2. Next page INTRODUCTION FUNDAMENTAL PRINCIPLES OF PUBLIC FINANCE

3. Jump to first page How are Governments Different from other Enterprises? What are the powers enumerated in the US Constitution? Can the US government exercise those powers anywhere Else?

4. Jump to first page How are Governments Different from other Enterprises? Powers? To spend? No; to borrow? No; to tax? Yes; to prohibit or compel? Yes. To create money? No, not really. Wage war? Make treaties with other sovereign states? Jurisdiction, geographic (in the US overlapping, unitary states, not so much).

5. Jump to first page Taxes are Coercive Nobody likes paying taxes Nobody much likes doing things they are forced to do Americans pay a lot of taxes (although less than in most other economically developed countries)

6. Jump to first page IF TAXES ARE SO BAD, WHY HAVE A PUBLIC SECTOR IN AN OPEN AND FREE SOCIETY?

7. Jump to first page IN SOME CASES THE BENEFITS OF COLLECTIVE ACTION (requiring spending) OFFSET THE HARMS DONE BY TAXES

8. Jump to first page Market Failure Markets equilibrate DEMAND (measured in terms of willingness and ability to PAY) and SUPPLY (measured in terms of willingness and ability to SELL) But markets can be unstable. People do not like instability.

9. Jump to first page Markets and the Functions of Government MARKET PRECONDITIONS System of law Protection of life and property Definition of property Enforcement of contracts Disclosure requirements Regulation of competition & natural monopolies Sound medium of exchange MARKET STABILIZATION Macroeconomic Income redistribution Microeconomic Public goods Toll goods Commons goods Private goods? Merit goods?

10. Jump to first page Markets and the Functions of Government MARKET STABILIZATION Macroeconomic Stabilization Income Stabilization Supply Stabilization MUSGRAVE’S LAYER CAKE

11. Jump to first page Politics (given the American liberal consensus) Left: cradle to grave security, aim to eliminate all the avoidable insecurities of life Right: watch out for waste, moral hazard, and adverse selection

12. Jump to first page Macroeconomic Stabilization Addressed to systemic risk (hazard) Automatic stabilizers Monetary policy Fiscal policy Business bailouts

13. Jump to first page Why Obama Is President of the US and Not McCain

14. Jump to first page Income Stabilization Idiosyncratic (personal) risk Social security Medicare/medicaid Earned income tax credit Unemployment insurance Food support (stamps) TANF

15. Jump to first page Supply Stabilization Idiosyncratic (supplier) risk Private suppliers could fail, often when most needed Pure public goods, toll goods, positive externalities would be undersupplied (negative ones oversupplied) How about merit goods?

16. Jump to first page What is a Public Good? Private Goods Public Goods Toll Goods Common Goods

17. Jump to first page Toll Goods I: Not a Natural Monopoly

18. Jump to first page Toll Goods II: Natural Monopoly

19. Jump to first page More Realistic example of a toll good

20. Jump to first page What about merit goods? What is a merit good? If publicly supported (supplied or subsidized), less personal idiosyncratic risk Examples?

21. Jump to first page Private Good Q = 60 - 2.5P

22. Jump to first page Public Good II P = 75 - 4Q

23. Jump to first page Public Good III

24. Jump to first page What Is a FAIR Tax/Price? IF THE LIGHTHOUSE COST $12000? Equal share? Equal net benefit? Equal ratio of MC to MB IF THE LIGHTHOUSE COST $12000 & A + B EACH HAD A BENEFIT LEVEL OF $2000 AND C’s BENFIT WAS $2750?

25. Jump to first page Government Spending and Taxation

26. Jump to first page It is important to distinguish between (a) government purchases of goods & services and (b) transfer payments. Government purchases: Goods supplied through the public sector. Examples: government spending on police and fire protection, medical services, administration, highways and jet planes. Transfer payments: Income transfers from taxpayers to recipients who do not provide current goods and services in exchange for these payments. Government Spending

27. Jump to first page Approximately three-fifths of government expenditures are undertaken at the federal level. In 2000, 85% of federal expenditures went for just four items: income transfers health care national defense net interest on the national debt Government Spending

28. Jump to first page Education accounts for almost 30% of state and local spending. Other major spending categories at the state and local level include public welfare (income transfers), health care and highways. Government Spending

29. Jump to first page What Governments Buy The major categories of government spending at both the federal and state and local levels are displayed above. federal Federal government spending 2000 -- $ 1,788 billion State & local government spending 1998 -- $ 1,526 billion Defense 16.2 % Net interest 12.5 % Transportation 2.6 % Other 12.1 % Social Security 22.9 % Income security 13.8 % Medicare & health 19.9 % Education 29.5 % Admin & other 16.7 % Insurance trusts 7.1 % Public welfare & health 21.2 % Police & fire 7.9 % Interest on debt 4.2 % Transportation 6.7 % Utilities & liquor stores 6.7 %

