Financing of Public Goods through Taxation in a General Equilibrium Economy: Theory and Experimental Evidence

We compare general equilibrium economies in which building and maintenance of a depreciating public facility is financed either by anonymous voluntary contributions or by taxing agents on their income from private production. Agents start with an endowment of private goods and money, while the government starts with an endowment of public good and money. All private goods produced are tendered for sale in exchange for money in a sell-all market mechanism. Agents’ proceeds from sale are taxed, and they individually allocate their private goods between current consumption and investment in production for the following period. The optimal levels of supply of the public good, and tax rate to sustain it over time, are defined and calculated for infinite and finite horizons. These equilibrium theoretical predications are compared to the outcomes of laboratory economies when (1) the starting public facility is either at or below the optimal level; and (2) the tax rate is either exogenously set at the optimal level, or at the median of rates proposed by individual agents. We find that the experimental economies sustain public goods at about 70-90 percent of the infinite horizon but considerably more than the finite horizon optimum. Payoffs (efficiency) is at 90 percent of the infinite horizon equilibrium level even when the rate of taxation is determined by voting. Starting conditions play only a minor role for outcomes of the economies, as efficiency and the stock of public good adjusts to about the same level irrespective of the starting level. These results contrast with rapid decline in provision of public goods under anonymous voluntary contributions, and point to the possibility that the social institution of government enforced taxation may have evolved to address the problem of under-production of public goods through anonymous voluntary contributions.