Gruber4e ch01

1.1 The Four Questions of Public Finance

1.2 Why Study Public Finance? Facts on Government in the United States and Around the World

1.3 Why Study Public Finance Now? Policy Debates over Social Security, Health Care, and Education

1.4 Conclusion

Why Study Public Finance? 1

Dan Sacks

P R E P A R E D B Y

C H A P T E R 1 ■ W H Y S T U D Y P U B L I C E C O N O M I C S ?

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The Four Questions of Public Finance

• Public finance: The study of the role of the government in the economy.

Four questions of public finance:

1. When should the government intervene in the economy?

2. How might the government intervene?

3. What is the effect of those interventions on economic outcomes?

4. Why do governments choose to intervene in the way that they do?

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When Should the Government Intervene in the

Economy?

• Economics generally presumes that markets deliver efficient outcomes, so why should government do anything?

• Primary motive for government intervention is therefore market failure.

• Market failure: Problem that causes the market economy to deliver an outcome that does not maximize efficiency.

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• Measles vaccine introduced in 1963, and measles cases had become relatively rare in the United States by the 1980s.

• 1989−1991: Huge resurgence in measles.

• This outbreak resulted from very low immunization rates among disadvantaged inner-city youths.

• Unimmunized children imposed a negative externality on other children.

APPLICATION: The Measles Epidemic of 1989−1991

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• The federal government responded to this health crisis in the early 1990s:

o Encouraged parents to immunize their children.

o Paid for the vaccines for low-income families.

• Impressive results:

• Immunization rates never higher than 70% prior to outbreak.

• Rose to 90% by 1995.

• Government intervention clearly reduced this negative externality.

APPLICATION: The Measles Epidemic of 1989−1991

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When Should the Government Intervene in the

Economy?

• Even if the market is well-functioning, an efficient outcome is not necessarily socially desirable.

• Redistribution is a second reason for government intervention.

• Redistribution: The shifting of resources from some groups in society to others.

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• Tax or Subsidize Private Sale or Purchase

o Use the price mechanism, changing the price of a good to encourage or discourage use.

• Taxes raise the price for private sales or purchases of goods that are overproduced.

• Subsidies lower the price for private sales or purchases of goods that are under-produced.

How Might Governments Intervene?

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• Restrict or Mandate Private Sale or Purchase

o Quotas restrict private sale of goods that are overproduced.

o Mandates require private purchase of goods that are under-produced.

• Public Provision

o The government can provide the good directly.

• Public Financing of Private Provision

o Governments pays, private companies produce.

How Might Governments Intervene?

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Interventions have direct and indirect effects.

• Direct effects: The effects that would be predicted if individuals did not change their behavior in response to the interventions.

o With 49 million uninsured, providing universal health insurance covers 49 million people.

• Indirect effects: The effects that arise only because individuals change their behavior in response to the interventions.

o If people drop private coverage, many more people may end up covered by the public plan.

What Are the Effects of Alternative Interventions?

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• Governments do not always choose efficient or socially desirable outcomes.

• Political economy: The theory of how the political process produces decisions that affect individuals and the economy.

Why Do Governments Do What They Do?

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The government is a huge part of the economy:

• Government spending represents a large sector of the economy, in the United States and around the world.

• This spending is financed with taxes or with debt, and these affect every facet of the economy.

• Many sectors of the economy are also directly affected by regulation.

Why Study Public Finance?

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• The methods and results derived from empirical economics are central to the development of public policy at all levels of government.

• The Congressional Budget Office (CBO) “scores” policy proposals by estimating their budget implications.

• CBO scoring uses the theoretical and empirical tools of public finance.

• CBO scores can determine the fate of legislation.

APPLICATION: The Congressional Budget Office as

Gatekeepers

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Federal Spending as a Percent of GDP, 1930−2011

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Total Government Spending Across Developed

Nations, 1960−2013

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Decentralization

• A key feature of governments is the degree of centralization across local and national government units.