30. Jump to first page Governments are financed by taxes, user charges, and borrowing. Borrowing implies higher future taxes. The major sources of federal revenue are the personal income tax (accounts for almost 50% of federal revenue) and the payroll tax (accounts for about a third of the total). Major revenue sources at the state and local level are sales and excise taxes, personal income taxes, user charges, and grants from the federal government. Taxes and other Sources of Funds

31. Jump to first page Sources of Revenue The revenue sources of both the federal and state and local governments are displayed above.federal state and local Federal government revenue 2000 -- $ 2,025 billion State & local government revenue 1999 -- $ 1,558 billion Payroll 32.2 % Personal income 49.6 % Corporate income 12.1 % User charges 28 % Property 15 % Payroll 2 % Sales & excise 19 % Other 4 % From Federal government 17 % Other 3.5 % Customs duties 1.0 % Excise 3.4 % Personal income 12 % Corporate income 2 %

32. Jump to first page Growth of Government

33. Jump to first page During the first 125 years of U.S. history, federal expenditures per person were small and they grew at a relatively slow rate. In contrast, federal spending soared throughout most of the 20 th century. In 1990, real federal spending per person was nearly 60 times the level of 1916. During the 1990s per capita real federal spending was relatively constant. In fact, it declined slightly during the decade. Growth of Government

34. Jump to first page Real Federal Expenditures Per Capita: 1792-2000 Real federal spending per person (measured in 2000 dollars) grew slowly during the first 125 years of U.S. history, but it soared throughout most of the 20th century. $ 7,000 $ 6,000 $ 5,000 $ 4,000 $ 3,000 $ 2,000 $ 1,000 $ 0 18001850190019502000 Real federal spending per person (in 2000 U.S. dollars)

35. Jump to first page The Changing Composition of Federal Spending

36. Jump to first page During the last 4 decades, the composition of federal spending has shifted away from national defense and toward spending on income transfers and health care. In 2000, national defense accounted for only 16.2% of the federal budget, down from 52.2% in 1960. In contrast, spending on income transfers and health care rose from 21.5% of the federal budget in 1960 to 56.6% in 2000. Changing Nature of Government

37. Jump to first page The Changing Composition of Federal Spending During the last four decades, federal spending has shifted sharply away from national defense and toward income transfers and health care. Defense expenditures (share of federal spending) Health & income transfer expenditures (share of federal spending) 19601970198019902000 19601970198019902000 52 % 42 % 23 % 24 % 16 % 22 % 30 % 44 % 56 % Health careIncome transfers

38. Jump to first page The Payment and Burden of Taxation

39. Jump to first page In 2000, total government revenues summed to 37.9% (and federal revenue to 25.6%) of national income. Both figures were at their highest level since World War II. A dollar of taxation cost the private economy much more than a dollar because: It is costly to administer, enforce, and comply with tax legislation. Taxes distort incentives and eliminate productive exchanges (and cause people to undertake some counterproductive activities). Economists refer to this as the “dead weight loss” of taxation. The Payment and Burden of Taxation

40. Jump to first page Payment of the personal income tax is skewed towards upper-income individuals. Even though the highest marginal tax rates are now lower than in 1980, the share of taxes collected from high income taxpayers has increased. The 1% of tax-filers with the highest incomes paid 36.2% of the federal personal income taxes in 1999, up from 19.1% in 1980. 66.5% of the personal income tax was collected from the top 10% of earners in 1999, compared to 49.3% in 1980. The Payment and Burden of Taxation

41. Jump to first page Overall, the U.S. tax system is generally progressive – the percentage of income taken from high earners is greater than for those with less income. More so in some states than others. US has one of the world’s most progressive tax systems; not so spending. The Payment and Burden of Taxation

42. Jump to first page Government Revenue As a Share of National Income In 2000, government revenue as a share of national income rose to the highest level since World War II. Government revenue as a share of National Income (as a share of national income) Total government revenue (federal, state, & local) 40 % 30 % 20 % 10 % 1946 195019601970198019902000 37.9 25.6 Federal revenue

43. Jump to first page Share of Federal Personal Income Taxes Paid By Various Income Groups Income group 198019901999 Share of total federal personal income tax paid Top 1% Top 5% Top 10% Next 40% Bottom 50% 19.1 % 36.8 % 49.3 % 43.7 % 7.0 % 25.1 % 43.6 % 55.4 % 38.8 % 5.8 % 36.2 % 55.5 % 66.5 % 29.5 % 4.0 %

44. Jump to first page Total Federal Taxes as a Share of Income Here we show the payment of federal taxes as a share of income for each income quintile. Note the overall federal tax structure is progressive. Lowest 5.9 % Second 11.7 % Third 17.4 % Fourth 20.1 % Highest 24.6 % –––– Family income groups –––– (quintiles) Federal taxes as a share of income (%)

