FUNDAMENTAL PRINCIPLES OF PUBLIC FINANCE

1
INTRODUCTION

• FUNDAMENTAL PRINCIPLES OF PUBLIC FINANCE

2
How are Governments Different from other
Enterprises?
What are the powers enumerated in the US
Constitution?
Can the US government exercise those powers
anywhere Else?
3
How are Governments Different from other
Enterprises?

• Powers? To spend? No to borrow? No to tax? Yes
  to prohibit or compel? Yes. To create money? No,
  not really. Wage war? Make treaties with other
  sovereign states?
• Jurisdiction, geographic (in the US overlapping,
  unitary states, not so much).

4
Taxes are Coercive

• Nobody likes paying taxes
• Nobody much likes doing things they are forced to
  do
• Americans pay a lot of taxes (although less than
  in most other economically developed countries)

5
IF TAXES ARE SO BAD, WHY HAVE A PUBLIC SECTOR IN
AN OPEN AND FREE SOCIETY?
6
IN SOME CASES THE BENEFITS OF COLLECTIVE ACTION
(requiring spending) OFFSET THE HARMS DONE BY
TAXES
7
Market Failure

• Markets equilibrate
• DEMAND (measured in terms of willingness and
  ability to PAY)
• and
• SUPPLY (measured in terms of willingness and
  ability to SELL)
• But markets can be unstable. People do not like
  instability.

8
Markets and the Functions of Government

• MARKET PRECONDITIONS
• System of law
• Protection of life and property
• Definition of property
• Enforcement of contracts
• Disclosure requirements
• Regulation of competition natural monopolies
• Sound medium of exchange

• MARKET STABILIZATION
• Macroeconomic
• Income redistribution
• Microeconomic
• Public goods
• Toll goods
• Commons goods
• Private goods?
• Merit goods?

9
Markets and the Functions of Government

• MARKET STABILIZATION
• Macroeconomic Stabilization
• Income Stabilization
• Supply Stabilization
• MUSGRAVES LAYER CAKE

10
Politics (given the American liberal consensus)

• Left cradle to grave security, aim to eliminate
  all the avoidable insecurities of life
• Right watch out for waste, moral hazard, and
  adverse selection

11
Macroeconomic Stabilization

• Addressed to systemic risk (hazard)
• Automatic stabilizers
• Monetary policy
• Fiscal policy
• Business bailouts

12
Why Obama Is President of the US and Not McCain
13
Income Stabilization

• Idiosyncratic (personal) risk
• Social security
• Medicare/medicaid
• Earned income tax credit
• Unemployment insurance
• Food support (stamps)
• TANF

14
Supply Stabilization

• Idiosyncratic (supplier) risk
• Private suppliers could fail, often when most
  needed
• Pure public goods, toll goods, positive
  externalities would be undersupplied (negative
  ones oversupplied)
• How about merit goods?

15
What is a Public Good?
Private Goods
Toll Goods
Common Goods
Public Goods
16
Toll Goods I Not a Natural Monopoly
17
Toll Goods II Natural Monopoly
18
More Realistic example of a toll good
19
What about merit goods?

• What is a merit good?
• If publicly supported (supplied or subsidized),
  less personal idiosyncratic risk
• Examples?

20
Private Good
Q 60 - 2.5P
21
Public Good II
P 75 - 4Q
22
Public Good III
23
What Is a FAIR Tax/Price?

• IF THE LIGHTHOUSE
• COST 12000?
• Equal share?
• Equal net benefit?
• Equal ratio of MC to MB

• IF THE LIGHTHOUSE COST 12000 A B EACH HAD A
  BENEFIT LEVEL OF 2000 AND Cs BENFIT WAS 2750?

24

• Government Spending
• and Taxation

25
Government Spending

• It is important to distinguish between (a)
  government purchases of goods services and (b)
  transfer payments.
• Government purchases Goods supplied through the
  public sector. Examples government spending on
  police and fire protection, medical services,
  administration, highways and jet planes.
• Transfer payments Income transfers from
  taxpayers to recipients who do not provide
  current goods and services in exchange for these
  payments.

26
Government Spending

• Approximately three-fifths of government
  expenditures are undertaken at the federal level.
  
