Economic Roles of Government

7/29/2019 Economic Roles of Government

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ECONOMIC ROLES OF

GOVERNMENT IN A

MARKET ECONOMY


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Under Ideal Market Conditions

Almost no role as long as societyonly cares about efficiency

Define and enforce privateproperty rights

Outcome will be efficient

That state of the world in which all

opportunities to make someone better off

without making anyone worse off are

exhausted


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Efficiency means not wasting

resources

all resources allocated so that no more of

one type of good can be produced

without having to produce less of another

type of good.

This concept of production efficiency can

be illustrated with a Production

Possibilities Curve


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Consumption Goods

CapitalGoods

0

Efficient

Inefficient

Production Possibilities Curve


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More generally, we can illustrate

efficiency with Supply/Demand efficiency means maximizing societysnet benefits from producing/consuming

supply curve reflects societys marginalcost of producing a good (MSC)

demand curve reflects societys marginal

benefit of consuming a good (MSB) societys net benefits are maximized

where MSC=MSB


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S = MSC

D = MSB

Qe

0

$

ApplesQ1 Q2

At Q1 MSB>MSC

so society can gainthis much extra net

benefit

At Q2 MSB


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In the Real World

Conditions are not ideal

market failures externalities

public goods

monopolies

business cycle recessions

economic booms


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Society cares about more than

efficiencycares about economic fairness

whatever that is!

wants to impose certain paternalistic

requirements on consumption merit/demerit goods


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The Roles of Government

Allocation

correcting market failures

merit/demerit goods

Redistributionredistributive tax structure

redistribution in cash and in kind

Stabilization

fiscal policy

monetary policy


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Allocation

Correcting market failure

externalitiespublic goods

monopolies

merit and demerit goods


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Externalities

Negative externality

costs not accounted for by economic

decision maker Positive externality

benefits not accounted for by economic

decision maker

Externalities (both + and -) in

production and consumption


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Causes divergence between market

supply and MSC or market demandand MSB

Thus, market equilibrium not

efficient

that is, the market fails to achieve an

efficient statesociety stands to gain from government

correction of the market failure


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Happens because of failure to

define a property right Air pollution

lack of private property right to the

atmosphere

factory uses the atmosphere as an input

for which it does not pay

society incurs a cost not accounted for by

the factory

too much of good produced


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D=MSB

S

MSC$

Q0

External cost

QmarketQeff

A

B

CABC = welfare loss triangle

= net social gain from

reducing output to Qeff

overproduction

Negative Externality From Pollution


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Education

students receive private benefits fromeducation

others receive benefit of associating with

educated personstudent cannot capture this public benefit

i.e., lacks property right needed to charge for this

service to others

causes too little education to be

consumed


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Q0

$

D

MSB

S=MSC

Qmarket

Qeff

A

B

C

= welfare loss triangle

= net social gain fromincreasing output to Qeff

ABC

Positive Externality From Education


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Externality Policies

PollutionPigouvian taxes

tax factory

shifts S up to MSC how to measure value of pollution/amount of tax

not common

gas tax

tax the product

works in short run but no incentive to find less

polluting technology

tax the pollutant

better long run incentives


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command and control

require pollution reducing capital, clean

fuels, etc. e.g., stack scrubbers

lacks long run incentive to find better technology same rules for all firms regardless of costs

easier to administer and politically more acceptable

past reluctance to adopt market-based solutions like taxes


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pollution rights

1990 Clean Air Act radical market-based departure from traditionalreliance on standards

power generating firms issued rights to pollute

these rights were for a level of pollution much lower thanthen-current levels

these rights are auctioned on the Chicago Board of

Trade

firms able to reduce pollution at lower cost than the price

of a pollution right will sell

firms for which the cost of pollution reduction is higher

will buy


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more pollution reduction by

allowing firms that can reduce at

lowest cost to reduce the most

incentive to find new ways to

produce power with less pollution anyone can buy, including

environmental groups

want to rid the Earth of a ton of S02each year? Itll cost you about

$200!


