Chapter 1:Introduction to Public Finance

summary to Public Finance

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 Chapter 1:Introduction to Public Finance

Introduction
The role of government in making a free market possible

Why free markets usually work well for consumers

Taxes, subsidies, regulations, and inefficiency

Problems for the free market

Problems for the government

Taxes and government spending in the United States

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 Chapter 1:Introduction to Public Finance

Public Finance :
Public Finance is the field of
economics that studies government
activities and their economic basis , as
well as the alternative means of
financing government expenditures .

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 Chapter 1:Introduction to Public Finance

1) The Role of Government in

Making a Free Market Possible
• A free market consists of the voluntary interaction of
producers and consumers of goods and services.
• Is it necessary to have a government?

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 Chapter 1:Introduction to Public Finance

Positive Economics Normative Economics What is

happening? Is

it good or bad?

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 Chapter 1:Introduction to Public Finance

2) Why Free Markets usually

Work Well for Consumers
Free markets are efficient • Productive efficiency
• Allocative efficiency
Figure 1.1

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 Chapter 1:Introduction to Public Finance

$14 S = (MC)
$12

$10

$8

$6
D = (MB)

90 100 110 Q

3) Taxes, Subsidies, Regulations, and

Inefficiency
A tax levied on producers or a tax levied on consumer

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 Chapter 1:Introduction to Public Finance

Figure 1.2 Figure 1.3

P P
S`
$14
$14
S S
$12 T=$4 $12

$10 T=$4 $10 T=$4

$8 $8
T=$4
$6 D
$6 D

D`
90 100 110 Q 90 100 110 Q

…produces the same effect.

A decrease in quantity.

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 Chapter 1:Introduction to Public Finance

Taxes, Subsidies, Regulations, and

Inefficiency
Deadweight loss • An inefficiency which causes
a reduction in society’s welfare
Figure 1.4

P
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$12 – B Chapter 1:Introduction to Public Finance

$10 – T=$4 D

$8 –
A Deadweight
$6 – D loss is
represented
by area
= BAD
90 100 110 Q

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 Chapter 1: Introduction to Public Finance

Taxes, Subsidies, Regulations, and Inefficiency

A subsidy given to producers or a subsidy given to consumers
Figure 1.5 Figure 1.6
P P
$14 S $14
S
$12 $12
S=$4
S=$4 S`
$10 $10 S=$4 D`
$8 $8
S=$4
$6 D $6 D

90 100 110 Q 90 100 110 Q

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 Chapter 1: Introduction to Public Finance

…produces the same effect:

an increase in quantity
Chapter 1:

Taxes, Subsidies, Regulations, and Inefficiency

Figure 1.7

P
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 $14 – S
Introduction to Public Finance
$12 – B
D
$10 – S=$4

$8 –
Deadweight loss
A
is represented by
$6 – D
area
= BAD

90 100 110 Q

Normative evaluation of resource use the

efficiency criterion :
Efficiency ( a normative criterion ) is satisfied
when resources are allocated in such a way as

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 Chapter 1: Introduction to Public Finance

to make it impossible through reallocation to

increase the well- being of any one person
without reducing the well- being of any other
person. Thus is the criterion of Pareto
optimality .

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 Chapter 1:Introduction to Public Finance

 Marginal conditions for efficiency:

 It can be measured by the maximum amount of
money person is willing to pay to get an additional
unit of a good.
 Marginal social benefit of a good refers to the extra
benefit obtained by making one more unit of the
good available over any given time period.
 MSC is the minimum amount of money which
required to pay for the inputs to produce this
additional unit of good.

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 Chapter 1: Introduction to Public Finance

 Marginal conditions for efficient resource allocation

is MSB (Marginal Social Benefit) = MSC
(Marginal
Social Cost).
4) Problems for the free market
Externalities and Government Policy
Externalities refer to the effects that economic activities
have on the well-being of economic agents not directly
involved in the activity in questions, that is third parties.

