Principles of Economics Chapter 15 Public Finance and Public Choice

Chapter 15 Public Finance and Public Choice Start Up Where Your Tax Dollars Go You pay sales taxes on most of the goods you purchase . If you smoke or drink or drive a car , you pay taxes on cigarettes , alcohol , and gasoline . If you work , you may pay income and payroll taxes . What does the government do with the taxes it collects ?

If you go to a public school , you are a consumer of public sector services . You also consume the services of the public sector when you drive on a public street or go to a public park . You consume public sector services since you are protected by law enforcement agencies and by the armed forces . And the production of everything else you consume is affected by regulations imposed by local , state , or federal agencies . The public sector is a crucially important segment of the economy , due in part to its size . The nearly government jurisdictions in the United States , from local fire protection districts to the federal government , either produce or purchase nearly of all domestic goods and services . The government is the largest single purchaser of goods and services in the world . This chapter examines the role of government in a market economy and the ways in which the taxes that support government affect economic behavior . The study of government expenditure and tax policy and of their impact on the economy is called public finance . We will also explore the economics of public sector choices . Economists put the notions of and the marginal decision rule to work in the analysis of choices made by people in the public , government employees , interest groups , and politicians . 507

The Role of Government in a Market Economy Learning Objectives . Discuss and illustrate government responses to the market failures of public goods , external costs and benefits , and imperfect competition and how these responses have the potential to reduce deadweight loss . Define merit and demerit goods and explain why government may intervene to affect the quantities consumed . Discuss ways in which governments redistribute income . What do we want from our government ?

One answer is that we want a great deal more than we did several decades ago . The role of government has expanded dramatically in the last years . In 1929 ( the year the Commerce Department began keeping annual data on performance in the United States ) government expenditures at all levels ( state , local , and federal ) were less than 10 of the nation total output , which is called gross domestic product ( In the current century , that share has more than tripled . Total government spending per capita , adjusted for , has increased more than six fold since 1929 . Figure Government Expenditures and Revenues as a Percentage of shows total government expenditures and revenues as a percentage of from 1929 to 2007 . All levels of government are included . Government expenditures include all spending by government agencies . Government revenues include all funds received by government agencies . The primary component of government revenues is taxes revenue also includes miscellaneous receipts from fees , fines , and other sources . We will look at types of government revenues and expenditures later in this chapter . Figure Government Expenditures and Revenues as a Percentage of 50 40 30 20 Percent of 10 1925 1935 1945 1955 1965 1975 1985 1995 2005 Receipts Expenditures i Government consumption plus gross investment Government expenditures and revenues have risen dramatically as a percentage of , the most widely used measure of economic activity . Source US . Department of Commerce , Bureau of Economic Analysis , NIPA Tables and . 508

The Role of Government in a Market Economy 509 Figure Government Expenditures and Revenues as a Percentage of also shows government purchases as a percentage of . Government purchases happen when a government agency purchases or produces a good or a service . We measure government purchases to suggest the opportunity cost of government . Whether a government agency purchases a good or service or produces it , factors of production are being used for public sector , rather than private sector , activities . A city police department purchase of new cars is an example of a government purchase . Spending for public education is another example . Government expenditures and purchases are not equal because much government spending is not for the purchase of goods and services . The primary source of the gap is transfer payments , payments made by government agencies to individuals in the form of grants rather than in return for labor or other services . Transfer payments represent government expenditures but not government purchases . Governments engage in transfer payments in order to redistribute income from one group to another . The various welfare programs for people are examples of transfer payments . Social Security is the largest transfer payment program in the United States . This program transfers income from people who are working ( by taxing their pay ) to people who have retired . payments on government debt , which are also a form of expenditure , are another example of an expenditure tha is not counted as a government purchase . Several points about Figure Government Expenditures and Revenues as a Percentage of bear attention . Note first the path of government purchases . Government purchases relative to rose dramatically during World War II , then dropped back to about their prewar level almost immediately afterward . purchases rose again , though less sharply , during the Korean War . This time , however , they did not drop back very far after the war . It was during this period that military spending rose to meet the challenge posed by the former Soviet Union and other communist Cold Government purchases have ranged between 15 20 of ever since . The Vietnam War , the Persian Gulf War , and the wars in Afghanistan and Iraq did not have the impact on purchases that characterized World War II or even the Korean War . A second development , the widening gap between expenditures and purchases , has occurred since the . This reflects the growth federal transfer programs , principally Social Security , programs to help people pay for costs , and to people . We will discuss these programs later in this chapter . Finally , note the relationship between expenditures and receipts . When a government revenues equal its expenditures for a particular period , it has a balanced budget . A budget surplus occurs if a government revenues exceed its expenditures , while a budget deficit exists if government expenditures exceed revenues . Prior to 1980 , revenues roughly matched expenditures for the public sector as a whole , except during World War 11 . But expenditures remained consistently higher than revenues between 1980 and 1996 . The federal government generated very large deficits during this period , deficits that exceeded surpluses that typically occur at the state and local levels of government . The largest increases in spending came from Social Security and increased care spending at the federal level . Efforts by the federal government to reduce and ultimately eliminate its deficit , together with surpluses among state and local governments , put the combined budget for the public sector in surplus beginning in 1997 . As of 1999 , the Congressional Budget Office was predicting that increased federal revenues produced by a growing economy would continue to produce budget surpluses well into the century . That rather rosy forecast was set aside after September 11 , 2001 . Terrorist attacks on the United States and later on several other countries led to sharp and sustained increases in federal spending for wars in Afghanistan and Iraq ,

510 Principles of Economics as well as expenditures for Homeland Security . The administration of George Bush proposed , and Congress approved , a tax cut . The combination of increased spending on the items and others , as well as tax cuts , produced substantial deficits . The evidence presented in Figure Government Expenditures and Revenues as a Percentage of does not fully capture the rise in demand for public sector services . In addition to governments that spend more , people in the United States have clearly chosen governments that do more . The scope of regulatory activity conducted by governments at all levels , for example , has risen sharply in the last several decades . Regulations designed to prevent discrimination , to protect consumers , and to protect the environment are all part of the response to a rising demand for public services , as are federal programs in health care and education . Figure Government Revenue Sources and Expenditures 2007 summarizes the main revenue sources and types of expenditures for the federal government and for the European Union . In the United States , most revenues came from personal income taxes and from payroll taxes . Most expenditures were for transfer payments to individuals . Federal purchases were primarily for national defense the other purchases category includes things such as spending for transportation projects and for the space program . Interest payments on the national debt and grants by the federal government to state and local governments were the other major expenditures . The situation in the European Union differs primarily by the fact that a greater share of revenue comes from taxes on production and imports and substantially less is spent on defense . Figure Government Revenue Sources and Expenditures 2007 USA Where It Comes From USA Where It Goes Transfer Payments to Rest of World Other Purchases personal Taxes Interest Payment ( 96 Transfer Payments to State and Local Government . National Business Taxes to Defense 55 Government , Enterprises ' 95 Transfer Payments to 110 individuals European Union where It comes From European Union Where It Goes on owe , 105 ( ome , et ( Gross Fixed 5903 ' Formation payment on Taxes on I I I ( not in kind ) Production and ' Imports Compensation of Transfer Capital Taxes Employees Payments ( in kind ) Other The four panels show the sources of government revenues and the shares of expenditures on various for all levels of in the United States and the European Union in 2007 . Sources Survey of Current Business , July 2003 , Tables and Paternoster , Anne , and , Alessandro , Statistics in Far and Finance , For EU revenues , Taxes on production and imports refers mainly to tax , import and excise duties , taxes on financial and capital transactions , on land and buildings , on payroll , and taxes on production . In the category Current taxes an income , wealth , are taxes on income and an holding

