Econ 344 Public Finance
Prof. Daniel Otto
Chapter 1 - Introduction
Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers
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Econ 344 Public Finance
Prof. Daniel Otto
Chapter 1 - Introduction
Why Study Public Finance?
Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers
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Public Finance and Public Policy, 2/e
Jonathan Gruber
Why Study Public Finance?
1
•Public Finance
Prepared by:
FERNANDO QUIJANO, YVONN QUIJANO,
KYLE THIEL & APARNA SUBRAMANIAN
© 2007 Worth Publishers Public Finance and Public Policy, 2/e, Jonathan Gruber
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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
The Four Questions of Public Finance
public finance The study of the role of the government in the economy.
Public finance is about the taxing and spending activities of the government.
Also known as “public sector economics” or “public economics.”
Focus is on microeconomic functions of government – polices that affect overall
unemployment or price levels are left for macroeconomics.
Scope of public finance wide-ranging – government has role in many activities, but
focus will be on taxes and spending.
four questions of public finance
•When should the government intervene in the economy?
•How might the government intervene?
•What is the effect of those interventions on economic outcomes?
•Why do governments choose to intervene in the way that they do?
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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
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Possible Working Groups on Federal
Deficit Issues
a.
b.
c.
d.
e.
Background and overview of deficit
Spending policy changes
Revenue generation strategies
Addressing entitlement programs
Overall assessment and policy
recommendations
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1.1 The Four Questions of
Public Finance
Why Study
Public Finance?
1.2 Why Study Public
Finance? Facts on
Government in the United
States and around the World
1.3 Why Study Public
Finance Now? Policy Debates
over Social Security, Health
Care, and Education
1.4 Conclusion
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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
1.1
The Four Questions of Public Finance
When Should the Government Intervene in the Economy?
Market Failures
market failure Problem that
causes the market economy to
deliver an outcome that does
not maximize efficiency.
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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
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The Four Questions of Public Finance

APPLICATION
The Measles Epidemic of 1989–1991
 After the measles vaccine was introduced in 1963, measles cases had
become relatively rare in the U.S. by the 1980s. Over the period from 1989
to 1991, however, there was a huge resurgence in measles.
 It is clear that this outbreak resulted from very low immunization rates
among disadvantaged inner-city youths:
 These unimmunized children were imposing a negative externality on
other children who had received their immunizations but for whom
immunization may have worn off.
 The federal government responded to this health crisis in the early 1990s:
 The government publicly encouraged parents to get their children
immunized.
 The government also paid for the vaccines for low-income families.
The result was impressive. Immunization rates, which had never been above
70% before the epidemic, rose to 90% by 1995. Government intervention
clearly reduced this negative externality.

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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
The Four Questions of Public Finance
When Should the Government Intervene in the Economy?
Redistribution
redistribution The shifting
of resources from some
groups in society to others.
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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
1.1
The Four Questions of Public Finance
How Might the Government Intervene?
Tax or Subsidize Private Sale or Purchase
One way that the government can try to address failures in the private
market is to use the price mechanism, whereby government policy is
used to change the price of a good in one of two ways:
1. Through taxes, which raise the price for private sales or
purchases of goods that are overproduced,
or
2. Through subsidies, which lower the price for private sales or
purchases of goods that are underproduced.
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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
The Four Questions of Public Finance
How Might the Government Intervene?
Restrict or Mandate Private Sale or Purchase
The government can directly restrict private sale or purchase of goods
that are overproduced, or mandate private purchase of goods that are
underproduced and force individuals to buy that good.
Public Provision
The government can provide the good directly, in order to potentially
attain the level of consumption that maximizes social welfare.
Public Financing of Private Provision
Governments may want to influence the level of consumption but may
not want to directly involve themselves in the provision of a good.
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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
The Four Questions of Public Finance
What Are the Effects of Alternative Interventions?
Direct Effects
direct effects The effects of
government interventions that
would be predicted if individuals
did not change their behavior in
response to the interventions.
Indirect Effects
indirect effects The effects of
government interventions that
arise only because individuals
change their behavior in
response to the interventions.
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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
1.1
The Four Questions of Public Finance

APPLICATION
The Congressional Budget Office:
Government Scorekeepers
 The methods and results derived from empirical economics
are central to the development of public policy at all levels
of government.
 The Congressional Budget Office (CBO) provides Congress
with the objective, timely, nonpartisan analyses needed for economic and budget
decisions.
 The CBO increasingly plays a critical role as a “scorekeeper” for government policy
debates.
 Legislative spending proposals that are to become law must first have their costs
estimated by the analysts at the CBO.
It is not an overstatement to say that the economists who work at the CBO
frequently hold the fate of a legislative proposal in their hands. The large price
tag that the CBO assigned to the Clinton administration’s plan to reform health
care in the United States in 1994 is often cited as a key factor in the defeat of
that proposal.

