Introduction to Public Introduction to Public Budgeting and FinanceBudgeting and Finance

Administrative StuffAdministrative Stuff

Use of WebCTUse of WebCT Any problems so far?Any problems so far?

Organization of courseOrganization of course Each session = 4 weeks, with corresponding Each session = 4 weeks, with corresponding

number of readingsnumber of readings Syllabus is rough guide onlySyllabus is rough guide only Not all reading materials will be covered in Not all reading materials will be covered in

lecture, but all should be read carefullylecture, but all should be read carefully Group projects Group projects Homework assignments due by following sessionHomework assignments due by following session Take home final due week after courseTake home final due week after course

Objectives of the courseObjectives of the course Survey the dominant theories in budgeting and Survey the dominant theories in budgeting and

finance, compare practice and trendsfinance, compare practice and trends Learn how to strategically plan a budget, how to Learn how to strategically plan a budget, how to

manage ongoing activities, and how to control manage ongoing activities, and how to control spending;spending;

Understand the role of public organizations in a Understand the role of public organizations in a market economymarket economy

Understand social security, public health and Understand social security, public health and other major categories of public expenditureother major categories of public expenditure

Understand the theory and practice of the Understand the theory and practice of the redistribution of wealth and resourcesredistribution of wealth and resources

Understand the impact of taxes on social welfare. Understand the impact of taxes on social welfare.  Learn from practitioners in the field. Learn from practitioners in the field.

What is Public Budgeting?What is Public Budgeting?

How governments strategically plan How governments strategically plan a budgeta budget

Manage ongoing activitiesManage ongoing activities Control spending Control spending

What is Public Finance?What is Public Finance?

The study of how governments collect The study of how governments collect and spend money and real resourcesand spend money and real resources

How do governments collect/spend How do governments collect/spend money? Positive analysismoney? Positive analysis

How should governments How should governments collect/spend money? Normative collect/spend money? Normative analysisanalysis

We are studying public finance in a We are studying public finance in a market economymarket economy

What is the Role of Government?What is the Role of Government?

To maintain and improve the welfare To maintain and improve the welfare of the peopleof the people To protect the people from harmTo protect the people from harm To provide the institutions that allow To provide the institutions that allow

market to function (e.g. protection of market to function (e.g. protection of property rights)property rights)

To provide the essential goods and To provide the essential goods and services that markets fail to adequately services that markets fail to adequately provideprovide

The Role of Government: IdeologyThe Role of Government: Ideology

Current TrendsCurrent Trends

Reagan tax cutsReagan tax cuts Shrink government “down to the size Shrink government “down to the size

where we can drown it in a bathtub”where we can drown it in a bathtub” Grover Norquist Grover Norquist

““The era of big government is over” The era of big government is over” Bill Clinton Bill Clinton

Bush tax cutsBush tax cuts Free market ideologyFree market ideology

Organic view of governmentOrganic view of government

Society is a natural organismSociety is a natural organism Goals of society set by stateGoals of society set by state Actions of individual are judged by Actions of individual are judged by

the contribution they make to the the contribution they make to the statestate

““Ask not what your country can do Ask not what your country can do for you; ask what you can do for your for you; ask what you can do for your country.”country.”

Mechanistic view of governmentMechanistic view of government

Individuals are paramount, government Individuals are paramount, government created to meet the needs of individualscreated to meet the needs of individuals

Big debate over importance of individual Big debate over importance of individual freedomfreedom

Two types of freedom:Two types of freedom: Freedom to do as you likeFreedom to do as you like Freedom not to suffer from activities of Freedom not to suffer from activities of

othersothers As society grows more crowded, second type As society grows more crowded, second type

of freedom becomes more importantof freedom becomes more important

The Role of Government: Objective AnalysisThe Role of Government: Objective Analysis

Complexity theory and systems thinkingComplexity theory and systems thinking Government in a market economyGovernment in a market economy

Complexity theory and Complexity theory and Systems thinkingSystems thinking

Bringing together many, many simple Bringing together many, many simple components leads to emergence of components leads to emergence of spontaneous order, complex system: spontaneous order, complex system: 2 H and 1 0 atoms form water molecule, 2 H and 1 0 atoms form water molecule,

molecules form cell, cells form organs, organs molecules form cell, cells form organs, organs make up humans, humans make up societymake up humans, humans make up society

Complex systems greater than the sum of Complex systems greater than the sum of their partstheir parts

Characterized by non-linearities, feedback Characterized by non-linearities, feedback loops, emergent properties, unpredictable loops, emergent properties, unpredictable surprises, etc. surprises, etc.

Government is a complex systemGovernment is a complex system

Government in a market economyGovernment in a market economy Economics is the allocation of scarce resources Economics is the allocation of scarce resources

among alternative desirable endsamong alternative desirable ends What are the desirable ends?What are the desirable ends?

