CHAPTER 1

All successful companies are able to accomplish two main goals:

1. All successful companies identify, create, and deliver products or services that are highly
valued by customers—so highly valued that customers choose to purchase from them
rather than from their competitors.
2. All successful companies sell their products/services at prices that are high enough to
cover costs and to compensate owners and creditors for the use of their money and
their exposure to risk.
The Key Attributes of Successful Companies
First, successful companies have skilled people at all levels inside the company, including
leaders, managers, and a capable workforce.
Second, successful companies have strong relationships with groups outside the company.
Third, successful companies have enough funding to execute their plans and support their
operations. Most companies need cash to purchase land, buildings, equipment, and materials.
Companies can reinvest a portion of their earnings, but most growing companies must also
raise additional funds externally by some combination of selling stock and/or borrowing in the
financial markets.
THE CORPORATE LIFE CYCLE
1) Proprietorship is an unincorporated business owned by one individual. Starting a
business as a proprietor is easy—one merely begins business operations after obtaining
any required city or state business licenses. The proprietorship has three important
advantages: (1) it is easily and inexpensively formed, (2) it is subject to few government
regulations, and (3) its income is not subject to corporate taxation but is taxed as part of
the proprietor’s personal income. However, the proprietorship also has three important
limitations: (1) it may be difficult for a proprietorship to obtain the capital needed for
growth; (2) the proprietor has unlimited personal liability for the business’s debts, which
can result in losses that exceed the money invested in the company (creditors may even
be able to seize a proprietor’s house or other personal property); and (3) the life of a
proprietorship is limited to the life of its founder. For these three reasons, sole
proprietorships are used primarily for small businesses.
2) A partnership exists whenever two or more persons or entities associate to conduct a
noncorporate business for profit. Partnership agreements define the ways any profits
and losses are shared between partners. A partnership’s advantages and disadvantages
are generally similar to those of a proprietorship. Regarding liability, the partners can
potentially lose all their personal assets, even assets not invested in the business,
because under partnership law, each partner is liable for the business’s debts.
Therefore, in the event the partnership goes bankrupt, if any partner is unable to meet
his/her pro rata liability then the remaining partners must make good on the unsatisfied
claims, drawing on their personal assets to the extent necessary. To avoid this, it is
possible to limit the liabilities of some of the partners by establishing a limited
partnership, wherein certain partners are designated general partners and others
limited partners. In a limited partnership, the limited partners can lose only the amount
of their investment in the partnership, while the general partners have unlimited
 liability. However, the limited partners typically have no control—it rests solely with the
general partners—and their returns are likewise limited.
3) A corporation is a legal entity created under state laws, and it is separate and distinct
from its owners and managers. This separation gives the corporation three major
advantages: (1) unlimited life—a corporation can continue after its original owners and
managers are deceased; (2) easy transferability of ownership interest—ownership
interests are divided into shares of stock, which can be transferred far more easily than
can proprietorship or partnership interests; and (3) limited liability—losses are limited to
the actual funds invested. The corporate form also has two disadvantages: (1) Corporate
earnings may be subject to double taxation—the earnings of the corporation are taxed
at the corporate level, and then earnings paid out as dividends are taxed again as
income to the stockholders. (2) Setting up a corporation involves preparing a charter,
writing a set of bylaws, and filing the many required state and federal reports, which is
more complex and time-consuming than creating a proprietorship or a partnership. The
charter includes the following information: (1) name of the proposed corporation, (2)
types of activities it will pursue, (3) amount of capital stock, (4) number of directors, and
(5) names and addresses of directors. The bylaws are a set of rules drawn up by the
founders of the corporation. Included are such points as (1) how directors are to be
elected; (2) whether the existing stockholders will have the first right to buy any new
shares the firm issues; and (3) procedures for changing the bylaws themselves, should
conditions require it. Professionals such as doctors, lawyers, and accountants often form
a professional corporation (PC) or a professional association (PA). These types of
corporations do not relieve the participants of professional (malpractice) liability.
Finally, if certain requirements are met, particularly with regard to size and number of
stockholders, owners can establish a corporation but elect to be taxed as if the business
were a proprietorship or partnership. Such firms, which differ not in organizational form
but only in how their owners are taxed, are called S corporations.
Growing and managing a corporation
When entrepreneurs start a company, they usually provide all the financing from their
personal resources, which may include savings, home equity loans, or even credit cards. Many
young companies are too risky for banks, so the founders must sell stock to outsiders, including
friends, family, private investors (often called angels), or venture capitalists. If the corporation
continues to grow, it may become successful enough to attract lending from banks, or it may
even raise additional funds through an initial public offering (IPO) by selling stock to the public
at large. After an IPO, corporations support their growth by borrowing from banks, issuing debt,
or selling additional shares of stock.
