Chapter 1 1.

Definition of public finance Public finance is the study of the role of the government in the economy The role of public finance is to understand the proper role of the government in the economy o Expenditure side: public vs. private o Revenue side: tax brackets in different economic situation 2. 4 questions of public finance When should the government intervene in the economy? Market failure and redistribution How might the government intervene? The government policy is used to change the price of a good in 1 of 2 ways o Through taxes, which raise the price for private sales or purchases of goods that are over-produced o Through subsidies, which lower the price for private sales or purchases of goods that are under-produced Restrict or mandate private sale or purchase: the government can directly restrict or mandate private sale or purchase of goods that are over-produced, or mandate private sale or purchase goods that are under-produced and force individuals to buy that good Public provision: the government can provide the good directly, in order to potentially attain the level of consumption that maximizes social welfare, such as parks, bridges, and streetlights, Public financing of private provision: the governments may want to influence the level of consumption but may not want to directly involve themselves in the provision of good, such as subsidizing for the price of the buss ticket What are the effects of those interventions on economic outcomes? Direct effects: the effects of government interventions that would be predicted if individuals did not change their behavior in response to the intervention.

Indirect effect: the effects of government interventions that arise only because individuals change their behavior in response to the interventions Why do governments do what they do? Political economy Governments face difficulties in finding out what the public wants and their preferred policies Government failures could lead to reduction in private welfare 3. Statebudget State budget is originated from the commodity economy and government establishment Government set tax rates and manage state budget to maintain the government operation, military and develop the economy 4. Characteristic of state budget Link directly with economic and political power of local government Delegation from state budget to provincial budgets Operate based on transparent, democratic, centralized and authorities Prioritize to archive social objectives, national benefits Balance between state revenue and state expenditure 5. Staterevenues Taxes Fees and fines Revenue from SOEs Foreign aids, contributions Government debts Others 6. State expenditures Social economic development projects National securities expenses
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 National defense expenses Pay national debts Contribute aids to other countries Other expenses 7. Distribution of spending Public goods Social insurance programs Chapter 4 1. Government budgeting Debt is the amount a government owes to those who have loaned it money at any point of time Deficit is the amount by which a governments spending exceeds its revenues in a given year The budget process distinguishes between 2 types of federal spending: o Entitlement spending: mandatory funds for programs, example: social security and social insurance o Discretionary spending: optional spending, example: infrastructure development and defense expenses Budget policies and deficits at state level o Balanced budget requirement (BBR) a law forcing a given government to balance its budget each year (spending = revenue) o Ex post BBR a law forcing a given government to balance its budget by the end of each year o Ex ante BBR a law forcing either the governor to submit a balanced budget or the legislature to pass a balanced budget at the start of each fiscal year, or both 2. Measuring the budgetary position: alternative approaches Real prices Nominal prices
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 Customer price index (CPI) Role of inflation and public debt: The higher inflation rate, the lower real deficit (example in the slide page 5 chapter 4) Standardized (structural) budget deficit is a long-term measure of the governments fiscal position, with short-term factors removed Cyclically adjusted budget deficit is a measure of the governments fiscal positionof theeconomy were operating at full potential GDP Cash accounting is a method of measuring the governments fiscal position as the difference between current spending and current revenues Capital accounting is a method of measuring the governments fiscal position that accounts for changes in the value of the governments net asset holdings Capital accounting Establish investment account to track capital expenditures such as buildings and highways Current consumption expenditures such as unemployment allowances Balancing budget by selling capital holding assets and licenses Chapter 5 1. Fiscal austerity Cut government spending or raise taxes To raise budget surplus (or reduce budget deficit) o To avoid economic overheating o Strengthen long-turn debt sustainability (deficit = debt) 2. Fiscal stimulus Raise government spending or cut taxes To provide short-term economic stimulus What is the best fiscal policy, austerity or stimulus? We cant choose because its based on the current economic situation 3. Keynes favored counter-cyclical policy
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 Fiscal stimulus when under conditions like: depressed income, high unemployment, low inflation, low interest rate - to moderate the downturn But the Fiscal contraction during boom periods, to prevent over-heating 4. Definition of pro-cyclical fiscal policy Governments raise spending (or cut taxes) in booms Forced to retrench in downturns 5. Three distinct US fiscal problems The long-term debt problem The medium-term economic problem The short-term political problem 6. How to reduce the budget deficit Spending o Eliminate agricultural subsides o Cut manned space program o Trim National Guard and Reserve o Close unwanted military bases o Cut unwanted weapons systems Tax revenue options o Can still curtail expensive and distorting tax expenditures o Or launch more tax reform Chapter 7: Public Goods 1. Definition of public goods Private trash collection, financed by a voluntary fee paid by neighborhood residents, faces the classic free rider problem Goods that suffer from this free rider problem are known in economic as public goods 2. Private versus Public goods Private goods are
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o Rivalrous only those who will to buy a good can have the benefit o Exclusive bought by person A, it is not available to person B Private goods satisfies an individual want while public good satisfies a collective wants Public good is a good that is non-rivalrous and non-excludable 3. Optimal provision of public goods Pure public goods: goods that are perfectly non-rival in consumption and are nonexcludable Non-rival in consumption: one individuals consumption of good does not affect anothers opportunity to consume a good Non-excludable: individuals cannot deny each other the opportunity to consume a good Impure public goods: goods that satisfy the two public good conditions (non-rival in consumption and non-excludable) to some extent, but not fully Excludable rival Private goods Food and clothing Car House Non-rival Low-congestion goods Cable TV Satellite radio Online WSJ Non-excludable Commons goods Fish in open sea Atmosphere Public waterways Public goods Tax-based: nuclear umbrella, the law Indirect private funding: search engine, on the air TV

