PUBLIC FINANCE A CONTEMPORARY APPLICATION OF THEORY TO POLICY 12TH EDITION BY DAVID N HAYMAN SOLUTIO by QuentinAxel

SOLUTIONS MANUAL

SOLUTION MANUAL FOR PUBLIC FINANCE A CONTEMPORARY APPLICATION OF THEORY TO POLICY 12TH EDITION DAVID N HYMAN

CHAPTER 1

Individuals and Government

INSTRUCTIONAL OBJECTIVES Chapter 1 is a general introduction to the field of public finance, emphasizing the relationship between individuals and government. The functions of government are outlined, and the importance of taxes in household budgets is highlighted. The chapter seeks to develop an understanding of the economic role of government as a supplier of useful goods and services. Students are also expected to digest data on the actual extent of government activity in the United States and other nations. They should know the current structure of government expenditures and revenues in the United States, how government has grown since 1920, and how the structure of federal government spending has changed since 1960. In addition, the chapter seeks to demonstrate that the problem of scarcity implies that an increase in resources devoted to government goods and services decreases availability of resources for nongovernment uses. It is also made clear to students how government provision of goods and services differs from market provision of goods and services.

CHANGES IN THIS EDITION 

Chapter 1 discusses the growth in government spending, the impact of slow economic growth on public finance on the federal, state and local government levels, and health care issues.

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All data on government spending and revenues have been updated to the latest available year. Public expenditure data have been revised using the latest National Income and Product Account (NIPA) figures for government consumption and investment, documenting the rise in the share of the public sector as a share of GDP since 2001.

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The International View on government spending has been revised and updated with the latest data.

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Discussion of mandatory versus discretionary federal government spending has been added.

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Graphs have been redone to reflect the latest available observations.

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The discussion of the mix between transfer payments and government consumption has been revised. The growth in health care spending by government has been documented, showing that it is now the largest and fastest growing category of federal government expenditure.

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The analysis of the implications of aging populations for public finance has been updated based on empirical analysis of the latest UN projections of changing world demographics. There is more discussion of European aging and implications for pension systems. The impact the aging population on health care spending in the United States is discussed.

CHAPTER OUTLINE Individuals, Society, and Government Governments and Political Institutions The Allocation of Resource between Government and Private Use The Mixed Economy, Markets, and Politics Government Expenditures in the United States International View: How Much Government? The Share of Government Expenditure in Modern Economies The Structure of State and Local Government Expenditure Financing Government Expenditure in the United States Market Failure and the Functions of Government: How Much Government Is Enough? Aging Populations: Implications for Public Finance

MAJOR POINTS AND LECTURE SUGGESTIONS 1. My objective in the first lecture is to make it clear to students how economic analysis of the functions and activities of governments fits in with their other courses. Since most students have already had at least one course in microeconomics, I point out how governments can be thought of as agents for supplying goods and services whose quantities have been determined through political, as opposed to market, interaction. The role of government in the mixed economy is schematically illustrated with a modified circular flow diagram. Figure 1.2 represents a useful starting point for illustrating how the economic analysis of government fits in with previous analyses of markets to which most students will have already been exposed. I usually draw the diagram on the board and show how both households and business firms have economic relations with governments. 2. The tradeoff between government goods and services, and private goods and services is illustrated with the production possibility curve. Figure 1.1 is familiar to most students, and its application to analysis of government goods and services usually captures their attention. It helps to use the graph in class to discuss reallocation of resources from military to nonmilitary uses. Another interesting use of the graph is to show how increased environmental quality improvement services supplied by government will require the sacrifice of material goods and services, as the prices of such products as fuel, electricity, and automobiles rise.

3. Emphasize that government goods and services are usually made available through nonprice rationing: a.

Government goods are often available for collective use at no direct charge, as is the case for roads, national defense, police services, fire protection, and environmental protection.

b. Eligibility for obtaining the benefits of government services is determined by criteria other than ability and willingness to pay. Politically determined criteria, such as age, income, family status, and location of residence, often determine a person’s eligibility to receive government transfers such as food stamps and services such as public schooling. 4. A general listing of the functions of government, as discussed in the text, is useful to students. These functions are as follows: a.

Provision of useful goods and services, including the establishment of property rights and the underlying legal system

b. Redistribution of income and economic opportunity among citizens c.

Stabilization (Note that this is not covered in the text.)

d. Regulation of private action 5. Note that the discussion of government finance in the chapter briefly outlines the fact that the consequences of alternative means of finance differ in terms of the impact on incentives to produce and on the distribution of well-being. 6. I usually photocopy the tables in Chapter 1 and bring them to class for the second lecture. I believe that it is important for students to have some appreciation of the current extent of government and the growth of expenditures and revenues in recent years. 7. In addition to illustrating the growth of government, I seek to show how the structure of federal government expenditure has changed significantly since 1960. First, point out to students the spectacular growth in the relative importance of transfers from 1960 to 1980. You can also point out that transfers stabilized at close to 40 percent of federal spending in the 1970s. After declining slightly as a share of federal spending in the 1980s, they rose again in the 1990s and now account for about 43 percent of federal spending. Federal government purchases of goods and services for consumption and investment has declined from over 60 percent of federal spending in 1960 to 27 percent in 1999. Since the end of the Cold War, purchases have declined as defense spending has been cut back. However, the terrorist attacks of September 11, 2001, resulted in both increased government spending and a shift away from transfers toward government consumption. 8. In discussing actual expenditures, use Table 1.3 and the accompanying pie chart to show the importance of Social Security, income security, Medicare, and health for the federal government; and point out that these programs account for about 63 percent of federal government expenditures. Also point out that about 32 percent of state and local government expenditure is accounted for by education. Health care spending by state and local governments, mainly for Medicaid, has been growing rapidly and now accounts for about 24 percent of state and local government spending. 9. Use the data and accompanying pie charts in the chapter to show students how income taxes, including payroll taxes and corporate profits taxes, account for more than 90 percent of federal government revenue. Also point out that sales and property taxes account for nearly half of state and local government revenues and that one in five dollars of receipts received by state and local governments comes from federal grants-in-aid. 10. Many instructors are now spending more time in class discussing state and local government fiscal problems. A section in Chapter 1 discusses the structural problems that are underlying state © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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government budgets and discusses the situation and impact on budgets for selected states that have been particularly hard hit by revenue shortfalls. 11.

Aging of populations has implications for public finance, especially for Social Insurance programs. A section in this chapter provides information on aging of the population, dependency ratios worldwide, along with implications for government spending.

ANSWERS TO TEXT PROBLEMS 1. Given a point on the old production possibility curve, the outward shift allows movement in the northeast direction to a point on the new production possibility curve corresponding to an increase in production of both private and government goods and services. 2. The increased allocation of resources to government provision of health services implies that fewer resources can be used for other goods and services. The student should plot health care services on one of the axes and ―all other goods and services‖ on the other axis. As production of health care services increases, given fixed resources and technology, production of other goods and services must decline. 3. Social Security pensions are government transfers. Except for a small amount of purchases for personnel and other resources to administer the transfer, no government purchases are required. 4. The debt accumulated by past budgets amounts to many times more than the amount of federal spending. It will take many years to retire the outstanding debt. The interest on the outstanding debt will have to be paid for many years until the debt is retired. Running a budget surplus would accelerate the rate of debt repayment. 5. Even though many programs are federally funded, such as, Medicare, programs such as Medicaid are partially state funded. Consequently, the aging population will increase state expenditures as Medicaid and other health care programs become more expensive due to increased demand. The aging population will also impact state government revenue as the population leaves the workforce and contributes less and less in the form of personal income tax, sales tax, and property tax.

A NOTE ON THE APPENDIX TO CHAPTER 1 The appendix to Chapter 1 is a concise review of basic microeconomic principles used throughout the text. The material is designed to aid students with weak backgrounds in basic economic theory. It also provides a convenient reference for students who wish to review basic concepts as they are needed. I advise my students to read the appendix, but I do not cover any of the material in class.

OUTLINE OF THE APPENDIX TO CHAPTER 1 Indifference Curve Analysis Analysis of Production and Cost Profit Maximization, Competition, and Supply

TRUE /FALSE QUESTIONS 1. On average, persons in the United States devote more of their annual budgets to taxes than they do to food. (T) 2. A universally observed function of government is the establishment of property rights. (T) 3. The total share of GDP accounted for by government spending in the United States has declined significantly since 1980. (F) 4. In 1929, the federal government spent more than was spent by state and local governments. (F) 5. Since 1930, the percent of GDP devoted to government expenditures has more than tripled. (T) 6. The costs imposed by government regulations on business firms are included in budget data on government expenditures. (F) 7. Government consumption does not require resources to be reallocated from private to government use. (F) 8. Since 1959, the percent of federal government expenditures devoted to transfers has increased by more than 50 percent. (T) 9. Transfer payments, including Social Security and welfare and medical assistance, account for nearly 60 percent of federal government expenditures. (T) 10. Interest on the federal government’s debt accounts for nearly one-quarter of federal government expenditure. (F) 11. Federal grants-in-aid to state and local governments finance about 22 percent of annual spending by these governments. (T) 12. The federal government allocates about 10 percent of its budget to Social Security. (F) 13. State and local governments in the United States spend a bit under one-third of their budgets on education. (T) 14. Sales taxes account for about 16 percent of state and local government revenue in the United States. (T) 15. The federal government obtains about half of its revenue annually from retail sales taxes. (F) 16. State governments do not fund any part of Medicaid. (F) 17. The social compact is an 18th-century idea by political theorists. (F) 18. The proportion of revenue received by the federal government from payroll taxes is higher than the proportion of revenue received by state and local governments from payroll taxes. (T)

MULTIPLE CHOICE QUESTIONS 1. The real cost of government goods and services is: a. money. b. taxes. c. the private goods and services foregone. d. inflation. © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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2. If the economy is currently operating on a point on the production possibility curve for government goods and services versus private goods and services, a. an annual increase in government goods and services can be obtained without any sacrifice of annual private goods and services. b. it will be impossible to increase annual output of government goods and services. c. a decrease in the annual output of government goods and services will have no effect on the annual output of private goods and services. d. a decrease in the annual output of government goods and services will allow an increase in annual output of private goods and services. 3. Government goods and services are usually: a. not rationed by prices. b. sold in markets. c. made available to persons according to their willingness and ability to pay. d. financed by revenue obtained from sales. 4. Taxes: a. are prices paid for the right to consume government goods and services. b. are compulsory payments not directly related to the benefits received from government goods and services. c. never affect economic incentives. d. are used by private firms to raise revenue. 5. A mixed economy is one in which: a. there are no markets. b. government activity accounts for a significant proportion of the value of goods and services produced and regulates economic activity. c. there is no government. d. all goods and services are sold in markets. 6. Government purchases for consumption and investment: a. are made to acquire resources necessary to produce government goods and services. b. are designed to redistribute purchasing power among citizens. c. have increased in importance as a percent of federal spending since 1959. d. do not withdraw resources from private use. 7. Transfer payments by the federal government in the United States account for about: a. 23 percent of federal government expenditures. b. 12 percent of federal government expenditures. c. 40 percent of federal government expenditures. d. 63 percent of federal government expenditures. 8. Total annual expenditures by federal, state, and local governments in the United States are in the range of: a. 20 to 25 percent of annual GDP. b. 26 to 30 percent of annual GDP. c. 31 to 35 percent of annual GDP. d. 36 to 40 percent of annual GDP. © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

9. Federal government expenditures in the United States account for about: a. 22 percent of annual GDP. b. 32 percent of annual GDP. c. 11 percent of annual GDP. d. 55 percent of annual GDP. 10. About 80 percent of federal receipts are accounted for by: a. corporate profits taxes. b. sales taxes. c. excise taxes. d. payroll and personal income taxes. 11. If the economy is operating at full employment and using resources efficiently, then an increase in spending for homeland security this year will: a. require that resources be reallocated to homeland security services without sacrificing any alternative goods and services. b. be possible if resources are reallocated to homeland security services, but it will also mean that the output of some other goods and services will have to fall. c. be impossible. d. be possible only if there is an improvement in technology or more resources made available. 12. Which of the following is an example of a political institution? a. A market b. Elections with winners determined by majority rule c. Representative government d. Both (b) and (c) are correct. 13. Nonmarket rationing means that: a. those willing to pay can buy as much of a product as they choose. b. goods and services are not rationed by prices. c. willingness to pay is not a factor in determining who can enjoy a good or service. d. both (b) and (c) are correct. 14. The U.S. economy is best characterized as a: a. pure market economy. b. socialist economy. c. pure capitalistic, free-enterprise system. d. mixed economy. 15. State and local government expenditure in the United States accounts for about: a. 31 percent of GDP. b. 21 percent of GDP. c. 11 percent of GDP. d. 7 percent of GDP. 16. Following the circular flow of a mixed economy, firms receive a flow of dollars from and send goods and services to: a. output markets. b. input markets. © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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c. households. d. government. 17. Following the circular flow of a mixed economy, which entity or entities distribute resources? a. Firms only b. Input markets only c. Government and households d. Households and input markets 18. During which of the following time periods did the United States experience government expenditures in the range of 40 to 50% of GDP? a. 2000 to 2009 b. 1950 to 1959 c. 1940 to 1949 d. This has never happened. 19. As of 2015, which country listed below had the highest percentage of government spending relative to GDP? a. France b. Ireland c. Japan d. Canada 20.

The old-age support ratio is: a. the proportion of the population that is 60 years or older over the proportion of the population that is less than 60 years of age. b. the proportion of the population that is 65 years or older over the proportion of the population that is 20 to 64 years of age. c. the proportion of the population that is 70 years or older over the proportion of the population that is 20 to 69 years of age. d. the total government expenditure on programs for the elderly over the number of citizens who are 65 years or older.

ESSAY QUESTIONS 1. Taxes are likely to affect the incentives that persons have to use their own resources in the most productive way. Suppose that the taxes used to finance G1 units of government goods and services could purchase X1 units of private goods and services. Assume that more than X1 units of private goods and services could be produced if taxes did not impair incentives to produce. Use the production possibility curve to illustrate the effect of taxes on the output mix in the economy. Show the loss in private output from taxes on your graph. Show how an improvement in the technology of producing government goods and services will affect the production possibility curve. 2. What is the difference between transfer payments and government purchases? How has the mix of transfers and government purchases changed in the federal budget since 1960? List the most important transfer payments in the federal budget. What significant changes have occurred in the mix of all categories of federal government expenditures since 1960?

CHAPTER 2

Efficiency, Markets, and Government

INSTRUCTIONAL OBJECTIVES The main objective of this chapter is to develop the concept of efficiency and show students how it is used to evaluate economic performance. To begin the discussion, it is necessary to draw the distinction between positive and normative economics. Both of these approaches are used in the chapter. An additional instructional objective is therefore to demonstrate the usefulness of each type of analysis. The concept of efficiency is carefully linked to resource allocation and economic transactions. The chapter also introduces the student to marginal analysis of resource allocation. The distinction between total social cost and benefit, and marginal social cost and benefit is drawn for students. Graphic analysis is then used to derive the marginal conditions for efficiency. The objective is to show students that maximization of net social benefit requires that all activities be undertaken in each time period up to the point at which MSB = MSC. The analysis is then used to evaluate resource allocation in competitive markets operating under conditions of perfect competition with no externalities. This is followed by examples showing how monopoly power and government intervention can result in losses in efficiency in markets. The objective here is to show how welfare triangles can be used to measure losses in well-being when efficiency is not achieved. The equity-efficiency trade-off is also introduced in the chapter. The utility possibility curve is used to show students how citizens often rationally oppose movements to efficient resource use when compensation for losses in well-being is not actually paid. Positive analysis of the equity-efficiency trade-off is also provided, thereby closing the chapter with an illustration of how the positive approach is useful to normative analysis.

CHANGES IN THIS EDITION 

The Public Policy Perspective has been updated to reflect changes in the U.S. income tax code that became effective in 2018.

CHAPTER OUTLINE Positive and Normative Economics Normative Evaluation of Resource Use: The Efficiency Criterion Markets, Prices, and Efficiency Conditions Market Failure: A Preview of the Basis for Government Activity Equity versus Efficiency © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Public Policy Perspective: The Tax System and the Birthrate—An Example of Positive Economic Analysis Positive Analysis Trade-Off Between Equity and Efficiency

MAJOR POINTS AND LECTURE SUGGESTIONS 1. Instructors may wish to emphasize the difference between the normative and positive approaches. The normative approach is based on underlying values that embody an individualistic ethic. The positive approach is simply a scientific method used to formulate hypotheses subject to empirical verification. I point out to my students that the normative approach in public finance sets up benchmarks against which the impact of government regulations, expenditures, and taxes can be evaluated. 2. There are two aspects of efficiency that are useful to emphasize in lectures: a.

Efficiency, as the term is commonly used by the layperson, simply means avoidance of waste in achieving any useful objective. Students are most likely already familiar with this aspect of efficiency.

b. The second aspect of efficiency deals with exchange. Even when production is accomplished without waste, additional net gains are usually possible through mutually agreeable exchanges. In discussing the second aspect of efficiency, with which students are less familiar, you can point out that freedom to trade is an important aspect of efficiency. Constraints on mutually agreeable trade thereby prevent attainment of efficiency when no third parties are affected by those transactions. 3. The derivation of the marginal conditions for efficiency provides a good opportunity to review marginal analysis for students. Make sure to confine your discussion to a particular good. The example in the text uses bread. I find that students are quite receptive to the notion that net social gains are maximized when each possible good or service is made available up to the point at which MSB = MSC. The inclusion of the total social benefit and total social cost curves in Figure 2.1 in the text helps students see how additional production of goods is inefficient beyond the point at which MSB = MSC, even though TSB > TSC for additional output. 4. Notice how the marginal net benefit is defined as the difference between the marginal social benefit and the marginal social cost of any given quantity of a good. 5. After deriving the efficiency conditions, I like to reinforce the theory by immediately showing students how the marginal conditions are satisfied under ideal conditions in perfectly competitive markets. In doing so, I introduce the concepts of marginal private benefit and marginal private cost. I show how P = MPB = MPC in competitive markets. Finally, I set the stage for future analysis in Chapter 3 by pointing out that, provided no third parties (other than buyers and sellers) are affected by market exchanges, P = MSB = MSC. Because these conditions are used throughout the text, it is important for students to understand the derivation. I find that students have little difficulty with the exposition. If you get the significance of these points across early in the course, it is easy to show how taxes and subsidies prevent prices from simultaneously reflecting marginal social costs and benefits. The numerical example in the text has been helpful to my students. Note that I use the same numbers when discussing competitive markets for bread. 6. The obvious next step is to provide your students with examples of cases for which markets do not achieve efficiency. The exercise of monopoly power is a good example of how lack of competition © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

in markets can cause losses in efficiency. This example can then be supplemented with analysis of the effects of taxes and subsidies on private choices in markets. The example of target prices for agriculture in the United States shows how subsidies to agriculture result in more than the efficient amount of resources allocated to agricultural uses. You might wish to supplement these examples with some of your own. In any case, the main instructional objective is to show students how losses in well-being resulting from inefficient output levels can be measured as triangular areas in the graphs. The Public Policy Perspective shows students how the personal exemption used to be used as a subsidy to raising children and has since been replaced by the Child Tax Credit, worth up to $2,000 per year per qualifying child under the age of 17. 7. I believe that it is important to emphasize the equity-efficiency trade-off early in the course. This provides an opportunity to show how the positive approach can be used to predict the net gains and losses to citizens. The utility possibility curve is a good tool to illustrate political conflict. First make sure that students see the similarity between the utility possibility curve and the production possibility curve. In particular, point out that the maximum possible level of well-being of any one person, given the well-being of others, depends on resources available and technology. The curve also shows how there is no one unique efficient allocation of resources. It can be used to show how the efficient outcomes of competitive interaction can result in a distribution of well-being for which many persons live in poverty. 8. I like to use the utility possibility curve to show how changes in resource allocation can result in both gainers and losers even when there is movement from inefficient to efficient resource use. Unless compensation is actually paid, the losers act to prevent the resource change that makes them worse off.

ANSWERS TO TEXT PROBLEMS 1. The marginal social benefit of the first concert is $10,000, and its marginal social cost is $5,000. The marginal social benefit of a second concert is $5,000, which falls short of its marginal social cost of $6,000. The efficient number of concerts is one. After the first concert, the marginal social cost exceeds the marginal social benefit. 2. a.

The efficient output is the one for which P = MC. If sold in a competitive market, the price of a television would be $100 and the quantity sold would be 200,000 – 500(100) = 150,000.

If sales were limited to 100,000 per year, the marginal social benefit of TVs would exceed the marginal social cost. Students should draw a graph showing the resulting loss of net benefits as a triangle above the marginal cost line and under the demand curve between the outputs of 100,000 and 150,000. If there is a complete ban on TV sales, the loss in net benefits will be the entire area under the demand curve and above the marginal cost curve corresponding to the consumer surplus from TV sales.

3. The senator’s logic is false. Equating the marginal social benefit of a service with its marginal social cost maximizes net gains. If output is increased to the point at which TSB = TSC, there will be more than the efficient amount of resources devoted to space exploration. 4. The price support for rice will increase annual production beyond the efficient level. At the price support, the marginal social cost of rice will exceed its marginal social benefit. 5. At the current market equilibrium under perfect competition, MSB = MSC = $100, implying efficiency. The $10 per night tax results in an increase in the market equilibrium price of hotel © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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rooms. At the higher prices, MSB exceeds MSC. The graph used to answer this question should be similar to Figure 2.3 in the text. The loss in net benefits would be an area like E'EB in Figure 2.3.

A NOTE ON THE APPENDIX TO CHAPTER 2 The appendix to Chapter 2 sets up a two-dimensional model of efficient resource. This appendix can easily be skipped because the basic notions are developed intuitively within the chapter. If, however, you have good students, you can assign the appendix and derive the conditions in class. The standard welfare model is developed in the appendix and Edgeworth-Bowley boxes are used to derive the efficiency conditions.

OUTLINE OF THE APPENDIX TO CHAPTER 2 A Model of Efficient Resource Use Productive Efficiency Pareto Efficiency Efficiency and Economic Institutions Market Imperfections

TRUE /FALSE QUESTIONS 1. The normative approach to public finance prescribes certain actions to achieve predetermined criteria. (T) 2. Positive economic analysis is based on underlying value judgments. (F) 3. ―The government should abolish tariffs to achieve efficiency‖ is a normative statement. (T) 4. It is possible for efficiency not to be attained even if all production is carried on without waste. (T) 5. Efficiency is attained when resources are used each year in such a way that no further net gain is possible. (T) 6. The efficient annual output of any given good is attained if that good is made available in amounts up to the point at which the total social benefit of the good equals the total social cost. (F) 7. If the marginal social benefit of smoke detectors exceeds its marginal social cost, then additional net gains are possible from increased annual smoke detector production. (T) 8. Monopoly power causes losses in efficiency because the marginal social benefit of output exceeds its marginal social cost at the monopoly output. (T) 9. Government regulations that require airlines to serve routes for which the maximum price that passengers are willing to pay for a trip fall short of the minimum price that sellers are willing to accept are likely to cause losses in efficiency. (T) 10. Points lying below a utility possibility curve are efficient. (F)

11. Government programs can achieve efficiency when the gains to gainers from those policies exceed the losses to those who bear the costs. (T) 12. If the marginal social cost of beer production exceeds its marginal social benefit, then more than the efficient amount of beer is being produced. (T) 13. Efficient outcomes are often viewed as inequitable. (T) 14. If it is not possible to make someone better off without harming another, then resource allocation is efficient. (T) 15. Compensation criteria are used to argue that changes in resource allocation should be made if the gains to some groups outweigh the losses to others, even though compensation for losses is not actually made. (T) 16. All points on a utility possibility curve are efficient but differ in terms of the distribution of wellbeing. (T) 17.

A tax on a product shifts the demand curve. (F)

18.

A government-subsidized price for a commodity that is higher than the market-driven price results in oversupply relative to the efficient allocation. (T)

19.

When comparing the allocation of two goods relative to two consumers with individual utility functions, multiple points of Pareto efficiency can exist. (T)

MULTIPLE CHOICE QUESTIONS 1. Positive economics: a. makes recommendations designed to achieve certain goals. b. establishes cause-and-effect relationships between economic variables. c. is based on value judgments. d. can never be used to make predictions. 2. If the efficient output of a good is produced each week, then the: a. marginal social benefit of the good equals its marginal social cost each week. b. marginal social benefit of the good is at a maximum. c. total social benefit of the good is at a maximum. d. total social benefit of the good equals its total social cost. 3. If the marginal social benefit of a good exceeds the marginal social cost at the current monthly output, then: a. it will be possible to make buyers of the good better off without harming sellers of the good. b. it will be possible to make sellers of the good better off without harming buyers of the good. c. both (a) or (b) are correct. d. a reduction in monthly output will be required for efficiency.

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4. The marginal social cost of bread exceeds the marginal social benefit at the current weekly output. Therefore, a. the marginal net benefit of bread is positive. b. the output of bread is efficient. c. a reduction in weekly output of bread is necessary to achieve efficiency. d. an increase in weekly output of bread is necessary to achieve efficiency. 5. The total social benefit of automobiles equals the total social cost at current annual output. It then follows that: a. the annual output of automobiles is efficient. b. the annual output of automobiles exceeds the efficient amount. c. less than the efficient annual output of automobiles is produced. d. it is not possible to make buyers of automobiles better off without harming sellers. 6.

Eggs are sold in a perfectly competitive market. No persons other than the buyers and sellers of eggs are affected in any way when eggs are traded in the market. It then follows that: a. the price of eggs equals the marginal social cost of eggs. b. the price of eggs equals the marginal social benefit of eggs. c. the price of eggs exceeds the marginal social benefit of eggs. d. both (a) and (b) are correct.

7. Diamonds are sold by a monopoly firm that maximizes profits. It then follows that: a. the marginal social benefit of diamonds exceeds its marginal social cost. b. the marginal social cost of diamonds exceeds its marginal social benefit. c. the price of diamonds equals its marginal social cost. d. the price of diamonds exceeds its marginal social benefit. 8. Points on a utility possibility curve represent: a. a given distribution of well-being between two persons. b. an efficient allocation of resources. c. the maximum well-being of any one person, given the resources available and the well-being of another person. d. all of these are correct. 9. If efficiency has been attained, a. it will be possible to make any one person better off without harming another. b. it will not be possible to make any one person better off without harming another. c. perfect competition must exist. d. the opportunity cost of any change in resource use must be zero. 10. A move from an inefficient resource allocation to an efficient one: a. will always be unanimously approved, even if gainers do not compensate losers. b. will be unanimously opposed. c. will be unanimously approved if gainers compensate losers. d. can never result in losers.

11. Which of the following is a normative statement? a. When interest rates rise, the quantity of loanable funds demanded for new mortgages will decline. b. To achieve efficiency, governments should prevent monopoly in markets. c. Unemployment increases during a recession. d. When governments increase income tax rates, people work less. 12. Normative economics: a. is not based on underlying value judgments. b. makes recommendations to achieve efficient outcomes. c. establishes cause-and-effect relationships between economic variables. d. makes ―if…then‖ type statements and checks them against the facts. 13. The extra benefit on one more unit of a good or service is its: a. marginal cost. b. marginal benefit. c. total benefit. d. total cost. 14. If the efficient output of computers is achieved this year, then market price of computers is equal to: a. the marginal social benefit of computers. b. the marginal social cost of computers. c. the total social benefit of computers. d. both (a) and (b) are correct 15. Suppose the efficient output currently prevails in the market for ice cream. A tax on ice cream consumption will: a. allow efficiency to continue to prevail in the market. b. result in more than the efficient output in the market. c. result in less than the efficient output in the market. d. cause the marginal social cost of ice cream to exceed its marginal social benefit at the market equilibrium output. 16. Positive economics is: a. an equity-based approach in which income should be redistributed. b. an objective approach without a particular goal based on underlying values. c. a goal-oriented approach based on desired policy outcomes. d. a belief that governments can implement economic policies for the greater good of society. 17. Normative economics is: a. completely free of any value system. b. completely objective. c. based on a conscious effort to implement a particular social goal. d. an approach that determines the effect of particular actions without judgment of the result being good or bad.

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18. An efficient level of output means: a. the total social benefit less the total social cost is maximized. b. the total social benefit is below the total social cost. c. the total social cost equals the total social benefit. d. the total social benefit less the total social cost can be improved. 19. If a government desires to increase production beyond the current competitively determined efficient level, the government should: a. tax the good. b. subsidize the good at a price higher than its current price. c. set the price below its current price. d. impose a fixed fee whenever the good is purchased. 20. Pareto efficiency between two consumers is achieved: a. only when the individual marginal rates of substitution are equal to the marginal rate of transformation. b. only when the individual marginal rates of substitution are less than one, but not necessarily equal. c. only when the individual marginal rates of substitution are greater than one and equal. d. only when the individual marginal rates of substitution are equal.

ESSAY QUESTIONS 1. The wine industry is currently composed of many firms, and wine is sold in a perfectly competitive market. The wine industry produces the efficient annual output of wine, which is 100,000 bottles per year. The market equilibrium price is $5 per bottle. a.

Draw the market demand and supply of wine and label the curves to show why the market output is the efficient output.

b. Suppose that the wine industry is consolidated into one large monopoly firm. As a result of the monopolization of the industry, the price of wine increases to $7 per bottle, and the annual quantity demanded falls to 75,000 bottles. Explain why this output is not efficient and show the loss in net benefits resulting from monopolization of the industry. 2. Explain why points on a utility possibility curve represent efficient allocations of resources. Why must the utility possibility curve be downward sloping? Draw a utility possibility curve and show how it is possible to achieve efficiency by moving from a point within the curve and the axes to a point on the curve.

CHAPTER 3

Externalities and Government Policy

INSTRUCTIONAL OBJECTIVES Chapter 3 introduces students to the important concept of an externality. Externalities are defined simply as costs or benefits of market transactions not reflected in prices. The chapter seeks to provide students with an understanding of why markets fail to achieve efficiency when externalities exist. A few extended examples are developed to show students how prices fail to reflect marginal social benefit or marginal social cost when positive or negative externalities exist in competitive markets. Another objective of the chapter is to discuss alternative means of internalizing externalities to achieve efficiency. Externalities are internalized when marginal private cost (or marginal private benefit) is adjusted so that resource users consider the actual marginal social cost (or marginal social benefit) of their actions when making decisions. The text considers corrective taxes (or subsidies), emissions standards, and property rights assignment (the Coase theorem) as alternative means of internalizing externalities. The advantage and disadvantage of each approach are highlighted for the student. The discussion is often very pragmatic, and it considers the transactions costs and data requirements for implementing each scheme.

CHANGES IN THIS EDITION 

The discussion of the EPA’s cap and trade program for sulfur and nitrogen dioxide allowance has been amended.

