AD-AS ANALYSIS: An economic model relating the price level and real production that is used to analyze business cycles, gross domestic product, unemployment, inflation, stabilization policies, and related macroeconomic phenomena. The AS-AD model, inspired by the standard market model, captures the interaction between aggregate demand (the buyers) and short-run and long-run aggregate supply (the sellers).
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The study of how the government (or public) sector pays for (or finances) expenditures through taxes and borrowing. Public finance is essentially the study of federal, state, and local government budgets, with expenditures on one side and revenues on the other. Particular emphasis is paid to the economic efficiency of government taxes and spending. Expenditures are used for public, near-public, or common-property goods, including national defense, police and fire protection, education, transportation, and the judicial system. Revenues are obtained from taxes levied on income, wealth, consumption, and other activities; and from borrowed funds, commonly obtained by issuing government bonds or securities. Public finance is an economics specialty that studies the revenue and expenditure functions of government. It is the study of how the public sector uses tax dollars, augmented with borrowed funds, to finance expenditures, especially expenditures used to provide "public" goods. In fact, the existence of governments -- federal, state, and local -- arises from the need for valuable "public" goods and services that cannot be provided efficiently by market exchanges and private sector efforts.
A Necessary EvilLike it or not, governments are a fact or life. They've been a part of civilized society in one form or another since, well, since there's been a civilized society. It's embarrassingly easy to find fault with government actions... high taxes, incompetent government workers, inefficient spending. But with all of the problems, with all of the questions, governments exist and persist. There must be a reason.
There is, or rather, are several important reasons that people put up with the coercive, taxing, intrusive existence of governments.
- Common Defense: At the top of the list of important government functions is defending society from outside forces, that is, national defense. This includes maintaining a military and purchasing whatever privately produced goods (clothing, vehicles, paper clips) are needed to accomplish this task.
- Education: Governments are also heavily engaged in education, from public schools to higher education to job training programs to public service announcements. Local and state governments are particularly involved in public education.
- Transportation: The distribution of goods and services relies on air, water, and land transportation system, much of which is supported in one form or another by governments. Governments are also involved in the transportation of information (telephone, Internet, entertainment broadcasting) and energy (electricity, natural gas).
- Public Health and Safety: Governments also defend society from internal threats through police and fire protection, disease control, and environmental quality regulation.
- Legal and Judicial System: Perhaps most important of all functions, governments establish and enforce the "rules of the game" for society, rules which make it easier for members of an economy to produce, consume, and exchange.
- Money: Lastly, governments play a key role in maintaining the value and stability of the money supply, which facilitates market exchanges.
The Budget Pie
The two pie charts to the right summarizes the major spending and tax categories for federal, state, and local governments combined. The proportions are based on government activity in the early 2000s and while they change a bit over time and from one political administration to another, this exhibit reflects the general priorities of the current government sector.
|The Government Budget|
Let's begin with revenue pie chart at the top of the exhibit. This chart indicates the assorted taxes collected by all levels of government combined -- federal, state, and local. Working clockwise from largest to smallest category...
Expenditures undertaken by federal, state, and local governments, presented in the lower pie of the exhibit to the right, are somewhat more diverse that the sources of tax collections. While diverse, we can identify several key categories. Once again, working clockwise around the pie chart from largest to smallest category...
- Personal Income: All levels of government -- federal, state, and local -- rely on personal income taxes, which is why this tax is about 34 percent of total tax collections.
- Excise: The second largest category is excise taxes, a significate 17 percent, which a wide assortment of taxes collected on specific goods, most notably imports. The federal government collects the bulk of these taxes, but state and local governments also collect their share.
- Social Security: Another major source of federal tax revenue is collected through Social Security taxes on wage earnings, about 16 percent of the total. While most of this tax revenue is used to provide Social Security benefits to the elderly and disabled, a portion is loaned the federal government and used to finance general expenditures.
- Other: This other category, about 13 percent of all tax government collections, includes a hodge-podge of taxes and other sources of revenue, most of which are individually relatively minor, but they do add up.
- Sales: A major source of tax revenue for state and local governments is general sales taxes, about 8 percent of total government collections.
- Property: Taxes on homes, real estate, and personal property are a important source of revenue for local governments. These are about 7 percent of total tax collections.
- Corporate Income: The smallest of the major tax categories is corporate income taxes, taxes collected on the profits earned by corporations. This tax is collected primarily by federal and state governments and comprises about 6 percent of total taxes.
