Ch 1 Gruber

When Barack Obama was inaugurated as the 44th President of theUnited States on January 20, 2009, he faced an economic crisisthat was the worst that the United States had seen in at least a

quarter century. The unemployment rate, which had been at 4.8% less thanone year earlier, had risen to 7.6%—over 3.6 million jobs were estimated tohave been lost since the start of the recession in December 2007. The DowJones stock market index had fallen 34.27% since January 22, 2008, and78.19% from its peak on October 9, 2007. As President Obama said in a meet-ing with nine Democratic and Republican leaders at the White House threedays after taking office, “We are experiencing an unprecedented economic crisisthat has to be dealt with and dealt with rapidly.”1

Leaders from both parties agreed on the importance of taking action todeal with the faltering economy, and they looked to pass a stimulus package ofsome sort. Senate Minority Leader Mitch McConnell called the potentialstimulus package “a critical piece of legislation”2 and Senator Majority LeaderHarry Reid warned that if Congress failed to pass a stimulus package, “ourentire country will suffer and the world will suffer.”3

Unfortunately, this consensus ended once the debate began over how tostimulate the economy. Democratic proposals for a stimulus package centeredaround increased spending, primarily for expanded health benefits for low-income families and the uninsured, increased aid to state and local governments,and increased educational spending. A second part of the stimulus (about one-third of the total) would come from tax cuts, primarily for middle- and lower-class taxpayers. As the Democratic Speaker of the House, Nancy Pelosi, said,“[President Obama] said he wanted action, bold and swift, and that is exactlywhat we’re doing today.”4

Republicans disagreed. Rep. Eric Cantor of Virginia, the second-rankingHouse Republican, called the stimulus bill “. . . a spending bill beyond anyone’s

Why Study Public Finance?

1

1

1.1 The Four Questions ofPublic Finance

1.2 Why Study PublicFinance? Facts on Governmentin the United States andAround the World

1.3 Why Study PublicFinance Now? Policy Debatesover Social Security, HealthCare, and Education

1.4 Conclusion

1 http://www.msnbc.msn.com/id/28811470.2 http://www.foxbusiness.com/story/markets/republicans-want-stimulus-plan/.3 http://abcnews.go.com/Politics/Story?id=6820336&page=3.4 http://www.nytimes.com/2009/01/29/us/politics/29obama.html?scp=3&sq=gop&st=cse.

imagination.”5 Republicans argued that the focus in any such bill should beon reducing tax burdens. They proposed lowering the lowest two income taxbrackets, introducing a tax credit for small businesses, cutting the corporatetax rate to 25 percent from 35 percent, and removing the taxation of unem-ployment benefits. The Republican alternative met with strong opposition aswell. As the New York Times editorialized, “Every dollar spent on a politicallyexpedient tax cut is money that is not spent where it could do more good. Italso perpetuates the corrosive debate in which taxes are portrayed as basicallyevil and tax cuts as unmitigated good. That is not a debate that Mr. Obamashould engage.”6

Given the strong Democratic majority in both houses of Congress and thenewly elected Democratic President, it is not surprising that the final stimulusbill corresponded more closely to the Democratic plans. The final bill had atotal price tag of $787.2 billion. Of that total, 63.4% was devoted to newspending initiatives, including $26 billion to local school districts, $54 billionin state fiscal relief, $24.7 billion to subsidize the purchase of health insuranceby unemployed workers, $19 billion for investments in health care technology,almost $40 billion in new subsidies to low-income and unemployed workers,over $30 billion to transform the nation’s energy transmission, distribution, andproduction systems, and over $80 billion to improve the nation’s roads, bridges,trains, and waterways. The remainder was devoted to tax reductions, mostly fromnew tax cuts and tax credits for low- and middle-income families. The final billwas popular, favored by 59% of the public just before its passage, but it still faceda host of critics on its size, including President Obama’s election opponent, Sen.John McCain of Arizona, who said, “We’re laying multitrillion dollars of debt onfuture generations of Americans. I can’t support such a thing.”7

The controversies over the proper role of the government in dealing withthis economic crisis raise the fundamental questions addressed by the branchof economics known as public finance. The goal of public finance is to under-stand the proper role of the government in the economy. On the expenditures side ofpublic finance, we ask: What kind of services should the government provide,if any? Why should the government be spending billions of dollars on aid tolocal schools, health insurance for the unemployed, and new electrical grids?More generally, why is the government the primary provider of goods andservices such as highways, education, and transfers to the unemployed, whilethe provision of goods and services such as clothing, entertainment, and prop-erty insurance is generally left to the private sector? On the revenue side ofpublic finance, we ask: How much should the government tax its citizens, andhow should that amount be related to the economic circumstances of thoseindividuals? What kinds of activities should be taxed or be given tax relief indifficult times? What effect do taxes have on the functioning of the economy?

2 P A R T I ■ I N T R O D U C T I O N A N D B A C K G R O U N D

5 http://www.nytimes.com/2009/01/29/us/politics/29obama.html?scp=3&sq=gop&st=cse.6 http://www.nytimes.com/2009/01/11/opinion/11sun1.html?_r=1.7 http://www.cnn.com/2009/POLITICS/02/09/stimulus.plan/index.html.

1.1The Four Questions of Public Finance

In the simplest terms, public finance is the study of the role of the govern-ment in the economy. This is a very broad definition. This study involves

answering the four questions of public finance:� When should the government intervene in the economy?� How might the government intervene?� What is the effect of those interventions on economic outcomes?� Why do governments choose to intervene in the way that they do?

In this section, we explore these four questions within the context of a spe-cific example: the market for health insurance, in which individuals pay a monthlypremium to insurance companies, in return for which insurance companiespay the individuals’ medical bills if they are ill. This is only one of many marketsin which the government is involved, but it is a particularly useful example,since health care spending is the single largest and fastest growing part of theU.S. government’s budget.

When Should the Government Intervene in the Economy?To understand the reason for government intervention, think of the economyas a series of trades between producers (firms) and consumers. A trade is efficientif it makes at least one party better off without making the other party worseoff. The total efficiency of the economy is maximized when as many efficienttrades as possible are made.

