CHAPTER 5



CHAPTER 5

THE PUBLIC SECTOR AND PUBLIC CHOICE

CHAPTER OVERVIEW

The direct and indirect impact of the government on the U.S. economy has been increasing rapidly over the past several decades. The chapter introduces the ways in which the government affects resource allocation in a modern mixed economy. It begins by examining the beneficial aspects of a price system. Then the issue of market failure is examined along with how government can deal with this problem. The other economic functions of government, which are providing a legal system, promoting competition, providing public goods and ensuring economic stability are discussed. The chapter moves to a discussion of the political functions of government that entail its involvement in the economy, i.e. influencing the output of merit and demerit goods and redistributing income. The chapter addresses taxation and taxation systems. Proportional, progressive, and regressive tax structures are examined in the context of average and marginal tax rates. Important federal taxes such as the personal income tax, corporate income tax, social security and unemployment taxes are discussed. Then federal, state, and local taxation and spending are compared. Finally an overview of the theory of collective choice is presented.

LEARNING OBJECTIVES

After studying this chapter students should be able to

1. Explain how market failures such as externalities might justify economic functions of government.

2. Distinguish between private goods and public goods and explain the nature of the free-rider problem.

3. Describe the political functions of government that entail its involvement in the economy.

4. Distinguish between average tax rates and marginal tax rates.

5. Explain the structure of the U.S. income tax system.

6. Discuss the central elements of the theory of public choice.

CHAPTER OUTLINE

I. WHAT A PRICE SYSTEM CAN AND CANNOT DO: The benefits of a price system are high levels of economic efficiency, the existence of consumer sovereignty, promotion of personal freedom, and prevention of coercion of buyers and sellers by the existence of competition. A price system can also produce market failure.

II. CORRECTING FOR EXTERNALITIES: An externality is a situation in which a benefit or a cost associated with an economic activity spills over to third parties, i.e. parties who are not direct participants in a market transaction.

A. External Costs in Graphical Form: (See Figure 5-1 (a)).

B. External Benefits in Graphical Form: (See Figure 5-1 (b)).

C. How Government Corrects Negative Externalities:

1. Special Taxes: Taxes on output would reduce output, but would not provide an incentive to reduce pollution per unit of output. Taxes on the amount of pollutants emitted would provide an incentive to reduce pollution per unit of output.

2. Regulation: The government could specify the amount of pollutants that could be emitted.

D. How Government Corrects Positive Externalities:

1. Government Financing and Production: When positive externalities are large (e.g. public goods), government may finance and produce the good or service.

2. Subsides: A subsidy is a negative tax; a payment to the consumer or producer of a good or service for consuming or producing a good or service

3. Regulation: Government can require that certain actions be undertaken, e.g. inoculations of school children.

III. THE OTHER ECONOMIC FUNCTIONS OF GOVERNMENT: The functions of government that affect the way in which exchange and resource allocation are carried out in the economy.

A. Providing a Legal System: All relationships among consumers and businesses are governed by legal rules. Much of the legal system is involved with defining and protecting property rights.

B. Promoting Competition: Promoting competition is a way of increasing the efficiency of the economy. Antitrust legislation is used to reduce the power of monopolies and to discourage certain activities that restrain trade.

C. Providing Public Goods: Public goods are goods to which the principle of mutual exclusivity does not apply. This is in contrast to private goods that can be consumed by only one person at a time.

1. Characteristics of Public Goods.

a. Public Goods are Often Indivisible: Public goods cannot be produced or sold very easily in small units.

b. Public Goods Can Be Used by More and More People at no

Additional Cost: The opportunity cost of one persons use of the public good once it is in place is zero.

c. Additional Users of Public Goods: Additional users do not deprive others of any of the service of the goods.

d. It is Difficult to Design a Collection System for a Public Good on the Basis of How Much Individuals Use It: It is nearly impossible to determine how much benefit any one person gets from a public good.

2. Free Riders: The free rider problem is a situation associated with public goods when individuals presume others will pay for public goods so they can escape paying for their portion without causing a reduction in production.

