The Importance of Government

Economic Functions Provide a legal system that makes transactions fast and easy Promote and maintain competition in the market Ensure economywide stability Redistribute resources

Provide public goods Characteristics of public goods –indivisible –additional users do not add to cost –not mutually exclusive in use –hard to collect based on use Free rider problem

Merit and Demerit Goods Government is to promote the production and consumption of merit goods –goods thought to benefit to society Government is to discourage the production and distribution of demerit goods –goods thought to harm society

Correct for Externalities Negative Externality –A transaction negatively impacts a third person Market Failure –equilibrium quantity is too high and equilibrium price is too low

Correcting Negative Externalities Shift supply curve to the left –tax –number of firms in the industry Shift demand curve to the left –population –income –tastes and preferences Demand Supply

Correct Externalities Positive Externality –a transaction benefits a third party Market Failure –Equilibrium quantity is too low and equilibrium price is too high

Correcting Positive Externalities Shift supply curve to right –subsidies –number of firms in the industry Shift demand curve to right –population –tastes and preferences –income Demand Supply

Government Failure Government spends more correcting externality than the amount of the damage caused by the externality

Income Redistribution

Why is Government so Large? Government Spending as a percentage of GDP – % – % – % – % Increased military spending Population growth Rising expectations Inflation

Changing Attitudes In the beginning - “best that governs least” 1930s - Public demanded government action and help 1960s - Johnson’s “War on Poverty” 1990s - Government seen as too large, inefficient, and corrupt. Many want the states and local governments to take over

The Federal Budget –The Office of Management and budget prepares budget 15 months ahead of implementation –President presents as recommendation to Congress in January before implementation –Congress makes any changes they feel necessary by passing appropriation and revenue bills; submit to president for signature –May change because: unexpected may occur and tax revenues may fall due to recession

Federal Revenues

Federal Expenditures

State and Local Revenues

State and Local Spending

Financing Government Three sources of government funds –taxation –borrowing –printing money

Why Taxes? Pay the cost of government Redistribute income and wealth Promote certain industries Influence consumer and business spending patterns Discourage certain behavior

Principles of Taxation Horizontal Equity –Equal income is taxed equally no matter how it is earned Vertical Equity –Unequal income is taxed unequally Ability to pay - those with higher incomes should pay more in taxes Benefits received - those who receive the greatest amount of benefit should pay more in taxes

Taxation Systems

Taxes in the United States

Federal Personal Income Tax Rates

Tax Incidence Inelastic Demand –Tax can be shifted to the consumer S 2 - After tax supply curve Q tax - A-amount received by producer A-B - tax paid by producer B-C -tax paid by consumer A-C -total amount of tax 0 Price Quantity D1D1 S1S1 PePe Q e S2S2 P tax Q tax A B C

Tax Incidence Inelastic Demand –Tax may be shifted back to suppliers –A- amount that goes to producers –A-B - amount of tax absorbed by producers –B-C - higher price paid by consumer –A-C- amount of tax 0 Price Quantity D1D1 S1S1 PePe Q e S2S2 P tax Q tax A B C