The earmarking of taxes refers to the designation of funds—either from a single tax base or from a wider pool of revenues—to a particular end use. This practice may be contrasted with general fund financing, whereby expenditures are met from consolidated receipts. Earmarking provisions are a pervasive fiscal phenomenon in both developed and developing countries and are even written into several constitutions. Typical examples include the earmarking of revenues from property taxes for education, gasoline taxes for highway construction, and payroll taxes for social security payments.

Abstract

The earmarking of taxes refers to the designation of funds—either from a single tax base or from a wider pool of revenues—to a particular end use. This practice may be contrasted with general fund financing, whereby expenditures are met from consolidated receipts. Earmarking provisions are a pervasive fiscal phenomenon in both developed and developing countries and are even written into several constitutions. Typical examples include the earmarking of revenues from property taxes for education, gasoline taxes for highway construction, and payroll taxes for social security payments.

The earmarking of taxes refers to the designation of funds—either from a single tax base or from a wider pool of revenues—to a particular end use. This practice may be contrasted with general fund financing, whereby expenditures are met from consolidated receipts. Earmarking provisions are a pervasive fiscal phenomenon in both developed and developing countries and are even written into several constitutions. Typical examples include the earmarking of revenues from property taxes for education, gasoline taxes for highway construction, and payroll taxes for social security payments.

For various reasons the practice has been condemned by economists as wasteful and inefficient. At the bottom of much of this criticism is the homely analogy to households forced to spend receipts from each source of income for specified items of consumption. But what economist has not experienced a twinge of shame when earmarking income from a spouse’s new job toward the downpayment on a house, or converting windfall profits into a vacation budget? The source of embarrassment, of course, is the knowledge that an earmarking provision is—from the individual’s perspective—an unnecessary constraint in the utility-maximization problem of allocating the last dollar to yield equal marginal utility in every direction. To appreciate the case for earmarked taxes, a necessary first step is to get away from the tendency to view the fiscal problem from the perspective of an individual called the benevolent social planner.

I. The Rationale for Earmarked Taxes

Decisions on the provision of public goods may be taken either in the context of a vigorous democracy with an active legislature or, alternatively, by executive decree. The former perspective is adopted here, with the legislature viewed as a forum wherein conflicting preferences are expressed and resolved.

Lindahl’s Theory

This essential feature, which distinguishes fiscal decisionmaking from that of the individual household, was elegantly captured in the writings of Eric Lindahl (1958) over sixty years ago. A by-product of that analysis was a welfare-theoretical case for earmarked taxation based on the Pareto criterion. The main point is that the alternative to earmarked taxes—general fund financing—will result in non-Pareto-efficient outcomes.

Following Johansen’s (1963) exposition, consider an economy with two pure public goods, G and S, and a composite private good X. Let YA and YB be the incomes of two types of individuals—A and B—and XA and XB their consumption of the private good X. Let h denote A’ s “tax share” in the financing of total expenditures (G + S), so that B’s share is (1 – h). Under general fund financing, both public goods are financed by the revenues derived from these lump-sum taxes. Given utility functions UA(XA, G, S) and UB(XB, G, S), each agent maximizes utility subject to the corresponding budget constraint,

YA=XA+h(G+S)(1)
YB=XB+(1h)(G+S),(2)

yielding the following first-order conditions:

dUA/dG=dUA/dS(3)
dUA/dS=hdUA/dXA(4)
dUB/dG=dUB/dS(5)
dUB/dS=(1h)dUB/dXB(6)

The system of equations consists of six equations but only five unknowns (G, S, XA, XB, and h) and hence is overdetermined. In other words, no tax share h is capable of meeting all the requirements for efficiency.

One way to arrive at a determinate solution is to assume that preferences are identical. Then equations (3) and (5) are duplicated, leaving five equations in five unknowns. But this trivializes the whole problem, robbing fiscal analysis of one of its distinguishing features.

Suppose instead that expenditures on G and S are met from two separate “earmarked” funds. Thus, expenditure on G is met by payment of gG by A and (1 – g)G by B; likewise, for S, A pays sS and B pays (1 – s)S. Agents now maximize utility functions subject to the new budget constraints,

YA=XA+gG+sS(1a)
YB=XB+(1g)G+(1s)S,(2a)

which yield a new set of first-order equations:

dUA/dG=gdUA/dXA(3a)
dUAdS=sdUA/dXA(4a)
dUB/dG=(1g)dUB/dXB(5a)
dUB/dG=(1s)dUB/dXB.(6a)

The system now consists of six equations and six variables and hence can be solved for the optimal values of G, S, XA, XB, g, and s.