For proprietorships, partnerships, and small corporations, the firm’s owners are also its
managers. This is usually not true for a large corporation, which means that large firms’
stockholders, who are its owners, face a serious problem. What is to prevent managers from
acting in their own best interests, rather than in the best interests of the stockholder/owners?
This is called an agency problem, because managers are hired as agents to act on behalf of the
owners. Agency problems can be addressed by a company’s corporate governance, which is
the set of rules that control the company’s behavior towards its directors, managers,
employees, shareholders, creditors, customers, competitors, and community.
The public sector in a mixed economy
Mixed economy: while many economic activities are undertaken by private firms, others are
undertaken by the government. In addition, the government alters the behavior of the private
sector through a variety of regulations, taxes, and subsidies. By contrast, in the former Soviet
Union most economic activities were undertaken by the central government. Since the 1980s,
however, privatization – converting government enterprises into private firms – has been the
trend in Europe.
Different perspectives on the role of government
1) One dominant view in the 18th century was that the government should actively
promote trade and industry. Advocates of this view were called mercantilists. It was
partly in response to the mercantilists that Adam Smith wrote, in which he argued for a
limited role for government. Smith attempted to show how competition and the profit
motive would lead individuals – in pursuing their own private interests – to serve the
public interest. The profit motive would lead individuals, competing against one
another, to supply the goods other individuals wanted. Only firms that produce what
was wanted and at as low a price as possible would survive. Smith argued that the
economy was led, as if by an invisible hand, to produce what was desired and in the best
possible way.
2) Many of the most important 19th - century economists promulgated the doctrine known
as laissez faire. In their view, the government should leave the private sector alone; it
should not attempt to regulate or control private enterprise. Unfettered competition
would serve the best interests of society. On one hand, private ownership of capital and
unfettered free enterprise, on the other, government control of the means of
production – these contrary principles were to become a driving force for international
politics and economics in the 20th century.
Government Failures
There are four major reasons for the systematic failures of the government to achieve its stated
objectives: the governments limited information, its limited control over private responses to
its actions, its limited control over the bureaucracy, and the limitations imposed by political
process.
1. Limited information. Often, government does not have the information required to do
what it would like to do. For instance, there may be a widespread agreement that the
government should help the disabled, but that those were capable of working should
not get a free ride at public expense. However, limited information on the part of the
government may preclude it from distinguishing between those were truly disabled and
those were pretending.
2. Limited control over private market responses. The government has only limited control
over the consequences of its actions. For example, the government failed to anticipate
the rapid increase in healthcare expenditures after the adoption of the Medicare
program. One reason for this is that government did not directly control the total level
of expenditures. Even when it set prices, it did not control utilization rates. Under the
 free-for-service system, doctors and patients determine how much and what kind of
services are provided.
3. Limited control over bureaucracy. Congress and state and local legislatures design
legislation, but delegate implementation to government agencies. An agency may spend
considerable time writing detailed regulations; how they’re drafted is critical in
determining effects of the legislation. In many cases, the failure to carry out the intent
of Congress is not deliberate but rather a result of ambiguities in Congress’s intentions.
In other cases, problems arise because bureaucrats lack appropriate incentives to carry
out the will of Congress.
4. Limitations imposed by political processes. Even if government were perfectly informed
about the consequences of all possible actions, the political process through which
decisions about actions are made would raise additional difficulties. For instance,
representatives have incentives to act for the benefits of special interest groups, if only
to raise funds to finance increasingly expensive campaigns. The electorate often has a
penchant for looking for simple solutions to complex problems; their understanding of
the complex determinants of poverty, for instance, may be limited.
The emerging consensus
Contemporary rethinking of the role of government has been reflected in two initiatives,
deregulation and privatization. The first (under President Carter) reduced the role of
government in regulating economy. For instance, the government stopped regulating prices for
airlines and long-distance trucking. The second initiative, privatization, sought to turn over to
the private sector activities previously undertaken by government. The privatization movement
was much stronger in Europe, where telephones, railroads, airlines, and public utilities were all
privatized.
What distinguishes institutions that we have labeled as “government” from private institutions?
There are two important differences. First, in a democracy the individuals who are responsible
for running public institutions are elected or are appointed by someone who is elected. In
contrast, those who are responsible for administering General Motors are chosen by the
shareholders of the General Motors, while those who are responsible for administering private
foundations are chosen by self-perpetuating board of trustees. Secondly, the government is
endowed with certain rights of compulsion that private institutions do not have. The
government has the right to force you to pay taxes and if you fail, it can confiscate your
property and/or imprison you. The government has the right to seize your property for public
use provided it pays you just compensation (this is called the right of eminent domain). Not
only do private institutions and individuals lank these rights, but the government actually
restricts the rights of individuals to give to others similar powers of compulsion. For instance,
the government does not allow you to sell yourself into slavery.