CHAPTER OUTLINE Externalities: A Classification and Some Examples Internalization of Externalities Property Rights to Resource Use and Internalization of Externalities: The Coase Theorem Environmental Protection Policies in the United States Markets for Pollution Rights in Practice: Sulfur Dioxide Allowances, and Capping and Trading the Right to Emit Global Perspective: Global Pollution—Externalities That Cross Borders © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

18 | Part One | The Economic Basis of Government Activity

MAJOR POINTS AND LECTURE SUGGESTIONS 1. Emphasize that an externality is basically an unpriced cost or benefit of market activity. You may wish to point out that nonmarket activities could also generate externalities. For example, home production of goods and services not for sale is basically an implicit transaction for which the producer is also the consumer. In such cases, the producer could impose marginal costs or benefits on his neighbors that are not considered in his decisions. 2. Students readily grasp the idea that a negative externality prevents attainment of efficiency because the marginal social cost exceeds the marginal social benefit of output at the competitive equilibrium. Figure 3.1 in the text makes this clear and demonstrates that the equilibrium occurs at the point at which MSB = MSC. Efficiency requires that MPC + MEC = MSB. You could point out to your students that common environmental problems such as pollution constitute externalities only if the marginal external cost is in fact positive. If an environmental resource that has no alternative use is damaged by pollution, there is no externality because the MEC = 0. 3. Students seem to have more difficulty grasping the concept of a positive externality than they do in grasping negative externalities. The example in the text relating to inoculations is one that students seem to understand easily. First make clear to students that when a positive externality exists, MSB > MSC at the market equilibrium. To achieve efficiency, output must be increased up to the point at which MPBi + MEB = MSB. To accomplish this, the price paid by consumers must decline to induce them to purchase more of the good. However, the price received by sellers must increase, except in cases for which supply is perfectly elastic. Figure 3.2 in the text shows the gains in efficiency possible from internalizing a positive externality. 4. Note that Figure 3.3 shows how the market can achieve an efficient output for a positive externality whose marginal value declines with output. This is an important conclusion. It implies that no government intervention is required in cases for which MEB = 0 at the market output. 5. Note that my development of the notion of internalizing an externality is much more complete than that found in competing texts. I emphasize the information costs involved in identifying parties involved in an externality and in measuring the monetary value of the marginal costs and benefits. 6. Students are very receptive to the discussion of corrective taxes in the text. They often ask why the technique is not used more often. They do, however, readily understand the political problems involved in agreeing on the tax and its magnitude. I emphasize the political aspects of the tax by pointing out the gainers and the losers in the process. I also make it clear to students that the tax does not reduce emissions to zero. It merely forces emitters to pay the marginal external cost of their emissions. I also point out the possible uses for the collected tax revenue, including compensation for the total external cost remaining after the externality is internalized. 7. I also introduce the theory of second best with an analysis of internalization of externalities in noncompetitive markets. The important point for students to understand here is that when monopolistic power results in less than the efficient output, a corrective tax to internalize an externality must be less than the marginal external cost. In the example used in the text, the distortion due to monopolistic power exactly offsets the distortion due to the negative externality. No corrective tax is necessary to achieve efficiency in this case. 8. The analysis of corrective subsidies emphasizes how the subsidy must reduce the price paid by consumers by MEB to achieve efficiency. Go through this example carefully in class because students seem to have a hard time with it. In addition, return to Figure 3.3 in the text and ask students to determine the corrective tax required for efficiency for each of the supply curves S and S'. © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

9. I believe that a discussion of the Coase theorem helps students understand the source of externalities and the role of government in controlling their undesirable effects. I emphasize that government can internalize externalities when the transactions costs of exchanging property rights are zero merely by assigning those rights and encouraging their exchange. I also make clear to the students that this assures efficiency independent of which competing user for the resource in dispute is assigned the property right. The example in the text uses land as the disputed resource. The two competing users are a beef producer and a wheat farmer. The graphs in Figure 3.7 of the text show how the marginal cost of wheat depends on the output of beef. Make it clear to students that when the beef producer has the right to use all unfenced land for grazing, his costs include the foregone payment of the farmer to reduce the size of his herd. This increases his marginal costs in the same way as would be the case if he were liable for damages. Note as well how the text shows that no matter who is assigned the rights, the users will choose the alternative to internalize the externality that gives them maximum profits. The mix of wheat and beef output on the land will be efficient no matter who is granted the property right. 10. The application of the Coase theorem to pollution rights is particularly relevant because markets for pollution rights are now established. The chapter discusses how the Clean Air Act of 1990 established a market for pollution rights. There is a discussion of how the provisions of the act have been put into practice, and a graph shows how the price of the allowances has varied since the inception of the trading program to control sulfur dioxide emissions and reduce acid rain. 11. Emissions standards remain the dominant means of controlling externalities in the United States. The graphs in Figures 3.10 and 3.11 show students how rigid emissions standards cause losses in efficiency when the marginal social benefit of emissions (in terms of increased profits of emitters) differs among firms, or the marginal external cost of emissions varies among regions. Students really see the light when comparing the current policies with the idea of the corrective tax. Also point out to them that standards allow emitters to emit wastes free of charge up to the point at which they reach the standards, then no more emissions are allowed no matter what the value of the right to emit to the firm. Also point out that emissions standards are often difficult to enforce, as are most command and control policies. 12. When discussing pollution rights, point out how trading of rights to emit can achieve a given reduction in pollution at lower cost than command-and-control policies. The text includes a numerical example to help convince students of the cost savings that can result from market-based approaches to pollution control. 13. It is important for students to have an international perspective on environmental problems. The Global Perspective at the end of the chapter discusses issues relating to ozone depletion and global warming. 14. Students might be surprised to find out that recycling is not necessarily an efficient means of dealing with the problem of disposal of solid wastes. Figure 3.9 might be a useful way of showing how economic analysis helps focus on resource use and efficiency.

ANSWERS TO TEXT PROBLEMS 1.

The dependent variable in both equations is quantity rather than price. Q would be plotted on the vertical axis and P on the horizontal axis if a graph were drawn based on the two equations. We can model the corrective tax as a reduction from the gross market price received by the seller rather than as an increase in the marginal cost. Sellers now make their decisions on the basis of market price less the corrective tax.

20 | Part One | The Economic Basis of Government Activity

The corrective tax drives a wedge between the net price (Pn) received by the seller and the gross market price actually paid by the buyer (Pg). The seller chooses Qs based on Pn = Pg – t. Interpreting the P in both equations as the market price (Pg), the correct solution can be obtained by subtracting the tax from the gross price received by the seller in the first equation: Qs = 5000(P – 20) Setting Qs = Qd and interpreting P as Pg gives: 5000(P – 20) = 400,000 – 1000P Solving for P gives P = $83.33, which is the new market equilibrium price after the corrective tax. The net price received by the seller will be $63.33. The corresponding equilibrium quantity is 316,670, which is efficient given that t = MEC = $20. The same result can be achieved by interpreting the P in the equations as the net price received by the seller. In this case we add $20 to the demand price (as stated in the answer in the IM). Buyers pay Pg = Pn + t, giving: Qd = 400,000 – 1000(P + 20). Setting Qs = Qd and interpreting P and Pn gives: 400,000 – 1000(P + 20) = 5000P Solving this gives a net price of $63.33, which implies a market equilibrium price after the tax is added of $83.33—the same as above. 2. The demand curve is obtained by plotting the data for MPB on the vertical axis and plotting the quantity on the horizontal axis. The difference between the marginal social benefit and the marginal private benefit is the MEB. At a price of $25 per gallon, the market equilibrium is not efficient because there is a marginal external benefit of $6 when 30 million gallons are sold per year. At a $15 price, the marginal external benefit is zero, and the market equilibrium is therefore efficient. 3. a.

The cost of meeting the standards is obtained by multiplying cost per ton for each plant and summing the results, which gives $220,000 per year.

b. The least-cost method would be to have Plant 5 reduce its emissions by 500 tons per year, which would cost only $100,000 per year. 4. At a $450 per ton charge, Plants 4 and 5 would cut back emissions at a total cost of $60,000. Plants 1, 2, and 3 would find it cheaper to pay the $450 fee, rather than cut back emissions. The total revenue generated by the purchase of the pollution rights by these firms for the 300-ton reduction in annual emissions would therefore be $135,000. 5. The efficient amount of pollution abatement occurs at the point at which the marginal social cost of abatement is equal to its marginal social benefit. Because the marginal social cost rises while the marginal social benefit declines, the efficient amount of abatement is likely to be greater than zero but less than 100 percent. In practice it is difficult to determine the efficient level of pollution abatement because of difficulty in assessing the costs and benefits of abating pollution and the way they vary at the margin as more abatement is achieved.

TRUE /FALSE QUESTIONS 1. If a negative externality exists for sales of gasoline in a competitive market, more than the efficient amount of gasoline will be sold per year. (T) 2. If the marginal external cost of pollution increases with the annual output of polluting goods, then the total external cost will increase at a constant rate with annual output. (F) 3. When a positive externality exists, benefits to third parties other than the buyers and sellers of a good will result from market exchange of the good. (T) 4. The marginal external benefit of the sale of smoke detectors in a city declines with annual output. The total external benefit of smoke detectors will therefore eventually become zero. (F) 5. When a negative externality exists, the marginal social cost of annual output sold in a competitive market will exceed the marginal social benefit of that output in equilibrium. (T) 6. If a negative externality is associated with the sale of wood stoves, then the marginal private cost of those stoves is less than their marginal social cost. (T) 7. If a positive externality is associated with college enrollment, then when college instruction is provided in a competitive market, the marginal social benefit of enrollment will exceed its marginal social cost in equilibrium. (T) 8. At the current level of annual supply of inoculations against polio, the marginal external benefit of an inoculation is zero. To achieve efficiency, a corrective subsidy must be provided to those being inoculated. (F) 9. To internalize an externality, a corrective tax must be set equal to the marginal external cost. (T) 10. According to the Coase theorem, corrective taxes are necessary to internalize negative externalities when the transactions costs of exchanging property rights to use resources are zero. (F) 11. The efficient amount of pollution abatement is likely to be 100 percent. (F) 12. Pollution rights can be used to price the right to emit pollutants and to provide incentives to reduce emissions by profit-maximizing firms. (T) 13. Emissions standards allow businesses to emit waste at zero cost until the limits set by the standards are reached. (T) 14. The market for sulfur dioxide allowance trading has lowered the cost of achieving a given reduction in sulfur dioxide emissions by electric power-generating plants. (T) 15. Command-and-control regulation to reduce emissions is likely to be a less costly way of reducing a given amount of emissions than tradeable emissions permits. (F) 16. When negative externalities exist, perfectly competitive markets produce less than the efficient output. (F) 17.

A toll road used to subsidize public transportation in an effort to reduce pollution is an example of a corrective tax. (T)

18.

Assuming no externalities and a competitive environment, the marginal private cost is equal to the marginal social cost. (T)

22 | Part One | The Economic Basis of Government Activity

19.

Assuming a negative externality, the price of a good will be lower than if the price was set in a competitive environment without an externality. (F)

MULTIPLE CHOICE QUESTIONS 1. A negative externality results from the sale of firewood in competitive markets. It then follows that the marginal private: a. cost of firewood is less than its marginal social cost. b. cost of firewood exceeds its marginal social cost. c. benefit of firewood is less than its marginal social benefit. d. benefit of firewood exceeds its marginal social benefit. 2. If a negative externality prevails in a competitive market for air travel, then: a. more than the efficient amount of annual air travel will be consumed in equilibrium. b. less than the efficient amount of annual air travel will be consumed in equilibrium. c. the marginal social cost of air travel will exceed its marginal social benefit in equilibrium. d. both (a) and (c) are correct 3. A positive externality results from the purchase of smoke detectors. If smoke detectors are sold in a competitive market, a. the marginal social benefit of smoke detectors is less than the marginal private benefit received by any consumer. b. the marginal social benefit will exceed the marginal private benefit received by any consumer. c. in equilibrium the marginal social cost of smoke detectors will equal the marginal social benefit. d. in equilibrium the marginal social benefit of smoke detectors is zero. 4. The marginal external cost associated with air pollution increases with the annual output of a polluting industry. At the current competitive equilibrium level of output per year, the marginal external cost is $10 per unit of output. To achieve efficiency, a corrective a. tax of $10 per unit of output is required. b. tax of more than $10 per unit of output is required. c. tax of less than $10 per unit of output is required. d. subsidy of $10 per unit of output is required. 5. The marginal external cost associated with paper production is constant at $10 per ton per year. The competitive market equilibrium for paper production is currently 10 million tons per year. A corrective tax on paper production will: a. collect $100 million annually. b. collect more than $100 million annually. c. collect less than $100 million annually. d. reduce annual damages to those other than buyers and sellers of paper to zero. 6. The marginal external cost per unit of effluent discharged into a river by a perfectly competitive chemical industry is currently estimated to be $50 per ton per year. Which of the following statements is true? a. Efficiency can be achieved with a $50 per ton annual effluent charge. b. At the competitive equilibrium output, the marginal social benefit of discharging effluent is $50. c. Efficiency can be achieved by banning discharge of effluent. d. At the efficient output, the marginal social benefit of discharging effluent will be zero. © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

7. Electric power is produced by an unregulated monopoly in a certain region. The monopolistic electric power company’s production of electricity results in $10 per kilowatt hour of pollution damage to parties other than the buyers of electricity in the region. To achieve efficiency, a. a $10 per kilowatt hour corrective tax is required. b. more than $10 per kilowatt hour corrective tax is required. c. a $10 corrective subsidy is required. d. less than $10 per kilowatt hour corrective tax is required. 8. The competitive market equilibrium price of sanitation services in a small town with no governmentsupplied sanitation services is $2 per trash pickup. There is a $1 marginal external benefit associated with each trash pickup. The elasticity of supply of trash pickups is infinite in the long run, implying a horizontal supply curve. To achieve the efficient output of sanitation services, a corrective a. subsidy must increase the price received by suppliers to $3 per pickup. b. subsidy must decrease the price paid by consumers of sanitation services to $1 per pickup. c. tax of $1 per pickup is required. d. subsidy must increase the price paid by buyers to $3 per pickup. 9. The current competitive market price of fish is $3 per pound. A chemical producer emits effluent into a lake used by a commercial fishing firm. Each ton of chemical output causes a 20-pound reduction in the annual catch of the fishing firm. Assuming that transactions costs are zero and the chemical firm has the legal right to dump effluent into the lake, a. the fishing firm would be willing to pay up to $60 per ton of chemicals per year to induce the chemical firm to reduce chemical output. b. the fishing firm would be willing to pay up to $3 per ton of chemicals per year to induce the chemical firm to reduce chemical output. c. the chemical firm would never consider the damage caused by its effluent. d. government intervention is required to achieve efficiency. 10. According to the Coase theorem, externalities can be internalized when transactions costs are zero through: a. corrective taxes and subsidies. b. effluent fees. c. assigning property rights to resource use but outlawing their exchange. d. assignment of property rights to use resources and allowing free exchange of assigned property rights. 11. Which of the following is true if a negative externality is associated with the sale of gasoline? a. Third parties other than the buyers and sellers of gasoline receive benefits. b. Third parties other than the buyers and sellers of gasoline bear costs. c. The marginal social cost of gasoline exceeds its marginal private cost. d. Both (b) and (c) are correct. 12. If a positive externality prevails in the market for smoke detectors, then when the market is in equilibrium, a. the marginal social benefit of smoke detectors exceeds the marginal social cost. b. the marginal social cost of smoke detectors exceeds the marginal social benefit. c. the marginal social cost of smoke detectors is equal to the marginal social benefit. d. more than the efficient amount of smoke detectors is sold. © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

24 | Part One | The Economic Basis of Government Activity

13. Regulations require that emissions of carbon monoxide be limited to 1,000 tons per 100 square miles for all regions of the nation. If the marginal external cost of the emissions varies among regions in the nation, then the regulations will: a. achieve the efficient amount of pollution abatement. b. achieve more than the efficient amount of pollution abatement. c. achieve less than the efficient amount of pollution abatement. d. be likely to achieve more than the efficient amount of abatement in some regions but less than the efficient amount in others. 14. If the marginal costs of reducing emissions varies among regions, then regulations requiring all regions in a nation to reduce emissions by the same amount will achieve: a. the efficient amount of pollution abatement. b. more than the efficient amount of pollution abatement. c. less than the efficient amount of pollution abatement. d. more than the efficient amount of pollution abatement in some regions but less than the efficient amount in other regions. 15. Which of the following is true about command-and-control regulation that allows businesses to emit pollutants up to a certain point and bans emissions after that limit is reached? a. They are equivalent to emissions charges. b. They make firms pay the marginal cost of the damages done by their emissions, no matter what the level. c. They allow firms to emit some pollutants at zero charge. d. They are likely to minimize the cost of achieving any given reduction in emissions. 16. Assuming a product can be manufactured competitively without any externalities at an efficient quantity of 1,000 units and an efficient price of $100.00 per unit, what efficient quantity-price combination would be consistent with a negative externality? a. 1,000 units, $95.00 per unit price. b. 950 units, $102.00 per unit price. c. 900 units, $90.00 per unit price. d. 1,100 units, $105 per unit price. 17. The effect of a negative externality is similar to a: a. supply curve (marginal social cost) shifting to the left. b. supply curve (marginal social benefit) shifting to the right. c. demand curve (marginal social cost) shifting to the left. d. demand curve (marginal social benefit) shifting to the right. 18. Assuming a product can be manufactured competitively without any externalities at an efficient quantity of 1,500 units and an efficient price of $50.00 per unit, what efficient quantity-price combination would be consistent with a positive externality? a. 1,500 units, $60.00 per unit price. b. 1,300 units, $45.00 per unit price. c. 1,600 units, $40.00 per unit price. d. 1,700 units, $56.00 per unit price.

19. The effect of a positive externality is similar to a: a. supply curve (marginal social cost) shifting to the left. b. supply curve (marginal social benefit) shifting to the right. c. demand curve (marginal social cost) shifting to the left. d. demand curve (marginal social benefit) shifting to the right. 20. Assuming a product can be manufactured competitively without any externalities at an efficient quantity of 500 units and an efficient price of $150.00 per unit, what efficient quantity-price net subsidy combination would be consistent with a corrective subsidy for a positive externality? a. 500 units, $150.00 per unit price net subsidy. b. 300 units, $120.00 per unit price net subsidy. c. 600 units, $160.00 per unit price net subsidy. d. 700 units, $100.00 per unit price net subsidy.

ESSAY QUESTIONS 1. The marginal external cost associated with the emissions of sulfur dioxide is estimated to be $30 per pound of this chemical per year. Assume that each ton of steel produced per year results in 5 pounds of sulfur dioxide emissions. Suppose that the supply of steel is infinitely elastic at a price of $500 per ton. The current equilibrium output of steel produced by a competitive industry is 10,000 tons. a.

Show how a corrective tax can be used to achieve efficiency. Predict the impact of the tax on the equilibrium price and quantity of steel. Explain how steel companies will react to the tax. Indicate the amount of tax revenue that will be collected.

b. Discuss the political support for the tax. In your discussion, show the net gain in well-being possible from the tax and indicate which groups will gain and which groups will lose as a result of its imposition. 2. How would you select an appropriate policy to internalize negative externalities associated with pollution? In your answer indicate the information required to internalize a negative externality. How do the transactions costs of exchanging the right to pollute affect the choice of policy? Explain why there would be no negative externalities associated with pollution if the transactions costs of establishing and exchanging the rights to pollute (or to have a pollution-free environment) were zero.

26 | Part One | The Economic Basis of Government Activity

CHAPTER 4

Public Goods

INSTRUCTIONAL OBJECTIVES Chapter 4 discusses the properties of public goods. The concept of a pure public good is developed and contrasted with the concept of a pure private good. Many examples are given to help students understand the important differences between these two types of goods. In addition, students are shown the important distinction between the demand curves for pure public goods and pure private goods. Throughout the chapter, the theory of externalities is applied to emphasize the fact that market provision of pure public goods is unlikely to be an efficient alternative. Intermediate cases between pure public goods and pure private goods are also analyzed. Congestible public goods and price-excludable public goods are explicitly considered along with many examples of other intermediate cases. The goal here is to make students aware of the fact that it is difficult to generalize about actual arrangements used to provide public goods. An important goal of this chapter is to derive the efficiency conditions for a pure public good. In deriving these conditions, I emphasize the external benefit associated with the provision of pure public goods. In this way, students see that consumption of a unit of a pure public good by any one person results in external benefits to all others. A pure public good, therefore, requires the annual output up to the point at which the sum of the marginal benefits of all consumers equals the marginal costs of making the good available. The sum of the individual marginal benefits is the marginal social benefit of each unit of the pure public good. An extended numerical example dealing with the provision of security protection in a small community is used to derive the efficiency conditions and to illustrate a Lindahl equilibrium. The model of cooperative supply for a pure public good shows the student how the efficient output of a pure public good could be provided in a small community without government. It sets the stage for analysis of the free-rider problem and provides a basis for understanding why government supply with compulsory taxation emerges in large groups.

CHANGES IN THIS EDITION 

The discussion of national defense has been updated to include current data.

CHAPTER OUTLINE Characteristics of Public Goods Public Policy Perspective: National Defense Spending in the United States Provision of Private Goods and Public Goods: Markets and Government The Demand for a Pure Public Good Efficient Output of a Pure Public Good © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Global Perspective: The Marginal Cost of the Persian Gulf War to the United States and How International Cost Sharing Financed It The Free-Rider Problem

MAJOR POINTS AND LECTURE SUGGESTIONS 1. Students easily catch on to the distinctions between pure public goods and pure private goods. Television programming is an excellent example of a good that is nonrival in consumption. An improvement in environmental quality through a reduction in air pollution provides a good example of a good whose benefits are nonexclusive. You can also point out that the transactions costs of excluding consumers depends on current technology. Improvements in technology can reduce the transactions costs of pricing goods and thereby subject them to exclusion. A pure public good is both nonrival and nonpriceable. 2. I believe that it is important to relate the theory of public goods to the theory of externalities. This helps students understand why pure public goods are unlikely to be efficiently supplied through markets. A pure public good is one whose market exchange would result in positive externalities to all citizens of a nation. 3. I also like to emphasize that the nonrival characteristic of a pure public good implies that the marginal cost of accommodating an additional consumer is zero for a given quantity of the good. Use Figure 4.1 in the text to make the distinction between the marginal cost of producing another unit of the good and the marginal cost of allowing another consumer to enjoy a given quantity of the good. 4. Students like the bread versus heat example. To make the point more strongly, I usually adjust the thermostat level in the classroom to emphasize that there is no way I can change the temperature for myself without changing it for everyone else in the room. 5. When discussing the difference between demand curves for pure public and pure private goods, point out that for private goods consumers have freedom to move along the quantity axis, given price. For the pure public good, consumers must move along the quantity axis together. 6. Cooperative supply of pure public goods requires a means of allowing consumers to express their valuation of additional units of pure public goods. The marginal social benefit of any given quantity of a pure public good is the sum of the individual marginal benefits of all consumers. To achieve efficiency, this must equal the marginal social cost of the good. 7. The security guard example is quite realistic. Some students may in fact live in condominiums where the problem of providing security must be confronted and financed. I recommend going through the example in class. I have been very careful in the text to point out that a person’s tax is stated as a certain amount per unit of the pure public good. Other texts are often sloppy on this point, and it leads to endless student confusion. The total tax bill in equilibrium for each member of the community is their tax per unit multiplied by the number of units supplied. The numerical example makes this clear. 8. Students readily see that the Lindahl equilibrium is efficient. The Lindahl prices are tax shares per unit of the public good equal to each person’s marginal benefit at the output for which MSB = MSC. 9. The free-rider problem is intuitively obvious to students. Perhaps the best example to illustrate this is the provision of public television and radio programming. It is clear that many beneficiaries of these services choose not to contribute to financing the programming. Nonetheless, many viewers © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

28 | Part One | The Economic Basis of Government Activity

and listeners do contribute. The analysis in the chapter alerts students to the fact that the free-rider problem can be overcome. You should, however, point out to students that the free-rider problem becomes more acute in large groups. This is because each participant realizes that withholding his contribution is unlikely to have a significant effect on total output. As all reason this way, the probability of non-voluntary contributions becomes all the greater. Discussion of the free-rider problem sets the stage for the analysis of compulsory taxation and the role of government in supplying pure public goods. 10. The discussion of goods that fall between the extremes of pure public and pure private goods is very pragmatic. The discussion and accompanying table alert students to the fact that in the real world actual provision of goods by alternative means must be evaluated on an ad hoc basis. In class emphasize the characteristics of congestible and price-excludable public goods and point out the implications for efficiency.

ANSWERS TO TEXT PROBLEMS 1. a. b. c. d.

10 $2,000 zero 2

2. The sum of the marginal benefits must equal the marginal cost in the Lindahl equilibrium. When MC is increasing, MC > AC for any given quantity supplied. At the efficient level of output, the sum of the contributions will be greater than AC. Because contributions per unit exceed cost per unit, the total revenue collected will exceed the cost of making the good available, which is AC(Q). Thus, there is a budget surplus. 3. At less than 50,000 vehicles per hour, no toll is required to achieve efficiency. When traffic rises above 50,000 vehicles per hour, the toll should be set at the marginal congestion cost. 4. a.

The demand curve shows how the sum of the marginal benefits of all consumers varies with the number of concerts. Number of Concerts 1 2 3 4

MB $975 $700 $425 $250

b. At a marginal cost of $1,000, it is efficient not to hold any outdoor rock concerts at all. At a marginal cost of $425, the efficient number of concerts per summer is three. 5. The efficient number of concerts would be four; John would be charged $75, and Mary would be charged $50, while Loren would pay $25 for each concert.

TRUE /FALSE QUESTIONS 1. Bread is an example of a good that is nonrival in consumption. (F) 2. A pure public good is one for which it is easy to exclude consumers from benefits if they refuse to pay. (F) 3. The marginal social cost of producing another unit of a pure public good will always be positive. (T) © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

4. To obtain a demand curve for a pure public good, the marginal benefit of each consumer must be summed for each possible quantity produced per time period. (T) 5. If the efficient amount of a pure public good is produced, each person consumes it up to the point at which his or her marginal benefit equals the marginal social cost of the good. (F) 6. In a Lindahl equilibrium, each consumer of a pure public good consumes the same quantity and pays a tax share per unit of the good equal to his or her marginal benefit. (T) 7. If the marginal social cost of a pure public good exceeds its marginal social benefit, additional units of the good can still be financed by voluntary contributions. (F) 8. The free-rider problem is less acute in small groups than it is in large groups. (T) 9. A congestible public good is one for which the marginal cost of allowing an additional consumer to enjoy the benefits of a given quantity is always zero. (F) 10. Television programming is a good example of a price-excludable public good. (T) 11. It is possible to price a pure public good and sell it by the unit. (F) 12. The demand curve for a pure public good is obtained by adding the quantities demanded by each individual consumer at each possible price. (F) 13. A Lindahl equilibrium usually has each participant paying the same tax share per unit of a public good even though their marginal benefit of that unit varies. (F) 14. Internet service is an example of a price-excludable public good. (T) 15. Clubs are a means of providing congestible public goods through markets. (T) 16.

A common way to fund a public good is through a government that raises funds through taxation. (T)

17.

Private education is an example of a price-excludable public good. (T)

18.

A congestible good has no limits on how much it can be consumed. (F)

MULTIPLE CHOICE QUESTIONS 1. A pure public good is: a. one that can easily be sold by the unit. b. one that is nonrival in consumption. c. one whose benefits are not subject to exclusion. d. Both (b) and (c) are correct. 2. The marginal cost of providing a certain quantity of a pure public good to an additional consumer after it is provided to any one consumer is: a. zero. b. positive and increasing. c. positive and decreasing. d. positive and constant.

30 | Part One | The Economic Basis of Government Activity

3. The nonrival property of pure public goods implies that the: a. benefits enjoyed by existing consumers decline as more consumers enjoy a given quantity of the good. b. benefits enjoyed by existing consumers are unaffected as more consumers enjoy a given quantity of the good. c. good cannot be priced. d. marginal cost of producing the good is zero. 4. The demand curve for a pure public good is: a. a horizontal line. b. obtained by adding the quantities individual consumers would purchase at each possible price. c. obtained by adding the marginal benefit obtained by each consumer at each possible quantity. d. the marginal cost curve for the pure public good. 5. The efficient output of a pure public good is achieved at the point at which: a. the marginal benefit obtained by each consumer equals the marginal social cost of producing the good. b. the sum of the marginal benefits of all consumers equals the marginal social cost of producing the good. c. the marginal benefit of each consumer equals zero. d. the marginal social cost of producing the good is zero. e. Both (c) and (d) are correct. 6. The monthly rental rate for a satellite dish antenna is $200. The maximum marginal benefit that any resident of a condominium community will obtain per month from the antenna is $50. There are 100 residents in the community, none of whom values the antenna at less than $25 per month. Assuming that the antenna is a pure public good for residents of the community, a. each resident of the community will rent his own antenna. b. it is inefficient for the community to rent an antenna. c. it is efficient for the members of the community to rent an antenna for their common use. d. it is efficient for each resident to rent his own antenna. 7. In a Lindahl equilibrium, a. each consumer purchases a pure public good up to the point at which his or her marginal benefit equals the marginal social cost of the good. b. each person pays a tax per unit of the pure public good equal to his or her marginal benefit. c. the sum of the marginal benefits of all consumers equals the marginal social cost of the good. d. Both (b) and (c) are correct. 8. The free-rider problem: a. becomes more serious as the number of persons involved in voluntarily financing a pure public good decreases. b. becomes more serious as the number of persons involved in voluntarily financing a pure public good increases. c. is independent of the number of persons involved in a scheme to voluntarily finance a pure public good. d. does not prevent voluntary cooperation from efficiently providing pure public goods.

9. The marginal cost of making a given quantity of a congestible public good available to more consumers is: a. always zero. b. positive and increasing. c. positive and decreasing. d. zero at first but eventually becomes positive and increasing. 10. Cable TV programming is an example of a: a. congestible public good. b. price-excludable public good. c. pure public good. d. pure private good. 11. A major distinction between pure public goods and pure private goods is that: a. pure private goods can easily be priced and sold in markets. b. pure public goods can easily be divided into units. c. pure public goods can only be collectively consumed. d. Both (a) and (c) are correct. 12. The principle of nonexclusion for pure public goods means that the benefits of the good: a. are shared. b. can be priced. c. cannot be withheld from consumers even if they refuse to pay. d. are not reduced to any one consumer when a given quantity is consumed by another. 13. Which of the following is true in a Lindahl equilibrium for cooperative supply of a pure public good? a. The sum of the tax shares per unit paid by each consumer is equal to the marginal social cost of the public good. b. The sum of the tax shares per unit paid by each consumer is equal to the marginal social benefit of the good. c. The sum of the tax shares per unit paid by each consumer is maximized. d. Both (a) and (b) are correct. 14. Which of the following is a good example of a congestible public good? a. TV programming b. a road c. a loaf of bread d. homeland security 15. Education is: a. a pure public good. b. a pure private good. c. a good that has characteristics of both public goods and private goods. d. not subject to the exclusion principle.

32 | Part One | The Economic Basis of Government Activity

16. An example of an undesirable public good (or public ―bad‖) is: a. government. b. private trash hauling. c. poor air quality. d. private property. 17. Public transportation is: a. a congestible good. b. a pure private good. c. a good without limits to the number of consumers who desire to use it. d. not subject to the exclusion principle. 18. A baseball field is: a. a pure public good. b. a pure private good. c. a good that has characteristics of both public goods and private goods. d. not subject to the exclusion principle. 19. A means of creating a price-excludable public good is: a. allowing food and beverages when entering. b. requiring costly tickets. c. to fund through taxation. d. requiring identification. 20. A free concert in a public arena is: a. a non-congestible public good. b. a good that can be consumed by all. c. a private good. d. subject to consumption limits.

ESSAY QUESTIONS 1. Summer open-air concerts are a pure public good in a small town. The average cost of each concert per night is constant at $500. Explain why it would be inefficient to require each resident of a community to hire their own orchestra at the $500 rate for each concert. Assuming that the marginal benefit of the first concert is $25 for each of the 1,000 residents of the community, prove that it will be efficient to have more than one concert per summer. If the concert were financed with voluntary contributions, what conditions would have to prevail to achieve the efficient number of concerts per summer? 2. The property of nonexclusion of a pure public good depends on the technology of pricing. Changes in technology can make it possible to price goods and services that were previously unpriceable. Suppose a new electronic device is available that can monitor the miles traveled by vehicles on public roads. The device would be required on all vehicles and would make it feasible to price each mile traveled at any rate. How would you determine the price of road services per mile to achieve efficient road utilization?

