Chapter 5 The Public Sector and Public Choice

Slide 5-2 Introduction Should a computer operating system be considered a public good? Economic theory offers some insight into the special characteristics of public goods.

Slide 5-3 Learning Objectives Explain how market failures such as externalities might justify economic functions of government Distinguish between private and public goods and explain the nature of the free- rider problem Describe the political functions of government that entail its involvement in the economy

Slide 5-4 Learning Objectives Distinguish between average tax rates and marginal tax rates Explain the structure of the U.S. income tax system Discuss the central elements of the theory of public choice

Slide 5-5 Chapter Outline What a Price System Can and Cannot Do What a Price System Can and Cannot Do Correcting for Externalities The Other Economic Functions of Government The Other Economic Functions of Government

Slide 5-6 Chapter Outline The Political Functions of Government Paying for the Public Sector The Most Important Federal Taxes Spending, Government Size, and Tax Receipts Spending, Government Size, and Tax Receipts Collective Decision Making: The Theory of Public Choice Collective Decision Making: The Theory of Public Choice

Slide 5-7 Did You Know That... The 1986 tax act was said by Congress to be a reform that would persist over the long term, yet more than 80 additional tax laws have been enacted since then? The amount of revenue the federal government collects in the form of an income tax exceeds $1 trillion annually?

Slide 5-8 What a Price System Can and Cannot Do A perfectly competitive price system can allocate resources efficiently through the interaction of markets. Market Failure –A situation in which an unrestrained market economy leads to too few or too many resources going to a specific economic activity

Slide 5-9 What a Price System Can and Cannot Do Market failure prevents economic efficiency. Market failure prevents individual freedom. Public policy (government) is often called upon to address market failure.

Slide 5-10 Correcting for Externalities Market efficiency occurs when individuals know the true opportunity cost of their actions.

Slide 5-11 Correcting for Externalities Market failure: an example –Assume No government regulation against pollution A town with clean air A steel mill opens and emits smoke that causes: –more respiratory diseases –dirtier clothes, houses, cars, etc.

Slide 5-12 Correcting for Externalities Market failure: an example –Market failure occurs: Steel mill does not pay for the clean air Costs of production have “spilled over” to the residents (third parties) Lower production cost –More steel is produced than would otherwise be the case

Slide 5-13 Correcting for Externalities Externalities –Occur when the consequence of an economic activity spillover to affect third parties Third Parties –Parties who are not directly involved in a given activity or transaction

Slide 5-14 Correcting for Externalities Externalities are examples of market failures. Pollution is an example of a negative externality.

Slide 5-15 External Costs and Benefits Figure 5-1, Panel (a) S2S2 S1S1 E1E1 E A Q2Q2 Q1Q1 P1P1 P2P2 Price of Steel per Ton Quantity of Steel per Year Panel (a) D

Slide 5-16 External Costs and Benefits Figure 5-1, Panel (b) S Q2Q2 Q1Q1 P1P1 P2P2 Price of Inoculation Quantity of Inoculations per Year D1D1 D2D2 Panel (b)

Slide 5-17 The Other Economic Functions of Government Providing a legal system –Enforcing contracts –Defining and protecting property rights –Establishing legal rules of behavior

Slide 5-18 The Other Economic Functions of Government Property Rights –The rights of an owner to use and to exchange property

Slide 5-19 The Other Economic Functions of Government Promoting competition –Market failure may occur if markets are not competitive. –Monopoly power –Antitrust legislation

Slide 5-20 The Other Economic Functions of Government Monopoly –A firm that has great control over the price Antitrust Legislation –Laws that restrict the formation of monopolies and regulate certain anticompetitive business practices

Slide 5-21 The Other Economic Functions of Government Providing Public Goods –Goods to which the principle of rival consumption does not apply –In contrast, private goods can be consumed by one individual at a time.

