiency and the positive effects on the actions
of buyers and sellers without the detailed descriptions of tax rules or
administrative issues that characterized many earlier public finance books.
Although this text opened up a new era in public finance, its limited
mathematics meant that it was weak in dealing with multiproduct problems and in
analyzing general equilibrium effects. The general absence of references to
econometric research reflected the state of the field at the time. Similarly,
although Musgrave discussed general principles of government spending, his
classic text did not deal with the specific areas of government spending that
would become the subject of much of public economics in the past three decades.
Arnold Harberger's work on the incidence of the corporate income tax (Harberger,
1962) demonstrated the power and importance of simple general equilibrium
models. By extending models originally developed to study international trade
issues, Harberger showed how elasticities of substitution in production and
consumption, factor intensities in production, and consumer preferences all
combined to determine the incidence of the corporate tax on labor and capital
and on consumers with different preferences. Gone were the earlier vague
statements about backward shifting and forward shifting. Although the new
general equilibrium models did not give unambiguous answers about corporate tax
incidence, we learned the reason for the ambiguity and how various factors like
capital mobility would affect incidence.
In two further studies, Harberger (1964, 1966) showed how the traditional
welfare loss triangle could be extended to multiple taxes on different products
and to evaluating the deadweight loss of the corporate income tax. Although
multiproduct deadweight loss calculations had been developed earlier by Irving
Fisher (1937),and John Hicks (1939), it was Harberger who showed their direct
application to excise taxes. Corlett and Hague (1953) made a seminal
contribution to the theory of the efficient design of multiproduct excise taxes
when some products are non-taxable or are taxed at an arbitrary rate. With these
ideas well established, the growing mathematical literacy of the economics
profession led to a rediscovery of the Frank Ramsey's (1927) theory of optimal
excise taxes. Diamond and Mirlees (1971) modernized Ramsey's analysis, showed
the optimality of maintaining production efficiency, and derived the conditions
that generalized the traditional inverse elasticity rules for optimal taxation.
At about the same time, Mirlees (1971) also developed a formal model of the
optimal labor income tax in which the optimal degree of progressivity depends on
the government's distributional preferences and on the responsiveness of
individuals to the tax schedule. The research provided a formal structure for
guiding a benevolent government through the process in which the government
optimizes the schedule of income tax rates knowing that the taxpayers will
respond by maximizing their own utility subject to the schedule of tax rates.
Although the analysis failed to provide any significant general results, it
clarified the nature of the optimization problem and provided a framework for
deriving results in models with more explicit parametric restrictions.
A further generalization of the original Diamond-Mirlees analysis dealt with
designing the optimal combination of income and excise taxes. In the end, that
research showed that the optimal tax rules depend on such unobservable
properties of the utility function as the separability between leisure and the
components of consumption as well as on the higher derivatives of utility as a
function of income.
These theoretical developments led to other studies of tax incidence in general
equilibrium models (including the important early work on computable general
equilibrium analysis by John Shoven and John Whalley ), to extensions of the
Diamond-Mirlees optimal tax analysis to include expenditure issues, to new work
on the incidence of taxes on corporate source income by David Bradford, Mervyn
King, and others, and to my own research on the efficiency effect of taxes on
capital income.
These developments in the theory of public finance in the 1960s and 1970s were
important in two ways. First, they clarified enormously the profession's
thinking about a number of important public finance questions. Although they did
not give unambiguous answers, they showed the errors of some earlier views and
provided substantial analytic insights. Second, they attracted an outstanding
generation of graduate students to the field of public economics. Most of them
did not go on to do theoretical research but the improved theoretical
foundations in public finance and the new standard of theoretical rigor
contributed to their empirical work.
Empirical Research
The development of empirical work in public economics has, more than anything
else, distinguished the research of the past 30 years from all that had gone
before. The late 1960s and early 1970s saw for the first time the availability
of high speed computers, reliable econometric software, and large
machine-readable data sets. These developments, plus the addition of
sophisticated econometric techniques to the standard tool kit of graduate
students, were all key to the empirical revolution in public economics.
The new data for public finance research included the first public availability
of the Current Population Survey, the Federal Reserve's Survey of Consumer
Finances, and the Internal Revenue Service public use sample of 100,000 tax
returns that became the basic data input for what is now the NBER Taxsim model.
For someone like me, recently trained in econometric methods, the newly
available data provided an exciting opportunity to do a kind of empirical public
finance that had not been done before and to confront some of the key questions
of public finance in a new and serious empirical way.