CHAPTER 5

Public Choice and the Political Process

INSTRUCTIONAL OBJECTIVES Public choice theory and economic analysis of the political process are the subjects of this chapter. The concept of political equilibrium is introduced as a means of providing the student a way of comparing market equilibrium with public sector equilibrium. Positive analysis is used to predict the outcome of political interaction under majority rule, while normative analysis is used to explore efficiency aspects of political interaction. At the outset of the chapter, the student is made aware of the simplifying assumptions to be used. The dependent variable is the output of a pure public good over a given time period. It is also assumed that each voter knows his or her share of the cost per unit of the public good. These simplifications allow the determination of the conditions required for political equilibrium. A major goal of the chapter is to make clear the differences between political and market equilibrium. To do so, an analogy is made between the tax shares, t, of citizens for public goods and the prices of market goods. It is then a simple matter to point out that a person’s most-preferred political outcome corresponds to the output for which MB = t. The political equilibrium itself depends on the public choice rule, information available to voters, the distribution of tax shares among voters, and the distribution of benefits of the public good among voters. The median voter model is emphasized in the chapter, and its implications for the behavior of political candidates is highlighted. The possibility of nonexistence of political equilibrium due to multiplepeaked preferences is also explored. There is, as well, a discussion of the likelihood of multiple-peaked preferences and Arrow’s impossibility theorem. The chapter also integrates important issues concerning the political process with the theory of public choice. These issues include (1) incentives to vote and the impact of nonvoting on political equilibrium, (2) political externalities and political transactions costs, (3) logrolling, and (4) the impact of special interest groups and bureaucracy on political equilibrium. The logrolling model shows how vote trading and the pairing of issues on the ballot can lead to losses in efficiency.

CHANGES IN THIS EDITION  

Information on voter turnout has been updated to include the 2016 presidential elections and the 2018 congressional elections. The Determinants of Political Equilibrium section was updated to add the 2016 election discussion.

34 | Part One | The Economic Basis of Government Activity

CHAPTER OUTLINE The Supply of Public Goods through Political Institutions: The Concept of Political Equilibrium A Model of Political Equilibrium under Majority Rule Uniqueness and Cycling of Outcomes under Majority Rule The Political Process Public Policy Perspective: Public Choice in U.S. Cities: Do Political Institutions Matter? Political Parties and Political Equilibrium Voting on More Than One Issue at a Time: Logrolling Public Policy Perspective: State Government Spending: Does the Size of the Legislature Matter? Special Interest Groups and Their Impact on Political Equilibrium Bureaucracy and the Supply of Public Output

MAJOR POINTS AND LECTURE SUGGESTIONS 1. Make sure students are aware of the simplifying assumptions made in most models of political equilibrium. The issue under consideration is single-dimensional. In most cases the variable is the quantity of a pure public good to supply per year. Voters are assumed to know the tax per unit of the public good before deciding how to vote. 2. Students are very receptive to the definition of a political equilibrium as an agreement on the level of periodic supply of a pure public good, given the collective choice rule and the distribution of tax shares among voters. 3. Emphasize that a person’s most-preferred political outcome is the one for which that person’s tax share equals his or her marginal benefit from the public good: ti = MBi. In class point out that this is analogous to P = MBi for a private good. However, each consumer can adjust consumption to achieve the latter condition in a market. Political supply of a pure public good under majority rule can result in some voters not achieving the former condition. Point out that any voter’s most preferred political outcome depends both on that person’s tax share and preferences. 4. The basic point you want to get across in class is that political equilibrium depends on certain important economic variables, given the collective choice rule and voter preferences. These include the distribution of marginal tax shares, the average and marginal cost of the public good, and the distribution of benefits of the public good. Note that throughout the chapter the marginal tax rate is assumed to equal the average tax rate for all voters. In addition, for simplicity, MC = AC for the public good. 5. The first model of political equilibrium in the chapter assumes that all voters have equal tax shares. This is the model developed by Bowen. The simple example in the text deals with the supply of security protection by seven members of a condominium community. Table 5.1 in the text shows the tally sheet for each successive election to increase security protection. Students must understand that voters vote in favor of hiring additional security guards as long as the marginal benefit of each extra guard does not fall short of the extra tax they must incur to finance that guard.

6. The median voter is defined as the one whose most-preferred outcome is the median of the mostpreferred outcome of all voters. Many students are easily confused because they think that the median voter is a particular person. My definition makes it clear that the identity of the median voter can change over time. For example, if all voters have the same most-preferred outcome, then any one of them can be regarded as the median voter. In fact, under those circumstances, the political equilibrium under majority rule will be identical to the political equilibrium under unanimous consent. Point out that the greater the dispersion of most-preferred outcomes from the median, the greater the dissatisfaction with political outcomes under majority rule. 7. The problem of absence of political equilibrium when multiple-peaked preferences exist is hard to get across to students. I use a simple numerical example that shows that when one out of three voters has multiple-peaked preferences, there is no political equilibrium. Point out to students that this means that there is no one alternative that when placed on the ballot will dominate others. Each winner can be paired with some other alternative and lose. This is the phenomenon of cycling. The students find the fireworks display example amusing. 8. Single-peaked preferences imply that there is one alternative that the voter prefers to all others and that he or she is made worse off if either more or less of the most-preferred output is supplied. 9. When all voters have single-peaked preferences, there can be no cycling. In the example, two fireworks displays per year is the political equilibrium. This means that whenever it appears on the ballot, it will defeat the alternative with which it is paired. Point out that the political equilibrium under majority rule in this case is always the median most-preferred outcome. This is the median peak of all the net benefit functions. 10. Most texts do not have a discussion of the likelihood of multiple-peaked preferences. I point out that multiple-peaked preferences are inconsistent with declining marginal benefit of a good. However, I also give examples of cases for which multiple-peaked preferences are reasonable. The first case deals with a government good (schooling) that has a market substitute. The second one deals with the Vietnam war. Students find these examples interesting. 11. Voter turnouts are commonly well below 100 percent in the United States. The cost of voting is positive, while the expected benefit to a particular voter is close to zero. The text also points out that the incentive to vote depends on the closeness of alternatives available to voters and the extent to which the voters most-preferred outcome approximates those on the ballot. 12. Although each person has only one vote in a democracy, there is always the incentive to expend resources to influence the votes of others. This provides the basis for political activity and contributions to political candidates or parties. 13. Nonvoting by citizens has the potential to affect the political equilibrium under majority rule. This is because the median most-preferred outcome of all those voting can differ from the median mostpreferred outcome of all citizens, when some citizens do not vote. However, when as many citizens on the left as on the right do not vote (i.e., the pattern of nonvoting is symmetric about the mean for a single dimensional issue), the median most-preferred outcomes of all voters and citizens will be identical. 14. The logrolling analysis shows how the pairing of two issues, neither of which can pass by itself under majority rule, can result in passage of both. The key to getting students to understand logrolling is to point out that the net gains to voters from passage of one issue must exceed the net loss from passage of the other. If there were symmetry between gains and losses on issues, logrolling would not change the political equilibrium.

36 | Part One | The Economic Basis of Government Activity

15. Under logrolling there is either explicit vote trading or implicit collusion to get issues paired on the ballot. Figure 5.8 in the text is based on a simple numerical example to show how logrolling gains passage of two issues—the supply of one fireworks display and the hiring of one security guard per week—even though neither can pass on its own. I have used this example in class many times, and students catch on to the point easily. They also readily see the possible losses in efficiency caused by logrolling. 16. Becker’s work on special-interest groups is timely and relevant. Two important points should be emphasized. First, successful special-interest groups are likely to be small relative to the portion of the population that finances its subsidies. This is because the cost of the subsidy per taxpayer will be smaller and more easily hidden when the total subsidy is small. Second, the limit to the process is the losses in efficiency that occur from the subsidies and the taxes that finance them. When persons are members of more than one pressure group, improved information could reduce the amount of subsidies that can be successfully passed. 17. Students find the assumption that bureaucrats try to maximize the size of their budgets a reasonable one. The implications for efficiency are made clear in Figure 5.9 in the text. The bureaucrat’s mostpreferred output is the one for which TSB = TSC. The bureaucrat tries to convince its funding source that extra output is warranted as long as TSB > TSC. The efficient output level, however, is less than this because it corresponds to the annual output for which MSB = MSC. It is essential to point out to students that this does not imply that the bureaucrat is successful in achieving its objective. Bureaus must compete for funds. A good system of budgeting would serve to make sure that the output of any bureau does not exceed its efficient level. The main point is that bureaucrats do have incentives to produce more than the efficient output. This incentive must be constrained appropriately to achieve efficiency.

ANSWERS TO TEXT PROBLEMS 1. a. If each resident had to buy landscaping services as a private good in the market, no gardeners would be hired because the marginal cost of $350 for the first gardeners exceeds the marginal benefit of $100 for any single resident. The arrangement is inefficient because the sum of the marginal benefits of the first gardener is $700, which exceeds the marginal cost of $350. b. The political equilibrium under majority rule will be three gardeners. At the $50 per voter tax share, given that all voters have identical marginal benefit schedules, the sum of the marginal benefits will be $350, which is equal to the marginal cost of gardening services. In fact, if hiring three gardeners is proposed, it would be the political equilibrium not only under majority rule, but also under unanimous consent, because all seven residents will vote in favor of it. There is no difference between the political equilibrium under majority rule and the Lindahl equilibrium in this case. 2. The political equilibrium under majority rule is two gardeners. This differs from the efficient quantity of three, which would result under a Lindahl equilibrium. Under the Lindahl equilibrium, each voter would pay a tax share per unit of the public good equal to their marginal benefit corresponding to three gardeners. Total taxes collected from the five residents would be $1,050 per week, which exactly covers the cost of the three gardeners each week. 3. A $60 transaction cost for Voters A and C would have to be subtracted from their marginal benefit. After the subtraction, both A and C would vote against one security guard and fireworks display per week because their net marginal benefit of only $190 each would be less than their $200 tax share. Similarly, Voter A would vote against the combined public good if his marginal benefit from the first security guard were only $150, because this would be below the $200 tax. © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

4. The median most-preferred outcome would shift to the liberal side if more conservatives than liberals chose not to vote. Assume that liberals want more government spending than conservatives; this would mean more public goods. 5. The marginal costs will seem lower than the actual marginal cost, and this will result in more than the efficient output.

TRUE /FALSE QUESTIONS 1. A political equilibrium for a pure public good is generally independent of the collective choice rule used. (F) 2. A voter’s most-preferred political outcome will change if, other things being equal, that person’s tax share per unit of the public good is changed. (T) 3. A proposal is put forward to increase the number of police officers. You estimate that your marginal benefit from police protection just equals your tax per police officer at the number of officers that would constitute the police force if the proposal passes. You will therefore vote in favor of the proposal. (T) 4. If all voters have the identical most-preferred political outcome, given their tax shares, then the political equilibrium under majority rule will be identical to the political equilibrium under unanimous consent. (T) 5. The median voter is the one whose most-preferred political outcome is the median of the mostpreferred outcome of all those voting. (T) 6. If all voters have single-peaked preferences, a political equilibrium will not be possible under majority rule. (F) 7. A person with multiple-peaked preferences is always made worse off as the quantity of a pure public good is increased, or decreased, once he or she attains his or her most-preferred political outcome. (F) 8. Logrolling always succeeds in passing two paired issues that could not pass if voted on separately. (F) 9. A bureaucrat who seeks to maximize the annual size of his budget each year will propose annual output levels corresponding to the amount for which MSB = MSC. (F) 10. Political transactions costs are likely to be greater under unanimous consent than under majority rule. (T) 11. Political externalities are likely to be negligible when collective choices are made under majority rule. (F) 12. Unanimous consent is a collective choice rule that will protect the rights of minorities. (T) 13. A person for whom the marginal benefit of a public good declines as more is made available has single-peaked preferences. (T) 14. Cycling can occur in elections under majority rule if some voters have multiple-peaked preferences. (T) 15. Special-interest groups are more likely to gain income through the political process if they are a large percentage of the population. (F) © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

38 | Part One | The Economic Basis of Government Activity

16.

A rational person’s most-preferred political outcome is when the cost of the quantity of government-supplied goods is below the marginal benefit. (F)

17.

A budget-maximizing bureaucrat seeks funding levels where the total social cost equals the total social benefit. (T)

18.

Logrolling can allow more than one issue of minority interest to be passed. (T)

MULTIPLE CHOICE QUESTIONS 1. A community currently hires 10 security guards per week to patrol their neighborhood. Each security guard costs $300 per week. Assuming that the tax-sharing arrangement agreed to results in each of 300 voters paying the same tax share, each voter pays a weekly tax bill of: a. $1. b. $3. c. $10. d. $30. 2. A small community currently taxes residents to provide monthly community concerts. Voter A currently pays a tax per concert equal to $50 per month. This voter receives a marginal benefit of $75 at the current political equilibrium number of concerts per month. Voter A: a. is the median voter. b. would be made better off if the number of monthly concerts were increased. c. would be made worse off if the number of monthly concerts were increased. d. has achieved his most-preferred political outcome for monthly concerts. 3. A proposal to build new roads in a small town is up for a vote. Voter B estimates that his marginal benefit of roads at the proposed new level would be $80 per year. This voter will vote against the proposal: a. no matter what her tax share. b. if her tax share is $80. c. if her tax share is less than $80. d. if her tax share exceeds $80. 4. Currently eight security guards patrol a condominium community each week. The number of guards has been determined by majority rule. Each voter pays a tax share of $50 per guard. If Voter M is the median voter, a. his marginal benefit from security guards is $50. b. his marginal benefit exceeds that of any other voter. c. the difference between his marginal benefit and $50 is at a maximum. d. he would be made better off if more security guards were hired per week. 5. If all voters have single-peaked preferences, then under majority rule: a. cycling of political outcomes can occur. b. a political equilibrium exists. c. the political equilibrium is the median most-preferred outcome. d. both (b) and (c) are correct.

6. If a person has multiple-peaked preferences for a pure public good, a. that person is always made worse off when moving away from his or her most-preferred political outcome. b. that person will become worse off at first, but then better off when moving away from his or her most-preferred political equilibrium. c. the marginal benefit of the pure public good always declines for that person as more is made available. d. both (b) and (c) are correct. 7. Implicit logrolling results when: a. any two issues are paired on a ballot. b. two voters succeed in pairing two issues on a ballot that can pass together but would fail individually. c. voters agree to trade votes on an issue. d. the pairing of two issues on a ballot allows the achievement of efficiency. 8. Voter A will normally vote in favor of one security guard per week because his marginal benefit is $125 and his tax share is $100 per week. Voter A receives zero marginal benefit from one concert a week and would vote against it. Voter B receives $125 marginal benefit from one concert per week but no marginal benefit from one security guard. One concert per week also will fail to gain a majority when put to the vote. Assuming that both Voter A and Voter B will pay $100 per week in tax for each concert and each security guard, a. they can both gain by engaging in logrolling on the two issues. b. pairing the issues on one ballot will result in both Voter A and Voter B voting in favor of the combined issue. c. pairing the issues on one ballot will result in both Voter A and Voter B voting against the combined issue. d. implicit logrolling will result in Voter A voting in favor of the combined issue but in Voter B voting against it. 9. A voter may choose not to vote in an election between two alternatives because: a. he or she is indifferent between the two alternatives. b. his or her probability of influencing the result is zero. c. his or her most-preferred alternative is far from the two offered on the ballot. d. all of these are correct. 10. If bureaucrats seek to maximize the size of their budgets, they will: a. seek to fund levels of services up to the point at which MSC = MSB. b. seek to fund levels of services for which TSB > TSC. c. seek to fund levels of services for which MSC > MSB. d. both (b) and (c) are correct. 11. The demand curve for a pure public good is: a. obtained by adding the quantity demanded at each possible price for all consumers. b. obtained by summing the marginal benefits of each consumer for each possible quantity. c. always upward sloping. d. always a flat line.

40 | Part One | The Economic Basis of Government Activity

12. A voter’s most-preferred political outcome will be that for which the: a. marginal benefit of a pure public good is equal to the voter’s tax share per unit. b. total benefit per unit of a pure public good is equal to the voter’s tax share per unit. c. difference between the marginal benefit of a pure public good and the voter’s tax share per unit is maximized. d. marginal benefit of a pure public good is equal to zero, no matter what the voter’s tax share per unit. 13. If all voters have single-peaked preferences for a pure public good, then the political equilibrium under majority rule: a. cannot be defined. b. is the median outcome. c. is the median most-preferred outcome of all voter’s voting. d. will not change if tax shares change. 14. Which of the following collective choice rules is likely to have the lowest political externalities? a. Two-thirds majority rule b. Simple majority rule c. Plurality rule d. Unanimous consent 15. Which of the following collective choice rules is likely to incur the highest political transactions costs? a. Two-thirds majority rule b. Simple majority rule c. Plurality rule d. Unanimous consent 16. If the marginal social benefit of one more unit of a good is 10 and the marginal social cost of one more unit of a good is 11, then: a. the output of the good is efficient. b. a bureaucrat can still increase the bureau’s budget. c. a bureaucrat can increase the bureau’s budget if the total social cost exceeds the total social benefit. d. a bureaucrat can increase the bureau’s budget if the total social cost is below the total social benefit. 17. The plurality rule is a: a. collective bargaining rule. b. rule that is guaranteed to have a majority decision. c. means of determining between only two possible outcomes. d. rule that cannot lead to a minority decision. 18. Arrow’s impossibility theorem states that a: a. unique political equilibrium for a public choice never exists. b. unique political equilibrium for a public choice cannot exist under majority rule. c. unique political equilibrium can exist if there is majority rule and multi-peaked preferences. d. unique political equilibrium for a public good cannot exist under unanimous consent. © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

19. Suppose tax shares are evenly distributed for a particular service at the amount of $100.00 per person. Which taxpayer suffers a political externality based on the taxpayer’s marginal benefit for the service? a. Taxpayer A has a marginal benefit of $100.00. b. Taxpayer B has a marginal benefit of $200.00. c. Taxpayer C has a marginal benefit of $90.00. d. Both (b) and (c) are correct. 20. A public choice is: a. free of any political interaction or process. b. by majority rule only. c. one made through political interaction of many people according to established rules. d. by unanimous consent only.

ESSAY QUESTIONS 1. Explain why all voters will have single-peaked preferences for a pure public good if the marginal benefit they receive from that good declines as more is made available per year. Explain how each voter decides whether to vote in favor of or against a proposal for a certain quantity of the pure public good to be made available per year. Assuming that tax shares are given, what can you say about the political equilibrium under majority rule? Show how an increase in the average cost of producing the pure public good will affect the political equilibrium. 2. a. What are the advantages and disadvantages of logrolling? How can logrolling for two pure public goods under majority rule prevent the attainment of efficient outcomes? b. How do government bureaus differ from private firms? Why is there good reason to believe that bureaucrats will seek to supply more than the efficient level of their output in any year? Use a graphic analysis to show the losses in efficiency that will result if a government bureau succeeds in maximizing its annual expenditures.

42 | Part One | The Economic Basis of Government Activity

CHAPTER 6

Cost-Benefit Analysis and Government Investments

INSTRUCTIONAL OBJECTIVES The main goals of the chapter are to introduce students to techniques of program budgeting and costbenefit analysis and to make it clear how these can be used to improve efficiency within government. The limitations of these techniques are also discussed. Some of the pitfalls of doing cost-benefit analysis are highlighted, and underlying theory is stressed. Many examples are provided in the chapter to highlight some of the pragmatic issues involved in doing budget and cost-benefit analysis. The chapter also discusses issues in government investment policy. An International View examines the return to government investment infrastructure in less-developed countries. A section of the chapter examines investment in infrastructure in the United States. There is also considerable analysis of human resource investments. A Public Policy Perspective provides a detailed analysis of costs and benefits of the Job Corps program in the United States.

CHANGES IN THIS EDITION 

The chapter is updated with data and discussion of infrastructure investments made by the government in 2018.



The Public Policy Perspective has been updated to reflect new data from 2018.

CHAPTER OUTLINE The Budget Process Economic Analysis for the Budget Process: Achieving the Least-Cost Means of Accomplishing an Authorized Objective Cost-Benefit Analysis Analysis of Government Investments: Cost-Benefit Analysis in Practice Public Policy Perspective: Cost-Benefit Analysis of the Job Corps Program

MAJOR POINTS AND LECTURE SUGGESTIONS 1. You may want to begin your lecture with a discussion of the difference between incentives faced by agents in a profit-maximizing firm and those faced by government bureaucrats. This will link some of the material in this chapter to the material on the theory of bureaucracy discussed in Chapter 5. Given the tendency for bureaucrats to seek to supply more than the efficient level of goods and services, budgeting systems can be viewed as a means of constraining this tendency. Ideally, a budgeting system should help achieve efficiency. 2. Program budgeting can achieve cost savings by budgeting for all agencies with similar missions together. This allows visibility of tradeoffs and substitution possibilities that would otherwise be difficult to see. Cost-effectiveness is achieved when any given government output is made available over a given time period at minimum cost. 3. Emphasize that cost-benefit analysis is a technique that aids in ranking alternative government projects according to the net benefits they provide. Figure 6.3 in the text shows how cost-benefit analysis can help achieve efficiency. Most economists include only real increases in well-being as benefits of a project. Transfers are not counted, although some economists have advocated weighting of benefits to achieve income redistributional goals. The text includes a complete analysis of costbenefit analysis, along with many examples that should prove helpful in developing lectures. 4. The discussion of the social rate of discount makes use of a graph to show how the gross return on investment can diverge from the return earned by savers when business investments are subject to tax. When this is the case, the opportunity cost of funds depends on whether saving or investment is displaced by the means of financing the project. The analysis holds as long as investment income is taxed at a higher rate than interest income received by savers. 5. The Public Policy Perspective on the Job Corps is a good example of how cost-benefit analysis can be used ex post to find out how well or poorly a program has achieved its objectives. It will be very worthwhile to discuss this example in class. The table accompanying the Perspective has real data with which to work.

ANSWERS TO TEXT PROBLEMS 1. The ratio of the price of the highway interchange to the price of the cardiac intensive care unit is 2. The ratio of the marginal products of the two programs and their current output levels is 10/3 = 3.33. Because the ratio of marginal products exceeds the ratio of prices, the current mix of programs is not cost-effective. To improve cost-effectiveness, more highway interchanges should be built and fewer cardiac units should be produced. As this occurs, the marginal product of highway interchanges will fall, while the marginal product of cardiac units will rise. Cost-effectiveness is achieved when the ratio of marginal products is adjusted to equal 2. 2. There is a $1 per trip cost savings on the existing 500,000, which provides a benefit of $500,000 per year. The gain in net benefits from the 100,000 new trips is 1/2($1)(100,000) = $50,000 per year. The annual increase in benefits to motorists as a result of the new road will therefore be $550,000. 3. The opportunity cost of funds to finance the investments will be 16 percent, which is the equilibrium gross return of airlines required to give a new return of 8 percent, which is the opportunity cost of capital in the economy. Since the project will yield only 12 percent, there will be no increase in net benefits because the opportunity cost of funds exceeds the return on the project.

44 | Part One | The Economic Basis of Government Activity

4. The net present value of the project at a 10-percent discount rate is –$1.98 million. The project therefore does not merit approval. Because it has a negative net present value at a 10-percent discount rate, it will also have a negative net present value at the higher interest rate of 15 percent. 5. At 0 percent, PV = $10,000 At 1 percent, PV = $9,471.30 At 3 percent, PV = $8,530.20 At 5 percent, PV = $7,721,73 At 10 percent, PV = $6,144.57 If the current cost of the project is $8,000, it will have a positive benefit-cost ratio at interest rates of 0 percent, 1 percent, and 3 percent.

TRUE /FALSE QUESTIONS 1. A cost-effective program mix is one that accomplishes a given mission at minimum cost. (T) 2. Cost-benefit analysis is a technique for determining the net benefits of alternative government projects. (T) 3. An increase in the profits of gasoline dealers on an improved road is a benefit of the road project. (F) 4. If increases in agricultural land values are viewed as a benefit of an irrigation project, then the market value of projected increased crops should also be included as a benefit of the project. (F) 5. The social rate of discount must equal the opportunity cost of funds used to finance a project. (T) 6. If a project has a B/C ratio of 0.9, its approval will result in net benefits to citizens of the nation. (F) 7. The benefits of widening a road consist only of the cost savings to existing users of the road. (F) 8. If the benefits of a new bridge exceed the costs, then there will be a net social gain from building the bridge. (T) 9. If the marginal social cost of a new road exceeds its marginal social benefit, then building the road will result in a net social gain. (F) 10. The higher the social rate of discount, the more government projects for which benefits will exceed costs. (F) 11. A lower discount rate favors more capital-intensive investments that yield net benefits further into the future. (T) 12. The present value of a stream of net benefits for 20 years will be less than the sum of those benefits unless the social rate of discount is zero. (T) 13. Building a new sports stadium results in food sales at the facility. These food sales should be considered a benefit of the new stadium. (F) 14. Program budgeting seeks to group agencies with similar purposes for budgeting, independent of the government department to which they belong. (T) 15. Cost-benefit analysis can be viewed as a way of minimizing the cost of any given government output. (F)

16.

Assuming costs are paid immediately, an increase in the social discount rate will lower the benefitcost rate. (T)

17.

The marginal rate of technical substitution (where the slope of the isocost and isoquant lines are equal) is the ratio of the prices of the two goods. (T)

18.

The marginal rate of technical substitution is the slope of the isoquant line. (F)

MULTIPLE CHOICE QUESTIONS 1. In program budgeting, an agency’s program is: a. its mission. b. a combination of government activities designed to produce a distinguishable output. c. its output. d. the cost of its output. 2. Program budgeting differs from line budgeting in that: a. all agencies with similar missions are budgeted for together, irrespective of the government department to which they belong. b. proposed expenditures in a given government department are compared only with other programs in the same department. c. a computer program is used. d. the effect of programs on the distribution of income is explicitly considered. 3. The mission of a government agency is: a. its program. b. its output. c. its cost. d. a measure of the inputs it uses. 4. Assuming a full-employment economy, which of the following should not be included as a benefit of a government project to build a new highway when doing a cost-benefit analysis? a. The income of construction workers employed to build the highway b. The value of the time saved on trips between points to be served by the new highway c. The increase in retail sales at sites bordering the highway d. Both (a) and (c) are correct. 5. A cost-benefit analysis of an irrigation project shows that the ratio of the discounted present value of benefits to costs is less than one. This implies that: a. the net benefit of the project is positive. b. the net benefit of the project is negative. c. efficiency can be attained by undertaking the project. d. the project will redistribute income to the poor.

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6. The social rate of discount is currently 10 percent. This implies that: a. all government projects will yield a 10-percent return. b. the opportunity cost of funds for all government projects is 10 percent. c. more capital-intensive projects will be ranked over less capital-intensive projects. d. the opportunity cost of funds for all government projects is 20 percent. 7. The social rate of discount used in cost-benefit analysis measures the: a. benefits of a project. b. cost of a project. c. rate of return on the project. d. opportunity cost of displaced private saving or investment. 8. Suppose that a business investment is subject to a 50-percent tax but that the return to private savings is not taxed. The after-tax rate of return on business investment is currently 9 percent. If a proposed government project is predicted to displace business investment, then the social rate of discount is: a. 9 percent. b. 18 percent. c. 36 percent. d. infinite. 9. A proposed road improvement project is expected to increase pollution in an urban area. The pollution damage should: a. be considered a cost of the project. b. be considered a benefit of the project. c. not be considered in evaluation of the project. d. be used as a justification to increase the social rate of discount. 10. A new road will lower the cost of a trip between two cities from $20 to $10. Currently, 100,000 trips per year are made between the two points. The benefit of the new road will: a. be $1 million per year. b. exceed $1 million per year. c. be less than $1 million per year. d. accrue only to current users. 11. Program budgeting is a way to: a. minimize the cost of producing a given amount of government services. b. rank projects according to their marginal net benefits. c. maximize the output of government. d. increase government spending. 12. Cost-benefit analysis is a way to: a. minimize the cost of producing a given amount of government services. b. rank projects according to their marginal net benefits. c. maximize the output of government. d. increase government spending.

13. If the social rate of discount falls, then the efficient amount of government capital spending will: a. increase. b. decrease. c. be unaffected. d. fall to zero. 14. A government agency has a new hydroelectric project that will take 15 years to build before it provides any benefits. The net present value of the project will be highest under which of the following discount rates? a. 0 percent b. 1 percent c. 3 percent d. 5 percent 15. Which of the following techniques is used by economists to value years of life saved by a highway safety program? a. Measuring the increased income that it allows b. Trying to get those affected by the improved safety to reveal their willingness to pay for the reduced risk of death c. Either (a) or (b) is correct. d. None of these are correct, because economists believe that it is impossible to put a value on life. 16. If the quantity of good A is on the vertical axis and the quantity of good B is on the horizontal axis, the slope of the corresponding isocost line is the: a. price of good B divided by the price of good A. b. negative of the price of good B divided by the price of good A. c. price of good A divided by the price of good B. d. negative of the price of good A divided by the price of good B. 17. If the quantity of good A is on the vertical axis and the quantity of good B is on the horizontal axis, the marginal rate of technical substitution of the corresponding isoquant line is the: a. marginal product of good B divided by the marginal product of good A. b. negative of the marginal product of good B divided by the marginal product of good A. c. marginal product of good A divided by the marginal product of good B. d. negative of the marginal product of good A divided by the marginal product of good B. 18. If the quantity of good A is on the vertical axis and the quantity of good B is on the horizontal axis, then the cost-effective mix between the two goods occurs when: a. the slope of the associated isoquant line equals the price of A divided by the price of B. b. the marginal rate of technical substitution equals the price of A divided by the price of B. c. the marginal rate of technical substitution equals the price of B divided by the price of A. d. both (a) and (c) are correct.

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19. The process of taking a previous period’s budget and making minor changes to produce the current year’s budget is called: a. zero based budgeting. b. enumerated budgeting. c. developmental budgeting. d. incremental budgeting. 20. The nominal interest rate is: a. the real rate of interest when there is inflation. b. less than the real rate of interest when there is inflation. c. inflation adjusted. d. not adjusted by inflation.

ESSAY QUESTIONS 1. Explain how a system of program budgeting has the potential to improve efficiency within the government sector of an economy. How does program budgeting differ from line budgeting? Use isoquant analysis to show how program budgeting achieves efficiency. What are the advantages and disadvantages of zero-base budgeting? 2. How would you set up a cost-benefit analysis of a program to reduce air pollution in a city? Carefully indicate the items you would include as benefits and costs, and discuss the problems encountered in measuring these benefits and costs.

CHAPTER 7

Government Subsidies and Income Support for the Poor

INSTRUCTIONAL OBJECTIVES This chapter discusses the economics of subsidies and transfers with special emphasis on policy issues relating to means-tested government transfer programs. The goal is to make students aware of the scope of these programs in the United States and their effectiveness in alleviating poverty. After reading the chapter, students should be able to use indifference curve analysis and welfare triangles to analyze the effects of price-distorting subsidies, in-kind subsidies, and other subsidy programs on resource use. They should also be able to analyze the impact of cash transfers on the incentives to work of those eligible for aid. The conflict between the equity and efficiency aspects of alleviating poverty is highlighted. To achieve these objectives, considerable factual information is provided. The problems of measuring poverty and counting the poor are discussed. The justification of programs of assistance to the poor is made clear along with the rules that have been established to determine eligibility. Students should understand both the status and means tests that must be passed to receive aid. They should also © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

understand the basic differences between cash and in-kind transfer programs. The data in the text put the programs in perspective by making the student aware of the percentage of government expenditures that go to the poor and the prevalence of in-kind assistance. The chapter provides students with tools for analyzing the impact of the transfer programs on resource use and efficiency. The impact of in-kind transfers on prices and consumption is extensively analyzed. The chapter also seeks to provide students with the basis for evaluating the impact of both cash and in-kind benefits on the work incentive of eligible recipients. Alternatives to the current system of assistance to the poor are also discussed.

CHANGES IN THIS EDITION 

This chapter has been extensively updated using latest census data on poverty and health insurance coverage.