Slide 5-22 The Other Economic Functions of Government Characteristics of public goods –Indivisible –Additional people can use public goods at no additional cost –Additional users of public goods do not deprive other users –Difficult to charge for a public good based on consumption—the exclusion principle

Slide 5-23 The Other Economic Functions of Government Free-Rider Problem –Arises when some individuals take advantage of the fact that others will take on the burden of paying for public goods Question –How much national defense did you consume last month?

Slide 5-24 The Political Functions of Government Merit Goods –Goods deemed socially desirable through the political process Museums Ballet Concerts Theater –Provided through subsidization

Slide 5-25 International Example: Free Rider Problems and Terrorism Political groups that can provide security and public services for residents are often given free reign to operate in a region. This was the case with the Taliban in Afghanistan and Hamas in the Palestinian territories.

Slide 5-26 International Example: Free Rider Problems and Terrorism Because these groups collected funds through the threat of force, they were better financed than were the official political entities in the region. Their coercive tactics is collecting financial support allowed them to avoid the free rider problem.

Slide 5-27 Paying for the Public Sector Marginal Tax Rate –The tax rate on the last dollars earned Average Tax Rate –The proportion of total income paid in taxes

Slide 5-28 Paying for the Public Sector Tax Bracket –A specified level of taxable income to which a specific and unique marginal tax rate is applied Marginal Tax Rate = change in taxes due change in taxable income

Slide 5-29 Paying for the Public Sector Taxation systems –Proportional Taxation (flat-rate tax) Marginal tax rate = Average tax rate Everyone pays the same percentage of their income in taxes

Slide 5-30 Paying for the Public Sector Proportional Taxation Proportional Tax Rate = 20% Taxable Income x Tax Rate = Tax Liability $10,00020%$2,000 $100,00020%$20,000 Marginal Tax Rate = 20% Average Tax Rate = 20%

Slide 5-31 Paying for the Public Sector Taxation systems –Progressive Taxation Marginal tax rate > Average tax rate As a person’s taxable income increases, the percentage of income paid in taxes increases

Slide 5-32 Paying for the Public Sector Progressive Taxation: Income Tax Taxable Income Tax Rate Tax Liability 0–$10,000 5%$500 $10,001–20,000 10%$1,000 $20,001–30,000 30%$3,000 $4,500 Income = $30,000 Marginal Tax Rate = 30% Average Tax Rate = 15% or $4,500/$30,000

Slide 5-33 Paying for the Public Sector Taxation systems –Regressive Taxation Marginal tax rate < Average tax rate As a person’s taxable income increases, the percentage of income paid in taxes decreases

Slide 5-34 Paying for the Public Sector Regressive Taxation: Social Security Hypothetical Example Taxable Income Tax Rate* Tax Liability $5,00010%$500 $100,000———$5,000 *Tax Rate = 10% on first $50,000 of income; no tax on additional income Income = $5,000 Marginal Tax Rate and Average Tax Rate = 10% Income = $100,000 Marginal Tax Rate = 0% Average Tax Rate = 5% or $5,000/$100,000

Slide 5-35 The Most Important Federal Taxes The federal personal income tax –Accounts for 46% of all federal revenue

Slide 5-36 Federal Marginal Income Tax Rates Table 5-1

Slide 5-37 The Most Important Federal Taxes Arguments for the progressive tax –Redistribution of income –Ability to pay –Benefits received Question –Does the income tax system redistribute income?

Slide 5-38 The Most Important Federal Taxes The treatment of Capital Gains (Losses) –Positive (negative) difference between the purchase price and the selling price of an asset –Capital gains are not indexed for inflation

Slide 5-39 The Most Important Federal Taxes The corporate income tax –Accounts for 12% of federal tax revenue

Slide 5-40 Federal Corporate Income Tax Schedule $0–$50,00015% $50,001–75,00025% $75,001–10,000,00034% $10,000,001 and up35% Progressive Taxation: Income Tax Corporate Taxable IncomeCorporate Tax Rate Source: U.S. Department of Treasury