4. Private sector under provision Free rider problem: when an investment has a personal cost but a common benefit, individuals will under-invest
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 Can private providers overcome the free rider problem? o The free rider problem does not lead to a complete absence of private provision of public goods o The private sector can in some cases combat the free rider problem to provide public goods by changing user fees that are proportional to their valuation of the public good When is private provision likely to overcome the free rider problem? o Private provision is particularly likely to surmount the free rider problem when individuals are not identical, and when some individuals have an especially high demand for the public good Chapter 25: Fundamental tax reform Tax compliance: efforts to reduce the evasion of taxes Tax evasion: illegal nonpayment of taxation The distinction between tax avoidance (legal) and tax evasion (illegal) is a fine one and there is a large community of tax lawyers and judges who struggle daily with this distinction There are 3 reasons why we care about tax evasion and should want to reduce it Efficiency Vertical equity (the fairness in the tax system) It is one of the clearest violations of horizontal equity that we have discussed Why fundamental tax reform? Improving tax efficiency o Direct effect of tax changes: a higher tax rate that raises revenues on a fixed base of taxation o Indirect effects of tax changes: a higher tax rate that lowers the size of the revenue base on which taxes are levied

 Gross income effect: a higher tax rate may reduce gross income generated by lowering the amount of labor supplied, the savings undertaken, or risk taking Reporting effect: for a given level of gross income, a higher tax rate will cause individuals to reclassify income in ways that are not subject to a tax Income exclusion effect: for a given reported income, a higher tax rate will cause individuals to take more advantage of the deductions and exclusions from gross income that are used in defining taxable income Compliance effect: finally, higher tax rates may reduce revenues through increased tax evasion The benefits of fundamental tax reform o Helps address all 3 of tax reform goals (increasing tax compliance, simplifying the tax code, and improving tax efficiency) o By expanding the tax base and lowering tax rates, fundamental tax reform improves tax compliance and tax efficiency o By ending large numbers of detailed exemptions and deductions from taxation, and taxing different forms of income at the same rate, fundamental tax reform also makes tax filing simpler Politics and economics of tax reform o Political pressures for a complicated tax code o Economic pressure against broadening the tax base Tax capitalization: the change in asset prices that occurs due to a change in the tax levied on the stream of returns from that asset Transitional inequities from tax reform: changes in the treatment of similar individuals who have made different decisions in the past and are therefore differentially treated by tax reform Grandfathering in Virginia Tax consumption
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Tax consumption: taxing individuals based not on what they earn but on what they consume (such as through a sales tax) Advantages of tax consumption o Improved efficiency A single-rate sales tax could reduce many of inefficiencies associated with the current tax system A particular source of inefficiency in our current tax system is the lack of a level playing field across investment choices o Simplicity In principle, it is much more straightforward to simply tax individuals on their purchases than on a complicated definition of income Disadvantages of tax consumption o Vertical equity The primary concern with consumption taxation is a reduction of vertical equity o Asymmetric information The government has only imperfect measures of ability o Transition issues By some estimates, the entire efficiency gain from a consumption tax over the first several generations would be used up if extra taxes had to be raised to make transition payments to existing generations o Compliance It is much harder to track consumption expenditures than it is to track income earned, where withholding from paychecks can solve compliance problems for the vast majority of the population o Cascading Businesses often pay sales taxes on their inputs and then again when they sell their outputs, so that a cascading problem develops
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 Expenditure tax: a consumption tax levied on yearly consumption rather than on specific sales The flat tax Features o Corporations pay a flat VAT on their sales, but also get to deduct wage payments to workers from their VAT tax base. There is no corporate income tax o Individual pay a tax on labor income only, not capital income, at that same flat rate o All tax expenditures would be eliminated (health insurance expenditures would be treated like wage payments, charitable contributions and home mortgage interest would no longer be deductible, and so on) and would be replaced by a single family-level exemption) Advantages of flat tax o The efficiency gains from having one flat rate on a board income definition o The flat tax would have enormous benefits in term of simplicity o Compliance would also likely improve because the simpler tax system would make it harder to find ways to evade taxes; for almost all taxpayers, their entire tax bill could be collected through withholding from earnings Disadvantages of flat tax o A flat tax can be made fairly progressive for low and middle income earners, it will be much less progressive for high income earners than our current system

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