There is up-to-date information on programs of assistance to the poor in the United States, such as Temporary Assistance to Needy Families (TANF) and Supplemental Security Income (SSI), and evaluation of the impact of welfare reform programs on poverty, work incentives, and efficiency of resource use.



Updates to the Medicaid program and its rapid growth in spending has been documented.



Data on the Earned Income Tax Credit (EITC) has been updated to 2018.

CHAPTER OUTLINE Poverty in the United States Public Policy Perspective: Changing the Poverty Threshold: When Are People Really Poor? Government Programs to Aid the Poor: The Basis and the Tradeoffs Government Programs of Assistance to the Poor in the United States Subsidies and Transfers to Individuals: Economic Analysis of Their Effects Medicaid and State Government Budgets: Skyrocketing Costs Subsidies to Housing and Food The Impact of Government Assistance Programs for the Poor on the Work Incentive of Recipients Programs With No Status Tests: The Negative Income Tax and Subsidies to the Working Poor TANF, Work, and Public Assistance: Welfare Reform in the United States Programs to Aid the Poor and the Distribution of Money Income in the United States

50 | Part One | The Economic Basis of Government Activity

MAJOR POINTS AND LECTURE SUGGESTIONS 1. In general, students are both ill-informed and eager to learn about transfer programs that assist the poor in the United States. The factual information in the chapter is of great interest to them. I recommend reproducing some of the tables from the text and bringing them to class. 2. The data on the way the poverty threshold is computed is worth going over in class. Emphasize that defining who is and who is not poor involves some arbitrary judgments. 3. Emphasize that the data in Table 7.1 includes cash transfers to the poor but does not include in-kind benefits. Counting noncash subsidies to the poor would reduce the poverty rate considerably. 4. The basis for government assistance to the poor is difficult to present in a rigorous way in class. Students can read the section in the text to see the arguments relating to minimum standards of well-being, collective benefits of transfers to the poor, and the safety net. Instructors can briefly discuss these arguments in class. 5. It is useful to outline the basic cash and in-kind assistance programs available to the poor in the United States in class. Even more important is to emphasize that both a means and status test must be passed in order for a person to qualify for these transfers. Once these tests are passed, a person is entitled to benefits. This is why these programs are often referred to as entitlements. The new law that is in effect puts a cap on payments in the aggregate and to particular recipients. 6. Many students do not know what the term ―in-kind‖ means. Make sure they understand the difference between a cash and in-kind transfer before discussing Supplemental Nutrition Assistance, Medicaid, housing, and other programs. 7. Students are very surprised to learn that Medicaid is the single most expensive program of assistance to the poor in the United States. The data in the chapter put in perspective cash and in-kind transfers to the poor. 8. The text provides a step-by-step analysis of the impact of subsidies for resource allocation. Indifference curves can be used to show how a price-distorting subsidy results in a deadweight loss compared to an equal-yield, lump-sum subsidy to the individual. After analyzing the effect of subsidies on individual choice, move on to the effects on resource use in the market and show how the subsidy increases consumption of the subsidized item beyond the point at which marginal benefit to the individual equals marginal social cost. You can then identify the excess burden of the subsidy. The analysis can then be applied to programs like Medicaid that reduce the demand price to zero and encourage overallocation of resources relative to the efficient level for the subsidized item. 9. The main point to make in the graphic analysis of the Supplemental Nutrition Assistance (formerly called food stamps) program is that the amount of food that can be purchased, even with the maximum monthly allotment of stamps, is so modest that the grant can be considered equivalent to cash for almost all recipients. The program is not likely to increase food consumption over the amount that would prevail if recipients were to receive the cash value of their stamps. 10. Housing subsidies differ from medical and food subsidies in the United States in that they distort prices paid by recipients rather than allowing them to consume a certain amount of goods with no direct charge. You can use the graphic analysis in the text to show the general effect of any pricedistorting subsidy. The graphs show the possible effects of the availability of public housing on the choices and well-being of eligible recipients. The analysis shows that some persons are induced to reduce their consumption of housing when they become eligible for public housing. Others actually

refuse the subsidies because moving into public housing would make them worse off, given their strong preferences for housing. 11. The impact of cash transfers on the work-leisure choice shows that transfers have both income and substitution effects. Refer the students to the appendix to Chapter 1 if they are not familiar with income-leisure indifference curves. Figure 7.9 shows how a transfer that declines with income is equivalent to a tax on wages until the transfer is phased out. You may want to point out that the resulting budget line is convex and could result in multiple equilibria. 12. The negative income tax and similar plans can be viewed as programs without status tests. Students should understand that these programs could be very expensive if the income guarantee is set close to the poverty income and if the rate at which the transfer is phased out is low. 13. The Earned Income Tax Credit (EITC) is now a major source of support to the poor in the United States. Figure 7.11 shows how the EITC is phased in and then out as taxpayers’ earnings increase. 14. Evidence now indicates that Temporary Assistance to Needy Families (TANF) has contributed to reduced welfare rolls and the increased labor force participation of single mothers. The text summarizes recent research on the impact of TANF that you can share with your students.

ANSWERS TO TEXT PROBLEMS 1. The supply of bread after the subsidy will be perfectly elastic at 50 pesos per loaf. In equilibrium the price of bread will fall to 50 pesos. At that price the marginal benefit of bread will be 50 pesos to consumers and the equilibrium quantity demanded. The marginal cost of producing bread will be 100 pesos. Because there are no externalities, this implies that the marginal social cost of bread will exceed the marginal social benefit, and more than the efficient amount will be produced. The subsidy lowers the market price of bread so that all consumers of bread, nonpoor as well as poor, will benefit. 2. The analysis here is similar to that for Supplemental Nutrition Assistance. Assuming that the person would spend at least $200 per month on housing anyway, the $200 subsidy would have the same effects as a $200 cash transfer. A recipient who would have chosen to spend less than $200 per month on housing if given a $200 cash transfer would be better off with the cash transfer. 3. The budget line begins at 24 hours of leisure. Income will increase by $4 only for the first hour of work. Thereafter, for each hour of work up to the point at which the transfer is reduced to zero, income per day increases by $0.33 of each additional dollar earned because of the 67-cents per dollar of earnings reduction in the transfer. The transfer will be reduced to zero after the recipient earns $17.91 of income per day, plus the $4 per day that does not count. This is a total of $21.91 per day and will correspond to an average of 5.48 hours per day. Because the resulting budget line is convex, multiple equilibria are possible. 4. The break-even level of income for a family of four is $48,000. All families below this level will be transfer recipients, and all families above this level will pay a 25-percent tax rate. The graph the student will draw should be similar to that in Figure 7.10 of the text. However, because the breakeven level of income is well above the median income in the United States, more than half of the population of families of four will be recipients of transfers. The plan is likely to be very expensive. 5. The graph derived from the IRS table for the current tax year will be similar to that shown in Figure 7.11 of the text. The EITC is a refundable negative tax that adds to the income of workers who have low earnings. It is usually included in the paycheck as a form of ―negative withholding.‖ Because the credit is available only to those with earnings, it provides a strong incentive to work. It is, in effect, a wage rate subsidy that increases wages. It provides a substitution effect to encourage workers © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

52 | Part One | The Economic Basis of Government Activity

to substitute work for leisure by raising the effective wage as much as 40 percent. It also provides an income effect that could encourage some cutback in work hours. After the maximum credit is reached, the phaseout of the credit results in an extra 20-percent effective tax rate on workers’ earnings that could discourage them from working more hours.

TRUE /FALSE QUESTIONS 1. The poverty threshold is independent of the size of a family and the age of a household head. (F) 2. The rate of poverty has increased in the United States since 1959. (F) 3. In calculating the official poverty rate, cash transfers to the poor are included in their income, but in-kind transfers are not. (T) 4. All persons in the United States with income below the poverty level are eligible for TANF or for SSI transfers designed to assist the poor. (F) 5. The cash benefit and eligibility for payments under TANF varies considerably from state to state. (T) 6. Cash transfers currently account for much less of the total transfers to the poor than in-kind transfers do. (T) 7. Medicaid is likely to result in incentives for recipients to consume medical services up to a point at which the marginal social cost of such services exceeds their marginal benefit. (T) 8. Supplemental Nutrition Assistance (formerly called food stamps) lower the price of food to recipients. (F) 9. A person receiving a lump-sum annual transfer is likely to work less than would otherwise be the case. (T) 10. The annual income guarantee under a negative income tax is $10,000 per family of four. This transfer declines by 50 cents for each dollar of annual earnings. The transfer received by a family of four will decline to zero when its annual earnings is $20,000. (T) 11. The Earned Income Tax Credit (EITC) is a way of subsidizing those who are unable to work and have no earnings. (F) 12. The Earned Income Tax Credit (EITC) is a form of wage-rate subsidy that increases the incomes of low-income people with earnings. (T) 13. The Earned Income Tax Credit (EITC) is a form of negative tax that increases the incomes of workers with earnings but is eventually phased out to zero as earnings rise above a certain level. (T) 14. Medicaid is jointly financed by the federal government and the state governments in the United States and now absorbs more than 17.8 percent of state government budgets. (T) 15. Since TANF has been introduced in the United States, welfare caseloads have declined and labor force participation of less-skilled single mothers has increased. (T) 16.

A two-person household headed by a person over 65 is classified as poor at the same level as a twoperson household not headed by an elderly person. (F)

17.

The poverty threshold stays constant from year to year. (F)

18.

In 2017 approximately one-third of the people classified as poor in the United States were children. (T)

MULTIPLE CHOICE QUESTIONS 1. In the United States, the poverty threshold is: a. the same for all households of a given size independent of the age of the household head. b. the cost of a minimally accepted diet for persons in the family. c. adjusted each year by multiplying the previous year’s threshold by the change in the Consumer Price Index and adding the increase to the previous year’s threshold.. d. adjusted each year by multiplying the previous year’s threshold by the change in the Consumer Price Index and subtracting the increase from the previous year’s threshold. . 2. Government transfers to the poor in the United States: a. are always in the form of cash. b. are available to all persons whose income is below the poverty threshold. c. succeed in eliminating poverty in the United States. d. are available to those meeting both the means test and the status test. . 3. The most expensive program of assistance to the poor in the United States in recent years has been: a. TANF. b. Supplemental Nutrition Assistance (formerly called food stamps). c. Medicaid. d. public housing.

54 | Part One | The Economic Basis of Government Activity

4. Cash transfers are: a. the dominant method of providing assistance to the poor in the United States. b. included in the income of recipients when calculating the official poverty rate. c. available only to the elderly in the United States. d. Both (a) and (b) are correct. 5. If the supply of medical services is perfectly elastic, then the effect of Medicaid is to: a. increase the market price of medical services. b. result in the efficient amount of medical services. c. cause recipients to consume medical services beyond the point at which their marginal benefits per year equal the marginal social costs of medical services. d. Both (a) and (c) are correct. 6. The Supplemental Nutrition Assistance (formerly called food stamps): a. reduces the market price of food to those eligible for Supplemental Nutrition Assistance. b. is likely to increase the market price of food to all consumers. c. is likely to increase food purchases by recipients but not other purchases. d. is likely to increase both food and nonfood purchases by recipients. 7. The value of a price-distorting subsidy for a three-bedroom apartment is $100 per month. This means that the person choosing to live in an apartment of that size would have to pay an extra $100 per month at the market rent. Then it follows that: a. that person would be worse off if she received a cash subsidy of $100 per month. b. that person would be better off if she received a cash subsidy of $100 per month. c. that person would be just as well off if she received a cash subsidy of less than $100 per month. d. Both (b) and (c) are correct. 8. Suppose a welfare recipient is given a cash grant that increases his monthly income. That grant will never be taken away no matter how much the recipient earns. The grant will result in a(n): a. substitution effect favorable to work. b. substitution effect unfavorable to work. c. income effect favorable to work. d. income effect unfavorable to work. 9. A welfare recipient receives a cash transfer of $100 per week. This grant is not reduced if the recipient earns less than $20 per week. However, after the recipient earns more than $20 per week, the grant is reduced by 66 cents for each dollar of earnings. The cash transfer will be reduced to zero if the recipient earns: a. $151.52 per week. b. $171.52 per week. c. $131.52 per week. d. $100.00 per week. 10. An income guarantee of $10,000 per year for all families is established with a phase-out rate of benefits of 50 cents per dollar of earnings. Then it follows that: a. only families with earnings of less than $10,000 per year will receive transfers. b. all families with earnings of less than $20,000 per year will receive transfers. c. all families with income of less than $30,000 per year will receive transfers. d. all families will receive transfers. © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

11. The Earned Income Tax Credit (EITC) is: a. a transfer to low-income people who are unable to work. b. a flat grant that increases by $4,000 the income of all workers below the poverty level. c. a subsidy to the poor who have low earnings that increases as they earn more, reaches a maximum, and then is phased out to zero as earnings increase above a certain maximum. d. available to all persons whose incomes are below the poverty level, whether they work or not. 12. The Earned Income Tax Credit (EITC): a. is a negative tax that transfers income to the poor who have earnings. b. can increase the incomes of those eligible by as much as 40 percent. c. is never phased out as the earnings of the recipients increase. d. Both (a) and (b) are correct. 13. Which of the following is true about Temporary Assistance to Needy Families (TANF)? a. It is an entitlement program administered by the federal government. b. It provides temporary and limited support for poor families through federal grants to state governments. c. State governments determine eligibility for its benefits and administer it. d. Both (b) and (c) are correct. 14.

Under Temporary Assistance to Needy Families (TANF), a. federal spending is capped and is allocated to states as a block grant. b. federal spending is an open-ended entitlement program that requires federal payments to all eligible recipients who meet means and status tests. c. the states do not determine eligibility and benefit levels; instead, the federal government sets these levels as national standards. d. recipients are not required to work and will receive benefits as long as they meet a means test.

15. Which of the following is true about the Medicaid program in the United States? a. It is entirely financed by the federal government. b. It is a means-tested entitlement program that mandates payment for medical services, mainly to those with low incomes. c. It is jointly financed by the federal and state governments and is absorbing a significant share of the state government budgets. d. Both (b) and (c) are correct. 16. The two major programs providing welfare assistance in the form of cash transfers to the poor in the United States are: a. Temporary Assistance to Needy Families and Aid to Families with Dependent Children. b. Temporary Assistance to Needy Families and Supplemental Security Income. c. Emergency Assistance and Aid to Families with Dependent Children. d. Supplemental Security Income and Aid to Families with Dependent Children. 17. In 1996, Temporary Assistance to Needy Families (TANF) replaced: a. no existing programs. b. one existing program. c. two existing programs. d. three existing programs. © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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18. Medicaid was enacted by Congress in: a. 1965. b. 1972. c. 1977. d. 1980. 19. Why rely on the government to aid the poor rather than private charities? a. The government can establish uniform standards for eligibility. b. Voluntary donations will most likely be inadequate. c. The government will most likely be able to meet all needs to the satisfaction of all citizens. d. Both (a) and (b) are correct. 20. An EITC program is more likely to encourage working when compared to NIT program because: a. participants are guaranteed income even if they are not working. b. participants must work to receive benefits. c. participants are eligible for work training. d. participants receive a wage rate subsidy.

ESSAY QUESTIONS 1. What criteria are used in the United States to determine eligibility for transfers to alleviate poverty? Explain why some people who are poor according to official statistics will be ineligible for aid. Explain why taxpayers can have their tax bills reduced, while most poor persons will be made no worse off if in-kind transfers were eliminated and replaced with their cash value to recipients. 2. Explain how the work incentive for low-wage workers is impaired by transfers based on a means test. Are transfers to the poor reduced on a dollar-for-dollar basis as the poor earn income on their own? What are the income and substitution effects of government assistance to the poor?

CHAPTER 8

Social Security and Social Insurance

INSTRUCTIONAL OBJECTIVES The chief goal of this chapter is to provide students with an understanding of how the Social Security system operates to provide pensions and other benefits to the elderly in the United States. Other aspects © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

of social insurance, such as unemployment insurance and health insurance to the elderly, are also discussed, but the emphasis is on government-supplied pensions. In addition to seeking to show students how the system works, the chapter also develops the necessary theory to explain how the availability of tax-financed pensions affects the incentives to save and work. The chapter has a balanced mix of fact, policy issues, and theory. Students must first see the difference between tax-financed government pensions and fully funded private pensions to understand why Social Security pension payments are transfers. To evaluate the generosity of Social Security pensions, students are introduced to the concepts of the net and gross replacement rates. Data are provided to show how these rates vary with preretirement earnings. The rates are estimated for Social Security pensions alone and for the sum of Social Security and private pensions. The return on Social Security taxes is then discussed by showing the factors that affect the rate of growth of taxes available to pay pensions. Students are then shown how demographic change affects this return. A final goal is to show students how indifference curve analysis can be used to explain how the availability of Social Security pensions affects work and saving incentives. For work incentives, the emphasis is on the work-leisure choice of the elderly. The earnings test is analyzed. For saving incentives, the relationship between taxes paid and promised pensions is analyzed and a balanced view of all possible effects is presented.

CHANGES IN THIS EDITION 

The chapter has been extensively updated to reflect 2018 data and where available to 2019. All calculations have been updated to reflect these new data.

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The section on Social Security Replacement Rates has been updated with data from 2018, and Table 8.1 has been updated to reflect data from 2018.

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The Global Perspective: Social Security throughout the World: Trends towards Privatization contains updated data and discussion.

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The Global Perspective: Social Security Pensions in the European Union has been updated with new dates and data.

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The discussion and data in the section ―Other Pension Income and the Well-Being of the Elderly‖ has been updated.

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The effect of Social Security tax rates and their discussion has been updated.

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The discussion on Unemployment Insurance has updated data from 2018 and where relevant to 2019. Critique on the system due to low-income and part-time workers has been added.

CHAPTER OUTLINE Social Security in the United States The Social Security Retirement System Social Security Replacement Rates Global Perspective Social Security Throughout the World: Trends toward Privatization Public Policy Perspective Social Security and the Family: Some Anomalies in the Modern Age © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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The Return to Workers: How Do Pension Benefits Compare with the Taxes that Workers Pay? Demographic Change and the Future of Social Security Proposals to Reform Social Security: Maintaining Benefits versus Partial Privatization The Impact of Social Security on Savings and Work Incentives Global Perspective: Social Security Pensions in the European Union Health Insurance for the Elderly: Medicare Unemployment Insurance

MAJOR POINTS AND LECTURE SUGGESTIONS 1. Eligibility for social insurance benefits is not contingent on passing a means test. However, the amounts received do vary with earnings. Coverage is based on paying an earmarked tax over a certain period of time. 2. Emphasize that under a pay-as-you-go system of government pensions, payroll taxes represent a direct transfer of purchasing power from those currently in the workforce to those currently retired. A fully funded retirement system requires a trust fund equal to the discounted present value of all promised future pension benefits. The projected growth of the Social Security trust fund balance through the first quarter of the 21st century will not make the system a fully funded one. There will, however, be a partial movement away from pay-as-you-go financing. 3. Students are surprised by the actual gross and net replacement rates for Social Security. Point out that pension benefits are indexed and that net replacement rates for workers with dependent spouses and less than average earnings are over 70 percent. Also emphasize that gross and net replacement rates are a declining function of preretirement earnings.

4. The average return to Social Security recipients in the aggregate can be computed for a fixed payroll tax rate, t, assuming a fixed workforce earning W dollars per year and zero inflation. The amount of taxes collected in any given year to pay pensions will therefore be tW. For any given t, the growth in revenue depends entirely on the growth in wages. The growth in wages has averaged 2 percent per year since 1935. 5. Up until the 1970s, Social Security revenues grew at more than 2 percent because of growth in the number of covered workers and increasing tax rates. On average, the system was a good deal for workers retiring up through the 1970s. This is because the return they could have earned elsewhere by investing the amount they had paid in Social Security taxes would have been less than the return that is implicit in their actual pensions. Social Security pensions will be a much poorer deal for the students in your class. They will have to pay high payroll taxes over their entire working life to maintain existing replacement rates for an increasing number of retirees. 6. Table 8.2 in the text shows payroll tax rates from 1937 to 2019 The last column of the table shows the maximum tax per worker based on the combined employee-employer rate. To make the example even more powerful, show the students how much Social Security taxes will be paid by a two-earner family with each spouse earning the maximum taxable wages in 2019. These two workers pay enough in taxes to support a typical retired person receiving maximum Social Security benefits! 7. The graphs in Figure 8.2 of the text show the impact of Social Security pensions on the work choice of retirees. Workers over normal retirement age are not subject to the earnings test. For these workers, the availability of Social Security pensions results only in an income effect unfavorable to work. For workers subject to the earning test, there is also a substitution effect after the maximum permissable earnings are reached. Of course, for such workers, as the graph shows, the pension benefits eventually become zero if there is more than a certain amount of earnings. Both the substitution and income effects are unfavorable to the work incentive. Point out to students that the labor force participation of men aged 65–69 declined from about 60 percent to only 19.3 percent between 1940 and 2016. However, in recent years, labor force participation rates of the elderly have been increasing and are expected to grow to 22 percent by 2026. 8. The indifference curve analysis of the asset-substitution effect is not difficult to get across to students. I show two cases. In the first case, Social Security taxes and the promise of a pension have no effect on the person’s allocation of current and future consumption. The taxes paid per year merely substitute for what the person would have saved for retirement. In the second case, the preferences are such that the taxes exceed what the person would have saved for retirement. This person reduces his or her savings for retirement to zero. There is an induced distortion in the pattern of consumption for this worker. This person is forced to consume less per year prior to retirement and more per year after retirement than he or she would otherwise choose. 9. There is no conclusive evidence on the impact of the availability of Social Security pensions on saving. The asset-substitution effect is likely to be offset, at least in part, by the induced-retirement effect and the bequest effect. 10. You will probably want to spend some time on alternatives for reform of the Social Security system. The section in the chapter on recent recommendations to reform the system will be useful.

ANSWERS TO TEXT PROBLEMS 1. The gross replacement rate is 1,000/1,500 = 0.67. The net replacement rate is 1,000/1,200 = 0.83. Including the value of Medicare, the net replacement rate is 2.5, assuming that this worker had no health insurance prior to retirement. If the worker did have health insurance, the value of these benefits would have to be added to preretirement earnings before computing the replacement rate. © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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2. The amount of taxes collected in any given year to pay pensions will therefore be tW. For any given t, the growth in revenue depends entirely on the growth in wages. On average, tax revenues will increase by 1 percent per year at constant tax rates. Workers with high incomes can expect negative returns because the discounted present value of taxes they pay will exceed the discounted present value of their Social Security pensions. 3. The daily pension for a $1,000 monthly pension is $33.33 per day. On average, the worker can earn $8,000/12 = $666.67 per month, or $22.22 per day, before the pension is reduced by $1 for each $3 of earnings. The budget line will be similar to the one in Figure 8.2A in the text. Because this budget line is convex, multiple equilibria are possible. 4. The graph the student will draw should be similar to Figure 8.3B in the chapter. The effect of Social Security on the individual’s well-being and savings rate depends on the wage level of the individual and the individual’s preferences for current versus future consumption. 5. a. b. c. d.

0.33 48 percent 16 percent The tax rate will increase to 24 percent. The tax rate can be reduced by any one or a combination of the following: (1) reduce the replacement rate, (2) reduce the number of retirees by raising the retirement age, (3) increase the workforce either through immigration or by encouraging more of the elderly to work, (4) increase productivity growth so that a lower tax can generate more revenue.

TRUE /FALSE QUESTIONS 1. The Social Security pension system is a fully funded retirement plan. (F) 2. Social Security pension benefits are transfers from workers to retirees. (T) 3. Social Security pensions are financed by voluntary contributions by workers. (F) 4. The gross replacement rate measures the ratio of taxes paid per year by workers to their annual Social Security pension when they retire. (F) 5. In the year prior to retirement, a worker earned $20,000 and paid $5,000 in taxes on those earnings. His annual Social Security pension is $10,000 per year. It then follows that his net replacement rate is 50 percent. (F) 6. The gross replacement rate for Social Security pensions is the same for all workers independent of their preretirement earnings. (F) 7. The annual growth in wages subject to Social Security taxes is 3 percent. Given the payroll tax rate, the growth in funds available to pay pension benefits is also 3 percent. (T) 8. The asset-substitution effect of Social Security pensions discourages saving. (T) 9. The availability of Social Security pensions to workers over normal retirement age results in an income effect unfavorable to work but no substitution effect. (T) 10. The bequest effect of Social Security encourages workers to save less. (F) 11. The normal retirement age for Social Security old-age pensions is 67 for people born in the United States in 1960 or later. (T) © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

12. Workers in the United States can retire under Social Security at age 62 with lower pensions than they would receive at their normal retirement age. (T) 13. Retired workers between the ages of 62 and their normal retirement age were subject to an ―earnings test‖ that reduced their pension by $1 for each $2 of earnings after a certain minimum level of earnings. (T) 14. Reducing the replacement rate will have no effect on the tax rate necessary to finance pensions under a pay-as-you-go, tax-financed pension system. (F) 15. Workers who quit their jobs are eligible for unemployment insurance benefits in the United States. (F) 16.

By 2060, the expected percentage of the U.S. population that is considered elderly will be less than 20%. (F)

17.

Social Security was created in 1965. (F)

18.

On average, the elderly are less likely to be poor when compared to the rest of the U.S. population. (T)

MULTIPLE CHOICE QUESTIONS 1. The Social Security retirement system: a. is a fully funded pension system. b. is a tax-financed system that pays benefits from taxes that are invested to return principal and interest to workers when they retire. c. is a tax-financed retirement system that finances pensions by taxing workers each year and transferring the bulk of revenues obtained directly to retirees. d. does not use taxes on workers to pay pensions to retirees. 2. The gross replacement rate: a. measures a worker’s monthly retirement benefit divided by monthly earnings before taxes in the year prior to retirement. b. measures a worker’s monthly retirement benefit divided by monthly earnings after taxes in the year prior to retirement. c. is an increasing function of gross monthly earnings prior to retirement. d. is independent of gross monthly earnings prior to retirement. 3. A worker earns $2,000 per month before taxes. He pays $140 per month payroll tax on those wages. In addition, the income taxes on those wages are $360 per month. On retirement, the worker receives a Social Security pension of $750 per month. Which of the following statements is true? a. The worker’s gross replacement rate is 50 percent. b. The worker’s net replacement rate is 50 percent. c. The worker’s net replacement rate is 38 percent. d. The worker’s net replacement rate is 75 percent.

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4. The growth in hourly wages over the past 50 years has averaged about 2 percent per year. However, the growth in Social Security pensions has far exceeded this 2-percent rate. The growth in tax revenue to finance Social Security benefits in excess of 2 percent per year can be accounted for by: a. increases in payroll tax rates. b. use of other taxes beside the payroll tax to pay Social Security benefits. c. an increase in the number of workers paying Social Security taxes. e. Both (a) and (c) are correct. 5. Given the structure and level of gross replacement rates and the expected future growth of labor earnings subject to the payroll tax, the tax rates used to tax payrolls were increased in the 1980s because: a. the number of retirees per worker will increase. b. the number of retirees per worker will decrease. c. wages are expected to decline. d. the size of the workforce is expected to increase. 6. Which of the following is likely to increase the net federal debt as a share of GDP? a. A federal budget surplus b. A federal budget deficit c. A recession d. Both (b) and (c) are correct. 7. The asset-substitution effect of the Social Security retirement system leads all workers to: a. save more for retirement. b. save less for retirement. c. save absolutely nothing for retirement. d. work more. 8. Which of the following is a consequence of a growing federal budget deficit in the United States? a. A decrease in the federal debt outstanding b. An increase in the federal debt outstanding c. A decrease in the portion share of federal government expenditures that must be allocated to interest in the future d. An increase in national saving 9. The induced-retirement effect of the Social Security pension system causes workers to: a. save less for retirement. b. save more for retirement. c. reduce savings for retirement to zero. d. work more after retirement. 10. Unemployment insurance benefits are: a. financed by payroll taxes levied on workers. b. financed by payroll taxes levied on employers. c. both (a) and (b) are correct. d. financed by sales taxes.

11. Which of the following is true about the Social Security pension system in the United States? a. Pensions received by retired workers are based entirely on their contributions to the Social Security pension trust fund and the investment return on that fund. b. Pensions received by married retirees with dependents are greater than that received by those without dependents. c. Gross replacement rates are inversely related to preretirement earnings. d. Both (b) and (c) are correct. 12. Which of the following can decrease tax rates necessary to pay pensions for a pay-as-you-go pension system? a. An increase in replacement rates b. A decrease in the retirement age c. An increase in the size of the workforce d. An increase in the number of retirees 13. Unless legislation is introduced to change the normal retirement age, people born in 1960 or later will be able to retire with full Social Security benefits at age: a. 62. b. 65. c. 66. d. 67. 14. The earnings test for retirees: a. increases their incentive to work. b. is applied only to retirees below normal retirement age. c. reduces pension benefits by $1 for each $2 of earnings for retirees under full retirement age. d. both (b) and (c) are correct. 15. A nation has 40 million current retirees and a workforce of 100 million. Which of the following is true? a. The replacement rate is 40 percent. b. The replacement rate is 2.5. c. The dependency ratio is 0.4. d. The dependency ratio is 2.5. 16. Social Security tax rates can be reduced if: a. taxable wages decline. b. the retirement age is lowered. c. the retirement age is raised. d. the workforce decreases in size. 17. A retiree subject to the earnings test under Social Security: a. can earn as much as he or she chooses without losing Social Security pension benefits. b. has his or her Social Security pension benefits reduced by one dollar for each dollar of labor earnings. c. has his or her Social Security pension benefits reduced immediately by one dollar for each three dollars of labor earnings. d. has his or her Social Security pension benefits reduced by one dollar for each two dollars of earnings after a certain minimum amount per year until they reach their full retirement age. © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

64 | Part One | The Economic Basis of Government Activity

18. A pay-as-you-go Social Security retirement system is: a. exemplified by the current U.S. Social Security system. b. exemplified by the current Chilean Social Security system. c. designed to have retirees set aside a contribution specifically for themselves during their earlier working life. d. both (a) and (b) are correct. 19. Approximately, what percentage of beneficiaries of U.S. Social Security are retired workers? a. About 53% b. About 63% c. About 73% d. About 83% 20. The Social Security Act was implemented in the United States in: a. 1927. b. 1935. c. 1947. d. 1965.

ESSAY QUESTIONS 1. If the Social Security retirement system were a private retirement system, it would be declared bankrupt. Explain why this is so and why the Social Security system can continue to pay benefits despite the fact that it can be considered bankrupt. Explain why the Social Security tax rate has increased so much in recent years. What measures could be taken to reduce the Social Security payroll tax rate? 2. Labor force participation of elderly men has declined drastically since the 1940s. More than half of the men between the ages of 65 and 69 worked to support themselves in the 1940s. Currently, less than one in five men in that age bracket chooses to work. Use indifference curve analysis to show how the availability of Social Security pensions has decreased work incentive for men over the age of 65.

CHAPTER 9

Government and Health Care

INSTRUCTIONAL OBJECTIVES Health care is an issue in public finance because governments finance two major health insurance programs (Medicare and Medicaid). Governments also subsidize the provision of private health insurance through exclusion of employer-provided insurance (which is labor compensation and a form of incomein-kind) from taxation. This chapter is designed to make students aware of general issues relating to the © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

market for health care and the provision of health insurance. Students are expected to be able to synthesize a set of related issues on the economics of health care and health insurance. The goal is to help students understand both the market for health care and the role of government in the provision of health insurance. They should also be able to apply the analysis to help understand the causes of soaring health care costs in the United States. The issues involved in moving to a system of national health insurance or taking other steps to ensure universal health insurance in the United States are discussed in this chapter.

CHANGES IN THE EDITION 

This chapter has been extensively revised. Data and information on health care expenditures in the United States and other nations has been updated to the latest available year.



The increase in health care costs is discussed, and data from the latest available years is incorporated.



Certain non-relevant sections have been deleted.

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The discussion of the Medicaid program has been updated.

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The discussion of the Patient Protection and Affordable Care Act of 2010 has been updated.

