Cost-Benefit Analysis and the Marginal Cost of Public Funds

The marginal cost of public funds defined as the ratio between the shadow price of tax revenues and the population average of the social marginal utility of income, is analysed within an explicit cost–benefit context. It is shown that for an optimal tax system the measure is always equal to one. Benefit and cost measures congruent with this definition are derived. Under optimal taxes a positive net social benefit is a necessary and sufficient condition for a project that passes the cost–benefit test. Under non–optimal taxes this is not the case: If taxes are too low a positive net social benefit is a necessary but not sufficient condition and if taxes are too high a sufficient but not necessary condition for an accepted project.