1 Chapter 22 The Public Sector Key Concepts Key Concepts Summary Practice Quiz Internet Exercises Internet Exercises ©2002 South-Western College Publishing

2 What is the purpose of this chapter? To examine public-sector decisions of politicians, government bureaucrats, voters, and special interest groups

3 What about the size of government? Since the 1950’s, government expenditures have grown from about one-quarter to over one third of GDP

Year 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% Total government expenditures Federal government expenditures 00 Government Expenditures State & Local Gov. Expenditures

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11 How do taxes in the U.S. compare to taxes in other countries? U.S. citizens are among the most lightly taxed people in the industrialized world

Year 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% Total government taxes Federal government taxes Growth in Taxes in the U.S., State & Local Gov. Taxes

13 What are two types of taxes? Benefits received Ability to pay

14 What is the benefits received principle? The concept that those who benefit from government expenditures should pay the taxes that finance their benefits

15 What is the ability to pay principle? The concept that those who have higher incomes can afford to pay a greater proportion of their income in taxes, regardless of the benefits

16 Which principle dominates in the U.S.? The ability-to-pay principle dominates the benefits- received principle

17 What is a progressive tax? A tax that charges a higher percentage of income as income rises

18 What is the average tax rate? Total tax due divided by total taxable income

19 What is the marginal tax rate? The change in taxes due divided by the change in taxable income

20 What is a regressive tax? A tax that charges a lower percentage of income as income rises

21 What is a proportional tax? A tax that charges the same percentage of income, regardless of the size of income

22 What is a flat rate tax? Same as a proportional tax

23 What is public choice theory? The analysis of the government decision- making process to allocate resources

24 Who is James Buchanan? The founder of public choice theory which applies economic analysis to politics

25 What is the benefit - cost analysis? The comparison of the additional rewards and costs of an economic alternative

26 What is the basic rule of benefit-cost analysis? A firm will produce additional units as long as marginal benefit exceeds the marginal cost

27 Why might government be inefficient in solving society’s problems? Majority rule problem Special interest effect Rationale ignorance Bureaucratic inefficiency Shortsightedness effect

28 What is the majority rule problem? Voting can lead to a rejection of projects with marginal total benefits exceeding the marginal cost

29 Can majority rule lead to inefficient solutions? Yes, “one person one vote” cannot measure the intensity of voters’ preferences as well as the market

30 What is the special- interest group effect? Special-interest groups can create government support for programs with costs out-weighing their benefits

31 Why can special- interest v oting be inefficient? A small group within the society can benefit while the whole society pays the costs

32 What is rational ignorance? The voters choose to remain uninformed because the marginal cost of obtaining information is higher than the marginal benefit from knowing it

33 What is bureaucratic inefficiency? The bureaucracy may become more powerful than elected officials

34 What is the shortsightedness effect? Democracy has a bias toward programs offering clear benefits and hidden costs

35 Key Concepts

36 Key Concepts What has happened to the size of government?What has happened to the size of government? How do taxes in the U.S. compare to other countries?How do taxes in the U.S. compare to other countries? What is the benefits received principle? What is the ability to pay principle? What is a progressive tax?

37 Key Concepts cont. What is the marginal tax rate? What is a regressive tax? What is a proportional tax? What is the majority rule problem? What is the special-interest group effect? What is rational ignorance? What is bureaucratic inefficiency? What is the shortsightedness effect?

38 Summary

39 Between 1970 and 2000, income security became the largest category of federal expenditures. During the same period, national defense declined from the largest spending category to the second largest.

40 Net interest on the federal debt has grown from 9 percent of the budget in 1970 to 12.5 percent in Therefore, income security and net interest payments combined accounted for 60.5 percent of federal outlays in 2000.

41 The government's share of total economic activity has generally increased since World War II ended in Most of the growth in combined government expenditures as a percentage of GDP reflects rapidly growing federal government transfer programs.

Year 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% Total government taxes Federal government taxes Growth in Taxes in the U.S., State & Local Gov. Taxes

43 State and local government tax revenues consist primarily of sales and property taxes. While states rely on income taxes for revenue, they also collect sales and excise taxes. In addition, state budgets depend greatly on charges and revenue-sharing grants from the federal government.

44 Local governments collect most of their tax revenue from property taxes, but the majority of their receipts are from charges and grants from the federal and state governments.

45 The largest outlays for state and local governments have been for education. Between 1970 and 1997, transfer payments for public welfare’s share of the budget rose.

46 The taxation burden, measured by taxes as a percentage of GDP, is lighter in the U.S. than many other advanced industrial countries. Since 1960, federal taxes have remained a fairly constant fraction of GDP. State and local taxes, however, have generally increased as a percentage of GDP since the 1950’s

47 The benefits-received principle and the ability-to-pay principle are the two basic philosophies of taxation fairness.

48 The gasoline tax is a classic example of the benefits-received principle because users of the highways pay the gasoline tax.

49 Progressive income taxes follow the ability-to-pay principle because there is a direct relationship between the average tax rate and income size.

50 Sales, excise, and flat-rate taxes are examples of a regressive tax because each results in a greater burden on the poor than the rich.

51 Public choice theory reveals the government decision making process. For example, government failure can occur for any of the following reasons:

52 (1) Majority voting may not follow benefit-cost analysis, (2) special interest groups can obtain large benefits and spread their costs over many taxpayers, (3) rational voter ignorance means a sizeable portion of the voters will decide not to make informed judgements, (4) bureaucratic behavior may not lead to cost effectiveness, an (5) politicians suffer from a short time horizon, leading to a bias toward hiding the costs of programs.

53 END