CHAPTER OUTLINE Characteristics of the U.S. Market for Health Care Public Policy Perspective: Why Worry about Growth in Health Care Costs? Governments and Health Care: Compensating for Market Failure Government Spending on Health Care in the United States Health Care Reform: Issues and Policies Universal Coverage Global Perspective: National Health Insurance and Health Services in Great Britain and Canada

MAJOR POINTS AND LECTURE SUGGESTIONS 1. Most students have heard about increasing expenditures on health care in the United States in recent years. They might not, however, understand that the opportunity cost of this increase is a decrease in available resources to produce other goods and services. It might help to get this point across by drawing a production possibility curve in class. Put health care services on the vertical axis and other goods and services on the horizontal axis. Show how allocating more resources to health care each year means that we have fewer resources to produce other goods and services. 2. A history of the growth of the government’s presence in the health care field might interest students. Discuss with students the ―Great Society‖ programs of Lyndon Johnson, and point out how a major commitment to increased government funding of health insurance occurred when the Medicare and Medicaid programs were introduced in 1965. These programs, which in part were designed to legitimately cope with the moral hazard associated with market-provided heath insurance for the elderly and those on public assistance, have contributed to the increased supply of and use of medical services.

66 | Part One | The Economic Basis of Government Activity

3. The indirect subsidy of private health insurance through nontaxation of fringe benefits is a key factor in the growth of private health insurance coverage. Employers and employees find this a good deal, and it explains much of the growth of employer-sponsored health insurance plans since the 1960s. Make clear to students that governments subsidize these plans by not taxing the incomein-kind that they provide to employees. Emphasize that health insurance coverage is a form of compensation of employees that is a higher percentage of the wages of low-income workers than it is of high-income workers. 4. A key part of your lecture should be a discussion of some of the unique features of the health care market. Point out issues involved in asymmetric information in the market. Doctors who monopolize information can manipulate the demand. When information is more freely available, the demand could decline. For example, a recent study showed how the dissemination of videos on alternatives for treating benign prostate disease at an HMO reduced the surgery rates for this common problem by as much as 60 percent! 5. Be sure to use supply-and-demand analysis to demonstrate how reduction in out-of-pocket costs for health care services increases the quantity demanded and encourages an overallocation of resources to health care provision. In effect, the system of third-party payments that has evolved in the United States has encouraged an overallocation of resources to health care relative to the efficient amount. 6. Students are interested in the uninsured who are having increasing difficulty in getting and paying for health care. Point out that young adults are disproportionately represented in this group. The text has a lengthy discussion on the uninsured. 7. Spend ample time in class on the problem of moral hazard and how the reduction in price to consumers, inherent to a third-party payment system, encourages overconsumption. Also point out how HMOs have incentives to economize on the use of medical resources when they receive capitation payments. Many HMOs are also now charging nominal fees for office visits to discourage visits for very minor ailments. 8. After discussing moral hazard, show how increased coinsurance and deductibles can reduce the overallocation of resources to health care. Use Figure 9.5 to illustrate how these techniques work. 9. Most national health insurance plans have global budgeting systems to limit and ration health care services. A key point to make is that any system that prevents price from rationing services must find another means to ration. In nations with national health insurance, budgets limit the allocation of resources to health care, and the services are rationed by long waiting lists for medical procedures with committees of physicians and other health care professionals making decisions about priorities for receiving service.

ANSWERS TO TEXT PROBLEMS 1. a.

The total market value of the health insurance provided for the 1,000 workers is $3 million per year. If this were paid as taxable income to employees, the government would collect 30 percent of that sum in taxes, which amounts to a subsidy of $900,000 for health insurance to the workers.

b. Each worker would have to pay for the policy out of taxable income. This means that the typical worker in the 30-percent tax bracket would have to earn $4,286, which would give the employee $3,000 after taxes to pay for the policy. The typical worker would be worse off and would be likely to decrease the amount of health insurance demanded. Even if the employer provided the worker with $3,000 of additional taxable compensation to adjust for the loss in $3,000 worth of

fringe benefits, the workers would be worse off compared to when they received $3,000 worth of nontaxable health insurance. 2. a.

$400 billion

b. The quantity demanded and supplied will increase to 7 billion units. Expenditures increase to $1,050 trillion—an increase of $650 billion. Efficiency is no longer attained because MSC exceeds MSB at the new output and more than the efficient output is produced. 3. The loss in efficiency is the triangular area between the supply and demand curves from their point of intersection to the output level of 7 billion units. Increasing the coinsurance to $50 would result in a smaller quantity demanded and supplied. The size of the triangular area representing the loss in net benefits would also be correspondingly smaller. 4. The limit in reimbursement would not decrease expenditures for health care if providers shifted the demand for health care outward by prescribing more services. 5. Monopsony power prevails in markets when one or more buyers purchase a significant enough quantity of a service to affect the price. Medicare and Medicaid pay for enough medical service to be able to shift the demand and lower the prices paid by sellers. Private health insurers in regional markets also possess this ability and use it to demand lower fees from health care providers serving their insured. This can decrease the quantity of the service supplied to recipients and also provide an incentive to decrease the quality of care by limiting the time that medical providers spend with those covered by insurance with low reimbursement rates. Currently, many medical providers are refusing service to those covered by Medicaid and Medicare because of low reimbursement rates and limits on services they can provide.

TRUE /FALSE QUESTIONS 1. In the United States the government pays the health bills of 90 percent of the population. (F) 2. As of 2019, the American system of health care is being financed by a mix of private and government insurance programs that pay over 90 percent of the health care bills for U.S. citizens. (T) 3. Spending per person on health care in the United States is less than in the United Kingdom, where national health insurance finances health expenditures. (F) 4. Government spending on health care is declining as a percent of total government spending. (F) 5. Medicare is a government program of health insurance for the elderly. (T) 6. Exclusion of employer-provided health insurance to employees is an indirect subsidy to private provision of health insurance. (T) 7. Third-party payments for health care services increase the quantity of health care demanded by reducing out-of-pocket costs to patients. (T) 8. An increase in coinsurance and deductibles for health insurance can contribute to a reduction in expenditures on health care. (T) 9. Half of Americans do not have health insurance coverage. (F) 10. Under national health insurance in Great Britain, the price system is used to ration health care. (F) © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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11. Approximately 18 percent of GDP was allocated to provision of health care in the United States as of 2016. (T) 12. Individuals in the United States, on average, pay 50 percent of their health care costs out-of-pocket, and the remaining 50 percent is paid by insurance, governments, and charity. (F) 13. Asymmetric information in the market for health care occurs when sellers of medical care are better informed about cost and quality of care than buyers. (T) 14. Because of third-party payment for services in the market for health care, the price paid by buyers is less than the payment sellers receive, and the marginal social cost of health care exceeds its marginal social benefit. (T) 15. Medicaid costs are paid entirely by the federal government. (F) 16.

Health care expenditures in the U.S. are projected to be 20% of GDP by 2026. (T)

17.

Asymmetric information can occur when the provider of a service is better informed than the consumer of the service. (T)

18.

A risk-averse individual prefers to pay certain modest costs in exchange for possible unforeseen high costs. (T)

MULTIPLE CHOICE QUESTIONS 1. Most of the medical bills of Americans in the United States are paid by: a. the patients. b. private and government health insurance. c. charities. d. Medicaid. 2. Since 1960, expenditures on health care as a percent of GDP has: a. been cut in half. b. more than tripled. c. remained the same. d. doubled. 3. The government program that provides the health insurance to the poor in the United States is called: a. national health insurance. b. Medicare. c. Medicaid. d. employer-provided health insurance. 4. Which of the following programs accounts for the greatest amount of government expenditures on public health in the United States? a. Medicare b. Worker’s compensation c. Public Health Service d. Medical research © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

5. Which of the following subsidizes private provision of health insurance? a. Medicare b. Medicaid c. Public Health Service d. Tax exclusion of the value of employer-provided health insurance to workers 6. Which of the following could help slow the rate of increase of spending on health care in the United States? a. A reduction in the deductibles on private health insurance policies b. An increase in the coinsurance rate on health insurance and subjecting a larger volume of services to coinsurance c. Extension of Medicaid insurance to all persons who are poor d. A reduction in the coinsurance rate on health insurance and subjecting a smaller volume of services to coinsurance 7. Which of the following is an example of the ―moral hazard of health insurance‖? a. An increase in the number of surgeries prescribed for benign prostate disease beyond the point at which the marginal benefit equals the marginal cost b. A decreased willingness of individuals to go to the doctor for minor ailments because of increases in coinsurance rates c. An underallocation of resources to medical care because of monopoly power of hospitals d. Experience rating of health insurance groups by health insurers 8. A third-party payment system for health care: a. results because of externalities in the production of health care services. b. encourages more than the efficient amount of resources to be allocated to health care. c. encourages patients and health care providers to economize on the use of health care resources. d. means that patients pay full price for health care services they consume. 9. Which of the following services is typically not covered under private health insurance and Medicare in the United States? a. treatment for heart attack b. surgery c. office visits to physicians d. long-term care services 10. Under national health insurance as operated in Great Britain, a. the British system pays fees equal to half of the costs of services provided to them. b. general practice physicians are paid on a per-patient rather than on a per-unit-of-service basis. c. patients requiring surgery can pick their surgeons and can usually obtain the surgery in a matter of days, even if it is not an emergency. d. there are no government limits on health care spending by hospitals. 11. Which of the following is true about the Medicaid program in the United States? a. It is a program of health insurance for the elderly. b. Its costs are paid entirely by the federal government. c. It is a program of health insurance for the poor. d. Its costs have been declining in recent years.

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12. In the United States, individuals pay approximately what percent of the cost of their medical care directly to providers? a. 100 percent b. 50 percent c. 14 percent d. zero 13. The percent of total health care costs in the United States paid for by governments is approximately: a. 90 percent. b. 44 percent. c. 25 percent. d. 10 percent. 14. The system of third-party payment for medical care in the United States has which of the following effects in the market for health care? a. It improves efficiency in the market. b. It causes the marginal social benefit of health care to exceed its marginal social cost. c. It causes the marginal social cost of health care to exceed its marginal social benefit. d. It results in less than the efficient quantity of health care services. 15. Which of the following is true about the Medicare program in the United States? a. It is only available to those who pass a means test. b. It is available to all citizens over the age of 65. c. The costs are completely financed by fees paid by insurees. d. It places no limits on reimbursement to medical care providers. 16. What would be the effect of having no health insurance available? a. The quantity of health care would be set where the marginal benefit and marginal cost are equal. b. Excess demand for health care would be the result because the quantity supplied would be at a level where the marginal benefit exceeds the marginal cost. c. Excess supply for health care would be the result because the quantity supplied would be at a level where the marginal benefit would be below the marginal cost. d. The quantity of health care would be at an inefficient level. 17. What proportion of Medicare beneficiaries are elderly? a. 95% b. 85% c. 77% d. 70% 18. What is the moral hazard associated with third-party payment for health services? a. The recipient of services is not as informed as the provider of the service. b. The recipient of services tends to decline more services than they should. c. The recipient of services tends to have more services than what is needed relative to the efficient level of services. d. There is no moral hazard.

19. Which is not reason for escalating health care costs in the United States? a. Increase in malpractice insurance b. Cross-subsidization of patients who cannot pay for health care or insurance c. Overuse of new technology d. Both (b) and (c) are correct. 20. If the quantity of health care is more than the efficient quantity, what is the consequence? a. Some who would have access at the efficient level will not have access to health care. b. The health care will suffer in quality. c. Capital could be more efficiently spent elsewhere, leading to less overall productivity. d. Marginal costs and marginal benefits will be lower.

ESSAY QUESTIONS 1. Discuss the system of finance for health care services that has evolved in the United States. Be sure to discuss the role of government in the system and the share of health care costs currently paid for by governments and financed by taxes. 2. Discuss the pros and cons of moving to a system of national health insurance in the United States. In your answer discuss how national health insurance could be financed, how it would affect the uninsured, and how it could decrease the quality of care enjoyed by some under the current system of private insurance.

CHAPTER 10

Introduction to Government Finance

INSTRUCTIONAL OBJECTIVES This chapter develops terminology used in analyzing taxes and discusses alternative means of government finance. Students are introduced to alternative philosophies of distributing the payment of taxes among citizens. A chief objective of the chapter is to make sure students are familiar with basic terms, such as tax base, tax rate structure, average tax rate, and marginal tax rate, and can use them when discussing taxes. The chapter also introduces students to criteria for evaluating taxes. Issues in tax compliance and tax evasion are also discussed.

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CHANGES IN THIS EDITION 

All tax data in this chapter have been updated using the latest available numbers.



The Global Perspective: Taxes and Tax Rates Throughout the World has been revised using recent OECD statistical releases.



The discussion and data surrounding the U.S. Postal Service’s large deficit has been updated to reflect changes in 2018.

CHAPTER OUTLINE Purpose and Consequences of Government Finance Principles of Taxation Global Perspective: Taxes and Tax Rates throughout the World How Should the Burden of Government Finance Be Distributed? Criteria for Evaluating Alternative Methods of Government Finance Alternatives to Taxation Public Policy Perspective: User Charges and Efficient Allocation of Resources to Transportation Infrastructure Government Enterprise Public Policy Perspective: State Lotteries—A Government Enterprise with a Hidden Regressive Tax on Gambling

MAJOR POINTS AND LECTURE SUGGESTIONS 1. Emphasize that payment of taxes is not usually a prerequisite for consuming government goods and services. Taxes do not ration goods and services in the way that is done by prices. It is a good idea to define taxes as ―compulsory payments associated with certain activities‖ to make sure your students understand the important differences between prices and taxes. 2. Emphasize that taxes are the main source of government finance. Taxes account for nearly all nonborrowed revenue raised by the federal government. State and local governments rely on user charges for a substantial amount of revenue. 3. The method of government finance is hypothesized to affect the political equilibrium, market equilibrium and efficiency, and the distribution of income. The effect on political equilibrium is discussed. 4. Emphasize that taxes constitute the largest single item in the budgets of most households. 5. In discussing the distribution of tax burden, it is useful to mention the benefit principle and the ability-to-pay principle to highlight the controversies involved in the normative analysis of taxes. I have chosen not to analyze various rules for achieving equity. These rules inevitably rest upon interpersonal comparisons of utility. Students also find the analysis of principles of minimum sacrifice difficult to understand. I believe the return gained from opening this can of worms is very © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

low for undergraduates, and I have therefore chosen not to include a rigorous analysis of minimum sacrifice in the text. Instead I have several numerical examples that highlight important issues in both horizontal and vertical equity. 6. The distinction between general tax and selective tax is a useful one to make. It will come in handy when discussing the difference between broad bases and other types of taxes. The major tax bases are income, consumption, and wealth. You may want to discuss how these bases are related to each other. 7. I believe that much confusion can be avoided later in the course if the student clearly understands the difference between average and marginal tax rates. These two concepts should be applied to the discussion of progressive, proportional, and regressive rate structures. Point out that the ―flatrate‖ tax often discussed is one with a proportional rate structure. Note that the text uses realistic examples of each of these types of rate structures. 8. The subject of tax evasion and compliance has been a fruitful area of research in recent years. In class make the distinction between tax avoidance (which is legal) and tax evasion (which is illegal). The boxed analysis discusses the economics of tax evasion and cites some recent research results. 9. I believe that it is important to discuss alternatives to taxation. Students should realize that taxes can be reduced if nontax revenue is increased. There is a brief discussion of debt finance in this chapter that will be amplified in Chapter 12. Government-induced inflation was used during the Johnson administration in an attempt to provide both ―guns and butter.‖ The inevitable result was a reduction in private purchasing power. 10. Donations are voluntary contributions that help to finance government services. The discussion of donations should be related to the Lindahl model. Point out that donations could be very effective in financing government services in small communities. 11. You may wish to skip some of the material on user charges in this chapter. The introductory analysis shows how user charges can work to improve efficiency while not necessarily having undesirable equity effects. Emphasize that when government goods that are subject to exclusion are not priced, the rich as well as the poor benefit. For income-elastic goods, like museum attendance, the net effect of zero-price financing could be to redistribute income from the poor to the rich. The Public Policy Perspective on road pricing is very interesting to students, and I strongly suggest that you go over it in class. 12. The material on government enterprise could also be skipped. However, the material on pricing of congestible public goods, not usually found in public finance texts, is enlightening to students.

ANSWERS TO TEXT PROBLEMS 1. Annual tax is $35,000. The extra tax on $10,000 additional income is $5,000. The average tax rate on $110,000 would be $40,000/$110,000 = 36.36 percent. 2. a. The restaurant worker has an average and marginal tax rate of 5 percent. b. The average tax rate for the bank manager is $1,500/$35,000 = 4.29 percent. The manager’s marginal tax rate is zero. c. The average tax rate for the CEO is $1,500/$500,000 = 0.3 percent. The marginal tax rate for the CEO is zero.

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3. a. Because the price is zero, water will be consumed up to the point at which its marginal benefit is zero. At that level of output, the marginal cost will be five cents, so more than the efficient amount of water will be consumed because the marginal cost of water exceeds its marginal benefit. b. The user charge of five cents will reduce quantity demanded until marginal benefit equals five cents. At that level of output, net gains from water production will increase by 0.5 (100,000)×5 cents = $2,500 per month, which is equal to the welfare triangle. Tax revenues of $5,000 per month will be freed, because water production will fall by 100,000 gallons per month. In addition, the user charge will collect $20,000 monthly from the sale of 400,000 gallons of water each month. A total of $25,000 in tax revenue will therefore be freed as a result of the user charge. 4. If the marginal cost of entering the road is zero, it is a pure public good and the efficient price is zero. During rush hours, congestion implies that the marginal cost exceeds zero, and the road is a congestible public good for which a toll should be charged to achieve efficiency. An AVI system should set tolls according to the marginal congestion cost to achieve efficiency. 5. a. An increase in marginal tax rates increases incentives for tax evasion by increasing the marginal benefit of tax evasion. b. A decrease in marginal tax rates decreases incentives for tax evasion by decreasing the marginal benefit of tax evasion. c. An increase in the complexity of the tax code makes it more difficult for authorities to determine if evasion is taking place. This probably decreases the marginal cost of tax evasion by decreasing the probability that the evasion will be detected. d. An increase in the penalty for tax evasion increases its marginal cost and decreases the equilibrium amount of evasion.

TRUE /FALSE QUESTIONS 1. Taxes simultaneously ration and finance government goods and services. (F) 2. The federal government finances only half of its expenditures with taxes. (F) 3. The benefit principle argues that the means of financing government goods and services should be linked to the benefits received from those goods and services. (T) 4. Horizontal equity is achieved when individuals of the same economic capacity pay the same amount of taxes over a given period. (T) 5. A flat-rate income tax is a proportional tax on an income base. (T) 6. The marginal tax rate will eventually exceed the average tax rate if the tax rate structure is proportional. (F) 7. The marginal tax rate for a payroll tax is 7 percent on all wages up to $60,000 per year. The marginal tax rate for wages in excess of $60,000 per year is zero. The payroll tax is therefore a regressive tax. (T) 8. Tax evasion would be less of a problem if tax rates were lowered. (T) 9. The user charge for a congestible public good should be zero at all times. (F) 10. Zero prices for price-excludable government services provide benefits only to the poor. (F) 11. The gasoline tax is an example of a general tax on consumption. (F) © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

12. For a proportional tax, the marginal tax rate is always equal to the average tax rate. (T) 13. Tax avoidance is an illegal activity in the United States. (F) 14. An increase in marginal tax rates is likely to increase tax evasion. (T) 15. Most studies indicate that state-run lotteries are equivalent to a progressive tax on gambling. (F) 16.

Government activity requires the reallocation of resources from government to private use. (F)

17.

A flat income tax is an example of a selective tax. (F)

18.

The average tax rate and marginal tax rate are the same under a progressive tax rate structure. (F)

MULTIPLE CHOICE QUESTIONS 1. According to the benefit principle, a. taxes should be distributed according to ability to pay. b. user charges are an ideal source of finance for government goods and services. c. the progressive income tax represents the ideal way of distributing taxes among citizens. d. flat-rate taxes are always the best kind. 2. If horizontal equity is achieved in taxation, a. vertical equity will also be achieved. b. individuals of equal economic capacity will pay equal taxes. c. a flat-rate tax will be used. d. the tax system will not result in losses in efficiency in markets. 3. The tax base of a payroll tax is: a. consumer expenditures. b. interest income. c. labor income. d. both (b) and (c) are correct. 4. A 5-percent retail sales tax on all consumer purchases in a state is imposed. The sales tax is: a. a flat-rate tax. b. a tax with a regressive rate structure. c. levied on an income base. d. all of these are correct. 5. A tax on the value of real estate holdings is a: a. selective tax on wealth. b. general tax on wealth. c. general tax on income. d. selective tax on income. 6. An excise tax is a: a. general consumption tax. b. selective consumption tax. c. general wealth tax. d. selective tax on wealth. © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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7. A proportional income tax has an average tax rate that: a. is always less than the marginal tax rate. b. always exceeds the marginal tax rate. c. equals the marginal tax rate at first and then becomes less than the marginal tax rate. d. always equals the marginal tax rate. 8. A payroll tax taxes a worker’s wages at 14 percent until the worker earns $60,000 per year. All labor earnings in excess of $60,000 are not subject to tax. The tax rate structure of the payroll tax is therefore: a. proportional. b. progressive. c. regressive. d. flat-rate. 9. A bridge becomes congested after 100 vehicles per hour use it on any day. To achieve efficiency, a toll: a. that charges all users of the bridge, no matter how many vehicles use it per hour, should be imposed. b. on additional users in excess of 100 per hour should be imposed. c. on all users should be imposed, if more than 100 users per hour are expected. d. is not required.

10. A government prints money to finance its expenditures. As a result, a. the economy can operate at a point outside its production possibility curve. b. inflation will occur. c. consumers will give up private goods to finance the increased government expenditures. d. both (b) and (c) are correct. 11. Taxes are likely to affect: a. market equilibrium. b. political equilibrium. c. the distribution of income. d. all of these are correct. 12. Taxes: a. are voluntary payments to governments. b. are unlikely to affect market supply and demand. c. never affect efficiency in the allocation of resources. d. are compulsory payments associated with certain activities. 13. A tax on real estate is a: a. general wealth tax. b. general consumption tax. c. selective wealth tax. d. selective income tax. 14. The marginal tax rate will eventually exceed the average tax rate for a: a. proportional tax. b. regressive tax. c. progressive tax. d. flat-rate tax. 15. Marginal tax rates were reduced in 2001. Other things being equal, this is likely to: a. increase tax evasion. b. decrease tax evasion. c. have no effect on tax evasion. d. increase tax avoidance. 16. What is an example of a normative criterion that a government must trade-off in its method of taxation? a. Equity b. Efficiency c. Administrative ease d. All of these are correct. 17. Tax avoidance is a: a. means of tax evasion. b. means of decreasing taxes paid by adjusting behavior. c. political process explicitly for the reduction of taxation. d. means to avoid tax owed. © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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18. If the marginal tax rate is 20 percent under a proportional tax rate structure, the average tax rate: a. should be 20 percent. b. should be above 20 percent. c. should be below 20 percent. d. cannot be determined. 19. If the average tax rate under a progressive tax rate structure is 35 percent, a possible marginal tax rate is: a. 30 percent. b. 25 percent. c. 42 percent. d. cannot be determined. 20. Which of the following countries has the highest average tax rate relative to GDP? a. Korea b. Sweden c. Iceland d. United Kingdom

ESSAY QUESTIONS 1. Explain why it is difficult to evaluate alternative means of government finance according to a single criterion. What important economic and social variables are likely to be affected by the means of financing government goods and services? Are flat-rate taxes inherently more desirable than taxes with progressive rate structures? 2. How do taxes differ from prices? What are the major alternatives to taxes as sources of government finance? How does a progressive rate structure differ from a proportional rate structure?

CHAPTER 11

Taxation, Prices, Efficiency, and the Distribution of Income

INSTRUCTIONAL OBJECTIVES This chapter is designed to make students aware of the impact of taxes in markets. The emphasis is on the effect taxes have on prices and how taxes change prices in ways that affect efficiency and income © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

distribution. This is a very important chapter because it develops the techniques of analysis that will be used in the following chapters on tax policy. Students should be advised to read this chapter carefully. Students should understand the concept of a lump-sum tax as a benchmark for comparing taxes. It is important for students to realize that a lump-sum tax results in income effects but has no substitution effects. Students should also thoroughly comprehend how a price-distorting tax causes losses in efficiency by making buyers and sellers react to different prices. This requires that students be able to use supply-and-demand analysis to show the excess burden of the tax and understand how it varies with key factors. Another goal is to show how tax-induced changes in prices affect income shares. Students should see that tax incidence is independent of the legal liability for taxes. It is very important to make it clear that tax incidence depends on market conditions rather than on whims of sellers to raise prices. Various techniques for evaluating the impact of taxes on the actual distribution of income are also discussed in the chapter.

CHANGES IN THIS EDITION 

Data in this chapter have been updated.



Measuring Income Inequality: The Gini Coefficient has been updated with a discussion based on the tax code changes from 2017.

CHAPTER OUTLINE Lump-Sum Taxes: A Benchmark Standard for Comparison Global Perspective: The Lump-Sum Tax Takes Its Lumps in the United Kingdom The Impact of Taxes on Market Prices and Efficiency Further Analysis of Tax Incidence General Equilibrium Analysis of the Excess Burden and Incidence of Taxes Taxes, Government Expenditures, and the Distribution of Income

MAJOR POINTS AND LECTURE SUGGESTIONS 1. It is essential to make sure students understand that much of the analysis in the chapter assumes perfect competition in markets. Individual sellers and buyers have no influence over the price. Emphasize that no single seller can raise the price in response to a tax. The way a tax affects price, and therefore quantity exchanged, in a market depends on conditions of demand and supply in the market. 2. I also emphasize that although evaluating the fairness of taxes is subjective, it requires accurate data on the impact of taxes on prices. Once again, this requires understanding of the way taxes affect market equilibrium for the taxed good and related goods. 3. Students must understand how economists use lump-sum taxes as a benchmark for evaluating price-distorting taxes. A price-distorting tax is one that causes the net price received by sellers to diverge from the gross price paid by buyers. If you can get this point across to students, they will be much less likely to be confused later on. Point out that any tax must reduce incomes to release © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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productive resources for government use. A lump-sum tax accomplishes this without preventing the prices of taxed goods from simultaneously equaling the marginal social benefit and marginal social cost of goods. A lump-sum tax results in income effects but no substitution effects. Use the head tax example appearing in the chapter to illustrate how lump-sum taxes can drastically affect the distribution of income. 4. The indifference curve analysis of lump-sum versus price-distorting taxes is tough going for most students. Nonetheless, it is important to show how the lump-sum tax has only an income effect and how a person will always be better off paying the same amount of tax from a price-distorting tax in a lump sum. I suggest copying the graph as a handout for students to make it easier for them to get it into their notes. Also refer the students back to the Appendix to Chapter 1 where indifference curves between quantity of a particular good and expenditures on all other goods is first presented. Make it clear that the graph assumes that the market price of the good increases by the full amount of the tax per unit. 5. In analyzing a unit tax, give examples in class. The gasoline tax is a unit tax, as is the cigarette tax and liquor tax. Most students will be familiar with shifting supply curves to show the impact of a tax. Note how I label the demand curve (in Figure 11.2) ―MSB‖ and the supply curve ―MSC.‖ Of course, this assumes no externalities—an assumption that is made explicit. This technique also is consistent with my analysis of efficiency in Chapter 2 of the text. 6. In discussing excess burden, make sure students realize that this measures the loss in net benefits from the taxed good that would not occur if a lump-sum tax were used. This means that the change in output must reflect only the substitution effect of the tax. If an equal-yield, lump-sum tax were levied on persons in this market, there would be an income effect but no substitution effect. The triangle is an accurate measure of excess burden when market supply and demand curves are used only if the income effects of tax-induced price changes are negligible. 7. I use a simple formula to estimate the excess burden. Then I give the students an intuitive analysis of why the excess burden varies quadratically with the tax. The simple formula for the triangle shows that the excess burden varies with t and the tax induces change in market quantity. This change in market quantity depends on the change in price, which is a function of the tax. Finally, I present the formula, which I derive in the appendix that shows how excess burden varies with price elasticities. I point out the price elasticity of demand as a negative number. That is why there is a minus sign in the numerator of Equation 11.3. When problems are assigned, treating ED as a negative number makes it easier for students to solve the equation. 8. The efficiency-loss ratio of a tax is also called its coefficient of inefficiency. This concept is useful in evaluating the gains and losses of transferring revenue from one tax to another. It is used in most empirical work on taxes. 9. Once you have analyzed the excess burden of a unit tax, it is easy to use the same graph to show how the tax paid is distributed between buyers and sellers. It is easiest to concentrate on the tax per unit and then show how this relates to total tax paid. 10. Make sure students see how ad valorem taxes differ from unit taxes. Equation 11.5 helps students see how the amount of tax paid per unit depends on the price of a good when an ad valorem tax is used. The same equation is used to derive expressions for the excess burden of an ad valorem tax in the text. 11. Note that it makes a difference whether the tax is levied on the gross or net price. In most of my examples, the tax is levied on the gross price. The difference between taxes on net and gross prices is a technical point that can be quite confusing. For example, the payroll tax levied on the wages received by workers is a tax on the gross wage. The workers receive the wage paid by employers, © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

and then the tax is deducted from the wage. The retail sales tax is actually a tax on the net price received by sellers. The buyers pay the market price of the good, then sellers are liable for a certain percentage of that price. This percentage is usually tacked on to the price paid by the buyer. The total price paid by the buyer is therefore the net price, PN, plus the tax, tPN. Therefore, PG = PN (1 + t) for a retail sales tax. Note how the formulas show students that the initial price and quantity must be used to compute the excess burden. 12. The text shows that the incidence of a tax is independent of its legal liability. Most students have a harder time conceptualizing a tax as a reduction from the marginal benefit received by consumers than they do seeing it as an addition in marginal cost incurred by sellers. My example shows how the tax on buyers affects the maximum price they will pay for any given quantity. 13. Multimarket analysis of incidence shows how a tax in one market can decrease prices in other markets. Emphasize how this affects incidence of the tax. Also point out how the prices of specialized inputs for each of the goods can be affected.

ANSWERS TO TEXT PROBLEMS 1. The equilibrium price is $10 per gallon. The equilibrium quantity is 300,000 gallons per year. After a $1 per gallon tax is imposed on sellers, the supply curve is described by the equation Qs = $30,000(P – 1). Solving for the new equilibrium price by setting quantity demanded equal to quantity supplied gives P = $10.60. The net price received by sellers after paying the unit tax is therefore $9.60. The new equilibrium quantity is therefore $288,000. Assuming no income effects, the excess burden of the tax will be 0.5(12,000) = $6,000 per year. The incidence of the tax will be shared by buyers and sellers of liquor. 2. The additional tax on clothing will decrease the supply of clothing and cause resources to flow into food production. The price of food will fall, while the price of clothing will rise. Assuming that the tax revenue is returned, the incidence of the tax will depend entirely on the changes in the prices of food and clothing, which will depend both on the elasticities of supply and of demand for these items.

3. Because both the price elasticity of demand and of supply of wine is unity, the excess burden is 1/2(200/6)×(1/2) = $8,333,333.33 per year If the tax rate goes up to two, the excess burden will quadruple to 1/2(4)(200/6)×(1/2) = $33,333,333.33 If there are negative externalities associated with drinking wine, then the tax can actually improve resource use despite its high excess burden. 4. To minimize the excess burden, a second-best type tax system would vary tax rates according to elasticities of demand and supply of taxed items. The tax system could encourage work by levying high taxes on commodities that would be complementary with leisure. 5. The excess burden is 0.5(0.1)2 ×150,000,000(–1) = –$750,000 per month. If the tax rate is doubled to 20 percent, the excess burden quadruples to a loss of $3 million per month. Because the supply is perfectly elastic, the incidence of the tax is borne fully by the buyers. For a 10 percent tax, the © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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market equilibrium price per square foot of construction will rise to $165. For a 20 percent tax, the market equilibrium price will rise to $180.