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Public Goods

an apple is a PRIVATE good

national defense is a PUBLIC good

What distinguishes private goods

from public goods?private goods are EXCLUDABLE

public goods are NONEXCLUDABLE an apple is a private good because a consumer who

does not pay the price can be excluded from

consuming it

no one can be excluded from consuming public

goods -- can anyone not be protected?


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private goods are RIVAL in consumption

public goods are NONRIVAL in

consumption if I eat an apple, you cannot

when I consume national defense, its still there for

you to consume

therefore, it costs nothing to provide to additionalconsumers

therefore, the efficient price is zero

since no one can be excluded from

consuming a public good, and since theefficient price is zero, the private sector

would ordinarily not be able to provide it


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WARNING! A good is public or

private because of thesecharacteristics, not because the

government provides it or doesnt

governments provide all sorts of things,including private goods

e.g., electricity, steel

private sector sometimes finds ways toprovide public goods

e.g., TV broadcasting


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Government provides public goods

at zero price Funding out of general budget

we pay taxes based on income,

consumption, etc., not on the amount ofpublic goods we consume

for example, a household earning $100,000 pays

more tax than a household earning $10,000 but bothconsume the same national defense

Quantity determined through

political process


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Mixed Goods

Mixed goods have characteristicsof both private and public goods

sometimes characteristics depend on

circumstances highways are nonrival as long as few drivers are on

them but become rival with congestion

sometimes a nonexcludable goodbecomes excludable when technology

changes

city streets


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Monopoly

Perfectly competitive firms

produce efficient output

efficient output where P=MC

Monopolies restrict output and

drive up pricemonopoly output not efficient because

P>MC

society suffers a welfare loss

l


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$

Q0

D

MC

MR

QM Qeff

Monopoly

PM

Peff

PM = monopoly price

Peff= efficient price

QM = monopoly quantity

Qeff = efficient price

Monopoly

welfare loss


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Two Types of Monopoly

Artificialrequires some kind of barrier to entry

legislated barrier, sole access to input, etc.

Microsoft??? What is Microsofts barrier to entry?

Natural

very high fixed costs must be spread overwhole market

breaking up makes no sense as it would raise

average fixed costs that would be passed on to

consumers


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Monopoly Policy

Artificialbreak up

prohibit collusion U.S. anti-trust law

Naturaltwo possibilities

regulate to force firm to act as if it were a perfectly

competitive firm the usual response to natural monopoly in U.S.

state provision the usual response everywhere else


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Merit and Demerit Goods

Goods provision of which societywants to encourage (in the case ofmerit goods) or discourage

merit education

housing

health care

demerit tobacco

alcohol


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Various subsidies and taxes used toencourage or discourageconsumption

housing allowancessin taxes on tobacco and alcohol

Direct provision

Medicaid


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Redistribution

Society cares about equity orfairness as well as efficiency

Thus a role of government is to

create a more fair distribution than

the market produces

distribution of incomedistribution of opportunity

education

health


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What is Fair?

We know what an efficientallocation is

We have no idea what a fairdistribution isequal income for all?

Redistribution creates inefficiencydistorts returns to productivity

drives wedge between cost and value


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Mechanisms to Redistribute

Via the tax structure

progressive taxation

negative income tax

Transfers

cashin-kind


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Progressive Taxation

A progressive tax makes the after-

tax (disposable) income more

equal

Burden of tax rises as income rises

as income rises, proportion of incomepaid as tax rises

in U.S., Federal Personal Income Tax


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A proportional tax has no

redistributive effect

as income rises, proportion paid as tax

stays the same in U.S., property taxes more or less proportional

A regressive tax makes after-tax

income less equal

as income rises, proportion paid as taxfalls

in U.S., Social Security tax, sales taxes


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In U.S., overall tax structure is

proportionalprogressivity of the Personal Income Tax

is offset by regressivity of sales and

Social Security taxation

Redistributive Effect of U.S. Tax

Structure

Negative Income Tax


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Negative Income Tax

Proposed from time to time

a variant of NIT is used in U.S.

