2.5. Public Goods And Taxes

PUBLIC GOODS AND TAXES

Objectives After studying this chapter, you will able to  Explain how government arises from market failure and redistribution  Distinguish between public goods and private goods, explain the free-rider problem, and explain how the quantity of public goods is determined  Explain why most of the government’s revenue comes from income taxes, why income taxes are progressive, and why some goods are taxed at a much higher rate than others

Government: The Solution or the Problem? Federal, state, and local governments employ almost 20 million people and spend $3 trillion. Do we need all this government? Is government too big? Does government help us to achieve an efficient use of resources?

The Economic Theory of Government The economic theory of government explains the purpose of governments, the economic choices that governments make, and the consequences of those choices. Governments exist for two main economic reasons: To establish property rights and set the rules for the redistribution of income and wealth. To provide a non-market mechanism for allocating scarce resources when the market economy results in inefficiency —a situation called a market failure.

The Economic Theory of Government Public choices deal with four economic problems:  Public goods  Taxes and redistribution  Monopoly  Externalities

The Economic Theory of Government Public Goods Public goods are goods that are consumed by everyone or by no one—such as national defense, law and order, and sewage and waste disposal services. The market economy under-produces these goods because it is impossible to exclude non-payers from enjoying them.

The Economic Theory of Government Taxes and redistribution Taxes pay for public goods and redistribute income. Altering the distribution of income requires taxing some people and redistributing the revenue to others. The market economy generates a distribution that a majority regards as unfair.

The Economic Theory of Government Monopoly Monopoly and rent seeking prevent the allocation of resources from being efficient and redistribute the consumer surplus to producers.

The Economic Theory of Government Externalities External costs and benefits are consequences of an economic transaction between two parties that are borne or enjoyed by a third party. A chemical factory that dumps waste into a river that kills the fish downstream imposes an external cost. A bank that builds a beautiful office building creates an external benefit. External costs and benefits prevent the market allocation of resources from being efficient.

The Economic Theory of Government Public Choice and the Political Marketplace Public choice theory applies the economic way of thinking to the choices that people and governments make in a political marketplace. The actors in the political marketplace are:  Voters  Politicians  Bureaucrats

The Economic Theory of Government Figure 16.1 illustrates the political market place. Voters are the “consumers” in the political marketplace. Politicians are the “entrepreneurs” of the political marketplace. Bureaucrats are the producers, or firms, of the political marketplace.

The Economic Theory of Government Voters express their preferences for publicly provided goods and services by allocating their votes, making campaign contributions, and lobbying government decision makers. They also pay the taxes that provide the funds that pay for public goods and services.

The Economic Theory of Government The objective of politicians is to get elected to office and remain in office. Votes to a politician are like profits to a firm, so they propose policies that they expect to attract enough votes to get elected. Bureaucrats produce the public goods and services.

The Economic Theory of Government Political Equilibrium A political equilibrium is the outcome of the choices of voters, politicians, and bureaucrats. It is a situation in which the choices of the three groups are compatible and no group can improve its own situation by making a different choice.

Public Goods and the Free Rider Problem Public Goods A public good is a good or service that can be consumed simultaneously by everyone and from which no one can be excluded—nonrival and nonexcludable. Nonrival: Consumption by one person does not decrease the consumption opportunities of another person. Nonexcludable: It is impossible or uneconomical to prevent someone from consuming the good once it is produced.

Public Goods and the Free Rider Problem A private good is rival and excludable and many goods combine elements of both a public and a private good. Figure 16.2 classifies goods according to these two criteria.

Public Goods and the Free Rider Problem The Free-Rider Problem A free rider is a person who consumes a good without paying for it. Public goods create a free-rider problem because the quantity of the good that a person is able to consume is not influenced by the amount that the person pays for the good, so no one has an incentive to pay and an unregulated market would produce too little of the good.

Public Goods and the Free Rider Problem The Benefit of a Public Good The value of a private good is the maximum amount that a person would pay for one more unit, which is shown by the person’s demand curve. The value of a public good is the maximum amount that all the people are willing to pay for one more unit of it. The total benefit of a public good to an individual is the dollar value that a person places on a given level of provision of the good.