• In 2000, 85 of federal expenditures went for
  just four items
• income transfers
• health care
• national defense
• net interest on the national debt

27
Government Spending

• Education accounts for almost 30 of state and
  local spending. Other major spending categories
  at the state and local level include public
  welfare (income transfers), health care and
  highways.

28
What Governments Buy
The major categories of government spending at
both the federal and state and local levels are
displayed above.
29
Taxes and other Sources of Funds

• Governments are financed by taxes, user charges,
  and borrowing. Borrowing implies higher future
  taxes.
• The major sources of federal revenue are the
  personal income tax (accounts for almost 50 of
  federal revenue) and the payroll tax (accounts
  for about a third of the total).
• Major revenue sources at the state and local
  level are sales and excise taxes, personal income
  taxes, user charges, and grants from the federal
  government.

30
Sources of Revenue
The revenue sources of both the federal and state
and local governments are displayed above.
31

• Growth of Government

32
Growth of Government

• During the first 125 years of U.S. history,
  federal expenditures per person were small and
  they grew at a relatively slow rate.
• In contrast, federal spending soared throughout
  most of the 20th century. In 1990, real federal
  spending per person was nearly 60 times the level
  of 1916.
• During the 1990s per capita real federal spending
  was relatively constant. In fact, it declined
  slightly during the decade.

33
Real Federal Expenditures Per Capita 1792-2000
Real federal spending per person(in 2000 U.S.
dollars)
7,000
6,000
5,000
4,000
3,000
2,000
1,000
0
1800
1850
1900
1950
2000
Real federal spending per person (measured in
2000 dollars) grew slowly during the first 125
years of U.S. history, but it soared throughout
most of the 20th century.
34

• The Changing Composition
• of Federal Spending

35
Changing Nature of Government

• During the last 4 decades, the composition of
  federal spending has shifted away from national
  defense and toward spending on income transfers
  and health care.
• In 2000, national defense accounted for only
  16.2 of the federal budget, down from 52.2 in
  1960.
• In contrast, spending on income transfers and
  health care rose from 21.5 of the federal budget
  in 1960 to 56.6 in 2000.

36
The Changing Composition of Federal Spending
1960
1970
1980
1990
2000
1960
1970
1980
1990
2000
During the last four decades, federal spending
has shifted sharply away from national defense
and toward income transfers and health care.
37

• The Payment and
• Burden of Taxation

38
The Payment and Burden of Taxation

• In 2000, total government revenues summed to
  37.9 (and federal revenue to 25.6) of national
  income. Both figures were at their highest level
  since World War II.
• A dollar of taxation cost the private economy
  much more than a dollar because
• It is costly to administer, enforce, and comply
  with tax legislation.
• Taxes distort incentives and eliminate productive
  exchanges (and cause people to undertake some
  counterproductive activities).
• Economists refer to this as the dead weight
  loss of taxation.

39
The Payment and Burden of Taxation

• Payment of the personal income tax is skewed
  towards upper-income individuals.
• Even though the highest marginal tax rates are
  now lower than in 1980, the share of taxes
  collected from high income taxpayers has
  increased.
• The 1 of tax-filers with the highest incomes
  paid 36.2 of the federal personal income taxes
  in 1999, up from 19.1 in 1980.
• 66.5 of the personal income tax was collected
  from the top 10 of earners in 1999, compared to
  49.3 in 1980.

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The Payment and Burden of Taxation

• Overall, the U.S. tax system is generally
  progressive the percentage of income taken from
  high earners is greater than for those with less
  income.
• More so in some states than others.
• US has one of the worlds most progressive tax
  systems not so spending.

41
Government Revenue As a Share of National Income
Government revenue as a share of National
Income(as a share of national income)
40
30
20
10
1950
1960
1970
1980
1990
2000
1946

• In 2000, government revenue as a share of
  national income rose to the highest level since
  World War II.

42
Share of Federal Personal Income Taxes Paid By
Various Income Groups
Share of total federalpersonal income tax paid
Income group
1980
1990
1999
Top 1
19.1
25.1
36.2
Top 5
36.8
43.6
55.5
Top 10
49.3
55.4
66.5
Next 40
43.7
38.8
29.5
Bottom 50
7.0
5.8
4.0
43
Total Federal Taxes as a Share of Income
Federal taxes as a share of income ()
Lowest
Second
Third
Fourth
Highest
Family income groups (quintiles)
Here we show the payment of federal taxes as a
share of income for each income quintile. Note
the overall federal tax structure is progressive.
44

• Size of the U.S. Government Compared to other
  Countries

45
Size of Government U.S. Versus Other Countries

• The U.S. size of government is smaller than that
  of Japan and major Western European countries,
  but larger than for a number of high-growth Asian
  economies.

