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INTRODUCTION
FUNDAMENTAL PRINCIPLES OF
PUBLIC FINANCE
Next page
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?
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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).
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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)
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IF TAXES ARE SO BAD,
WHY HAVE A PUBLIC
SECTOR IN AN OPEN
AND FREE SOCIETY?
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IN SOME CASES THE
BENEFITS OF COLLECTIVE
ACTION (requiring
spending) OFFSET THE
HARMS DONE BY TAXES
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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.
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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
•
•
•
•
•
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Public goods
Toll goods
Commons goods
Private goods?
Merit goods?
Markets and the
Functions of Government
MARKET STABILIZATION
• Macroeconomic Stabilization
• Income Stabilization
• Supply Stabilization
MUSGRAVE’S LAYER CAKE
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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
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Macroeconomic
Stabilization
• Addressed to systemic risk
(hazard)
• Automatic stabilizers
• Monetary policy
• Fiscal policy
• Business bailouts
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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.
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Income Stabilization
•
•
•
•
•
•
•
Idiosyncratic (personal) risk
Social security
Medicare/medicaid
Earned income tax credit
Unemployment insurance
Food support (stamps)
TANF
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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?
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What is a Public Good?
Private Goods
Common
Goods
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Toll Goods
Public Goods
More Realistic
example of a toll good
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What about merit
goods?
• What is a merit good?
• If publicly supported
(supplied or subsidized), less
personal idiosyncratic risk
• Examples?
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Private Good
Q = 60 - 2.5P
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Public Good II
P = 75 - 4Q
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Public Good III
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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?
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Government Spending
and Taxation
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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.
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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
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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.
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What Governments Buy
Social
Security 22.9 %
Defense
16.2 %
Insurance trusts 7.1 %
Public welfare
& health 21.2 %
Net
interest
12.5 %
Education
29.5 %
Police
& fire
7.9 %
Income
security
13.8 %
Other 12.1 %
Transportation 2.6 %
Medicare &
health 19.9 %
Federal government spending
2000 -- $ 1,788 billion
Admin &
Transportation
other 16.7 %
6.7 %
Interest
Utilities &
liquor stores 6.7 % on debt 4.2 %
State & local government spending
1998 -- $ 1,526 billion
The major categories of government spending at both the
federal and state and local levels are displayed above.
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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.
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Sources of Revenue
Personal
income
49.6 %
Payroll
32.2 %
Property 15 %
User charges 28 %
Payroll
2%
Sales &
excise 19 %
Personal
Other
income
3.5 %
12 %
Customs
Other 4 %
Corporate
duties 1.0 %
Corporate
Excise
From Federal income 2 %
income 12.1 % 3.4 %
government 17 %
Federal government revenue
State & local government revenue
2000 -- $ 2,025 billion
1999 -- $ 1,558 billion
The revenue sources of both the federal and state and local
governments are displayed above.
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Growth of Government
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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.
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Real Federal Expenditures
Per Capita: 1792-2000
Real federal spending per person
$ 7,000
(in 2000 U.S. dollars)
$ 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.
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The Changing
Composition
of Federal Spending
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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.
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The Changing Composition
of Federal Spending
56 %
52 %
42 %
44 %
44 %
1980
1990
30 %
23 %
24 %
22 %
16 %
1960
1970
1980
1990
2000
1960
1970
2000
Health & income transfer
expenditures
Defense expenditures
(share of federal spending)
(share of federal spending)
Health care
Income transfers
During the last four decades, federal spending has shifted
sharply away from national defense and toward income
transfers and health care.
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The Payment and
Burden of Taxation
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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.
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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 world’s most
progressive tax systems; not so
spending.
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Government Revenue
As a Share of National
Income
Government revenue as a share of National Income
(as a share of national income)
40 %
Total government revenue
(federal, state, & local)
30 %
37.9
20 %
25.6
Federal revenue
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.
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Share of Federal Personal
Income Taxes Paid By
Various Income Groups
Share of total federal
personal income tax paid
Income group
Top 1%
Top 5%
Top 10%
Next 40%
Bottom 50%
1980
1990
19.1 %
36.8 %
49.3 %
43.7 %
7.0 %
25.1 %
43.6 %
55.4 %
38.8 %
5.8 %
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1999
36.2 %
55.5 %
66.5 %
29.5 %
4.0 %
Total Federal Taxes as a Share of
Income
Federal taxes as a share of income (%)
24.6 %
20.1 %
17.4 %
11.7 %
5.9 %
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.
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Size of the U.S.
Government Compared
to other Countries
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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
France
Greece
Denmark
Austria
Belgium
Japan
Italy
Germany
Netherlands
Canada
New Zealand
United Kingdom
Australia
Ireland
United States
Singapore
South Korea
Hong 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 %
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Deficits, Surpluses,
and the National Debt
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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 deficit
as a share of GDP
2%
0%
-2%
-4%
1950
Surplus
Deficit
1960
Gross & net federal debt
as a share of GDP
80 %
60 %
40 %
20 %
1950
1970
National debt
as a % of GDP
1960
1970
1980
Other federal debt
1980
1990
2000
Privately held federal
debt as a % of GDP
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.
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Budget Deficits & the
National Debt
Federal deficit
as a share of GDP
2%
0%
-2%
-4%
1950
Surplus
Deficit
1960
Gross & net federal debt
as a share of GDP
80 %
60 %
40 %
20 %
1950
1970
National debt
as a % of GDP
1960
1970
1980
Other federal debt
1980
1990
2000
Privately held federal
debt as a % of GDP
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?
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Who Owns the National Debt
U.S. Government
Agencies 41 %
Foreign
Investors 42 %
Federal
Reserve
Banks 9 %
Private
Investors 50 %
(a) National debt = $5.77 trillion
Domestic
Investors 58 %
(b) Privately held federal debt = $2.88 trillion
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
Net interest on
Net public debt
Countries
government debt, 2000
as a share of GDP, 2000
1.5 %
2.2 %
2.6 %
2.8 %
2.9 %
3.1 %
1.3 %
3.5 %
6.3 %
6.6 %
Australia
United Kingdom
United States
Germany
France
Spain
Japan
Canada
Italy
Belgium
12 %
34 %
35 %
42 %
43 %
43 %
51 %
66 %
99 %
103%
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?
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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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End
Class 1
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