The Role of Government in a Market Economy 511 gains of households and corporations , current taxes on capital , taxes on international transactions , and payments for licenses . Capital taxes refer to taxes levied at irregular and infrequent intervals on the value of assets , or net worth owned , or transferred in the form of legacies or gifts . Social contributions cover actual amounts receivable from employers and employees . To understand the role of government , it will be useful to distinguish four broad types of government involvement in the economy . First , the government attempts to respond to market failures to allocate resources efficiently . In a particular market , efficiency means that the quantity produced is determined by the intersection of a demand curve that reflects all the benefits of consuming a particular good or service and a supply curve that reflects the opportunity costs of producing it . Second , government agencies act to encourage or discourage the consumption of certain goods and services . The prohibition of drugs such as heroin and cocaine is an example of government seeking to discourage consumption of these drugs . Third , the government income through programs such as welfare and Social Security . Fourth , the government can use its spending and tax policies to influence the level of economic activity and the price level . We will examine the first three of these aspects of government involvement in the economy in this chapter . The fourth , efforts to influence the level of economic activity and the price level , fall within the province of . Responding to Market Failure In an earlier chapter on markets and efficiency , we learned that a market maximizes net benefit by achieving a level of output at which marginal benefit equals marginal cost . That is the efficient solution . In most cases , we expect that markets will come close to achieving this is the important lesson of Adam Smith idea of the market as an invisible hand , guiding the economy scarce factors of production to their best uses . That is not always the case , however . We have studied several situations in which markets are unlikely to achieve efficient solutions . In an earlier chapter , we saw that private markets are likely to produce less than the efficient quantities of public goods such as national defense . They may produce too much of goods that generate external costs and too little of goods that generate external benefits . In cases of imperfect competition , we have seen that the market output of goods and services is likely to fall short of the efficient level . In all these cases , it is possible that government intervention will move production levels closer to their efficient quantities . In the next three sections , we shall review how a government could improve efficiency in the cases of public goods , external costs and benefits , and imperfect competition . Public Goods A public good is a good or service for which exclusion is prohibitively costly and for which the marginal cost of adding another consumer is zero . National defense , law enforcement , and generally available knowledge are examples of public goods . The difficulty posed by a public good is that , once it is produced , it is freely available to everyone . No consumer

512 Principles of Economics can be excluded from consumption of the good on grounds that he or she has not paid for it . Consequently , each consumer has an incentive to be a free rider in consuming the good , and the firms providing a public good do not get a signal from consumers that reflects their benefit of consuming the good . Certainly we can expect some benefits of a public good to be revealed in the market . If the government did not provide national defense , for example , we would expect some defense to be produced , and some people would contribute to its production . But because behavior will be common , the market production of public goods will fall short of the efficient level . The theory of public goods is an important argument for government involvement in the economy . Government agencies may either produce public goods themselves , as do local police departments , or pay private firms to produce them , as is the case with many research efforts . An important debate in the provision of public education revolves around the question of whether education should be produced by the government , as is the case with traditional public schools , or purchased by the government , as is done in charter schools . External Costs and External costs are imposed when an action by one person or firm harms another , outside of any market exchange . The social cost of producing a good or service equals the private cost plus the external cost of producing it . In the case of external costs , private costs are less than social costs . Similarly , external benefits are created when an action by one person or firm benefits another , outside of any market exchange . The social benefit of an activity equals the private benefit revealed in the market plus external benefits . When an activity creates external benefits , its social benefit will be greater than its private benefit . The lack of a market transaction means that the person or firm responsible for the external cost or benefit does not face the full cost or benefit of the choice involved . We expect markets to produce more than the efficient quantity of goods or services that generate external costs and less than the efficient quantity of goods or services that generate external benefits . Consider the case of firms that produce memory chips for computers . The production of these chips generates water pollution . The cost of this pollution is an external cost the firms that generate it do not face it . These firms thus face some , but not all , of the costs of their production choices . We can expect the market price of chips to be lower , and the quantity produced greater , than the efficient level . Inoculations against infectious diseases create external benefits . A person getting a flu shot , for example , receives private benefits he or she is less likely to get the flu . But there will be external benefits as well Other people will also be less likely to get the flu because the person getting the shot is less likely to have the flu . Because this latter benefit is external , the social benefit of flu shots exceeds the private benefit , and the market is likely to produce less than the efficient quantity of flu shots . Public , private , and charter schools often require such inoculations in an effort to get around the problem of external benefits .

The Role of Government in a Market Economy 513 Imperfect Competition In a perfectly competitive market , price equals marginal cost . If competition is imperfect , however , individual firms face demand curves and will charge prices greater than marginal cost . Consumers in such markets will be faced by prices that exceed marginal cost , and the allocation of resources will be inefficient . An imperfectly competitive private market will produce less of a good than is efficient . As we saw in the chapter on monopoly , government agencies seek to prohibit monopoly in most markets and to regulate the prices charged by those monopolies that are permitted . Government policy toward monopoly is discussed more fully in a later chapter . Assessing Government Responses to Market Failure In each of the models of market failure we have reviewed goods , external costs and benefits , and imperfect market may fail to achieve the efficient result . There is a potential for government intervention to move inefficient markets closer to the efficient solution . Figure Correcting Market Failure reviews the potential gain from government intervention in cases of market failure . In each case , the potential gain is the deadweight loss resulting from market failure government intervention may prevent or limit this deadweight loss . In each panel , the deadweight loss resulting from market failure is shown as a shaded triangle . Figure Correcting Market Failure

514 Principles of Economics Panel ( a ) Panel ( A Public Good External Costs Price per unit Price per unit Quantity per period Quantity per period Panel ( Panel ( External Imperfect Competition Deadweight lo . I . I , Om . Quantity per period Quantity per period In each panel , the potential gain from government intervention to correct market failure is shown by the deadweight loss avoided , as given by the shaded triangle . In Panel ( a ) we assume that a private market produces units of a public good . The efficient level , is defined by the intersection of the demand curve for the public good and the supply curve Panel ( shows that if the production of a good generates an external cost , the supply curve reflects only the private cost of the good . The market will produce units of the good at price . If the public sector finds a way to confront producers with the social cost of their production , then the supply curve shifts to , and production falls to the efficient level Qe . Notice that this intervention results in a higher price , which confronts consumers with the real cost of producing the good . Panel ( shows the case of a good that generates benefits . Purchasers of the good base their choices on the private benefit , and the market demand curve is . The market quantity is This is less than the efficient quantity , Qe , which can be achieved if the activity that generates benefits is subsidized . That would shift the market demand curve to , which intersects the market supply curve at the efficient . Finally , Panel ( shows the case of a monopoly that produces units and charges a price . The efficient level of output , Qe , could be achieved by imposing a price ceiling at . As is the case in each of the other panels , the potential gain from such a policy is the elimination of the deadweight loss shown as the shaded area in the exhibit . Panel ( a ) of Figure Correcting Market Failure illustrates the case of a public good . The market will produce some of the public good suppose it produces the quantity But the demand curve that the social benefits of the public good , intersects the supply curve at that is the efficient quantity of the good . Public sector provision of a public good may move the quantity closer to the efficient level . Panel ( shows a good that generates external costs . Absent government intervention , these costs will not be