A NOTE ON THE APPENDIX TO CHAPTER 11 If your students are above average, you will want to assign the appendix to this chapter. I believe you will find the material on compensated demand curves and compensated supply curves in this chapter very useful. Much of the material in the appendix is rarely found in an undergraduate textbook. The appendix does more than derive formulas. It shows students how the substitution effect of tax-induced price changes can be isolated by using compensated demand and supply curves. This is done with graphic analysis that is then used to show how estimates of excess burden made with noncompensated curves can result in biases.

OUTLINE OF THE APPENDIX TO CHAPTER 11 The Excess Burden of Taxation: Technical Analysis

TRUE /FALSE QUESTIONS 1. A lump-sum tax results in both income and substitution effects. (F) 2. A consumer currently pays $500 a year in retail sales taxes. She would be better off if she paid the same amount annually as a lump-sum tax. (T) 3. Clothing is sold in perfectly competitive markets where no externalities prevail. An excise tax on clothing will result in a market price for clothing that equals the marginal social benefit and marginal social cost of service. (F) 4. Assuming that the income effects are negligible and that beer is sold in a competitive market, a tax of 10 cents per can of beer that causes a decline in sales of 10,000 cans per month will result in an excess burden of $1,000 per month. (F) 5. A tax on land results in an income effect on landlords but no substitution effect. It then follows that the excess burden of a tax on land will be zero. (T) 6. The excess burden of a tax on interest income is $5 billion per year. Total interest income per year is $50 billion. The tax currently collects $15 billion in revenue per year. The efficiency-loss ratio of the tax is therefore 0.33. (T) 7. A payroll tax results in a difference between the gross wages paid by employers and the net wages received by workers. (T) 8. If the market supply of labor services is perfectly inelastic, a tax on labor income will reduce the net wages received by workers by the full amount of the tax per labor hour. (T) 9. If a $10 per unit tax is levied on the output of a monopolist, more of that tax will be shifted to consumers than would be the case if the same good were produced by a competitive industry. (F) 10. A study indicates that taxes in the United States reduce the Gini coefficient for the nation by 10 percent. This implies that taxes make the income distribution more equal. (T) 11. A lump-sum tax only results in income effects. (T) © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

12. An income tax is an example of a price-distorting tax. (T) 13. The more price-elastic the demand of a taxed item, the lower the excess burden of a tax on the sale of that item. (F) 14. If the tax on the sale of gasoline is doubled from 20 cents per gallon to 40 cents per gallon, the excess burden of the tax will quadruple. (T) 15. If the compensated elasticity of supply of labor is zero, then a tax on labor earnings will have zero excess burden. (T) 16.

Lump-sum taxes do not prevent prices from equaling the marginal social cost and benefit of any goods and services. (T)

17.

Lump-sum taxes can vary in amount based on income level. (F)

18.

A lump-sum tax can distort prices and affect consumption behavior. (F)

MULTIPLE CHOICE QUESTIONS 1. A lump-sum tax: a. distorts market prices so that they do not simultaneously equal MSB and MSC. b. can result in price changes but does not prevent prices from simultaneously being equal to MSB and MSC. c. results in substitution effects that change prices. d. results in both substitution effects and income effects that change prices. 2. The current price of compact discs, which are traded in perfectly competitive markets, is $10. A $1 per unit tax is levied on the discs. Annual record sales decline from five million to four million as a result of the tax. Assuming that the income effect of the tax-induced price change is negligible, the excess burden of the tax will be: a. $500,000 per year. b. $1 million per year. c. $2 million per year. d. $2.5 million per year. 3. The elasticity of supply of land is zero. A tax on land results only in an income effect to landlords. It then follows that a 10 percent tax on land rents will: a. have a positive excess burden. b. be paid entirely by landlords. c. have zero excess burden. d. both (b) and (c) are correct. 4. Currently, a 10 cent per gallon tax is levied on gasoline consumption. The tax is increased to 20 cents per gallon. The excess burden of the tax will: a. remain the same. b. double. c. increase four times. d. decline.

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5. The supply of new cars is perfectly elastic. A $400 per car tax is levied on buyers. As a result of the tax, the a. price received by sellers will fall by $400. b. price paid by buyers, including the tax, will increase by $400. c. quantity of cars sold per year will be unchanged. d. excess burden of the tax will be zero. 6. Other things being equal, the more inelastic the demand for a taxed good, the a. greater the portion of the tax paid by sellers. b. greater the excess burden of the tax. c. greater the portion of the tax paid by buyers. d. less the portion of a tax on sellers that can be shifted to buyers. 7. The market supply of labor is perfectly inelastic. However, the income effect of tax-induced wage changes are believed to be substantial. It then follows that a tax on labor income will: a. have zero excess burden. b. have positive excess burden. c. be paid entirely by workers as a reduction in net wages. d. both (b) and (c) are correct. 8. Suppose an economy is comprised of only two markets: one for food and the other for housing. A tax on food used to finance transfer payments is likely to: a. decrease the price of food. b. increase the price of housing. c. decrease the price of housing. d. have no effect on either the price of food or housing. 9. Differential tax incidence measures the effect: a. that a tax and the expenditures it finances have on the distribution of income. b. that one tax alone has on the distribution of income. c. on the distribution of income of substituting one tax for another while holding the size and composition of the budget fixed. d. on the distribution of income of substituting one tax for another while changing the kinds of government services financed. 10. Most studies of tax incidence assume that taxes on labor income and other input services are borne entirely by the workers and other input owners that supply the services. This implies that the: a. supply of those input services is very elastic. b. supply of those input services is of unitary elasticity. c. supply of those input services is perfectly inelastic. d. demand for those input services is perfectly elastic. 11. Most studies show that the price elasticity of demand for gasoline is –0.2. If the price elasticity of supply is 2, then a tax on gasoline will: a. cause the market equilibrium price of gasoline to fall. b. cause the market equilibrium price paid by buyers to rise. c. cause the net price received by sellers to fall. d. both (b) and (c) are correct. © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

12. The demand for medical care is very inelastic. If a 10 percent tax is levied on the sale of medical services and is collected from medical-care providers, then: a. the incidence of the tax is likely to be borne entirely by medical-care providers. b. most of the tax is likely to be shifted to those who purchase medical care. c. the market equilibrium price of medical care will fall. d. the excess burden of the tax is likely to be very high. 13. Which of the following is true about a lump-sum tax? a. It prevents efficiency from being attained in competitive markets. b. It causes substitution effects. c. It causes income effects. d. It causes both income effects and substitution effects. 14. Housing construction is generally believed to be an industry of constant costs. In the long run, which of the following is true if a $10 per square foot tax on housing construction is collected directly from builders? a. The incidence of the tax will be borne by builders. b. The excess burden of the tax will be zero. c. The quantity of new construction supplied will be unaffected. d. The tax will be fully shifted to buyers of new construction. 15. If the price elasticity of supply of labor is equal to 0.5 and the price elasticity of demand for labor is –2, then which of the following is likely to result from a tax on labor earnings? a. The tax will be fully borne by workers. b. Some of the tax will be shifted to employers as market equilibrium wages increase. c. Market equilibrium wages will decline. d. There will be no effect on market equilibrium wages. 16. If a lump-sum tax is imposed, the slope of the new budget line relative to the budget line prior to the tax: a. remains unchanged. b. increases. c. decreases. d. can increase and decrease in different regions. 17. Viewed from origin, a price distorting tax creates a new budget line with a ______ slope relative to the budget line without the tax. a. less steep b. more steep c. similar d. varying 18. A $0.30 per unit tax is imposed on a good that reduces the quantity supplied and demanded by 1000 units. What is the deadweight loss (ignore price elasticities)? a. $300.00 b. $100.00 c. $150.00 d. Cannot be determined. © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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19. If a per unit tax is imposed but the quantity supplied and demanded does not change, then: a. the demand is perfectly inelastic. b. the supply is perfectly inelastic. c. there is no deadweight loss. d. all of the these are correct. 20. The efficiency-loss ratio relative to tax is: a. the deadweight loss less the tax revenue. b. the deadweight loss divided by the tax revenue reduced by one. c. the excess burden divided by the tax revenue. d. none of these are correct.

ESSAY QUESTIONS 1. Explain why the excess burden of a lump-sum tax will always be zero. Why is the payroll tax not a lump-sum tax? Show how a payroll tax affects the wages paid by employers and received by workers, assuming that it is withheld from their paychecks. Assuming that the supply of labor is not perfectly inelastic, show how the excess burden can be measured. 2. A 10 percent tax is levied on the sale of soft drinks. This tax is collected from the sellers of the drinks. A critic of the tax argues that the sellers will shift the entire tax to the buyers and therefore be no worse off. Evaluate this argument by showing the market conditions that would have to prevail for the prediction to be correct. Indicate under what circumstances the tax will be shared by the buyers and the sellers of soft drinks.

CHAPTER 12

Budget Balance and Government Debt

INSTRUCTIONAL OBJECTIVES This chapter introduces students to issues and facts about government budget surpluses, deficits, and debt. The main objectives are to make students aware of actual data relating to the government debt and to help them to understand the theoretical issues involved in evaluating the impact of surpluses and deficits. The issues of whether or not a surplus can remain as a political equilibrium is discussed. The consequences of using the surplus to finance tax reductions, as opposed to using it to retire the federal debt, is also discussed within the context of the effects on national saving. © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

There is considerable data in the chapter on the ownership pattern of the debt. Students are shown the distinction between internal and external debt. The facts discussed in the chapter help students to evaluate arguments relating to the burden of the government debt and deficit finance.

CHANGES IN THIS EDITION 

Data in this chapter has been extensively updated. The federal budget deficit and trends in use of the deficit as a means of finance are analyzed using the latest available data.



Federal budget data and discussion has been updated to include data from 1969 and projected through 2029.



The discussion of the deficit and national saving has been updated.



The analysis of the federal debt has been updated and expanded to include historical data from 1790 to 2018; projections through 2049 have been added.

CHAPTER OUTLINE The Federal Budget Balance Public Policy Perspective: How Did the Deficit Get So Big in 2009? The Impact of Recessions and Public Policies Economic Effects of the Federal Budget Balance Government Debt Borrowing by State and Local Governments Burden of the Debt Global Perspective: Consequences Uncontrolled Budget Deficit Growth: The Case of Turkey Sovereign Debt: Default Risk, Interest Rates, and Austerity

MAJOR POINTS AND LECTURE SUGGESTIONS 1. Begin your lecture by emphasizing that borrowing was the most common alternative to tax finance used by the federal government between 1970 and 1998. You may wish to discuss the fact that the budget balance became a surplus between 1998 and 2001. Part of the surplus was used as a means of financing tax reductions. Having discussed this, then point out how the budget could balloon after the first quarter of the twenty-first century as the dependency ratio of retirees to workers increases, unless benefits are cut or taxes are increased to pay the promised Social Security and Medicare benefits. Also point out that after 2002, deficit finance was once again used in part to finance a military buildup and for homeland security. 2. It is important to show students how the budget balance is sensitive to fluctuations in the level of economic activity and how these effects can be adjusted for by computing the high employment deficit. In fact, faster than anticipated growth of GDP in the late 1990s contributed to ballooning federal budget surpluses well in excess of what was forecast. Recessions in 2001 and 2007–2009 contribute to sharp increases in the federal budget deficit. 3. The issue of the effect of the deficit on interest rates remains controversial. I take a step-by-step approach in the text to introduce the concept of Ricardian equivalence, which suggests that an © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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increase in saving in response to the deficit can offset the upward pressure on interest rates that results from increased government borrowing. The increase in the supply of savings offsets the increase in demand for loanable funds by the government. The net effect is that interest rates remain unchanged. You should also discuss Barro’s view that deficit finance increases bequests to the next generation. This point is crucial in evaluating the burden of the debt. 4. Also discuss the effect of a budget surplus on the credit markets. Figure 12.4 is provided in the text for this purpose. If the surplus is used to retire federal debt, then it increases national saving. If it is used for personal tax cuts, it is likely to increase consumption, given the incredibly low savings rates of U.S. households. 5. Students are very interested in the national debt. I recommend copying some of the graphs and tables in the chapter for distribution to students in class. If surpluses are continually run in the years to come, the federal debt could be retired. A section in the text analyzes the impact of retiring the debt. The net federal debt as a percent of GDP leveled off in the late 1990s, but increased sharply after 2010 as the federal deficit increased in part as a result of the recession of 2007–2009. 6. It is clear that deficit finance has shifted the payment of taxes to future generations. A crucial issue is whether increases in private saving and bequests offset this burden.

ANSWERS TO TEXT PROBLEMS 1. At the current equilibrium interest rate of 8 percent, the allocation of credit is $500 billion to investment, $100 billion to consumer credit, and $100 billion to government. An increase in government demand will crowd out some consumer and investment credit and also increase the quantity of loanable funds demanded. If there is anticipation of an increase in future taxes, the supply of credit will increase, putting downward pressure on interest rates. 2. Each time the debt is repaid, income will flow from U.S. citizens to foreigners. 3. Classical economists believed that prices were flexible enough to keep the economy at full employment at almost all times. Under such circumstances, an increase in government spending, no matter how financed, could only reallocate resources from private to government use. 4. a.

Other things being equal, national saving will increase, assuming that the supply of private saving does not decrease as the government relies less on borrowing and more on taxes.

b. Interest rates will fall, assuming that the supply of private saving does not decrease as the government relies less on borrowing and more on taxes. c.

Private investment will increase, assuming that the supply of private saving does not decrease as the government relies less on borrowing and more on taxes and assuming that investment demand is responsive to a decline in interest rates.

d. Economic growth in the future will increase because of higher saving and higher investment rates. e.

An increase in economic growth will improve future living standards.

5. Personal saving is 1 percent of GNP. A surplus amounts to government saving, so a federal budget surplus will increase national saving. A budget deficit is negative government saving and will reduce national saving. Other things being equal, a federal budget deficit increases the demand for credit and bids up interest rates. This, combined with the fact that the deficit absorbs savings that would © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

otherwise finance investment, can decrease investment in the United States and decrease future economic growth.

TRUE /FALSE QUESTIONS 1. From 1950 to 2009, the federal government budget has been in balance in most years. (F) 2. The high employment budget deficit implies that increases in economic activity will not eliminate the actual deficit. (T) 3. Other things being equal, an increase in government borrowing is likely to increase interest rates. (T) 4. If taxpayers anticipate future tax increases when government borrows to finance deficits, increased government borrowing will increase interest rates. (F) 5. The net federal debt is projected to soar from about 80 percent of GDP in 2020 to more than 150 percent of GDP by 2050. (T) 6. From 1950 to 1980, the value of the federal debt as a percent of GDP declined. (T) 7. More than 50 percent of the federal debt in recent years has been outside debt. (F) 8. An increase in market rates of interest tends to decrease the market value of outstanding government debt. (T) 9. Deficit finance postpones taxation from the present to the future. (T) 10. The burden of the debt is borne by those who purchase government bonds. (F) 11. The federal government budget recorded surpluses between 1998 and 2001. (T) 12. State and local governments are usually required by state law to keep the budgets in balance. (T) 13. If business and personal saving are constant, then a federal budget deficit will have no impact on national saving. (F) 14. Other things being equal, a government surplus increases the supply of loanable funds available for investment. (T) 15. State revenue bonds are backed by the taxing power of state governments. (F) 16.

A federal budget surplus can lead to more credit being available for productive activity. (T)

17.

A federal budget deficit can strain credit markets, forcing the real rate of interest to decrease. (F)

18.

The U.S. deficit in the 1980s was structural in the sense that federal spending would exceed federal revenue even at a level of full employment. (T)

MULTIPLE CHOICE QUESTIONS 1. The outstanding federal debt will decline in value if: a. budget deficits continue. b. the government runs a budget surplus. c. the market rate of interest increases. d. both (b) or (c) are correct. © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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2. The federal budget has been in deficit: a. every year between 1970 and 1997. b. every year between 1950 and 1997. c. only since 1980. d. every year between 1960 and 1997. 3. The high employment deficit is estimated at $100 billion. Assuming that the economy is operating below full employment and that it will not overheat during the year, a. the actual budget is not in deficit. b. increasing GDP will eliminate the deficit. c. increasing GDP will not eliminate the deficit. d. the actual budget is in surplus. 4. An increase in government borrowing has no effect on the willingness of citizens to save or on the demand for credit. Increased borrowing to cover deficits will therefore: a. reduce interest rates. b. increase interest rates. c. have no effect on interest rates. d. not require increased taxes in the future. 5. As a result of government borrowing to cover deficits, citizens increase the supply of savings to provide themselves with funds to pay anticipated increases in future taxes. It then follows that increased government borrowing will: a. reduce private investment. b. increase private investment. c. have no effect on private investment. d. increase interest rates. 6. As of 2019, interest payments on the federal debt account for what percent of federal expenses? a. Around 25 percent b. Around100 percent c. Around 10 percent d. Around 5 percent 7. The federal government, its agencies, and the Federal Reserve System: a. are not permitted to hold outstanding federal debt. b. hold 50 percent of the outstanding federal debt. c. hold 27 percent of the outstanding federal debt. d. hold 75 percent of the outstanding federal debt. 8. The largest portion of the net federal debt outstanding is owed to: a. foreigners. b. U.S. citizens and companies. c. federal government agencies. d. state and local governments. 9. The debt of state and local governments is mostly: a. internal. b. external. © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

c. owed to citizens of other nations. d. worthless. 10. Government borrowing will: a. postpone taxation to the future. b. increase government interest cost. c. eliminate taxes. d. both (a) and (b) are correct. 11. Which of the following is true about the federal government budget balance in the United States? a. The federal budget has never had a surplus. b. The federal budget had a surplus every year from 1970 to 2008. c. The federal budget had a surplus from 1998 until 2001. d. The federal budget had a deficit from 1998 until 2001. 12. Which of the following can contribute to a decrease in national saving? a. A federal budget deficit b. An increase in the state and local government aggregate surplus c. A federal budget surplus d. An increase in personal saving 13. Other things being equal, a government budget surplus: a. increases the demand for loanable funds. b. increases the supply of loanable funds. c. is likely to increase market equilibrium interest rates. d. is unlikely to affect market equilibrium interest rates. 14. If the federal government runs a surplus consistently, then which of the following is likely to occur? a. National saving will decline. b. The gross federal debt will increase. c. The gross federal debt will decrease. d. Market equilibrium interest rates are likely to rise as a result of the surpluses. 15. General obligation bonds of state and local governments are: a. backed by revenue from public facilities such as sports stadiums. b. backed by the taxing power of state and local governments. c. usually used to finance capital expenditures. d. both (b) and (c) are correct. 16. A bond that is backed by the tolls collected from a bridge to be constructed from the proceeds of the bond is an example of: a. a general obligation bond. b. a non-obligation bond. c. a revenue bond. d. none of the these are correct. 17. Evidence of ―crowding out‖ in the market for loanable funds at a rate of 8 percent could be: a. private investors who will borrow only at a rate lower than 8 percent. b. private investors who are willing to accept a rate higher than 8 percent for borrowing. © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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c. a government surplus. d. a social security surplus. 18. High-employment deficit or surplus is: a. an extreme economic situation requiring emergency measures. b. the amount of deficit or surplus available, assuming current employment levels. c. the amount of deficit or surplus available when employment is at its approximately full capacity. d. the amount of deficit or surplus available when unemployment is at a relatively high level. 19. A government’s internal debt is: a. debt owed to other government agencies. b. debt owed to other governments. c. debt owed to its citizens. d. both (a) and (c) are correct. 20. The National Income and Product Accounts budget balance reflects: a. an inflation-adjusted budget balance less social security surplus. b. new debt resulting from a federal budget deficit. c. the real budget balance. d. the nominal budget balance.

ESSAY QUESTIONS 1. What are the advantages and disadvantages of preventing the federal budget from ever being in deficit? In your answer discuss only public finance aspects of the deficit rather than macroeconomic issues. Explain why the high employment deficit or surplus might differ from the actual budget deficit or surplus. 2. What effects do government borrowing and deficit finance have on the distribution of income and well-being? In your answer discuss the intergenerational effects of deficits and the impact of deficits on saving, investment, interest rates, and economic growth.

CHAPTER 13

The Theory of Income Taxation

INSTRUCTIONAL OBJECTIVES This is the first of two chapters on income taxation. This chapter discusses the theoretical aspects of income taxation, while the following chapter emphasizes income taxation as actually practiced in the United States. A major objective of this chapter is to define the concept of comprehensive income and acquaint the student with some of the conceptual and practical problems of measuring income. Once this is accomplished, the rest of the chapter develops the theory necessary to understand the economic effects of a flat-rate tax on comprehensive income. This allows students to see the consequences of a pure tax levied on all income, irrespective of its source or use, at the same rate. The text shows how such a tax impairs efficiency in labor markets and how it can prevent attainment of efficiency in investment markets. Empirical research results are integrated with the theory.

CHANGES IN THIS EDITION 

The data in this chapter have been updated.

CHAPTER OUTLINE Comprehensive Income: The Haig-Simons Definition A General Tax on Comprehensive Income: Economic Effects of a Flat-Rate Income Tax Labor Market Analysis of Income Taxation Public Policy Perspective: The Incidence of Payroll Taxes in the United States Taxation of Interest Income and Its Effect on Saving Market Analysis of Taxation on Interest and Investment Income Public Policy Perspective: The Supply-Side Tax Cuts of the 1980s

MAJOR POINTS AND LECTURE SUGGESTIONS 1. In beginning of your lecture, point out that the goal is to find out the economic effects of a tax that is levied on all income, irrespective of its source or use. The actual federal income tax is very complex because it taxes income at different rates depending on its source or use. The emphasis in this chapter is on a flat-rate tax on all income. © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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2. The definition of comprehensive income should be discussed from both the sources and the uses sides. Make sure students see that income is a flow. Also make sure they know what net worth means. 3. I like to spend a bit of time in class on the problems of measuring comprehensive income. However, if you wish to proceed directly to the theory, you can simply advise students to read the text. You should, however, make sure students know what capital gains are and the difference between realized and unrealized capital gains. Also, I think the problems of measuring income-in-kind are interesting. The most important source of income-in-kind is imputed rents on owner-occupied housing. 4. It is also worth pointing out that under a comprehensive income tax there would be no need for a separate corporation income tax. Corporate income would simply be allocated to shareholders on a pro rata basis according to the proportion of ownership represented by stock shares. 5. Refer students to the Appendix to Chapter 1 of the text for an introduction to the way that indifference curves are used to analyze the work-leisure choice. 6. It is best to divide income into two broad categories: income from labor (wages) and income from saving or investment (interest, dividends, and capital gains). A flat-rate tax on comprehensive income does not distort the price of labor relative to the price of capital input in ways that cause losses in efficiency. It does, however, cause losses in efficiency in labor and investment markets. 7. Emphasize how the tax causes the gross wage that is paid by employers to diverge from the net wage received by workers. Most students have experienced tax withholding, and this point should be obvious to them. The wedge caused by the tax results in losses in efficiency in labor markets. 8. I find that students can easily follow derivation income and substitution effect of a tax on labor income. The trick is drawing the graph on the blackboard without making a mistake! I suggest copying the graph in Figure 13.2 of the text and distributing it to students in class. This shows how the income effect and substitution effect work in opposite directions. After you do this, it is simple to point out to students that a lump-sum tax could collect the same amount from any person without any substitution effect for the work-leisure choice. You can also point out that the excess burden of the income tax depends only on the substitution effect for work caused by the tax. The substitution effect of a tax-induced wage decline is always unfavorable to work. The income effect of the wage decline is favorable to work provided that leisure is a normal good. 9. After you cover income and substitution effects, you can point out that a perfectly inelastic labor supply curve implies that the income effect of wage changes exactly offsets the substitution effect. The compensated supply curve, which only reflects the substitution effect of wage changes, is upward sloping. Figure 13.3 in the text illustrates this nicely. I have been amazed how quickly students grasp this point when it is illustrated in this way. The compensated supply curve is used to derive the change in labor hours per year necessary to compute the excess burden of the tax. Similarly, the graph in Figure 13.4 of the text shows how using a regular labor supply curve instead of a compensated supply curve will underestimate the excess burden of the tax. 10. The analysis of taxation of interest income is more difficult for students to comprehend. The model I use assumes that consumers allocate a given amount of current income between two periods. Consumption in the second period therefore depends on the amount of current income saved. The analysis also discusses income and substitution effects and shows how the tax distorts the interest rate by causing the net return to diverge from the gross return. 11. The incidence of the tax depends on its effect on market wages and interest rates. For example, when interest rates rise as a result of the tax, annual investment will decline. The increase in interest © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

rates can contribute to higher prices of goods by increasing production costs. Reduced investment decreases labor productivity and thereby reduces wages.

ANSWERS TO TEXT PROBLEMS 1. Mary has a real unrealized capital gain of $2,000. Her comprehensive income is therefore $52,000. Under a 20 percent, flat-rate tax, her tax liability would be $10,400 for the year. 2. A $10 billion reduction in taxes on capital income will reduce the excess burden by $4.5 billion. A $10 billion increase in taxes in labor income will result in a new added excess burden of $1.5 billion. There will be a net increase in well-being of $3 billion as a result of the change. 3. The marginal rate of time preference in equilibrium is 8%(1 – .31) = 5.52% A decrease in the marginal tax rate will increase the equilibrium marginal rate of time preference to 8%(1 – .2) = 6.4% John will increase the amount of current income saved as future consumption is substituted for current consumption if the substitution effect outweighs the income tax. 4. If leisure were an inferior good, both the income and substitution effects of a tax-induced wage decline would be favorable to work effort. The compensated labor supply curve would be steeper than the regular labor supply curve. 5. The excess burden is not zero because a perfectly inelastic market labor supply means that the income effect is offset by an equal and opposite substitution effect. The existence of a substitution effect means that there is a positive excess burden. A perfectly inelastic market labor supply implies that the incidence of the tax is borne entirely by the workers, market equilibrium wages do not rise in response to the tax, and none of the tax is shifted to the employers. Overall market labor supply includes responses of many demographic groups. Spouses and the elderly often have more elastic labor supply than prime-age males. Factors that might affect labor supply that are difficult to measure include early retirement, absenteeism, reduced intensity of work, unwillingness to invest in more training, and choice of occupation.

TRUE /FALSE QUESTIONS 1. The actual federal income tax currently taxes all income irrespective of its source or use at the same tax rate. (F) 2. Comprehensive income excludes unrealized capital gains. (F) 3. Under a comprehensive income tax, transfer payments received by Social Security recipients would be fully taxable. (T) 4. Homeowners earn rental income-in-kind from their home that would be taxable under a comprehensive income tax. (T) 5. A comprehensive income tax is a lump-sum tax. (F) 6. A comprehensive income tax will result in a divergence between gross wages paid by employers and net wages received by workers. (T) © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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7. A comprehensive income tax will always reduce work effort by taxpayers. (F) 8. The substitution effect of a tax-induced decline in wages always leads workers to work less. (T) 9. The market wage elasticity of labor is zero. If this is the case, the excess burden of a tax on labor income will also be zero. (F) 10. Points on a compensated labor supply curve are always more elastic than points for corresponding wage levels on a regular labor supply curve. (T) 11. Comprehensive income is the sum of annual consumption and the change in net worth. (T) 12. A tax on interest income does not prevent the credit market from efficiently allocating resources. (F) 13. If an individual is subject to a 30 percent income tax, then the net interest on a certificate of deposit yielding 5 percent would be 3.5 percent after taxes. (T) 14. Because a tax on interest income results in income and substitution effects, it is not possible to predict the effect it will have on saving. (T) 15. Most empirical studies indicate that the interest elasticity of supply of savings is close to zero. (T) 16. Income tax became a permanent fixture in the United States starting in the early nineteenth century. (F) 17. The Haig-Simons definition of income is different from comprehensive income. (F) 18. Comprehensive income equals consumption plus the change in net worth. (T)

MULTIPLE CHOICE QUESTIONS 1. Comprehensive income: a. is the sum of annual consumption and realized capital gains. b. is the sum of annual consumption and changes in net worth. c. excludes corporation income. d. is the sum of annual consumption and net worth. 2. A tax on labor income: a. results only in an income effect that always decreases hours worked per year. b. results in a substitution effect that always decreases hours worked per year. c. results in an income effect that increases hours worked per year if leisure is a normal good. d. both (b) and (c) are correct.

3. The market supply of labor is perfectly inelastic. It then follows that: a. the substitution effect of wage changes is zero. b. the income effect of wage changes is zero. c. leisure is a normal good and the income effect of wage changes exactly offsets the substitution effect. d. the excess burden of a tax on labor income will be zero. 4. The compensated labor supply curve: a. will always be vertical. b. will always be upward sloping. c. will always be downward sloping. d. reflects both the income and substitution effects of wage changes. 5. Using a regular labor supply curve instead of a compensated supply curve to calculate the excess burden of a tax on labor income will: a. result in an accurate estimate of the excess burden. b. overestimate the excess burden. c. underestimate the excess burden. d. accurately estimate the excess burden only if the market supply of labor is perfectly inelastic. 6. Most empirical research indicates that the market supply curve of labor hours by prime-age males is: a. very elastic. b. almost perfectly inelastic. c. always upward sloping. d. perfectly elastic. 7. A flat-rate tax on labor income will: a. always reduce hours worked per year. b. always increase hours worked per year. c. either increase or decrease hours worked per year. d. never have any effect on the amount of leisure hours per year. 8. A tax on interest income: a. causes the gross interest rate paid by investors to exceed the net interest rate received by savers. b. will always reduce saving. c. will always increase saving. d. is equivalent to a lump-sum tax. 9. If the market supply curve of savings is upward sloping, a tax on interest income will: a. increase the amount of saving. b. increase the market rate of interest. c. decrease the market rate of interest. d. have no effect on the market rate of interest.

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10. If the supply of labor is perfectly inelastic, then the incidence of a payroll tax levied entirely on employers will be: a. borne by employers as a reduction in profits. b. split between workers and employers. c. paid entirely by workers. d. shifted forward to consumers. 11. Which of the following is true about comprehensive income? a. Only labor income is included. b. Only capital income is included. c. Capital gains are not included. d. Both realized and unrealized capital gains are included. 12. Which of the following will increase a person’s comprehensive income? a. An increase in the market value of the person’s home b. A decrease in the value of the person’s stock portfolio c. A decrease in labor income d. A decrease in consumption 13. A tax on labor income will: a. increase the net wage received by workers. b. decrease the net wage received by workers. c. cause the net wage received by workers to decline below the gross wage paid by employers. d. both (b) and (c) are correct. 14. If the return to savings, r, is subject to taxation at rate t, then in equilibrium a saver’s marginal rate of time preference will equal: a. r b. t c. (1 + r) d. [1 + r(1 – t)] 15. The higher the compensated elasticity of supply of savings, a. the lower the excess burden of a tax on capital income. b. the higher the excess burden of a tax on capital income. c. the higher the excess burden of a tax on labor income. d. both (b) and (c) are correct. 16. The Haig-Simons definition of income: a. is the sum of annual consumption and realized capital gains. b. is the sum of annual consumption and changes in net worth. c. excludes corporation income. d. is the sum of annual consumption and net worth. 17 Comprehensive income: a. includes realized capital gains, but not unrealized capital gains b. includes both realized and unrealized capital gains. c. excludes cash from the sale of assets. d. excludes increases in the value of assets. © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

18. Income-in-kind: a. is exemplified by nonpecuniary returns. b. is generally non-taxable because there is no monetary transaction. c. is generally taxable. d. both (a) and (b) are correct. 19. An example of a nonpecuniary return is: a. job satisfaction. b. unemployment benefits. c. employer contributions to a retirement plan. d. both (b) and (c) are correct. 20. Income from labor services (wages) account for what percentage of gross income in the United States? a. More than 90 percent b. More than 75 percent c. More than 60 percent d. More than 80 percent

ESSAY QUESTIONS 1. A 20 percent, flat-rate tax on labor income is imposed. Show how the excess burden of the tax could be estimated. In your answer list all the data you would require to make your estimate. Under what circumstance will workers not bear the full incidence of a tax on labor income? Under what circumstances will an increase in the tax rate decrease tax revenue? 2. Interest income tends to increase with the total income of persons. This means that upper-income groups are likely to receive higher amounts of interest income as a percent of their income than lower-income groups. This implies that a flat-rate tax on interest income will take more dollars per year from the rich than from the poor. Do you agree with this argument? Indicate the market conditions that would have to prevail to prevent the shifting of a tax on interest income to groups other than those who earn interest. What will be the incidence of the tax if those conditions do not prevail?