The fundamental lesson of basic microeconomics is that in most cases thecompetitive market equilibrium is the most efficient outcome for society—that is, it is theoutcome that maximizes the gains from efficient trades. As discussed in muchmore detail in Chapter 2, the free adjustment of prices guarantees that, incompetitive market equilibrium, supply equals demand. When supply equalsdemand, all trades that are valued by both producers and consumers are beingmade. Any good that consumers value above its cost of production will beproduced and consumed; goods that consumers value at less than their cost ofproduction will not be produced or consumed.

If the competitive market equilibrium is the most efficient outcome for soci-ety, why do governments intervene in the operation of some of these markets?There are two reasons why governments may want to intervene in marketeconomies: market failures and redistribution.

Market Failures The first motivation for government involvement in theeconomy is the existence of market failures, problems that cause a marketeconomy to deliver an outcome that does not maximize efficiency. Through-out this book, and in particular in Chapters 5–17, we discuss a host of marketfailures that impede the operation of the market forces you learned about in

C H A P T E R 1 ■ W H Y S T U D Y P U B L I C F I N A N C E ? 3

public finance The study ofthe role of the government inthe economy.

four questions of publicfinance When should thegovernment intervene in theeconomy? How might thegovernment intervene? What isthe effect of those interventionson economic outcomes? Why dogovernments choose to inter-vene in the way that they do?

market failure Problem thatcauses the market economy todeliver an outcome that doesnot maximize efficiency.

basic microeconomics. Here we briefly explore a failure in the health insur-ance market that may cause its equilibrium outcome to be inefficient.

At first glance, the market for health insurance seems to be a standard text-book competitive market. Health insurance is supplied by a large number ofinsurance companies and demanded by a large number of households. In themarket equilibrium where supply equals demand, social efficiency should bemaximized: anyone who values health insurance above its cost of productionis able to buy insurance.

In 2007, there were 45 million persons without health insurance in theUnited States, or 17.2% of the non -elderly population (as we’ll discuss inChapter 15, the elderly are provided universal health coverage in the UnitedStates under the Medicare program).8 The existence of such a large numberof uninsured does not, however, imply that the market doesn’t work. After all,there are many more Americans who don’t have a large -screen TV, or a newcar, or a home of their own. That a small minority of the population is unin-sured does not by itself prove that there is a problem in the market; it justimplies that those without insurance don’t value it enough to buy it at exist-ing prices.

Is this equilibrium outcome, which leaves 45 million people withouthealth insurance, the most efficient outcome for society? It may not be, as thefollowing example shows. Suppose that I am uninsured, and as a result do notget my yearly vaccination for influenza. By not getting my flu shot, I increasemy risk of getting the flu, and increase the risk of passing it on to all ofthe students who come into contact with me and have not had flu shots. Ifthese students become ill, their medical costs will rise and their performancein class will worsen. Thus, the total or social value of health insurance is notjust the improvement it causes in my health, but also the improvement itcauses in my students’ health, which lowers their medical costs and improvesclass performance. Thus, I should have insurance if the total social value, bothto myself and to others with whom I have contact, exceeds the cost of thatinsurance.

When I make my insurance decision, however, I don’t consider that totalsocial value, only the value to myself. Suppose that I value the insurance at lessthan its cost because I don’t mind getting the flu, but that society values theinsurance at more than its cost because it is very costly for my students to goto the doctor and to perform poorly in class if they get sick. In this situation, Iwon’t buy insurance, even though society (which includes me and my students)would be better off if I did. In this case, the competitive outcome has notmaximized total social efficiency.

This is an example of a negative externality, whereby my decision imposes onothers costs that I don’t bear. As a result of this negative externality, I am under-insuring myself from society’s perspective because I don’t take into accountthe full costs that my medical decisions impose on others. We will discuss


8 Employee Benefit Research Institute (2005).

externalities in much more detail in Chapters 5 and 6, but this example illus-trates the type of market failure that can cause the competitive equilibrium todeliver a socially inefficient outcome. Later chapters in the book discuss othertypes of market failure as well.

If the competitive equilibrium does not lead to the efficiency -maximizingoutcome, there is the potential for efficiency improvement through govern-ment intervention. Since the government can take into account not only mycosts and benefits but also the costs and benefits to others as well, the govern-ment can more accurately compare the social costs to the social benefits, andinduce me to buy insurance if the total benefits exceed the total costs. As weemphasize in answering the fourth question, however, the fact that the privatemarket outcome is not efficiency maximizing does not imply that govern-ment intervention will necessarily improve efficiency.

�

The Measles Epidemic of 1989–19919

One of the illnesses for which all children are supposed to be immunized ismeasles. Measles is transmitted from person to person by respiratory dropletsand is characterized by a high fever and severe rash that lasts five to six days. Inthe early 1960s, there were thought to be 3 to 4 million cases annually in theUnited States, resulting in 500 reported deaths each year. Other costs associat-ed with measles infection included medical expenditures and work time lostfor parents in caring for sick children.

Then, in 1963, a measles vaccine was introduced. Measles vaccinationgreatly reduces, but does not eliminate, the chance of contracting measles, andthe vaccine can wear off over time if you don’t get periodic “booster” shots toreactivate the immunity. As a result of the vaccine, measles cases had becomerelatively rare in the United States by the 1980s, with fewer than 3,000 casesreported per year and very few deaths. Over the period from 1989 to 1991,however, there was a huge resurgence in measles in the United States, with over50,000 cases and 123 deaths from a disease thought to be largely eradicated.What happened?

In retrospect, it is clear that this outbreak resulted from very low immuniza-tion rates among disadvantaged inner -city youths. One -third of all of the newcases were in Los Angeles, Chicago, and Houston, and one -half of those chil-dren who contracted measles had not been immunized, even though manyhad regular contact with a physician. These unimmunized children wereimposing a negative externality on other children who had received theirimmunizations but for whom immunization may have worn off. There was anegative externality because the unimmunized children raised the risk thatthese other children would become sick, without bearing any of the costs ofraising this risk.

APPLICATION


9 Wood and Brunell (1995).

The federal government responded to this health crisis in the early 1990s,first through publicly encouraging parents to get their children immunized,and then through an initiative that paid for the vaccines for low -income fam-ilies. The result was impressive. Immunization rates, which had never beenabove 70% before the epidemic, rose to 90% by 1995. And, by 1995, therewere only about 300 confirmed cases of measles. Government interventionclearly reduced this negative externality. �

Redistribution The second reason for government intervention is redistri-bution, the shifting of resources from some groups in society to others. Thinkof the economy as a pie, the size of which is determined by the social efficiencyof the economy. If there are no market failures, then the private market forces ofdemand and supply maximize the size of the pie; if there are market failures,there is the potential for the government to increase the size of the pie.

