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Common Sense Economics

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1 Common Sense Economics
Ten Elements of Clear Thinking About Economic Progress and the Role of Government Common Sense Economics James Gwartney, Richard L. Stroup, and Dwight R. Lee

2 Some Questions to Consider:
How does a democratic government really work? Is it a corrective device? Does it sometimes thwart economic progress? Will a policy supported by a voting majority be productive? What are the unintended consequences of well-intended governmental policies and programs? What is needed to reduce waste and direct governments toward productive activities? Each of these questions, as posed in the text, can serve as great discussion starters for students either pre- or post-reading. For more small group discussion questions, see the accompanying document.

3 What Role for Government?
“A wise and frugal government, which shall restrain men from injuring one another, which shall leave them otherwise free to regulate their own pursuits of industry and improvements, and shall not take from the mouth of labor the bread it has earned. This is the sum of good government.” -Thomas Jefferson

4 Clear Thinking Proposition #1
Government promotes economic progress by: protecting the private rights of individuals and supplying goods that cannot be provided through markets.

5 Government’s Protective Function
Government’s protective function includes the maintenance of a framework for security and order. Protect people and their property against aggressors through force if necessary. Enforce contracts. Help avoid restrictions, regulations and discriminatory taxes. Note that the protective function also includes the provision of national defense (a public good) and local police protection, not just a formal legal system. The importance of contract law, however, should also be emphasized here.

6 "If men were angels, no government would be necessary.”
James Madison Federalist Paper No. 51 1788

7 Life, Liberty and the Pursuit of Happiness
Government promotes economic progress by protecting individuals rights to life, liberty, and the pursuit of happiness. It can use force to protect against loss of life, threat to liberty, and damage of property. Individuals will use resources efficiently, invest and innovate if their rights to benefit from doing so are protected. Economic progress ensues.

8 Government’s Productive Function
Government’s productive function includes the provision of public goods – goods that cannot be provided easily in private markets. Public goods Are available to others once provided to an individual. Are difficult to provide only to paying customers. * National defense * Flood control projects Ask students to generate examples of other public goods. Some examples might include national defense and many infrastructure systems, etc. Once examples have been generated, ask student if each should be provided by the public sector, or whether the private sector might have any advantages in their production. (Note: This discussion is continued later in this section, especially with the Matrix of Production and Payment.)

9 The Case for Public Goods
The legitimate object of government is to do for a community of people whatever they need to have done, but cannot do, at all, or cannot, so well do, in their separate and individual capacities.” ~ Abraham Lincoln

10 Clear Thinking Proposition #2
Government is not a corrective device. It can and does fail!!!!

11 A Democratic Government
A method of social organization where individuals make and carry out choices collectively.

12 In a Democratic Government
Decisions are made at the margin. Voters, elected officials and lobbyists support those proposals from which they expect to derive net benefits. Too often the secondary effects of political actions are ignored and/or pushed into the future when the elected officials are out of office. So there is no assurance that governmental actions will be productive.

13 CSE Table 3. Benefits and Costs of a Hypothetical Government Project
 Building a Road or Civic Center Tax Payment Voter Benefits Received Plan A Equal Tax Plan B Taxed Proportionate to Benefits Adams $15.00 (30% of $50) $12.00 $18.00 (30% of $50) Brown Green Jones $ (6% of $50) $ 3.60 (6% of $50) Smith $ 2.00 (4% of $50) $ 2.40 (4% of $50) TOTAL $50.00 in total benefits $60.00 Use to illustrate that the democratic process can be used to pass an unproductive governmental proposal. Aggregate benefits are less than the aggregate costs. Reference CSE, Table 3. Reference: CSE, pages If the link benefits are linked proportionately to the taxes paid, the proposal will not pass. However, a voting majority could pass Plan A which is unproductive. Jones and Smith must participate and pay.

