Next page

INTRODUCTION

FUNDAMENTAL PRINCIPLES OF PUBLIC FINANCE

Jump to first page

How are Governments Different from other Enterprises?

What are the powers enumerated in the US Constitution?

Can the US government exercise those powers anywhereElse?

Jump to first page

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).

Jump to first page

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)

Jump to first page

IF TAXES ARE SO BAD,WHY HAVE A PUBLICSECTOR IN AN OPEN AND FREE SOCIETY?

Jump to first page

IN SOME CASES THE BENEFITS OF COLLECTIVE ACTION (requiring spending) OFFSET THE HARMS DONE BY TAXES

Jump to first page

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.

Jump to first page

Markets and the Functions of GovernmentMARKET

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?

Jump to first page

Markets and the Functions of Government

MARKET STABILIZATION• Macroeconomic Stabilization• Income Stabilization• Supply Stabilization

MUSGRAVE’S LAYER CAKE

Jump to first page

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

Jump to first page

Macroeconomic Stabilization• Addressed to systemic risk

(hazard)• Automatic stabilizers• Monetary policy• Fiscal policy• Business bailouts

Jump to first page

Why Obama Is President of the US and Not McCain

QuickTime™ and a decompressor

are needed to see this picture.

QuickTime™ and a decompressor

are needed to see this picture.

Jump to first page

Income Stabilization

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

Jump to first page

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?

Jump to first page

What is a Public Good?

Private Goods

Public Goods

Toll Goods

CommonGoods

Jump to first page

More Realistic example of a toll good

Jump to first page

What about merit goods?• What is a merit good?

• If publicly supported (supplied or subsidized), less personal idiosyncratic risk

• Examples?

Jump to first page

Private Good

Q = 60 - 2.5P

Jump to first page

Public Good II

P = 75 - 4Q

Jump to first page

Public Good III

Jump to first page

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 C’s BENFIT WAS $2750?

Jump to first page

Government Spending and Taxation

Jump to first page

• 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.

Government Spending

Jump to first page

• 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

Government Spending

Jump to first page

• 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.

Government Spending

Jump to first page

What Governments Buy

The major categories of government spending at both the federal and state and local levels are displayed above.

Federal government spending2000 -- $ 1,788 billion

State & local government spending1998 -- $ 1,526 billion

Defense16.2 %

Netinterest12.5 %

Transportation 2.6 %

Other 12.1 %

SocialSecurity 22.9 %

Incomesecurity13.8 %

Medicare & health 19.9 %

Education29.5 %

Admin &other 16.7 %

Insurance trusts 7.1 %

Public welfare& health 21.2 %

Police& fire7.9 %

Intereston debt 4.2 %

Transportation6.7 %

Utilities &liquor stores 6.7 %

Jump to first page

• 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.

Taxes and other Sources of Funds

Jump to first page

Sources of Revenue

The revenue sources of both the federal and state and local governments are displayed above.

Federal government revenue2000 -- $ 2,025 billion

State & local government revenue1999 -- $ 1,558 billion

Payroll32.2 %Personal

income49.6 %

Corporateincome 12.1 %

User charges 28 %Property 15 %

Payroll2 %

Sales &excise 19 %

Other 4 %

From Federalgovernment 17 %

Other3.5 %

Customsduties 1.0 %

Excise3.4 %

Personalincome12 %

Corporateincome 2 %

Jump to first page

Growth of Government

Jump to first page

• 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.

Growth of Government

Jump to first page

Real Federal Expenditures Per Capita: 1792-2000

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.

$ 7,000

$ 6,000

$ 5,000

$ 4,000

$ 3,000

$ 2,000

$ 1,000

$ 01800 1850 1900 1950 2000

Real federal spending per person(in 2000 U.S. dollars)

Jump to first page

The Changing Compositionof Federal Spending

Jump to first page

• 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.

Changing Nature of Government

Jump to first page

The Changing Composition of Federal Spending

During the last four decades, federal spending has shifted sharply away from national defense and toward income transfers and health care.

Defense expenditures(share of federal spending)

Health & income transfer expenditures

(share of federal spending)

1960 1970 1980 1990 2000 1960 1970 1980 1990 2000

52 %

42 %

23 % 24 %

16 %22 %

30 %

44 % 44 %

56 %

Health care Income transfers

Jump to first page

The Payment and Burden of Taxation

Jump to first page

• 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.

