1 c h a p t e r 15 1 © 2001 prentice hall business publishingeconomics: principles and tools,...

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© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin

Public Goods, Taxes, and Public Choice

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Overview of Government

Providing public goods and services such as streets, education, parks, public safety, national defense, and space exploration

Redistributing income to the poor

Collecting taxes to support spending programs

Trade policy to control international trade, to promote or to restrict some types of trade

In most modern societies, governments are involved in the following activities:

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Rationale for the Existence of Government

Certain goods and services would not exist unless we make a collective effort to produce them.

The government can help make collective decisions about paying for goods that generate spillover benefits.

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Local Governments

There are more than 80,000 local governments in the United States.

Local governments spend most of their money on: Education (kindergarten through high school) Public welfare and health (payments to poor

households and support for public hospitals) Highways Police protection

Local governments provide goods and services such as water, fire protection, and libraries.

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Local Expenditures, 1996

Education (42.00%)Administration and other (34.00%)

Public welfare (5.00%)Police protection (5.00%)

Highways (5.00%)Health and hospitals (9.00%)

Local Expenditures (1996)

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State Governments

At the state level, the biggest spending programs are:

Education (including colleges and universities)

Public welfare

Highways

Health and hospitals

Corrections (state courts and prisons)

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State Expenditures, 1996

Education (34.65%)Correction (3.96%)

Administration and other (19.80%)

Public welfare (25.74%)

Highways (7.92%)

Health and hospitals (7.92%)

State Expenditures (1996)

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Federal Governments

At the federal level, the biggest spending programs are: Income security

National defense

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Federal Expenditures, 1996

Health (7.92%)International affairs (0.99%)

National defense (15.84%)

Net interest (14.85%)

Other (11.88%)

Medicare (11.88%)

Income security (13.86%)Social security (22.77%)

Federal Expenditures (1998)(1996)

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Spillover Benefits

A market with spillover benefits is inefficient, so there is an opportunity for government to promote efficiency.

Spillover PRINCIPLE

For some goods, the costs or benefits associated with the good are not confined to the person or organization that decides how much of the good to produce or consume.

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Spillover Benefits

Number of people 100,000

Benefit per person $5

Total benefit of dam(100,000 x $5)

$500,000

Assumed total cost of dam (greater than personal benefit of $5)

$200,000

Tax per person $2

Tax revenue(100,000 x $2)

$200,000

In this example, if each person considers only the personal benefit relative to the cost of the dam, no dam will be built.

Since everyone will support a tax per person that is less than the benefit per person, the government can use its taxing power to provide a good that would otherwise not be provided.

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Public Goods

A public good is a good available for everyone to consume, regardless of who pays and who doesn’t.

A private good is consumed by a single person or household.

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Public Goods

Public goods are nonrival in consumption (available for everyone to consume) and nonexcludable (it is impractical to exclude people who don’t pay).

Private goods are rival in consumption (only one person can consume the good), and excludable (it is possible to exclude a person who does not pay for the good).

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Public Goods

National defense

Law enforcement

Space exploration

Preservation of endangered species

Protecting the earth’s ozone layer

Income transfers to the poor

Examples of public goods:

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Private Goods With Spillover Benefits

A good such as education generates workplace and civic spillovers benefits, thus, the government should adopt policies to encourage people to become educated.

Local governments provide free primary and secondary education. States subsidize higher education, and the federal government provides financial aid to students in private and public schools.

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Voluntary Contributions and the Free-rider Problem

The problem with using voluntary contributions to support public goods is the free-rider problem.

Each person will try to get the benefits of a public good without paying for it.

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Overcoming the Free-rider Problem

Give contributors something in return

Arrange matching contributions

Appeal to people’s sense of civic or moral responsibility

Techniques to encourage people to contribute:

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Financing Government: Taxes

For local governments is the property tax.

For state governments are sales taxes and individual income taxes.

For the federal government are individual income taxes and “social insurance and retirement receipts.”