The Role of Government in a Market Economy 515 reflected in the market solution . The supply curve , will be based only on the private costs associated with the good . The market will produce units of the good at a price . If the government were to confront producers with the external cost of the good , perhaps with a tax on the activity that creates the cost , the supply curve would shift to and reflect the social cost of the good . The quantity would fall to the efficient level , and the price would rise to . Panel ( gives the case of a good that generates external benefits . The demand curve revealed in the market , reflects only the private benefits of the good . Incorporating the external benefits of the good gives us the demand curve that reflects the social benefit of the good . The market output of units of the good falls short of the efficient level Qe . The government may seek to move the market solution toward the efficient level through subsidies or other measures to encourage the activity that creates the external benefit . Finally , Panel ( shows the case of imperfect competition . A firm facing a demand curve such as will select the output at which the marginal cost curve intersects the marginal revenue curve . The government may seek to move the solution closer to the efficient level , defined by the intersection of the marginal cost and demand curves . While it is important to recognize the potential gains from government intervention to correct market failure , we must recognize the difficulties inherent in such efforts . Government officials may lack the information they need to select the efficient solution . Even if they have the information , they may have goals other than the efficient allocation of resources . Each instance of government intervention involves an interaction with consumers and firms , none of whom can be assumed to be passive participants in the process . So , while the potential exists for improved resource allocation in cases of market failure , government intervention may not always achieve it . The late George , winner of the Nobel Prize for economics in 1982 , once remarked that people who advocate government intervention to correct every case of market failure reminded him of the judge at an amateur singing contest who , upon hearing the first contestant , awarded first prize to the second . point was that even though the market is often an inefficient allocator of resources , so is the government likely to be . Government may improve on what the market does it can also make it worse . The choice between the market allocation and an allocation with government intervention is always a choice between imperfect alternatives . We will examine the nature of public sector choices later in this chapter and explore an economic explanation of why government intervention may fail to move market solutions closer to their efficient levels . Merit and Demerit Goods In some cases , the public sector makes a determination that people should consume more of some goods and services and less of others , even in the absence of market failure . This is a normative judgment , one that presumes that consumers are not always the best judges of what is good , or bad , for them . Merit goods are goods whose consumption the public sector promotes , based on a presumption that many individuals do not adequately weigh the benefits of the good and should thus be induced to consume more than they otherwise would . Many local governments support symphony concerts , for example , on grounds that the private market would not provide an adequate level of these cultural activities .

516 Principles of Economics Indeed , government provision of some merit goods is difficult to explain . Why , for example , do many local governments provide tennis courts but not bowling alleys , golf courses but not auto racetracks , or symphony halls but not movie theaters ?

One possible explanation is that some with a fondness for tennis , golf , and classical been more successful than others in persuading their fellow citizens to assist in funding their preferred activities . Demerit goods are goods whose consumption the public sector discourages , based on a presumption that individuals do not adequately weigh all the costs of these goods and thus should be induced to consume less than they otherwise would . The consumption of such goods may be prohibited , as in the case of illegal drugs , or taxed heavily , as in the case of cigarettes and alcohol . Income Redistribution The proposition that a private market will allocate resources efficiently if the efficiency condition is met always comes with a qualification the allocation of resources will be efficient given the initial distribution of income . If of the people receive 95 of the income , it might be efficient to allocate roughly 95 of the goods and services produced to them . But many people ( at least 95 of them ! might argue that such a distribution of income is undesirable and that the allocation of resources that emerges from it is undesirable as well . There are several reasons to believe that the distribution of income generated by a private economy might not be satisfactory . For example , the incomes people earn are in part due to luck . Much income results from inherited wealth and thus depends on the family into which one happens to have been born . Likewise , talent is distributed in unequal measure . Many people suffer handicaps that limit their earning potential . Changes in demand and supply can produce huge changes in the the market assigns to particular skills . Given all this , many people argue that incomes should not be determined solely by the marketplace . A more fundamental reason for concern about income distribution is that people care about the welfare of others . People with higher incomes often have a desire to help people with lower incomes . This preference is demonstrated in voluntary contributions to charity and in support of government programs to redistribute income . A public goods argument can be made for government programs that redistribute income . Suppose that people of all income levels feel better off knowing that financial assistance is being provided to the poor and that they experience this sense of whether or not they are the ones who provide the assistance . In this case , helping the poor is a public good . When the poor are better off , other people feel better off this benefit is nonexclusive . One could thus argue that leaving private charity to the marketplace is inefficient and that the government should participate in income redistribution . Whatever the underlying basis for redistribution , it certainly occurs . The governments of every country in the world make some effort to redistribute income . Programs to redistribute income can be divided into two categories . One transfers income to poor people the other transfers income based on some other criterion . A transfer payment is one for which the recipient qualifies on the basis of income programs transfer income from people who have more to people who have less . The largest program in the United States is Medicaid , which provides health care to the poor . Other programs include Temporary Assistance to Needy Families ( and food stamps . A transfer payment is one for which income is not a qualifying factor .

The Role of Government in a Market Economy 517 Social Security , a program that taxes workers and their employers and transfers this money to retired workers , is the largest transfer program . Indeed , it is the largest transfer program in the United States . It transfers income from working families to retired families . Given that retired families are , on average , wealthier than working families , Social Security is a somewhat regressive program . Other tested transfer programs include Medicare , unemployment compensation , and programs that aid farmers . Figure Federal Transfer Payment Spending shows federal spending on and programs as a percentage of , the total value of output , since 1962 . As the chart suggests , the bulk of income redistribution efforts in the United States are programs . Figure Federal Transfer Payment spending 14 1962 1972 1982 2002 Yea The chart federal and non transfer payment spending as a percentage uf . Congressional Budget Office , The Budget and Economic Outlook Fiscal Years 20042013 ( 2003 ) Table . 157 thereafter January , 2008 , Table with as medicaid plus security and tested everything else . The fact that most transfer payments in the United States are not leads to something of a paradox some transfer payments involve taxing people whose incomes are relatively low to give to people whose incomes are relatively high . Social Security , for example , transfers income from people who are working to people who have retired . But many retired people enjoy higher incomes than working people in the United States . Aid to farmers , another form of payments , transfers income to farmers , who on average are wealthier than the rest of the population . These situations have come about because of policy decisions , which we discuss later in the chapter . Key Takeaways One role of government is to correct problems of market failure associated with public goods , external costs and benefits , and imperfect competition . Government intervention to correct market failure always has the potential to move markets closer to efficient solutions , and thus reduce deadweight losses . There is , however , no guarantee that these gains will be achieved . Governments may seek to alter the provision of certain goods and services based on a normative judgment that consumers will consume too much or too little of the goods . Goods for which such judgments are made are called merit or demerit goods . Governments redistribute income through transfer payments . Such redistribution often goes from people

518 Principles of Economics with higher incomes to people with lower incomes , but other transfer payments go to people who are relatively better off . Try It ! Here is a list of actual and proposed government programs . Each is a response to one of the justifications for government activity described in the text correction of market failure ( due to public goods , external costs , external benefits , or imperfect competition ) encouragement or discouragement of the consumption of merit or demerit goods , and redistribution of income . In each case , identify the source of demand for the activity described . The Justice Department sought to prevent Corporation from releasing Windows 98 , arguing that the system internet browser represented an attempt by to monopolize the market for . In 2004 , Congress considered a measure that would extend taxation of cigarettes to vendors that sell cigarettes over the Internet . The federal government engages in research to locate asteroids that might hit the earth , and studies how impacts from asteroids could be prevented . The federal government increases spending for food stamps for people whose incomes fall below a certain level . The federal government increases benefits for recipients of Social Security . The Environmental Protection Agency sets new standards for limiting the emission of pollutants into the air . A state utilities commission regulates the prices charged by utilities that provide natural gas to homes and businesses . Case in Point Fixing the Gasoline Market Figure

The Role of Government in a Market Economy 519 Emily gas prices in san . Moderating the price of gasoline is not an obvious mission for the government in a market economy . But , in an economy in which angry voters wield considerable influence , trying to fix rising gasoline prices can turn into a task from which a wise politician does not shrink . By the summer of 2008 , crude oil was selling for more than 140 per barrel . Gasoline prices in the United States were with the mark . There were perfectly good market reasons for the in prices . World oil demand has been rising each year , with China and India two of the primary sources of increased demand . The world ability to produce oil is limited and tensions in the Middle East were also adding doubts about getting those supplies to market . Ability to produce gasoline is limited as well . The United States has not built a new oil refinery in more than 30 years . But , when oil prices rise , economic explanations seldom carry much political clout . Predictably , the public demands a response from its political gets it . Largely Democratic Congressional proposals in 2008 included such ideas as a bill to classify the Organization of Petroleum Exporting Countries ( as an illegal monopoly in violation of antitrust laws , taxing excessive profits of oil companies , investigating possible price gouging , and banning speculative trading in oil futures . With an overwhelming majority on both sides of the aisle , Congress passed a bill to suspend adding oil to the Strategic Petroleum 727 million gallon underground reserve designed for use in national emergencies . President Bush in 2008 was against this move , though in 2006 , when gas prices were approaching a gallon , he supported a similar move . Whether or not to offer a tax holiday on the cents per gallon federal gas tax stymied some politicians during the 2008 presidential campaign because Hillary Clinton , a Democrat , and John McCain , a Republican , supported it , while Barack Obama , a Democrat , was against it . Mostly Republican proposals to allow offshore drilling and exploration in the Arctic National Wildlife Refuge also received attention . These measures were unlikely to have much affect on gas prices , especially in the . For example , the federal government would normally in a period deposit 10 million gallons of gasoline in the strategic reserve consumption in the United States is about 20 million gallons of gasoline per day . World gasoline consumption is about 87 million gallons per day . Putting an additional 10 million gallons into a global market which will consume about billion gallons in a period is not likely to have any measurable impact . The higher oil prices were very good for oil companies . Mobil , the largest publicly traded oil company in the United States , reported profits of nearly 11 billion for the first quarter of 2008 . Whenever oil prices rise sharply , there