Cash assistance through income tax

Structure of a negative income taxdefine income guarantee (IG)

define rate at which transfer phased out (t)

if transfer is T,earned income is IE, anddisposable income is ID,

T = IG - t IE

ID = IE + T


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For example, suppose

IG = $10,000

t = 0.5

then

Illustration of NIT


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IE

T ID

$0 $10,000 $10,000

$1,000 $9,500 $10,500

$2,000 $9,000 $11,000

$5,000 $7,500 $12,500

$10,000 $5,000 $15,000

$15,000 $2,500 $17,500

$20,000 $0 $20,000

Illustration of NIT


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Note that the higher IG or the lower t,the higher the income getting transfers

we can calculate break-even income, theincome at which T reaches $0:

IB = IG/t

for our example:

IB = $10,000/0.5 = $20,000


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Transfers

Taxes

45o

IB

IG

0

DisposableIncome

Earned Income (IE)

Negative Income Tax


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NIT Advantages/Disadvantages

Advantages

simple and straightforward would be administered through income tax

could replace myriad of cash and in-kind

programs

Disadvantages

either t has to be high or IG low or NIT

gets to be very expensive


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Earned Income Tax Credit

Like an NIT but only for workers

takes the form of a tax credit on Personal

Income Tax that increases tax refund

Credits depend on income,

children, and other factorsaffecting living expenses

M j f f i f


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Major form of income support for

the poor in U.S.

As of 1996, maximum credit was40% of first $8,900

max credit therefore $3,560 Max credit earned until $11,650

and then phased out at rate of

21.06%

Dollar amounts indexed to

inflation after 1996


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45o

0

ID

IE

Earned Income Tax Credit

$8,900 $11,650 $28,450

$12,460

$15,219

$28,450

Transfers

Taxes

Transfers to the Poor (Welfare)


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Transfers to the Poor (Welfare)

Two major forms of cash transfersto the poor funded by Federal

government

Temporary Assistance to Needy Families(TANF)

Supplemental Security Income (SSI)

States also have general assistanceprograms for singles or childless

couples


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Several in-kind transfers

Medicaidfood stamps

housing assistance

other employment and training

social services

child care, rehabilitation, legal aid, etc.

energy assistance


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Temporary Assistance to Needy

Families (TANF) State administered

Federal government makes blockgrants to states to fund TANF

block grant set amount that increases

each year for inflation only if a state spends less it can keep difference

if it spends more, it has to fund difference

incentive for states to get poor off welfare

K l t f TANF


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Key elements of TANF

recipients must eventually work, be

seeking work, or be in training or school recipient who has children over the age of five and

who declines an offer of work arranged by

caseworker loses benefits

recipients lose benefits after two years without work only those with children under one year of age exempt

states receive grants to support child care so parents

can work

maximum lifetime benefit of five years

states may waive above requirements for

disabled and others unable to work

no more than 20% of caseload


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teen mothers on TANF required to

live at home with responsible adultand attend school

unmarried mothers who do not help

establish paternity lose 25% ofbenefits

funds available to help enforce child-support

laws states that reduce out-of-wedlock births the

most receive bonus from Federal

government

Each state responsible for


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Each state responsible forestablishing its own rules within

Federal requirementsFlorida cuts payments for additionalchildren born to those on TANF

Massachusetts limits support for twoyears in any five-year period

Wisconsin exempts virtually no one fromwork requirement

Mississippi has very low benefits andurges churches and charities to playgreater role


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TANF Is New

Result of major welfare reform

enacted in 1996

For article from Economist

magazine on consequences of the

reform, go to:http://www.economist.com/world/na/displayStory.

cfm?Story_ID=751378
http://www.economist.com/world/na/displayStory.cfm?Story_ID=751378http://www.economist.com/world/na/displayStory.cfm?Story_ID=751378http://www.economist.com/world/na/displayStory.cfm?Story_ID=751378http://www.economist.com/world/na/displayStory.cfm?Story_ID=751378


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Supplemental Security Income