Note that rearranging equations (3a)–(6a) yields

(dUA/di)/(dUA/dXA)+(dUB/di)/(dUB/dXB)=1,i=G,S.(7)

The terms on the left are the sums of A and B’s marginal rates of substitution for each public good. The marginal rates of transformation of G and S for X are, by construction, unity. The earmarking solution, then, is equivalent to Samuelson’s (1969) well-known condition for the Pareto-efficient allocation of public goods and, indeed, is necessary for Pareto efficiency: any move from earmarking to general fund financing would leave both individuals worse off.

This case for earmarking has been couched in terms of numbers of equations and unknowns. However, if one recalls that the problem is resolved when preferences are identical, it should be clear that the role of earmarking lies in facilitating the mutual accommodation of differing preferences in the economy. Note also that, because tax shares are derived from individuals’ marginal rates of substitution in utility, the tax shares may be viewed as a form of “benefits taxation.” Although everyone consumes the same level of public goods, agents pay for this in accordance with their marginal utility (benefit).

A well-known shortcoming of Lindahl’s (1958) analysis is the assumption that agents in the economy will truthfully reveal their preferences. Owing to nonexcludability in consumption inherent in pure public goods, an agent has every incentive to understate the marginal benefit derived from an additional unit of the public good. Although economists have devised clever (sometimes bizarre) mechanisms for the truthful revelation of preferences that approximate the Lindahl equilibrium, the implementation of Lindahl’s solution remains a complex and difficult issue.

The Public Choice Perspective

Whereas a mainstream theorist might view earmarking as a constraint on expenditure, the public choice school stands this proposition on its head and argues instead that, in the context of majority voting, it is general fund financing that imposes constraints on voters’ choices. An insightful distinction between earmarked taxation and general fund financing can be illustrated as follows.

Under earmarking, the equilibrium quantity of each public good is determined by a separate vote on expenditure together with a specified tax, or set of taxes, to finance that expenditure. The opportunity cost to the voter of an additional battleship, then, is higher taxes rather than reduced expenditures on other public goods. General fund financing, on the other hand, is characterized by separate voting on the size of the budget (tax bills) and the composition of expenditures (expenditure bills). Given the government’s separately determined budget constraint, the opportunity cost of an extra battleship is no longer higher taxes but instead reduced expenditure on other public goods. This separation of tax decisions and expenditure decisions lies at the heart of the public choice school’s distaste for general fund financing.

One strand of this approach—initiated in Buchanan’s (1963) seminal paper—argues that the voter who might have approved a tax increase if it were earmarked for, say, environmental protection would oppose it under general fund financing because he or she may expect the increment to be allocated to an unfavored expenditure such as defense. Earmarked taxation then permits a more satisfactory expression of individual preferences. Although Buchanan’s analysis is basically an exercise in positive economics, it has distinct normative overtones.

A second strand—developed in Browning (1975)—draws attention to the possibility of perverse outcomes under general fund financing. The constraints imposed by the separation of tax decisions and expenditure decisions under majority voting may be such that a lower quantity of a public good will be supplied even if every voter’s preference for that good has increased.

The public choice approach is frequently received with courteous cynicism; Goode (1984), for example, has drawn attention to its irrelevance in countries that lack provision for citizen participation. A stronger criticism (see, for example, Deran (1965)) is the observed tendency for earmarking provisions to become embedded in the state’s financial structure and not to be re-evaluated as conditions change (as is implicitly assumed in the public choice model). In practice, the level of public goods supplied may depend entirely on the amount of earmarked revenues and costs, regardless of whether that level has become excessive or deficient. Whereas the usual example cited in this regard is something of a caricature (the continued presence in two U.S. states during the mid-1960s of taxes earmarked for Confederate pensions), most would agree that rigidity in earmarking provisions is the ultimate flaw in the concept. The moral, then, is that such provisions should be reviewed regularly whenever their introduction becomes inevitable.