520 Principles of Economics are always cries of price But , repeated federal investigations of the industry have failed to produce any evidence that such gouging has occurred . Meanwhile , market forces responding to the higher gasoline prices are already at work . Gasoline producers are looking at cellulosic ethanol , which can be produced from materials such as wood chips , stalks , and rice straw . Automobile producers are examining whose batteries could be charged not just by driving but by plugging the car in a garage . The goal is to have a car that could go some distance on its battery before starting to use any gasoline . Consumers are doing their part . Gasoline consumption in the United States fell more than by the summer of 2008 from its level one year earlier . These potential market responses are the sort of thing one would expect from rising fuel prices . Ultimately , it is difficult to see why gasoline prices should be a matter for public sector intervention . But , the public sector consists of people , and when those people become angry , the urge for intervention can become unstoppable . Sources Paul and Chris Woodyard , Proposals To Cut Gas Prices Scrutinized , USA Today , May 11 , 2006 , Joseph Curl , Bush Orders Suspension Of Gas Rules Federal Probe To Look At Charges , The Washington Times , April 26 , 2007 , David , As Gasoline Prices Soar , Politicians Fall Back on Familiar Solutions , The New York Times , May , 2008 , Richard Simon , The Nation Mixing Oil and Politics Congress Votes To Stop Shipments to the Nation Reserve . The Move Could Save Motorists Some Money , Las Angeles Times , May 14 , 2008 , Answers to Try It ! Problems This is an attempt to deal with monopoly , so it is a response to imperfect competition . Cigarettes are treated as a demerit good . Protecting the earth from such a calamity is an example of a public good . Food Stamps are a program to redistribute income . Social Security is an example of a income redistribution program . This is a response to external costs . This is a response to monopoly , so it falls under the imperfect competition heading .

Financing Government Learning Objectives . Explain the and the principles of taxation . Distinguish among regressive , proportional , and progressive taxes . Define tax incidence analysis and explain and illustrate the conditions under which the burden of an excise tax falls mainly on buyers or sellers . If government services are to be provided , people must pay for them . The primary source of government revenue is taxes . In this section we examine the principles of taxation , compare alternative types of taxes , and consider the question of who actually bears the burden of taxes . In addition to imposing taxes , governments obtain revenue by charging user fees , which are fees levied on consumers of services . The tuition and other fees charged by public universities and colleges are user fees , as are entrance fees at national parks . Finally , government agencies might obtain revenue by selling assets or by holding bonds on which they earn interest . Principles of Taxation Virtually anything can be taxed , but what should be taxed ?

Are there principles to guide us in choosing a system of taxes ?

a minister of finance in France , is generally credited with one of the most famous principles of taxation The art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing . Economists , who do not typically deal with geese , cite two criteria for designing a tax system . The first is based on the ability of people to pay taxes and the second focuses on the benefits they receive from particular government services . Ability to Pay The principle holds that people with more income should pay more taxes . As income rises , the 521

522 Principles of Economics doctrine asserts , people are able to pay more for public services a tax system should therefore be constructed so that taxes rise too . Wealth , the total of assets less liabilities , is sometimes used as well as income as a measure of ability to pay . The doctrine lies at the heart of tax systems that link taxes paid to income received . The relationship between taxes and income may take one of three forms taxes can be regressive , proportional , or progressive . Regressive Tax A regressive tax is one that takes a higher percentage of income as income falls . Taxes on cigarettes , for example , are regressive . Cigarettes are an inferior consumption falls as incomes rise . Thus , people with lower incomes spend more on cigarettes than do people with higher incomes . The cigarette taxes paid by people represent a larger share of their income than do the cigarette taxes paid by people and are thus regressive . Proportional Tax A proportional tax is one that takes a fixed percentage of income . Total taxes rise as income rises , but taxes are equal to the same percentage no matter what the level of income . Some people argue that the income tax system should be changed into a flat tax system , a tax that would take the same percentage of income from all taxpayers . Such a tax would be a proportional tax . Progressive Tax A progressive tax is one that takes a higher percentage of income as income rises . The federal income tax is an example of a progressive tax . Table Federal Income Tax Brackets , 2007 shows federal income tax rates for various brackets of income for a family of four in 2007 . Such a family paid no income tax at all if its income fell below . At higher income levels , families faced a higher percentage tax rate . Any income over , for example , was taxed at a rate of 35 . Whether or not to make the tax system more progressive was a major debating point during the presidential election of 2008 . Table 151 Federal Income Tax Brackets , 2007

152 Financing Government 523 2007 adjusted gross income ( family of four ) Personal income tax rate applied to bracket Less than Zero ( family may receive earned income credit ) 15 25 28 33 Greater than 35 The federal income tax is progressive . The percentage tax rate rises as adjusted gross income rises . While a pure tax would be proportional , most proposals for such a tax would exempt some income from taxation . Suppose , for example , that households paid a flat tax of 20 on all income over per year . This tax would be progressive . A household with an income of per year would pay no tax . One with an income of per year would pay a tax of ( times ) or of its income . A household with an income of per year would pay a tax of ( times ) per year , or 12 of its income . A flat tax with an income exemption would thus be a progressive tax . Received An alternative criterion for establishing a tax structure is the principle , which holds that a tax should be based on the benefits received from the government services funded by the tax . Local governments rely heavily on taxes on property , in large part because the benefits of many local services , including schools , streets , and the provision of drainage for wastewater , are reflected in higher property values . Suppose , for example , that public schools in a particular area are especially good . People are willing to pay more for houses served by those schools , so property values are higher property owners benefit from better schools . The greater their benefit , the greater the property tax they pay . The property tax can thus be viewed as a tax on benefits received from some local services . User fees for government services apply the principle directly . A student paying tuition , a visitor paying an entrance fee at a national park , and a motorist paying a highway toll are all paying to consume a publicly provided service they are thus paying directly for something from which they expect to benefit . Such fees can be used only for goods for which exclusion is possible a user fee could not be applied to a service such as national defense . Income taxes to finance public goods may satisfy both the and principles . The demand for public goods generally rises with income . Thus , people with higher incomes benefit more from public goods . The principle thus suggests that taxes should rise with income , just as the pay principle does . Consider , for example , an effort financed through income taxes by the federal government to clean up the environment . People with higher incomes will pay more for the cleanup than people with lower incomes , consistent with the principle . Studies by economists consistently show that people with

524 Principles of Economics higher incomes have a greater demand for environmental improvement than do people with lower clean environment is a normal good . Requiring people with higher incomes to pay more for the cleanup can thus be justified on the principle as well . Certainly taxes can not respond precisely to benefits received . Neither the nor the doctrine gives us a recipe for determining just what each person should pay in taxes , but these doctrines give us a framework for thinking about the justification for particular taxes . Figure Sources of Government Revenue , 2007 Sources of Government Revenue , 2007 Other Property Taxes 31 Payroll Taxes Individual Income Taxes Corporate User Fees Income Tax 999 Sales and Excise Taxes The chart shows sources of revenue for federal , state , and local governments in the United States . The data omit revenues from utilities and liquor stores . All are in billions of dollars . Source Bureau of the Census , Statistical Abstract of US , 2008 ( online ) Tables 422 and 461 . It is hard to imagine anything that has not been taxed at one time or another , Windows , closets , buttons , junk food , salt , have been singled out for special taxes . In general , taxes fall into one of four primary categories .

