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C h a p t e r
16
PUBLIC GOODS
AND TAXES
O u t l i n e
Government: The Solution or the Problem?
A. Federal, state, and local governments employ almost 20
million people and spend $3 trillion.
B. Do we need all this government? Is government too big?
C. Does government help us to achieve an efficient use of
resources?
I.
The Economic Theory of Government
A. The economic theory of government explains the purpose of
governments, the economic choices that governments make,
and the consequences of those choices.
1. Governments exist for two main economic reasons:
a)To establish property rights and set the rules for
the redistribution of income and wealth.
b)To provide a non-market mechanism for allocating
scarce resources when the market economy results in
inefficiency—a situation called a market failure.
2. Public choices deal with four economic problems.
a) Public goods
b) Taxes and redistribution
c) Monopoly
d) Externalities
B. Public Goods
1. Public goods are goods that are consumed by everyone
or by no one—such as national defense, law and order,
and sewage and waste disposal services.
2. The market economy under produces these goods because
it is impossible to exclude non-payers from enjoying
them.
C. Taxes and redistribution
1. Taxes pay for public goods and redistribute income.
2. Altering the distribution of income requires taxing
some people and redistributing the revenue to others.
3. The market economy generates a distribution that a
majority regards as unfair.
D. Monopoly
Monopoly and rent seeking prevent the allocation of
resources from being efficient and redistribute the
consumer surplus to producers.
E. Externalities
1. External costs and benefits are consequences of an
economic transaction between two parties that are
borne or enjoyed by a third party.
a) A chemical factory that dumps waste into a river
that kills the fish downstream imposes an external
cost.
b) A bank that builds a beautiful office building
creates an external benefit.
2. External costs and benefits prevent the market
allocation of resources from being efficient.
F. Public Choice and the Political Marketplace
1. Public choice theory applies the economic way of
thinking to the choices that people and governments
make in a political marketplace.
2. Figure 16.1 (page 371) illustrates the political
market place.
a) Voters are the “consumers” in the political
marketplace. They express their preferences for
publicly provided goods and services by allocating
their votes, by making campaign contributions, and
by lobbying government decision makers.
b) Politicians are the “entrepreneurs” of the
political marketplace. Their objective is to get
elected to office and remain in office. Votes to a
politician are like profits to a firm, so they
implement policies that expect to attract enough
votes to get elected.
c) Bureaucrats are the producers, or firms, of the
political marketplace. They are the officials
appointed by politicians to run government
departments and agencies. Bureaucrats are assumed
to maximize their department’s budget, which in
turn maximizes their power and prestige, and
maximizes the opportunity for advancement within
the bureaucracy.
G. Political Equilibrium
1. A political equilibrium is the outcome of the choices of
voters, politicians, and bureaucrats.
2.
It is a situation in which the choices of the three
groups are compatible and no group can improve its own
situation by making a different choice.
II. Public Goods and the Free Rider Problem
A. Public Goods
1. A public good is a good or service that can be consumed
simultaneously by everyone and from which no one can
be excluded—nonrival and nonexcludable.
a)Nonrival in consumption: Consumption by one person
does not decrease the consumption opportunities of
another person.
b)Nonexcludable: It is impossible or uneconomical to
prevent someone from consuming the good once it is
produced.
2. A private good is rival and excludable and many goods
combine elements of both a public and a private good.
Figure 16.2 (page 372) classifies goods according to
these two criteria.
B. The Free-Rider Problem
1. A free rider is a person who consumes a good without
paying for it.
2. Public goods create a free-rider problem because the
quantity of the good that a person is able to consume
is not influenced by the amount that the person pays
for the good, so no one has an incentive to pay and an
unregulated market would produce an too little of the
good.
C. The Benefit of a Public Good
1. The value of a private good is the maximum amount that
a person would pay for one more unit, which is shown
by the person’s demand curve.
2. The value of a public good is the maximum amount that
all the people are willing to pay for one more unit of
it.
3.The total benefit of a public good to an individual is
the dollar value that a person places on a given level
of provision of the good.
4.The marginal benefit of a public good to an individual
is the increase in total benefit that results from a
one-unit increase in the quantity provided. The
marginal benefit of a public good diminishes with the
level of the good provided.
5.Everyone can consume each unit of a public good, which
means the marginal benefit for the economy is the sum
of marginal benefits of each person at each quantity.
6.The economy’s marginal benefit curve for a public good
is the vertical sum of each individual’s marginal
benefit curve. It contrasts with the demand curve for
a private good, which is the horizontal sum of the
individual demand curves at each price.
7.Figure 16.3 (page 373) shows how the marginal benefits
of a public good are summed at each quantity of the
good provided.
D. The Efficient Quantity of a Public Good
1.The efficient quantity of a public good is the
quantity that maximizes net benefit—total benefit
minus total cost—which is the same as the quantity at
which marginal benefit equals marginal cost.
2.Figure 16.4 (page 375) illustrates the efficient
quantity.
E. Private Provision
1.If a private firm tried to produces and sell a public
good, almost no one would buy it.
2. The free-rider problem results in too little of the
good being produced.
F. Public Provision
1.Because the government can tax all the consumers of
the public good and force everyone to pay for its
provision, public provision overcomes the free-rider
problem.
2.If two political parties compete, each is driven to
propose the efficient quantity of a public good. A
party that proposes either too much or too little can
be beaten by one that proposes the efficient amount,
because more people vote for an increase in net
benefit.
3.The attempt by politicians to appeal to a majority of
voters leads them to the same policies, which is an
example of the principle of minimum differentiation—the
tendency for competitors to make themselves identical
to appeal to the maximum number of clients (voters).
(The same principle applies to competing firms such as
McDonald’s and Burger King).
