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Chapter 1
Why Study Public Finance?
Public Finance and Public Policy
Author: Jonathan Gruber
Instructor: Yigang Zhang
Introduction
 Hurricane Katrina in 2005 and raised questions
regarding the role of government.
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1200 lives lost, $80 billion in damage
Coordination between levels of government during
the disaster
Should New Orleans be rebuilt, and who should pay
for it?
Introduction
 In September 2008, an unprecedented financial
crisis in lending led to the creation of the Troubled
Asset Relief Fund (TARP), which allowed the U.S.
Treasury to buy up to $700 billion in troubled assets.

Should the government “bail out” private
companies?
Introduction
 On a more local level, some Kentucky lawmakers
have proposed that chain restaurants provide calorie
information on their menus and menu boards.
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Lawmakers state that the bill’s purpose is to help
consumers make healthier eating choices.
“Studies show time and again that people use this
information to make smarter, healthier choices,”
Rep. Kelly Flood, Lexington.
Introduction
 The issues brought up with Hurricane Katrina and
TARP are typical in public finance.
 What is the proper role of the government in the
economy?
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Expenditure side: What services should the
government provide?
Taxation side: How should the government raise its
money?
4 Questions
 When should the government intervene?
 How might the government intervene?
 What is the effect of those interventions?
 Why do governments choose to intervene in the
way that they do?
When?
 Private markets usually provide “efficient”
outcomes for the economy.
 Government intervention can be justified when
there are:
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Market failures
Redistribution concerns
When ?
 In a typical market, the efficient outcome is where
the supply and demand curves intersect.
 Using the health insurance market as an example in
this lesson, some people value health insurance at
less than the price they would have to pay, and
choose to be uninsured.
When?
Market failures
 In 2004, 45.5 million uninsured individuals in US.
 Lack of insurance could cause negative
externalities from contagious diseases.
 One example is the measles epidemic from 1989-
1991.
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Government subsidized vaccines for low-income
families, and the incidence of measles fell from
16,000/year to 300/year.
 Govt. response to 2009 swine flu outbreak –
distribute vaccine for free and ration its distribution.
When?
Redistribution
 Both the size of the “economic pie” & each
person’s slice of that pie matter.

We may value an additional $1 of consumption by
the poor person more highly than by the rich.
 Redistribution is the shifting of resources from
one group to another.
When?
Redistribution
 75% of uninsured have incomes below the median.

May want to redistribute from rich (with health
insurance) to poor (without health insurance)
 Redistribution results in inefficiency.

Redistribution can change a person’s behavior.
Taxing the rich & giving the money to the poor
could cause both groups to work less hard.
How?
 Options for government intervention:
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Change Prices
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Individual or Employer Mandate
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“Pay-or-play” mandates force individuals or firms to provide
health insurance. Massachusetts recently passed one. It’s a
centerpiece of the current U.S. House/U.S. Senate bills.
Public Provision
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Tax credits lower the price of health insurance.
The Medicare program for U.S. senior citizens.
Public Financing of Private Provision
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Private companies administer the drug insurance for
Medicare.
What Are the Effects?
 Empirical public finance assesses “direct” and
“indirect” effects of government actions.
 Direct effects

Assumes “no behavioral responses” and examines
the intended consequences of policy.
 Indirect effects

People change their behavior when policy is passed.
This is sometimes called the “law of unintended
consequences.”
What Are the Effects?
Expanding health insurance
 What happens if we simply give $2000 of health insurance to the
uninsured?
 Direct effect
 45.5 million people covered for $91 billion. This would be the
intent of the law.
 Indirect effects
 “Crowd-out” of private health insurance for free government
health insurance.
 200 million Americans had private insurance in 2004.
 If 45% dropped private insurance, this would triple the cost.
 If 10% dropped insurance, the costs would $131 billion.
 Key question: How many of these people would respond?
Why?
 Governments do not simply behave as benign
actors who intervene only because of market failure
and redistribution.
 Political economy: How governments make public
policy decisions.
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Government failures lead to inappropriate government
intervention.
Why?
 Variation in health care delivery suggests efficiency
and redistribution are not the only issues.
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U.S.: Private health insurance
Canada: National public health insurance
Germany: Mandates private health coverage
U.K.: Free national health care
Timeliness
 Public finance topics are at the heart of public policy
debates.
 Liberal and conservative viewpoints differ.
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Social Security: Privatize or raise payroll taxes?
Health care: Socialized medicine or tax subsidies?
Education: Higher teacher pay or vouchers?