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CHAPTER 14

Taxation of Personal Income in the United States

INSTRUCTIONAL OBJECTIVES This chapter shows students how the personal income tax is actually administered in the United States. The difference between comprehensive income and taxable income is made clear. Students are shown how tax preferences affect choices and efficiency in markets. The tax base and tax rate structure are analyzed, and students learn how the U.S. personal income tax differs from a flat-rate income tax levied on comprehensive income. After reading this chapter, students should have a good notion of how complex the actual personal income tax is in the United States and how to use economic theory to evaluate the current tax structure and reform proposals.

CHANGES IN THIS EDITION 

This chapter has been extensively updated to reflect the Tax Cut and Jobs Act of 2017.



The provisions of the Tax Cut and Jobs Act of 2017 and the changes in the Federal Income Tax and tax rates for 2018 are discussed.



Estimates of tax expenditures have been updated to 2019.



Data on marginal and average tax rates for the federal personal income tax have been updated using recent statistics and analysis from the Congressional Budget Office on the marginal tax rates on labor and capital income for the U.S. economy.



Information on state individual income taxes and deductions has been updated based on the TCJA and deduction limits discussion added.

CHAPTER OUTLINE The Tax Base: Basic Rules for Calculating Taxable Income and Why Much of Income Is Untaxed Tax Preferences Tax Preferences under the U.S. Income Tax System Issues in Income Tax Policy Global Perspective: Income Taxes and Economic Growth How Progressive Are Federal Income Taxes? Effective Average and Marginal Tax Rates © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Public Policy Perspective: Measuring the Progressivity of the Federal Personal Income Tax

MAJOR POINTS AND LECTURE SUGGESTIONS 1. When beginning your lecture, emphasize that tax reform and changes in tax policy are a continual process. The Tax Cut and Jobs Act of 2017 was a major overhaul of the personal income tax. You can use the general principles developed in this chapter to discuss current issues of income tax policy as the burgeoning federal budget surplus gives rise to further political maneuvering for still more taxpayer relief for families and other groups. 2. It is important for students to see how taxable income differs from adjusted gross income. Table 14.1 is very useful and could be copied for distribution to students. The point that you want to emphasize is that a person can influence his or her tax bill by varying the sources and uses of income when tax preferences exist. Make it clear that taxable income amounts to less than half of personal income in the United States. 3. Figure 14.1 illustrates the statutory marginal tax rates that prevailed under the personal income tax in 2018. 4. The earned income tax credit has emerged as a major means of federal support for the working poor. It is worth going over this provision in class to show how it results in negative tax rates for the working poor. This provision is a significant work-incentive aspect of the tax code. 5. The concept of tax preferences explains differences between comprehensive income and taxable income. Choose a few of the major tax preferences and discuss their justification and economic consequences. Be careful not to go over too many details of the tax code. You do not want to overwhelm the students with facts, rules, and regulations. Your goal should be to outline the basic features of the tax code. 6. Students are very receptive to the analysis of the excess burden of tax preferences. Figure 14.3 shows how reducing marginal tax rates reduces the excess burden of existing tax preferences. 7. The concept of tax expenditures should also be introduced in class when discussing tax preferences. Again, avoid getting caught up in details. I prefer to discuss just broad categories of tax preference items. Table 14.2 shows the fourteen largest tax expenditures for fiscal year 2019. Students are very curious about the tax code and are likely to ask questions in class about aspects that relate to their own or their parents’ finances.

ANSWERS TO TEXT PROBLEMS 1. The more work on average per day, the higher the marginal tax rate is. The budget line therefore becomes flatter, and more leisure is traded for work. The line drawn by students should have four distinct linear segments, each flatter than the previous segment as leisure is given up. Assuming that leisure is a normal good, it is likely that work effort will be reduced, provided that substitution effects outweigh income effects. However, the effects are quite complex because net wage rates are also a function of the amount of leisure given up. 2. The initial real interest rate is 4 percent. When inflation increases to 8 percent next year, while the nominal interest rate rises to 10 percent, the real interest rate actually falls to 2 percent, but the rate of taxation of nominal interest remains the same. This raises the effective rate of taxation on real interest. Inflation increases the rate of taxation of real capital gains because the tax rate remains the same and is applied to the nominal gain rather than the real gains. © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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3. The standard deduction in 2018 for a single taxpayer was $12,000. It therefore does not pay for this taxpayer to itemize deductions because her itemized deductions amount to only $2,500. The worker’s adjusted gross income is $35,000. Her taxable income is $23,000, which is obtained by subtracting the $12,000 standard deduction from the adjusted gross income. The tax is .10($9,525) + 0.15($13,475) = $952.5 + $2,021.25+952.5 = $2,973.75 (Rounded to $2,974.00) 4. The marginal tax rate is 40 percent, not considering the deductibility of the state income tax. In effect, 0.31(9%) of the state tax is paid by the federal government as a reduction in federal tax collection. The effective state tax rate for the worker is therefore 6.21 percent, which gives an effective overall marginal tax rate of 37.21 percent. The state tax rate does increase the marginal tax rate for the worker and therefore increases the excess burden of the mortgage interest deduction. Considering the Social Security payroll tax, the worker’s marginal tax rate is 44.86 percent. 5. The tax rate structure is a two-step progressive rate with a zero rate applying to the first bracket up to $10,000 and 15 percent applying to income above that amount. Elimination of tax preferences will reduce the excess burden of the income tax, but distortions in labor and capital markets will remain. The prices of tax-preferred activities are likely to be affected. For example, home prices could fall because of the elimination of the tax deductibility of mortgage interest. Interest rates paid for borrowing by state and local government would rise because that interest income would no longer be tax exempt. Similarly, there will be many shifts in demand and supply affecting the market prices of a slew of previously tax-preferred activities. To the extent to which the tax code is simplified, compliance costs will be reduced. Fees paid to tax preparers, accountants, and tax lawyers will fall and be reallocated for use elsewhere. Typical objections to the flat-rate tax are based on notions of vertical equity. Many believe that the upper-income groups should pay higher percentages of their income in taxes than lower-income groups do. A shift from the current tax structure to the flat-rate tax will clearly increase the after-tax income of the upper-income groups and increase the tax burden on the lower-income groups.

TRUE /FALSE QUESTIONS 1. Taxable income in the United States exceeds adjusted gross income. (F) 2. Taxable income in the United States includes all capital gains earned, whether or not they are realized. (F) 3. Taxable income in the United States amounts to less than 50 percent of personal income. (T) 4. Tax preferences are really subsidies to certain activities. (T) 5. A tax deduction allowed for an activity for which positive externalities are not likely to exist (such as home ownership) is likely to cause the marginal social cost of the activity to exceed its marginal social benefit. (T) 6. The value of a personal exemption to a taxpayer varies with his or her marginal tax rate. (F) 7. The U.S. personal income tax is not a progressive tax. (F) 8. The highest statutory marginal tax rate under the federal personal income tax is 50 percent. (F) 9. Under current rules, only real interest earned is subject to income tax. (F) 10. Realized, long-term capital gains that reflect inflation are currently exempt from taxation. (F) © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

11. The tax base under the personal income tax in the United States is the Haig-Simons definition of comprehensive income. (F) 12. Tax credits vary with a person’s marginal tax rate. (F) 13. The cuts in marginal tax rates initiated in 2001 were introduced to reduce the excess burden of tax preferences. (T) 14. The earned income tax credit is a negative tax that subsidizes the earnings of low-income workers. (T) 15. If a progressive income tax is replaced with an equal-yield, flat-rate tax, then work effort will unequivocally increase. (F) 16.

As of 2018, the marriage penalty still applies for the highest income taxpayers. (T)

17.

Tax preferences are exclusions, exemptions, and deductions from the tax base. (T)

18.

Income-in-kind is not considered a tax preference. (F)

MULTIPLE CHOICE QUESTIONS 1. Adjusted gross income, as defined by the United States Tax Code, a. exceeds taxable income. b. equals taxable income. c. is less than taxable income. d. is greater than comprehensive income. 2. Tax preferences: a. are exclusions, exemptions, and deductions from the tax base. b. are in the tax code by accident. c. are extra taxes on certain taxpayers. d. increase the amount of income that is taxable. 3. Currently, the tax treatment of capital gains in the United States is such that: a. all capital gains are taxed. b. all realized capital gains are taxed. c. most realized capital gains are taxed. d. only capital gains adjusted for inflation are taxed. 4. The exclusion of interest of state and local bonds from taxation by the federal government: a. decreases interest costs for state and local governments. b. increases interest costs for state and local governments. c. benefits lower-income taxpayers more than upper-income taxpayers. d. discourages borrowing by local governments.

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5. Based on TJCA, the value of personal exemptions: a. is $0.00. b. is $2400.00. c. varies with taxpayers’ marginal tax rates. d. is the same as the standard deduction. 6. A taxpayer is in a 33-percent tax bracket and itemizes deductions. He obtains a mortgage from a bank at 9-percent interest. The actual rate of interest he pays is: a. 6 percent. b. 9 percent. c. 20 percent. d. 25 percent. 7. Tax expenditures are: a. expenditures made to collect taxes. b. losses in revenue due to tax preferences. c. less than 1 percent of tax revenue. d. both (b) and (c) are correct. 8. Under the federal personal income tax rules prevailing as of 2018, a. all interest expense is tax deductible. b. the interest expense for mortgages on first and second homes is tax deductible. c. the interest expense for mortgages only on first homes is tax deductible. d. no interest is tax deductible. 9. The reduction in marginal tax rates will: a. increase the excess burden of tax preferences. b. increase tax expenditures. c. decrease the excess burden of tax preferences. d. have no effect of tax expenditures. 10. ―Bracket creep‖ is no longer a problem in the United States because: a. the tax brackets are indexed. b. capital gains are now fully taxable. c. only real interest is taxed. d. capital gains are indexed. 11. Which of the following is true for the federal income tax in the United States? a. All income irrespective of its source or use is taxed at the same rate. b. Comprehensive income is the tax base. c. The tax base is less than 50 percent of comprehensive income. d. All realized and unrealized capital gains are included in the tax base. 12. Because of the Earned Income Tax Credit, the effective tax rate for the lowest-income taxpayers in the United States is: a. only 15 percent. b. higher than that paid by upper-income taxpayers. c. zero. d. negative. © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

13. The excess burden of tax preferences: a. depends on average tax rates. b. will be higher, the higher the marginal tax rate is. c. will be lower, the higher the marginal tax rate is. d. is independent of marginal tax rates. 14. A shift to an equal-yield, flat-rate personal income tax from the current progressive income tax rate structure will: a. reduce the tax burden on upper-income groups. b. increase the tax burden on upper-income groups. c. increase the share of taxes paid by lower-income groups. d. both (a) and (c) are correct. 15. Removing savings from the tax base of the personal income tax is likely to: a. increase work effort. b. decrease work effort. c. lower market equilibrium interest rates by increasing the supply of loanable funds. d. increase market equilibrium interest rates, thereby increasing the demand for loanable funds. 16. Which is a justification for tax preferences? a. Administrative difficulties b. Improving equity c. Encouraging private expenditures that create external benefits d. All of these are correct. 17. If the excess burden from tax is $10 million, lowering marginal tax rates should make the excess burden: a. more than $10 million. b. less than $10 million. c. remain at $10 million. d. none of these is certain to occur 18. Which of the following is the result of The Economic Growth and Tax Relief Reconciliation Act enacted in 2001? a. The highest marginal tax rate was reduced. b. increased The marriage penalty increased. c. It created a new 40% tax bracket. d. Both (a) and (c) are correct. 19. As of 2018, the highest marginal tax rate was: a. 39%. b. 38%. c. 37%. d. 32%.

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20. Which is an example of an itemized deduction under the U.S. code as of 2018? a. State and local income tax b. State and local property tax c. All medical expenses d. Both (a) and (b) are correct.

ESSAY QUESTIONS 1. The personal income tax in the United States is very different from a comprehensive income tax. How would income distribution and resource use change if a flat-rate tax on comprehensive income were substituted for the current progressive income tax? 2. There are several features in the federal income tax that encourage home ownership. List those features and show how they provide subsidies for homeowners. Explain how the price of housing might be affected if all these subsidies were eliminated. Why has the reduction in marginal tax rates in recent years reduced tax expenditures that subsidize home ownership?

CHAPTER 15

Taxation of Corporate Income

INSTRUCTIONAL OBJECTIVES The corporate income tax remains controversial. A major goal of this chapter is to show students how economic theory reveals the complex effects of this tax. This should expose students to some of the difficulties in actually determining the incidence and excess burden of a tax. Both the short-run and longrun impact of the tax are discussed. The chapter addresses issues relating to separate taxation of corporate income. It also shows students how the current system measures corporate income and how it results in double taxation of that income. The treatment of depreciation is also discussed as a general problem in business taxation, as are the difficulties that arise because of inflation when neither capital gains nor interest payments are indexed.

CHANGES IN THIS EDITION 

This chapter has been updated as needed.



The section on corporate tax rates in OECD nations has been updated with data from 2018.



A new section Reduction in Corporate Tax Rates in 2018 and Other Changes in Taxation of Business Income has been added and discussion of TCJA 2017 incorporated.

CHAPTER OUTLINE The Tax Base: Measuring Business Income Separate Taxation of Corporate Income: Issues and Problems Global Perspective: Tax Treatment of Multinational Corporations Reduction in Corporate Tax Rates in 2018 and Other Changes in Taxation of Business Income Corporate Taxation Throughout the World: International Comparisons Short-Run Impact of the Corporate Income Tax Long-Run Impact of the Corporate Income Tax Public Policy Perspective: A New Way to Tax Corporate Income—The Corporate Cash Flow Tax Incidence of the Corporate Income Tax

MAJOR POINTS AND LECTURE SUGGESTIONS 1. You might want to discuss some general issues in computation of business income before getting into the details of the corporate income tax. The first section of the chapter discusses depreciation and the impact of inflation on real business income. 2. It is useful to remind students that a separate corporate income tax would not be necessary under a comprehensive income tax. If comprehensive income were used as the tax base, corporate income would simply be allocated to individual taxpayers according to their proportionate share of ownership. The introduction to the chapter discusses this issue. 3. The issue of double taxation of dividends and other aspects of corporate taxation are best discussed within the context of the effective tax rate on the return to capital. The corporate income tax does contribute to decreasing the return to investment. In view of long-term goals of increasing capital formation, it is clear that the tax does distort investment choices and adds to the effects of the personal income tax in reducing the return to capital. 4. Table 15.1 shows how debt financing can increase the return to equity substantially under a corporate income tax when interest expense is deductible from operating income. It would be worth photocopying this table and going over it in class. 5. The actual tax base is the sum of normal and economic profits. This means that the corporate income tax is levied on a cost as well as on pure profits. 6. Point out that most large corporations pay the top statutory marginal tax rates. Also point out that elimination of the investment tax credit and changes in depreciation rules have contributed to higher marginal effective tax rates for corporations even though the statutory marginal tax rates have been reduced.

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7. Emphasize that the long-run impact of the tax is dependent on its short-run effects. If, as some believe, the tax is passed on to consumers in the first place as an increase in prices, the tax does not depress the return to capital in the corporate sector and no resource flows result in the long run. 8. A profit-maximizing firm has no incentive to adjust output in response to an ad valorem tax on its economic profits in the short run. The best way to get this across to students is by saying that the output that maximizes 100 percent of profits also maximizes 50 percent (or any fraction) of profits that remain after taxes. Note that in the short run normal profits are a fixed cost. Therefore, the conclusion holds even if the tax is levied on the sum of normal and economic profits. Since there is no incentive to reduce output, there is no shift in supply. Price does not change. The short-run incidence of the tax is therefore on the shareholders of the corporation. 9. The long-run impact of the tax is to induce a flow of investment out of the corporate sector, assuming that the tax is borne by shareholders in the short run. The text presents both a narrative and a graphic analysis of the Harberger model. The conclusion is that the tax is borne by investors in both the corporate and noncorporate sector, assuming a perfectly inelastic supply of capital for the economy as a whole. 10. Make sure that students understand that the marginal social cost of a corporate investment is the marginal social return foregone by not using the funds to make an investment in the noncorporate sector. I have labeled the demand and supply curves in the graphs to show this. Also point out that the loss in efficiency from the tax results from a misallocation of investment between the sectors.

11. When the overall supply of savings is not perfectly inelastic, some of the burden of the corporation income tax is shifted to the workers as interest rates rise in response to a reduction in the supply of savings. This results in a reduction in investment that over the long run reduces worker productivity, causing a reduction in wages. There is an additional excess burden in this case.

ANSWERS TO TEXT PROBLEMS 1. Total corporate profits are $4 million for the year. Because corporate income is over $4 million, the corporation pays a flat-tax rate of 34 percent, which gives it a tax liability of $1.36 million for the year. Assuming an 8-percent opportunity cost of capital, the normal profit is $560,000. This corporation has therefore incurred economic profit of $3.46 million, and its tax liability as a percent of its economic profit is 39 percent. 2. a.

The equity of the corporation is $2 million. Net profit after deduction of interest paid is $450,000, and the tax liability is $148,500. The net profit after taxes is $301,500, which is 15 percent of equity.

b. With no debt, the tax liability would be $250,000 and equity would by $5 million. Net profit after taxes would be $500,000, which would be only 10 percent of equity. 3. In the long run the net return to capital will be 6.6 percent. If the elasticity of supply of savings were greater than zero, the net return to capital would not fall by the full amount of the tax. 4. There would no longer be double taxation of dividends. This would reduce the differential between corporate and noncorporate income taxation and would improve the allocation of resources between the two sectors. The tax rate on capital income would also fall, and this would reduce the excess burden of the tax. The reduction in the tax rate would also reduce the effective tax burden on upperincome groups who own most of the capital. 5. Assuming that it is not shifted forward to consumers at the outset, the corporate income tax is a tax on capital income. The payroll tax is a tax on labor income. If an equal-yield payroll tax replaces the corporate income, then the tax rate on capital income falls, while the tax rate on labor income rises. The excess burden in the capital markets declines, but there is an increase in the excess burden of taxation in the labor market. The differential incidence is likely to be regressive because the capital ownership tends to be concentrated in the hands of upper-income groups. The tax burden on capital falls, while that on labor income increases.

TRUE /FALSE QUESTIONS 1. The corporate income tax in the United States is levied only on economic profits. (F) 2. Imputed interest from retained earnings are not deducted when computing taxable corporate income. (T) 3. In general, the shorter the depreciation period allowed for tax purposes, the higher the tax burden on corporations. (F) 4. Accelerated depreciation allows a firm to deduct more than the actual economic depreciation from its income each year. (T) 5. Inflation causes an understatement of true depreciation cost. (T)

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6. The Tax Cut and Jobs Act of 2017 replaces the top marginal tax rate of 35 percent with a new flat rate corporate tax rate of 21 percent (T). 7. Assuming that the corporate income tax is not shifted to consumers in the short run, the long-run effect will be a reduction in the return to investment in both the corporate and noncorporate sector. (T) 8. The excess burden of the corporate income tax stems from a misallocation of investment between the corporate and noncorporate sectors when the supply of savings is perfectly inelastic. (T) 9. When the supply of savings is not perfectly inelastic, the corporate income tax can be shifted to workers. (T) 10. In the long run the corporate income tax has no effect on the price of products produced by corporations. (F) 11. The corporate income tax in the United States is levied on the sum of economic and normal profits. (T) 12. The corporate income tax is levied only on retained earnings with dividends paid out exempt from taxation. (F) 13. Because the corporate income tax base includes dividends, those dividends are taxed twice if they are also included in the personal income tax base. (T) 14. Because the opportunity cost of a corporate equity is not tax deductible, the corporate income tax encourages borrowing, which allows interest cost to be deducted from corporate income. (T) 15. If the corporate income tax is not shifted in the short run, then in the long run it will reduce the return to capital in the corporate sector only. (F) 16.

Depreciation is based on historic cost. (T)

17.

During periods of inflation historic cost overstates replacement cost. (F)

18.

Corporate dividends are paid from post-tax income. (T)

MULTIPLE CHOICE QUESTIONS 1. The tax base for the corporate income tax in the United States is: a. the sum of normal and economic profits of corporations. b. economic profits of corporations. c. normal profits of corporations. d. retained earnings of corporations. 2. Accelerated depreciation allows corporations to: a. earn more interest on their capital costs. b. reduce capital costs to zero. c. reduce labor costs. d. increase the time period over which assets are depreciated.

3. If corporations maximize profits, the short-run incidence of a tax on its profits will be borne by: a. consumers. b. all investors. c. corporate shareholders. d. workers. 4. Assuming that corporations maximize profits and investors seek to maximize the return to their investments, the long-run impact of a corporate income tax is to: a. reduce the incomes of corporate shareholders only. b. reduce the incomes of workers only. c. reduce the incomes of all investors. d. increase the price of both corporate and noncorporate goods. 5. Assuming that the supply of savings is perfectly inelastic, the corporate income tax prevents the attainment of efficiency by: a. reducing annual savings. b. reducing annual investment. c. reducing wages. d. causing a misallocation of investment between the corporate and noncorporate sectors. 6. Assuming that corporations maximize profits and investors maximize the return from their investments, a corporate income tax is likely to: a. increase the price of corporate goods. b. decrease the price of noncorporate goods. c. have no effect on output prices. d. both (a) and (b) are correct. 7. Inflation affects corporate income by: a. understating depreciation and inventory costs. b. overstating capital gains. c. always increasing taxes. d. both (a) and (b) are correct. 8. Assuming that corporations maximize profits, that investors maximize the return to their investments, and that the supply of savings is not perfectly inelastic, in the long run a corporate income tax will: a. not prevent investment markets from achieving efficiency. b. reduce investment. c. reduce wages. d. both (b) and (c) are correct. 9. Which of the following is true about the economic effects of the corporate income tax? a. Its incidence is likely to be borne entirely by workers. b. Its incidence is likely to be borne only by shareholders of corporations. c. Its incidence is likely to be borne only by consumers of corporate products. d. Its incidence is likely to be shared by owners of capital, workers, and consumers of corporate products.

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10. According to the Harberger model of the incidence of the corporate income tax, the tax: a. reduces the return to capital in the corporate sector of the economy only. b. reduces the return to capital in all uses. c. has no effect on the return to capital. d. increases the return to capital. 11. If corporations maximize profit, a corporate income tax: a. has no affect on the profit-maximizing output in the short run. b. reduces the profit, maximizing output in the short run. c. increase the profit, maximizing output in the short run. d. increases the supply of corporate output in the short run. 12. Under the corporation income tax in the United States, a. interest on borrowed money cannot be deducted from the tax base. b. only economic profits are taxed. c. only normal profit is taxed. d. the opportunity cost of equity cannot be deducted from the tax base. 13. If the supply of savings is not perfectly elastic, the corporate income tax is likely to: a. increase investment. b. decrease investment. c. increase the supply of labor. d. decrease the supply of labor. 14. In the long run a corporate income tax that initially reduces the return to investment in the corporate sector will also: a. reduce the return to capital in noncorporate sectors. b. increase the output of corporate goods. c. decrease the output of noncorporate goods. d. both (b) and (c) are correct. 15. Under the corporate income tax, a. dividends paid out to shareholders are deducted from corporate income. b. dividends are included in corporate income. c. retained earnings are included in corporate income. d. both (b) and (c) are correct. 16.

The double taxation of dividends under U.S. tax code means: a. dividends are taxed while not being adjusted for inflation. b. dividends are paid from after-tax corporate income and then taxed again as personal income. c. dividends are deducted as an expense at the corporate level, but as a gain at the personal level. d. both (a) and (b) are correct.

17.

If an all-equity firm has after-tax income of $100,000 based on a 34% income tax, what is the aftertax income of an equivalent firm that pays $15,000 in interest that is tax deductible? a. $85,000.00 b. $105,100.00 c. $90,100.00 d. $100,000.00

18.

If interest on corporate debt is tax deductible, a firm’s return on equity increases because: a. after-tax income increases with the presence of debt. b. generally, the presence of debt reduces the amount of equity to a greater effect than the reduction in after-tax. c. debt reduces equity and increases after-tax income. d. the presence of debt to lead to increases in dividends.

19.

Assuming there is no change in the payout structure, what measure would reduce corporate financing costs? a. Allowing dividends to be deducted from income prior to assessing tax. b. A reduction in the tax rate. c. Limiting the amount of interest that can be deducted from income prior to assessing tax. d. Both (a) and (b) are correct.

20.

The effective tax rate is: a. the same as the statutory tax rate. b. based on real economic profits. c. based on the nominal profits. d. not inflation adjusted.

ESSAY QUESTIONS 1. a.

Many citizens who believe that the rich should pay more in taxes argue that the taxes levied on corporations should increase. Is it likely that increased taxes on corporations will increase taxes paid by the rich? In your answer make sure you consider all possibilities for the incidence of the tax and make your assumptions explicit.

b. Assuming that corporations maximize profits and investors maximize the return to their investment, explain how the corporate income tax will prevent efficiency from being attained. 2. Explain how business income is measured. Why can an increase in the rate of inflation increase the effective tax burden of corporations?

114 | Part One | The Economic Basis of Government Activity

CHAPTER 16

Taxes on Consumption and Sales

INSTRUCTIONAL OBJECTIVES This chapter introduces students to consumption as a tax base. The advantages and disadvantages of exempting savings from taxation are outlined. A tax on comprehensive consumption is equivalent to a tax on comprehensive income that exempts savings from the tax base. The text exposes students to both the equity and efficiency arguments for and against such a tax. The chapter also provides analysis of the retail sales tax and the value-added tax. Much of the discussion of the value-added tax, which is always waiting in the wings of Congress for the right moment, draws on European experience with the tax.

CHANGES IN THIS EDITION 

This chapter has been updated with most recent available data.



The discussion of the value-added tax in the Global Perspective has been updated with 2019 VAT rates.



Discussion of sales taxes has been updated with the most recent available data.

CHAPTER OUTLINE Consumption as a Tax Base Direct Taxation of Consumption: The Expenditure Tax A Comprehensive Consumption Tax Base A General Tax on Comprehensive Consumption Impact on Efficiency in Labor Markets Sales Taxes Turnover Taxes Value-Added Taxes Global Perspective: Current Use of the VAT

MAJOR POINTS AND LECTURE SUGGESTIONS 1. A good way to begin your lecture on consumption taxes is to discuss how some saving is already exempt from taxation under current rules. Self-employed workers can defer taxes on savings for retirement by setting up Keogh Act retirement accounts. Many workers have opportunities to defer taxes on savings for retirement by setting up 401K and 403B retirement accounts. Employer (and in some cases employee) contributions to pension funds are also tax deferred, and some workers can still defer contributions to individual retirement accounts. Of course, these exemptions are limited to certain maximums, and there is a penalty for early withdrawal of the saving that is placed in special accounts. A general direct tax on consumption would simply go one step further by exempting all savings from taxation. The tax base would be comprehensive income less savings. Of course, in any year, under a consumption tax, any withdrawals (or borrowing) from savings accounts would be included in the tax base. 2. A numerical example will show students how a consumption tax can be viewed as more conducive to horizontal equity than an income tax when viewed from a lifetime perspective. The example in the text uses a two-period, life-cycle model to show how two persons with equal capacity to earn labor income pay exactly the same discounted present value of taxes under a consumption tax. The income tax discriminates against persons who save. It is worth going over this example in class. I have used it with my students, and they grasp the point easily. The example shows that when a consumption tax is used, the two persons are taxed according to their labor incomes only. 3. Emphasize that interest is not taxed when it accrues, when a consumption tax is used. The only tax benefit from saving (if all saving is eventually liquidated as consumption) is the interest earned on deferred tax payments. The text explains this nicely with a bit of algebra. 4. Comprehensive consumption is equal to comprehensive income less any annual increments in net worth. Actually, comprehensive consumption is easier to measure than comprehensive income. This is because unrealized capital gains are not included in the tax base. There are no problems adjusting for inflation because current expenditures are taxed. 5. The chief advantage of a tax on comprehensive consumption is the elimination of excess burden in investment markets. However, any net gains in investment markets could be offset by net losses in labor markets when an equal-yield consumption tax replaces an income tax. This is because the tax rate on labor income must be higher under the consumption tax than under the income tax as long as saving is positive. Use Figures 16.1 and 16.2 in the text to illustrate this to your students. 6. Assuming a very inelastic labor supply curve, a comprehensive income tax will be borne largely according to labor income. 7. In discussing the retail sales tax, emphasize that it is a tax used mainly by state governments in the United States. Most states exempt personal services from the tax. Many states allow exemptions and exclusions to achieve equity goals. It is common to exempt food, drugs, and public utility services. 8. In discussing the overall incidence of the retail sales tax, point out to students that the belief that the tax is regressive with respect to income assumes that the tax is always fully reflected in prices and that all consumption is taxed. It is possible that much of the tax is shifted backward to owners of inputs. Many of the poor do not supply input services and have transfers indexed against price increases. 9. Note the discussion of the value-added tax and how it works in European nations. Many students are confused about the definition of value added. Make sure you define it well before you discuss the tax. The invoice method of collecting the tax does not require firms to explicitly measure value added. © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

116 | Part One | The Economic Basis of Government Activity

ANSWERS TO TEXT PROBLEMS 1. The discounted present value of income taxes for the worker who does not save is calculated as follows: $3,000 + $3,000/(1 + 0.15) + $3,000/(1 + 0.15)2 = $3,000 + $2,608.70 + $2,268.43 = $7,877.13 The worker who does save has interest income in the second and third periods. The interest income on the $4,000 in saving for the second period is $400, and the tax liability on the interest is $60. In the third period, interest is $8,400(10%) = $840, and the tax liability on this is $126. The discounted present value of taxes is calculated as follows: $3,000 + $3,060/(1.15) + $3,126/(1.15)2 = $3,000 + $2,660.87 + $2,363.71 = $8,024.58 Under a comprehensive consumption tax, the tax rate would have to be higher if it were to raise the same amount of revenue as the income tax, because in any given year saving is in the tax base. The saver is penalized for saving under the income tax, even though he has the same labor earnings as someone who does not save. Under a consumption tax, the discounted present value of taxes will be lower for the worker who saves because interest income is not taxed until it is used for consumption and the portion of income saved in any period is not subject to tax. 2. The tax distorts the pattern of demand in favor of the nontaxed goods. The prices of these goods are higher because of the tax-induced increase in demand. Increasing the price of goods consumed by low-income groups could add to the regressive effects of the retail sales tax. 3. The tax would uniformly reduce real wages and distort the work–leisure choice. However, regional effects of the tax will be eliminated so that the pattern of consumption and location will not be distorted as it is when state and local taxes have locational effects. 4. Value added is $500,000 – $200,000 = $300,000. Because this is a consumption-type tax, the $50,000 of equipment purchases is deducted from the tax base, giving taxable value added of $250,000. The tax liability is $37,500. 5. If not shifted in the short run, the corporate income tax is a tax on capital income from all sources in the long run. A general consumption-type, value-added tax is equivalent to a tax on labor income. As a result of the substitution, the excess burden in the capital markets is reduced, but the excess burden in the labor markets increases. The differential incidence is likely to be regressive because the burden of taxation is shifted from capital to labor, and capital ownership is heavily concentrated in upper-income groups.