The major sources of revenue:

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Local Revenue, 1996

Sales (10.00%)

Charges and miscellaneous (38.00%)

Other (4.00%)

Property (45.00%)

Individual income taxes (3.00%)

Local Revenue (1996)

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State Revenue, 1996

Sales (38.00%)Charges, fees, other (26.00%)

Licenses (5.00%)

Property (2.00%)Corporate income taxes (5.00%)


State Revenue (1996)

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Federal Revenue, 1996


Social insurance & retirement receipts (33.00%)

Corporation income taxes (11.00%)Other (8.00%)

Federal Revenue (1998)(1996)

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The Effects of a Tax

In a competitive market, equilibrium price ($200) is just enough to cover the cost of providing an apartment.

A tax of $80 imposed on housing firms increases the average cost of providing 900 apartments by $80, to $280.

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At each price, fewer apartments will be supplied.

The tax increases equilibrium price and decreases the output of the industry.

The tax shifts the supply curve to the left.

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Housing firms now offer 750 apartments at $230 per unit. After they pay the $80 tax, only $150 remains to pay input suppliers.

Firms collect more money from consumers and pay less money to input suppliers, so consumers and input suppliers indirectly pay the tax.

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The $80 tax per apartment is split between consumers and input suppliers.

After the tax, consumers pay $30 more and input suppliers receive $50 less per apartment.

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Revenue for the government from the 750 apartments equals $750 x $80, or $60,000. Consumers pay $22,500 and producers $37,500.

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Deadweight Loss From Taxation

Both consumer surplus and producer surplus are less after the tax.

Some of the losses are transferred to the government.

But the triangles C and E are net losses not transferred to anyone.

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Tax Shifting: Forward and Backward

A forward-shifted tax is a tax imposed on producers but passed on to consumers. The amount of a tax shifted forward depends on the price elasticity of demand for the taxed good.

A backward-shifted tax is a tax borne by firms and input suppliers. The amount of backward shifting to input suppliers depends on their responsiveness to changes in input prices.

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Tax Shifting: Forward and Backward

When demand is relatively inelastic, the tax burden is forward-shifted.

When demand is relatively elastic, the tax burden is backward-shifted.

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Public Choice

Public choice economics is a field of study that explores contrasting views about how governments operate.

Four contrasting views of government: Governments take actions to promote efficiency Voters tell governments what to do Government officials pursue their own self-

interest Special-interest groups manipulate the

government

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Governments Take Actions to Promote Efficiency

The public-interest view of government is based on the idea that governments make the economy more efficient.

As we have seen, governments can use their power to collect taxes to provide public goods that would otherwise not exist.

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Voters Tell Governments What to Do

Voters affect government decisions.

In a democracy, the government takes actions that are approved by the majority of citizens.

If governments respond to voters, the voting public ultimately makes all the important decisions.

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The Median-voter Rule

The median-voter rule says that the choices made by government will reflect the preferences of the median voter.

When two candidates offer divergently opposed views, powerful forces pull them toward the preferences of the median voter.

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People “Vote With Their Feet”

According to economist Charles M. Tiebout, people “vote with their feet.”

The choice of which community to live in is based in part on the taxing and spending policies of different communities. Households express their preferences by moving to communities that offer the best package of services and taxes.

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Government Officials Pursue Their Own Self-Interest

The Nobel Laureate James Buchanan, among others, has suggested a model of government that focuses on the selfish behavior of government officials.

The self-interest theory of government suggests that voters don’t have much information about the costs and benefits of public services, and may not be able to evaluate the actions of politicians.

Limitations on taxes and spending are necessary safeguards against politicians and bureaucrats who benefit from large budgets.

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Special-interest Groups Manipulate the Government

This model of government is based on the idea that small groups of people manipulate government for their own gain.

When a few people share the benefit from a project and a large number of people share the cost, government is more likely to approve inefficient projects.

Special-interest groups form whenever the benefits are concentrated on a few citizens but costs are spread out over many citizens.

1 c h a p t e r 15 1 © 2001 prentice hall business publishingeconomics: principles and tools,...

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