Macro Economic

Department of Economics
Introduction to Public Finance

Concepts, Topics and Methods
Topic 1
Public Finance
Jakob Egholt Søgaard

Spring 2018
Public Finance, Spring 2018

Slide 1
Lecture overview
• Course practicalities
• What is Public Finance?
• Why study Public Finance?
• Two key tools in Public Finance:
• Economic theory: welfare and behavioral responses
• Applied econometrics: causal identification of key parameters
• How to read scientific/journal articles

Slide 2
Practical information
• Main lecturer: Jakob Egholt Søgaard
• My second time as the lecturer of this course

• I am still working on the precise contents and format of this
course
• Write me with any suggestions / questions
• Or ask me after class
• Don’t just wait until the midterm evaluations
• I strong tendency to speak fast, so stop me if you do not follow

Slide 3
Who am I?
Academic career: Professional career:

2011: Cand.polit 2011: Ministry of Finance
Thesis on local public goods and Model building used for the 2011
tax externalities. retirement reform.
2015: PhD in Economics Model building and empirical
analyses regarding the effect of
Claus Thustrup as supervisor.
education on labor supply.
Thesis on:
Model building and empirical
• Empirical work on Inequality, analyses used by the 2015
Labor supply and The gender unemployment commission.
pay gap
2016: Ministry of taxation
2018: Postdoc at CEBI
Model building used in the 2017
real estate taxation reform.
Slide 4
• Exam
• 3 hours closed books
• Readings
• Textbook: Hindriks and Myles (2013). But...
• Scientific journal articles
• Slides: raw + annotetad with be uploaded to the course site.
• Supplement reading
• Gruber (2007). Public Finance book with good intuition, but the
level is equivalent to our first year principles of economics.
• Angrist and Pischke (2009). Great econometrics book. Mandatory
reading in other courses.

Slide 5
• Two purposes of this course

• Getting you ready for the exam
• Introducing you to the real world of (public) economics
• It is sometimes difficult to teach to both purposes
• Slides with extra curriculum discussions are makes by

Slide 6
Topics covered in this course
1. Deadweight loss and excess burden
2. Labor supply and taxes
3. Measurement of behavioral responses
4. Tax incidence
5. Tax evasion
6. Taxation of firms
7. Social welfare
8. Inequality and intergenerational mobility
9. Optimal income taxation
10. Social insurance
11. Public goods and fiscal federalism

Slide 7
Different teaching styles

• Lectures:
• Old school teaching
• Lecture exercises: have pen and paper ready at the lectures
• One exercise class: Getting the math right
• Two workshops: Opportunity to try (empirical) methods in practices

Slide 8
What is Public Finance?
Understand the proper role of the government in the economy.

Typically limited to the revenue and expenditures of the public budget
(Musgrave and Musgrave, 1989)
• Expenditure side:
What services and transfers should the government provide?
• Taxation side:
How should the government raise its money?
Thus, public finance does not include:

• Competition policy → industrial organization
• Monetary policy → Monetary economics/Macroeconomics

Slide 9
The four questions of public finance/public economics (Gruber, 2007)

• When should the government intervene in the economy?
• How should the government intervene?
• What are the economic effects of intervention?
• Why do governments do what they do?
OBS: Positive economics versus normative economics
We will work on the first three.

• No. 4 (the why) → Political economy.

Slide 10
The development of public finance over time
<1990 1990s 2010s

Mainly theoretical Increasingly empirical Increasingly papers
papers. papers. using big data.
Many seminal Effort to estimate key Development of
papers on “Optimal parameters for in the behavioral public
…”. theoretical models. finance.
This course mainly focus on public finance from before the 2010s as it is the
key building blocks for modern public finance.
But we will touch upon behavioral aspects.
For more: take the master course on Tax Policy.
Slide 11
Relation to other economics courses
• Tax Policy: Advanced Master’s course in public finance.

• Seminar course: Term paper seminar in public finance.
• Applied Econometric Policy Evaluation: More applications of the
econometric tools we use in public finance.
• Advanced Microeconometrics: develops (more theoretically) the
tools we use in public finance.
• Labor economics: uses many of the same (empirical) tools as in
public finance. Great as building blocks in the positive part of public
finance.
• Political economy: explains why societies not always choose what
we say is ”optimal”.
• Health economics, Environmental economics, Economics of
Education: Focus on specific parts of the public sector.
Slide 12
Why study Public Finance?

