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Chapter 5

The Public Sector and Public Choice

Slide 5-2

Introduction

Should a computer operating system be considered a public good?

Economic theory offers some insight into the special characteristics of public

goods.

Slide 5-3

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

Slide 5-4

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

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Chapter Outline

� What a Price System Can and Cannot Do

� Correcting for Externalities

� The Other Economic Functions of Government

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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

Slide 5-7

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?

Slide 5-8

What a Price System Can and Cannot Do

� 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

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Slide 5-9

What a Price System Can and Cannot Do

� 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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Correcting for Externalities

� 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.

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� 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

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Slide 5-13


� 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.

Slide 5-15

External Costs and Benefits

Figure 5-1, Panel (a)

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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

Pric

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Inoc

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Quantity of Inoculations per Year

D1

D2

Panel (b)

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The Other Economic Functions of Government

� 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

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� 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

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� 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.

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� 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

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� 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?

Slide 5-24

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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Slide 5-25

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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Paying for the Public Sector

� Marginal Tax Rate– The tax rate on the last dollars earned

� Average Tax Rate– The proportion of total income paid in

taxes

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� 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

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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%

Slide 5-31


� 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

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Progressive Taxation: Income Tax

Taxable Income Tax Rate Tax Liability0–$10,000 5% $500

$10,001–20,000 10% $1,000$20,001–30,000 30% $3,000

$4,500

Income = $30,000Marginal Tax Rate = 30%Average Tax Rate = 15% or $4,500/$30,000

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Slide 5-33


� 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

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

Slide 5-35

The Most Important Federal Taxes

� The federal personal income tax– Accounts for 46% of all federal revenue

Slide 5-36

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?

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� 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

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� 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

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� 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

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� Who really pays the corporate income tax?– Tax Incidence (the distribution of tax

burdens among various groups in society)• Consumer• Stockholder• Employees

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� Social Security tax– Social Security rates today are imposed

on earnings up to about $80,000

OASDI Medicare* Matched by Employer6.20% 2.90% 6.20%

*Medicare matched by employer

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� 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

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Slide 5-45

Spending, Government Size, and Tax Receipts

� Government receipts– The federal government

– State and local government

Slide 5-46

Total Government Outlays Over Time

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

and Economic Indicators, various issues

Slide 5-47

Sources of Government Tax Receipts

Figure 5-3

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

Slide 5-48

Federal Government Spending Compared to State and Local Spending

Budget of the United States Government; Government Finances

Figure 5.4

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Slide 5-49

Collective Decision Making: The Theory of Public Choice

� 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

Slide 5-52


� 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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Slide 5-53


� Differences between market and collective decision making– Voting versus spending

• Political system versus market system– Political System

» Run by majority rule– Market System

» Run by proportional rule

Slide 5-54


� 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

Slide 5-55


� Differences between market and collective decision making – Voting versus spending

• Spending of dollars can indicate intensity of want

• Votes cannot; each vote counts with the same intensity

Slide 5-56

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.

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Slide 5-57

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

Slide 5-58


� 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

Slide 5-59


� 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