Introduction to Public Budgeting and Finance Administrative Stuff

Introduction to Public Budgeting and Finance

Administrative Stuff n Use of Web. CT n n Any problems so far? Organization of course n n n Each session = 4 weeks, with corresponding number of readings Syllabus is rough guide only Not all reading materials will be covered in lecture, but all should be read carefully Group projects Homework assignments due by following session Take home final due week after course

Objectives of the course n n n n Survey the dominant theories in budgeting and finance, compare practice and trends Learn how to strategically plan a budget, how to manage ongoing activities, and how to control spending; Understand the role of public organizations in a market economy Understand social security, public health and other major categories of public expenditure Understand theory and practice of the redistribution of wealth and resources Understand the impact of taxes on social welfare. Learn from practitioners in the field.

What is Public Budgeting? n n n How governments strategically plan a budget Manage ongoing activities Control spending

What is Public Finance? n n The study of how governments collect and spend money and real resources How do governments collect/spend money? Positive analysis How should governments collect/spend money? Normative analysis We are studying public finance in a market economy

What is the Role of Government? n To maintain and improve the welfare of the people To protect the people from harm n To provide the institutions that allow market to function (e. g. protection of property rights) n To provide the essential goods and services that markets fail to adequately provide n

The Role of Government: Ideology

Current Trends n n n Reagan tax cuts Shrink government “down to the size where we can drown it in a bathtub” Grover Norquist “The era of big government is over” Bill Clinton Bush tax cuts Free market ideology

Organic view of government n n Society is a natural organism Goals of society set by state Actions of individual are judged by the contribution they make to the state “Ask not what your country can do for you; ask what you can do for your country. ”

Mechanistic view of government n n n Individuals are paramount, government created to meet the needs of individuals Big debate over importance of individual freedom Two types of freedom: Freedom to do as you like n Freedom not to suffer from activities of others n As society grows more crowded, second type of freedom becomes more important n

The Role of Government: Objective Analysis Complexity theory and systems thinking n Government in a market economy n

Complexity theory and Systems thinking n Bringing together many, many simple components leads to emergence of spontaneous order, complex system: n n 2 H and 1 0 atoms form water molecule, molecules form cell, cells form organs, organs make up humans, humans make up society Complex systems greater than the sum of their parts Characterized by non-linearities, feedback loops, emergent properties, unpredictable surprises, etc. Government is a complex system

Government in a market economy n n Economics is the allocation of scarce resources among alternative desirable ends What are the desirable ends? n n n To maintain and improve the welfare of the people Government and economics have the same desirable ends What are the scarce resources? What are the characteristics of the scarce resources? Whether resources should be allocated by government or the market depends on the physical nature of the scarce resources Once we agree on the desirable ends, deciding on the role of government moves towards objective science and away from ideology.

Legal Framework

Federal Government: Expenditure n n Constitution empowers government to “pay the debts and provide for the common defense and general welfare of the United States. ” Bills to appropriate expenditures can be initiated in either house, must be approved by both houses and President

Federal Government: Revenue n n n Duties, imposts and excises must be uniform throughout US Constitutional amendment (16 th) required for federal income tax 5 th amendment– can’t take away property without due process of law, compensation required Can’t tax articles exported from states Empowered to borrow money

State and local governments n n n States have power not explicitly relegated to federal government Can’t impose duties on imports or exports Power of local governments granted by states

The Size of Government

Historical context n What was the highest marginal tax rate n Under Eisenhower? • Under Kennedy? • Today? • Highest tax bracket currently applies to single people earning $54, 000/yr

What has happened to the deficit?

What has happened to the size of government as a share of GDP?

How does size of US government compare with other countries (2001)? USA 29. 3% of GDP Australia 31% Canada 37. 4% Japan 38. 3% UK 38. 8% France 49. 4% Sweden 53. 1%

How does the federal government spend its money?

How do state governments spend money? n n Miscellaneous (~43%, +) Education (~35%, -) Public welfare (~17%, +) Highways (~5%, -)

Where does the government get its money? n Federal n n Individual income tax (+) Social insurance (++) Corporate tax (--) Other (-) n State and local n n n Other (+) Sales tax Grants from federal government (+) Property tax (-) Individual income tax (+) Corporation tax

How do we Objectively Measure Government Performance?

Role of Theory n n n Observe, form hypotheses Test hypotheses through continued observation, measurement and experiments Confirm hypotheses repeatedly and you have theory Reject hypotheses and you’re back to the drawing board Theory tells us what questions to test

If we fail to test our theories and their assumptions, or continue to believe them when they fail the tests, they become ideology, not theory

Neoclassical Economic Theory n Assumes humans are rational, self interested utility maximizers n n Assumes perfect market competition n Empirical studies reject this Assumes in perfect markets invisible hand leads to efficient allocation: greatest good for greatest number Can’t be tested in practice, because governments always intervene with perfect functioning of market

Ecological Economic Theory n n Assume economy is subset of ecosystem Ecologically sustainable scale is first priority Socially just distribution 2 nd Efficient allocation 3 rd

Georgist Economic Theory n n Ownership of land leads to poverty Value of land is created by nature and society, not hard work of individual Land tax could finance all government expenditure, prevent land speculation and concentration of ownership, end poverty Land tax could be extended to include all value created by nature and society

Empirical methods for Testing theories n Interviews n n Subjective, hard to interpret Experiments Ethical issues, self selection, etc. n Sample size n n Econometrics (statistics) n n Torture the data and it will confess Theories can be very hard to test

Measurement in a complex system n Very hard to isolate cause and effect n n E. g. feedback loops Rarely have adequate baseline data Systems evolve over time Values matter

How do we normatively measure government Performance?

Why do we need normative measures? n n n We need some way to measure social welfare, and choose between alternative states Economic theory provides some guidelines Theory can be very incomplete Different theories make different ethical assumptions The most commonly taught approach is neoclassical welfare economics

Pareto Efficiency n n n Pareto improvement-- Any change in allocation that makes at least one person better off without making anyone worse off Pareto optimum– an allocation where no further Pareto improvements are possible We always want to be at a Pareto optimum

Indifference curves in Edgeworth box

Contract curve

Marginal rate of substitution n If you lose one fig, how many apples would you need to remain just as happy? Determined by slope of indifference curve Pareto optimum occurs when

Production possibilities frontier

Marginal cost n Marginal cost of figs is the number of apples you have to give up to get one more fig

Efficiency demands that across all goods and all people in the economy

First Fundamental Theorem of Welfare Economics n Assumptions: n n n If all producers receive the same price And there is a perfect market for every commodity And people are perfectly rational, Then, the free market automatically leads to a Pareto Efficient allocation If assumptions hold and all we care about is Pareto efficiency, then government should be minimized But some Pareto optimums may be better for society than others

Second Fundamental Theorem of Welfare Economics n n We can attain any point on the contract curve by changing initial endowments and letting market take over. So initial distribution matters, big time

Conclusions n n If markets functioned according to theory, the major role of government would focus on initial distribution Markets unfortunately do not function according to theory, as we’ll learn in next lecture