Gruber Ch1: Why study Public Finance?

Introduction

• Obama’s presidency (44th, Jan 20, 2009), a democratic one, was concerned with the economic crisis, worst that had been observed in the last 25 years. (Jan 20, 2009)
  • Unemployment rate: $2.8\%\to 7.6\%$
  • Dow Jones stock market index fell by $34.7\%$ in an year. $78.19\%$ from its peak
• Minority (Republican) Leader (Mitch McConnell)
• Majority (Democrat) Leader (Harry Reid)

Both of them conceded, but debated on the “how to” stimulate the economy with this stimulus package.

• Democratic
  • Expanded health benefits for low income families
  • Increased aid to state and local govt
  • Increased educational spending
  • Tax cuts for middle- and lower- class tax payers
• Republican (Rep. Eric Cantor of Virginia)
  • “…a spending beyond anyone’s imagination”
  • Lower the lowest two income tax brackets
  • Corporate tax rate cut ($35\%\to 25\%$)
  • Remove taxation from unemployment benefits

Democrats won obviously (majority and presidency).

Final bill: \ 787.2$ billion

Percentage	Area	Subarea	Amount
63.4%	New spending initiatives	Local School Districts	$26 billion
		Fiscal Relief	$54 billion
		Subsidize purchase of health insurance for unemployed workers	$24.7 billion
		Investments in Healthcare and tech	$19 billion
		New subsidies for low-income and unemployed workers	$40 billion
		National energy transmission, distribution and production systems	$30 billion
		Improve nations’ roads, bridges and waterways	$80 billion
Remainder	Tax reductions	New tax cuts	-
		Tax credits for low- and middle-income families.	-
Criticism: “We’re laying multitrillion dollars of debt on future generations of Americans. I can’t support such a thing.” - Sen. John McCain of Arizona, Republican

• Many questions arise, few of them are:
  • What kind of services should govt provide with that kind of money?
  • Why is government spending on health-care? And leave other things to the private sector?
  • How much should the government tax citizens?

These questions are addressed by the branch of economics called public finance.

1.1 The four questions of public finance

Why should the government intervene in the Economy?

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• A trade is called Efficient if it causes a benefit to at least one of the parties without being disadvantageous to any of the parties.

  • Microeconomics teaches us: competitive market equilibrium creates the maximum profits from efficient trades.
  • When supply equals demand, a trade is made only when the consumers see the value of the good is $\ge$ the cost of production of the good.

• If so, then why does the government need to intervene?

  • Market Failures
  • Redistribution

• Market Failures

  • Market for health insurance looks like a textbook competitive market (as per definition, people who value health insurance above its cost of production should should be able to buy insurance)
  • In 2017, 45 million people we uninsured in US (17.5% of the non-elderly population)
  • Is this equilibrium outcome most efficient? (since it may be just because these 45 million don’t value health insurance). The example of “Total social value that the insurance adds instead of just personal health value”
  • But while buying insurance, only the personal value is considered (overlooking the social value) so, the competitive outcome didn’t maximize the total social efficiency.
  • Negative Externality, one’s decision imposes on other’s cost that one doesn’t bear.
  • Thus, there is a potential for efficiency improvement by government intervention, since it will consider social benefits too.
  • Case study: The Measles Epidemic of 1989 to 1991

• Redistribution

  • Shifting resources from one group in the society to the other
  • A trade-off between the “size of pie” and “equitable distribution of the pie”.
  • If rich paid more taxes than the poor (& poor got tax-deductions and benefits)
    • The rich won’t work anymore, because they will be paying more of the extra earned money as tax
    • The poor won’t work because without doing anything they are getting benefits from the government. Then why should they?
    • This will finally lead to the reduction in social efficiency, as the goods that the consumers will value aren’t being produced due to them not working enough.
  • Equity-efficiency tradeoff

How might the government Intervene?

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• Tax or subsidize private sales or purchase
  • Taxes, raise price of private sales and purchase of goods that are overproduced.
  • Subsidies, lower price of private sales or purchases of goods that are underproduced.
• Restrict or mandate private sales or purchase
• Public provision
• Public financing of private provision

Effects of alternative interventions

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• Evaluation is the focus of Empirical Public Finance
• Policy-makers must keep in mind that any policy decision has
  • Direct Effects:
    • Effects predicted if individuals didn’t change their behavior in response to the interventions
    • The desired outcome of the policy
  • Indirect Effects:
    • If I am uninsured, I might choose to remain uninsured since the government is already providing for me for free
    • Also, if I am already insured, I might move out of my private insurance and get a public insurance for free
    • This would make the burden more on the government, and initially it had planned only a small number assuming that the people who are already insured wouldn’t change their behavior.
• The Congressional Budget Office: Government Scorekeepers (CBO)
  • They estimate costs for the spending proposals in government policy debates
  • Their say in the policy decision, have a very strong value, which might lead the policies to not get passed (Health Reform in 1994, failed to be implemented)
  • Go through morelater

Why do governments do what they do?