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Size of Government An International Comparison
Government expenditures as a share of GDP, 2000
Sweden
52.7
France
51.4
Greece
50.9
Denmark
50.2
Austria
47.6
Belgium
47.0
Japan
45.3
Italy
44.4
Germany
42.9
Netherlands
41.5
Canada
40.9
New Zealand
40.2
United Kingdom
39.2
Australia
32.7
Ireland
30.0
United States
29.4
Singapore
25.9
South Korea
23.8
Hong Kong
21.3
Thailand
18.3
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• Deficits, Surpluses,
• and the National Debt

48
Deficits, Surpluses, and the National Debt

• National debt Outstanding loans that have been
  made to the U.S. Treasury.
• A budget deficit increases the size of the
  national debt by the amount of the deficit.
  Conversely, a budget surplus allows the federal
  government to pay off bondholders and so reduce
  the size of the national debt.
• The national debt represents the cumulative
  effect of all the prior budget deficits and
  surpluses.

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Budget Deficits the National Debt
Federal deficitas a share of GDP
2
0
- 2
- 4
1950
1960
1970
1980
1990
2000
Gross net federal debtas a share of GDP
80
60
40
20
1950
1960
1970
1980
1990
2001

• Through most of the 1950s 1960s, federal
  budget deficits were small as a of GDP
  occasionally there was a surplus.

• During this period, the national debt declined
  as a of GDP.

50
Budget Deficits the National Debt
Federal deficitas a share of GDP
2
0
- 2
- 4
1950
1960
1970
1980
1990
2000
Gross net federal debtas a share of GDP
80
60
40
20
1950
1960
1970
1980
1990
2001

• During 1974-1995, budget deficits were quite
  large, causing the national debt to increase
  as a of GDP.

• During the last few years of the 20th century,
  the national debt fell as a share of the economy.

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• Who Owns
• the National Debt?

52
Who Owns the National Debt
Source The Treasury Bulletin, September 2001
and http//www.federalreserve.gov..
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• Concerns About
• the National Debt

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How Does Debt Financing Influence Future
Generations?

• For domestically held debt (58.5 of total
  privately held debt), the future generations that
  pay the tax liability accompanying the debt will
  also receive the interest income.
• The opportunity cost of resources used by the
  government is incurred during the current period
  regardless of how the government activity is
  financed.

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• Debt Financing
• in Other Countries

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Government Debt of Industrial Countries
Net public debtas a share of GDP, 2000
Net interest on government debt, 2000
Australia
1.5
United Kingdom
2.2
United States
2.6
Germany
2.8
France
2.9
Spain
3.1
Japan
1.3
Canada
3.5
Italy
6.3
Belgium
6.6
Source OECD Economic Outlook, June 2001.

• Several countries have government debt to GDP
  ratios greater than the United States.

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• How Does Social Security Influence the National
  Debt?

58
Social Security, Budget Deficits, and the
National Debt

• Social Security revenues and expenditures are
  generally included in budget deficit
  calculations.
• Because the Social Security system is now running
  a surplus, inclusion of these figures reduces the
  size of the reported deficit.

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• Demographics and
• Debt Financing

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Favorable Budgetary Factors During the 1990s

• The following favorable factors shifted the
  federal budget from deficit to surplus during the
  1990s
• Rapid economic growth
• Reductions in defense expenditures in the
  aftermath of the Cold War
• Favorable demographics-- the baby boomers were
  in their prime earning years and the number
  of people moving into the retirement phase of
  life grew slowly.

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Budget Prospects

• Budget deficits reemerged in the last decade and
  could get worse
• Spending on defense and domestic security grew
  rapidly as the result of terrorist threats.
• The Great Recession
• Spending on Social Security Medicare will grew
  rapidly , and will grow even faster once the baby
  boomers begin retiring after 2010.

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EndClass 1