Motivations for professional economists
In practice, all modern economies are mixed economies:
• Government revenue and expenditures in Denmark ≈ 50% of GDP.
• The public sector heavily affects economic outcomes by e.g. taxation
and transfers.
• The public sector supply a number of goods that could also be
supplied by the private sector: health services, education etc.
Public Finance is one of the key courses if you wish to work in
places like:
• The economic ministries (Finance, Taxation, Economic, …)
• Economic think tanks (DØR, Kraka, AE, Cepos, …)
• Or many consultancy firms (HBS, Damvad, …)

Slide 13

Motivations for academic economists
• Typically great data to apply new empirical methods.
• Modern Public Finance relies heavily on big data.
• Close link between theory and data.
• New research is often directly relevant for public policy.

Slide 14

The two fundamental theorems of welfare economics
We will almost always start our thinking with:
• First Theorem: (i) perfect competition, (ii) no
externalities/internalities, (iii) perfect information, (iv) price flexibility.
→ market equilibrium is Pareto efficient.
• Second Theorem: (i) convex preferences and technology, (ii) no
externalities/internalities, (iii) perfect information, (iv) price flexibility.
→ any Pareto efficient allocation can be achieved as a market
equilibrium with appropriately selected endowments.
→ No need for government intervention apart from protection of
property rights and a "once and for all" redistribution of
endowments.
Market first approach: Public intervention is justified by market failure.

Slide 15

Breakdown of the two fundamental theorems of welfare economics
In general we can think of the government as having the following
policy objectives/Fiscal functions (Musgrave and Musgrave, 1989):
• Allocation function ("efficiency")
• Distribution function
• Stabilization function (OBS: today often not considered as part of PF)

Slide 16

The allocation function
Market outcomes may be inefficient due to market failures:
• market power (competition policy not part of PF)
• public goods and common resources
• externalities
• internalities (the government knows best: paternalism)
• imperfect information
→ Scope for policies to improve economic efficiency.

Slide 17

The distribution function
Market outcomes are often unequal
• preference for equal opportunities
• preference for equality (equal outcomes)
→ Scope of redistribution policies
Redistribution policy generally entails efficiency costs

→ Equity-efficiency trade-off faced by policy makers

Slide 18

The stabilization function
Shocks, price rigidity, imperfect information, market power and
externalities
• → business cycles
• → efficiency loss and arbitrary redistribution
→ Scope for government stabilization policies

Slide 19
Why do governments intervene and why not?

A case for caution
Public finance is in most cases focused on ”optimal” policy.
→ a clear role for public intervention.
But are government benign maximizers of social welfare? ...or are
policies shaped by:
• special interest groups / lobbies.
• self-interested politicians (Fisman, 2001)
• budget-maximizing bureaucrats
• media pressure (Eisensee and Strömberg, 2007)
• paternalism
“Government failure” can very well be worse than “market failure”
→ Political Economy
Slide 20
Two key tools in Public Finance
• Economic theory:
• Guide to welfare assessments.
• Guide to empirical investigations.
• Applied econometrics
• Connecting theory to the real world
• Focus on identification.
• One of the fields in economics that pioneered the use of big
data.

Slide 21
Using economic theory

Mechanical versus behavioral effects of tax changes
Individuals maximize utility
wrt. c and h subject to the budget constraint
Where c is consumption, t is the tax rate, w is the wage rate and h is

work hours.
v(h) captures the disutility of working.
Assume that v’(h) > 0 and v’’(h) > 0.
The optimal solution is characterized by
which implicitly defines a labor supply function h* = h((1 – t)w)

Slide 22

Government tax revenue:
What are the effects of a (small) tax change on the government

revenue and household welfare?
Government revenue:
which may be negative if

• t is large and
• dh*/dt is large
→ behavioral responses are important

Slide 23

What about household welfare?
Recall: u = c – v(h) subject to c = (1 – t)wh
Recall that household optimization implies: v’(h) = (1 – t)w
Effect of a tax small tax change:
The effect on household welfare equals the mechanical effect.

→ Behavioral effects are not important. The result is due to the
Envelope Theorem.
Slide 24

The Envelope Theorem
h
h*
Slide 25

Lessons from the example with the impact of a (small) tax change
Lesson 1: Behavioral responses are important for revenue and
efficiency.
• It may imply that an increase in a tax rate reduces tax revenue
(Pareto sub-optimal)
• We will later see that the behavioral effect on government revenue is
directly related to the effect on economic efficiency.
Lesson 2: Behavioral responses are not important for household
welfare.
• The effect on household welfare is simply equal to the mechanical
effect → simple to compute distributional consequences.
• We will later see that behavioral responses are important when
determining who bears the welfare effects (incidence).
Slide 26
Aim of the theoretical part of the course
Introduction to ...
• the main concepts
• standard methods
• general insights and basic intuition
... applied in Public Finance

Slide 27
Using empirical methods

The identification issue
Estimating mechanical effects of tax-benefit changes are often not so
difficult (e.g. Lovmodellen used by the ministries)
Estimating behavioral effects is much more difficult.
Ideally we would like to know:
• if individual i faces tax rate t0, he works hi0 hours
• if individual i faces tax rate t1, he works hi1 hours
→ raising the tax rate from t0 to t1 causes a change in hours worked of
hi1 − hi0
How would we ideally measure this treatment effect (TE)?
• We would like to compare the same individual at the same time, but
under to different tax rates.
→ Use a time machine!
Slide 28

The identification issue
1. We never observe same individual in different (policy)
environments at the same time
2. We do observe different individuals in different (policy)
environments at the same time
3. We do observe same individual in different (policy) environments
in different time periods
What mistake do we make by estimation the treatment effect from 2.
(or 3.) instead of 1.?
Key question: What is the size of the bias term?