G. The Role of Bureaucrats
1.Figure 16.5 (page 376) shows the goal of the
bureaucrat, which is to seek the highest attainable
budget for providing a public good.
2.Bureaucrats might provide the efficient quantity but
try to increase their budget to equal the total
benefit of the public good and drive the net benefit
to zero.
3.Bureaucrats might also try to over provide a public
good.
4.Well-informed voters would ensure that the politicians
prevented the bureaucrats from increasing their budget
above the minimum total cost of producing the
efficient quantity. But is it not rational for voters
to be well informed.
H. Rational Ignorance
1.Rational ignorance is the decision by a voter not to
acquire information about a policy or public goods
provision because the expected benefit to the voter
from knowing the information is less than the cost of
acquiring the information.
2.For voters who consume but don’t produce a public
good, it is rational to be ignorant about the costs
and benefit. For voters who produce a public good, it
is rational to be well informed. So the political
equilibrium is one that favors the producer and
bureaucrat and is an inefficient over provision of
public goods.
I. Two Types of Political Equilibrium
1.The two types of political equilibrium—efficient
provision and inefficient over provision of public
goods correspond to two theories of government:
a) Public interest theory predicts that political
equilibrium achieves efficiency because wellinformed voters refuse to support inefficient
policies.
b) Public choice theory predicts that government delivers
an inefficient allocation of resources—that
government failure parallels market failure.
J. Why Government Is Large and Grows
1.Government grows because the demand for some public
goods is income elastic.
2.Government might be too large because of inefficient
overprovision.
K. Voters Strike Back
1.If government grows to large relative to the value
voters place on public goods, there might be a voter
backlash that leads politicians to propose smaller
government.
2. Privatization is one way of coping with overgrown
government and is based on distinguishing between
public provision and public production of public
goods.
III. Taxes
A. Taxes generate the financial resources that provide
public goods. Figure 16.6 (page 378) shows the five basic
types of taxes used by various levels of government in
the United States:
1. Income taxes
2. Social Security taxes
3. Sales taxes
4. Property taxes
5. Excise taxes
B. Income Taxes
1.Income taxes are taxes on personal income and
corporate profits. These taxes generated $1,287
billion or 51 percent of total tax revenues in 2000.
2.Personal income tax: The amount of tax a person pays
depends on taxable income and the legislated tax
rates.
a) The marginal tax rate is the percentage of an
additional dollar of income that is paid as tax.
b) The average tax rate is the percentage of total income
paid as tax.
3.The personal income tax is a progressive tax, which
means that the marginal tax rate exceeds the average
tax rate for all levels of income and the average tax
rate increases with income. This arrangement contrasts
with a proportional tax that has the same average tax
rate at all levels of income and a regressive tax,
which has a falling average tax rate as income
increases.
4.Figure 16.7 (page 379) shows the effects of the
personal income tax in the labor market.
a) The tax decreases the supply of labor, raises the
pre-tax wage rate, lowers the after-tax wage rate,
decreases employment, and creates a deadweight
loss.
b) The inefficiency is greater the higher is the
marginal tax rate, other things remaining the same.
5.The political equilibrium delivers a progressive
income tax because this arrangement benefits the
median voter and enables politicians who propose it to
get elected.
a)The median voter model benefits because her/his
income is less than the average income.
b) The progressive tax system favors the median voter
at the expense of the average.
6.The corporate profits tax is a tax on economic profit
and the income from capital.
a) The tax decreases the quantity of capital and
decreases labor productivity.
b) Lower labor productivity decreases the demand for
labor, lowers the equilibrium wage rate, and
decreases the quantity of labor employed.
C. Social Security Taxes
1.Social Security taxes are contributions by employees
and employers to provide social security benefits,
unemployment compensation, and health and disability
benefits.
2.Figure 16.8 (page 381) shows the effects of social
security taxes.
a)If the social security tax is levied on the
employee, it works like the personal income tax. It
decreases the supply of labor, raises the pre-tax
wage rate, lowers the after-tax wage rate,
decreases employment, and creates a deadweight
loss. The burden of the tax is shared by the
employee and the employer in proportions that
depend on the elasticities of demand and supply.
b)If the social security tax is levied on the
employer, it decreases the demand for labor, raises
the pre-tax wage rate, lowers the after-tax wage
rate, decreases employment, and creates a
deadweight loss. The burden of the tax is shared by
the employee and the employer in proportions that
depend on the elasticities of demand and supply in
exactly the same way as when the tax is levied on
the employee.
3.Congress cannot determine who pays a tax.
D. Sales Taxes
1.Sales taxes are taxes levied by state governments on a
wide range of goods and services.
2.Chapter 6 explains the effects of the sales tax, which
is to decrease the quantity of the taxed item and
create a deadweight loss.
3.A sales taxes system taxes a person’s expenditure on
goods and services, but not savings. Savings increase
with income, which means that the average tax rate
decreases with income and a sales tax system is
regressive.
E. Property Taxes
1.Property taxes are collected by state and local
governments and used to provide local public goods—goods
and services consumed by all the people who live in a
particular area such as local parks, museums, and safe
neighborhoods.
2.High property taxes and a large quantity of local
public goods and low property taxes and a small
quantity of local public goods can both exist in
political equilibrium.
F. Excise Taxes
1.An excise tax is a tax on the sale of a specific good
such as gasoline and automobile and truck tires.
2.Figure 16.9 (page 382) shows the effects of an excise
tax on an item with an inelastic demand.
3.Figure 16.10 (page 383) shows the effects of an excise
tax on an item with an elastic demand.
4.An excise tax creates a deadweight loss, which is
larger the more elastic is the demand for the good
being taxed (given the elasticity of supply).
5. In political equilibrium, the goods taxed are those
with a low elasticity of demand.