An important early subject of empirical research was the study of the effects of
taxes on labor supply, or, more accurately, on labor force participation and
hours. These studies benefitted also from new econometric techniques for dealing
with limited dependent variables and with self-selection bias in estimating
behavior from a subset of the population. The results showed important effects
of taxes on the participation and hours of women. But the apparent lack of
response by men was a warning that an accurate characterization of labor supply
must be a much broader measure that includes things like effort, location,
acquisition of human capital, and choice of occupation.
More generally, what matters for evaluating the deadweight loss of the
distortions induced by labor income taxes is not the change in labor supply
alone (even broadly defined) but the change in the individual's taxable income,
including the effect on the form of compensation (i.e., on the choice of fringe
benefits and working conditions instead of cash) and on the deductions taken by
individuals who itemize their tax returns (Feldstein, 1999). Fortunately, unlike
the impossibility of studying broadly defined labor supply, it is possible to
estimate the effect of changes in marginal tax rates on taxable income using
panels of tax data that include repeated observations on the same individuals
or, under some conditions, using pooled cross sections of data.
Econometric tax research on the effect of interest income taxes on household
saving is difficult because neither the tax return panels nor other panel files
give adequate data on saving. Time series data on saving indicates that taxes
that reduce the net return on saving do depress saving but these results are
subject to a variety of estimation problems. Much more solid evidence on the
effects of tax policies on saving have been derived in studies of the effects of
IRA and 401-k plans. Although controversy continues, the evidence appears to
support the conclusion that these saving incentives do significantly increase
overall saving.
A series of legislative changes in the tax treatment of capital gains provided
the basis for several studies of the effect of the capital gains tax rate on the
selling of corporate stock and the realization of capital gains. Related studies
analyzed how tax rates affect the way households allocate their wealth among
different types of financial assets. Although results differ among the
individual studies, the overall implication is that households do respond to
differences in tax rates and to changes in tax rules.
Closely related to these studies of the effect of taxes on financial investment
are the studies of the effects of marginal tax rates on home ownership. Because
mortgage interest payments are deductible in calculating taxable income while
the imputed value of housing services is not included in taxable income,
individuals with high marginal tax rates have a strong incentive to own a home
and to increase their investment in owner-occupied housing when tax rates rise.
Several econometric studies confirm that both inferences are correct, estimate
the magnitude of the distortion, and calculate the resulting efficiency losses.
Other empirical studies of the effects of taxation deal with such things as
charitable giving and the demand for health insurance. There is, in short, no
aspect of household tax-related behavior that has not been studied. But with new
tax policies and improved data sets, there will be new opportunities in the
future to improve and refine our empirical knowledge in a wide range of areas.
In addition to these empirical studies, there have also been analytic studies of
taxation that sharpened our understanding of the effect of taxes on risk taking
by individuals, of how taxes affect the financial policy of corporations, and of
the implications of analyzing tax issues in the context of a growing economy.
Government Spending
A second major aspect of the transformation of research in public finance since
the 1960s has been to broaden the subject to include government spending as well
as taxation. This shift in focus was no doubt stimulated by the enormous
expansion of government spending. In the United States, non-defense spending of
the federal government rose from less than 10 percent of GDP in 1965 to more
than 15 percent in 2000, reflecting a wide array of new programs ranging from
pre-school education to health care for the aged. Economists responded to the
challenge of studying these new programs. The field of public finance was thus
transformed from the study of the taxes used to finance basic government
services to the field of public economics that looked also at the effect of
government spending on a wide range of programs.
Much of the growth of government spending has been for social insurance programs
and the research in public economics has matched that emphasis. Social Security
pensions, unemployment insurance, workers' compensation, and the
Medicare/Medicaid programs of health care for the aged and the poor raised new
theoretical as well as empirical issues that became a major focus for research.
Social insurance programs were attractive research subjects not only because
they are the largest part of government spending but also because they have many
analytic similarities to taxation. The analyses of public spending programs
study not only the extent to which they achieve their stated purposes but also
the incidence and excess burden of each program. The design of social insurance
programs involves tradeoffs between protection and distortion that are analogous
to the tradeoffs between distribution and efficiency considerations in taxation.