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 Chapter 1:Introduction to Public Finance

Externalities represent benefits or costs of market

transactions that are not reflected in prices.
That is market prices do not accurately reflect either all
the marginal social benefit (MSB) or all the marginal
social cost (MSC) of traded items when there is an
externality.
Externalities and Efficiency:

Economic agents will always act so as to equate their

marginal private cost (MPC), with their marginal private
benefit (MPB).

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 Chapter 1: Introduction to Public Finance

MPB = MPC

Setting MPB = MPC is not equivalent to equating marginal

social benefit (MSB) and marginal social cost (MSC).
If MSB is not equal to MSC, then we fail to reach
economic efficiency .
efficiency achieving when:
MSC=MSB

Negative Externalities:

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 Chapter 1:Introduction to Public Finance

Negative externalities are costs to third parties, other

than the buyers or the sellers of an item, not reflected
in the market price.
Example: The damage done by industrial pollution to
persons and their property
Solution?
A corrective tax.
Problems for the Free Market
Externalities: Chapters 2 and 6
Figure 1.8

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 Chapter 1: Introduction to Public Finance

MSC
Negative P

B
externality $14 –S
D
(MC) $4

$12 –
A
MSC = (MC + marginal

90 100 110 Q
–
$10

environmental damage)
$8 –

Solution? $6 –
D (MB)

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 Chapter 1:Introduction to Public Finance

A corrective tax.

The efficient point is D at which MSB = MSC and the net gains
equal the area ABD.

Positive Externalities:

Positive externalities are benefits to third parties,

other than the buyers or the sellers of a good or
service, not reflected in prices. Buyers in positive

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 Chapter 1: Introduction to Public Finance

externalities do not consider the fact that each unit

produced provides benefits to others.

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 Chapter 1: Introduction to Public Finance

Example:
a positive externality is likely to exist for fire
prevention, because the purchase of smoke alarms and
fire proofing materials is likely to benefit those other
than the buyers and sellers by reducing the risk of the
spread of fire.
Buyers and sellers of these goods do not consider the
fact that such protection decreases the probability of
damage to the property of third parties.

Solution?
A corrective subsidy.

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 Chapter 1: Introduction to Public Finance

Problems for the Free Market

Externalities
Figure 1.9

Positive P

B
externality $14 – S
D
(MC) $4

$12 –
A
MSB = (MC + marginal
–MSB
$10

benefit to other people)

$8 –
90 100 110 Q
Solution? $6 – D (MB)

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 Chapter 1: Introduction to Public Finance

A corrective subsidy.

The efficient point is D at which MSB = MSC and the net gains
equal the area ABD.

Introduction to
Government Finance

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 Chapter 1: Introduction to Public Finance

What are taxes?

Taxes are compulsory payments associated with
certain activities. The revenues collected through
taxation are used to purchase the inputs necessary
to produce government supplied goods and
services or to redistribute purchasing power among
citizens.
The taxation:

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 Chapter 1: Introduction to Public Finance

is the main source of revenue for government in

the developed countries, and it should be for all
countries, accounting for 75% of total
Governments Revenue.
The Tax Base:
is the item or economic activity on which the
tax is levied. The most commonly used tax bases
can be grouped into three categories; income,
consumption, and wealth. These are economic

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 Chapter 1: Introduction to Public Finance

bases, their values depend on decisions made by

individuals
Taxes on economic bases can be general or
selective.

1. A General tax is one that taxes cover all of

the components of the economic Base, with no
exclusions
2. A selective tax is one that taxes cover only a
certain portions of the tax base or it might allow

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 Chapter 1: Introduction to Public Finance

exemptions and deductions from the general tax

base.
The Tax Rate Structure:
describes the relationship betweenthe tax
collected during a given accounting period and
the tax base.
A proportional Tax:
A progressive tax:
A regressive tax
A proportional Tax:

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 Chapter 1: Introduction to Public Finance

rate structure is one for which the rate of

taxation, expressed as a percent of the base,
does not vary with the size of the tax base. For
example, a person with a 10,000$ income and a
person with a 1,000$ income would each be
subject to the same rates of taxation.
Ifsomeonemakes$20,000ayearandpays$1,000in
salestaxesonconsumergoods,5%oftheirannual
incomegoestosalestax.Butiftheyearn$100,000ayear
andpaythesame$1,000insalestaxes,thisrepresents
only1%oftheirincome.