E. Ensuring Economy-wide Stability: The federal government is charged under the Employment Act of 1946 to stabilize the economy at high levels of employment.

IV. POLITICAL FUNCTIONS OF GOVERNMENT: These are normative functions of government.

A. Merit and Demerit Goods: The government defines certain goods and services as desirable or undesirable. A merit good is a good (museums) that has been deemed socially desirable by the political process, and will be provided by government or subsidized. A demerit good is a good that has been deemed socially undesirable by the political process (heroin), and it will be prohibited, taxed, or regulated to reduce consumption.

B. Income Redistribution: Government explicitly redistributes income by progressive taxation and by transfer payments and transfer in kind. Transfer payments are money payments made to individuals for which no services or goods are concurrently rendered. Transfers in kind are payments for which no goods or services are concurrently rendered in the form of goods and services.

V. PAYING FOR THE PUBLIC SECTOR: In order to understand what amount of tax someone is paying, the difference between average tax rate and marginal tax rate must be made.

A. Average Tax Rate: Total tax payment must be divided by total income. It is the proportion of total income paid in taxes.

B. Marginal Tax Rate: The change in the tax payment divided by the change in income, or the percent of additional dollars of income that must be paid in taxes. The marginal tax rate is applied to the highest tax bracket of taxable income reached.

VI. TAXATION SYSTEMS: All taxes can fit into one of three types of taxation systems; proportional, progressive and regressive.

A. Proportional Taxation: This is a tax system in which as the individual's income goes up, the tax bill goes up in exactly the same proportion. Average and marginal tax rates are equal and constant at each income level.

B. Progressive Taxation: This is a tax system in which as one earns more income, a higher percentage of the additional dollars is taxed. The marginal tax rate exceeds the average tax rate and both rise as income rises.

C. Regressive Taxation: A tax system in which as more dollars are earned, the percentage of tax paid on them falls is called a regressive tax system. The marginal tax rate is less than the average tax rate and both the marginal and average tax rates fall as income rises.

VII. THE MOST IMPORTANT FEDERAL TAXES: The Federal government imposes income taxes on both individuals and corporations. It collects social security taxes and a variety of other taxes.

A. The Federal Personal Income Tax: This tax accounts for 44 percent of federal revenues and is the most important tax in our economy. It is progressive up to a given income level. The evidence is not strong that the tax system has done much redistribution of income. (See Table 5-1).

B. The Treatment Capital Gains: Currently capital gains, the positive difference between the selling and buying price of an asset, is taxed as ordinary income. In the past it was taxed at a lower rate.

C. The Corporate Income Tax: Corporations pay taxes on corporate profits and that tax is progressive. (See Table 5-2).

1. Double Taxation: Corporate profits are taxed once as corporate profits with the tax paid by the corporations. Profits distributed as dividends to individuals are taxed again as personal income. If the corporation retains profits and invests them, the value of the business increases and its stock price rises. Upon selling the stock, the shareholder pays tax on the gain.

2. Who Really Pays the Corporate Income Tax?: Corporations do not really exist apart from owners, employees and customers. The question arises of tax incidence on who pays the corporate income tax. Some economists say that corporations charge higher prices to pay the tax, while others argue that shareholders and employees get lower incomes.

D. Social Security and Unemployment Taxes: These are taxes on payrolls. The Social Security tax is a tax on earnings up to a taxable base. In 2000 the employer and employee each pay 7.65 percent of the first $76,200 of earnings. The tax is regressive, benefits are not related to contributions and current workers subsidize retired workers. The Unemployment Tax is a payroll tax paid by the employer of 0.8 percent of the first $7,000 in annual wages of each employee who earns more than $1,500. The tax finances unemployment benefits.

VIII. SPENDING, GOVERNMENT SIZE, AND TAX RECEIPTS: The Size of government can be measured by total government spending as a percentage of GDP or by resource using government purchases, i.e., expenditures that involve the use of resources expressed as a percent of GDP. (See Figure 5-3).