To maintain and improve the welfare of the peopleTo maintain and improve the welfare of the people Government and economics have the same desirable Government and economics have the same desirable

endsends What are the scarce resources?What are the scarce resources? What are the characteristics of the scarce What are the characteristics of the scarce

resources?resources? Whether resources should be allocated by Whether resources should be allocated by

government or the market depends on the government or the market depends on the physical nature of the scarce resourcesphysical nature of the scarce resources

Once we agree on the desirable ends, deciding on Once we agree on the desirable ends, deciding on the role of government moves towards objective the role of government moves towards objective science and away from ideology.science and away from ideology.

Legal FrameworkLegal Framework

Federal Government: ExpenditureFederal Government: Expenditure

Constitution empowers government Constitution empowers government to “pay the debts and provide for the to “pay the debts and provide for the common defense and general common defense and general welfare of the United States.”welfare of the United States.”

Bills to appropriate expenditures can Bills to appropriate expenditures can be initiated in either house, must be be initiated in either house, must be approved by both houses and approved by both houses and PresidentPresident

Federal Government: RevenueFederal Government: Revenue

Duties, imposts and excises must be Duties, imposts and excises must be uniform throughout USuniform throughout US

Constitutional amendment (16Constitutional amendment (16thth) ) required for federal income taxrequired for federal income tax

55thth amendment– can’t take away amendment– can’t take away property without due process of law, property without due process of law, compensation requiredcompensation required

Can’t tax articles exported from statesCan’t tax articles exported from states Empowered to borrow moneyEmpowered to borrow money

State and local governmentsState and local governments

States have power not explicitly States have power not explicitly relegated to federal governmentrelegated to federal government

Can’t impose duties on imports or Can’t impose duties on imports or exportsexports

Power of local governments granted Power of local governments granted by statesby states

The Size of GovernmentThe Size of Government

Historical contextHistorical context What was the What was the

highest marginal highest marginal tax rate tax rate Under Eisenhower?Under Eisenhower?

•Under Kennedy?Under Kennedy?•Today?Today?

•Highest tax bracket currently applies to single people earning $54,000/yr

What has happened to the deficit?What has happened to the deficit?

What has happened to the size of What has happened to the size of government as a share of GDP?government as a share of GDP?

How does size of US government How does size of US government compare with other countries (2001)?compare with other countries (2001)?

USAUSA 29.3% of GDP29.3% of GDP

AustraliaAustralia 31%31%

CanadaCanada 37.4%37.4%

JapanJapan 38.3%38.3%

UKUK 38.8%38.8%

FranceFrance 49.4%49.4%

SwedenSweden 53.1%53.1%

How does the federal government How does the federal government spend its money?spend its money?

How do state governments spend How do state governments spend money?money?

Miscellaneous (~43%, +)Miscellaneous (~43%, +) Education (~35%, -)Education (~35%, -) Public welfare (~17%, +)Public welfare (~17%, +) Highways (~5%, -)Highways (~5%, -)

Where does the government get its Where does the government get its money?money?

FederalFederal Individual income Individual income

tax (+)tax (+) Social insurance (+Social insurance (+

+)+) Corporate tax (--)Corporate tax (--) Other (-)Other (-)

State and localState and local Other (+)Other (+) Sales taxSales tax Grants from federal Grants from federal

government (+)government (+) Property tax (-)Property tax (-) Individual income Individual income

tax (+)tax (+) Corporation taxCorporation tax

How do we Objectively Measure How do we Objectively Measure Government Performance?Government Performance?

Role of TheoryRole of Theory

Observe, form hypothesesObserve, form hypotheses Test hypotheses through continued Test hypotheses through continued

observation, measurement and observation, measurement and experimentsexperiments

Confirm hypotheses repeatedly and Confirm hypotheses repeatedly and you have theoryyou have theory

Reject hypotheses and you’re back Reject hypotheses and you’re back to the drawing boardto the drawing board

Theory tells us what questions to testTheory tells us what questions to test

If we fail to test our theories and If we fail to test our theories and their assumptions, or continue their assumptions, or continue to believe them when they fail to believe them when they fail

the tests, they become the tests, they become ideology, not theoryideology, not theory

Neoclassical Economic TheoryNeoclassical Economic Theory Assumes humans are rational, self Assumes humans are rational, self

interested utility maximizersinterested utility maximizers Empirical studies reject thisEmpirical studies reject this

Assumes perfect market competitionAssumes perfect market competition Empirical studies reject thisEmpirical studies reject this

Assumes in perfect markets invisible hand Assumes in perfect markets invisible hand leads to efficient allocation: greatest good leads to efficient allocation: greatest good for greatest numberfor greatest number