The government may care not only about the size of the pie, however, butalso its distribution, or the size of each person’s slice. For reasons we discuss inChapter 2, society may decide that the resource allocations provided by themarket economy are unfair; for example, society may view another dollar ofconsumption by a very rich person as less valuable than another dollar of con-sumption by a very poor person. The primary way to correct such misalloca-tions is through government interventions that redistribute resources from thosegroups that society has deemed “too well off ” to those groups that society hasdeemed “not well off enough.” For example, in the United States in 2007, 70%of the uninsured are in families with incomes below $50,000. Thus, society mayfeel that it is appropriate to redistribute from those with insurance, who tend tohave higher incomes, to those without, who tend to have lower incomes.

In some cases, society can undertake redistributions that change only thedistribution of the pieces and not the size of the pie itself. Usually, however,redistributing resources from one group to another will entail efficiency losses.These losses occur because the act of redistribution causes individuals to shifttheir behavior away from the efficiency -maximizing point. For example, ifwe tax the rich to distribute money to the poor, then this tax may cause therich to work less hard (since they don’t get to take home as much money fromtheir work) and the poor to work less hard (since they don’t have to work ashard to maintain their living standards). When these groups work less hard,they don’t produce goods that would be valued by consumers at more thanthey cost to produce, so social efficiency is reduced.

In general, then, there will be a trade -off between the size of the pie andthe distribution of the pie, which we call an equity–efficiency trade -off. Societiestypically have to choose between pies that are larger and more unequally dis-tributed and pies that are smaller and more equally distributed.

How Might the Government Intervene?Having decided whether to intervene, the next question is how the govern-ment should do so. There are several different general approaches that the gov-ernment can take to intervention.


redistribution The shifting ofresources from some groups insociety to others.

Tax or Subsidize Private Sale or Purchase One way that the governmentcan try to address failures in the private market is to use the price mechanism,whereby government policy is used to change the price of a good in one oftwo ways:

1. Through taxes, which raise the price for private sales or purchases of goodsthat are overproduced, or

2. Through subsidies, which lower the price for private sales or purchases ofgoods that are underproduced.

Returning to the example of health insurance, one policy option that iscurrently popular in the United States is for the government to subsidize thepurchase of private health insurance to reduce the number of uninsured. Forexample, the Bush administration has repeatedly proposed that individualsreceive a credit against their taxes for expenditures on health insurance.

Restrict or Mandate Private Sale or Purchase Alternatively, the govern-ment can directly restrict private sale or purchase of goods that are overpro-duced, or mandate private purchase of goods that are underproduced andforce individuals to buy that good. Current debates over health reforms pro-posed by President Obama and Democratic Legislators have focused on arequirement that individuals purchase health insurance or face a tax penalty.Many other nations, such as Germany, mandate that almost all citizens havehealth insurance coverage.

Public Provision Another alternative is to have the government provide thegood directly, in order to potentially attain the level of consumption that max-imizes social welfare. In the United States, more than one -quarter of the pop-ulation has insurance that is provided to it directly by the government; Canadaand many other developed nations have publicly provided health insurance fortheir entire populations.

Public Financing of Private Provision Finally, governments may want toinfluence the level of consumption but may not want to directly involvethemselves in the provision of a good. In such cases, the government canfinance private entities to provide the desired level of provision. For example,the 2003 legislation to add a prescription drug benefit to the U.S. Medicareinsurance program for the disabled and elderly involves federal governmentreimbursement of private insurers to provide prescription drug insurance.

As you can see, there is a wide spectrum of policy options. When consider-ing how to intervene, policy makers should carefully evaluate alternativeoptions before deciding which option is best. This evaluation leads naturallyto the third question: How can we evaluate alternative policy options?

What Are the Effects of Alternative Interventions?Answering this third question requires that policy makers understand theimplications of each policy option under consideration. This evaluation is thefocus of empirical public finance, which involves gathering data and developing


statistical models to assess how people and firms might respond to policy inter-ventions. We discuss empirical public finance in much more detail in Chapter 3.

In assessing the effects of government interventions, policy makers mustkeep in mind that any policy has direct and indirect effects.

Direct Effects The direct effects of government interventions are those effectsthat would be predicted if individuals did not change their behavior in responseto the interventions. For example, suppose that the government wants to try toaddress the problem of the uninsured by providing free public health care, as isdone in the United Kingdom. The government computes that, with 45 millionuninsured, and an average cost of treating each uninsured person of $2,000 peryear, this intervention would cost $90 billion per year. This is a huge amount,but it is much smaller than existing spending on health care by the U.S. govern-ment ($550 billion). According to this calculation, we could cover all of theuninsured for less than 4% of the federal budget.10

Indirect Effects The indirect effects of government intervention are effectsthat arise only because individuals change their behavior in response to theinterventions. For example, being uninsured is something that people canchange about themselves; it is not a fixed personal characteristic such as beingmale or African American. By providing free health care to those who areuninsured, the government provides strong incentives for those paying for theirown health insurance to drop that insurance and take part in the government’sfree health care program.

Suppose that half of the non -elderly who are privately insured behaved thisway.This would add another 95 million persons to the pool using this publicsource of care. If each person in this group also costs $2,000 on average, thegovernment cost of the program would more than triple, to $280 billion peryear! On the other hand, if only 10% of the privately insured behaved this way,the government cost of the program would rise to only $128 billion per year.

The key question for evaluating free public health care for the uninsured istherefore: How many privately insured will drop their privately purchasedcoverage to join a free public option? This is an empirical question. The publicfinance economist needs some means of drawing on data to make the bestestimate of the extent of such movement. Throughout this book, we discuss avariety of ways that empirical public finance economists make such estimates,and how economists use these to inform their understanding of the effects ofalternative government interventions.