152 Financing Government 525 Income taxes are imposed on the income earned by a person or firm property taxes are imposed on assets sales taxes are imposed on the value of goods sold and excise taxes are imposed on specific goods or services . Figure Sources of Government Revenue , 2007 shows the major types of taxes financing all levels of government in the United States . Personal Income Taxes The federal personal income tax is the largest single source of tax revenue in the United States most states and many cities tax income as well . All income tax systems apply a variety of to a taxpayer total income before arriving at taxable income , the amount of income that is actually subject to the tax . In the federal income tax system , for example , a family deducted from total income earned in 2005 for each member of the family as part of its computation of taxable income . Income taxes can be structured to be regressive , proportional , or progressive . Income tax systems in use today are progressive . In analyzing the impact of a progressive tax system on taxpayer choice , economists focus on the marginal tax rate . This is the tax rate that would apply to an additional of taxable income earned . Suppose an individual was earning taxable income of and paid federal income taxes of , or 10 of taxable income ( we are ignoring exemptions that would eliminate taxes for such an individual ) If the taxpayer were to receive 100 more of taxable income , however , that 100 would be taxed at a rate of 15 , the rate that applied in 2008 to taxable incomes between for individuals . That person thus faced a marginal tax rate of 15 . Economists argue that choices are made at the margin it is thus the marginal tax rate that is most likely to affect decisions . Say that the individual in our example is considering taking on additional work that would increase his or her income to per year . With a marginal tax rate of 15 , the individual would keep of the additional earned . It is that that the individual will weigh against the opportunity cost in forgone leisure in deciding whether to do the extra work . Property Taxes Property taxes are taxes imposed on assets . Local governments , for example , generally impose a property tax on business and personal property . A government official ( typically a local assessor ) determines the property value , and a proportional tax rate is then applied to that value . Property ownership tends to be concentrated among higher income groups economists generally view property taxes as progressive . That conclusion , however , rests on assumptions about who actually pays the tax , an issue examined later in this chapter .

526 Principles of Economics Sales Taxes Sales taxes are taxes imposed as a percentage of firms sales and are generally imposed on retail sales . Some items , such as food and medicine , are often exempted from sales taxation . People with lower incomes generally devote a larger share of their incomes to consumption of goods covered by sales taxes than do people with higher incomes . Sales taxes are thus likely to be regressive . Excise Taxes An excise tax is imposed on specific items . In some cases , excise taxes are justified as a way of discouraging the consumption of demerit goods , such as cigarettes and alcoholic beverages . In other cases , an excise tax is a kind of tax . Excise taxes on gasoline , for example , are typically earmarked for use in building and maintaining highways , so that those who pay the tax are the ones who benefit from the service provided . The most important excise tax in the United States is the payroll tax imposed on workers earnings . In 2007 , the payroll tax was and was levied on incomes up to . The Medicare portion of the payroll tax , was levied on all earned wages without limit . Half of the payroll tax is charged to employers , half to employees . The proceeds of this excise on payrolls finance Social Security and Medicare benefits . Almost of households pay more in payroll taxes than in any other taxes . Tax Incidence Analysis Next time you purchase an item at a store , notice the sales tax imposed by your state , county , and city . The clerk rings up the total , then adds up the tax . The store is the entity that pays the sales tax , in the sense that it sends the money to the government agencies that imposed it , but you are the one who actually foots the are you ?

Is it possible that the sales tax affects the price of the item itself ?

These questions relate to tax incidence analysis , a type of economic analysis that seeks to determine where the actual burden of a tax rests . Does the burden fall on consumers , workers , owners of capital , owners of natural resources , or owners of other assets in the economy ?

When a tax imposed on a good or service increases the price by the amount of the tax , the burden of the tax falls on consumers . If instead it lowers wages or lowers prices for some of the other factors of production used in the production of the good or service taxed , the burden of the tax falls on owners of these factors . If the tax does not change the product price or factor prices , the burden falls on the owner of the owner of capital . If prices adjust by a fraction of the tax , the burden is shared . Figure Tax Incidence in the Model of Demand and Supply gives an example of tax incidence analysis . Suppose and are the demand and supply curves for beef . The equilibrium price is per pound the equilibrium quantity is million pounds of beef per day . Now suppose an excise tax of per pound of beef is imposed . It does not matter whether the tax is levied on buyers or on sellers of beef the important thing to see is

152 Financing Government 527 that the tax drives a per pound wedge between the price buyers pay and the price sellers receive . This tax is shown as the Vertical green line in the exhibit its height is . Figure Tax incidence in the Model of Demand and Supply Price per pound Millions of pounds per day suppose the market price is per pound die equilibrium quantity is million pounds per day . Now suppose an excise tax of per pound is imposed , shown by are green line . we insert this tax wedge between Lhe demand and supply curves . raises the market price to per pound , suggesting that buyers pay half Lhe tax in the form of a higher price . sellers receive a price of per pound they pay half Lhe tax by receiving a lower price . The equilibrium quantity falls El million pounds per day . We insert our tax wedge between the demand and supply curves . In our example , the price paid by buyers rises to per pound . The price received by sellers falls to per pound the other goes to the government . The quantity of beef demanded and supplied falls to million pounds per day . In this case , we conclude that buyers bear half the burden of the tax ( the price they pay rises by per pound ) and sellers bear the other half ( the price they receive falls by per pound ) In addition to the change in price , a further burden of the tax results from the reduction in consumer and in producer surplus . We have not shown this reduction in the graph . Figure Tax Incidence and the Elasticity of Demand and of Supply shows how tax incidence varies with the relative of demand and supply . All four panels show markets with the same initial price , determined by the intersection of demand and supply . We impose an excise tax , given by the vertical green line . As

528 Principles of Economics before , we insert this tax wedge between the demand and supply curves . We assume the amount of the tax per unit is the same in each of the four markets . Figure Tax Incidence and Lhe Elasticity uf Demand and at supply Panel ( a ) Panel in ) With relatively elastic supply , buyers bear most of the burden of an ( tax . With relatively inelastic supply , sellers . an excise tax . OZ , 010 , Quantity per period Quantity per period Panel ( Panel ( relatively elastic ' demand , sellers bear most of the burden of an excise tax . With relatively inelastic demand . buyers bear most of the burden of an excise tax . Price per unit Price per unit a 02 Quantity per period Quantity per period we show effect of an excise tax , given by the green line , in die same way that we did in Figure Tax incidence in the Model of Demand and Supply . we see that buyers bear must at the burden at such a tax in cases at relatively elastic supply Panel ( and of relatively inelastic demand Panel ( sellers bear must at the burden in cases of relatively supply ( Panel 03 ) and of relatively elastic demand ( Panel ) In Panel ( a ) we have a market with a relatively elastic supply curve . When we insert our tax wedge , the price rises to the price increase is nearly as great as the amount of the tax . In Panel ( we have the same demand curve as in Panel ( a ) but with a relatively inelastic supply curve . This time the price paid by buyers barely rises sellers bear most of the burden of the tax . When the supply curve is relatively elastic , the bulk of the tax burden is borne by buyers . When supply is relatively inelastic , the bulk of the burden is borne by sellers . Panels ( and ( of the exhibit show the same tax imposed in markets with identical supply curves . With a relatively elastic demand curve in Panel ( notice that we are in the upper half , that is , the elastic portion of the curve ) most of the tax burden is borne by sellers . With a relatively inelastic demand curve in Panel ( notice that we are in the lower half , that is , the inelastic portion of the curve ) most of the burden is borne by buyers . If demand is relatively elastic , then sellers hear more of the burden of the tax . If demand is relatively inelastic , then buyers bear more of the burden .