Can’t be tested in practice, because Can’t be tested in practice, because governments always intervene with governments always intervene with perfect functioning of marketperfect functioning of market

Ecological Economic TheoryEcological Economic Theory

Assume economy is subset of Assume economy is subset of ecosystemecosystem

Ecologically sustainable scale is first Ecologically sustainable scale is first prioritypriority

Socially just distribution 2Socially just distribution 2ndnd

Efficient allocation 3Efficient allocation 3rdrd

Georgist Economic TheoryGeorgist Economic Theory

Ownership of land leads to povertyOwnership of land leads to poverty Value of land is created by nature and Value of land is created by nature and

society, not hard work of individualsociety, not hard work of individual Land tax could finance all government Land tax could finance all government

expenditure, prevent land speculation expenditure, prevent land speculation and concentration of ownership, end and concentration of ownership, end povertypoverty

Land tax could be extended to include Land tax could be extended to include all value created by nature and societyall value created by nature and society

Empirical methods for Testing Empirical methods for Testing theoriestheories

InterviewsInterviews Subjective, hard to interpretSubjective, hard to interpret

ExperimentsExperiments Ethical issues, self selection, etc.Ethical issues, self selection, etc. Sample sizeSample size

Econometrics (statistics)Econometrics (statistics) Torture the data and it will confessTorture the data and it will confess

Theories can be very hard to testTheories can be very hard to test

Measurement in a complex systemMeasurement in a complex system

Very hard to isolate cause and effectVery hard to isolate cause and effect E.g. feedback loopsE.g. feedback loops

Rarely have adequate baseline dataRarely have adequate baseline data Systems evolve over timeSystems evolve over time Values matterValues matter

How do we normatively measure How do we normatively measure government Performance?government Performance?

Why do we need normative Why do we need normative measures?measures?

We need some way to measure social We need some way to measure social welfare, and choose between welfare, and choose between alternative statesalternative states

Economic theory provides some Economic theory provides some guidelinesguidelines

Theory can be very incompleteTheory can be very incomplete Different theories make different Different theories make different

ethical assumptionsethical assumptions The most commonly taught approach The most commonly taught approach

is neoclassical welfare economicsis neoclassical welfare economics

Pareto EfficiencyPareto Efficiency

Pareto improvement-- Any change in Pareto improvement-- Any change in allocation that makes at least one allocation that makes at least one person better off without making person better off without making anyone worse offanyone worse off

Pareto optimum– an allocation where Pareto optimum– an allocation where no further Pareto improvements are no further Pareto improvements are possiblepossible

We always want to be at a Pareto We always want to be at a Pareto optimum optimum

Indifference curves in Edgeworth boxIndifference curves in Edgeworth box

Contract curveContract curve

Marginal rate of substitutionMarginal rate of substitution

If you lose one fig, how many apples If you lose one fig, how many apples would you need to remain just as happy? would you need to remain just as happy?

Determined by slope of indifference curveDetermined by slope of indifference curve Pareto optimum occurs whenPareto optimum occurs when

Eveaf

Adamaf MRSMRS

Production possibilities frontierProduction possibilities frontier

Marginal costMarginal cost

Marginal cost of figs is the number of Marginal cost of figs is the number of apples you have to give up to get one apples you have to give up to get one more figmore fig

f

aaf MC

MCMRT

Efficiency demands thatEfficiency demands that

Eveaf

Adamafaf

f

a MRSMRSMRTMC

MC

across all goods and all people in the economy

First Fundamental Theorem of First Fundamental Theorem of Welfare EconomicsWelfare Economics

Assumptions:Assumptions: If all producers receive the same priceIf all producers receive the same price And there is a perfect market for every And there is a perfect market for every

commoditycommodity And people are perfectly rational,And people are perfectly rational,

Then, the free market automatically leads Then, the free market automatically leads to a Pareto Efficient allocationto a Pareto Efficient allocation

If assumptions hold and all we care about If assumptions hold and all we care about is Pareto efficiency, then government is Pareto efficiency, then government should be minimizedshould be minimized

But some Pareto optimums may be better But some Pareto optimums may be better for society than othersfor society than others

Second Fundamental Theorem of Second Fundamental Theorem of Welfare EconomicsWelfare Economics

We can attain any point on the We can attain any point on the contract curve by changing initial contract curve by changing initial endowments and letting market take endowments and letting market take over.over.

So initial distribution matters, big So initial distribution matters, big timetime

ConclusionsConclusions

If markets functioned according to If markets functioned according to theory, the major role of government theory, the major role of government would focus on initial distributionwould focus on initial distribution

Markets unfortunately do not Markets unfortunately do not function according to theory, as we’ll function according to theory, as we’ll learn in next lecturelearn in next lecture