�

The Congressional Budget Office: Government ScorekeepersEmpirical economics is not just the plaything of academics. The methods andresults derived from empirical economics are central to the development of

APPLICATION


10 Office of Management and Budget (2006a), Table 3.1.

direct effects The effects ofgovernment interventions thatwould be predicted if individualsdid not change their behavior inresponse to the interventions.

indirect effects The effects ofgovernment interventions thatarise only because individualschange their behavior inresponse to the interventions.

public policy at all levels of gov ernment. A particularlygood example of the power of empirical economics isprovided by the Congressional Budget Office (CBO).

The CBO was created in 1975 with a mission toprovide Congress with the objective, timely, nonparti-san analyses needed for economic and budget deci-sions.11 The CBO increasingly plays a critical role as a“scorekeeper” for government policy debates. Legisla-tive spending proposals that are to become law mustfirst have their costs estimated by the analysts at theCBO. Given budgetary pressures on the federal gov-ernment, policy makers have increasingly referredtheir legislation to the CBO earlier and earlier in thedevelopment process. If they know what “score” theirspending proposal will receive (i.e., how much theCBO says it will cost), they can tailor the proposal tofit within a given budget target.

It is not an overstatement to say that the economistswho work at the CBO frequently hold the fate of alegislative proposal in their hands. Indeed, the largeprice tag that the CBO assigned to the Clintonadministration’s plan to reform health care in the United States in 1994 isoften cited as a key factor in the defeat of that proposal.12 The CBO appearsto be playing an equally influential role in the debate over health care reformin the current Congress, as discussed in Cohn (2009), who calls the CBO the“tiny agency . . . that helped kill health reform in 1994 and has the power todo so again.” The methods we study in Chapter 3 and many of the results thatwe learn about throughout this book are central to the internal deliberationsof the analysts at the CBO. �

Why Do Governments Do What They Do?Finally, as students of public policy, we must recognize that we cannot simplymodel governments as benign actors who intervene only to mitigate marketfailures or assure the proper distribution of social resources. In practice, the gov-ernment faces the difficult problems of aggregating the preferences of millionsof citizens into a coherent set of policy decisions, raising the fourth questionof public finance: Why do governments do what they do? Note the importantdifference between this question and the second (How should governmentsintervene?). The second question was a normative question, one concerned


11 Information on the CBO comes from its Web site: http://www.cbo.gov/aboutcbo/Policies.shtml.12 The Clinton administration had claimed that its health care reform plan would save the nation $60 bil-lion over the 1995–2000 period, but the CBO (1994) reported that in fact it would cost the nation $70 bil-lion over that period.

“We don’t use the Congressional Budget Office. We have our own figures.”

© T

he N

ew Y

orke

r Col

lect

ion

1996

Pet

er S

tein

er fr

om c

arto

onba

nk.c

om. A

ll Ri

ghts

Res

erve

d.

with how things should be done. This is a positive question, one concernedwith why things are the way they are.

To answer this question, we will turn in Chapter 9 to the tools of politicaleconomy, the theory of how governments make public policy decisions.Governments face enormous challenges in figuring out what the public wantsand how to choose policies that match those wants. In addition, governmentsmay be motivated by much more than simply correcting market failures orredistributing income. Just as there are a host of market failures that can inter-fere with the welfare -maximizing outcome from the private market, there area host of government failures that can lead to inappropriate government inter-ventions. Politicians must consider a wide variety of viewpoints and pressures,only two of which are the desire to design policies that maximize economicefficiency and redistribute resources in a socially preferred manner.

One only needs to look at the wide variety of health insurance policies invery similar countries to see that governments may have more in mind thansimply efficiency or redistribution. Why does the United States rely primarilyon private health insurance, while Canada, a similar country bordering theUnited States, relies on national public health insurance? Why does Germanymandate private health insurance coverage, while the United Kingdom pro-vides free national health care? Coming back to the first question (Whenshould the government intervene?), then, we have an additional concern thatmust be addressed before recommending government intervention: In prac-tice, will the government actually reduce or solve the problem? Or will gov-ernment failures cause the problem to grow worse?

1.2Why Study Public Finance? Facts on Governmentin the United States and Around the World

Thus far, we have clarified what public finance is. But it still may not beclear why you should spend your precious time on this topic. What makes

public finance so compelling is the dominant role that governments play inour everyday lives. In this section, we detail that role by walking you throughthe key facts about government in the United States and other developednations. In addition, to motivate the study of public finance, we propose someinteresting questions that arise from these facts.

The Size and Growth of GovernmentFigure 1-1 shows the growth in federal government spending in the UnitedStates over the twentieth century. In 1930, the federal government’s activityaccounted for less than 3% of GDP. Since the 1970s, federal governmentspending has amounted to about 20% of the total size of the U.S. economy.

This growth is mirrored in other developed nations, as seen in Figure 1-2.Thisfigure shows the growth of government spending since 1960 in the UnitedStates, Sweden, Greece, and the average for the industrialized nations that are


political economy The theoryof how the political processproduces decisions that affectindividuals and the economy.


Federal Government Spending as a Percent of GDP, 1930–2008 • From 1930 to2008, federal government spending as a share of GDP has grown from less than 3% to21%. The huge spike in spending over the 1941–1945 period was due to the massiveincrease in defense expenditures during World War II.

Source: Office of Management and Budget (2008a), Table 1.2.

50%

40

30

20

10

% ofGDP

2000 2005 20101995199019851980197519701965196019551950194519401930 1935

■ FIGURE 1-1

Total Government Spending Across Developed Nations, 1960–2008 • Governmentspending as a share of GDP has grown throughout the developed world, but the pace of growthhas varied. The United States has seen a modest growth in its government share over this period,while government spending in Greece has more than tripled as a share of the economy.

Source: Organization for Economic Cooperation and Development (2008b). Annex Table 30.

■ FIGURE 1-2

2010

10

20

30

40

50

60

70%

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

% ofGDP

Sweden OECD average

United States

Greece

part of the Organization for Economic Cooperation and Development (OECD).The patterns are quite interesting. In 1960, the United States was squarely inline with the average of the OECD in terms of the government share.13 Yet,while the government share grew on average in the OECD by 50%, it grewby only 20% in the United States. Greece started with a government sharewell below that of the United States in 1960, but government tripled as ashare of Greece’s GDP, so that today its share is much larger than the U.S. gov-ernment’s share. In 1960, Sweden’s government’s share of GDP was similar toother nations’, but this share grew enormously, so that by the early 1990s gov-ernment spending was about two -thirds of Sweden’s GDP. Since then Swe-den’s government’s share has fallen rapidly and now accounts for slightly morethan half of GDP, similar to Greece.