IX. GOVERNMENT RECEIPTS: The main source of revenue for all levels of government is taxes.

A. The Federal Government: The largest source of tax receipts is from the personal income tax (44 percent), followed by social insurance taxes (40 percent, and the corporate income tax (10 percent). (See Figure 5-4).

B. State and Local Governments: The largest source of tax revenue comes from sales, excise and gross receipts taxes (27 percent), followed by personal and corporate income taxes (26 percent), and property taxes (19 percent). (See Figure 5-4).

C. Comparing Federal with State and Local Spending: The largest categories of federal spending are defense, income security, and Social Security which make up about 60 percent of total spending. State and local governments' largest categories of spending are education and public welfare at around 40 percent. (See Figure 5-5).

X. COLLECTIVE DECISION-MAKING: THEORY OF PUBLIC CHOICE: Collective decision making is how voters, politicians and other interested parties act to influence non-market decisions. The theory of public choice is the study of collective decision making.

A. Similarities in Market and Public Sector Decision-Making:

1. Self-interest: This is the motivating force in both sectors.

2. Scarcity in Both Sectors: Since resources are fixed, there is a scarcity constraint. All collective actions have an opportunity cost. At any point in time more government goods mean fewer private goods.

3. Competition in Both Sectors: In the public sector the competition is between bureaucrats, elected representatives and appointed official for available funds.

4. Similarity of Individuals: Persons in government face a different incentive structure; the system of rewards and punishments individuals face with respect to their own actions. They are no different than persons who hold similar jobs in the private sector.

B. Differences Between Market and Collective Decision-Making:

1. Government Goods at Zero Price: Most goods and services governments produce or provide are provided to the user free of charge and are paid for by general tax revenues. Rarely does government adopt a user charge system whereby the consumer pays more or less directly for these goods and services by specific fees or taxes.

2. Use of Force: Governments can legally use force in the regulation of economic affairs, but those in the private sector cannot.

3. Voting Versus Spending: In the market sector a dollar voting system exists and is not equivalent to the voting system in the public sector in three ways.

a. In the political system one person equals one vote. In the market system one dollar equals one vote.

b. The political system is run by majority rule. The market system is run by proportional rule.

c. Dollars can indicate intensity of want, whereas because of the all-or-nothing nature of political voting, a vote cannot.

SELECTED REFERENCES

Bator, F.M., "The Anatomy of Market Failure," Quarterly Journal of Economics, Vol. 72, August, 1958, pp. 351-379.

Edgeworth, F.H., "The Subjective Element in the First Principles of Taxation," Quarterly Journal of Economics, Vol. 24, May 1910, pp. 459-470.

Friedman, MiIton, Free to Choose, New York: Harcourt, Brace, Jovanovich, 1980.

Lee, Dwight R., The Political Economy of Social Conflict, or Malice in Plunderland, Los Angeles: International Institute for Economic Research, OriginaI Paper 36, 1982.

McKean, Roland, "The Unseen Hand in Government," American Economic Review, June 1965, pp. 496-506.

Musgrave, R.R., and P.B. Musgrave, Public Finance in Theory and Practice, New York: McGraw Hill, 1980.

Phelps, Edmund S., ed., Private Wants and Public Wants, New York: W.W. Norton, 1965.

Tollison, Robert D., "Public Choice and Antitrust," The Cato Journal, Vol. 4, No. 3, Winter 1985, pp. 905-923 (including a comment on that article by Kenneth G. Elzinga and D.T. Armentano.

Browning, Edgar K. and William R. Johnston, The Distribution of the Tax Burden, Washington, D.C.: American Enterprise Institution, 1979.

The Budget of the United States Government, Fiscal Year 1993.

Clark, Lindley H., The Secret Tax, New York: Dow Jones Books, 1976.

Laffer, A.B. and J.P. Seymour, eds., The Economics of the Tax Revolt: A Reader, New York: Harcourt, Brace, Jovanovich, 1979.

Ott, David J. and Attiat F. Ott, Federal Budget Policy, 3rd ed., Washington: The Brookings Institute, 1977.

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