Federally administered

Provides assistance to the poorwho are aged, blind, or disabled

States can supplement SSI


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Medicaid

Health care for the poor under 65

Jointly funded by Federal

governments and states Eligibility determined by states

generally eligible if on TANF or SSI

Medical services billed directly to

state

states determine reimbursement rates


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Most expensive of all programs of

assistance to the poor

6.35% of all Federal spending in 1997 $105 billion

projected to rise to $243 billion by 2006

24 million recipients


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Food Stamps

Federally funded and stateadministered

Recipients receive coupons thatcan be redeemed for food andrelated items

Varies with income and householdsize


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Housing Assistance

Subsidized housing for the poor

Public housing at low rents thatvary by income

Subsidies for private housing

Federal Expenditures 1997


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Federal Expenditures, 1997

% Total

Federal

Program Amount Spending

SSI $27B 1.63

TANF 20 1.21EITC 20 1.21

% T t l


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% Total

Federal

Program Amount Spending

Medicaid $105B 6.35

Food stamps 26 1.57

Social services 7 0.42Child nutrition 9 0.54

Cash versus In Kind Transfers


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Cash versus In-Kind Transfers

More than twice as much spendingin-kind than cash

although most of in-kind is Medicaid

Why not just give cash to spend as

they like?

equivalent cash would make them betteroff than in-kind from THEIR perspective

but donors are better off dictating

consumption to the poor

Mi i W


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Minimum Wage

Federal legislation requiring firmsto pay workers no less than a

minimum wage

currently $5.15 per hour

Purpose to assure workers receive

a living wage Makes low-skilled workers less

employable

Effects of Minimum Wage


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WE

WMin

0Labor

Wage

LELMin LS

DL

SLIncreased unemployment

II

Effects of Minimum Wage

I III

I: Better off - working

at higher wage

II: Worse off -

unemployedIII: Want to work at

higher wage but

cannot find work

Di t ib ti f I i U S


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Distribution of Income in U.S.

11.8% lived in poverty in 1999poverty defined as income equal to three

times that needed to buy an adequate diet

arbitrary definition but gives us a benchmark tomake annual comparisons

Percent poor fell steeply from 1960(22.2%) to 1973 (11.2%), rose tonew high in 1983 (15.2%) and fellto 13.8% in 1995, 12.7% in 1998,and 11.8% in 1999


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Ratio of rich to poor has risensteadily, however

In 1947 ratio of richest fifth to

poorest fifth of households was 8.6

In 1997 ratio was 13.7

P t Sh M I


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Percent Share Money Income

Lowest HighestYear Fifth Fifth Ratio

1947 5.0 43.0 8.6

1967 4.0 43.8 11.0

1977 4.3 43.7 10.2

1987 3.8 46.7 12.31997 3.6 49.4 13.7

1999 3.6 49.4 13.7


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Lorenz Curves

Graphical representation of

distribution of income

Table shows distribution byquintiles for 1968 and 1992

We can plot these data to construct


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We can plot these data to construct

a Lorenz Curve


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The diagonal represents perfect

equality

The more unequal, the more bowed

out from the diagonal Good way to visualize, but not

good when quantification needed

Gi i C ffi i


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Gini Coefficient

Households ranked by income

Percentincome

0%

100%

100%

A

B

Gini Coefficient =

Area A

(Area A+Area B)

Lorenz Curve


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Gini coefficient takes value of

zero with perfect equality and 1with perfect inequality

Gini coefficient makes it easy toplot distribution of income overtime, as in the following graph


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Increasing equality until late

60s followed by increasinginequality

Table and graphs on Lorenz

curve and Gini coefficient fromhttp://www.panix.com/~dhenwood/Gini_supplement.html

Social Security
http://www.panix.com/~dhenwood/Gini_supplement.htmlhttp://www.panix.com/~dhenwood/Gini_supplement.htmlhttp://www.panix.com/~dhenwood/Gini_supplement.htmlhttp://www.panix.com/~dhenwood/Gini_supplement.html


