Public Finance: Government Intervention, Market Failures, and Fiscal Policy

Public finance

The study of the role of the government in the economy.

Four questions of public finance

When should the government intervene in the economy? How might the government intervene? What is the effect of those interventions on economic outcomes? Why do governments choose to intervene in the way they do?

Reasons for government intervention

Market failures (e.g., externalities, public goods) and Redistribution (shifting resources across groups).

Market failure

A situation where markets fail to maximize efficiency. Example: Not getting vaccinated creates negative externalities by increasing others' infection risk.

Redistribution

Redistribution shifts resources across groups, but usually creates an equity-efficiency tradeoff: bigger pies vs. fairer slices.

Ways government might intervene

Taxes or subsidies, Restricting/mandating private sale or purchase, Public provision, Public financing of private provision.

Direct effects of intervention

Predicted if behavior doesn't change (e.g., covering the uninsured adds 49 million people).

Indirect effects of intervention

Arise when behavior changes (e.g., people drop private plans to join free government insurance).

Political economy

The study of how the political process produces decisions that affect individuals and the economy.

Federal spending as a share of GDP in 1930

1930: ~3.4% of GDP.

Federal spending as a share of GDP since the 1950s

Since 1950s: ~20% of GDP on average (higher during recessions).

Share of total U.S. government spending by state/local governments

About 40% (over 17% of GDP).

Surplus

Revenues > Spending.

Deficit

Revenues < Spending (adds to debt).

Debt

Accumulated past deficits.

Largest U.S. federal program today

Social Security.

Federal spending change between 1960 and 2019

1960: ~50% defense. 2019: Defense <20%, big growth in social insurance (esp. health).

Federal revenue sources shift since 1960

Corporate taxes: 25% → 12%, Payroll taxes: 16% → 35%+.

Major tax component of federal and state/local revenue in 2019

Income taxes.

Measles epidemic (1989-1991) government response

Low vaccination rates caused outbreaks. Government funded vaccines for low-income families, raising immunization rates to 90% by 1995.

Vaccination policy as market failure

Unvaccinated people create negative externalities by raising disease risk for others.

CARES Act (2020)

A $2.2 trillion COVID relief package including unemployment benefits, household payments, and business loans.

Political disagreement during COVID

Democrats: favored unemployment benefits, mask mandates. Republicans: favored business loans, looser guidelines.

Role of the Congressional Budget Office (CBO)

Not defined in the provided text.

Government intervention

Four main ways: Taxes/subsidies, restrictions/mandates, public provision, public financing of private provision.

Federal spending as % of GDP (1930)

1930 = ~3.4%.

Federal spending as % of GDP (since 1950s)

Since 1950s = ~20%.

Share of total government spending by state/local

~40% (over 17% of GDP).

Federal spending (1960)

1960 = ~50% defense.

Federal spending (2019)

2019 = defense <20%, social insurance ↑.

Federal revenue shift since 1960

Corporate tax ↓ (25% → 12%). Payroll tax ↑ (16% → 35%+).

Major component tax for federal & state/local

Income tax.

Vaccination as market failure

People ignore positive externalities → under-consume vaccines → gov must subsidize/mandate.

Political divide in CARES Act

Republicans = PPP loans/business aid. Democrats = unemployment benefits + state/local aid.

Role of the CBO

Nonpartisan budget analysis → scores bills → influences Congress.

Difference between deficit and debt

Deficit = yearly gap. Debt = all past deficits.

Importance of payroll tax today

Corporate tax shrank → payroll tax funds Social Security & Medicare.

Example of indirect effect of intervention

Free public insurance → people drop private coverage → higher costs than predicted.

Equity-efficiency tradeoff

More equity (fairness) usually reduces efficiency (total wealth). Gov must balance.