Taxes and transfers constitute a key component in public policy. Too few people, unfortunately, understand the economics of taxes and transfers.

Controversy over the debt ceiling in the United States is a case in point. Ask any commentator. He is likely to remark that the US is running an unsustainable fiscal deficit, and that it needs to rein in its spending. Ask any Republican. The chances are that "taxes must not be increased." The underlying assumption is that tax increases will lead to more public spending, and that more public spending is bad.

Of course public spending is not all bad. Cut the budget for the police sufficiently, and the streets will become dangerous. Cut the budget for infrastructure maintenance, and some time in the future more bridges and roads will collapse, and there will be more floods leading to loss of homes and lives. Cut the budget for education, and the economy will lose its competitiveness over the long run, and its people will be less educated, possibly leading to more obesity, more illiteracy, and a less civil society.

Because public spending may produce more benefits than costs, they may deserve support. There is a case then to raise revenue, and there is a case to levy taxes.

Some public spending is in the nature of transfers, and transfers, too, may produce more benefits than costs. When they do, there is a case to raise the amount of revenue in order to finance them. When they don't, of course, they should be cut. So once again we need to compare costs with benefits.

Some transfers are really necessary, especially in a market economy such as Hong Kong. It is well known that the market economy does not distribute the claims to output fairly, but the market economy does allocate resources efficiently through the mediation of price signals.

If someone owns a piece of prime commercial property, he can count on earning substantial amounts of money that will grow as the economy grows. Competition for its use from various contenders will guarantee that.

The successful bidder, who is typically an entrepreneur, will have to invest capital, time, and effort, only to discover that he earns a small surplus after paying the rent. The market economy rewards owners of scarce resources lavishly, while owners of abundant factors of production may have to make a huge effort but earn only a "normal return".

Taxi drivers in Hong Kong know this very well. They work long hours, but the rent that they pay for each shift will eat up so much of their revenue that they literally are left "making a living", with little left over after paying for the essentials of their livelihood.

Some transfers are "in kind" rather than "in cash". Public rental housing is one such "in-kind transfer". Economists have long proved that in-kind transfers are less efficient than in-cash transfers, if the objective is to improve the well being of the assisted.

However, there are social objectives beyond simply improving the well being of the assisted. Public housing that meets basic standards of security, hygiene, safety, and living space will satisfy society's need for decency. Besides, substandard housing is a hazard and an eyesore for neighbors.

For this reason, transfers in-kind, such as housing, education, and medical care, are generally regarded as meeting social objectives and deserve a place in society.

The CSSA, the disability allowance, and the old age allowance ("fruit money") are the main in-cash transfers in Hong Kong. The old age allowance used to serve as a token for the community's respect for the elderly, but over the years an increasing number of the elderly are actually depending on it to supplement their day-to-day living expenses.

Last week I argued that it is far better to means-test subsidizing contributions to a fully-funded pension plan than to provide a means-tested allowance to the elderly poor, because the latter could cause the problem of moral hazard. People may over-consume and gamble away their savings, counting on the safety net to bail them out.

To alleviate the intergenerational poverty problem, there is a case for a family allowance for dependents who cannot earn incomes for themselves. The in-cash family allowance should be net of all in-kind transfers and based on the number of dependents, excluding the worker himself. The worker already enjoys the protection of the minimum wage.

His income, minus his maintenance, will be called the "personal surplus", which he can use in support of his dependents. The gross family allowance minus the personal surplus of the working members of the family minus any other in-kind or in-cash transfers from the government (other than any disability allowance) will be the net family allowance that his family should receive.

I would also argue that to finance the family allowance, the standard tax rate that currently protects the top income earners from having to pay according to the tax brackets be abolished. At the same time, I would support creating another tax bracket at the very top, so that the top marginal tax rate for the top earners will be raised to 20 percent.

While I support raising taxes for the highest income earners, I would like the profits tax rate to fall to 15 percent. That will encourage more investment and create more jobs.

 The author is director of the Centre for Public Policy Studies, Lingnan University.