Public Goods and the Free Rider Problem The marginal benefit of a public good to an individual is the increase in total benefit that results from a one-unit increase in the quantity provided. The marginal benefit of a public good diminishes with the level of the good provided. Everyone can consume each unit of a public good, which means the marginal benefit for the economy is the sum of marginal benefits of each person at each quantity.

Public Goods and the Free Rider Problem Figure 16.3 shows how the marginal benefits of a public good are summed at each quantity of the good provided. Part (a) shows Lisa’s marginal benefit. Part (b) shows Max’s marginal benefit.

Public Goods and the Free Rider Problem The economy’s marginal benefit of a public good is the sum over the individuals at each quantity of the good provided. The economy’s marginal benefit curve for a public good is the vertical sum of each individual’s marginal benefit curve.

Public Goods and the Free Rider Problem

It contrasts with the demand curve for a private good, which is the horizontal sum of the individual demand curves at each price.

Public Goods and the Free Rider Problem The Efficient Quantity of a Public Good The efficient quantity of a public good is the quantity that maximizes net benefit —total benefit minus total cost—which is the same as the quantity at which marginal benefit equals marginal cost. Figure 16.4 illustrates the efficient quantity.

Public Goods and the Free Rider Problem The total cost curve, TC, is like the total cost curve for a private good. The total benefit curve, TB, is just the sum of the marginal benefit at each output level. The efficient quantity is where net benefit is maximized.

Public Goods and the Free Rider Problem

Equivalently, the efficient quantity is produced where marginal benefit equals marginal cost.

Public Goods and the Free Rider Problem The marginal benefit curve, MB, is the one we’ve just derived. The marginal cost curve, MC, is just like the MC curve for a private good. The efficient quantity is where marginal benefit equals marginal cost.

Public Goods and the Free Rider Problem Private Provision If a private firm tried to produce and sell a public good, almost no one would buy it. The free-rider problem results in too little of the good being produced.

Public Goods and the Free Rider Problem Public Provision Because the government can tax all the consumers of the public good and force everyone to pay for its provision, public provision overcomes the free-rider problem. If two political parties compete, each is driven to propose the efficient quantity of a public good. A party that proposes either too much or too little can be beaten by one that proposes the efficient amount, because more people vote for an increase in net benefit.

Public Goods and the Free Rider Problem The attempt by politicians to appeal to a majority of voters leads them to the same policies, which is an example of the principle of minimum differentiation—the tendency for competitors to make themselves identical to appeal to the maximum number of clients (voters). (The same principle applies to competing firms such as McDonald’s and Burger King.)

Public Goods and the Free Rider Problem The Role of Bureaucrats Figure 16.5 shows the goal of the bureaucrat, which is to seek the highest attainable budget for providing a public good.

Public Goods and the Free Rider Problem Bureaucrats might provide the efficient quantity. But they try to increase their budget to equal the total benefit of the public good and drive the net benefit to zero. Bureaucrats might also try to overprovide a public good.

Public Goods and the Free Rider Problem Well-informed voters would ensure that the politicians prevented the bureaucrats from increasing their budget above the minimum total cost of producing the efficient quantity. But it is not rational for voters to be well-informed.

Public Goods and the Free Rider Problem Rational Ignorance Rational ignorance is the decision by a voter not to acquire information about a policy or public goods provision because the expected benefit to the voter from knowing the information is less than the cost of acquiring the information.

Public Goods and the Free Rider Problem For voters who consume but don’t produce a public good, it is rational to be ignorant about the costs and benefit. For voters who produce a public good, it is rational to be well-informed. So the political equilibrium is one that favors the producer and bureaucrat and is an inefficient overprovision of public goods.

Public Goods and the Free Rider Problem Two Types of Political Equilibrium The two types of political equilibrium—efficient provision and inefficient overprovision of public goods correspond to two theories of government: Public interest theory predicts that political equilibrium achieves efficiency because well-informed voters refuse to support inefficient policies. Public choice theory predicts that government delivers an inefficient allocation of resources—that government failure parallels market failure.

