Chapter 1: Introduction to Public Finance

Chapter 1 Introduction
to Public Finance

McGraw-Hill/Irwin 1 - 1.
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved
 Chapter 1: Introduction to Public Finance

Introduction

The role of government in making a free market possible

Why free markets usually work well for consumers

Taxes, subsidies, regulations, and inefficiency

Problems for the free market

Problems for the government

Taxes and government spending in the United States

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 Chapter 1: Introduction to Public Finance

The Role of Government in Making a Free

Market Possible
• A free market consists of the voluntary interaction of
producers and consumers of goods and services.
• Is it necessary to have a government?

Positive Economics Normative Economics

What is happening? Is it good or bad?

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 Chapter 1: Introduction to Public Finance

Why Free Markets usually Work Well for

Consumers
Free markets are efficient • Productive efficiency
• Allocative efficiency
Figure 1.1

$14 S = (MC)
$12

$10

$8

$6
D = (MB)

90 100 110 Q

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 Chapter 1: Introduction to Public Finance

Taxes, Subsidies, Regulations, and Inefficiency

A tax levied on producers or a tax levied on consumer
Figure 1.2 Figure 1.3
P P
S`
$14
$14
S S
$12 T=$4 $12

$10 T=$4 $10 T=$4

$8 $8
T=$4
$6 D
$6 D

D`
90 100 110 Q 90 100 110 Q

…produces the same effect.

A decrease in quantity.

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 Chapter 1: Introduction to Public Finance

Taxes, Subsidies, Regulations, and Inefficiency

Deadweight loss • An inefficiency which causes
a reduction in society’s welfare
Figure 1.4

$14 – S
$12 – B

$10 – T=$4 D

$8 –
A Deadweight loss is
$6 – D represented by area
= BAD
90 100 110 Q

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 Chapter 1: Introduction to Public Finance

Taxes, Subsidies, Regulations, and Inefficiency

A subsidy given to producers or a subsidy given to consumers
Figure 1.5 Figure 1.6
P P
$14 S $14
S
$12 $12
S=$4
S=$4 S`
$10 $10 S=$4 D`
$8 $8
S=$4
$6 D $6 D

90 100 110 Q 90 100 110 Q

…produces the same effect:

an increase in quantity

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 Chapter 1: Introduction to Public Finance

Taxes, Subsidies, Regulations, and Inefficiency

Figure 1.7

$14 – S
$12 – B
D
$10 – S=$4

$8 –
Deadweight loss is
A
represented by area
$6 – D
= BAD

90 100 110 Q

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 Chapter 1: Introduction to Public Finance

Problems for the Free Market

Externalities: Chapters 2 and 6
Figure 1.8

P MSC
Negative
B
externality $14 – S (MC)
D
$12 – $4
MSC = (MC + marginal $10 –
A
environmental damage)
$8 –

Solution? $6 – D (MB)
A corrective tax.
90 100 110 Q

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 Chapter 1: Introduction to Public Finance

Problems for the Free Market

Externalities: Chapters 2 and 6
Figure 1.9

Positive P
externality $14 –
B
S (MC)
D
$12 – $4
MSB = (MC + marginal $10 –
MSB
benefit to other people) A
$8 –

Solution? $6 – D (MB)
A corrective subsidy.
90 100 110 Q

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 Chapter 1: Introduction to Public Finance

Problems for the Free Market

Public Goods: Chapter 3

• A public good has 2 properties:
1. Non-rivalry
2. Non-excludability
• Free-rider problem

Social Insurance: Chapters 5 and 6

• Old-age insurance – Social Security
• Health insurance – Medicare

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 Chapter 1: Introduction to Public Finance

Problems for the Free Market

Income distribution, taxation and efficiency:
Chapters 7, 8 and 9
• Income redistribution
• Taxation – progressive, regressive,
and proportional
• Efficiency trade-offs

Education: Chapter 11
• Private or government
• Quality and price variations
• Consumption externality

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 Chapter 1: Introduction to Public Finance

Problems for the Free Market

Low income assistance: Chapter 12

• Medicaid
• Earned income tax credit (EITC)
• Unemployment compensation
• Disability insurance
• Worker’s compensation

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 Chapter 1: Introduction to Public Finance

Problems for the Government

Political economy: Chapter 3
• Island wall

Cost-benefit analysis: Chapter 4

• Compare costs against benefits

Which level of government?: Chapter 10

• Federal, state, and local
• Types of taxes

Borrowing instead of taxing: Chapter 13

• Borrowing and the effects of borrowing

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 Chapter 1: Introduction to Public Finance

Taxes and Government Spending in the U.S.

Question 1:
30%
a) U.S. taxes (federal, state, and local) as a % of GDP: _____
20%
b) U.S. federal taxes as a % of GDP: _____
10%
c) U.S. state and local taxes as a % of GDP: _____
d) OECD taxes as a % of GDP: _____40%
e) Scandinavian taxes as a % of GDP: _____50%

Figure 1.10 Taxes as a percent of GDP

U.S. Federal S&L

OECD
Scandinavia
10% 20% 30% 40% 50% 60%

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 Chapter 1: Introduction to Public Finance

Taxes and Government Spending in the U.S.

Question 2: Federal tax revenue as a % of GDP is
(much higher than, about the same as, much lower than)
forty years ago.
Figure 1.11
% of GDP

24%
23%
22%
21% Federal
20% Spending
19%
18% Federal
17% Taxes
16%
1965 1970 1975 1980 1985 1990 1995 2000 2005 Year

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 Chapter 1: Introduction to Public Finance

Taxes and government spending in the U.S.

Question 3: How has federal debt changed over time?
Figure 1.12
% of GDP
50%

45%

40%
Federal
35%
Debt
30%

25%
1965 1970 1975 1980 1985 1990 1995 2000 2005 Year

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 Chapter 1: Introduction to Public Finance

Taxes and government spending in the U.S.

Question 4: What are the important sources of federal
tax revenue?
Figure 1.13

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 Chapter 1: Introduction to Public Finance

Taxes and Government Spending in the U.S.

A serious problem looms on the horizon.
Table 1.2

Medicare, Medicaid, and Social Security (“The Big 3”) as a % of GDP

“The Big 3” Fed Spending Fed Taxes Fed Deficit

2000 8% 20% 20% 0%
2010 10% 22% 20% 2%
2020 12% 24% 20% 4%
2030 14% 26% 20% 6%
2040 16% 28% 20% 8%

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 Chapter 1: Introduction to Public Finance

Summary
The role of government in making a free market possible

Why free markets usually work well for consumers

Taxes, subsidies, regulations, and inefficiency

Problems for the free market

Problems for the government

Taxes and government spending in the United States

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 Chapter 1: Introduction to Public Finance

Preview of Chapter 2:
Externalities and the Environment

The economist’s approach to pollution

Economic analysis of a pollution tax and

tradable permits

Applications: Acid rain and global warming

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