45. Jump to first page Size of the U.S. Government Compared to other Countries

46. Jump to first page The U.S. size of government is smaller than that of Japan and major Western European countries, but larger than for a number of high-growth Asian economies. Size of Government: U.S. Versus Other Countries

47. Jump to first page Size of Government: An International Comparison Sweden France Greece Denmark Austria Belgium Japan Italy Germany Netherlands Canada New Zealand United Kingdom Australia Ireland United States Singapore South Korea Hong Kong Thailand 52.7 % 51.4 % 50.9 % 50.2 % 47.6 % 47.0 % 45.3 % 44.4 % 42.9 % 41.5 % 40.9 % 40.2 % 39.2 % 32.7 % 30.0 % 29.4 % 25.9 % 23.8 % 21.3 % 18.3 % Government expenditures as a share of GDP, 2000

48. Jump to first page Deficits, Surpluses, and the National Debt

49. Jump to first page Deficits, Surpluses, and the National Debt National debt: Outstanding loans that have been made to the U.S. Treasury. A budget deficit increases the size of the national debt by the amount of the deficit. Conversely, a budget surplus allows the federal government to pay off bondholders and so reduce the size of the national debt. The national debt represents the cumulative effect of all the prior budget deficits and surpluses.

50. Jump to first page Budget Deficits & the National Debt Through most of the 1950s & 1960s, federal budget deficits were small as a % of GDP; occasionally there was a surplus. During this period, the national debt declined as a % of GDP. 1950 196019701980 19902000 2 % - 2 % - 4 % 0 % Federal deficit as a share of GDP 1950196019701980 1990 2001 80 % 40 % 20 % 60 % Privately held federal debt as a % of GDP National debt as a % of GDP Other federal debt Surplus Deficit Gross & net federal debt as a share of GDP

51. Jump to first page Budget Deficits & the National Debt 1950 196019701980 19902000 2 % - 2 % - 4 % 0 % Federal deficit as a share of GDP 1950196019701980 1990 2001 80 % 40 % 20 % 60 % Privately held federal debt as a % of GDP National debt as a % of GDP Other federal debt Surplus Deficit Gross & net federal debt as a share of GDP During 1974-1995, budget deficits were quite large, causing the national debt to increase as a % of GDP. During the last few years of the 20th century, the national debt fell as a share of the economy.

52. Jump to first page Who Owns the National Debt?

53. Jump to first page (a) National debt = $5.77 trillion Source: The Treasury Bulletin, September 2001 and http://www.federalreserve.gov.. Who Owns the National Debt Private Investors 50 % Federal Reserve Banks 9 % U.S. Government Agencies 41 % (b) Privately held federal debt = $2.88 trillion Foreign Investors 42 % Domestic Investors 58 %

54. Jump to first page Concerns About the National Debt

55. Jump to first page How Does Debt Financing Influence Future Generations? For domestically held debt (58.5% of total privately held debt), the future generations that pay the tax liability accompanying the debt will also receive the interest income. The opportunity cost of resources used by the government is incurred during the current period regardless of how the government activity is financed.

56. Jump to first page Debt Financing in Other Countries

57. Jump to first page Belgium United Kingdom Australia Government Debt of Industrial Countries United States Germany France Spain Japan Canada Italy 103% 34 % 12 % 35 % 42 % 43 % 51 % 66 % 99 % Net public debt as a share of GDP, 2000 Source: OECD Economic Outlook, June 2001. Net interest on government debt, 2000 6.6 % 2.2 % 1.5 % 2.6 % 2.8 % 2.9 % 3.1 % 1.3 % 3.5 % 6.3 % Several countries have government debt to GDP ratios greater than the United States.

58. Jump to first page How Does Social Security Influence the National Debt?

59. Jump to first page Social Security, Budget Deficits, and the National Debt Social Security revenues and expenditures are generally included in budget deficit calculations. Because the Social Security system is now running a surplus, inclusion of these figures reduces the size of the reported deficit.

60. Jump to first page Demographics and Debt Financing

61. Jump to first page Favorable Budgetary Factors During the 1990s The following favorable factors shifted the federal budget from deficit to surplus during the 1990s: Rapid economic growth Reductions in defense expenditures in the aftermath of the Cold War Favorable demographics -- the baby boomers were in their prime earning years and the number of people moving into the retirement phase of life grew slowly.

62. Jump to first page Budget Prospects Budget deficits reemerged in the last decade and could get worse : Spending on defense and domestic security grew rapidly as the result of terrorist threats. The Great Recession Spending on Social Security & Medicare will grew rapidly, and will grow even faster once the baby boomers begin retiring after 2010.

63. Jump to first page End Class 1