Introduction to Public
Budgeting and Finance
Administrative Stuff
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Use of WebCT
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Any problems so far?
Organization of course
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Each session = 4 weeks, with corresponding number
of readings
Syllabus is rough guide only
Not all reading materials will be covered in lecture,
but all should be read carefully
Group projects
Homework assignments due by following session
Take home final due week after course
Objectives of the course
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Survey the dominant theories in budgeting and finance,
compare practice and trends
Learn how to strategically plan a budget, how to manage
ongoing activities, and how to control spending;
Understand the role of public organizations in a market
economy
Understand social security, public health and other major
categories of public expenditure
Understand the theory and practice of the redistribution
of wealth and resources
Understand the impact of taxes on social welfare.
Learn from practitioners in the field.
What is Public Budgeting?
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How governments strategically plan a
budget
Manage ongoing activities
Control spending
What is Public Finance?
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The study of how governments collect and
spend money and real resources
How do governments collect/spend
money? Positive analysis
How should governments collect/spend
money? Normative analysis
We are studying public finance in a market
economy
What is the Role of Government?
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To maintain and improve the welfare of
the people
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To protect the people from harm
To provide the institutions that allow market
to function (e.g. protection of property rights)
To provide the essential goods and services
that markets fail to adequately provide
The Role of Government: Ideology
Current Trends
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Reagan tax cuts
Shrink government “down to the size
where we can drown it in a bathtub”
Grover Norquist
“The era of big government is over”
Bill Clinton
Bush tax cuts
Free market ideology
Organic view of government
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Society is a natural organism
Goals of society set by state
Actions of individual are judged by the
contribution they make to the state
“Ask not what your country can do for
you; ask what you can do for your
country.”
Mechanistic view of government
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Individuals are paramount, government
created to meet the needs of individuals
Big debate over importance of individual
freedom
Two types of freedom:
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Freedom to do as you like
Freedom not to suffer from activities of others
As society grows more crowded, second type
of freedom becomes more important
The Role of Government: Objective Analysis
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Complexity theory and systems thinking
Government in a market economy
Complexity theory and
Systems thinking
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Bringing together many, many simple
components leads to emergence of spontaneous
order, complex system:
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2 H and 1 0 atoms form water molecule, molecules
form cell, cells form organs, organs make up humans,
humans make up society
Complex systems greater than the sum of their
parts
Characterized by non-linearities, feedback loops,
emergent properties, unpredictable surprises,
etc.
Government is a complex system
Government in a market economy
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Economics is the allocation of scarce resources
among alternative desirable ends
What are the desirable ends?
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To maintain and improve the welfare of the people
Government and economics have the same desirable ends
What are the scarce resources?
What are the characteristics of the scarce resources?
Whether resources should be allocated by
government or the market depends on the physical
nature of the scarce resources
Once we agree on the desirable ends, deciding on the
role of government moves towards objective science
and away from ideology.
Legal Framework
Federal Government: Expenditure
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Constitution empowers government to
“pay the debts and provide for the
common defense and general welfare of
the United States.”
Bills to appropriate expenditures can be
initiated in either house, must be
approved by both houses and President
Federal Government: Revenue
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Duties, imposts and excises must be
uniform throughout US
Constitutional amendment (16th) required
for federal income tax
5th amendment– can’t take away property
without due process of law, compensation
required
Can’t tax articles exported from states
Empowered to borrow money
State and local governments
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States have power not explicitly relegated
to federal government
Can’t impose duties on imports or exports
Power of local governments granted by
states
The Size of Government
Historical context
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What was the highest
marginal tax rate
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Under Eisenhower?
•Under Kennedy?
•Today?
•Highest tax bracket currently applies to single people earning $54,000/yr
What has happened to the deficit?
What has happened to the size of
government as a share of GDP?
How does size of US government
compare with other countries (2001)?
