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FUNDAMENTAL PRINCIPLES OF PUBLIC FINANCE INTRODUCTION
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?
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).
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)
IF TAXES ARE SO BAD, WHY HAVE A PUBLIC SECTOR IN AN OPEN AND FREE SOCIETY?
IN SOME CASES THE BENEFITS OF COLLECTIVE ACTION (requiring spending) OFFSET THE HARMS DONE BY TAXES
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.
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? Markets and the Functions of Government
MARKET STABILIZATION Macroeconomic Stabilization Income Stabilization Supply Stabilization MUSGRAVE’S LAYER CAKE Markets and the Functions of Government
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
Macroeconomic Stabilization • Addressed to systemic risk (hazard) • Automatic stabilizers • Monetary policy • Fiscal policy • Business bailouts
Income Stabilization • Idiosyncratic (personal) risk • Social security • Medicare/medicaid • Earned income tax credit • Unemployment insurance • Food support (stamps) • TANF
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?
What is a Public Good? Private Goods Toll Goods Common Goods Public Goods
What about merit goods? • What is a merit good? • If publicly supported (supplied or subsidized), less personal idiosyncratic risk • Examples?
Private Good Q = 60 - 2.5P
Public Good II P = 75 - 4Q
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? What Is a FAIR Tax/Price?
Government Spending and Taxation
Government Spending • 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 • 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 • 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.
SocialSecurity 22.9 % Insurance trusts 7.1 % Defense16.2 % Public welfare& health 21.2 % Education29.5 % Netinterest12.5 % Police& fire7.9 % Incomesecurity13.8 % Admin &other 16.7 % Transportation6.7 % Other 12.1 % Medicare & health 19.9 % Intereston debt 4.2 % Utilities &liquor stores 6.7 % Federal government spending2000 -- $ 1,788 billion Transportation 2.6 % State & local government spending1998 -- $ 1,526 billion What Governments Buy The major categories of government spending at both the federal and state and local levels are displayed above.
Taxes and other Sources of Funds • 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.
Payroll32.2 % User charges 28 % Property 15 % Personalincome49.6 % Payroll2 % Sales &excise 19 % Other3.5 % Personalincome12 % Customsduties 1.0 % Corporateincome 2 % Other 4 % Corporateincome 12.1 % Excise3.4 % From Federalgovernment 17 % Federal government revenue2000 -- $ 2,025 billion State & local government revenue1999 -- $ 1,558 billion Sources of Revenue The revenue sources of both the federal and state and local governments are displayed above.
Growth of Government • 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 20th 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.
Real Federal Expenditures Per Capita: 1792-2000 Real federal spending per person(in 2000 U.S. dollars) $ 7,000 $ 6,000 $ 5,000 $ 4,000 $ 3,000 $ 2,000 $ 1,000 $ 0 1800 1850 1900 1950 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.
The Changing Composition of Federal Spending
Changing Nature of Government • 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.
56 % 52 % 44 % 44 % 42 % 30 % 24 % 23 % 22 % 16 % Health & income transfer expenditures(share of federal spending) Defense expenditures(share of federal spending) Health care Income transfers The Changing Composition of Federal Spending 1960 1970 1980 1990 2000 1960 1970 1980 1990 2000 During the last four decades, federal spending has shifted sharply away from national defense and toward income transfers and health care.
The Payment and Burden of Taxation
The Payment and Burden of Taxation • 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 • 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 • 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.
Total government revenue(federal, state, & local) Federal revenue 37.9 25.6 Government Revenue As a Share of National Income Government revenue as a share of National Income(as a share of national income) 40 % 30 % 20 % 10 % 1950 1960 1970 1980 1990 2000 1946 • In 2000, government revenue as a share of national income rose to the highest level since World War II.
Share of Federal Personal Income Taxes Paid By Various Income Groups Share of total federalpersonal income tax paid Income group 1980 1990 1999 Top 1% 19.1 % 25.1 % 36.2 % Top 5% 36.8 % 43.6 % 55.5 % 49.3 % 55.4 % 66.5 % Top 10% Next 40% 43.7 % 38.8 % 29.5 % Bottom 50% 7.0 % 5.8 % 4.0 %
24.6 % 20.1 % 17.4 % 11.7 % 5.9 % Total Federal Taxes as a Share of Income Federal taxes as a share of income (%) Lowest Second Third Fourth Highest –––– Family income groups –––– (quintiles) 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.
Size of Government: U.S. Versus Other Countries • 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: An International Comparison Government expenditures as a share of GDP, 2000 Sweden 52.7 % France 51.4 % Greece 50.9 % Denmark 50.2 % Austria 47.6 % Belgium 47.0 % Japan 45.3 % Italy 44.4 % Germany 42.9 % Netherlands 41.5 % Canada 40.9 % New Zealand 40.2 % United Kingdom 39.2 % Australia 32.7 % Ireland 30.0 % United States 29.4 % Singapore 25.9 % South Korea 23.8 % Hong Kong 21.3 % Thailand 18.3 %
Deficits, Surpluses, and the National Debt
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.
Surplus Deficit Privately held federaldebt as a % of GDP National debtas a % of GDP Other federal debt Budget Deficits & the National Debt Federal deficitas a share of GDP 2 % 0 % - 2 % - 4 % 1950 1990 2000 1960 1970 1980 Gross & net federal debtas a share of GDP 80 % 60 % 40 % 20 % 1950 1960 1970 1980 1990 2001 • 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.
Surplus Deficit Privately held federaldebt as a % of GDP National debtas a % of GDP Other federal debt Budget Deficits & the National Debt Federal deficitas a share of GDP 2 % 0 % - 2 % - 4 % 1950 1990 2000 1960 1970 1980 Gross & net federal debtas a share of GDP 80 % 60 % 40 % 20 % 1950 1960 1970 1980 1990 2001 • 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.
Who Owns the National Debt?
U.S. GovernmentAgencies 41 % ForeignInvestors 42 % FederalReserveBanks 9 % PrivateInvestors 50 % DomesticInvestors 58 % (b) Privately held federal debt = $2.88 trillion (a) National debt = $5.77 trillion Who Owns the National Debt Source: The Treasury Bulletin, September 2001 and http://www.federalreserve.gov..