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• Aggregate the preferences of millions of citizens into a coherent set of policy decisions.
  • In short, people will think about themselves, not about public, naturally. So, no one will be bothered with saying that some roads need to be built in their locality. Thus, the people elect a government to do that for them. Whatever is promised to them by the government, if they like it and feel that the party is credible, they vote for them.
• The government is motivated by more than just correcting market failures and redistribution.
• There are also government-failures.query “Lead to inappropriate government interventions” such as?
  • Swachh Bharat Abhiyan: The government spent a lot on construction of toilets, but did it actually work? The government didn’t understand the ground-level reality. Delhi mein AC room mein baith ke policy banane se nahi hoga. Some people consider toilets in their homes inauspicious. Women socialize in these sessions.
• Different governments tackle the healthcare insurance problem in different ways

1.2 Why study public finance?

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What role does government play in our everyday lives?

Size and growth of the government

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• Figure 1-1, average federal government spending
  • 3% in 1930
  • 50% in 1940s World War II
  • 20% (stable and rising) in 1970s
• Figure 1-2
  • USA, Sweden, Greece and average for industrialized nations part of the Organization for Economic Cooperation and Development (OECD)
  • Each of the government spending pattern has changed in very different ways
    • USA rose by only 20%
    • OECD by 50%
    • Greece tripled, larger than USA
    • Sweden rose but later fell back, similar to Greece

Decentralization

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• The amount of expenses that should be taken up by the other levels of the government
  • State
  • County
  • Local
• In USA, its a 60-40 split (60% federal)
• How much is the ideal split?

Spending, Taxes, Deficits and Debts

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• Household runs on a budget. Excess income is cash-flow surplus. Shortfall of income below spending is called cash-flow deficit (has to be financed by past savings or borrowing). This borrowing builds up household debt that has to be paid back from future cash inflows.
• In case of a government,
  • Outflows: Public spending
  • Inflows: Tax revenue
  • Budget surplus
  • Budget deficit

$$\text{Revenue}-\text{Spending}=\text{Budget Surplus/Deficit}$$

• Debt in USA
  • Rose during the World War II, and had been stably paid off since the 1940 s, close to balance by 1960s.
  • Then started to rise again

Why are local and state governments able to balance their budgets while federal government is not able to?

• A simple reasoning seems to be that the federal government is also pitching in when the local government is in a tight spot. But there is no one to do that for the federal government.

Distribution of spending

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• Defense, a public good took up half of the federal government spending in the 1960s.
  • Buying a missile to protect Boston. Everyone including myself gets benefitted.
  • But if the cost is entirely born by me, I’d probably not buy it.
• Defense spending has fallen to 1/5th of the federal budget, today. They spend more of the chunk in
  • Social Security Programs (income support for retired elderly people) (20%)
  • Health Care Programs (health insurance to the elderly, poor and disabled) (25%)
• These Social Insurance Programs are designed to prevent failures in private insurance markets.

Distribution of Revenue Sources

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• Federal level
  • USA, Major source is individual income tax. (around 43-45%)
  • Rapid shrinking of corporate tax revenues (tax levied on income of businesses) 25% to 14%
  • Financed by payroll taxes (directly from workers) (17% to 37%)
  • Why? And what are its implications?
• State and local level
  • Sales tax: cigarettes and gasoline
  • Federal grants-in-aid: redistribution of funds from feds to lower levels of govt
  • Drop in Property taxes (40% to 20%)
  • Financed by grants-in-aid (doubled to 20%) and income tax (tripled to 15%).
  • Why? And what are its implications?

Regulatory role of the government

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• Reviewlater

1.3 Why study Public Finance now?

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Policy debates over the following topics, paraphrasing the liberal and conservative position on each of the topics.

• Social Security
• Health care
• Education

Social Security

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• Young lads finance the retirement benefits of old people. Works OK as long as the later is little in number
• 75 million baby boomers have now moved into old age.
  • Working tax-payers : Elderly recipients
    • 8:1 in 1950
    • 3:1 by 2050
• Liberals argue
  • Should shore Social Security system by raising resources through higher payroll taxes
  • Lowers efficiency of the economy and Not politically popular!
• Conservatives argue
  • Fundamental weakness of the system: transfer from young to old
  • Individuals should save for their own retirement
    • But already existing retired people owe money under the social security system, if individuals start to save for their own, who will finance these remaining obligations?

Health care

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• 45 million (18% of non-elderly population) is uninsured in USA.
• Problems
  • Cost of health care is increasing (premium prices of employer-sponsored health insurance plans grow 4 times faster than workers’ earnings)
  • Health care will consume half of the GDP
• Liberals argue
  • Intervention of government: mandate health insurance or heavily subsidize private health insurance or free public sector health insurance provision.
  • Rely on government regulations: limit prices of medial provisions
• Conservatives argue
  • Interventions are too expensive
  • Tax deductions for health insurance
  • Cost control through government price-setting will cause more damage, rather introduce competition

Education

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• US has not put enough resources into the educational system. Dissatisfied with the results when comparing US students’ performance to other countries.
• Liberals
  • Higher pay for teachers in disadvantageous areas
• Conservatives
  • Fundamental problem is that public schools dominate the primary and secondary educational system. They are local monopolies and have no incentive to improve their quality.
  • Inject competitive forces: give students a choice to go to public/private school, providing them resources to make the choice (vouchers for educational expense)

1.4 Conclusion

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Should the role of the government expand, contract or stay the same?

After thought

• COVID Vaccine (similar to Measles case study in USA)
• In India, Universal Immunization Scheme.
• HPV virus. Sikkim. Cervical cancer. 12 to 14 years.
  • Cancer screening awareness is lacking in our country