Slide 29

Case: Education and earnings (Card, 1999)

Slide 30

Case: Education and earnings
Strong correlation between education level and earnings (z):
But to be a causal effect of education on earnings the bias term has to

be zero.
What would the earnings of educated individuals be if they had not
taken the education?
• Taste for education correlated with earning ability → Bias > 0
• Learning capacity correlated with earning ability → Bias > 0
• Earning ability itself may affect education choice → Bias < 0
• Mick Jagger (The Rolling Stones) dropped out of LSE.

Slide 31

Case: Education and earnings
We use econometric tool in an attempt remove the bias term.
One strategy is a simple OLS estimation with controls:
Control for as much as possible (kitchen sink regressions) →

hope/assume that it reduces the bias term to zero.
But no matter how good the controls are, you should always
wonder:
• If your controls make individuals with different educations
comparable ... why have they choosen different educations?
In general, we prefer estimation strategies that use clear
exogenous variation in variable of interest.
Slide 32

Randomized experiments
In practice the ideal way to identify causal effects are:
• Randomized experiments
• Almost as good as a time machine.
• The gold standard of causal identification.
Randomized experiment about the return to education?
Random assignment of education:
• Control group: zero education
• Treatment groups: (a) primary, (b) high-school, (c) BA, (d) MA
Earnings differences between treatment and control groups are causal
effects of education.
Unfortunately randomized experiments are often impossible in
economics.
Slide 33

Other methodologies
Control strategies:
• Twin studies: compare education and earnings of twins (Ashenfelter
and Krueger, 1995)
Instrumental variable studies:
• “Technicalities” in compulsory schooling laws: Different years of
compulsory schooling depending on birth month (Angrist and
Krueger, 1991)
• Vietnam draft lottery: men drafted to the Vietnam war could avoid
service by going to college (Angrist and Krueger, 1992)
Natural experiments:
• Changes in compulsory schooling laws: increases in the years of
compulsory schooling. Oreopoulos (2006)

Slide 34
Aim of the empirical part of the course
Introduction to empirical work and empirical methods applied in Public

Finance.
Understand:
• Why is it difficult?
• Different identification strategies / identifying assumptions?
• What are the strengths and weaknesses of the identification
strategies?

Slide 35
Research articles in economics

Where to find them and how to read them?
• Finding relevant literature can be difficult even for experienced
researchers.
• And for econ students, who have spend most of their bachelor
reading text books, it can be a real pain in the ass.
• Both finding the right literature
• And digesting it.
• However it is an important step in becoming a fully educated
economist.
• And it is an important skill when you have to write bigger
assignments such as the bachelor or master thesis.

Slide 36
Sciences is a puzzle
This is an article
Slide 37

How do new research ideas and insight spread?
The idea is
They write a included in a
working paper survey article 20 years
Year 0 later
Somebody get a The paper is Somebody write

new research published as a a new text book
idea article in a journal including the
idea
Peer review

Slide 38

Hierarchy of journals
Peer reviewed journals
Top Journals
Handbook Special Working

Top Field Journals
chapters Journals papers
Other Journals

Slide 39

General advice on finding literature
A good place to start:
• Handbook chapters:
Prominent researches summarizing the current research frontier on
key areas (long articles). Handbooks are written with 10-20 year
intervals.
• Journal of Economic Literature:

Prominent researchers summarizing the current research frontier
also on more specialized areas (long articles).
• Journal of Economic Perspectives:

Prominent researches giving they opinion on selected topics (short
articles).

Slide 40

Which journals are what?
Top General Purpose Journals (Top 5)
• Econometrica (EMCA)
• American Economic Review (AER)
• Quarterly Journal of Economics (QJE)
• Review of Economics Studies (ReStud)
• Journal of Political Economy (JPE)
If an article is published in one of these, you know that it is of high
quality.
Also most seminal articles are published here – although sometimes
genius’ are not recognized right away.