Public Goods and the Free Rider Problem Why Government Is Large and Grows Government grows because the demand for some public goods is income elastic. Government might be too large because of inefficient overprovision.

Public Goods and the Free Rider Problem Voters Strike Back If government grows too large relative to the value voters place on public goods, there might be a voter backlash that leads politicians to propose smaller government. Privatization is one way of coping with overgrown government and is based on distinguishing between public provision and public production of public goods.

Taxes Taxes generate the financial resources that provide public goods and they redistribute income. Some examples of taxes are:  Income taxes  Sales taxes  Property taxes  Excise taxes

Taxes Income Taxes Income taxes are taxes on personal income and corporate profits. These taxes generated $1,287 billion or 51 percent of total tax revenues in 2000.

Taxes Personal income tax The amount of tax a person pays depends on taxable income and the legislated tax rates. The marginal tax rate is the percentage of an additional dollar of income that is paid as tax. The average tax rate is the percentage of total income paid as tax.

Taxes The personal income tax is a progressive tax, which means that the marginal tax rate exceeds the average tax rate for all levels of income and the average tax rate increases with income. This arrangement contrasts with a proportional tax that has the same average tax rate at all levels of income, and a regressive tax which has a falling average tax rate as income increases.

Taxes Figure 16.7 shows the effects of the personal income tax in the labor market. The tax decreases the supply of labor, raises the pre-tax wage rate, lowers the after-tax wage rate, decreases employment, and creates a deadweight loss.

Taxes The inefficiency is greater the higher is the marginal tax rate, other things remaining the same. Here, the marginal tax rate is 15 percent.

Taxes The inefficiency is greater the higher is the marginal tax rate, other things remaining the same. Here, the marginal tax rate is 15 percent. Now, the marginal tax rate is 39.6 percent, and the deadweight loss is much larger.

Taxes The political equilibrium delivers a progressive income tax because this arrangement benefits the median voter and enables politicians who propose it to get elected. The median voter model benefits because her/his income is less than the average income. The progressive tax system favors the median voter at the expense of the average.

Taxes The corporate profits tax is a tax on economic profit and the income from capital. The tax decreases the quantity of capital and decreases labor productivity. Lower labor productivity decreases the demand for labor, lowers the equilibrium wage rate, and decreases the quantity of labor employed.

Taxes

Figure 16.8 shows the effects of social security taxes. If the social security tax is levied on the employee, it works like the personal income tax.

Taxes It decreases the supply of labor, raises the pre-tax wage rate, lowers the after-tax wage rate, decreases employment, and creates a deadweight loss.

Taxes

The burden of the tax is shared by the employee and the employer in proportions that depend on the elasticities of demand and supply.

Taxes If the social security tax is levied on the employer, it decreases the demand for labor, lowers the after-tax wage rate, raises the pre-tax wage rate, decreases employment, and creates a deadweight loss.

Taxes The burden of the tax is shared by the employee and the employer in proportions that depend on the elasticities of demand and supply in exactly the same way as when the tax is levied on the employee. Congress cannot determine who pays a tax.

Taxes Sales Taxes Sales taxes are taxes levied by state governments on a wide range of goods and services. Effects of the sales tax, which is to decrease the quantity of the taxed item and create a deadweight loss. A sales tax system taxes a person’s expenditure on goods and services, but not savings. Savings increase with income, which means that the average tax rate decreases with income and a sales tax system is regressive.

Taxes Property Taxes Property taxes are collected by state and local governments and used to provide local public goods— goods and services consumed by all the people who live in a particular area such as local parks, museums, and safe neighborhoods. High property taxes and a large quantity of local public goods and low property taxes and a small quantity of local public goods can both exist in political equilibrium.

Taxes Excise Taxes An excise tax is a tax on the sale of a specific good such as gasoline and automobile and truck tires. Figure 16.9 shows the effects of an excise tax on an item with an inelastic demand.

Taxes Figure 16.10 shows the effects of an excise tax on an item with an elastic demand. An excise tax creates a deadweight loss, which is larger the more elastic is the demand for the good being taxed (given the elasticity of supply).

Taxes In political equilibrium, the goods taxed are those with a low elasticity of demand.

PUBLIC GOODS AND TAXES

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