Chapter 1: Introduction to Public Finance 1 - 1 Chapter 1 Introduction to Public Finance Copyright...

Chapter 1: Introduction to Public Finance

1 - 1

Chapter 1

Introduction to Public Finance

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin


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Introduction

The role of government in making a free market possible

Why free markets usually work well for consumers

Problems for the free market

Problems for the government

Taxes, subsidies, regulations, and inefficiency

Taxes and government spending in the United States


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The Role of Government in Making a Free Market Possible

• A free market consists of the voluntary interaction of producers and consumers of goods and services.

• Is it necessary to have a government?

Positive Economics Normative Economics

What is happening? Is it good or bad?


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Why Free Markets usually Work Well for Consumers

Free markets are efficient • Productive efficiency

• Allocative efficiencyFigure 1.1

D

P

90 100 110 Q

S

$10

$8

$14

$12

$6 = (MB)

= (MC)


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Taxes, Subsidies, Regulations, and Inefficiency

A tax levied on producers

T=$4

T=$4

S

D

Figure 1.2

90 100 110 Q

S`P

$10

$8

$14

$12

$6

T=$4

T=$4

Figure 1.3

90 100 110 Q

S

D

D`

P

$10

$8

$14

$12

$6

or a tax levied on consumer

…produces the same effect.A decrease in quantity.


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Deadweight loss

T=$4

90 100 110 Q

Figure 1.4

P

$14 – $12 – $10 – $8 – $6 –

S

D

A

D

B

• An inefficiency which causes a reduction in society’s welfare

Deadweight loss is represented by area

= BAD


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S=$4

S=$4

S=$4

S=$4

Figure 1.5

90 100 110 Q

S

D

S`

P

$10

$8

$14

$12

$6

A subsidy given to producers Figure 1.6

90 100 110 Q

S

D

D`

P

$10

$8

$14

$12

$6

or a subsidy given to consumers

…produces the same effect:an increase in quantity


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Figure 1.7

90 100 110 Q

P

$14 – $12 – $10 – $8 – $6 –

S

D

S=$4

A

D

B

Deadweight loss is represented by area

= BAD


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Problems for the Free Market

$4

A

D

B

MSC = (MC + marginal environmental damage)

Figure 1.8

S (MC)

D (MB)

P

$14 – $12 – $10 – $8 – $6 –

90 100 110 Q

MSCNegative externality

Solution? A corrective tax.

Externalities: Chapters 2 and 6


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A

D

B

$4

Externalities: Chapters 2 and 6

MSB = (MC + marginal benefit to other people)

Figure 1.9

90 100 110 Q

P

$14 – $12 – $10 – $8 – $6 –

MSB

S (MC)

D (MB)

Positive externality

Solution? A corrective subsidy.


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Public Goods: Chapter 3

Social Insurance: Chapters 5 and 6

• A public good has 2 properties:

2. Non-excludability

1. Non-rivalry

• Old-age insurance – Social Security

• Health insurance – Medicare

• Free-rider problem


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Income distribution, taxation and efficiency:

Chapters 7, 8 and 9

• Income redistribution

• Taxation – progressive, regressive, and proportional

• Efficiency trade-offs

Education: Chapter 11

• Private or government

• Quality and price variations

• Consumption externality


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Low income assistance: Chapter 12

• Medicaid

• Earned income tax credit (EITC)

• Unemployment compensation

• Disability insurance

• Worker’s compensation


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Problems for the Government

Political economy: Chapter 3

• Island wall

• Compare costs against benefits

• Federal, state, and local• Types of taxes

Cost-benefit analysis: Chapter 4

Which level of government?: Chapter 10

• Borrowing and the effects of borrowing

Borrowing instead of taxing: Chapter 13


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Taxes and Government Spending in the U.S.Question 1:

a) U.S. taxes (federal, state, and local) as a % of GDP: _____

b) U.S. federal taxes as a % of GDP: _____

c) U.S. state and local taxes as a % of GDP: _____

d) OECD taxes as a % of GDP: _____

e) Scandinavian taxes as a % of GDP: _____

Figure 1.10 Taxes as a percent of GDP

U.S.OECD

Scandinavia 10% 20% 30% 40% 50% 60%

Federal S&L

30%20%

10%40%

50%


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Taxes and Government Spending in the U.S. Question 2: Federal tax revenue as a % of GDP is

(much higher than, about the same as, much lower than) forty years ago.

Figure 1.11% of GDP

24%

23%

22%

20%

19%

18%

1965 1970 1975 1980 1985 1990 1995 2000 2005 Year

Federal Spending

21%

17%

16%

Federal Taxes


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Taxes and government spending in the U.S.

Question 3: How has federal debt changed over time?

Figure 1.12

% of GDP

50%

45%

40%

35%

30%

25%

1965 1970 1975 1980 1985 1990 1995 2000 2005 Year

Federal Debt


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Taxes and government spending in the U.S.

Question 4: What are the important sources of federal tax revenue?

Figure 1.13


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“The Big 3” Fed Spending Fed Taxes Fed Deficit

2000 8% 20% 20% 0%

2010 10% 22% 20% 2%

2020 12% 24% 20% 4%

2030 14% 26% 20% 6%

2040 16% 28% 20% 8%

Taxes and Government Spending in the U.S.

A serious problem looms on the horizon.

Table 1.2

Medicare, Medicaid, and Social Security (“The Big 3”) as a % of GDP


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Summary

The role of government in making a free market possible

Why free markets usually work well for consumers

Problems for the free market

Problems for the government

Taxes, subsidies, regulations, and inefficiency

Taxes and government spending in the United States


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Preview of Chapter 2:

Externalities and the Environment

Applications: Acid rain and global warming

Economic analysis of a pollution tax and tradable permits

The economist’s approach to pollution

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