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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
The Four Questions of Public Finance
Why Do Governments Do What They Do?
political economy The theory
of how the political process
produces decisions that affect
individuals and the economy.
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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
The Legal Framework
Federal government
Federal Constitutional provisions
Article 1, Section 8 —provide for general welfare
Article 1, Section 9 -fair tax, interstate commerce
16th Amendment –income tax
5th Amendment –reasonable in power of eminent domain
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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
The Legal Framework
State governments
Federal constitutional provisions
10th amendment -state get whatever Feds don’t spell out
The State constitutions –fiscal power
Local governments
Derive power to tax and spend from the States
Fiscal independence of local governments
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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
Why Study Public Finance? Facts on Government in the
United States and around the World
The Size and Growth of Government
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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
Why Study Public Finance? Facts on Government in the
United States and around the World
The Size and Growth of Government
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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
Why Study Public Finance? Facts on Government in the
United States and around the World
Decentralization
A key feature of governments is the
degree of centralization across local
and national government units—that
is, the extent to which spending is
concentrated at higher (federal) levels
or lower (state and local) levels.
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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
Why Study Public Finance? Facts on Government in the
United States and around the World
Spending, Taxes,
Deficits, and Debts
Federal Revenues and
Expenditures, Surplus or
Deficit, and Debt, 1930–2008 •
For most of the twentieth century,
except for the World War II
period, federal government tax
receipts have kept pace with
expenditures. But expenditures
have exceeded receipts by
several percentage points of
GDP on average since the
1970s. The resulting federal
government debt is now at about
40% of GDP.
Source: Office of Management and Budget
(2008), Tables 1.2 and 7.1. (Debt figures for
1930–1939 come from the U.S. Department of
the Treasury’s Bureau of the Public Debt.)
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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
Why Study Public Finance? Facts on Government in the
United States and around the World
Spending, Taxes, Deficits, and Debts
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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
Why Study Public Finance? Facts on Government in the
United States and around the World
Spending, Taxes, Deficits, and Debts
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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
Why Study Public Finance? Facts on Government in the
United States and around the World
Distribution of Spending
The Distribution of Federal
and State Expenditures,
1960 and 2007 • This figure
shows the changing
composition of federal and
state spending over time, as
a share of total spending. (a)
For the federal government,
defense spending has fallen
and Social Security and
health spending have risen.
(b) For the states, the
distribution has been more
constant, with a small decline
in education and welfare
spending and a rise in health
spending.
Source: Bureau of Economic Analysis,
NIPA Table 3.16.
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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
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Why Study Public Finance? Facts on Government in the
United States and around the World
Distribution of Spending
public goods Goods for
which the investment of any
one individual benefits
everyone in a larger group.
social insurance programs
Government provision of
insurance against adverse
events to address failures in
the private insurance market.
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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
Why Study Public Finance? Facts on Government in the
United States and around the World
Distribution of Revenue Sources
The Distribution of Federal and
State Revenues, 1960 and 2008 •
This figure shows the changing
composition of federal and state
revenue sources over time, as a
share of total revenues. (a) At the
federal level, there has been a
large reduction in corporate and
excise tax revenues and a rise in
payroll tax revenues. (b) For the
states, there has been a decline in
property taxes and a rise in income
taxes and federal grants.
Source: Bureau of Economic Analysis, NIPA
Tables 3.2 and 3.3.
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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
Why Study Public Finance? Facts on Government in the
United States and around the World
Regulatory Role of the Government
Another critical role the government plays in all nations is that of
regulating economic and social activities:
 The Food and Drug Administration (FDA) regulates the labeling and
safety of nearly all food products and bottled water, tests cosmetics to
ensure their safety, and approves drugs and medical devices to be sold
to the public.
 The Occupational Safety and Health Administration (OSHA) is
charged with regulating the workplace safety of the 135 million
Americans employed at 8.9 million job sites.
 The Federal Communications Commission (FCC) regulates interstate
and international communications by radio, television, wire, satellite,
and cable.
 The Environmental Protection Agency (EPA) is charged with
minimizing dangerous pollutants in the air, water, and food supplies.
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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
Why Study Public Finance Now? Policy Debates over
Social Security, Health Care, and Education
Social Security, health care, and education are each the subject of debate,
with both the “liberal” and “conservative” positions holding differing views
in their approach to these major policy issues.
Social Security
Social Security is the single largest government expenditure program. The
financing structure of this program is basically that today’s young workers
pay the retirement benefits of today’s old.
Health Care
There are currently 45 million Americans without any health insurance,
about 18% of the non-elderly U.S. population. Projections suggest that
health care will consume almost half of our GDP within the next century.
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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
Why Study Public Finance Now? Policy Debates over
Social Security, Health Care, and Education
Education
There is an enormous dissatisfaction
with our current educational system,
highlighted by the dismal
performance of U.S. students on
international tests.
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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
Conclusion
It is clear from the facts presented here that the government plays a central
role in the lives of all Americans.
It is also clear that there is ongoing disagreement about whether that role
should expand, stay the same, or contract.
The facts and arguments raised in this chapter provide a backdrop for
thinking about the set of public finance issues that we explore in the
remainder of this book.
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