GOVERNMENT SPENDING AND TAXATION

Exhibit 1 on p. 113 shows the growth of Government Spending as a percent of GDP during 20th century.  Federal spending used to be only 2.5%, now it's close to 20%, about an 8x increase.  State spending has only increased from 7% to 11%, about a 1.5x increase.  Overall govt. spending has slowed somewhat during the last 20 years.  

Exhibit 2 on p. 114 shows government revenue and government spending.  Major sources of govt. revenue are income taxes (30%) and payroll taxes (18%).  Biggest spending is for education, health care, Social Security, and other transfer payments.   

About 30% of national income comes from activities of the federal, state and local governments.  In addition, about 40% of our land is owned by the government.  Government rules, laws, legislation, regulation, etc. exert an enormous impact on the economy, so we will spend two chapters on the role of government in the economy.  The importance of government (public sector) is reflected in the title of the text: "Macroeconomics: Private and Public Choice."

Questions / Issues: Under what conditions will privates market fail to serve the public interest, fail to promote welfare of society?  Under which situations will government intervention improve upon market outcomes?  Under what conditions will the public sector fail to efficiently promote the general or public interest?  We want to discuss the possibilities of a) market failure and b) government failure, where "failure" means a failure to promote the general interests of society or a failure to operate efficiently from an economic point of view.
 

WHAT IS GOVERNMENT?

What distinguishes government from the private sector?  Government usually have a monopoly on the use of force in society, which makes governments different from other groups in the economy.

For example, if you don't want to buy a Buick, GM can't force you to.  Private firms rely on voluntary behavior - GM can't force anyone to work there, can't force anyone to buy its stock, can't force a bank or bondholders to lend it money, can't force customers to buy its cars, etc.  On the other hand, if you don't pay your income taxes or property taxes, the government can force you to pay, with the threat of putting you in jail.  Governments have unique powers of coercion and force, which private individuals, private firms, and private organizations do NOT have.

What is the potential danger of government's unique powers????

Ultimate issue: What is the proper role (size) of government in a free society?  What is the optimal amount of government?  Studies usually show that the lower the degree of economic and political freedom, and the greater the size and role of the public sector, the lower the standard of living, demonstrating that excess government power can reduce prosperity.  Question is: What is the OPTIMAL size of government?

One common source of "government failure" is that the reward and incentive structure of government decision making encourages politicians and bureaucrats to help well organized, narrowly focused special interest groups at the expense of the unorganized general public.   Example: sugar industry.  Domestic sugar is about 20 cents / lb, vs. the world price of 5 cents / lb.

PUBLIC CHOICE analysis: the use of economics to study the public sector, using insights and tools of economics to study politics. Links economics and political science. Let's start using Public Choice Economics to look at the: 

DIFFERENCES AND SIMILARITIES BETWEEN MARKET AND COLLECTIVE ACTION:

Important points: a) Incentive matter in both areas, b) market activity is generally based on voluntary exchange between individuals and c) collective decisions are usually based on majority rule principle.  

1. Competitive behavior is present in both sectors. Politicians compete to get into office, bureaus and agencies compete for funding, special interest groups compete to get funding or regulation or deregulation. Private and public sectors are both competitive. Public sector is not profit/loss though, so the competition can be different. See page 117.
 
2. Public sector organization breaks the individual consumption-individual payment link. Market - you pay for what you consume. Public sector  - not the case.

Examples:
a. Everybody pays for public libraries, not every one uses in proportion to their payment vs. Blockbuster (private video library) where individuals pay for their exact amount of consumption of videos.
b. All property owners pay school taxes, not everyone has children, or has children in public schools, not everyone has the same number of children...
c. Everybody pays taxes for roads/highways, not everybody uses the same amount.

3. Scarcity still exists, so that the aggregate consumption - aggregate payment link will remain. We still have to pay as a group/state/country for what we consume. There are still no free lunches.  Genesee County and the city of Flint have to pay for the cost of libraries each year.
 
4. Compulsion/coercion exists in the public sector. GM might be economically powerful, but they can't force anybody to buy their cars, or work for them, or lend them money or sell them products or buy their stock, etc. Can't put people in jail for not buying their products. Rely on voluntary action and behavior. Government has the exclusive right to use force and coercion, it can put people in jail if they don't pay taxes or follow federal laws, etc. Govt. can compel payment.