� What explains the growth in government spending over the twentiethcentury?

DecentralizationA key feature of governments is the degree of centralization across local andnational government units—that is, the extent to which spending is concen-trated at higher (federal) levels or lower (state and local) levels. Figure 1-3shows government spending in the United States divided into the share of

spending by the federal government and the share of spendingby other levels of government: state, county, and local govern-ments. The federal government provides the majority of gov-ernment spending in the United States, but other governmentspending is quite large as well, amounting to roughly one -thirdof total government spending, and over 10% of GDP. The levelof centralization (the share of spending done by the federal gov-ernment) varies widely across nations, sometimes rising toalmost 100% in countries where the federal government doesalmost all of the government spending.

� What is the appropriate extent of centralization anddecentralization in government activity?

Spending, Taxes, Deficits, and DebtsWhen you run a household, you live on a budget. Outflows ofcash for groceries, rent, clothing, entertainment, and other usesmust be financed by inflows of cash from work or othersources. Any excess of income over spending is a cash flow sur-plus that can be saved to finance your own spending in futureperiods or, by way of an inheritance (also referred to as abequest), your children’s spending after you pass on. Any shortfallof income below spending is a cash flow deficit, and must be


13 Note that the size of government as a share of GDP is larger in Figure 1-2 than in Figure 1-1; this isbecause Figure 1-2 includes all levels of government, while Figure 1-1 is for federal government only.

■ FIGURE 1-3

Federal: 63.5% of totalgovernment spending

(21% of GDP)

State/local: 36.5%of total governmentspending (12.1%

of GDP)

Federal vs. State/Local GovernmentSpending, 2008 • State and localspending today amounts to roughly one -third of total government spending in theUnited States, at over 12% of GDP.

Source: Office of Management and Budget (2008b), Table 15.3.

financed by past savings or by borrowing from others. Any borrowing resultsin the buildup of some household debt, which must ultimately be repaid fromfuture inflows of cash.

Fundamentally, the finances of the government are no different. Its outflowsare government spending and its inflows are tax revenues. If revenues exceedspending, then there is a budget surplus; if revenues fall short of spending,there is a budget deficit. Each dollar of government deficit adds to the stock ofgovernment debt. That is, the deficit measures the year -to-year shortfall of rev-enues relative to spending; the debt measures the accumulation of past deficitsover time. This government debt must be financed by borrowing from eithercitizens of one’s own local or national area, or by borrowing from citizens ofother areas or other nations.

The three panels of Figure 1-4 (page 14) show government spending andrevenues, the deficit or surplus, and the level of government debt for the U.S.federal government. As shown in panels (a) and (b), with the exception of anenormous increase in spending unmatched by increased taxation duringWorld War II (1941–1945), the federal government’s budget was close to bal-anced until the late 1960s. From the mid -1970s through the mid -1990s, therewas a relatively large deficit that rose to about 5% of GDP. This deficit shrankdramatically in the 1990s, and actually turned into a sizeable surplus by the endof the decade. But the United States was back in deficit by the early twenty -first century, at levels similar to those in the 1970s.

The resulting implications for the federal debt are shown in panel (c) ofFigure 1-4. The stock of debt rose sharply in World War II, then fell steadilyuntil large deficits caused it to rise in the 1980s. The debt has risen consider-ably since, with a brief pause in the mid- to late 1990s, and now is roughly40% of GDP. Figure 1-5 (page 15) compares the level of U.S. debt to the levelof debt of other developed nations. The United States is roughly in the middleof the pack, with some nations having paid off their debts and gone into sur-plus, and others having a debt load that is twice as high as a share of GDP.

� What are the costs of having larger deficits and a larger national debt?

Figure 1-6 (page 15) shows the spending and revenues of state and localgovernments over time in the United States. Interestingly, unlike the federalgovernment, state and local governments’ budgets are almost always in eithersurplus or balance; there is very little deficit overall across the state and localgovernments in any year.

� Why are state and local governments able to balance their budgetswhile the federal government is not?

Distribution of SpendingThus far we have discussed only the sum total of government spending in theUnited States, and not on what these funds are spent. Figure 1-7 (page 16) showsthe distribution of spending across several broad categories for the federal gov-ernment and state and local governments in 1960 and 2004. Several conclusionsare apparent. First, the composition of federal government spending (panel (a))



Federal Revenues and Expenditures, Surplus or Deficit, and Debt, 1930–2008 • For most of thetwentieth century, except for the World War II period, federal government tax receipts have kept pacewith expenditures. But expenditures have exceeded receipts by several percentage points of GDP onaverage since the 1970s. The resulting federal government debt is now at about 40% of GDP.

Source: Office of Management and Budget (2008), Tables 1.2 and 7.1. (Debt figures for 1930–1939 come from the U.S. Department of the Treasury’s Bureau of thePublic Debt.)

■ FIGURE 1-4Revenue and

spending(% of GDP)

2000 2005 20101995199019851980197519701965196019551950194519401930 1935

(a)

Revenue

Spending

50%

40

30

20

10

0

5%

–5

–10

–15

–20

–25

–302000 20051995199019851980197519701965196019551950194519401930 1935 2010

Surplus/Deficit

(b)Surplus/Deficit

(% of GDP)

Debt(% of GDP)

Debt

(c)

20

40

60

80

100

120%

1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010


Debt Levels of OECDNations in 2008 • The UnitedStates has a debt level that istypical of developed nations,although there is wide variation.

Source: Organization for Economic Cooperationand Development (2008), Annex Table 31.

% ofGDP

Swed

en

New Ze

aland

Austr

alia

Denmark

Spain

Icelan

d

Canad

a

Unite

d King

dom

Franc

e

Austr

ia

Unite

d Stat

es

Netherl

ands

German

y

Belgi

umJa

pan

Italy

OECD Av

erage

–20

0

20

40

60

80

100%

■ FIGURE 1-5

State and Local Government Receipts, Expenditures, and Surplus, 1947–2008 • Stateand local revenues almost always exceed expenditures, although surpluses have been close tozero in recent years.

Source: Office of Management and Budget (2008). Tables 15.1 and 15.3.

