introduction to public finance

1. Chapter 1: Introduction to Public Finance
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Chapter 1 Introduction
to Public Finance
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin

2. Chapter 1: Introduction to Public Finance
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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

3. Chapter 1: Introduction to Public Finance
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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 efficiency
Figure 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.

6. Chapter 1: Introduction to Public Finance
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Taxes, Subsidies, Regulations, and Inefficiency
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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Taxes, Subsidies, Regulations, and Inefficiency
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

8. Chapter 1: Introduction to Public Finance
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Taxes, Subsidies, Regulations, and Inefficiency
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

9. Chapter 1: Introduction to Public Finance
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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
MSC
Negative
externality
Solution?
A corrective tax.
Externalities: Chapters 2 and 6

10. Chapter 1: Introduction to Public Finance
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Problems for the Free Market
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.

11. Chapter 1: Introduction to Public Finance
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Problems for the Free Market
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

12. Chapter 1: Introduction to Public Finance
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Problems for the Free Market
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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Problems for the Free Market
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
Personal
Income
45%
Payroll
35%
Corporate
10%
Other
10%
Taxes

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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

20. Chapter 1: Introduction to Public Finance
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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