Majority rule prevails in collective decision making, the minority is compelled to go along.  In the market if 51% of the people want US cars and 49% want foreign cars, everyone gets their first choice and the minority is able to be satisfied.  If 51% of the people vote for school vouchers, then majority rule imposes the decision of the majority on the minority (49%).  Point: With voluntary exchange, minority groups (< 50%) get what they want, with majority rule they don't.

5. When collective decisions are made legislatively, voters have to chose among candidates who represent a bundle of positions. We can choose a legislator, but we have no direct control over how they vote on individual bills. We have very little control to express our preferences on each issue. We make a "bundle purchase" in politics and have no decision making power after that.  Market is not constrained with bundle purchases - you get to vote daily with your "dollar votes."  Market = a "virtual voting booth."

6. Political power is different than power in the marketplace. Political connections and knowledge of the political process are rewarded. Success in politics is different from success in the private sector.  Just like there is an unequal distribution of income and wealth in the private sector, there is an unequal distribution of political influence and power in the public sector.
 

ECONOMIC EFFICIENCY AND THE ROLE OF GOVT.

To compare public-sector policies/outcomes to private-sector policies/outcomes, we need some standard of comparison. We can use the standard of Economic Efficiency, which is the idea that we want to Maximize Net Benefits, or Minimize Net Costs. All actions involve Cost and Benefits, and we want to engage in economizing or maximizing behavior for all decisions, both private and public. At a given level of costs, we want to get the Max benefit possible. Or given a certain level of benefits, we want to achieve it at the lowest possible cost.

The Rules of Economic Efficiency are:

RULE 1.  Only engage in activities where the Benefits are greater than the Costs. Increases welfare.
Failure to pursue activities where the B > C means that potential gains have been lost / foregone.

RULE 2.  Avoid activities where the Costs outweigh the Benefits. Counterproductive results. Reduces social welfare.  It is like spending $2 in gas to drive to save $1, you are made worse off.  

Failure to undertake efficient activities (Rule 1) and engaging in inefficient activities (Rule 2), result in ECONOMIC INEFFICIENCY, meaning that our economic prosperity as a country is reduced, or our overall standard of living as a society is now lower.

In most cases, a market economy results in economic efficiency, because market prices and market forces guide the economy to efficient outcomes. Or stated differently, in most cases government intervention would lead to economic inefficiency, compared to the market. In most cases, there would be "Government Failure" if the government intervened and could not improve on Market outcomes.

But what about the cases where the market outcome is inefficient? In some cases, perhaps a government outcome can increase efficiency, or decrease inefficiency. Example: pollution.
 

TWO LEGITIMATE FUNCTIONS OF GOVERNMENT

1. Protective function.  Govt. should protect individuals and their property from acts of aggression - force, fraud, and coercion.  Establish the rule of law, enforce private property and contracts with an infrastructure/framework of rules and laws.  Protect citizens from foreign invasion (national defense) and protect citizens from each other.  Government in the role of a REFEREE or UMPIRE or OFFICIAL to enforce the rules, settle disputes, penalize those who violate the rules, etc.  Market economy assumes an underlying framework of laws, private property, contracts, i.e. the "rule of law", so that true VOLUNTARY EXCHANGE can take place.

We have the advantage in the U.S. of a 200 year+ tradition of a well developed and relatively efficient legal, financial, and institutional framework underlying the economy.  Explains partly why we have the highest standard of living on the planet.  Also explains the problems in Russia and other E. European countries making a transition to a market economy - they don't have a very developed underlying legal system or framework - weak property rights, contracts not always enforceable, undeveloped legal and financial system, etc. See "The Case of Russia" story on p. 119.   

2. Productive function.  In some cases the market has trouble supplying a good or service when 1) it is hard to establish a 1-to-1 link between individual consumption and individual payment or 2) it is costly to monitor individual use of a good or service and collect payment.   

Examples: national defense, local police and fire protection, monetary stability, highways, subways, etc., these are generally referred to as PUBLIC GOODS.  For example, a private company (security company) could easily provide the service of police protection for a small town.  However, it would be extremely hard to establish the amount of police services each individual consumed in a year, and would be extremely hard to collect payments from individuals.  Explains why private bodyguard services are provided by the private sector, but police protection is generally supplied by the public sector.

Important distinction: The private sector can easily SUPPLY the service (police protection), but it would have a hard time collecting payment.  Therefore, there are really two options.  1) Hire a private company to provide the service through the private sector, but collect and pay for the service collectively through taxes.  Use tax dollars to pay for a private police service. OR 2) Have police services provided through the public sector and paid for with tax dollars.  Pay public employees with tax dollars.

Another productive function of the govt. might be monetary and price level stability, which could be seen as public goods.  We all benefit from a unit of currency ($) that is stable, and maintains purchasing power from period to period.  Countries with HYPERINFLATION suffer significant economic costs, which we will discuss later.
 

WHY MIGHT THE INVISIBLE HAND (MARKET) FAIL?

1. Lack of competition -

Market competition:                                                            
1) prevents sellers from taking advantage of buyers, keeps prices low, sellers compete with each other.
2) prevents buyers from taking advantage of sellers, competition for buying keeps prices up.

Examples: a) what if GM, as a buyer of labor services, offered starting salaries of $12,000 for engineering graduates? Competitive pressure from other buyers, Ford, Chrysler, would prevent that from happening.  Buyers compete against other buyers. b) What if engineering grads tried to all ask for $125,000 starting salaries?  Competitive pressure from other workers would prevent that from happening.

Example: Bidding in auction markets, e.g. Ebay.  Houses for sale - competition from sellers keeps price competitive, competition from buyers keeps price competitive.

Sellers don't always like the competitive pressure of the market. Competition is good when someone else faces it. We would all like less competition sometimes. Very competitive to get into college, competitive to get into grad school, it is competitive to make the team, the dating market is competitive, job market is competitive, etc.

See graph page 121. Sellers restrict supply and actually increase revenue, but produce less output. Optimal output/price for society is P₁ and Q₁. Optimal price for sellers might be P₂/Q₂. Sellers could try to form a cartel, act collusively, engage in price fixing, restrict or prevent entry, etc., engage in a conspiracy against the consumers.  

Traditional view: We need government intervention to maintain competition in the market, prevent big companies from becoming monopolies and generally acting to restrain trade, engaging in anti-competitive behavior.

Alternative view: How can a private firm prevent entry in a free market?  What about using the government to reduce competition?  Government intervention can be pro-competitive but can also be anti-competitive.  Sometimes producers can effectively use the government to REDUCE competition, and erect barriers to entry that restrict competition.  Examples:  tariffs, occupational licensing, regulations, etc.

POINT: Competition in the market serves as a very effective natural regulator, imposes strong discipline on sellers.  Government intervention may or may NOT be able to improve on competitive market outcomes.  Example: special interest groups appeal to Congress to REDUCE competition, e.g. domestic producers (U.S. sugar farmers) ask for tariff protection against more efficient foreign competitors, resulting in higher prices, damage to consumers.
 

2. EXTERNALITIES - spillover effects (or side effects) on non-consenting second parties.  Externalities can be either positive or negative, imposing either external costs or external benefits on second parties.

Example of Negative Externality: Pollution of the water, air or land by producers, who do not have to bear the full cost to society of polluting.  Factory pollutes the air or water and does not have to pay the cost of clean up.  The reason that pollution can take place is that sometimes property rights are not clearly defined, allowing the polluter to damage common property. Tragedy of the commons, again.

See page 123, Panel (a). S₁ represents the supply curve when negative externalities are ignored. P₁ and Q₁ represent the actual amount supplied and the actual price, when the producer can ignore the costs of pollution on second parties.  S₂ represents the supply curve taking into account the costs of pollution. (Remember that anything that increases the cost of production DECREASES the Supply curve).  Q₂ is optimal output from society's viewpoint, taking into account all costs and benefits.  If producers are able to shift some of the cost of production onto society by polluting, they want to produce more than the optimal amount.  Market will overproduce goods when they can impose external costs (negative externalities) on nonconsenting parties.  Efficiency RULE 2 is violated.  In the overall picture, P₁ and Q₁ (market outcome) result in units of output being produced whose TOTAL COSTS > BENEFITS.

Some goods and services generate external benefits, or positive externalities, e.g. literacy, education.  We all benefit by living in a highly educated, literate society.  However, education is costly, and the market might underproduce the optimal amount of education since it won't fully account for the spillover benefits.  Assume that education was provided only by the market (no public schools) and that there were no mandatory attendance laws.  This outcome would be represented by the graph on page 128, panel b.  The ideal output for education is Q₂, taking into account the external benefits of education.  The market would not fully account for the positive externalities, and would only produce Q₁ amount of education.

Government intervention in the form of a) mandatory attendance and b) public provision of education, would achieve the optimal amount of education at Q₂, and would improve on the market outcome of Q₁.

SUMMARY: 1) When negative externalities are present (pollution), the market will OVERPRODUCE certain goods, leading to possible "market failure."  Government intervention in the form of pollution laws, pollution permits, pollution taxes, EPA, etc. may improve upon the market outcome.

2) When positive externalities are present, the market may UNDERPRODUCE certain goods, another form of "market failure."  Government intervention such as public education or subsidies (student loans) may correct the market failure.

Not always a market failure, it can be property rights problem.

3. Public Goods - Goods or services that are: a) jointly consumed and b) nonexcludable goods.  Examples: national defense and radio/TV broadcasts.  No way to exclude nonpaying users. If the market provided the goods and collected voluntary contributions for something like national defense, people would have an incentive to be "free riders" - they would know they would get the benefits whether they paid or not.

Because of the non-excludability of certain goods that provide positive externalities and the potential free rider problem, people wouldn't voluntarily pay for the goods or services and the market may not provide the socially optimal amount of certain goods. Like national defense, the legal system, law enforcement, national highway system, national parks, the monetary system, fire departments, lighthouses, etc. National defense benefits everybody, you can't provide it for some and not others. Market relies on voluntary behavior. Really a failure of people, not market. Market would provide it, it just wouldn't be able to collect for it. We might have to coerce people and force them to pay for highways, courts, national defense, etc. Imagine a voluntary fund-raising drive by the Department of Defense.

Important Point: It is the characteristics of a good or service (joint consumption and nonexcludability) that makes it a "public" good, not whether the public or private sector provides it. Public goods CAN and WILL BE supplied by the private market, especially when the "free rider" problem can be overcome. And governments can supply non-public goods, so just because a service is provided by the govt. does not necessarily mean it a pure public good.

Examples: a) Radio and TV are public goods supplied by the market. How do they deal with the free rider problem?
b) Garbage collection, police protection, fire departments, road building, etc. are public goods and services that the private sector can provide, and how is the free rider problem dealt with?
c) Software is a public good supplied by the private market. Bill Gates became rich supplying a public good! How do software companies prevent or minimize "free riding", i.e. people copying software for free??
d) Government provides first class mail service, education, Amtrak train service, public transportation which could easily be provided by the private sector also. If Greyhound provides intercity bus service, why couldn't they also provide intracity bus service?

POINT: If we relied only on the market to supply all public goods, the optimal amount would NOT be supplied, especially of things like national defense due to the free rider problem. Private sector would UNDERSUPPLY some public goods from society's viewpoint, resulting in economic efficiency (not having public goods/services whose B > C) - "market failure." Therefore, economic efficiency may be improved if some public goods are supplied by the public sector - society will be better off overall.

4. Potential Information Problems - Will the market provide the optimal amount of information, or is government interference necessary? 

a. What if consumers can't tell the difference between high quality, safe products and low-quality, unsafe products?  Profit-maximizing firms could use this situation to their advantage by producing low-quality products to save on production costs.  Example: Can consumers evaluate the safety features of cars?  Probably not, so there may be a role for government to mandate certain safety equipment and minimum safety standards.  Pharmaceutical drugs are another example, where you can justify a regulatory role for the FDA.

b. There are also numerous examples of private firms providing valuable information to consumers without government oversight or regulation.  For example, there is the Good Housekeeping Seal of Approval, Underwriter's Laboratory (an independent, not-for-profit product safety testing and certification organization), Zagat's Dining guides, Consumer Reports, Edmunds' New Cars & Trucks Buyer's Guide (www.Edmunds.com), etc.  Also, franchises provide low cost information about quality.  For example, you have a very accurate idea of the quality of a Holiday Inn Hotels or Best Western Hotels anywhere in the world, because of the uniform standards imposed by the company.  See the example of Best Western Hotels on p. 126, Best Western doesn't own a single hotel, they act as a regulator of independent hotels that bear its name, and it imposes and enforces minimum standards worldwide. 

