CHAPTER
15
Public Goods, Taxes, and
Public Choice
1
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
1
Overview of Government
In most modern societies, governments are
involved in the following activities:
 Providing public goods and services such as
streets, education, parks, public safety, national
defense, and space exploration

Redistributing income to the poor

Collecting taxes to support spending programs

Trade policy to control international trade, to
promote or to restrict some types of trade
2
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Rationale for the Existence of
Government

Certain goods and services would not
exist unless we make a collective effort
to produce them.

The government can help make collective
decisions about paying for goods that
generate spillover benefits.
3
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Local Governments


There are more than 80,000 local governments in
the United States.
Local governments spend most of their money
on:





Education (kindergarten through high school)
Public welfare and health (payments to poor
households and support for public hospitals)
Highways
Police protection
Local governments provide goods and services
such as water, fire protection, and libraries. 4
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Local Expenditures, 1996
Local Expenditures (1996)
Administration and other (34.00%)
Police protection (5.00%)
Highways (5.00%)
Health and hospitals (9.00%)
Education (42.00%)
Public welfare (5.00%)
5
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
State Governments

At the state level, the biggest spending
programs are:

Education (including colleges and universities)

Public welfare

Highways

Health and hospitals

Corrections (state courts and prisons)
6
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
State Expenditures, 1996
State Expenditures (1996)
Administration and other (19.80%)
Education (34.65%)
Correction (3.96%)
Highways (7.92%)
Health and hospitals (7.92%)
Public welfare (25.74%)
7
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Federal Governments

At the federal level, the biggest spending
programs are:

Income security

National defense
8
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Federal Expenditures, 1996
(1996)
Federal Expenditures (1998)
Other (11.88%)
Net interest (14.85%)
National defense (15.84%)
International affairs (0.99%)
Health (7.92%)
Medicare (11.88%)
Social security (22.77%)
Income security (13.86%)
9
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Spillover Benefits

A market with spillover benefits is
inefficient, so there is an opportunity for
government to promote efficiency.
Spillover PRINCIPLE
For some goods, the costs or benefits associated
with the good are not confined to the person or
organization that decides how much of the good to
produce or consume.
10
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Spillover Benefits
Number of people
100,000
Benefit per person
$5
Total benefit of dam
(100,000 x $5)
$500,000
Assumed total cost
of dam (greater than
personal benefit of
$5)
$200,000
Tax per person
$2
Tax revenue
(100,000 x $2)
$200,000


In this example, if each
person considers only the
personal benefit relative to
the cost of the dam, no dam
will be built.
Since everyone will support a
tax per person that is less
than the benefit per person,
the government can use its
taxing power to provide a
good that would otherwise
not be provided.
11
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Public Goods

A public good is a good available for
everyone to consume, regardless of who
pays and who doesn’t.

A private good is consumed by a single
person or household.
12
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Public Goods

Public goods are nonrival in consumption
(available for everyone to consume) and
nonexcludable (it is impractical to
exclude people who don’t pay).

Private goods are rival in consumption
(only one person can consume the good),
and excludable (it is possible to exclude
a person who does not pay for the good).
13
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Public Goods
Examples of public goods:

National defense

Law enforcement

Space exploration

Preservation of
endangered species

Protecting the earth’s
ozone layer

Income transfers to
the poor
14
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Private Goods With Spillover Benefits

A good such as education generates
workplace and civic spillovers benefits, thus, the
government should adopt policies to encourage
people to become educated.

Local governments provide free primary and
secondary education. States subsidize higher
education, and the federal government provides
financial aid to students in private and public
schools.
15
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Voluntary Contributions and the Freerider Problem

The problem with using voluntary
contributions to support public goods is
the free-rider problem.

Each person will try to get the benefits of
a public good without paying for it.
16
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Overcoming the Free-rider Problem
Techniques to encourage people to contribute:

Give contributors something in return

Arrange matching contributions

Appeal to people’s sense of civic or moral
responsibility
17
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Financing Government: Taxes
The major sources of revenue:

For local governments is the property tax.

For state governments are sales taxes and
individual income taxes.

