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Abstract - This paper points out the similarities and differences between cost-benefit analysis and tax reform. By restricting the analysis to the margin it is shown that both areas can be handled by the same method. In both areas, there is a need to define social distributional weights and to evaluate the Marginal Efficiency Cost of Public Funds (MECF). It is suggested that the social distributional weights be derived from popular inequality indices. Such derivation enables the decomposition of the impact of the project (tax reform) on growth and redistribution so that one can evaluate the trade-off between the two.
INTRODUCTION
The systematic listing of and comparison between the costs and benefits associated with any policy measure is a fundamental tool of the decision making process developed by economists. The theory and practical evaluation of costs and benefits under different circumstances, such as market distortions and imperfections, externalities and risk, has been refined in several handbooks and hundreds of papers.1
Cost-benefit analysis involves efficiency considerations and distributional issues. Both issues require value judgement. However, whereas efficiency considerations require the minimal value judgement embodied in the Pareto criterion (which approves any cost-less improvement in the economic welfare of any individual), distributional issues require the evaluation of the social value of benefits and costs accruing to different individuals. When it comes to distributional issues, the handbook recommendation is to apply distributional weights, but it is not clear from where to draw these distributional weights, and it is hard to defend the use of arbitrary weights. Moreover, some experiments using distributional weights led Harberger to conclude "the implication for policy of a thorough and consistent use of distributional weights turn out to be quite disturbing" (Harberger, 1978, p. S111).2
Until quite recently, this weakness of cost-benefit analysis could be dismissed as not crucial because the primary interest of The World Bank and other major users of cost-benefit analysis was in lending for and approving physical projects that are primarily intended to promote growth. In this case, one can ignore distributional considerations due to several possible reasons: (a) one does not care about distributional issues, (b) distributional issues are dealt with by other instruments (c) it is assumed that the status quo represents the optimal income distribution.3 However,...