% ofGDP

2003 2007199919951991198719831979197519711967196319591955

14%

1947 1951

12

10

8

6

4

2

0

Surplus/Deficit

Spending

Revenue

–2

■ FIGURE 1-6

has changed dramatically over time. In 1960, nearly half of federal governmentspending was on national defense, military expenditures either at home orabroad. Defense is a classic example of what economists call public goods,goods for which the investment of any one individual benefits a larger groupof individuals: if I purchased a missile to protect Boston, that would benefitnot just me but all of the residents of the city. As we will discuss at length in


The Distribution of Federal and State Expenditures, 1960 and 2007 • This figure shows thechanging composition of federal and state spending over time, as a share of total spending. (a) For thefederal government, defense spending has fallen and Social Security and health spending have risen. (b) For the states, the distribution has been more constant, with a small decline in education and welfare spending and a rise in health spending.

Source: Bureau of Economic Analysis, NIPA Table 3.16.

1960

(a) Federal spending (% of total spending)

(b) State/local spending (% of total spending)

1960

National defense(49.5%)

Education, welfare,housing (3.9%)

SocialSecurity(13.4%)

Unemployment,disability

(8.7%)

Health(including Medicare)

(2.9%)Other(12.0%)

Net interest(9.7%)

Public orderand safety

(10.2%)

Education(38.8%)

Health(8.2%)Other

(21.1%)

Transportation(11.7%)

Welfare,social services

(10.0%)

2007

2007

Transportation(5.7%)

Unemployment,disability (6.1%)

Other(19.1%)

Welfare,social

services(6.5%)

Education(35.1%)

Netinterest(10.9%)

Other(8.4%) Health

(includingMedicare)

(24.9%)

Nationaldefense(20.1%)

SocialSecurity(20.3%)

Education, welfare,housing (9.2%)

Health(20.7%)

Public orderand safety

(12.9%)

■ FIGURE 1-7

public goods Goods for whichthe investment of any one indi-vidual benefits everyone in alarger group.

Chapter 7, the private sector may underprovide such public goods: if I bearthe full cost of buying a missile, but it benefits everyone in town, then I prob-ably won’t spend the money on that missile. This makes provision of publicgoods an important job for the government, as reflected in the large share ofgovernment spending in this area.

Today, however, defense spending has fallen to one -fifth of the federal budget.The offsetting spending growth can be found largely in two areas. The first isthe Social Security program, which provides income support to the elderlywho are retired from their jobs. This is the single largest government programin the United States today, consuming about 20% of the entire federal budget.Another large and rapidly growing category is health care programs, a varietyof federal government interventions to provide health insurance for the elderly,the poor, and the disabled; this consumes almost 25% of the budget.

These types of programs are called social insurance programs, programsdesigned to address failures in private insurance markets. As we discussed earlier,private health insurance markets may not provide the appropriate amount ofhealth insurance to the population. This market failure has motivated the gov-ernment to intervene in health insurance markets; indeed, almost one -half ofall health spending in the United States is done by governments. Similarly, thefederal government is concerned that individuals may not plan appropriatelyfor the decline in income they will face when they retire, which motivates theexistence of the Social Security program.

� Are large government interventions in insurance markets warranted,and do they correct or exacerbate market failures?

The distribution of state and local spending (Figure 1-7, panel (b)) is muchdifferent. At the state and local level, education, welfare, and housing account forover 40% of spending. Less than 10% of federal spending supports these pro-grams. Likewise, there is no Social Security program or defense expenditure atthe state or local level.

� What is the appropriate type of spending to be done at the federalversus state or local level?

Distribution of Revenue SourcesFigure 1-8 breaks down the sources of federal and state and local revenue overtime. The major source of revenue for the federal government (panel (a)) is theindividual income tax, a tax levied on the income of U.S. residents. This tax pro-vides somewhat less than half of federal revenues and has remained roughly con-stant as a share of revenues over time. The major shift over time at the federal levelhas been the rapid shrinking of corporate tax revenues, the funds raised by taxingthe incomes of businesses in the United States. While corporate tax revenuesonce provided almost 25% of federal government revenue, they now provide lessthan 14%. There has also been a sizeable reduction in excise taxes, taxes levied onthe consumption of certain goods such as tobacco, alcohol, or gasoline.

The decrease in revenue from these taxes has been largely replaced by thegrowth of revenue from payroll taxes, the taxes on worker earnings that fundsocial insurance programs. Payroll taxes differ from the income tax in that the


social insurance programsGovernment provision of insur-ance against adverse events toaddress failures in the privateinsurance market.

income tax includes all sources of income, such as the return on savings, whilepayroll taxes apply solely to earnings from work. Payroll taxes have grownfrom a sixth of federal revenues to well over a third.

� What are the implications of moving from taxing businesses and con-sumption to taxing workers’ earnings?

At the state and local level (Figure 1-8, panel (b)), revenue sources areroughly equally divided between sales taxes (including state and local excise


The Distribution of Federal and State Revenues, 1960 and 2008 • This figure shows thechanging composition of federal and state revenue sources over time, as a share of total rev-enues. (a) At the federal level, there has been a large reduction in corporate and excise tax rev-enues and a rise in payroll tax revenues. (b) For the states, there has been a decline in propertytaxes and a rise in income taxes and federal grants.

Source: Bureau of Economic Analysis, NIPA Tables 3.2 and 3.3.

Excise tax(2.6%)

Other(2.9%)

1960

(a) Federal revenues (% of total revenue)

2008

(b) State/local revenues (% of total revenue)

1960 2008

Income tax(44.5%)

Payroll tax(17.0% )

Corporate tax(22.8%)

Excise tax(12.8%)

Income tax(5.9%)

Sales tax(28.8%)

Federal grants(9.4%)

Property tax(38.2%)

Other(17.7%)

Income tax(15.8%)

Sales tax(22.5%)

Federal grants(20.1%)

Property tax(20.9%)

Other(20.7%)

Other(4.5%)

Corporate tax(11.3%)

Income tax(43.7%)

Payroll tax(37.8%)

■ FIGURE 1-8

taxes on products such as cigarettes and gasoline), federal grants -in-aid (redistri-bution of funds from the federal government to lower levels of government),income taxes, and property taxes (taxes on the value of individual properties,mostly homes). Over the past 40 years, the substantial drop in revenue fromproperty taxes has been made up by rising federal grants and income taxes.

� What are the implications of shifting from taxation of property to taxa-tion of income?

Regulatory Role of the GovernmentThe discussion throughout this section has focused on the government as anentity that exerts influence through its powers of taxation and spending.Another critical role the government plays in all nations is that of regulatingeconomic and social activities. Consider some examples of how daily existence isaffected by the government in the United States:14

� The foods you eat and the medications you take have all beenapproved by the Food and Drug Administration (FDA), an agency thatspends less than 0.1% of the government’s budget each year, but whoseregulatory powers cover $1.5 trillion worth of goods annually, 20%of total consumer expenditures. The FDA regulates the labeling andsafety of nearly all food products and bottled water, tests cosmetics toensure their safety, and approves drugs and medical devices to be soldto the public.

� If you’ve lost a limb or developed carpal tunnel syndrome becauseof your work, you might want to contact the Occupational Safetyand Health Administration (OSHA), which is charged with regulat-ing the workplace safety of the 135 million Americans employed at8.9 million job sites. In 2008, the agency sent its 1,100 inspectors on39,000 visits to workplaces, which resulted in reports of over 87,000workplace violations for which firms paid over $100 million inpenalties.

� The radio stations in your car and the channels you watch on cable areregulated by the Federal Communications Commission (FCC), whichregulates interstate and international communications by radio, televi-sion, wire, satellite, and cable. Check any device in your home thatemits radiation of communication frequencies (wireless phones, remotecontrols, etc.) and you’ll find an FCC identification number somewhereon it.

� The air you breathe, the tap water you drink, and the land your home is built upon are all regulated by the Environmental Protection Agency(EPA), which is charged with minimizing dangerous pollutants in theair, water, and food supplies.


14 Information on these regulatory agencies can be found at their respective Web sites: http://www.fda.gov,http://www.osha.gov, http://www.fcc.gov, http://www.epa.gov, and http://www.uspto.gov.

1.3Why Study Public Finance Now? Policy Debatesover Social Security, Health Care, and Education

No matter when you take a public finance course, it will be the mosttimely economics course you will take! This is because the questions we

address in this book are the questions that are always in the news and that arethe source of current policy debates. Indeed, three of the major policy issuesfacing the United States today—Social Security, health care, and education—are each the subject of different chapters. In this section, we review the debateover these issues, paraphrasing the “liberal” and “conservative” positions on eachtopic. Once again, our discussion of these issues raises important questions thatwe will address in the chapters on these topics.

Social SecurityAs just noted, Social Security is the single largest government expenditure pro-gram. As we will learn in great detail in Chapter 13, the financing structure ofthis program is basically that today’s young workers pay the retirement benefitsof today’s old. So long as the number of young people remains large relative tothe number of older persons, this system works. As the giant group of babyboomers (the roughly 75 million people born between 1946 and 1964) movesinto old age, however, the system is running into trouble: the ratio of working -age taxpayers to elderly recipients was almost 8 to 1 in 1950, but by 2050 is pro-jected to be less than 3 to 1.15 Indeed, our Social Security system is projected tohave insufficient funds to pay promised retiree benefits in less than 30 years.16

What should we do about this problem? As with many questions we discussthroughout this course, conservatives and liberals provide very different answersto this question. Liberals argue that the Social Security system has worked well,and that we should simply shore it up by raising the necessary resources throughhigher payroll taxation or some other means. As we learn later in this book,however, higher taxes may be costly in terms of reducing the efficiency withwhich the economy operates. Moreover, they are not very politically popular!

Conservatives argue instead that this demographic episode points out thefundamental weakness in our system, which relies on transfers from the youngto the old. They claim that we should replace this system with a system in whichindividuals save for their own retirement. This approach has the problem thatthere are currently a large number of elderly to whom Social Security benefitsare owed, and the government must find some way of financing those payments.

� How large a role should the government play in mandating or regulat-ing an individual’s retirement savings? How can the government bestreform the Social Security system to address its long -range fundingshortfall?


15 U.S. Bureau of the Census (2009). Historical data come from earlier versions of the Statistical Abstract ofthe United States. Working age taxpayers are 18 to 64 years old. 16 Social Security Trustees (2009).

Health CareAs noted earlier, there are currently 45 million Americans without any healthinsurance, about 18% of the non -elderly U.S. population. A large body of evi-dence suggests that their medical treatment and health outcomes are signifi-cantly worse as a result of their being uninsured. Moreover, after almost a decadeof relatively moderate cost growth, the cost of health care is exploding again inthe United States, with premiums for employer-sponsored insurance rising fourtimes as fast as workers’ earnings since 1999.17 Projections suggest that healthcare will consume almost half of our GDP within the next century.

These problems have prompted liberals to suggest major changes in the waythat health insurance is structured in the United States. Foremost among thesesuggestions are major government interventions in health insurance coverageto address the problem of the uninsured, either through mandating and/ormassively subsidizing the purchase of private health insurance, or through pro-viding more health insurance through the public sector. Liberals would relyon government regulations to control costs, for example, by limiting the pricesthat medical providers can charge for their services.

Conservatives, on the other hand, believe these types of interventions aremuch too expensive, and have recommended instead much more limitedinterventions that would bolster the existing private market through tax subsi-dies to purchase insurance. They argue that cost control through governmentprice setting would cause much more damage to the system than would intro-ducing the powers of competition. Competition could keep prices down bypromoting individual choice across health plans and allowing the plans tocompete through lower prices.

� Is this conservative approach sufficient to overcome the failures in healthinsurance markets and substantially increase health insurance coverage?Can either group’s approach put a halt to rapidly escalating medical costs?

EducationThere is an enormous dissatisfaction with our current educational system,highlighted by the dismal performance of U.S. students on international tests.A 2007 study of eighth-grade math and science skills in 48 countries foundthat U.S. students were only the 9th best at math skills and 11th best at sci-ence skills, behind nations such as Hungary, Russia, and Lithuania.18 Whilethis dissatisfaction is widespread, there are once again great differences acrossthe political spectrum on how to address this problem. Liberals generallybelieve that the problem is that we have not put enough resources into oureducational system. They argue that higher pay for teachers and moreresources to schools in disadvantaged areas are required to improve the per-formance in the U.S. system.