For the federal government are individual
income taxes and “social insurance and
retirement receipts.”
18
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Local Revenue, 1996
Local Revenue (1996)
Other (4.00%)
Sales (10.00%)
Charges and miscellaneous (38.00%)
Property (45.00%)
Individual income taxes (3.00%)
19
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
State Revenue, 1996
State Revenue (1996)
Charges, fees, other (26.00%)
Sales (38.00%)
Property (2.00%)
Corporate income taxes (5.00%)
Individual income taxes (24.00%)
Licenses (5.00%)
20
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Federal Revenue, 1996
Federal Revenue (1998)
(1996)
Social insurance & retirement receipts (33.00%)
Individual income taxes (48.00%)
Corporation income taxes (11.00%)
Other (8.00%)
21
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Effects of a Tax

In a competitive market,
equilibrium price ($200) is
just enough to cover the
cost of providing an
apartment.

A tax of $80 imposed on
housing firms increases
the average cost of
providing 900 apartments
by $80, to $280.
22
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Effects of a Tax

The tax shifts the supply
curve to the left.

At each price, fewer
apartments will be
supplied.

The tax increases
equilibrium price and
decreases the output of
the industry.
23
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Effects of a Tax


Housing firms now offer
750 apartments at $230
per unit. After they pay
the $80 tax, only $150
remains to pay input
suppliers.
Firms collect more money
from consumers and pay
less money to input
suppliers, so consumers
and input suppliers
indirectly pay the tax.
24
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Effects of a Tax


The $80 tax per
apartment is split
between consumers
and input suppliers.
After the tax, consumers
pay $30 more and input
suppliers receive $50
less per apartment.
25
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Effects of a Tax

Revenue for the
government from the
750 apartments equals
$750 x $80, or
$60,000. Consumers
pay $22,500 and
producers $37,500.
26
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Deadweight Loss From Taxation

Both consumer surplus
and producer surplus
are less after the tax.

Some of the losses are
transferred to the
government.

But the triangles C and
E are net losses not
transferred to anyone.
27
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Tax Shifting: Forward and Backward

A forward-shifted tax is a tax imposed on
producers but passed on to consumers. The
amount of a tax shifted forward depends on the
price elasticity of demand for the taxed good.

A backward-shifted tax is a tax borne by firms
and input suppliers. The amount of backward
shifting to input suppliers depends on their
responsiveness to changes in input prices.
28
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Tax Shifting: Forward and Backward

When demand is relatively
inelastic, the tax burden is
forward-shifted.

When demand is relatively
elastic, the tax burden is
backward-shifted.
29
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Public Choice
Public choice economics is a field of study that
explores contrasting views about how
governments operate.
Four contrasting views of government:
 Governments take actions to promote efficiency
 Voters tell governments what to do
 Government officials pursue their own selfinterest
 Special-interest groups manipulate the
government

30
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Governments Take Actions to Promote
Efficiency

The public-interest view of government
is based on the idea that governments
make the economy more efficient.

As we have seen, governments can use
their power to collect taxes to provide
public goods that would otherwise not
exist.
31
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Voters Tell Governments What to Do

Voters affect government decisions.

In a democracy, the government takes
actions that are approved by the majority
of citizens.

If governments respond to voters, the
voting public ultimately makes all the
important decisions.
32
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Median-voter Rule

The median-voter rule says that the
choices made by government will reflect
the preferences of the median voter.

When two candidates offer divergently
opposed views, powerful forces pull them
toward the preferences of the median
voter.
33
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
People “Vote With Their Feet”

According to economist Charles M. Tiebout,
people “vote with their feet.”

The choice of which community to live in is
based in part on the taxing and spending
policies of different communities. Households
express their preferences by moving to
communities that offer the best package of
services and taxes.
34
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Government Officials Pursue Their
Own Self-Interest

The Nobel Laureate James Buchanan, among others,
has suggested a model of government that focuses on
the selfish behavior of government officials.

The self-interest theory of government suggests that
voters don’t have much information about the costs and
benefits of public services, and may not be able to
evaluate the actions of politicians.

Limitations on taxes and spending are necessary
safeguards against politicians and bureaucrats who
benefit from large budgets.
35
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Special-interest Groups Manipulate
the Government

This model of government is based on the idea that
small groups of people manipulate government for their
own gain.

When a few people share the benefit from a project and
a large number of people share the cost, government is
more likely to approve inefficient projects.

Special-interest groups form whenever the benefits are
concentrated on a few citizens but costs are spread out
over many citizens.
36
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin