Chapter 1 Why Study Public Finance? Public Finance and Public Policy Author: Jonathan Gruber Instructor: Yigang Zhang

Introduction Hurricane Katrina in 2005 and raised questions regarding the role of government. 1200 lives lost, $80 billion in damage Coordination between levels of government during the disaster Should New Orleans be rebuilt, and who should pay for it?

Introduction In September 2008, an unprecedented financial crisis in lending led to the creation of the Troubled Asset Relief Fund (TARP), which allowed the U.S. Treasury to buy up to $700 billion in troubled assets. Should the government “bail out” private companies?

Introduction On a more local level, some Kentucky lawmakers have proposed that chain restaurants provide calorie information on their menus and menu boards. Lawmakers state that the bill’s purpose is to help consumers make healthier eating choices. “Studies show time and again that people use this information to make smarter, healthier choices,” Rep. Kelly Flood, Lexington.

Introduction The issues brought up with Hurricane Katrina and TARP are typical in public finance. What is the proper role of the government in the economy? Expenditure side: What services should the government provide? Taxation side: How should the government raise its money?

4 Questions When should the government intervene? How might the government intervene? What is the effect of those interventions? Why do governments choose to intervene in the way that they do?

When? Private markets usually provide “efficient” outcomes for the economy. Government intervention can be justified when there are: Market failures Redistribution concerns

When ? In a typical market, the efficient outcome is where the supply and demand curves intersect. Using the health insurance market as an example in this lesson, some people value health insurance at less than the price they would have to pay, and choose to be uninsured.

When? Market failures Application In 2004, 45.5 million uninsured individuals in US. Lack of insurance could cause negative externalities from contagious diseases. One example is the measles epidemic from 1989-1991. Government subsidized vaccines for low-income families, and the incidence of measles fell from 16,000/year to 300/year. Govt. response to 2009 swine flu outbreak – distribute vaccine for free and ration its distribution.

When? Redistribution Both the size of the “economic pie” & each person’s slice of that pie matter. We may value an additional $1 of consumption by the poor person more highly than by the rich. Redistribution is the shifting of resources from one group to another.

When? Redistribution 75% of uninsured have incomes below the median. May want to redistribute from rich (with health insurance) to poor (without health insurance) Redistribution results in inefficiency. Redistribution can change a person’s behavior. Taxing the rich & giving the money to the poor could cause both groups to work less hard.

How? Options for government intervention: Change Prices Tax credits lower the price of health insurance. Individual or Employer Mandate “Pay-or-play” mandates force individuals or firms to provide health insurance. Massachusetts recently passed one. It’s a centerpiece of the current U.S. House/U.S. Senate bills. Public Provision The Medicare program for U.S. senior citizens. Public Financing of Private Provision Private companies administer the drug insurance for Medicare.

What Are the Effects? Empirical public finance assesses “direct” and “indirect” effects of government actions. Direct effects Assumes “no behavioral responses” and examines the intended consequences of policy. Indirect effects People change their behavior when policy is passed. This is sometimes called the “law of unintended consequences.”

What Are the Effects? Expanding health insurance What happens if we simply give $2000 of health insurance to the uninsured? Direct effect 45.5 million people covered for $91 billion. This would be the intent of the law. Indirect effects “Crowd-out” of private health insurance for free government health insurance. 200 million Americans had private insurance in 2004. If 45% dropped private insurance, this would triple the cost. If 10% dropped insurance, the costs would $131 billion. Key question: How many of these people would respond?

Why? Governments do not simply behave as benign actors who intervene only because of market failure and redistribution. Political economy: How governments make public policy decisions. Government failures lead to inappropriate government intervention.

Why? Variation in health care delivery suggests efficiency and redistribution are not the only issues. U.S.: Private health insurance Canada: National public health insurance Germany: Mandates private health coverage U.K.: Free national health care

Timeliness Public finance topics are at the heart of public policy debates. Liberal and conservative viewpoints differ. Social Security: Privatize or raise payroll taxes? Health care: Socialized medicine or tax subsidies? Education: Higher teacher pay or vouchers?