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Social Security Several programs all funded through

payroll taxesgovernment-provided pension

what most think of by the term Social Security

disability payments

health care for the elderlyunemployment compensation

The most expensive of all government

programs in U.S.surpassed national defense in 1993

S i l S i b Si


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Social Security Web Sites

The official SSA site:http://www.ssa.gov/

The Heritage Foundation:

http://www.heritage.org/library/keyissues/socialsecurity/

Brookings:http://www.brookings.org/es/research/areas/soc

ial/socsec.htm

NBER:http://www.nber.org/socialsecurity/

Social Security Retirement
http://www.ssa.gov/http://www.heritage.org/library/keyissues/socialsecurity/http://www.heritage.org/library/keyissues/socialsecurity/http://www.brookings.org/es/research/areas/social/socsec.htmhttp://www.brookings.org/es/research/areas/social/socsec.htmhttp://www.nber.org/socialsecurity/http://www.nber.org/socialsecurity/http://www.brookings.org/es/research/areas/social/socsec.htmhttp://www.brookings.org/es/research/areas/social/socsec.htmhttp://www.heritage.org/library/keyissues/socialsecurity/http://www.heritage.org/library/keyissues/socialsecurity/http://www.ssa.gov/


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y

Pensions funded by payroll taxes

of 7.65% paid by both employeesand employers on first $72,600 of

wages (in 1999)

self-employed pay 15.3%

maximum wage base indexed to inflation

Basic pension available atretirement at age 65

retirement at 62 with reduced pension

available


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Essentially a pay-as-you-go

systemprivate retirement systems are fully

funded

contributions build a fund from which

earnings pay benefits


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Social Security not fully funded

benefits paid from taxes collectedessentially a transfer from workers to retirees

because of baby-boom tax revenues exceed

pension payments so a fund is building up

currently will reach its max sometime during the next

twenty years as baby-boomers retire

fund will then shrink until it is gone unless

tax rates go up, retirement age is increased,or some other adjustment is made

P i t f ti f t


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Pension amount a function of past

earnings, age, marital status,

number of dependents, etc.

must have paid Social Security taxes for

at least forty quarters to qualify

Pensions also paid to dependent

spouses over 65 at one-half the

workers pensionwidows/widowers get what the spouse

would have gotten

St di t ib ti l l t


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Strong redistributional element

gross replacement rate (ratio of benefits

to pre-retirement wages) falls as pre-retirement income rises

worker earning 45% of average wage earnings

would have a GRR of almost 60% average wage earner a little over 40%

worker earning at the maximum wage tax base

around 25%

Social Security pensions are tax-free average wage earners 40% GRR is more like 50%

on an after-tax basis


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Incentive effects

obvious disincentive to work past 65 many opt to retire at 62 when Social Security

becomes available at a reduced rate

savings and capital formation reduces need to save for retirement

disincentive to work past 65 increases need to save

for retirement

net effect may be a wash

Health Insurance For The Elderly


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Health Insurance For The Elderly

Two parts

Part A is hospitalization insurance

for the elderlyFinanced by 2.9% tax on all wages paid

by both employers and employees

covers only medically necessary care inhospitals and is subject to a deductible

Part B is voluntary medical


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Part B is voluntary medical

insurance available at highly

subsidized ratespremiums cover only about a fourth of

costs

subject to deductible of 20% and

maximum payments for each medical

procedure

Medicare spending amounts to

over 11% of total federal spending

or 2 4% of GDP

Unemployment Compensation


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Unemployment Compensation

Income support for workers

temporarily out of work

temporarily laid offlost job through fault not of their own

does not cover loss of job through misconduct

does not cover work loss due to labor disputes

worker must be full-time and have

worked a minimum time to qualify for

benefits

Funded by Federal tax on payrolls


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y p y

first $7,000 of wages

tax levied on employer only tax rate varies by each firms

employment record

firms that lay off workers frequently pay highertaxes

Each state levies own tax to

supplement Federal fundbase and rates vary by state

base always equal to or greater than

Federal base

Benefits vary widely by state


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high of about two-thirds of lost wages

plus dependent allowance

average only about 35% has been declining in recent years

Benefits normally last only for amaximum of 26 weeks

Benefits extended 13 weeks in

recessions

Congress may extend even further

Average worker uses only 8 weeks


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Incentive effects

availability of unemploymentcompensation makes the period of

unemployment easier to take

both negative and positive effects reduces incentive to look for a job

increases unemployment rate

one study estimates that a ten percentage point

increase in replacement rate increases unemployment

by 1.5 weeks

allows worker to extend job search

potentially more fruitful job search

Documents

Economic Roles of Government