TRUE /FALSE QUESTIONS 1. Comprehensive consumption is measured by excluding increments in net worth from comprehensive income. (T) 2. If two persons have equal labor earnings over their lifetimes and never receive any gifts or inheritances, then the discounted present value of income taxes that they pay will be the same despite any differences in their rates of saving. (F) 3. A tax on comprehensive consumption will not prevent the attainment of efficiency in investment markets. (T) © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

4. Under a comprehensive consumption tax, liability for payment of taxes on the amount of income saved in any year is deferred rather than eliminated. (T) 5. Under a consumption tax, borrowing money will increase taxes that are due in the year the funds are borrowed. (T) 6. If a flat-rate tax on comprehensive consumption yields the same revenue as a flat-rate tax on comprehensive income, the tax rate for the two taxes must be equal. (F) 7. Substituting a comprehensive consumption tax for an equal-yield comprehensive income tax will reduce excess burden in the labor market. (F) 8. Sales taxes in the United States generally tax all personal services. (F) 9. The value-added tax as used in Western Europe generally exempts investment goods from taxation. (T) 10. The value-added tax, collected through the invoice method, exempts intermediate purchases from taxation. (T) 11. A comprehensive income tax is more favorable to the incentive to save than a comprehensive consumption tax. (F) 12. A comprehensive consumption tax is equivalent to a comprehensive tax on labor income. (T) 13. A comprehensive consumption tax will not prevent labor markets from attaining efficiency. (F) 14. The retail sales tax is a major source of revenue for the federal government in the United States. (F) 15. As used in Europe, the value-added tax typically excludes services from the tax base. (F) 16.

A consumption tax is the same as an income tax. (F)

17.

Annual comprehensive consumption is equal to annual comprehensive income if there is no annual savings. (T)

18.

A sales tax encourages saving and discourages consumption. (T)

MULTIPLE CHOICE QUESTIONS 1. A flat-rate tax on comprehensive consumption: a. will reduce the market rate of interest. b. will reduce net interest received by savers in any given year. c. will not result in any difference between the gross interest rate paid by borrowers and the net interest rate received by savers. d. causes no loss of efficiency in labor markets. 2. Assuming that a person never receives any cash gifts or bequests, a tax on comprehensive consumption is equivalent to a(n): a. tax on capital income. b. tax on labor income. c. income tax. d. wealth tax. © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

118 | Part One | The Economic Basis of Government Activity

3. A tax on comprehensive consumption: a. will not influence a taxpayer’s work–leisure choice. b. will not affect the incentive to save in ways that cause losses in efficiency. c. is likely to reduce saving. d. will exempt consumption of personal services from taxation. 4. Substitution of an equal-yield general consumption tax for an income tax will: a. improve efficiency in investment markets. b. impair efficiency in the labor market. c. increase taxes paid by those earning interest on income. d. both (a) and (b) are correct. 5. The differential incidence of substituting a tax on comprehensive consumption for a tax on comprehensive income is likely to be: a. regressive. b. progressive. c. proportional. d. uncertain. 6. Suppose two individuals earn the same salary each year over their lifetimes. One individual saves 25 percent of his income each year, while the other saves nothing. Over their lifetimes under a comprehensive income tax, the a. discounted present value of taxes paid will be the same for both. b. discounted present value of taxes paid will be greater for the saver. c. discounted present value of taxes paid will be greater for the nonsaver. d. saver will pay no tax on his interest income. 7. In most states, the retail sales tax can be regarded as equivalent to a: a. comprehensive tax on consumption. b. comprehensive tax on income. c. set of selective excise taxes. d. tax on the profits of retailers. 8. A consumption-type, value-added tax: a. will not cause losses in efficiency in labor markets. b. will not cause losses in efficiency in investment markets. c. taxes interest income. d. both (a) and (b) are correct. 9. The invoice method of collecting the value-added tax: a. requires firms to compute value added. b. taxes a firm’s sales at a fixed rate but allows a credit for taxes paid on purchases of intermediate goods. c. requires firms to pay a fixed rate of taxation on both sales and purchases. d. taxes only intermediate purchases at a fixed rate.

10. Which of the following statements about taxes on consumption are true? a. Taxes on consumption do not distort choices between current and future consumption in ways that impair efficiency. b. Taxes on consumption have the same economic effects as taxes on income. c. Taxes on consumption are likely to reduce saving. d. Taxes on consumption have no effect on real wages. 11. Comprehensive consumption is: a. equal to comprehensive income. b. comprehensive income plus savings. c. comprehensive income minus savings. d. excludes services. 12. A direct tax on comprehensive consumption: a. requires taxpayers to report their annual income. b. requires taxpayers to report their annual savings. c. taxes savings. d. both (a) and (b) are correct. 13. Which of the following taxes is likely to be most favorable for capital accumulation? a. A comprehensive income tax b. A comprehensive tax on wealth c. A comprehensive tax on consumption d. An excise tax on gasoline 14. As administered in most states in the United States, the retail sales tax: a. has zero excess burden. b. distorts the choice between taxed goods and untaxed services, resulting in some efficiency loss. c. taxes all services. d. discourages saving. 15. The value-added tax used in the European Union: a. generally exempts services from taxation. b. requires all taxpayers to report value added. c. exempts investment purchases from taxation. d. taxes all transactions at the same low rate. 16. Nicholas Kaldor argued: a. consumption is a better index of the ability to pay than income. b. savings entails sacrifice and results in no increase in well-being. c. consumption provides little personal satisfaction and should be taxed for that reason. d. both (a) and (b) are correct. 17. An adult’s life cycle is considered to begin: a. at 18 years of age. b. at 21 years of age. c. upon earning fulltime employment. d. none of these are correct. © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

120 | Part One | The Economic Basis of Government Activity

18. Consumption-in-kind: a. is exemplified by services provided and consumed in the household. b. is the same as income-in-kind. c. is easily determined. d. both (a) and (b) are correct. 19. Which of the following is taxable under a consumption tax system? a. Savings b. Contributions to Social Security c. Contributions to retirement funds d. A bequest at death 20. A cash-flow tax is: a. a modified version of a consumption tax. b. a modified version of an income tax. c. a tax that allows some savings to be excluded from tax. d. both (a) and (c) are correct.

ESSAY QUESTIONS 1. Proponents of a consumption tax have argued that the tax can ultimately increase labor incomes and actually prove to be more equitable in the long run than an income tax. Indicate the net gains possible from substituting a consumption tax for an income tax in the United States. In your answer be sure to indicate your assumptions about the tax base and the conditions in the relevant markets. 2. Suppose a consumption-type, value-added tax is introduced as a new source of revenue in the United States. Briefly describe the way the tax would work and how it would affect efficiency in labor markets and investment markets.

CHAPTER 17

Taxes on Wealth, Property, and Estates

INSTRUCTIONAL OBJECTIVES This chapter explores the consequences of a comprehensive wealth tax. The wealth tax is compared to taxes on comprehensive income and consumption. The incidence of a comprehensive wealth tax is analyzed and shown to depend on the interest elasticity of supply of saving. Wealth is defined as the discounted present value of future land and capital income. A tax on a stock, such as wealth, introduces problems not previously encountered for taxation of income and consumption, both of which are flows. The assessment problem is given considerable attention in the chapter. After discussing the general wealth tax, it is pointed out that taxation of wealth in the United States is largely through the local property tax, which mainly taxes real estate. The controversy concerning the incidence and excess burden of the local property tax is highlighted. The idea that property tax payments are highly correlated with consumption of housing is contrasted with the view that the tax reduces the income of all investors. A brief discussion of property transfer taxes concludes the chapter. The economic effects of these taxes are stressed.

CHANGES IN THIS EDITION 

This chapter has been updated with the latest available data.



Changes brought by TJCA 2017 in regard to the estate tax have been added.

CHAPTER OUTLINE A Comprehensive Wealth Tax Base Assessment of Property Value A Comprehensive Wealth Tax Selective Property Taxes Tax Capitalization Capitalization and the Elasticity of Supply of Taxed Assets Property Taxation in the United States © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

122 | Part One | The Economic Basis of Government Activity

Public Policy Perspective: Capitalization of Property Tax Rate Differentials Land Taxes Property Transfer Taxes

MAJOR POINTS AND LECTURE SUGGESTIONS 1. Emphasize that wealth is the market value of accumulated assets in a nation. A wealth tax is therefore equivalent to a tax on the return to saving. The text has a simple algebraic example that shows students how the wealth tax rate can be converted into an equivalent tax rate applied to the dollar return to saving in any given year. I suggest going over this in class. It makes it easier to analyze the impact of the wealth tax on flows of saving and investment as is done in Figures 17.1 and 17.2 of the text. 2. Double-counting must be avoided in measuring the wealth base. An asset and a paper claim against that asset should not both be included in the tax base. For example, the value of assets owned by a corporation should not be taxed if the value of the stocks held by shareholders is also going to be taxed. The value of the stock reflects, in part, the value of assets owned by the corporation. Similarly, the value of a home and the value of a mortgage should not both be included in the tax base. 3. Difficulties encountered in measuring human capital will impede the development of a general wealth tax. 4. A tax on comprehensive wealth will be borne by savers if the supply of savings is perfectly inelastic. Because the distribution of wealth is highly unequal, with wealth concentrated in the hands of upperincome groups, the tax is likely to be highly progressive with respect to income in this case. Note that there will still be an excess burden unless substitution effects are zero. 5. If the supply of savings is responsive to changes in its return, the incidence of the tax is quite different. As a result of the tax, there will be a reduction in the quantity of funds supplied for investment each year. This reduction in investment will result in increases in the market rate of interest and decreases in wages. There will also be a loss in efficiency in investment markets. 6. As administered in the United States, the wealth tax is mainly a tax on real estate. The text discusses the incidence of such a tax by first considering the economic effects of a national tax on real estate. Then the complications introduced by explicitly considering the fact that the tax is a local one are analyzed. 7. Point out that about 80 percent of the local property tax base is in real estate and half of the total tax base is accounted for by single-family homes. 8. In discussing the economic effects of the property tax in the United States, you may want to use a Harberger-type model similar to the one used to explain the incidence of the corporation income tax. The portion of the tax common to all jurisdictions (this can be thought of as the average tax rate in the United States) will reduce the return to all investments. The tax causes a distortion in the pattern of investment, resulting in less investment in real estate than is efficient. 9. The tax differentials among jurisdictions cause regional flows of investment. High-tax jurisdictions lose capital. This loss in capital reduces land rents in those areas (assuming that capital complements land in production). If labor is immobile, wages in these regions could also decline. Regions with negative tax differentials gain capital. Land rents and possibly wages in these regions increase because of the tax. © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

10. Point out that assessment inequities can affect the burden of the property tax. Also, special treatment of elderly homeowners and farmers can affect the tax incidence. 11. In discussing tax capitalization, it is best to view the effect on the price of real estate as a capital discount necessary to sell a taxed asset at a return competitive with nontaxed assets. Many students are familiar with the way bond markets work. Point out that tax capitalization is equivalent to the reduction in the price of a bond that occurs when the market rate of interest rises above the coupon rate on the bond. 12. Emphasize that property transfer tax rates are quite low. Point out that inheritance and gift taxes could reduce investment.

ANSWERS TO TEXT PROBLEMS 1. The percentage return to saving is 10 percent. When the supply of saving is perfectly inelastic, the tax will yield $10 billion. The gross return to saving will remain 10 percent. However, the net return to saving will fall to 0.1 – 0.01 = 0.09 = 9 percent If the supply of saving were not perfectly inelastic, the gross return to saving would increase and the net return would not fall by the full 1 percent tax. 2. Of all taxes, property taxes are the most harmful to saving incentives. It would be best to avoid property taxes in the nation. 3. The market price of the asset is $10,000/0.1 = $100,000. The value of the land after the 5 percent property tax is levied is $10,000/0.15 = $66,666.67 If you sell the land, you will pay the discounted present value of all future tax payments. There is no way you can avoid the tax. 4. The current pretax value of the property is $12,000/0.08 = $150,000. After the tax, the value of the property is $12,500/0.13 = $96,153.85 If there were no increase in rent, the value of the property after the tax would be $12,000/0.13 = $92, 307.69 The property owner therefore succeeds in shifting $3,846.16 of the tax (present value) because of the increase in market rent. The remainder of the tax is capitalized. The landlord therefore suffers a reduction in net wealth of $150,000 – $96,153.85 = $53,846.15 as a result of the tax. 5. If it is above the national average, the property tax differential is positive and is likely to decrease the demand for real estate in the area over the long run. This results in an ―out-migration‖ of capital that could reduce real estate prices, rents, and labor price in the area. If the tax differential is negative, there will be an ―in-migration‖ of capital that could increase real estate prices, rents, and labor prices in the area. The portion of the property tax rate that is common to all jurisdictions (roughly equal to the average tax rate) is borne by all owners of capital in the long run, and investors shift to equalize the after-tax returns to capital.

124 | Part One | The Economic Basis of Government Activity

TRUE /FALSE QUESTIONS 1. Wealth is a flow. (F) 2. A wealth tax is equivalent to a tax on the return on savings. (T) 3. If the supply of savings is perfectly inelastic, a comprehensive wealth tax will increase the market rate of interest. (F) 4. Assuming that the supply curve of savings is upward sloping, a comprehensive wealth tax will reduce annual investment. (T) 5. As administered in the United States, the local property tax is mainly a tax on real estate. (T) 6. The property tax in the United States is likely to reduce the equilibrium return to investment. (T) 7. The town of Oz has raised its property tax rates considerably above the national average. Other things being equal, capital is likely to flow into Oz in the long run because of the tax. (F) 8. If a real estate tax causes rents to rise, it cannot be fully capitalized. (T) 9. A tax on the value of land is likely to be fully capitalized. (T) 10. The local property tax is likely to result in less than the efficient amount of investment in real estate. (T) 11. A general tax on wealth will cause efficiency loss in labor markets. (F) 12. The local property tax, as administered in the United States, is a general tax on wealth. (F) 13. The local property tax in the United States will reduce the return to real estate only in the long run. (F) 14. Other things being equal, if the property tax rate is above the national average for a jurisdiction, capital can be expected to flow out of the region in that area. (T) 15. If a local property tax increase is fully capitalized, property owners at the time of the increase cannot shift any of the current or future tax increase to buyers if they sell the property. (T) 16. A person who never saves any income and receives no gifts and inheritances will never accumulate wealth. (T) 17. Wealth taxes are a relatively new form of taxation. (F) 18. Total wealth definitions never include intangible personal property. (F)

MULTIPLE CHOICE QUESTIONS 1. Wealth is: a. a flow. b. a stock. c. the market value of accumulated assets. d. both (b) and (c) are correct.

2. A comprehensive wealth tax base includes: a. all real tangible, intangible, and human wealth, less any claims against those assets. b. only real property. c. only intangible assets. d. only tangible assets. 3. If the interest elasticity of supply of savings is zero, a comprehensive wealth tax will: a. increase the market rate of interest. b. reduce the income of savers. c. reduce the income of workers. d. both (b) and (c) are correct. 4. If the supply curve of savings is upward sloping, a comprehensive wealth tax will: a. increase the market rate of interest. b. reduce the market rate of interest. c. have zero excess burden. d. have no effect on investment. 5. A comprehensive wealth tax will: a. impair efficiency in labor markets. b. impair efficiency in investment markets. c. have no excess burden. d. both (a) and (b) are correct. 6. Assuming that investors seek to maximize the return on their investment, the long-run effect of a national tax on real estate will be to: a. reduce the return to investment in real estate only. b. reduce the return to investment in all assets. c. reduce wages only. d. increase the return to all investors. 7. A local property tax, such as that used in the United States, is likely to: a. increase investment in the economy. b. cause a flow of investment among jurisdictions. c. decrease the return to saving in all uses. d. both (b) and (c) are correct. 8. If a property tax on real estate is capitalized, a. the price of real estate will rise. b. the price of real estate will fall. c. the price of real estate will be unaffected. d. the burden of the tax will be transferred to buyers of real estate.

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9. Suppose that the current market rate of interest is 10 percent. The market rent on a parcel of land is $6,000 per year. A 10-percent land tax is imposed. As a result of the tax, the price of the land parcel: a. falls from $60,000 to $30,000. b. increases from $30,000 to $60,000. c. falls 10 percent. d. falls 20 percent. 10. If a tax on real estate results in a decrease in the supply of housing, the tax will be: a. fully capitalized. b. only partially capitalized. c. not capitalized at all. d. borne entirely by renters. 11. If the supply of saving is not perfectly inelastic in the nation, then which of the following taxes will cause efficiency loss in capital markets? a. A general wealth tax b. A national tax on real estate c. A consumption tax d. Both (a) and (b) are correct. 12. The local property tax in the United States is levied primarily on: a. personal property. b. intangible property. c. business property. d. real estate. 13. Which of the following would not be included in a comprehensive wealth tax base? a. real estate b. personal property c. intangible assets d. residential rents 14. If the supply of real estate is not perfectly inelastic, then the local real estate property tax differentials: a. cannot be shifted to tenants. b. can be shifted to tenants through increases in rents. c. will be fully capitalized. d. both (a) and (c) are correct. 15. If the supply of saving is not perfectly inelastic, then substituting a value-added tax for an equalyield general wealth tax will: a. decrease market equilibrium interest rates. b. increase the efficiency loss in labor markets. c. decrease the efficiency loss in labor markets. d. both (a) and (b) are correct.

16.

Intangible personal property includes: a. stock in companies. b. corporate bonds. c. cash. d. all of these are correct.

17.

If the annual amount of savings is $10 billion, what is the effect of a wealth tax assuming supply is perfectly inelastic? a. Annual savings remain at $10 billion. b. Annual savings increase above $10 billion. c. Annual savings fall below $10 billion. d. No particular effect is guaranteed to happen.

18.

If the annual amount of savings is $10 billion, what is the effect of a wealth tax assuming supply is responsive? a. Annual savings remain at $10 billion. b. Annual savings increase above $10 billion. c. Annual savings fall below $10 billion. d. No particular effect is guaranteed to happen.

19.

From the point of view of locality, increasing property taxes: a. increases the price of locally produced goods. b. decreases income of owners of land in the associated community. c. does not affect buyers of locally produced goods fro outside of the community. d. both (a) and (b) are correct.

20.

Tax capitalization is: a. a decrease in the value of a taxed asset at a level related to the discounted value of the future tax liability. b. partially recognized when the supply of a taxed asset is perfectly inelastic. c. only partially recognized on assets like land. d. both (b) and (c) are correct.

ESSAY QUESTIONS 1. Taxes on wealth are favored by those who want to increase the taxes paid by the rich. Is the incidence of a comprehensive wealth tax likely to be progressive? Is the property tax, as used in the United States, a comprehensive wealth tax? Evaluate the incidence and effects on efficiency of the property tax in the United States. Why do some critics of the tax argue that it is regressive? Do you agree with their arguments? 2. What is tax capitalization? Explain why a comprehensive wealth tax would not be capitalized.

128 | Part One | The Economic Basis of Government Activity

CHAPTER 18

Fiscal Federalism and State and Local Government Finance

INSTRUCTIONAL OBJECTIVES Chapter 18 introduces students to some of the unique aspects of public finance in a federal system of government. Fiscal federalism analyzes the efficient division of responsibility for provision of government services and funding of those services among various levels of government. The objective of the chapter is to develop a theoretical framework for analyzing the advantages and disadvantages of a federal system of government. The consequences of both centralized and decentralized collective choices are analyzed. The implications for political equilibrium and the well-being of citizens are highlighted for the student. Chapter 18 also seeks to expose students to certain aspects of local government finance. The main objective is to point out that local tax bases are more elastic than national tax bases. This is because local taxes can be more easily avoided than can national taxes. Students must realize that taxes that would have a low excess burden when used nationally can have a much higher excess burden when used locally. Finally, intergovernmental grants are discussed. Students are expected to understand the role of grants in state and local finance and how such grants influence resource allocation and income distribution.

CHANGES IN THIS EDITION 

This chapter has been updated with latest available data.



The data on federal grants has been updated to incorporate 2018 data.

CHAPTER OUTLINE Fiscal Federalism Global Perspective: Fiscal Federalism in the European Union Centralized versus Decentralized Government Citizen Mobility and Decentralized Government The Theory of Taxation within a Decentralized System Variation in Fiscal Capacity Intergovernmental Fiscal Relations The Theory of Grants © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Matching versus General Purpose Grants: An Application of the Theory of Collective Choice under Majority Rule Education Finance

MAJOR POINTS AND LECTURE SUGGESTIONS 1. Define fiscal federalism as the means of dividing expenditure and finance functions among levels of government. 2. The efficient allocation of expenditure functions depends in part on the geographic range of the spillover of benefits when local governments provide services. 3. Some services require central coordination and cannot be effectively provided by lower, decentralized levels of government. Good examples of these functions include stabilization and income redistribution. 4. Emphasize that the scope for avoiding taxes is greater on the state and local level than it is on the national level. Some taxes that have a low excess burden when used nationally can have a high excess burden when used locally. For example, a head tax does not prevent efficiency from being attained in markets when it is levied on all persons in a nation. However, when it is applied only to persons in a particular region by a local government, it causes migration to avoid the tax that prevents the efficient geographical allocation of resources. 5. Point out that the chief advantage of a decentralized system of government is its capacity to allow for accommodation of a wide variety of tastes for various government goods and services. 6. Make sure that students are aware of the fact that the opportunity to form local governments in a decentralized system results in a tendency for individuals of similar taste and income to congregate and form local governments. Discuss the advantages and disadvantages of this in class. 7. Under a centralized government, political equilibrium corresponds to the median most-preferred outcome of all national voters. Instead if collective choices are made locally, each locality would supply the quantity of public goods corresponding to the median most-preferred outcome of local voters. There would therefore be more diversity in government services in a decentralized system. 8. Assuming that persons in a given jurisdiction can control the number of residents in their community in various ways (use of entry taxes, zoning, and so on), the efficient size corresponds to the point at which the marginal benefit of residents just equals their marginal cost. The marginal cost includes crowding costs. The marginal benefit to existing residents in the decrease in tax shares is made possible by increased population financing for a given quantity of public goods. 9. In discussing the Tiebout model, emphasize that it assumes zero mobility costs, no interjurisdictional externalities, and economies of scale in the provisions of public services that are eventually exhausted. The model is best applied to explain suburbanization in a metropolitan area where residents can join a suburban jurisdiction while still retaining their jobs in the central city. 10. Point out that interjurisdictional externalities can spill out and spill in and can be positive or negative. 11. Tax exporting is constrained by market competition, tax rates in competing jurisdictions, and the mobility of resources. The boxed analysis summarizes some recent research and may be worth going over in class.

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12. Define categorical grants in terms of the restriction put on the use of funds. Discuss the matching requirement usually associated with this type of grant and point out to students how this lowers the price of certain government goods and services to recipient jurisdictions. You may wish to comment on the decline in federal grants in recent years when you begin your lecture. 13. Emphasize that categorical grants can be used to internalize interjurisdictional externalities. Point out the differences between categorical grants and broad-based grants. The boxed analysis in the chapter illustrates this nicely. You might want to go over it in class. 14. It is important to emphasize that the fungibility of money blurs the distinction between restricted and unrestricted grants. Insofar as any grant allows the recipient jurisdiction to lower taxes or release funds for alternative government services, it is difficult to restrict the use to which grant funds are actually applied. 15. The text has a graphic analysis of the impact of a grant. Emphasize that matching grants have both income and substitution effects, while nonmatching grants only result in income effects. Any grant affects the political equilibrium in the recipient jurisdiction. Note that insofar as grants serve to decrease local tax rates, they are equivalent to a reduction in local taxes. 16. Things change fast in local finances. You may wish to supplement the data and facts in the chapter with more recent information.

ANSWERS TO TEXT PROBLEMS 1. The per capita cost is $30 per person per year. The per capita costs for a given number of officers declines as population increases. However, congestion and other social problems that arise as the population increases can increase the demand for police officers. As this occurs, the per capita cost of police protection can rise. 2. Minimum lot size can serve to make it impossible for low-income citizens to locate in the area. By restricting the density of development, the minimum lot size also keeps the population of the town low. High-income residents have the incentive to keep low-income residents out to keep their tax bills from rising. Low-income residents have the incentive to come in; relatively low tax rates (made possible by low population and high property value per capita) make the community a good buy for them, because they can get good quality local government services for a low tax bill. 3. A 10 percent increase in the property tax rate would result in a 20 percent decline in property values. This would imply that an increase in tax rates would actually reduce tax revenues for the town. This must imply that there are good opportunities to avoid the tax by locating businesses and residences in alternative jurisdictions where property taxes are lower. 4. Students should draw a graph similar to the one in Figure 18.1 to answer the question. The matching grant has substitution effects that encourage spending on local public goods. This makes such a grant more effective in increasing road paving than an equal lump-sum grant that has only income effects. 5. In a rich jurisdiction, property values are relatively high and a given tax rate will generate more revenue than in a poor jurisdiction where property values are low. When property taxation is the sole source of finance for public schooling, equal quality and quantity of education across jurisdictions will require a relatively high rate of taxation in localities that are relatively poor. To assure equality of educational opportunity, state governments typically give grants to localities based on formulas designed to equalize expenditures per pupil. These grants are inversely related to property values per pupil in the area. States vary widely in the methods they use to assure equality © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

of educational opportunity and in their success in providing it. In some states (North Carolina, for example) teachers’ base salaries are paid out of state revenues, and the teachers are state employees. On average in the United States today, more than 50 percent of revenues to finance local education is provided by state governments.

TRUE/FALSE QUESTIONS 1. A federal system of government allows a wider diversity of preferences for government-provided services to be accommodated when compared to nonfederal, centralized government. (T) 2. Income redistribution is a service likely to be most effectively administered by the federal government. (T) 3. Economic stabilization can be easily supplied to citizens by local governments. (F) 4. When each local government supplies goods and services to its citizens, the political equilibrium in each jurisdiction corresponds to the median most-preferred outcome of all national voters. (F) 5. A federal system of government allows both centralized and decentralized collective choices. (T) 6. Local tax bases are less elastic than national tax bases. (F) 7. Tax exporting occurs if the price of goods produced in the state and purchased by out-of-state residents rises as a result of in-state taxes. (T) 8. Matching categorical grants can be used to internalize interjurisdictional positive externalities. (T) 9. Matching grants only result in income effects. (F) 10. A matching grant will increase local government expenditures by more than an equal-value, general-purpose grant. (T) 11. A federal system of government only has a central government that supplies all public goods and services. (F) 12. According to the Tiebout model of fiscal federalism, a system of many local governments improves the efficiency of allocation of resources to and among public goods. (T) 13. If a local jurisdiction’s tax base is elastic, an increase in tax rates will decrease tax revenue. (T) 14. Taxing hotel rooms and restaurant meals in a city with lots of tourism is an example of tax exporting. (T) 15. Financing local schooling with the local property tax can guarantee equality of opportunity in education. (F) 16.

According to Tiebout, individuals will self-select into communities where the government budget best satisfies their own personal preferences. (T)

17.

Mobility between communities is not critical to the Tiebout model. (F)

18.

Interjurisdictional externalities are costs or benefits of local government goods and services to residents in other political jurisdictions. (T)

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MULTIPLE CHOICE QUESTIONS 1. Under a federal system of government, a. all government goods and services are supplied by a central government. b. all government goods and services are supplied by local governments. c. both central and noncentral governments supply goods and services. d. all public choices are made nationally. 2. Economic stabilization is most effectively provided by: a. a central government. b. state governments. c. local governments. d. regional governments. 3. A decentralized system of government: a. tends to result in uniformity in the quantity and quality of government services in all jurisdictions. b. allows diversity in the quantity and quality of government goods and services. c. conducts national elections on all issues. d. is undemocratic. 4. The political equilibrium in a local jurisdiction for a given public good corresponds to the median most-preferred outcome of: a. all national voters. b. the President. c. local voters. d. both (a) and (c) are correct. 5. In general, local tax bases tend to be: a. less elastic than national tax bases. b. more elastic than national tax bases. c. equally elastic when compared with national tax bases. d. very inelastic. 6. According to the Tiebout model of local government expenditure, a. all local governments will supply the same kinds and amounts of services. b. mobile citizens respond to differences in taxes and expenditures by moving to the jurisdiction that maximizes their well-being. c. the average costs of government services is constant. d. tax rates do not influence a citizen’s choice of residence. 7. A categorical grant: a. does not restrict the use of transferred funds. b. usually specifies the use to which the funds must be applied. c. is used rarely in the United States. d. is not used at all in the United States.

8. A federal highway grant will provide funds for roads supplied by state and local governments if these governments pay 50 percent of the cost of the roads. This grant is an example of: a. revenue sharing. b. a matching categorical grant. c. a general purpose grant. d. a nonmatching block grant. 9. A grant received by a local government will: a. not affect the political equilibrium in that jurisdiction. b. change the political equilibrium in that jurisdiction. c. always increase government expenditures in the recipient jurisdiction by the amount of grant. d. both (b) and (c) are correct. 10.

Matching grants: a. will not increase government spending in recipient jurisdictions. b. increase government expenditures in recipient jurisdictions more than nonmatching grants of an equal amount. c. increase government expenditures in recipient jurisdictions less than nonmatching grants of an equal amount. d. increase tax rates in recipient jurisdictions.

11. Which of the following is true about a federal system of government? a. There is only one level of government. b. There are several levels of government. c. A central government directs local governments to supply all public goods at levels determined nationally. d. There are only local governments. 12. The central economic problem of fiscal federalism is: a. the division of taxing and expenditure functions among different levels of government. b. the choice of the collective choice rule for central governments only. c. the level of public goods to be provided by a central government only. d. how to achieve an equitable distribution of income. 13. Which of the following is best supplied by local governments? a. National defense b. Income redistribution c. Money d. Fire protection 14. Local public goods: a. are pure public goods for the entire nation. b. are those whose benefits are nonrival only for the population of a particular geographical area. c. have benefits that are subject to exclusion by pricing for local consumers. d. are best provided by a central government.

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15. An increase in the local retail sales tax rate will increase revenue collected by a local government: a. if the tax base is elastic. b. if the tax base is unit elastic. c. if the tax base in inelastic. d. no matter what the value of the elasticity of the tax base. 16. Which is an example of a interjurisdictional externality? a. Residential property tax b. Local sales tax c. Wage tax on all workers in a community d. Both (b) and (c) are correct. 17. Mobility: a. is not essential to the Tiebout model. b. can hamper a jurisdiction’s ability to raise revenues. c. may be part of the reason for the reliance on local property taxes for the raising of local government revenue. d. both (b) and (c) are correct. 18. A local wage tax can: a. create tax competition if a neighboring jurisdiction does not have such a tax. b. export tax onto workers in the local jurisdiction who live outside of the local jurisdiction. c. prevent tax competition among other local jurisdictions. d. both (a) and (b) are correct. 19. Fiscal capacity: a. decreases with the ability of the jurisdiction to export tax. b. is a measure of the ability of a jurisdiction to finance government-provided services. c. is always enhanced by mobility. d. is not dependent on the wealth of the community. 20. Which of the following is generally the best measure of fiscal capacity for local governments? a. Income per capita b. Per capita retail sales c. Assessed valuation per capita d. Per capita expenditure

ESSAY QUESTIONS 1. The increased suburbanization of an urban population was an important social phenomenon of the 1960s and 1970s in metropolitan areas in the United States. Explain how the decision to migrate to another jurisdiction in a metropolitan area is influenced by policies of central city and suburban government policies. What steps could a central city government use to encourage the return of the middle-income class to the city? Explain why regressive taxes may be necessary to retain middleand upper-income residents in the city. 2. Show how a matching grant provides incentives for residents of state and local jurisdictions to provide themselves with more of the services than the grant subsidizes. Why are matching grants more effective than nonmatching grants in increasing expenditures? © 2021 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.