Public Goods, Taxes, and Public Choice

Overview of Government In most modern societies, governments are involved in the following activities: • Providing public goods and services such as streets, education, parks, public safety, national defense, and space exploration • Redistributing income to the poor • Collecting taxes to support spending programs • Trade policy to control international trade, to promote or to restrict some types of trade © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin

Rationale for the Existence of Government • Certain goods and services would not exist unless we make a collective effort to produce them. • The government can help make collective decisions about paying for goods that generate spillover benefits. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin

Local Governments • There are more than 80,000 local governments in the United States. • Local governments spend most of their money on: • Education (kindergarten through high school) • Public welfare and health (payments to poor households and support for public hospitals) • Highways • Police protection • Local governments provide goods and services such as water, fire protection, and libraries. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin

State Governments • At the state level, the biggest spending programs are: • Education (including colleges and universities) • Public welfare • Highways • Health and hospitals • Corrections (state courts and prisons) © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin

Federal Governments • At the federal level, the biggest spending programs are: • Income security • National defense © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin

Spillover Benefits • A market with spillover benefits is inefficient, so there is an opportunity for government to promote efficiency. Spillover PRINCIPLE For some goods, the costs or benefits associated with the good are not confined to the person or organization that decides how much of the good to produce or consume. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin

Spillover Benefits In this example, if each person considers only the personal benefit relative to the cost of the dam, no dam will be built. Since everyone will support a tax per person that is less than the benefit per person, the government can use its taxing power to provide a good that would otherwise not be provided. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin

Public Goods • A public good is a good available for everyone to consume, regardless of who pays and who doesn’t. • A private good is consumed by a single person or household. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin

Public Goods • Public goods are nonrival in consumption (available for everyone to consume) and nonexcludable (it is impractical to exclude people who don’t pay). • Private goods are rival in consumption (only one person can consume the good), and excludable (it is possible to exclude a person who does not pay for the good). © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin

National defense Law enforcement Space exploration Preservation of endangered species Protecting the earth’s ozone layer Income transfers to the poor Public Goods Examples of public goods: © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin

Private Goods With Spillover Benefits • A good such as education generates workplace and civic spillovers benefits, thus, the government should adopt policies to encourage people to become educated. • Local governments provide free primary and secondary education. States subsidize higher education, and the federal government provides financial aid to students in private and public schools. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin

Voluntary Contributions and the Free-rider Problem • The problem with using voluntary contributions to support public goods is the free-rider problem. • Each person will try to get the benefits of a public good without paying for it. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin

Overcoming the Free-rider Problem Techniques to encourage people to contribute: • Give contributors something in return • Arrange matching contributions • Appeal to people’s sense of civic or moral responsibility © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin

Financing Government: Taxes The major sources of revenue: • For local governments is the property tax. • For state governments are sales taxes and individual income taxes. • For the federal government are individual income taxes and “social insurance and retirement receipts.” © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin

The Effects of a Tax • In a competitive market, equilibrium price ($200) is just enough to cover the cost of providing an apartment. • A tax of $80 imposed on housing firms increases the average cost of providing 900 apartments by $80, to $280. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin

The Effects of a Tax • At each price, fewer apartments will be supplied. The tax shifts the supply curve to the left. The tax increases equilibrium price and decreases the output of the industry. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin

The Effects of a Tax • Housing firms now offer 750 apartments at $230 per unit. After they pay the $80 tax, only $150 remains to pay input suppliers. Firms collect more money from consumers and pay less money to input suppliers, so consumers and input suppliers indirectly pay the tax. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin

The Effects of a Tax • The $80 tax per apartment is split between consumers and input suppliers. After the tax, consumers pay $30 more and input suppliers receive $50 less per apartment. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin

The Effects of a Tax • Revenue for the government from the 750 apartments equals $750 x $80, or $60,000. Consumers pay $22,500 and producers $37,500. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin

Deadweight Loss From Taxation • Both consumer surplus and producer surplus are less after the tax. Some of the losses are transferred to the government. But the triangles C and E are net losses not transferred to anyone. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin

Tax Shifting: Forward and Backward • A forward-shifted tax is a tax imposed on producers but passed on to consumers. The amount of a tax shifted forward depends on the price elasticity of demand for the taxed good. • A backward-shifted tax is a tax borne by firms and input suppliers. The amount of backward shifting to input suppliers depends on their responsiveness to changes in input prices. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin

When demand is relatively inelastic, the tax burden is forward-shifted. When demand is relatively elastic, the tax burden is backward-shifted. Tax Shifting: Forward and Backward © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin

Public Choice • Public choice economics is a field of study that explores contrasting views about how governments operate. Four contrasting views of government: • Governments take actions to promote efficiency • Voters tell governments what to do • Government officials pursue their own self- interest • Special-interest groups manipulate the government © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin

Governments Take Actions to Promote Efficiency • The public-interest view of government is based on the idea that governments make the economy more efficient. • As we have seen, governments can use their power to collect taxes to provide public goods that would otherwise not exist. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin

Voters Tell Governments What to Do • Voters affect government decisions. • In a democracy, the government takes actions that are approved by the majority of citizens. • If governments respond to voters, the voting public ultimately makes all the important decisions. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin

The Median-voter Rule • The median-voter rule says that the choices made by government will reflect the preferences of the median voter. • When two candidates offer divergently opposed views, powerful forces pull them toward the preferences of the median voter. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin

People “Vote With Their Feet” • According to economist Charles M. Tiebout, people “vote with their feet.” • The choice of which community to live in is based in part on the taxing and spending policies of different communities. Households express their preferences by moving to communities that offer the best package of services and taxes. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin

Government Officials Pursue Their Own Self-Interest • The Nobel Laureate James Buchanan, among others, has suggested a model of government that focuses on the selfish behavior of government officials. • The self-interest theory of government suggests that voters don’t have much information about the costs and benefits of public services, and may not be able to evaluate the actions of politicians. • Limitations on taxes and spending are necessary safeguards against politicians and bureaucrats who benefit from large budgets. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin

Special-interest Groups Manipulate the Government • This model of government is based on the idea that small groups of people manipulate government for their own gain. • When a few people share the benefit from a project and a large number of people share the cost, government is more likely to approve inefficient projects. • Special-interest groups form whenever the benefits are concentrated on a few citizens but costs are spread out over many citizens. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin

Public Goods, Taxes, and Public Choice