The Social Security program of benefits to retirees, dependents and the disabled
is the largest form of government spending. Empirical studies have shown that
Social Security reduces saving and induces early retirement in the United States
and other countries. In addition to these studies of the behavioral effects of
Social Security, there have been a variety of empirical studies of the general
equilibrium effects of Social Security and Social Security reform, including the
effects of shifting from the current pay-as-you-go system to systems that rely
in whole or in part on investment-based accounts. Separately, analytic studies
have examined the optimal design of social security retirement and disability
programs.
Studies of other social insurance programs, including disability insurance and
worker's compensation, also estimated behavioral effects, analyzing the
distortions to incentives and the efficacy of the programs in providing the
protection for which they are intended.
Government health care programs are important fiscally as well as socially. Even
in the United States, the government accounts for nearly half of total health
care spending and exceeds six percent of GDP. The large volume of microeconomic
data about the cost and provision of health care services also encouraged the
growth of research in this area. The introduction of changes in the state level
Medicaid program at different times in different states provided a source of
identification for studying different aspects of this significant program.
While early work on the economics of education focused on measuring and
explaining the returns to human capital accumulation, the public finance
research on education has looked at issues like the effect of alternative local
tax and grant rules on the level and distribution of local government education
spending. Important also have been the Tiebout-inspired analyses of the effects
of competition in education on various educational outcomes. The government's
increased role in providing scholarships for higher education has also induced
public finance economists to study the impact of such spending on college
enrollment and graduation as well as on household saving.
Other government programs ranging from child care to the criminal justice system
have been the subject of public finance studies that compare the cost of
achieving program goals to the full cost of the taxes needed to finance that
spending, including the deadweight loss associated with that tax revenue.
Macroeconomic Issues
Although Keynesian fiscal policy was a major focus of Richard Musgrave's The
Theory of Public Finance, by the 1970s the analysis of stabilization policies
had largely shifted to the field of macroeconomics where the emphasis was much
more on monetary policy than on variations in fiscal stimulus through changes in
budget deficits and surpluses. Public finance research nevertheless contributed
to the debate by studying how tax rules like the investment tax credit and
depreciation allowances could be used to stimulate business investment in a
counter-cyclical way.
The major social insurance programs also lie on the border between
macroeconomics and public finance. Unemployment insurance raises the level of
unemployment and contributes to its cyclical volatility. Public finance
researchers have crossed the border into macroeconomics and labor economics to
study the effect of unemployment insurance on the level and character of
unemployment and to analyze ways in which unemployment insurance can be improved
to reduce the inefficient labor market distortions without decreasing protection
against the hardships of unemployment. Social Security pensions can also have an
important macroeconomic effect by changing the rate of capital accumulation and
therefore the rate of economic growth.
The high inflation rate in the late 1970s inspired research on how the
interaction of inflation and tax rules affects the level and distribution of
saving and investment. This research showed that the neutrality of money and
money growth in theoretical macroeconomic models does not hold in actual
economies that tax nominal capital income. The analysis also led to calculations
showing that the substantial deadweight loss of even moderate rates of
inflation.
Fiscal Federalism
The complex federal structure of the U.S. government assigns important
decision-making authority to state and local governments. Those state and local
governments are now responsible for spending an amount equal to more than 60
percent of the spending by the federal government. An important area of public
economics research has been the analysis of how those governments choose their
tax and spending policies, how those choices are affected by the policies of
higher levels of government (including block grants and matching grants), and
how the resulting inter-area differences in taxes and spending affect the
behavior of the private sector and the outcomes of government programs. Although
such work has dealt primarily with the United States, it is likely to become
more important as the European Union evolves toward a more federal fiscal
structure.
Looking Ahead
The past three decades have been an enormously productive period for the field
of public economics with important advances in theoretical analysis and
empirical knowledge. The central role of the government in the economy and the
associated high marginal tax rates mean that the problems of taxing and spending
will continue to provide challenging opportunities for research in public
economics. If those studies are to be useful in improving public policy, they
must continue to speak to the real problems of the economy and must combine
appropriate analytic models with sound empirical research.
Cambridge, MA
September 2001
References
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1. Professor of Economics, Harvard University and President of the National
Bureau of Economic Research. This essay, written for the 30th Anniversary of the
Journal of Public Economics, focuses on research that has been described in the
English language and therefore primarily on work done in the United States and
Britain. The Journal played an important role in the transformation described
here. I am grateful for the opportunity to serve as a Co-Editor of the Journal
from 1972 through 1986, as an associate editor from 1987 through 1997, and as an
an Advisory Editor since that time.