Chapter 5 The Public Sector and Public Choice. Slide 5-2 Introduction Should a computer operating...

Chapter 5

The Public Sector and Public Choice

2

Introduction

Should a computer operating system be considered a public good?

Economic theory offers some insight into the special characteristics of public

goods.

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

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

5

Chapter Outline

What a Price System Can and Cannot Do

Correcting for Externalities

The Other Economic Functions of Government

6

Chapter Outline

The Political Functions of Government

Paying for the Public Sector

The Most Important Federal Taxes

Spending, Government Size, and Tax Receipts

Collective Decision Making: The Theory of Public Choice

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?

8


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

9


Market failure prevents economic efficiency.

Market failure prevents individual freedom.

Public policy (government) is often called upon to address market failure.

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Market efficiency occurs when individuals know the true opportunity cost of their actions.

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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.

12


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

13


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

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Externalities are examples of market failures.

Pollution is an example of a negative externality.

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External Costs and Benefits

Figure 5-1, Panel (a)

S2

S1E1

EA

Q2 Q1

P1

P2

Pri

ce o

f S

tee l

per

To

n

Quantity of Steel per Year

Panel (a)

D

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External Costs and Benefits

Figure 5-1, Panel (b)

S

Q2Q1

P1

P2

Pri

ce o

f In

ocu

lati

on

Quantity of Inoculations per Year

D1

D2

Panel (b)

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Providing a legal system

– Enforcing contracts

– Defining and protecting property rights

– Establishing legal rules of behavior

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Property Rights

– The rights of an owner to use and to exchange property

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Promoting competition

– Market failure may occur if markets are not competitive.

– Monopoly power

– Antitrust legislation

20


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

21


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.

22


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

23


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?

24

The Political Functions of Government

Merit Goods

– Goods deemed socially desirable through the political process• Museums• Ballet• Concerts• Theater

– Provided through subsidization

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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.

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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.

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Marginal Tax Rate

– The tax rate on the last dollars earned

Average Tax Rate

– The proportion of total income paid in taxes

28


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

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Taxation systems

– Proportional Taxation (flat-rate tax)• Marginal tax rate = Average tax rate• Everyone pays the same percentage of their

income in taxes

30


Proportional Taxation

Proportional Tax Rate = 20%

Taxable Income x Tax Rate = Tax Liability

$10,000 20% $2,000

$100,000 20% $20,000

Marginal Tax Rate = 20%Average Tax Rate = 20%

31


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

32


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

33


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

34


Regressive Taxation: Social Security Hypothetical Example

Taxable Income Tax Rate* Tax Liability$5,000 10% $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 = $100,000Marginal Tax Rate = 0%Average Tax Rate = 5% or $5,000/$100,000

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The federal personal income tax

– Accounts for 46% of all federal revenue

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Federal Marginal Income Tax Rates

Table 5-1

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Arguments for the progressive tax– Redistribution of income

– Ability to pay

– Benefits received

Question– Does the income tax system redistribute

income?

38


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

39


The corporate income tax

– Accounts for 12% of federal tax revenue

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Federal Corporate Income Tax Schedule

$0–$50,000 15%$50,001–75,000 25%

$75,001–10,000,000 34%$10,000,001 and up 35%

Progressive Taxation: Income Tax

Corporate Taxable Income Corporate Tax Rate

Source: U.S. Department of Treasury

41


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

42


Who really pays the corporate income tax?

– Tax Incidence (the distribution of tax burdens among various groups in society)• Consumer• Stockholder• Employees

43


Social Security tax

– Social Security rates today are imposed on earnings up to about $80,000

OASDI Medicare* Matched by Employer

6.20% 2.90% 6.20%*Medicare matched by employer

44


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

45

Spending, Government Size, and Tax Receipts

Government receipts

– The federal government

– State and local government

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Total Government Outlays Over Time

Figure 5-2Source: Facts and Figures on Government Finance

and Economic Indicators, various issues

47

Sources of Government Tax Receipts

Figure 5-3

Source: U.S. Department of Commerce, Bureau of Economic Analysis

48

Federal Government Spending Compared to State and Local Spending

Budget of the United States Government; Government Finances

Figure 5.4

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Collective Decision Making

– How voters, politicians, and other interested parties act and how these actions influence non-market transactions

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Theory of Public Choice

– The study of collective decision making

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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

52


Differences between market and collective decision making

– Government (political) goods at zero price• Goods (and services) provided by the public

sector

– Use of force

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– Voting versus spending• Political system versus market system

– Political System» Run by majority rule

– Market System» Run by proportional rule

54


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

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– Voting versus spending• Spending of dollars can indicate intensity of

want• Votes cannot; each vote counts with the same

intensity

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.

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

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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

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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 5The Public Sector and Public Choice

Chapter 5 The Public Sector and Public Choice. Slide 5-2 Introduction Should a computer operating...

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