- Transfers: The largest category of expenditures by all levels of government combined is transfer payments, which includes veterans benefits and public assistance payments to the poor, but excludes Social Security. This category is about 17 percent of the total.
- Education: The largest expenditure category for state and local governments is education, which helps to make it 15 percent of all government spending.
- Other: The diversity of government activity is indicated by the size of the other category, 14 percent, which includes such areas as agriculture, international affairs, and regional development.
- Social Security: Social Security benefits paid to elderly and disabled accounts for 14 percent of all government expenditures. Combined with other transfer payments, over 30 percent of government expenditures are used to redistribute income among the population.
- Interest: In that all levels of government supplement tax revenue with borrowed funds, approximately 11 percent of expenditures are devoted to paying interest on these loans.
- Health: All three levels of government devote a combined 11 percent of expenditures for assorted health care, including Medicare, Medicaid, public health programs, and a whole lot more.
- National Defense: The second largest expenditure category for the federal government is national defense, which brings it in at 10 percent of all government expenditures.
- Transportation: All levels of government are responsible for transportation expenditures, including highways, streets, bridges, etc. These expenditures are 4 percent of the total.
- Police and Fire: State and local governments, with modest assistance from the federal government, are responsible for expenditures on police and fire protection. These expenditures are 2 percent of the total.
- Administration: Lastly, and perhaps surprising to many, administration expenditures paid as salaries to elected officials, mayors, governors, legislators, their staffs, and for related "operating" expenses account for only 2 percent of total government expenditures.
On the Expenditure SideGovernments arise in large part to address problems or failures found in normal market exchanges. While markets do a relatively good (that is, efficient) job of allocating resources under most circumstances, at times that don't, at times they fail. Market failures occur when markets do not efficiently allocate resources in a manner which achieves the greatest possible level of satisfaction. Market failures come in four varieties:
The market failure of public goods plays a central role in very existence of governments. However, all four market failures give rise to important government expenditures. The role of government expenditures on public goods is further clarified with a look at two characteristics of goods -- which gives rise to four distinct types of goods.
- Public Good: A public good is a good that can be consumed simultaneously by a large number of people without the consumption by one imposing an opportunity cost on others.
- Market Control: Market control arises when buyers or sellers are able to exert influence over the price of a good and/or the quantity exchanged.
- Externality: An externality exists if a benefit is not included in the demand price or a cost is not included in the supply price.
- Imperfection Information: The lack of information among buyers or sellers often means that the demand price does not reflect all benefits of a good or the supply price does not reflect all opportunity costs of production.
- Consumption Rivalry: This characteristic indicates whether the consumption of a particular good by one person prevents simultaneous consumption by, or imposes an opportunity cost on, another person.
- Nonpayer Excludability: This characteristic indicates whether or not nonpayers can be excluded from consuming a particular good, which is based on the ability to possess and transfer property rights or ownership of a good.
Matching up consumption rivalry (rival versus nonrival) and nonpayer excludability (yes versus no) in the matrix chart to the right reveals four types of goods.
- Private: Private goods are characterized by rival consumption and the ability to exclude nonpayers. Private goods can be easily, effectively, and efficiently exchanged through markets.
- Public: Public goods are characterized by nonrival consumption and the inability to exclude nonpayers. Public goods cannot be exchanged through markets. The only efficient way to provide public goods is through governments.
- Common-Property: Common-property goods are characterized by rival consumption and the inability to exclude nonpayers. These goods cannot be efficiently exchanged through markets and governments are often called upon to control or regulate their use.
- Near-Public: Near-public goods are characterized by nonrival consumption and the ability to exclude nonpayers. These goods are often exchanged through markets, but are more efficiently provided by governments.
On the Tax SideThe financing part of public finance primarily comes from taxes. Governments impose taxes for two reasons -- to generate revenue (the revenue effect) or to change resource allocation (the allocation effect).
All taxes have both effects. However, different taxes achieve the two effects to different degrees. The key to generating revenue is to identify taxes that have very little allocation effect. This is best achieved with broad-based taxes that create the same degree of disincentives for all types of goods and activities. And when seeking to change allocation taxes should have very little revenue effect. This is best achieved with narrow taxes that create greater disincentives for some types of goods and activities. The revenue effect tends to be greater for relative inelastic goods and the allocation effect is greater for relative elastic goods.
- Revenue Effect: The primary reason governments impose taxes is to generate the revenue used to finance the operation of government, most notably the provision of public goods.