• Centralization: The extent to which spending is concentrated at higher (federal) levels or lower (state and local) levels.

• In the United States, state and local spending is about one-fourth of total government spending.

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Federal Revenues and Expenditures, 1930−2011

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Federal Surplus/Deficit, 1930−2011

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Federal Debt, 1930−2011

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Debt Level of OECD Nations in 2011

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State and Local Government Receipts,

Expenditures, and Surplus, 1947−2008

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Distribution of Spending

• Public goods: Goods for which the investment of any one individual benefits everyone in a larger group.

o Example: Defense spending

• Social insurance programs: Government provision of insurance against adverse events to address failures in the private insurance market.

o Example: Health insurance

• Over time, spending has shifted dramatically toward social insurance, especially health insurance.

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Distribution of Federal Spending, 1960 and 2012

Category: 1960 2012

National defense 49.4% 19.1%

Social Security 13.4 15.9

Net interest 9.7 7.6

Unemployment, disability 8.6 9.1

Education, welfare, housing 4.0 11.0

Health (including Medicare) 2.9 25.2

Other 12.0 12.1

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Distribution of State/Local Spending, 1960 and 2012

Category: 1960 2012

Education 38.8% 33.4%

Transportation 11.7 5.9

Public order and safety 10.2 12.9

Welfare, social services 10 6.6

Health 8.2 22.3

Other 21.1 18.6

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Distribution of Federal Revenue Sources, 1960 and

Category: 1960 2012

Income taxes 44% 42%

Corporate taxes 23 35

Social insurance contributions 17 13

Excise taxes 13 7

Other 3 3

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Distribution of State/Local Revenue Sources, 1960

and 2011

Category: 1960 2012

Property taxes 36% 21%

Sales taxes 27 22

Federal grants-in-aid 9 24

Income taxes 6 14

Other 22 19

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Regulatory Role of the Government

The government regulates a wide range of economic and social activities:

• The Food and Drug Administration (FDA): food, cosmetics, drugs, and medical devices.

• The Occupational Safety and Health Administration (OSHA): workplace safety.

• The Federal Communications Commission (FCC): radio, television, wire, satellite, and cable.

• The Environmental Protection Agency (EPA): pollution of air, water, and food supplies.

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Many heated policy debates concern the impact of major public programs:

• The role of Social Security, health care, and education are all contentious subjects.

• “Liberal” and “Conservative” positions hold differing views on how to approach these major policy issues.

Why Study Public Finance Now? Policy Debates over

Social Security, Health Care, and Education

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Social Security is the single largest government expenditure program.

• The financing structure of this program is basically that today’s young workers pay the retirement benefits of today’s old.

• As the population ages, it is increasingly difficult to fund.

• Liberals argue that we should raise necessary resources through higher payroll taxes.

• Conservatives argue that, rather than transfer from young to old, we should encourage people to save.

Why Study Public Finance Now? Social Security

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• 49 million Americans lack any health insurance, about 18% of the non-elderly U.S. population.

• The Affordable Care Act (ACA) promises to cover 32 million, using mandates and subsidies.

o Supporters argue that the ACA corrects serious market in the insurance market.

o Opponents charge that it represents an enormous, expensive, unwarranted expansion of government power.

Why Study Public Finance Now? Health Care

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There is an enormous dissatisfaction with our current educational system.

• In 2009, the United States ranked 17th in reading, 23rd in science, and 35th in math skills in a study of 65 countries.

• Will more spending improve educational outcomes?

• Or might competition among schools help?

Why Study Public Finance Now? Education

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• Government plays a central role in the lives of all Americans.

• There is ongoing disagreement about whether that role should expand, stay the same, or contract.

• The facts and arguments raised in this chapter provide a backdrop for thinking about the set of public finance issues that we explore in the remainder of this book.

Conclusion

Gruber4e ch01

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