Conservatives argue that our system is fundamentally broken and that moreresources will not solve the problem. The problem, they argue, is that the public


17 Kaiser Family Foundation (2009).18 Gonzales et al. (2008).

schools that dominate our primary and secondaryeducational system are local monopolies, with noincentives to improve their performance. What isneeded instead, they argue, is to inject into educationthe same type of competitive forces that have workedso well in other sectors: give students a choice of whatschool to go to, public or private, and provide themwith the resources to effectively make that choice byissuing vouchers for educational expenses that theycan use to attend any school they like.� Can more spending solve the problems of the U.S.

educational system? If not, can competition workin the education market as well as it has in othermarkets? How do we deal with students who are“left behind” by such a system, in areas wherethere are bad schools and insufficient choice?

1.4Conclusion

It is clear from the facts presented here that the government plays a centralrole in the lives of all Americans. It is also clear that there is ongoing dis-

agreement about whether that role should expand, stay the same, or contract.The facts and arguments raised in this chapter provide a backdrop for thinkingabout the set of public finance issues that we explore in the remainder of thisbook.


“Big deal, an A in math. That would be a D in any other country.”

© T

he N

ew Y

orke

r Col

lect

ion

1998

Mik

e Tw

ohy

from

car

toon

bank

.com

. All

Righ

ts R

eser

ved.

■ When deciding how to intervene, the governmentneeds some approach for evaluating the impacts ofalternative interventions on the economy. The toolsof empirical economics provide one such approach.

■ A major question for public finance is: Why do gov-ernments choose to pursue the policies that theydo? We are particularly concerned about govern-ment failure, whereby government intervention canmake problems worse, not better.

■ Government, which consists of both national (fed-eral) and local units (states, counties, cities, andtowns), is large and growing in the United Statesand throughout the world. The nature of government

■ There are four key questions considered in thestudy of public finance. The first is: When should thegovernment intervene in the economy? Our base-line presumption is that the competitive equilibri-um leads to the outcome that maximizes socialefficiency. So government intervention can only bejustified on the grounds of market failure (increas-ing the size of the pie) or redistribution (changingthe allocation of the pie).

■ Having decided whether to intervene, the govern-ment needs to decide how to intervene. There aremany policy options that can be pursued to achievethe same goal, such as public provision, mandates forprivate provision, and subsidies to private provision.

� H I G H L I G H T S

spending and revenue sources is also evolving overtime as governments move away from being providersof traditional public goods (such as defense) to beingproviders of social insurance (such as Social Securityand health insurance).

■ Governments also affect our lives through regulatoryfunctions in a wide variety of arenas.


■ Public finance is central to many of the policydebates that are active in the United States today,such as those over the Social Security program,health care, and education.

� Q U E S T I O N S A N D P R O B L E M S

1. Many states have language in their constitutionsthat requires the state to provide for an “adequate”level of education spending. What is the economicrationale for such a requirement?

2. How has the composition of federal, state, andlocal government spending changed over the past40 years? What social and economic factors mighthave contributed to this change in how govern-ments spend their funds?

3. Some goods and services are provided directly bythe government, while others are funded publiclybut provided privately. What is the differencebetween these two mechanisms of public financ-ing? Why do you think the same governmentwould use one approach sometimes and the otherapproach at other times?

4. Why does redistribution cause efficiency losses?Why might society choose to redistribute resourcesfrom one group to another when doing so reducesthe overall size of the economic pie?

5. Consider the four basic questions of public financelisted in the chapter. Which of these questions arepositive—that is, questions that can be proved ordisproved—and which are normative—that is, ques-tions of opinion? Explain your answer.

6. One rationale for imposing taxes on alcohol con-sumption is that people who drink alcoholimpose negative spillovers on the rest of society—for example, through loud and unruly behavior orintoxicated driving. If this rationale is correct, inthe absence of governmental taxation, will peopletend to consume too much, too little, or the rightamount of alcohol?

7. What is the role of the Congressional BudgetOffice? Why is independence and impartialityimportant when conducting empirical analyses?

8. In order to make college more affordable for stu-dents from families with fewer resources, a gov-ernment has proposed allowing the student of anyfamily with less than $50,000 in savings to attenda public university for free. Discuss the direct andpossible indirect effects of such a policy.

9. The country of Adventureland has two citizens,Bill and Ted. Bill has a private legal business. Heearns $50 per hour. At a tax rate of 0%, Bill works20 hours. At a 25% tax rate he works only 16 hours,and at a 40% tax rate he works only 8 hours perweek. Ted works a manufacturing job. He works20 hours per week and earns $6 per hour, regardlessof the tax rate. The government is consideringimposing an income tax of either 25% or 40% onBill and using the revenues to make transfer pay-ments to Ted. The accompanying table summarizesthe three possible policies. Does either tax policyraise social welfare? Are either of the policies obvi-ously less than optimal? Explain your answers.

Effects of Redistributive Policies in Adventureland

0% 25% 40%

Bill’s pre -tax income $1000 $800 $400Bill’s taxes 0 $200 $160Bill’s net income $1000 $600 $240Ted’s pre -tax income $120 $120 $120Ted’s transfer payment 0 $200 $160Ted’s net income $120 $320 $280


� A DVA N C E D Q U E S T I O N S

10. In the United States, the federal government paysfor a considerably larger share of social welfarespending (that is, spending on social insuranceprograms to help low -income, disabled, or elderlypeople) than it does for education spending forgrades K through 12. Similarly, state and localgovernments provide a larger share of educationspending and a smaller share of welfare spending.Is this a coincidence, or can you think of a reasonfor why this might be so?

11. The urban African -American community isdecidedly split on the subject of school vouchers,with community leaders comprising some of themost vocal proponents and opponents of increased

school competition. Why do you think this splitexists?

12. Many states have constitutional requirements thattheir budgets be in balance (or in surplus) in anygiven year, but this is not true for the U.S. federalgovernment. Why might it make sense to allowfor deficits in some years and surpluses in others?

13. Proper hygiene, such as regular hand-washing, cangreatly limit the spread of many diseases. Howmight this suggest a role for public interventions?What kinds of public interventions might be pos-sible? Suggest three distinct types of possibleinterventions.

Ch 1 Gruber

Documents

Transcript of Ch 1 Gruber