The Economics of Government

Study Questions

n 1. What is the role of government to insure public goods are available to society?

n 2. What is the role of government when dealing with a negative externality?

n 3. What is the role of government when dealing with a positive externality?

n 4. List four activities where government acts as the agent for society.

n 5. Contrast a progressive tax system with a regressive tax system.

n 6. What is the function of a transfer payment?

n 7. Relate the government budget to the national debt.

n 8. Contrast decision making in the voting booth with decision making in the market place.

n 9. Contrast running a bureaucracy with running a business.

n 10. How does government define the poverty line?

n 11. Describe the conflict between the two economic goals of equity and efficiency.

Roles of Government

n Agent of society.

¨ make society function smoothly and efficiently

¨ pass laws to govern our conduct

¨ adjudicate and resolve conflict

¨ provide assistance to needy society members

¨ provide or arrange for goods and services

¨ consumes goods and services

Public goods

n private good:

¨ rival in consumption

¨ exclusionary

n public good:

¨ non-rival in consumption

¨ non-exclusionary

Public goods

n Free rider problem:

¨ Once produced, a public good can be used by everybody “for free”

¨ Therefore, nobody will pay for a public good

¨ Firms see nobody who will pay, so they do not produce the public good

Public goods

n Solution:

¨ government becomes the buyer

¨ firms produce the good and get paid by government

¨ people use the good “for free”

¨ government collects taxes or fees to fund the purchase

Externalities

n A cost or benefit arising from an activity that falls on a third party (someone other than the producer or the consumer)

¨ Third party cost? Negative externality

¨ Third party benefit? Positive externality

Negative externality

n Example: pollution

¨ Producer keeps costs low by dumping waste into a river

¨ People living along the river suffer a cost as they live in a degraded environment

n Society adds this externalized cost to the private costs of buyer and seller

Negative externality

n Social costs = private costs + external (third party) costs.

¨ Society says these goods are:

n over consumed

n over produced

¨ External costs are not included in market decision making.

¨ Government intervenes.

Negative externality

n Government can:

¨ force the producer to internalize the cost.

¨ prohibit the producer from making the product.

¨ reward the producer for reducing the external cost.

Positive externality

n Example: K-12 education

¨ Society benefits from:

n an educated work force.

n an educated citizenry.

n Society adds this externalized benefit to the private benefits of student (buyer) and teacher (seller).

Positive externality

n Social benefits = private benefits + external (third party) benefits.

¨ Society says these goods are:

n under consumed

n under produced

¨ External benefits are not included in market decision making.

¨ Government intervenes.

Positive externality

n Government can:

¨ subsidize the producer to produce more

¨ subsidize the consumer by offering the good at a very low price

¨ coerce the consumer by mandating the use of the good

Establish Rules of Conduct

n Government provides and enforces an envelope within which an economy can operate.

¨ law of contracts

¨ fraud laws

¨ protection of property rights

Property rights

n If protected:

¨ people work hard, earn more, and accumulate property to obtain a better standard of living.

¨ enables those in poverty to move upward and create a prosperous middle class.

n If not protected:

¨ incentive to work and accumulate is removed.

¨ those in poverty are doomed to stay there.

Taxes

n Government earns nothing and produces no wealth.

n Taxes provide an income stream for government.

¨ Taxes are paid by income earners.

¨ Taxes transfer the earner’s purchasing power to the government.

Progressive Tax System

n When the tax rate increases as income increases, the system is progressive.

¨ High income earners pay a higher percentage of their income in taxes.

¨ Low income earners pay a lower percentage of their income in taxes.

Regressive Tax System

n When the tax rate decreases as income increases, the system is regressive.

¨ High income earners pay a lower percentage of their income in taxes.

¨ Low income earners pay a higher percentage of their income in taxes.

Transfer payments

n A payment from the government that a person or institution receives because he or it is entitled to it by law.

¨ There is no requirement for the recipient to do or to provide anything in return.

¨ Government redistributes some of the taxpayer’s income to provide a social safety net.

Special interest groups

n Not all transfer payments go to low income earners.

¨ Special interest groups petition government for special favors: handouts, subsidies, favoritism in government contracts, and tax breaks.

n Lobbying for these favors can impact decision making by members of Congress and by bureaucrats.

Government budgeting

n Most state and local government agencies must operate with a balanced budget:

¨ Revenues must equal spending.

n The Federal government usually does not have a balanced budget:

¨ Deficit: Revenues less than spending.

¨ Surplus: Revenues greater than spending.

Budget deficits and the national debt

n Federal budget is usually in deficit.

¨ Increased spending is politically palatable.

¨ Increased taxes are not politically palatable.

¨ To finance the deficit, the US Treasury Department must borrow by offering government securities to the public.

n This added borrowing increases the national debt.

Problems with deficit spending

n “Crowding out”

¨ When the government needs to borrow, it taps into the same funds pool used by consumers and businesses to borrow.

¨ More for government? Less for the private sector.

n Interest payments

¨ Government must pay interest to all debt holders.

¨ More debt? More interest payments must be funded by taxes.

The tax burden

n Ideally, high income earners should pay more taxes than middle- or low-income earners.

n In reality, high-income earners lobby for special tax breaks and hire accountants and lawyers to help them avoid paying high taxes.

¨ Middle- and low-income earners can’t do this; they simply pay their taxes.

¨ In our system, middle-income earners end up paying most of the taxes.

Decision making in government

n Each government decision maker uses his own value system to do cost-benefit analysis.

n In government, however, the benefits and costs do not accrue to the decision maker, but to other groups.

n The decision maker cannot properly evaluate the costs and benefits as well as an individual would for himself.

Decision making in government

n Benefits accrued by one group will be offset by costs accrued by another group.

n Special interest groups will lobby the government decision maker with incentives and penalties, which influence the decision making.

Voting booth vs. Market

n Voting booth:

¨ vote for the candidate that satisfies you the most

¨ get the winner (who was preferred by the majority), who might not have been your preference

n Market:

¨ vote for the product that satisfies you the most

¨ get that product (no matter what the majority of customers prefer)

¨ markets are more democratic than voting booths

Bureaucracy

n A business firm has a profit motive.

¨ produce a customer satisfying product (otherwise, the customer will choose a rival’s product)

¨ constantly strive to keep costs low

¨ the measure of success is to increase profits

n A bureaucracy has no profit motive.

¨ customers have no alternative to choose from.

¨ the measure of success is to increase the bureaucracy’s budget (increase costs)

Figure 5-1. Profit-Seeking Firms and Bureaucratic Agencies

Income distribution

n Income is earned.

¨ Produce goods in high demand; earn a high income.

¨ Produce goods in low demand; earn a low income.

¨ Produce nothing; earn nothing.

n Income is distributed unequally in America (and in all other countries of the world).

Unequal Income Distribution

n Reasons why:

¨ education level

¨ intact vs. broken family structure

¨ work ethic

¨ talents and skills availability

¨ age and experience

¨ health

¨ willingness to take risks or endure hardship

¨ discrimination in hiring

¨ luck (be in the right place at the right time)

Poverty

n Officially defined:

¨ A family lives in poverty if its income is less than three times the cost of a nutritional diet.

¨ For a family of four, in 2005, that was $19,350.

n Family income is a qualifying factor for eligibility for government income-assistance programs.

Equality vs. Efficiency

n These goals are in conflict.

n Unequal incomes generate a highly efficient, productive society with the highest standard of living.

n Requiring equal incomes destroys incentive to work hard, to improve oneself, or to seek better opportunity. Society is less efficient, less productive, and has a lower standard of living.