Thinking like a public sector economist
Economists study scarcity – how societies make choices concerning the use of limited resources
– and they inquire into 4 central economic questions:
What is to be produced?
How is it to be produced?
For whom is it to be produced?
How are these decisions made?
Like all economists, public sector economists are concerned with these fundamental questions
of choice. But their focus is the choices made within the public sector, the role of the
government, and the ways government affects the decisions made in the private sector.
1. What is to be produced? How much of our resources should be devoted to the
production of public goods, such as defense and highways, and how much of our
resources should we devote to the production of private goods, such as cars, TV sets,
and video games? We often depict this choice in terms of the production possibilities
schedule, which traces the various amounts of two goods that can be produced
efficiently with the given technology and resources. In our case the two goods are public
goods and private goods. Production possibilities schedule allow us to make the
following statement: society can spend more on public goods, such as national defense,
but only by reducing what is available for private consumption. When we produce at a
point, which is below the production possibilities schedule, it is said to be inefficient:
society could get more public goods and more private goods. When we produce at a
point, which is above the production possibilities schedule, it is said to be infeasible: it’s
not possible, given the current resources and technology, to have at the same time that
quantity of public goods and that quantity of private goods.
2. How should it be produced? Under this question are subsumed such decisions as
whether to produce privately or publicly, to use more capital and less labor or vice
versa, or to employ energy-efficient technologies. Other issues are also subsumed under
this question. Government policy affects how firms produce the goods they produce:
environmental protection legislation restricts pollution by firms; payroll taxes that firms
must pay on the workers that they employ may make labor more expensive and thus
discourage firms from using production techniques that require much labor.
3. For whom is it to be produced: the question of distribution. Government decisions about
taxation or welfare programs affect how much income different individuals have to
spend. Similarly, the government must decide what public goods to produce. Some
groups will benefit from the production of one public good, others from another.
4. How are choices made? In public sector, choices are made collectively. Collective
choices are the choices that a society must make together – those, for instance,
concerning its legal structure, the size of its military establishment, its expenditures on
the public goods, etc.
Revenue Forecasting
Concepts and the Tool
Before forecasting, several things need to be determined. First, the forecast subject—what is
being forecast—must be decided. Is a tax, a fee, or a user charge being forecasted? Is the
forecast for the whole organization/jurisdiction, or just a part of it? Second, a forecast horizon
—the length of the forecast—must be established. Should revenue be projected for the next
month, the next year, or the next five years? Third, the forecaster must become familiar with
forecasting techniques in order to select one that is proper for the forecasting need. This
selection involves a comparison of the forecast accuracies of different techniques in order to
choose the most accurate one.
Simple Moving Average (SMA)
Using the simple moving average (SMA) technique, we calculate the arithmetic average of
revenues in previous forecast periods (“years” in this case) and use it as the forecast. To do so,
we need first to determine the number of forecast periods in calculation. SMA is very simple to
understand and easy to use. But it has a major drawback—it weighs all previous revenues
equally in averaging. In other words, it treats the revenue from ten years ago as if it is as
important as last year’s revenue. Common sense says that we should place more weight on the
more recent revenue.
Exponential Smoothing (EXS)
The exponential smoothing (EXS) technique assigns different weights to data of different
periods. It allows us to assign larger weights to the more recent data. Forecasters call the
weight 0.40 a smoothing constant, or α (alpha is Greek letter a), and they use the following
equation in forecasting: Ft+1 =αAt+(1–α)Ft. In the equation, t is the current period and t +1 is the
next period. Ft+1 is the forecast for the next period. At is the actual revenue of the current
period. Ft is the average (or smoothed) revenue of previous periods.
How to determine α? The values of α go from 0 to 1. The value of 1 indicates that the most
recent revenue is used as the forecast; the value of 0 suggests that the most recent revenue is
not considered in forecasting. We also know that a larger α indicates a larger weight assigned to
the most recent revenue data. However, there is no rule on what α is best. A good method of
selecting α is by trial and error, in which you try different αs (from 0 to 1) for a revenue and
select the α that gives the most accurate forecast.
An important point is that, when revenues show trends of increase or decrease over time, EXS
may not provide the most accurate forecast (If we have an upward trend, we have underforecast—the
forecast is smaller than the actual. This happens because EXS averages past data in their smoothing. If we
have a downward trend—the revenues have been getting smaller over time—EXS will overforecast.).
Transformation Moving Average (TMA)
A trend occurs when the revenue shows a distinctive direction over time. A positive trend is
upward: the revenue gets larger over time. On the other hand, a negative trend shows a
downward direction over time. In TMA, we take the trend into consideration by computing
incremental changes over time. TMA is a very simple technique. In general, it is more accurate
than SMA and EXS for trend data.