Slide 41

Which journals are what? (Selected sample)
Top Field Journals Second-tier field journals
Journal of Public Economics International Tax and Public
Finance
American Economic Journal:
Economic Policy Journal of Public Economic Theory
Second-tier General Purpose Public Finance
Journals Analysis/FinanzArchiv
Economic Journal
Journal of the European Economic
Association
Economica
Scandinavian Journal of Economics
European Economic Review
Slide 42
What makes a good research paper?

Editors’ preferences
Relevance
Quality of the analysis /

Identification

Slide 43
How to read research articles
First read-through:
Read it fast – don’t try to understand everything right away.
Try to answer the following key questions:
• What is the research/policy question in the paper?
• How do the authors try to answer the question?
• Empirical: what method do they use? Where does the variation in
the data come from?
• Theoretical: what type of model?
• What are the results? Try to find the key graph, table or equation
and understand it well.
• What are the key assumptions driving the results?

Slide 44
How to read research articles
Second read-through:
Papers that you need to understand in depth, you to read more
carefully.
• E.g. papers you wish to replicate or papers that is curriculum in a
class.
Here you need:
• Go through the math in the paper. Can you follow the derivations?
• Understand the model extensions in theoretical papers.
• Understand the robustness check in empirical papers.
• Understand all parts of the argument in policy papers.

Slide 45
References
(*) Hindriks and Myles (2013): “Intermediate Public Economics”, 2nd

edition, MIT Press, Cambridge. [Ch. 1, 2 + 4]
(*) Musgrave, Richard and Peggy Musgrave (1989). "Public Finance in
Theory and Practice." McGraw-Hill, fifth edition. [Ch. 1]
Gruber, Jonathan (2007). Public Finance and Public Policy. Worth
Publishers, second edition.
Angrist, Joshua D. and Pischke, Jörn-Steffen (2009): Mostly harmless
Econometrics: An Empiricist's Companion. Princeton University Press.
Political economy
Eisensee, Thomas and David Strömberg. 2007. News Droughts, News
Floods and US Disaster Relief. Quarterly Journal of Economics, 693-
728.

Slide 46
References
Fisman, Raymond. 2001. The Value of Political Connections. American

Economic Review 91(4), 1095-1102.
Estimating the returns to education
Angrist, Joshua and Alan Krueger. 1991. Does compulsory school
attendance affect schooling and earnings. Quarterly Journal of
Economics 106, 979-1014.
Angrist, Joshua and Alan Krueger. 1992. Estimating the payoff to
schooling using the Vietnam-era draft lottery. NBER working paper
no. 4067.
Ashenfelter, Orley and Alan Krueger. 1994. Estimates of the economic
return to schooling for a new sample of twins. American Economic
Review 84,1157-1173.
Card, David. 1999. The Causal effect of Education on Earnings.
Handbook of Labor Economics, p 1801-1863.
Slide 47

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Department of Economics

Introduction to Public Finance

Jakob Egholt Søgaard

Public Finance, Spring 2018

• What is Public Finance?

• Why study Public Finance?

• Two key tools in Public Finance:

• Economic theory: welfare and behavioral responses

• Applied econometrics: causal identification of key parameters

• How to read scientific/journal articles

Public Finance, Spring 2018

• Main lecturer: Jakob Egholt Søgaard

• My second time as the lecturer of this course

• I strong tendency to speak fast, so stop me if you do not follow

Public Finance, Spring 2018

Academic career: Professional career:

Public Finance, Spring 2018

• Two purposes of this course

• Slides with extra curriculum discussions are makes by

Public Finance, Spring 2018

Different teaching styles

Public Finance, Spring 2018

What is Public Finance?

Understand the proper role of the government in the economy.

Thus, public finance does not include:

Public Finance, Spring 2018

What is Public Finance?

The four questions of public finance/public economics (Gruber, 2007)

OBS: Positive economics versus normative economics

We will work on the first three.

Public Finance, Spring 2018

What is Public Finance?

The development of public finance over time

<1990 1990s 2010s

Relation to other economics courses

• Tax Policy: Advanced Master’s course in public finance.

Why study Public Finance?

Public Finance, Spring 2018

Why study Public Finance?

• Close link between theory and data.

• New research is often directly relevant for public policy.

Public Finance, Spring 2018

Why study Public Finance?

Public Finance, Spring 2018

Why study Public Finance?

Public Finance, Spring 2018

Why study Public Finance?

Public Finance, Spring 2018

Why study Public Finance?

Redistribution policy generally entails efficiency costs

Public Finance, Spring 2018

Why study Public Finance?

Public Finance, Spring 2018

Why do governments intervene and why not?

Two key tools in Public Finance

Public Finance, Spring 2018

Using economic theory

wrt. c and h subject to the budget constraint

Where c is consumption, t is the tax rate, w is the wage rate and h is

which implicitly defines a labor supply function h* = h((1 – t)w)

Using economic theory

What are the effects of a (small) tax change on the government

which may be negative if