Market Failures and Government Intervention

1. Chapter 5 The Public Sector and Public Choice

2. Should a computer operating system be considered a public good? Economic theory offers some insight into the special characteristics of public goods. Introduction

3. Learning Objectives • Explain how market failures such as externalities might justify economic functions of government • Distinguish between private and public goods and explain the nature of the free-rider problem • Describe the political functions of government that entail its involvement in the economy

4. Learning Objectives • Distinguish between average tax rates and marginal tax rates • Explain the structure of the U.S. income tax system • Discuss the central elements of the theory of public choice

5. Chapter Outline • What a Price System Can and Cannot Do • Correcting for Externalities • The Other Economic Functions of Government

6. Chapter Outline • The Political Functions of Government • Paying for the Public Sector • The Most Important Federal Taxes • Spending, Government Size, and Tax Receipts • Collective Decision Making: The Theory of Public Choice

7. Did You Know That... • The 1986 tax act was said by Congress to be a reform that would persist over the long term, yet more than 80 additional tax laws have been enacted since then? • The amount of revenue the federal government collects in the form of an income tax exceeds $1 trillion annually?

8. What a Price System Can and Cannot Do • A perfectly competitive price system can allocate resources efficiently through the interaction of markets. • Market Failure • A situation in which an unrestrained market economy leads to too few or too many resources going to a specific economic activity

9. What a Price System Can and Cannot Do • Market failure prevents economic efficiency. • Market failure prevents individual freedom. • Public policy (government) is often called upon to address market failure.

10. Correcting for Externalities • Market efficiency occurs when individuals know the true opportunity cost of their actions.

11. Correcting for Externalities • Market failure: an example • Assume • No government regulation against pollution • A town with clean air • A steel mill opens and emits smoke that causes: • more respiratory diseases • dirtier clothes, houses, cars, etc.

12. Correcting for Externalities • Market failure: an example • Market failure occurs: • Steel mill does not pay for the clean air • Costs of production have “spilled over” to the residents (third parties) • Lower production cost • More steel is produced than would otherwise be the case

13. Correcting for Externalities • Externalities • Occur when the consequence of an economic activity spillover to affect third parties • ThirdParties • Parties who are not directly involved in a given activity or transaction

14. Correcting for Externalities • Externalities are examples of market failures. • Pollution is an example of a negative externality.

15. S2 E1 P2 E A D Q2 External Costs and Benefits Panel (a) S1 Price of Steel per Ton P1 Q1 Quantity of Steel per Year Figure 5-1, Panel (a)

16. P2 D2 Q2 External Costs and Benefits Panel (b) S P1 Price of Inoculation D1 Q1 Quantity of Inoculations per Year Figure 5-1, Panel (b)

17. The Other Economic Functions of Government • Providing a legal system • Enforcing contracts • Defining and protecting property rights • Establishing legal rules of behavior

18. The Other Economic Functions of Government • Property Rights • The rights of an owner to use and to exchange property

19. The Other Economic Functions of Government • Promoting competition • Market failure may occur if markets are not competitive. • Monopoly power • Antitrust legislation

20. The Other Economic Functions of Government • Monopoly • A firm that has great control over the price • Antitrust Legislation • Laws that restrict the formation of monopolies and regulate certain anticompetitive business practices

21. The Other Economic Functions of Government • Providing Public Goods • Goods to which the principle of rival consumption does not apply • In contrast, private goods can be consumed by one individual at a time.

22. The Other Economic Functions of Government • Characteristics of public goods • Indivisible • Additional people can use public goods at no additional cost • Additional users of public goods do not deprive other users • Difficult to charge for a public good based on consumption—the exclusion principle

23. The Other Economic Functions of Government • Free-Rider Problem • Arises when some individuals take advantage of the fact that others will take on the burden of paying for public goods • Question • How much national defense did you consume last month?

24. The Political Functions of Government • Merit Goods • Goods deemed socially desirable through the political process • Museums • Ballet • Concerts • Theater • Provided through subsidization

25. International Example: Free Rider Problems and Terrorism • Political groups that can provide security and public services for residents are often given free reign to operate in a region. • This was the case with the Taliban in Afghanistan and Hamas in the Palestinian territories.

26. International Example: Free Rider Problems and Terrorism • Because these groups collected funds through the threat of force, they were better financed than were the official political entities in the region. • Their coercive tactics is collecting financial support allowed them to avoid the free rider problem.