14 A Democratic Government: Some Important Points
Policies proposed by the government may or may not be productive. Policies favored by the voting majority do not necessarily promote economic progress. The benefits and costs faced by voters belonging to different interest groups are often disproportionate. It may be useful to provide a brief description of public choice economics here. Lessons on logrolling and voter models are also very useful in emphasizing to students the variance between differing groups’ benefits and costs in pursuing public policy.

15 Unlike Democratic Governments, When Markets Are Competitive
Producers can not force consumers to buy their products. They have incentives to undertake only productive activities.

16 Let’s Compare Democratic Governments and Markets
The government can use coercion to tax and subsidize. Markets can not. Markets can charge high prices but can not force people to pay. Governments “can” and “do”. Unconstrained political democracy is a system of majority rule, while market allocation is based on proportional representation. In markets, consumers buying one commodity will not interfere with the ability of others to buy a different one.* Point out to students that no such coercive power (i.e., as the government’s power to tax) exists in the private sector. Markets are analogous to a system of proportional representation, whereas political democracy is a system of majority rule, where a slim majority can impose its will on a nearly equal sized segment of the citizenry. Instructors may want to elaborate on the meaning of proportional representation. Consumers buying one commodity will not interfere with the ability of others to buy alternatives. For example, 20% of all auto consumers can purchase Chevrolets and 15% can buy Fords. And their consumption decisions will not interfere with the choices of others to buy different models. Ask students to generate examples of goods or services that seem to actually be valued LESS than what they cost. Answers will vary, but any publicly-financed product which students believe is “not worth it” will do.

17 What Is Needed to Encourage Democratic Governments To Be Productive?
To reduce the likelihood that people can participate in government projects without paying, it is important to link benefits proportionately to costs. A democratic majority vote does not guarantee the passage of productive proposals. Supermajority support (75% of the voters) will increase the likelihood of passing productive projects.

18 Clear Thinking Proposition #3
The costs of government are not only taxes. The amount of revenue a government collects in taxes is often misconstrued to represent the total costs of the institution, its services, and policies. Nothing is further from the truth…Tax revenue figures fail to account for the opportunity costs associated with tax policy decisions.

19 Which of the following is true of taxes?
Taxes increase the volume of mutually advantageous exchanges. Tax increases are the primary cause of inflation. Business taxes generate government revenue without imposing a burden on consumers and households. Taxes drive a wedge between what buyers pay and what sellers receive. Answer: d

20 3 Types of Costs Incurred
The loss of private sector output that could otherwise be produced The cost of resources expended in tax collection and enforcement of government mandates The cost of price distortions caused by taxes and borrowing As always, the concept of opportunity cost is extremely relevant here. Federal budget simulations may be useful here. Just one example of such a simulation is found at Such simulations tend to demonstrate to students that it is easy to decide on expenditures, until you begin to consider the alternative uses of these same funds.

21 Costs of Collection & Enforcement
Preparation, monitoring and enforcement of tax law and regulatory legislation require time, talent and money. These resources could be used elsewhere. People will use resources to avoid taxes. Government expenditures plus compliance costs and mandated private spending represent more than 1/2 of GDP. The White House estimates that it takes a total of 3 billion hours to comply with the tax code, or about 27 hours per taxpayer. Estimates of the cost of complying with the U.S. tax code top the $200 billion mark, not inclusive of enforcement and regulation. In other words, U.S. citizens spend nearly $200 billion in man hours essentially preparing their taxes. The U.S. tax code is up to nearly 55,000 PAGES in length.

22 Let’s Review How To Measure Government’s Share of Total Output
Government expenditure’s share of total U.S. spending on goods and services produced represents approximately 35% of total GDP. When the costs of regulations are added, this share rises to over 50% of GDP. Government is big in the U.S.!