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 Chapter 1: Introduction to Public Finance

Taxpayers pay a set percentage of annual income

(5%) regardless of how much they earn. The fixed
rate doesn't increase or decrease as income rises or
falls. An individual who earns $25,000 annually would
pay $1,250 at a 5% rate, whereas someone who earns
$250,000 each year would pay pays $12,500 at that
same rate.
A progressive tax:
expressed as a percentage of the base increases
with the size of the base. Many individuals
believe that progressive taxes are "fairer" than
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 Chapter 1: Introduction to Public Finance

others because they believe that one's ability to

pay increases more than proportionally with
income.
Example:
• Calculate the taxes owed on an individual
whose annual income is $120,000.
• Determine the value of the basic income in this
country
• The type of tax applied under the following tax
schedule:

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 Chapter 1: Introduction to Public Finance

tax schedule
Income Segments($) Tax rate
(%)
From zero to 20000 zero
More than2000 to 40000 10
More than 40000 to 60000 20
More than 60000 to 80000 30
More than 80000 40

first slice = 20000 × 0% =0 $

second slice=20000 × 10%= 2000

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 Chapter 1: Introduction to Public Finance

$ third slice = 20000 × 20% =

4000 $ fourth slice = 20000 × 30%
= 6000 $
Fifth slice = 40000 × 40% = 16000 $
The total assessed tax = 0+2000+4000+6000+16000 =
28000 $
Average tax rate = (28000 / 120000 ) × (100 /100) = 23.3%
Marginal tax rate = (16000 /40000) × (100/100) = 40%

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 Chapter 1: Introduction to Public Finance

The basic income = Income that is exempt from tax = 20000

$
The type of tax is A progressive tax
A regressive tax:
the rate expressed as a percentage of the base
will decline as the size of the base increases.
There is strong opposition to regressive taxes
in many societies, because they are believed to
violate accepted notions of ability-to-pay. The

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 Chapter 1: Introduction to Public Finance

term "regressive" is often used to describe

some taxes in terms of their effects on the
distribution of income
Example:
• Calculate the taxes owed on an individual whose
annual income is $120,000.
• Determine the value of the basic income in this
country
• The type of tax applied under the following tax
schedule
tax schedule

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 Chapter 1: Introduction to Public Finance

Income Segments($) Tax rate

(%)
From zero to 20000 40
More than2000 to 40000 30
More than 40000 to 60000 20
More than 60000 to 80000 10
More than 80000 zero
first slice = 20000 × 40% =8000 $
second slice=20000 × 30%= 6000
$ third slice = 20000 × 20% =

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 Chapter 1: Introduction to Public Finance

4000 $ fourth slice = 20000 × 10%

= 2000 $
Fifth slice = 40000 × zero% = zero $
The total assessed tax = 8000+6000+4000+2000+0 =
20000 $
Average tax rate = (20000 / 120000 ) × (100 /100) = 16.6%
Marginal tax rate = (zero /40000) × (100/100) = zero%
The basic income = Income that is exempt from tax = zero
$ The type of tax is A regressive tax:

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 Chapter 1: Introduction to Public Finance

Problems for the Free Market

Public Goods:
• A public good has 2 properties:
1. Non-rivalry
2. Non-excludability
• Free-rider problem

Social Insurance:
• Old-age insurance – Social Security
• Health insurance – Medicare

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 Chapter 1: Introduction to Public Finance

Problems for the Free Market

Income distribution, taxation and efficiency:

• Income redistribution
• Taxation – progressive, regressive, and
proportional
• Efficiency trade-offs

Education:
• Private or government
• Quality and price variations

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 Chapter 1: Introduction to Public Finance

• Consumption externality
Problems for the Free Market

Low income assistance

• Medicaid
• Earned income tax credit (EITC)
• Unemployment compensation
• Disability insurance
• Worker’s compensation

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 Chapter 1: Introduction to Public Finance

Problems for the Government

Political economy:
• Island wall

Cost-benefit analysis:
• Compare costs against benefits

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