The Benefits Principle of Taxation and the Economics of User Charges

Frequently, the use of earmarked taxation is justified by invoking the “benefits principle of taxation,” which argues that taxes should be borne by those who most benefit from the associated expenditure. The notion is appealing to economists because it parallels the market mechanism for private goods. The analogy makes most sense when an impure public good is characterized by excludability in consumption.1 Then it becomes possible to finance the activity with a user charge. Although user charges are in a sense “earmarked” for their associated activity, the implementation of a user charge is not equivalent to an earmarked tax in terms of efficiency and equity. When the implementation of user charges is judged to be administratively infeasible or too costly, an earmarked tax can be used as a second-best instrument of finance (for example, a gasoline tax as a proxy for charges on highway users).

The simple economics of user charges sheds some tight on the principles that determine the extent of revenues to be earmarked. Consider the provision of an excludable public good characterized by positive externalities. In Figure 1, the marginal social benefit (MSB) from a unit of consumption exceeds the corresponding private benefit (MPB). The marginal cost of production (MCP) is, for simplicity, assumed to be constant at p1. The optimal level of consumption for society is q*, for which consumers are willing to pay only p2. Then q* can be publicly provided by a user charge of p2, together with a per unit subsidy of p1 – p1. Ideally, earmarked revenues should total p2q*, with the remainder, (p1p2)q* being financed by general revenues unrelated to the level of consumption of the good. This is precisely how expenditure on road construction and maintenance is financed in a number of countries. Eklund (1972) reports that, for a cross section of countries with earmarking provisions, an average of 63 percent of all road expenditure was financed out of the general fund.

Bureaucracy Versus the Legislature

A somewhat more institution a list perspective on earmarking may be gained by pursuing in greater detail—as Niskanen (1971) has done—the question of precisely who supplies public goods and services. Although demand for public goods is expressed and resolved in the legislature, public goods are in general supplied by bureaucracies. According to this view, the two distinguishing characteristics of a bureaucracy are the absence of external control on efficiency and weak internal incentives. Weak external control results from the ambiguous nature of a bureaucracy’s output and the dependence of the legislature on the bureaucracy for information. Weak internal incentives to produce efficiently are a consequence of an absence of financial incentives for managers and a lack of competition in the market for their final output. The effect of this constellation of circumstances is to make bureaucrats pursue goals other than efficiency, such as larger staff establishments, prestige, and patronage.

Figure 1.
Figure 1.

Provision of a Public Good with Positive Externalities

Citation: IMF Staff Papers 1988, 003; 10.5089/9781451972986.024.A007

This approach to bureaucratic behavior can be used to rationalize the legislative tactic of earmarking revenues for specific end uses. There are a great many expenditures that are clearly in the public interest, but bureaucracies may have little interest in pursuing them adequately. A good example is expenditure on the operations and maintenance of public structures and capital. The prestige-maximizing bureaucrat in general prefers to see his department’s allocation go to new and high-profile investment and construction projects rather than to something as mundane as maintaining an old road or irrigation ditch. Although it is true that bureaucratic reputation may depreciate along with public structures, the process is long, and managers are rarely stationary targets. Since proper maintenance of the capital stock is an urgent issue in many countries, the legislature (or the executive branch) may force the bureaucracy’s hand on the matter by earmarking funds for such use.

Earmarking and Intertemporal Horsetrading

Earmarked revenues can also serve to enforce long-term deals between legislators—and in the process be welfare enhancing. Consider the case of the U.S. Hazardous Substance Response Fund (or “Super-fund”), which obtains revenue from excise taxes on petroleum and chemicals and uses the proceeds to help clean up environmental damage caused by production and disposal of these same goods. Even though taxing the chemical industry as a whole can be rationalized as a crude approximation to the “polluter-must-pay” principle, one can still question the validity of earmarking the proceeds to a special fund. Why should such revenues not be assigned to—and expenditures be met from—the general fund?

Consider now the following explanation. The ex ante probability of discovering a toxic waste dump is roughly the same across the country. Ex post, however, a legislator from Nevada has no incentive to approve cleanup expenditures in New York (because it is a pure income transfer) unless the legislator from New York can assure reciprocal support in the event of a similar disaster in Nevada at some future date. But Legislators from New York cannot bind their successors to such promises. A way out of this impasse is to earmark revenues for a special fund whose expenditures do not require legislative approval. Such a one-time agreement enforces mutual promises through time and, in this instance, permits the introduction of a welfare-enhancing public activity.