Point: Market does provide tremendous amounts of information, and there is "private regulation" by Underwriter's Laboratory, etc., but there may be some cases (automobile safety and pharmaceutical drugs) where the government can increase economic efficiency.   

OPPORTUNITY COST OF GOVERNMENT

What is the cost of government?  How to measure?  Do taxes paid accurately measure the cost of govt.?  Not really.  There are three costs when govt. undertakes an activity:

1. Opportunity cost of the resources used to supply the good or service to the public.  If the federal government provides a football stadium, library, park, school, or freeway, it has to bid the resources away from alternative uses.  The value of the resources used elsewhere is the Opportunity Cost of government provision of goods and services.  Taxes paid may or may not fully reflect the full opportunity cost since the government can use current taxes to pay for the stadium, but could also use government debt (deficit spending) or money creation to pay for the stadium.  Therefore, Opportunity Cost is more accurate reflection of total cost than just taxes paid.

Also, the government could mandate regulations that would be costly to private individuals or firms, but would not involve direct payment by the government.  Examples: Air bags, catalytic converters, handicap accessibility, wetland protection, endangered species protection could all impose real, significant costs on private individuals or private firms that would not be reflected in direct taxes paid.

Example:
Tax Freedom Day - about May 6 (Average taxpayer works from Jan 1 to May 6 to pay all taxes owed)
Tax Spending Day - about May 16 (Includes all govt. spending, i.e. deficit spending)
Total Cost of Government Day - about July 11 (total federal, state and local govt. spending, PLUS Federal regulatory costs)

2. Costs of tax collection, enforcement costs of govt. mandates, and costs of tax compliance.  Includes the cost of the IRS and all state tax departments, costs of regulatory agencies like the EPA, and the costs of record-keeping and filing taxes by individuals and firms.  Estimate: Individuals and firms spend 5.5B hours / year to fill out tax forms, equal to a real cost of $55B @ $10 hour.

3. Excess Burden of Taxation is another real economic cost imposed on the economy.  Regulations and taxes distort economic activity by distorting incentives, raise prices, reduce economic activity and exchange, all leading to economic inefficiencies that we call the Deadweight Loss or Deadweight Cost or Excess Burden of Taxation that we covered in Chapter 4.  Loss of consumer and producer surplus = DWL or DWC.

SUMMARY: COST OF GOVERNMENT ACTIVITIES = 1) opportunity COST of resources used to supply the government good or service + 2) the COST of tax and regulatory compliance + 3) the COST of the Excess Burden of Taxation and Regulation.  Therefore, when the government spends $10m on a program or resource or agency, it really costs the economy more than $10m.  Govt. spending can be compared to transferring water (resources) from the private sector to the public sector (govt. spending) but with a LEAKY BUCKET.
 

WHO PAYS THE TAX BILL?

1. Middle and upper income pay most of the taxes.
Top 1% pays 29% of all taxes collected (taxable income >$195,000)
Top 5% pays 47% of all taxes collected (income>$90,000)
Top 10% pays 59% of all taxes (income>$68,000)
Top 25% pays 80% of all taxes ($42,000+)
Top 50% pays 95% of all taxes ($21,000+)
Bottom 50% pays 5% (less than $21,000)

2. PEOPLE pay all taxes. Corporations don't pay taxes, INDIVIDUALS (people) pay ALL taxes. Corporations collect the taxes, but individuals PAY the tax - shareholders, customers, or employees. Corporation is a legal fiction - papers. If corporate taxes are raised, the firm will have to either 1) raise prices for customers, 2) reduce wages (or not give wage increases as generous as without the tax) or 3) reduce dividends.  Therefore, we in our roles as either customers, workers or shareholders PAY TAXES.