Financing Government 529 The Congressional Budget Office ( has prepared detailed studies of the federal tax system . Using the tax laws in effect in August 2004 , it ranked the population according to income and then divided the population into ( groups containing 20 of the population ) Then , given the federal tax burden imposed by individual income taxes , payroll taxes for social insurance , corporate income taxes , and excise taxes on each quintile and the income earned by people in that quintile , it projected the average tax rate facing that group in 2006 . The study assigned taxes on the basis of who bears the burden , not on who pays the tax . For example , many studies argue that , even though businesses pay half of the payroll taxes , the burden of payroll taxes actually falls on households . The reason is that the supply curve of labor is relatively inelastic , as shown in Panel ( of Figure Tax Incidence and the Elasticity of Demand and of Supply . Taking these adjustments into account , the results , showing progressivity in federal taxes , are reported in Table Federal Tax Burdens in the United States . Table 152 Federal Tax Burdens in the United States Income Households ( number , Average comprehensive Effective federal tax rate , 2006 category millions ) household income ( percent ) 24 18 568 quintile ' quintile Middle quintile quintile Highest 24 227 677 26 quintile ' All In a regressive tax system , people in the lowest face the highest tax rates . A proportional system imposes the same rates on everyone a progressive system imposes higher rates on people in higher . The table gives estimates by the of the burden on each quintile of federal taxes in 2006 . As you can see , the tax structure in the United States is progressive . Source , Effective Federal Tax Rates under Current Law , 2001 to 2014 , August , 2004 , Table and Table ( adjusted by authors using assumptions concerning rates of growth of income and households ) Numbers of households do not add up to total because of excluded categories . contains equal numbers of people . Key Takeaways The primary principles of taxation are the and principles . The percentage of income taken by a regressive tax rises as income falls . A proportional tax takes a constant percentage of income regardless of income level . A progressive tax takes a higher percentage of income as taxes as incomes rise . The marginal tax rate is the tax rate that applies to an additional dollar of income earned .

530 Principles of Economics Tax incidence analysis seeks to determine who ultimately bears the burden of a tax . The major types of taxes are income taxes , sales taxes , property taxes , and excise taxes . Buyers bear most of the burden of an excise tax when supply is relatively elastic and when demand is relatively inelastic sellers bear most of the burden when supply is relatively inelastic and when demand is relatively elastic . The federal tax system in the United States is progressive . Try It ! Consider three goods , A , and The prices of all three goods are determined by demand and supply ( that is , the three industries are perfectly competitive ) and equal 100 . The supply curve for good A is perfectly elastic the supply curve for good is a typical , curve and the supply curve for good is perfectly inelastic . Suppose the federal government imposes a tax of 20 per unit on suppliers of each good . Explain and illustrate graphically how the tax will affect the price of each good in the short run . Show whether the equilibrium quantity will rise , fall , or remain unchanged . Who hears the burden of the tax on each good in the short run ?

Hint Review the chapter on the elasticity for a discussion of perfectly elastic and perfectly inelastic supply curves remember that the tax increases variable cost by 20 per unit . Case in Point What Are Marginal Tax Rates ?

Figure 152 Financing Government 531 Emily gas prices in San . We speak often of the importance of tax rates at the how much of an extra dollar earned through labor or interest on saving will be kept by the . It turns out , however , that figuring out just what that marginal tax rate is is not an easy task . Consider the difficulty of untangling just what those marginal tax rates are . First , Americans face a bewildering complex of taxes . They all face the federal income tax . Each many additional taxes on income . Then there is the payroll tax , federal and state corporate income taxes , and excise taxes , as well as federal , state , and local sales taxes . A person trying to figure out his or her marginal tax rate can not stop there . Gaining an additional dollar of income will affect not only taxes but eligibility for various transfer payment programs in the level of payments the individual or household can expect to receive . Given the enormous complexity involved , it is safe to say that no one really knows what his or her marginal rate is . Economists Laurence and David of Boston University have taken on the task of sorting out marginal tax rates for the United States . They used a commercial tax analysis program , Economic Security Planner , and added their own computer programs to incorporate the effect of additional income on various transfer payment programs . Their analysis assumed the taxpayer lived in Massachusetts , but the general tenor of their results applies to people throughout the United States . Consider a couple earning per year . That couple is eligible for a variety of welfare programs . With food stamps , there is a reduction in aid for each additional dollar of income earned . In effect , the couple faces an effective marginal tax rate of 100 . Considering all other taxes and welfare programs , the economists concluded that the couple faced a marginal tax rate of about 50 on labor income . Overall , they found that a pattern of marginal rates for various ages and income levels could be described in a single word The tables below give the economists estimates of marginal rates for current year labor supply for a single individual and for couples with children at various incomes and ages . While the overall structure of taxes in the United States is progressive , the special treatment of welfare programs can add a strong element of regressivity . Marginal Net Tax Rates on Labor Supply ( Couples , percentages ) Total Annual Household Earnings ( 0005 ) Age 10 20 30 50 75 30 45 60 Age 100 150 200 300 500 30 45 60 Source Laurence and David , Does It Pay , At the Margin , to Work and Save ?

Tax Policy the Economy , 2007 , 21 ( The tables shown here are Tables and in the article .

532 Principles of Economics Marginal Net Tax Rates on Labor Supply ( Individuals , percentages ) Total Annual Household Earnings ( 0005 ) Age 30 45 60 Age 30 45 60 10 125 20 150 30 200 50 250 75 Look again at our couple . It faces a very high marginal tax rate . A younger couple with the same income actually faces a negative marginal tax its labor income by a dollar actually increases its income by more than a dollar . Why the difference ?

The economists assumed that the younger couple would have children and thus qualify for a variety of programs , including the Earned Income Tax Credit . The couple at age 60 still faces the reduction in payments in the Food Stamp program . No one designed these marginal incentives . They simply emerge from the bewildering mix of welfare and tax programs households face . Answer to Try It ! Problem The tax adds a 20 wedge between the price paid by buyers and received by sellers . In Panel ( a ) the price rises to 120 the entire burden is borne by buyers . In Panel ( the price remains 100 sellers receive just 80 . Therefore , sellers bear the burden of the tax . In Panel ( the price rises by less than 20 , and the burden is shared by buyers and sellers . The relative of demand and supply determine whether the tax is borne primarily by buyers or sellers , or shared equally by both groups . Figure Panel ( a ) Panel ) Panel ( 120 5100 i . I OZ 01 Quantity of A per period Quantity of per period Quantity of per period

Choices in the Public Sector Learning Objectives . Compare public interest theory and public choice theory . Use public choice theory to explain rational abstention and why legislative choices may serve special interests . How are choices made in the public sector ?

This section examines two perspectives on public sector choice . The first is driven by our examination of market failure . Choices in the public sector are a matter of locating problems of market failure , determining the efficient solution , and finding ways to achieve it . This approach , called the public interest theory of government , assumes that the goal of government is to seek an efficient allocation of I . An alternative approach treats public sector choices like private sector choices . The body of economic thought based on the assumption that individuals involved in public sector choices make those choices to maximize their own utility is called public choice theory . Public choice theory argues that individuals in the public sector make choices that maximize their as voters , politicians , or bureaucrats , people seek solutions consistent with their . People who operate business firms may try to influence public sector choices to increase the profits of their firms . The effort to influence public choices to advance one own is called seeking behavior . Public Interest Theory In the approach to the analysis of public sector choices known as public interest theory , decision making is a technical matter . The task of government officials is to locate the efficient solution and find a way to move the economy to that point . For a public good , the efficient solution occurs where the demand curve that reflects social benefits intersects the supply curve for producing the good that is , the solution at quantity Qe and price given in Panel ( a ) of Figure Correcting Market Failure Because this demand curve for a public good is not revealed in the market , the task for government officials is to find a way to estimate these curves and then to arrange for the production of the optimum quantity . For this purpose , economists have developed an approach called analysis , which seeks to quantify the costs and benefits of an activity . Public officials can use analysis to try to locate the efficient solution . In general , the efficient solution occurs where the net benefit of the activity is maximized . Public sector intervention to correct market failure presumes that market prices do not reflect the benefits and costs of a particular activity . If those prices are generated by a market that we can regard as perfectly competitive , 533

