Chapter 10 Essentials of Economics Paul Gregory 6t Lecture Notes

Chapter 10
1. No Market Test for
Government Spending
Rule: Any economic activity will be carried
out as long as its marginal benefits exceed its
marginal costs (Private/Public)
A market test ensures that private goods
and services yield benefits equal to or greater
than their costs.
Government spending is carried out by
87,000 federal, state and local governments
in the U.S.
1. No Market Test for
Government Spending – cont.
Exhaustive expenditures are government
purchases that divert resources from the private
sector, making them no longer available for private
use. (Ex. A local government hires a police officer or
repairs a road).
Transfer payments transfer income from one
individual or organization to another. (Ex. Payments
to families with dependent children transfer income
taxpayers to poor families).
The Social Security transfer program transfers income
from currently employed workers to retired or
disabled workers.
2. Taxation
Government rarely sells its goods or
Except in rare cases, government
programs must be financed through
2.1 Principles of Taxation
The benefit principle of taxation argues that
those who benefit from a public expenditure program
should pay for the program.
Two basic advantages: 1) People who do not benefit
do not pay (non-drivers taxed to build roads). 2)
Benefit taxes are more likely to ensure that benefits
equal or outweigh the costs.
Disadvantage: difficult to determine who benefits,
who benefits from police protection, national
defense, etc.
2.1 Principles of Taxation
– cont.
The ability-to-pay principle of taxation
states that those better able to pay should
bear the greater burden of taxation, whether
or not they benefit.
The rich should bear a heavier responsibility
for public schools, national defense, etc. as
they are better able to pay than the poor.
Negative: those who work harder and earn
more are penalized by having to pay more for
government programs that benefit others.
2.2 Taxes and Private
Decision Making
Experts and politicians have long
debated whether taxes should be:
Neutral—affect private decision making as
little as possible.
Used to promote social goals.
Most governments use taxes designed
to affect private behavior.
2.2.1. Progressive and
Regressive Taxes
With a proportional tax, taxpayers
earning different incomes pay the same
percentage of their income as taxes.
With a progressive tax, higher-income
taxpayers pay a higher percentage of their
income as taxes. (Distributes income from
rich to poor).
With a regressive tax, high-income
taxpayers pay a smaller percentage of their
income as taxes.
2.2.2 Marginal Tax Rates
The marginal tax rate is the ration of the
increase in taxes to the increase in income.
A marginal tax rate of 50 percent means that
for every extra dollar earned, 50 cents goes
to taxes and the remaining 50 cents stays
with the taxpayer as after-tax income.
The marginal tax rate can have an effect on
work effort.
2.3 Government Revenues
The federal government raises $1.6 trillion of
its $1.9 trillion in revenues from personal
income taxes and payroll (Social Security)
The federal government collects the relatively
small remainder of its revenue in the form of
corporate profit taxes and sales taxes.
State and local governments collect most of
their revenues through sales taxes, which
tend to be regressive.
2.4 The Size of
The most common measure of the size of
government is government’s share of total
spending of the entire economy.
In the year 2002, government in the U.S.
accounts for more than 30 percent of all
United States spend less in the economy
versus other affluent countries; they have to
collect enormous amounts for social security.
3. The Federal Budget
Special attention needs to be given to the
budget of the federal government.
The spending and taxation of state and local
government are diffused and uncoordinated;
they are thus beyond the control of national
The federal government, on the other hand,
are subject to control by the federal executive
and legislative branches; they regulate the
pace of economic activity.
3.1 Deficits and Debt
The federal budget runs a deficit if federal
expenditures exceed federal tax collections
and other revenues.
 The national dept is the total of outstanding
federal government IOUs (outstanding
government bonds).
The Burden of the Debt on Different
Generations Example
 National debt is internal if it is owed to the
citizens of the country. It is external if it is
owed to citizens of other countries.
2.2 Problems of Deficit
Politicians, economists, and the general
public favor deficit reduction.
Why is it so difficult to achieve a
balanced budget in the last quartercentury?
75 percent of all federal government
spending is for relatively uncontrollable
2.2 Problems of Deficit
Reduction – cont.
To cut the size of the federal deficit, federal
revenues must be increased, federal outlays
must be reduced, or a combination of these
 Everyone favors deficit reduction, few are
willing to pay the personal price of a lower
deficit, particularly when it comes to giving
up spending and tax programs that are of
benefit to themselves.
Where did the $4 Trillion Surplus Go? Example
4. Majority Rule: The
Power of the Median Voter
The median voter is the voter whose
preferences are such that 50 percent of the
voting population desires less of the public
good and 50 percent desires more of it.
Under majority rule, the median voter
determines the outcome and this raises
three important questions:
Social choices need not respond to individual wants.
Majority voting rules may not reflect the intensity of
Majority voting need not be efficient.
5. Logrolling
When public choices involve multiple decisions, there
is no assurance that majority rule will prevail.
 Logrolling permits the approval of projects by votetrading coalitions that would be opposed by a
majority if considered in isolation.
 Ex. A favor interstate highway, B favors a new ship
channel, A en B coalition, each agree to support the
other’s project.
Dairy Subsidies: Rational Ignorance and Logrolling
6. Rational Ignorance
Rational ignorance is a decision not to
acquire additional information because the
marginal costs exceed the marginal benefits.
Private choices: individuals inform themselves
about the price and qualities of cars, TVs, etc.
Public choices: individuals must gather information
about complex and confusion public issues, e.g.
Should a new flood control project be build?
6. Rational Ignorance
– cont.
Special-interest groups are minority voting
groups with intense preferences about
specific government policies.
Dairy farmers and domestic steel manufacturers
are well informed about public policies that affect
their economic well-being.
A central problem of public choice is that
benefits of government policies are highly
concentrated while the costs are highly