Slide 5-41 The Most Important Federal Taxes Double taxation –Corporation pays taxes on its profits –Corporation declares a dividend on after- tax profits –Dividend income is taxed –Retained earnings may increase the value of the stock

Slide 5-42 The Most Important Federal Taxes Who really pays the corporate income tax? –Tax Incidence (the distribution of tax burdens among various groups in society) Consumer Stockholder Employees

Slide 5-43 The Most Important Federal Taxes Social Security tax –Social Security rates today are imposed on earnings up to about $80,000 OASDIMedicare*Matched by Employer 6.20%2.90%6.20% *Medicare matched by employer

Slide 5-44 The Most Important Federal Taxes Unemployment tax –0.8% of first $7,000 of wages for employees earning more than $1,500 –Paid by employer –States levy an additional tax up to 3% based on record of the employer

Slide 5-45 Spending, Government Size, and Tax Receipts Government receipts –The federal government –State and local government

Slide 5-46 Total Government Outlays Over Time Figure 5-2 Source: Facts and Figures on Government Finance and Economic Indicators, various issues

Slide 5-47 Sources of Government Tax Receipts Figure 5-3 Source: U.S. Department of Commerce, Bureau of Economic Analysis

Slide 5-48 Federal Government Spending Compared to State and Local Spending Budget of the United States Government; Government Finances Figure 5.4

Slide 5-49 Collective Decision Making: The Theory of Public Choice Collective Decision Making –How voters, politicians, and other interested parties act and how these actions influence non-market transactions

Slide 5-50 Collective Decision Making: The Theory of Public Choice Theory of Public Choice –The study of collective decision making

Slide 5-51 Collective Decision Making: The Theory of Public Choice Similarities in market and public-sector decision making –Individuals motivated by self-interest –Scarcity and opportunity cost –Competition –Similarity of individuals and incentives Incentive Structure –The system of rewards and punishments individuals face with respect to their actions

Slide 5-52 Collective Decision Making: The Theory of Public Choice Differences between market and collective decision making –Government (political) goods at zero price Goods (and services) provided by the public sector –Use of force

Slide 5-53 Collective Decision Making: The Theory of Public Choice Differences between market and collective decision making –Voting versus spending Political system versus market system –Political System »Run by majority rule –Market System »Run by proportional rule

Slide 5-54 Collective Decision Making: The Theory of Public Choice Majority rule versus proportional rule –Majority rule Group decisions are made on the basis of 50.1 percent of the votes Whatever more than half of the electorate votes for, the entire electorate must accept –Proportional rule Actions are based on the proportion of the “votes” cast and are in proportion to them

Slide 5-55 Collective Decision Making: The Theory of Public Choice Differences between market and collective decision making –Voting versus spending Spending of dollars can indicate intensity of want Votes cannot; each vote counts with the same intensity

Slide 5-56 Issues and Applications: Computer Software as a Public Good Does a computer operating system fit the definition of a public good? –It is possible for more users to be added at no additional cost. –But an operating system does not satisfy the exclusion principle. It would be possible to prevent people from using the system if they had not paid for it.

Slide 5-57 Summary Discussion of Learning Objectives How market failures such as externalities might justify economic functions of government –Market failure is a situation in which an unhindered market allocates too many or too few resources to a specific economic activity. Private goods versus public goods and the free-ride problem –Private goods are subject to rival consumption –Public goods are not subject to rival consumption –Free-rider problem

Slide 5-58 Summary Discussion of Learning Objectives Political functions of government that lead to its involvement in the economy –Defining merit and demerit goods –Redistributing income Average versus marginal tax rates –Average tax rate: the ratio of total tax paid to total income paid in tax –Marginal tax rate: the change in tax payment induced by a change in income

Slide 5-59 Summary Discussion of Learning Objectives The U.S. income tax system –Progressive tax: marginal tax rate > average tax rate –Proportional tax: marginal tax rate = average tax rate –Regressive tax: marginal tax rate < average tax rate Central elements of the theory of public choice –The study of collective decision making

End of Chapter 5 The Public Sector and Public Choice