534 Principles of Economics then the failure of prices to convey information about costs or benefits suggests that there is a problem on the demand side or an external cost problem on the supply side . In either case , it is necessary to estimate costs or benefits that are not revealed in the marketplace . The public interest perspective suggests an approach in which policy makers identify instances of potential market failure and then look for ways to correct them . Public choice theory instead looks at what motivates the people making those policy choices . The Public Choice Perspective Public choice theory discards the notion that people in the public sector seek to maximize net benefits to society as a whole . Rather , it assumes that each participant in the public sector seeks to maximize his or her own utility . This section introduces the flavor of the public choice approach by examining two of its more important conclusions that many people will abstain from voting , and that legislative choices are likely to serve special interests . Economics and Voting The Rational Abstention Problem Public choice theory argues that individuals do not leave their behind when they enter the voting even when they are thinking about whether to go to the voting booth . The assumption of utility maximization by voters helps us to understand why most people do not vote in most elections . Suppose your state is about to hold a referendum on expanded support for state recreation areas , to be financed by an increase in the state sales tax . Given your own likely use of these areas and the way in which you expect to be affected by the tax , you estimate that you will be better off if the program passes . In fact , you have calculated that the present value of your net benefits from the program is . Will you vote ?

As a utility maximizer , you will vote if the marginal benefits to you of voting exceed the marginal costs . One benefit of voting is the possibility that your vote will cause the measure to be passed . That would be worth to you . But is a benefit to you of voting only if it is your vote that determines the outcome . The probability that any statewide election will be decided by a single vote is , effectively , zero . State elections that are decided by as many as a few hundred votes are likely to be subject to several recounts , each of which is likely to produce a different result . The outcomes of extremely close elections are ordinarily decided in the courts or in legislative bodies there is no chance that one vote would , in fact , determine the outcome . Thus , the benefit that you expect to receive will not be a factor in your decision about whether to vote . The other likely benefit of voting is the satisfaction you receive from performing your duty as a citizen in a free society . There may be additional personal benefits as well from the chance to visit with other people in your precinct . The opportunity cost of voting would be the value of the best alternative use of your time , together with possible transportation costs . The fact that no one vote is likely to determine the outcome means that a decision about whether to vote is likely to rest on individual assessments of the satisfactions versus the costs of voting . Most people making such decisions

Choices in the Public Sector 535 find the costs are greater . In most elections , most people who are eligible to vote do not vote . Public choice analysis suggests that such a choice is rational a decision not to vote because the marginal costs outweigh the marginal benefits is called rational abstention . Rational abstention suggests there is a public sector problem of external benefits . Elections are a way of assessing voter preferences regarding alternative outcomes . An election is likely to do a better job of reflecting voter preferences when more people vote . But the benefits of an outcome that reflects the preferences of the electorate do not accrue directly to any one voter a voter faces only some of the benefits of voting and essentially all of the costs . Voter turnouts are thus likely to be lower than is economically efficient . In the 2000 presidential election , for example , just of the population actually cast votes . President Bush received of the vote , which means he was elected with the support of just 24 of the electorate . Bush actually received fewer votes than his opponent , Albert Gore , Bush , however , won a majority in the Electoral College . The Case in Point essay describes the 2000 election in more detail . Voter turnout was higher in the 2004 and 2008 presidential elections . Legislative Choice and Special Interests One alternative to having the general public vote on issues is to elect representatives who will make choices on their behalf . Public choice theory suggests that there are some difficulties with this option as well . Suppose legislators seek to maximize the probability that they will be reelected . That requires that a legislator appeal to a majority of voters in his or her district . Suppose that each legislator can , at zero cost , learn the preferences of every voter in his or her district . Further , suppose that every voter knows , at zero cost , precisely how every government program will affect him or her . In this imaginary world of costless information and ambitious legislators , each representative would support programs designed to appeal to a majority of voters . Organized groups would play no special role . Each legislator would already know how every voter feels about every issue , and every voter would already know how every program will affect him or her . A world of costless information would have no lobbyists , no pressure groups seeking a particular legislative agenda . No voter would be more important than any other . Now let us drop the assumption that information is costless but retain the assumption that each legislator goal is to be reelected . Legislators no longer know how people in the district feel about each issue . Furthermore , voters may not be sure how particular programs will affect them . People can obtain this information , but it is costly . In this more realistic world of costly information , groups suddenly play an important role . A legislator who does not know how elderly voters in his or her district feel about a certain issue may find a conversation with a representative of the American Association of Retired Persons ( to be a useful source of information . A chat with a lobbyist for the Teamster Union may reveal something about the views of union members in the district . These groups also may be able to influence voter preferences through speeches and through public information and political action efforts . A legislator in a world of costly information thus relies on groups for information and for support .

536 Principles of Economics To ensure his or her reelection , the legislator might try to fashion a program that appeals not to a majority of individuals but to a coalition of groups capable of delivering the support of a majority of voters . These groups are likely to demand something in exchange for their support of a particular candidate they are likely to seek special programs to benefit their members . The role of groups is thus inevitable , given the cost of information and the desire of politicians to win elections . In the real world , it is not individual voters who count but groups that can deliver the support of voters to a candidate . Public choice theorists argue that the inevitable importance of groups explains many choices the public sector makes . Consider , for example , the fact noted earlier in this chapter that a great many transfer payments go to groups , many of whose members are richer than the population as a whole . In the public choice perspective , the creation of a federal transfer program , even one that is intended to help poor people , will lead to competition among interest groups to be at the receiving end of the transfers . To win at this competition , a group needs money and poor people are not likely to have . In the competition for federal transfers , then , it is the who often win . The perception of growing power of groups in the United States has led to proposals for reform . One is the imposition of term limits , which restrict the number of terms a legislator can serve . Term limits were first established in Colorado in 1990 California and Oklahoma established term limits the same year . Subsequently , 18 other states adopted them . They have been found unconstitutional in four State Supreme Courts ( Massachusetts , Oregon , Washington , and Wyoming ) They have been repealed by the state legislatures of Idaho and Utah . Thus , term limits now apply in 15 states ( National Conference of State Legislatures , 2005 ) One argument for limits from the public choice perspective is that over time , incumbent legislators establish such close relationships with interest groups that they are virtually assured reelection limiting may weaken these relationships and weaken special interests . The Supreme Court ruled in 1995 that individual states could not impose term limits on members of Congress . If such limits are to prevail at the federal level , a constitutional amendment will be required . Arguments against the term limits approach include the fact that term limits automatically remove experienced legislators who could be very effective . They also restrict voter choice . A second type of reform effort is a proposal that campaigns for seats in Congress be federally funded . If candidates did not need to seek funding from special interests , the of these groups would wane . Key Ta Public interest theory examines government as an institution that seeks to maximize public or net social benefit . It assumes government will seek the efficient solution to market failure problems . Public choice theory assumes that individuals engage in behavior by pursuing their in their dealings with the public sector they continue to try to maximize utility or profit . It may be rational for eligible voters to abstain from voting , according to the public choice theory . Public choice theory suggests that politicians seeking reelection will try to appeal to of interest groups .