- Allocation Effect: A second reason governments impose taxes is to change the allocation of resources by creating disincentives to produce, consume, and exchange.
While taxes might be placed on different goods, services, assets, and activities, all taxes are ultimately paid with income. Tax proportionality is the proportion of income paid in taxes at different levels of income.
As the ones setting and enforcing the rules, governments have a great deal of power to impose taxes. However, while governments have the taxing authority, they often temper this with the fairness of taxes.
- Proportional: A proportional tax is one in which the proportion of income paid in taxes is the same for all income levels. A proportional income tax exists, for example, if ever taxpayer pays exactly the same proportion of their income in taxes, that is, the same tax rate.
- Progressive: A progressive tax is one in which the proportion of income paid in taxes is greater for higher income levels. A progressive income tax exists, for example, if taxpayers with more income pay a larger proportion in taxes, that is, a higher tax rate.
- Regressive: A regressive tax is one in which the proportion of income paid in taxes is smaller for higher income levels. A regressive income tax exists, for example, if taxpayers with more income pay a smaller proportion in taxes, that is, a lower tax rate.
The ability-to-pay principle gives rise to two notions of "fairness" and "equity."
- Benefit Principle: The benefit principle states that taxes should be based on the benefits received, that is, those who receive the greatest benefits should pay the most taxes. On the surface, this principle is quite logical and easily justified. The people who benefit from public goods are logically the ones who should pay for their provision. However, the benefit principle does not work well for the efficient provision of public (and near-public) goods. Due to nonrival consumption, such goods are efficiently allocated with a zero price. Making users pay means an nonzero price an inefficiency.
- Ability-to-Pay Principle: The ability-to-pay principle states that taxes should be based on the ability to pay taxes, that is, those who have more income should pay more taxes. This principle also makes a great deal of sense, especially for the provision of public goods that are consumed by all. If everyone benefits from public goods, without exclusion, then everyone should pay. However, not everyone CAN pay, so those who CAN afford to pay, need to bear the burden.
- Horizontal Equity: This tax equity principle states that people with the same ability to pay taxes should pay the same amount of taxes. For example, if two people earn $50,000 in income, then both should pay $5,000 in taxes.
- Vertical Equity: This tax equity principle states that people with a different ability to pay taxes should pay a different amount of taxes. For example, if one person earns $50,000 in income and pays $5,000 in taxes, then another who earns $100,000 in income should pay $10,000 in taxes.
A Word About Public ChoiceClosely related to public finance is the study of public choice. Public choice is the study of collective decisions made by groups of individuals, especially those decisions made by government organizations. Public choice is a recognition that governments do not necessarily address market failures with efficient policies. While markets fail to efficiently allocate resources due to public goods, externalities, market control, and imperfect information, government allocation decisions are also fraught with imperfections.
Four key inefficiencies underlying the study of public choice are:
- Politicians: The public choice contention is that politicians are utility-maximizing political entrepreneurs. These leaders are motivated to seek reelection and remain in office, a pursuit which is frequently in conflict with the efficient implementation of government policies. In particular, politicians need only the support of a majority of those actually voting in the election, a majority which may or may not reflect the interest of society or at least a majority of the population.
- Voters: A significant amount of government inefficiency rests on the shoulders of the voters. As utility-maximizing consumers, voters choose to vote or not to vote based on the costs and benefits of voting. That is, voters often choose rational ignorance -- voters choosing NOT to be informed about an issue or candidate because the cost of acquiring the information exceeds the benefits -- and rational abstention -- choosing NOT to vote because the cost of voting exceeds the benefits. The combination of both (voter apathy) means that those who choose to vote do not necessarily reflect the interests and preferences of the entire population.
- Special Interest Groups: Voter apathy among some means that those who choose to be informed and who choose to vote are also likely to have greater influence in the election process. In particular, those voters who are likely to gain or lose the most from an election have a "special interest" in the outcome and are also likely to exert a great deal of effort to influence the outcome. And when the special interest groups exert their influence, efficient government policies are not necessarily implemented.
- Bureaucracies: Even if voters and politicians select efficient policies, such policies might not be effectively implemented due to the bureaucratic structure of government agencies. With bureaucracy, individual workers can avoid taking personal responsibility for their actions and correct information is not necessarily transmitted from worker to worker. As such, the "best laid plans" are bound to go awry.
PUBLIC FINANCE, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2020. [Accessed: April 8, 2020].
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