It is interesting to note that the Superfund may not be used to clean up oil spills (even in the unlikely event that the perpetrator cannot be identified). This feature of the Superfund can be explained by the fact that the ex ante probability of an oil spill is not uniform across states. Only coastal states are concerned, and legislators from the interior of the country will naturally oppose a long-term commitment (that is, an earmarked fund) for such purposes.

The role of earmarking in enforcing commitments among legislators can be extended to several situations. Eklund (1969), for instance, has pointed out that, in fractionalistic societies with unstable majority coalitions, earmarking may be the only way in which new expenditure decisions can be agreed on. In the absence of such a provision, society will tend toward the status quo, in the process forgoing public projects with a high return to society.2

Although the rule-enforcing aspect of earmarking enhances welfare in these cases, the opposite may also occur in practice. Interest groups may want to earmark specific taxes as a means of limiting their tax burden. The petroleum industry, for example, may lobby for earmarking any gasoline tax for highway maintenance, if they suspect that there is limited scope for expansion of this activity. Similarly, firearms manufacturers would attempt to earmark taxes levied on their industry for a complementary activity such as maintenance of wildlife.

Other Arguments

One justification for earmarking taxes concerns the effects of erratic financing that results in costly idling of manpower and machinery over extended periods. Earmarking receipts from a stable revenue base is a means of protecting socially important projects from the exigencies of a budgetary crunch and can, over time, be an important cost-saving device for the public sector.

A second justification is that in some developing countries, where democratic institutions are weak and mistrust of the government is high, earmarked taxation can improve tax compliance. If the public can be assured that taxes will be spent in their locality rather than used, say, to indulge a political strongman’s penchant for military expansion, they will be more willing to comply with existing taxes. In this case earmarking substitutes for lack of representative power in the executive and legislative branches of government.

Third, many countries have in recent years been forced to make painful (but necessary) fiscal adjustments to serious external shocks. In some cases the brunt of fiscal adjustment has been borne entirely by capital and infrastructural expenditure, with minimal reduction of current expenditures. Although the distinction between current and development expenditure should not be exaggerated—underfunding of the recurrent costs of development expenditure is a long-standing problem in developing countries—there is a tendency to cut back on vital infrastructural and maintenance expenditures rather than on public sector employment and wages. An earmarking clause, designed to protect vital projects and expenditures, would strengthen the government’s hand in reducing less socially productive components of public expenditure.

II. Conclusions

The foregoing has examined several theoretical reasons and practical circumstances under which earmarking revenues might be socially beneficial. There is one practical criticism of earmarking that has not been addressed so far: the proposition that earmarking induces budgetary rigidity and inefficiency.

One can respond to this proposition in at least two ways. First, is the alternative any better? The arguments against earmarking implicitly assume that general fund financing will eliminate the problems associated with earmarking. For instance, it is implicitly assumed that expenditures under general fund financing are indeed periodically reviewed and adjusted to ensure that no program is under- or overfunded. The empirical basis for such an assertion is highly questionable. Most budgeting under general fund financing occurs incrementally rather than by a procedure that evaluates each tax and expenditure afresh from year to year. Indeed, Bird (1982) has argued that the growth of earmarked taxes and the decentralized sector in Colombia should be viewed as a flight from the exceedingly cumbersome and inefficient budgetary and expenditure systems in that country.

Second, it should be recognized that, although widespread earmarking may induce rigidities in the budget, there are ways to reduce this effect. For example, adjustments can be made to the base or the tax rate of an earmarked pool of revenues. Alternatively, an activity can be jointly financed by both earmarked and general fund revenues, the latter providing the latitude necessary to make discretionary changes at the margin.

More fundamentally, one can question whether it is really worth making such a fuss about budgetary rigidity. Earmarked taxes are an application of the benefits principle of taxation and may be associated with higher revenues. As Bird (1984, p. 110) has pointed out, “it makes little sense to criticize earmarking for budgetary rigidity, since without earmarking, there would be less of a budget to be rigid about.”

References

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*

Mr. Teja is an economist in the Asian Department. He holds degrees from Delhi University, Jawaharlal Nehru University, and Columbia University. This paper was written while he was with the Fiscal Affairs Department of the Fund.

1

An example of a pure public good that is not excludable in consumption is street lighting.

2

Legislators are not the only class that may resort to earmarking in such a circumstance. Wilkie (1974) and (Premchand 1983) have suggested that, in several Latin American countries, earmarking was motivated by the executive branch of government, which wanted to bypass the problem posed by legislative logrolling and unstable coalitions.