Choices in the Public Sector 537 Try It ! Here is a list of possible explanations for government programs and policies . In each case , identify whether the explanation reflects the public interest theory or the public choice theory of government action . It is possible to explain much government activity by investigating the public demand for government services , but one should not ignore the incentives for increased supply of government . Through careful application of analysis , we can identify the amount of a public good that should be provided by the . The determination of what are merit or demerit goods is inherently political rather than scientific and more often than not can be traced to the efforts of groups with an ax to grind or some private motive to . While it is possible that policy makers follow some application of or principles , it is more credible to recognize that many of the taxes in this country reflect the fact that groups find it in their interest to organize to get tax burdens shifted to . It is in the public interest to correct the market failure caused by monopoly firms . Therefore , it behooves us to do Case in Point The Presidential Election of 2000 I Figure 1511 Vaguely Vote . Public opinion polls on the eve of the election between George Bush and Al Gore showed the race to be a . Ordinarily , one might expect this to produce a large turnout . But barely more than registered voters went to the polls . The 2000 election provides an illustration of the concept of rational abstention . It also illustrates another point made in the text . If an election is close , the outcome is likely to be determined in the courts . Florida , with its 25 electoral votes , proved to be the decisive state . The winner of that state electoral votes would win the presidency . The outcome in that state was not determined until late November , when Florida Secretary of State , Republican Katherine Harris , declared George Bush the winner by a few hundred votes . Gore took the case to court . The Florida State Supreme Court ordered a recount .

538 Principles of Economics The recounting process proved to be one of the most bizarre chapters in American political history . Thousands of lawyers descended on the state . Each ballot in key counties was scrutinized in an effort to determine which candidate each voter intended to choose . Chads , the small pieces of paper that are removed from a ballot , turned out to be of crucial importance . Hanging chads , which occurred when the ballot was not thoroughly punched and which literally remained hanging from the ballot , prevented a ballot from being counted by the state electric counting machines . The Florida Supreme Court ruled that the roughly ballots that had been discarded by the machines because they were not properly punched had to be . As the recounting went on , other controversies arose . Pursuant to Florida law , Harris had ordered County Clerks to remove from their registered voter lists . One clerk , seeing her own name on the list , refused to remove the names . Harris had come up with a list of for her scrub The precise number of voters removed is not known . Harper Magazine columnist Greg charges that 90 of the voters on the scrub list were not , in fact , He notes that they were , however , likely to vote of who are allowed to vote vote Democratic . In the end , the case went to the United States Supreme Court . The Court decided , by a single vote , that Harris certification of the outcome would stand , and George Bush became the of the United States . All elections have stories of irregularities . The 2000 election was certainly no exception . What made it different was that the outcome came down to the votes in a single state . The official tally in Florida had Bush with and Gore with . What was the real outcome ?

No one will ever know . Sources Florida Secretary of State , John Fund , Vote Early and . The Wall Street Journal , December 12 , 2001 Greg , The Great Florida Game , Magazine , March , 2002 and Supreme Court , George Bush et al . Albert Gore , et , December 12 , 2000 . Answer to Try It ! Problem Statements ( and ( reflect a public interest perspective . Statements ( and ( a public choice perspective . References National Conference of State Legislatures , Legislative Term Limits An Overview , April 22 , 2005 .

Review and Practice Summary In this chapter we examined the role of the public sector in the market economy . Since 1929 , both the size and scope of government activities in the market have expanded considerably in the United States . People demand government participation in three areas of economic activity . First , people may want correction of market failure involving public goods , external costs and benefits , and inefficient allocation created by imperfect competition . In each case of market failure , the shift from an inefficient allocation to an efficient one has the potential to eliminate or reduce deadweight losses . Second , people may seek government intervention to expand consumption of merit goods and to reduce consumption of demerit goods . Third , people often want government to participate in the transfer of income . Programs to transfer income have grown dramatically in the United States within the past few decades . The bulk of transfer payment spending is not . Government activity is financed primarily by taxes . Two principles of taxation are the principle , which holds that tax payments should rise with income , and the principle , which holds that tax payments should be based on the benefits each taxpayer receives . Taxes may be regressive , proportional , or progressive . The major types of taxes in the United States are income taxes , sales and excise taxes , and property taxes . Economists seek to determine who bears the burden of a tax by examining its incidence . Taxes may be borne by buyers or sellers , depending on the relative of demand and supply . Two broad perspectives are used to examine choices in the public sector . One is the public interest approach , which uses analysis to find the efficient solution to resource allocation problems . It assumes that the goal of the public sector is to maximize net social benefits . analysis requires the estimation of benefits and costs that are not revealed in the marketplace . The second approach to the analysis of the public sector is public choice theory , which assumes and behavior on the part of participants in the public sector and those trying to it . We examined two insights stemming from public choice theory the problem of rational abstention from voting and the role of special interests . Concept Problems . Identify each of the following government programs as efforts to correct market failure , to promote or discourage the consumption of merit or demerit goods , or to transfer income . Head Start , a preschool program for children Sports leagues for children sponsored by local governments . A program to limit air pollution generated by power plants Species preservation efforts by the government . Public Broadcasting System ( stations regularly solicit contributions from viewers . Yet only about 11 of these viewers , who on average have much higher incomes than the rest of the population , ever contribute . Why ?

Do you expect to benefit from the research efforts sponsored by the American Cancer Society ?

Do you contribute ?

If you answered Yes , then No , does this make you a free rider ?

539 540 Principles of Economics 10 . 11 . 12 . 13 . Su ) pose the population of the United States increases . What will happen to the demand for national de ense ?

What will happen to the efficient quantity of defense ?

How could a program that income from rich to poor be considered a public good ?

We noted that local governments typically supply tennis courts but not bowling alleys . Can you give a pu choice explanation for this phenomenon ?

How about a public interest explanation ?

Find out the turnout at the most recent election for student body president at your school . Does the turnout inc student apathy ?

Some welfare programs reduce benefits by for every that recipients earn in effect , this is a tax of 100 on recipient earnings . Who pays the tax ?

Su ) pose the quality of elementary education is a public good . How might we infer the demand for elementary school quality from residential property values ?

Lenin , founder of the former Soviet Union , wrote that the State is a machine for the oppression of one class by Explain whether Lenin view the public interest or the public choice school of sector choice . Sugar prices in the United States are several times higher than the world price of sugar . This disparity results from a federal government program that keeps enough sugar out of the United States to ho sugar prices at a high level . The program raises the price of all sweetened foods produced in the United States it boosts food costs for the average household by more than a hundred dollars per year . Who benefits from the program ?

Why do you suppose it exists ?

The table on federal income tax rates facing various income groups suggests that the marginal tax rate in the United States has fallen since the period used in the study of marginal tax rates and labor supply discussed in the Case in Point essay . What would your prediction be as to how this reduction in the marginal tax rate would affect the quantity of labor supplied in the United States ?

Given that we can not have a perfectly accurate count of the votes in any election , is there any point in having elections at all ?

Numerical Problems In an effort to beautify their neighborhood , four households are considering leasing a small section of vacant land for a park . For a monthly leasing fee , the owner of the vacant land is willing to arrange for some of the maintenance and to make the park available only to the four households . The demand curves for the four households ( A , and ) wanting parkland are as follows ( all demand curves are linear ) Acres of Parkland Demanded per Month A 100 75 50 25

Review and Practice 541 Draw the demand curves for the four neighbors , and show the neighborhood demand curve for parkland . Suppose the owner of the vacant land will provide for and maintain a neighborhood park at a fee of 125 per acre the neighbors may lease up to acres of land per month . Add this information to the graph you drew in Problem , and show the efficient solution . Are the neighbors likely to achieve this solution ?

Explain the problems involved in achieving it . The perfectly competitive blank compact disc industry is in equilibrium , selling blank discs for apiece . Now the government imposes an excise tax of per disc produced . Show what happens to the price and output of discs in the short run . Now show the impact in the long run . Who pays the tax ?

Note Show quantities as , etc . A monopoly firm has just taken over the blank industry . There have been technological advances that have lowered production cost , but the monopoly firm charges a price greater than average total cost , even in the long run . As it turns out , the firm is still selling compact discs for . The government imposes an excise tax of per disc produced . What happens to price ?

What happens to output ?

Compare your results to your answer in Problem and explain . The following hypothetical data give annual spending on various goods and services for households at different income levels . Assume that an excise tax on any of these would , in the long run , be shifted fully to consumers . Income range Average income Food Clothing Entertainment 500 ( Determine whether a tax on any of the following goods would be progressive , proportional , or regressive . Food . Clothing . Entertainment .