23 Government Can Distort Prices
Taxes alter consumption and production incentives. Consider supply and demand. Taxes increase what consumers pay and reduce what sellers receive. They reduce the volume of exchanges and squeeze out some of the gains from trade. Some exchanges will not occur because the tax wedge makes them disadvantageous. Deadweight loss of taxation adds 9-16% above the costs of compliance and regulation.

24 Taxes in a Nutshell Taxes distort prices.
Taxes transfer income from individuals to the government. Businesses do not pay taxes. Instead, they collect taxes from customers, employees and shareholders. Politicians want to conceal the tax costs of their programs and make you “think” businesses are paying!

25 Do you agree or disagree? Explain.
“Taxing is much like plucking a goose. It is the art of getting the greatest number of feathers with the least amount of hissing.” ~ Senator Bob Dole Wall Street Journal December 16, 1983

26 Clear Thinking Proposition #4
Unless restrained by constitutional rules, special-interest groups will use the democratic process to fleece taxpayers and consumers.

27 A Democratic Government
Can contribute to economic progress when it fills its protective and productive roles. However, more than a majority rule and popular vote is needed to assure that it restricts itself to those roles. Why? Incentives matter! Consider the following three examples.

28 1. Democratic Government Incentives
“Government regulators and legislators may be heavily influenced by lobbyists and the possibility of securing highly paid jobs after leaving government, and so they may focus on the interests of the regulated party rather than citizens.”* NCEE VE (3.0.3)

29 The Power of Special Interests
Special interest groups will help politicians get elected through donations and getting workers to vote. While the majority of unorganized voters is harmed, there is little incentive to act in opposition. In varying degrees, all politicians cater to special interests. Ask students if they have ever engaged in activism for a cause that required political (hence fiscal) action. Have they ever argued for such action based on the “look how little it costs you to save/do/better ____”? Have they ever heard such a ply being used on behalf of other causes? How effective is this strategy?

30 2. Democratic Government Incentives
“If a small but organized group cares a great deal about a certain government policy, while the majority is unorganized and apathetic, then the special interest often prevail.”* NCEE VE (3.0.3) NCEE VE 3.0.3

31 Consider This “Sweet” Example
In 2000, the sugar lobby contributed $13 million to politicians. The government restricts sugar imports into the U.S. through quotas. The average U.S. consumer pays $20 per year in higher sugar prices while sugar growers gain about $1.9 billion. IS THIS A SOUND GOVERNMENT PROGRAM? DISCUSS.

32 3. Democratic Government Incentives
Log-rolling: implicit vote trading among legislators They vote for programs that benefit the districts of other legislators in exchange for votes for their pet projects. Federally funded dams, highways, housing projects, Veterans Administration hospitals, and job-training centers are often reflective of logrolling. NCEE VE 3.0.3

33 Are based on careful analysis of benefits relative to costs.
Question: Restrictions that limit sugar imports, subsidies for the construction of sports stadiums, and federal spending on programs like the construction of an indoor rain forest in Iowa all provide examples of government programs that, Are based on careful analysis of benefits relative to costs. Are designed to redistribute income from the rich to the poor. Reflect the political attractiveness of special-interest issues. Promote the general welfare. Answer: c

34 Clear Thinking Proposition #5
Unless restrained by constitutional rules, legislators will run budget deficits and spend excessively.

35 The Attractiveness of Deficit Spending to Legislators
Budget Deficit: Government spending that exceeds revenues. Deficits are financed by borrowing. Spending is attractive to legislators because it allows them to take credit for programs that benefit voters. Taxes are unattractive because they impose visible costs on voters. Thus, legislators tend to spend more than they are willing to tax.

36 The National Debt The cumulative effect of all past budget deficits and surpluses of the federal government. Check out the U.S. Debt. The U.S. Treasury borrows funds by selling securities like U.S. Treasury Bills, Notes, and Bonds. Borrowing makes the current cost of running the government less visible. A surplus exists when government revenue exceeds spending.

37 Deficit Spending and National Debt
Borrowing pushes the visible cost of running the government and policies into the future. Bottom line. Immediate benefits with deferred costs are politically attractive! Deficit spending and public debt appear to transfer costs into the future when current politicians are no longer office.

38 Constitutional Changes That May Restrain Legislators
Require the federal government to balance its budget like most states. Require a 2/3 or ¾ majority vote in both branches of Congress to fund deficit spending or increase its borrowing power. Require that Congress only spends an amount equal to last year’s tax revenue.

39 Clear Thinking Proposition #6
Government slows economic progress when it becomes heavily involved in trying to help some people at the expense of others.

40 Production or Plunder? A neutral government can help make the economic “production” pie bigger when it protects property rights and provides public goods! It shrinks the economic pie when it “plunders” the income of one group to satisfy the interests of another. Ask students is a “neutral government” (or individual policy-maker) is even a real possibility? Stress that this does NOT mean that policy-makers are inherently bad, wasteful, uncaring, etc., but rather that the incentives to spend are unavoidable in our political system. “Counterproductive, favor-seeking activities are a natural outgrowth of unrestrained democracy.” CSE, p97

41 Clear Thinking Proposition #7
The costs of government income transfers are far greater than the net gain to intended beneficiaries.

42 Income Transfers It is difficult to improve people’s well-being through income transfers when benefits are not attached to costs. The unintended consequences of secondary effects can get in the way.

43 The Unintended Consequences of Income Transfers
Reduce incentives of both taxpayer and transfer recipient to earn income “Free” income reduces work effort and innovation among transfer beneficiaries. Increased tax burdens stifle incentives to produce and earn more among persons earning income and paying taxes. Competition for transfers erodes most of the long-term gain of the targeted beneficiaries. When qualification requirements must be met, resources and potential production are wasted as individuals seek to qualify for the transfers. Ask students if the above claim about diminished work effort is controversial. Why or why not? If the claim is true, why does it not influence the politics of transfer payments?

44 Income Transfers (cont.)
Protection from adversity arising from imprudent decisions makes people more likely to increase the likelihood of that adversity. Consequences of adversity become less severe. Potential recipients have less incentive to avoid adversity. If you subsidize something, you get more of it. Transfers directed toward the poor unintentionally encourage high-risk lifestyles. Charitable efforts are crowded out. The moral hazard problem is useful to introduce to students here. Using car and/or health insurance as policies that encourage riskier behavior is a non-controversial way to introduce the concept. That is, ask students to explain why insured drivers might be more likely than uninsured drivers to take risks/drive aggressively. Then you may be able to connect easier to the moral hazard issue in terms of income transfer programs.

45 The “War on Poverty” Illustrates These Points
Poverty rates in the US were falling before the launch of the “War on Poverty”. It has hovered around 10%. The U.S. poverty rate started falling before the government’s war on poverty. Data source:

46 Clear Thinking Proposition #8
Central planning replaces markets with politics, which wastes resources and retards economic progress.

47 The “Man of System” “The man of system is apt to be very wise to his own conceit. He seems to imagine that he can arrange the different members of a great society with as much ease as the hand arranges the different pieces upon a chess-board.” -Adam Smith

48 The “Fatal Conceit” of Central Planning
Central planning merely substitutes politics for market outcomes. Subsidies and investment funds disbursed by planners are influenced by political considerations. “Old” firms tend to be favored over “new”, growth-oriented firms. “Pork barrel” projects are still pursued.

49 The “Fatal Conceit” of Central Planning
The incentive of government-operated firms to keep costs low, be innovative, and supply goods efficiently is weak. Boosting efficiency or lowering costs generate little political gain. Per-unit costs rise as increased inefficiencies get built into the political allocation.

50 The “Fatal Conceit” of Central Planning
Investors risking their own money will make better investment choices than central planners spending the money of taxpayers. Private investors bear the consequences of poor decisions directly but central planners do not. Private investors have a strong incentive to increase productivity and keep costs low. In contrast, political rather economic considerations are more important for central planners.

51 The “Fatal Conceit” of Central Planning
There is no way that central planners can acquire enough information to create, maintain, and constantly update a plan that makes sense. Market prices generally channel information quickly and accurately to both producers and consumers. On the other hand a political process, particularly one with checks and balances like those found in the U.S., will respond slowly and often in a contradictory manner.

52 Clear Thinking Proposition #9
Competition is just as important in government as in markets.

53 Government & Competition
Leaders of public sector firms have little incentive to cut costs or boost performance when there is little competition. Inefficient programs are permitted to linger. Failure to achieve goals is often rewarded by increased funding. Consider increased funding in police departments with higher crime rates. In the market economy, profits and losses register performance. Inefficient producers are weeded out and efficient ones are rewarded. There is no parallel in the centralized government. Ask students why private firms are penalized for incurring losses while the public sector is not (and in fact, may even see budgetary INCREASES if losses are sustained). What effect does this have on the overall productivity of the economy?

54 Government & Competition
3. Increased competition among decentralized government units or between the government and private sector creates incentives for government officials to work productively, seek efficiency, cut costs and innovate. 4. Citizens with differing preferences and views about government activities can vote with their feet in a decentralized system; a centralized system does not permit this.

55 Clear Thinking Proposition #10
Constitutional rules that bring the political process and sound economics into harmony will promote economic progress.

56 Constitutional Checks
The scope of government must be limited. An unrestrained government results in the fleecing of citizens. Constitutional checks: 10th Amendment 5th Amendment Please note that the text includes a proposed “Economic Bill of Rights” as suggestions for accomplishing the objectives above. A separate Power Point presentation on this “Bill of Rights” is also included. 10th amendment “The powers not delegated to the United States by the Constitution, nor prohibited by it to the States, are reserved to the States respectively, or to the people. “ It limits the power of the federal government to those presented in the U.S. Constitution. Fifth Amendment. Life the 10th Amendment, it is a part of the Bill of Rights and it involves due process.

57 A Positive Program for Prosperity
List the seven constitutional constraints presented by the authors. Explain the purpose of each constraint. Indicate why you think it will be either effective or ineffective.

58 A Positive Program for Prosperity: 7 Constitutional Suggestions
No government shall use its regulatory powers to take private property, either partially or in its entirety, for public use without paying the owner the full market value of the property taken.

59 A Positive Program for Prosperity: 7 Constitutional Suggestions
2. The right of individuals to compete in a business or profession and/or buy and sell legally tradable goods and services at mutually acceptable terms shall not be infringed by Congress or any of the States.[i] Footnote i. Points (2) and (3) are borrowed from Milton and Rose Friedman, Free to Choose, (New York: Harcourt Brace Jovanovich, 1980). See particularly chapter 10.

60 A Positive Program for Prosperity: 7 Constitutional Suggestions
3. Congress shall not levy taxes or impose quotas on either imports or exports. 4. A three-fourths approval of both Houses of Congress shall be required for all expenditure programs of the federal government. At least two-thirds approval of the legislative branches of state government shall be required for the approval of expenditures by state governments.

61 A Positive Program for Prosperity: 7 Constitutional Suggestions
5. A three-fourths approval of both Houses of Congress shall be required before the federal government is permitted to borrow any funds to finance a deficit in its annual budget.

62 A Positive Program for Prosperity: 7 Constitutional Suggestions
6. A three-fourths approval of both Houses of Congress shall be required for the federal government to mandate any expenditures by either state governments or private business firms.

63 A Positive Program for Prosperity: 7 Constitutional Suggestions
7. The function of the Federal Reserve System (Fed) is to maintain the value of the currency and establish a stable price level. If the price level either increases or decreases by more than 4 percent annually during two consecutive years, all Governors of the Federal Reserve System shall be required to submit their resignations.

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