The Payment and Burden of Taxation

Jump to first page

• 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.

The Payment and Burden of Taxation

Jump to first page

• 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 world’s most

progressive tax systems; not so spending.

The Payment and Burden of Taxation

Jump to first page

Government Revenue As a Share of National Income

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

Government revenue as a share of National Income(as a share of national income)

Total government revenue(federal, state, & local)

40 %

30 %

20 %

10 %

19461950 1960 1970 1980 1990 2000

37.9

25.6Federal revenue

Jump to first page

Share of Federal Personal Income Taxes Paid By Various Income Groups

Income group 1980 1990 1999

Share of total federalpersonal income tax paid

Top 1%Top 5%Top 10%Next 40%Bottom 50%

19.1 %36.8 %49.3 %43.7 %

7.0 %

25.1 %43.6 %55.4 %38.8 %

5.8 %

36.2 %55.5 %66.5 %29.5 %

4.0 %

Jump to first page

Total Federal Taxes as a Share of Income

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.

Lowest

5.9 %

Second

11.7 %

Third

17.4 %

Fourth

20.1 %

Highest

24.6 %

–––– Family income groups –––– (quintiles)

Federal taxes as a share of income (%)

Jump to first page

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

Jump to first page

• 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.

Size of Government: U.S. Versus Other Countries

Jump to first page

Size of Government: An International Comparison

SwedenFranceGreece

DenmarkAustria

BelgiumJapanItaly

GermanyNetherlands

CanadaNew Zealand

United KingdomAustralia

IrelandUnited States

SingaporeSouth KoreaHong Kong

Thailand

52.7 %51.4 %50.9 %50.2 %

47.6 %47.0 %

45.3 %44.4 %

42.9 %41.5 %

40.9 %40.2 %

39.2 %32.7 %

30.0 %29.4 %

25.9 %23.8 %

21.3 %18.3 %

Government expenditures as a share of GDP, 2000

Jump to first page

Deficits, Surpluses, and the National Debt

Jump to first page

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.

Jump to first page

Budget Deficits & the National Debt

• 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.

1950 1960 1970 1980 1990 2000

2 %

- 2 %- 4 %

0 %

Federal deficitas a share of GDP

1950 1960 1970 1980 1990 2001

80 %

40 %20 %

60 %

Privately held federaldebt as a % of GDPNational debt

as a % of GDP Other federal debt

Surplus

Deficit

Gross & net federal debtas a share of GDP

Jump to first page

Budget Deficits & the National Debt

1950 1960 1970 1980 1990 2000

2 %

- 2 %- 4 %

0 %

Federal deficitas a share of GDP

1950 1960 1970 1980 1990 2001

80 %

40 %20 %

60 %

Privately held federaldebt as a % of GDPNational debt

as a % of GDP Other federal debt

Surplus

Deficit

Gross & net federal debtas a share of GDP

• 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.

Jump to first page

Who Owns the National Debt?

Jump to first page

(a) National debt = $5.77 trillionSource: The Treasury Bulletin, September 2001 and http://www.federalreserve.gov..

Who Owns the National Debt

PrivateInvestors 50 %

FederalReserveBanks 9 %

U.S. GovernmentAgencies 41 %

(b) Privately held federal debt = $2.88 trillion

ForeignInvestors 42 %

DomesticInvestors 58 %

Jump to first page

Concerns About the National Debt

Jump to first page

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.

Jump to first page

Debt Financingin Other Countries

Jump to first page

Belgium

United KingdomAustralia

Government Debt of Industrial Countries

United States Germany

France Spain JapanCanada

Italy103%

34 %12 %

35 %42 %43 %43 %

51 %66 %

99 %

Net public debtas a share of GDP, 2000

Source: OECD Economic Outlook, June 2001.

Net interest on government debt, 2000

6.6 %

2.2 %1.5 %

2.6 %2.8 %2.9 %3.1 %1.3 %3.5 %6.3 %

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

Jump to first page

How Does Social Security Influence the National Debt?

Jump to first page

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.

Jump to first page

Demographics andDebt Financing

Jump to first page

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.

Jump to first page

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.

Jump to first page

EndClass 1