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

2. Chapter 1: Introduction to Public Finance 1 - 2 Introduction The role of government in making a free market possible Why free markets usually work well for consumers Problems for the free market Problems for the government Taxes, subsidies, regulations, and inefficiency Taxes and government spending in the United States

3. Chapter 1: Introduction to Public Finance 1 - 3 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 EconomicsNormative Economics What is happening?Is it good or bad?

4. Chapter 1: Introduction to Public Finance 1 - 4 Why Free Markets usually Work Well for Consumers Free markets are efficient Productive efficiency Allocative efficiency Figure 1.1 D P 90 100 110 Q S $10 $8 $14 $12 $6 = (MB) = (MC)

5. Chapter 1: Introduction to Public Finance 1 - 5 Taxes, Subsidies, Regulations, and Inefficiency A tax levied on producers T=$4 S D Figure 1.2 90 100 110 Q S` P $10 $8 $14 $12 $6 T=$4 Figure 1.3 90 100 110 Q S D D`D` P $10 $8 $14 $12 $6 or a tax levied on consumer …produces the same effect. A decrease in quantity.

6. Chapter 1: Introduction to Public Finance 1 - 6 Taxes, Subsidies, Regulations, and Inefficiency Deadweight loss T=$4 90 100 110 Q Figure 1.4 P $14 – $12 – $10 – $8 – $6 – S D A D B An inefficiency which causes a reduction in society’s welfare Deadweight loss is represented by area = BAD

7. Chapter 1: Introduction to Public Finance 1 - 7 Taxes, Subsidies, Regulations, and Inefficiency S=$4 Figure 1.5 90 100 110 Q S D S` P $10 $8 $14 $12 $6 A subsidy given to producers Figure 1.6 90 100 110 Q S D D` P $10 $8 $14 $12 $6 or a subsidy given to consumers …produces the same effect: an increase in quantity

8. Chapter 1: Introduction to Public Finance 1 - 8 Taxes, Subsidies, Regulations, and Inefficiency Figure 1.7 90 100 110 Q P $14 – $12 – $10 – $8 – $6 – S D S=$4 A D B Deadweight loss is represented by area = BAD

9. Chapter 1: Introduction to Public Finance 1 - 9 Problems for the Free Market $4 A D B MSC = (MC + marginal environmental damage) Figure 1.8 S (MC) D (MB) P $14 – $12 – $10 – $8 – $6 – 90 100 110 Q MSC Negative externality Solution? A corrective tax. Externalities: Chapters 2 and 6

10. Chapter 1: Introduction to Public Finance 1 - 10 Problems for the Free Market A D B $4 Externalities: Chapters 2 and 6 MSB = (MC + marginal benefit to other people) Figure 1.9 90 100 110 Q P $14 – $12 – $10 – $8 – $6 – MSB S (MC) D (MB) Positive externality Solution? A corrective subsidy.

11. Chapter 1: Introduction to Public Finance 1 - 11 Problems for the Free Market Public Goods: Chapter 3 Social Insurance: Chapters 5 and 6 A public good has 2 properties: 2. Non-excludability 1. Non-rivalry Old-age insurance – Social Security Health insurance – Medicare Free-rider problem

12. Chapter 1: Introduction to Public Finance 1 - 12 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

13. Chapter 1: Introduction to Public Finance 1 - 13 Problems for the Free Market Low income assistance: Chapter 12 Medicaid Earned income tax credit (EITC) Unemployment compensation Disability insurance Worker’s compensation

14. Chapter 1: Introduction to Public Finance 1 - 14 Problems for the Government Political economy: Chapter 3 Island wall Compare costs against benefits Federal, state, and local Types of taxes Cost-benefit analysis: Chapter 4 Which level of government?: Chapter 10 Borrowing and the effects of borrowing Borrowing instead of taxing: Chapter 13

15. Chapter 1: Introduction to Public Finance 1 - 15 Taxes and Government Spending in the U.S. Question 1: a)U.S. taxes (federal, state, and local) as a % of GDP: _____ b)U.S. federal taxes as a % of GDP: _____ c)U.S. state and local taxes as a % of GDP: _____ d)OECD taxes as a % of GDP: _____ e)Scandinavian taxes as a % of GDP: _____ Figure 1.10 Taxes as a percent of GDP U.S. OECD Scandinavia 10% 20% 30% 40% 50% 60% Federal S&L 30% 20% 10% 40% 50%

16. Chapter 1: Introduction to Public Finance 1 - 16 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% 20% 19% 18% 1965 1970 1975 1980 1985 1990 1995 2000 2005 Year Federal Spending 21% 17% 16% Federal Taxes

17. Chapter 1: Introduction to Public Finance 1 - 17 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% 35% 30% 25% 1965 1970 1975 1980 1985 1990 1995 2000 2005 Year Federal Debt

18. Chapter 1: Introduction to Public Finance 1 - 18 Taxes and government spending in the U.S. Question 4: What are the important sources of federal tax revenue? Figure 1.13

19. Chapter 1: Introduction to Public Finance 1 - 19 “The Big 3”Fed SpendingFed TaxesFed Deficit 20008%20% 0% 201010%22%20%2% 202012%24%20%4% 203014%26%20%6% 204016%28%20%8% 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

20. Chapter 1: Introduction to Public Finance 1 - 20 Summary The role of government in making a free market possible Why free markets usually work well for consumers Problems for the free market Problems for the government Taxes, subsidies, regulations, and inefficiency Taxes and government spending in the United States

21. Chapter 1: Introduction to Public Finance 1 - 21 Preview of Chapter 2: Externalities and the Environment Applications: Acid rain and global warming Economic analysis of a pollution tax and tradable permits The economist’s approach to pollution