USA
29.3% of GDP
Australia
31%
Canada
37.4%
Japan
38.3%
UK
38.8%
France
49.4%
Sweden
53.1%
How does the federal government
spend its money?
How do state governments spend
money?
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Miscellaneous (~43%, +)
Education (~35%, -)
Public welfare (~17%, +)
Highways (~5%, -)
Where does the government get its
money?
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Federal
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Individual income tax
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Social insurance (++)
Corporate tax (--)
Other (-)
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State and local
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Other (+)
Sales tax
Grants from federal
government (+)
Property tax (-)
Individual income tax
(+)
Corporation tax
How do we Objectively Measure
Government Performance?
Role of Theory
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Observe, form hypotheses
Test hypotheses through continued
observation, measurement and
experiments
Confirm hypotheses repeatedly and you
have theory
Reject hypotheses and you’re back to the
drawing board
Theory tells us what questions to test
If we fail to test our theories and
their assumptions, or continue
to believe them when they fail
the tests, they become
ideology, not theory
Neoclassical Economic Theory
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Assumes humans are rational, self interested
utility maximizers
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Assumes perfect market competition
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Empirical studies reject this
Empirical studies reject this
Assumes in perfect markets invisible hand leads
to efficient allocation: greatest good for greatest
number
Can’t be tested in practice, because
governments always intervene with perfect
functioning of market
Ecological Economic Theory
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Assume economy is subset of ecosystem
Ecologically sustainable scale is first
priority
Socially just distribution 2nd
Efficient allocation 3rd
Georgist Economic Theory
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Ownership of land leads to poverty
Value of land is created by nature and
society, not hard work of individual
Land tax could finance all government
expenditure, prevent land speculation and
concentration of ownership, end poverty
Land tax could be extended to include all
value created by nature and society
Empirical methods for Testing
theories
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Interviews
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Experiments
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Ethical issues, self selection, etc.
Sample size
Econometrics (statistics)
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Subjective, hard to interpret
Torture the data and it will confess
Theories can be very hard to test
Measurement in a complex system
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Very hard to isolate cause and effect
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E.g. feedback loops
Rarely have adequate baseline data
Systems evolve over time
Values matter
How do we normatively measure
government Performance?
Why do we need normative
measures?
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We need some way to measure social
welfare, and choose between alternative
states
Economic theory provides some guidelines
Theory can be very incomplete
Different theories make different ethical
assumptions
The most commonly taught approach is
neoclassical welfare economics
Pareto Efficiency
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Pareto improvement-- Any change in
allocation that makes at least one person
better off without making anyone worse
off
Pareto optimum– an allocation where no
further Pareto improvements are possible
We always want to be at a Pareto
optimum
Indifference curves in Edgeworth box
Contract curve
Marginal rate of substitution
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If you lose one fig, how many apples would you
need to remain just as happy?
Determined by slope of indifference curve
Pareto optimum occurs when
MRS
Adam
af
 MRS
Eve
af
Production possibilities frontier
Marginal cost
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Marginal cost of figs is the number of apples
you have to give up to get one more fig
MCa
MRTaf 
MC f
Efficiency demands that
MCa
Adam
Eve
 MRTaf  MRS af  MRS af
MC f
across all goods and all people in the economy
First Fundamental Theorem of
Welfare Economics
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Assumptions:
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If all producers receive the same price
And there is a perfect market for every commodity
And people are perfectly rational,
Then, the free market automatically leads to a
Pareto Efficient allocation
If assumptions hold and all we care about is
Pareto efficiency, then government should be
minimized
But some Pareto optimums may be better for
society than others
Second Fundamental Theorem of
Welfare Economics
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We can attain any point on the contract
curve by changing initial endowments and
letting market take over.
So initial distribution matters, big time
Conclusions
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If markets functioned according to theory,
the major role of government would focus
on initial distribution
Markets unfortunately do not function
according to theory, as we’ll learn in next
lecture