27. Paying for the Public Sector • Marginal Tax Rate • The tax rate on the last dollars earned • Average Tax Rate • The proportion of total income paid in taxes

28. change in taxes due change in taxable income Marginal Tax Rate = Paying for the Public Sector • Tax Bracket • A specified level of taxable income to which a specific and unique marginal tax rate is applied

29. Paying for the Public Sector • Taxation systems • Proportional Taxation (flat-rate tax) • Marginal tax rate = Average tax rate • Everyone pays the same percentage of their income in taxes

30. Paying for the Public Sector Proportional Taxation Proportional Tax Rate = 20% Taxable Income x Tax Rate = Tax Liability $10,000 20% $2,000 $100,000 20% $20,000 Marginal Tax Rate = 20% Average Tax Rate = 20%

31. Paying for the Public Sector • Taxation systems • Progressive Taxation • Marginal tax rate > Average tax rate • As a person’s taxable income increases, the percentage of income paid in taxes increases

32. Paying for the Public Sector Progressive Taxation: Income Tax Taxable Income Tax Rate Tax Liability 0–$10,000 5% $500 $10,001–20,000 10% $1,000 $20,001–30,000 30% $3,000 $4,500 Income = $30,000 Marginal Tax Rate = 30% Average Tax Rate = 15% or $4,500/$30,000

33. Paying for the Public Sector • Taxation systems • Regressive Taxation • Marginal tax rate < Average tax rate • As a person’s taxable income increases, the percentage of income paid in taxes decreases

34. Paying for the Public Sector Regressive Taxation: Social Security Hypothetical Example Taxable Income Tax Rate* Tax Liability $5,000 10% $500 $100,000 ——— $5,000 *Tax Rate = 10% on first $50,000 of income; no tax on additional income Income = $5,000 Marginal Tax Rate and Average Tax Rate = 10% Income = $100,000 Marginal Tax Rate = 0% Average Tax Rate = 5% or $5,000/$100,000

35. The Most Important Federal Taxes • The federal personal income tax • Accounts for 46% of all federal revenue

36. Federal Marginal Income Tax Rates Table 5-1

37. The Most Important Federal Taxes • Arguments for the progressive tax • Redistribution of income • Ability to pay • Benefits received • Question • Does the income tax system redistribute income?

38. The Most Important Federal Taxes • The treatment of Capital Gains (Losses) • Positive (negative) difference between the purchase price and the selling price of an asset • Capital gains are not indexed for inflation

39. The Most Important Federal Taxes • The corporate income tax • Accounts for 12% of federal tax revenue

40. Federal Corporate Income Tax Schedule $0–$50,000 15% $50,001–75,000 25% $75,001–10,000,000 34% $10,000,001 and up 35% Progressive Taxation: Income Tax Corporate Taxable Income Corporate Tax Rate Source: U.S. Department of Treasury

41. The Most Important Federal Taxes • Double taxation • Corporation pays taxes on its profits • Corporation declares a dividend on after-tax profits • Dividend income is taxed • Retained earnings may increase the value of the stock

42. The Most Important Federal Taxes • Who really pays the corporate income tax? • Tax Incidence (the distribution of tax burdens among various groups in society) • Consumer • Stockholder • Employees

43. The Most Important Federal Taxes • Social Security tax • Social Security rates today are imposed on earnings up to about $80,000 OASDI Medicare* Matched by Employer 6.20% 2.90% 6.20% *Medicare matched by employer

44. The Most Important Federal Taxes • Unemployment tax • 0.8% of first $7,000 of wages for employees earning more than $1,500 • Paid by employer • States levy an additional tax up to 3% based on record of the employer

45. Spending, Government Size, and Tax Receipts • Government receipts • The federal government • State and local government

46. Total Government Outlays Over Time Source: Facts and Figures on Government Finance and Economic Indicators, various issues Figure 5-2

47. Sources of Government Tax Receipts Source: U.S. Department of Commerce, Bureau of Economic Analysis Figure 5-3

48. Federal Government Spending Compared to State and Local Spending Budget of the United States Government; Government Finances Figure 5.4

49. Collective Decision Making: The Theory of Public Choice • Collective Decision Making • How voters, politicians, and other interested parties act and how these actions influence non-market transactions

50. Collective Decision Making: The Theory of Public Choice • Theory of Public Choice • The study of collective decision making