Regression Against Time (Regression)
Like TMA, regression is a trend technique. In regression, a relationship is established between
revenue and forecast periods (years, months, and so forth) in the following fashion:
Forecast revenue = a + b (forecast period)
In the equation, a is baseline revenue. It means the revenue without any forecast period (i.e.,
the forecast period is equal to 0). b is the revenue increment in response to the change in
forecast period. It indicates the revenue change from one period to another. Also, in regression
language, forecast revenue is designated by Y and the forecast period is designated by X.
Regression forecasting may be more accurate for trend data than SMA and EXS, but it is more
expensive to use. It often requires computer support. It can be technically and conceptually
challenging for forecasters. Also, no evidence shows that it is more accurate than TMA for trend
data.
A Quasi-Causal Forecasting Model
SMA, EXS, TMA, and regression techniques use historical revenue information in forecasting.
The techniques that use historical data of revenue in forecasting are called time-series
forecasting techniques, and the historical data are called time-series data.
In some cases, however, time-series revenue data simply do not exist, or the data exist but
have limitations that significantly affect their utility. For example, data may be missing for
certain years in the past. Two revenue sources may be merged in the past to create a new
revenue category. Tax rate or tax base may have changed significantly in the past to reflect a
new revenue need. Under these circumstances, the use of time-series data in forecasting is
either impossible or improper.
If we can identify several predictors that are highly associated with revenue, we can use these
predictors in forecasting. For example, if we know the tax base and tax rate of a specific tax,
then the tax revenue is the product of tax base and tax rate. Tax base and tax rate are
predictors of tax revenue. If we use T for tax revenue, B for tax base, and R for tax rate, then:
T=B×R
This tool may be accurate for short-period forecasting (one to three years). It probably is more
accurate for revenues whose predicators can be con- trolled to some degree. For example, if
local property tax rates are determined by a local government, forecasters in that government
will know the rates for the forecast period, and the forecast could be more accurate because of
reduced uncertainty in forecasting.
Determining Forecast Accuracy
How accurate is our forecast? To answer this question, we can use two measures: the absolute
percentage error (APE) and the mean absolute percentage error (MAPE). These measures
estimate the difference of the forecast from the actual revenue. A smaller actual-versus-
forecast difference indicates more accurate forecasting.

F is the forecast revenue; A is the actual revenue. / / is the absolute sign, and any number
coming out of it is positive. APE is the forecast-actual difference in percentage. A smaller APE
indicates a more accurate forecast. APE is simple to understand and easy to use, but it does not
tell the direction of forecast error: whether it is an underestimate or overestimate.
To increase the reliability of our results, we need to get MAPE. MAPE is the average (or mean)
of multiple APEs.
How We Pay for the Federal Government
The federal government
Roughly 80% of the federal government’s revenue is from two sources: the individual income
tax and social insurance receipts. The income tax an individual pays is determined by their
taxable income, tax rate, and any applicable tax preferences. Taxable income is an individual’s
income minus any tax preferences. The federal government offers a standard exemption, or a
reduction of an individual’s taxable income, that all taxpayers can claim. Beyond that standard
deduction, eligible taxpayers can claim hundreds of other exemptions and other tax benefits
related to home ownership, retirement savings, health insurance, investments in equipment
and technology, and dozens of other areas. Why does the federal government offer these
preferences? To encourage taxpayers to save for retirement, buy a home, invest in a business,
or participate in many other types of economic activity. Whether tax preferences actually
encourage those behaviors is the subject of substantial debate and analysis. The tax rate is the
amount of tax paid per dollar of taxable income. An individual’s effective tax rate is their tax
liability divided by their taxable income. If an individual claims a variety of tax preferences, their
effective tax rate might be much lower than the statutory tax rate. Social insurance receipts are
taxes levied on individuals’ wages. Employers take these taxes out of workers’ wages and send
them to the federal government on their behalf. That’s why they’re often called payroll taxes or
withholding taxes. Social insurance receipts are the main funding source for social insurance
programs like Social Security and Medicare.
The remaining 20% or so of federal revenue is from a variety of sources including the corporate
income tax (taxes on business income, rather than individual income), excise taxes (taxes on the
purchase of specific goods like gasoline, cigarettes, airline tickets, etc.), and estate taxes (a tax
imposed when a family’s wealth is transferred from one generation to the next).

Federal government spending is divided roughly equally across six main areas:
 National defense includes pay and benefits for all members of the US Army, Navy, Air Force,
and Marines, and all civilian support services. It also includes capital outlays – or spending
on items with long useful lives – for military bases, planes, tanks, and other military
hardware.
 Medicare is the federal government’s health insurance program for the elderly. By some
estimates, Medicare paid for nearly one-quarter of all the health care delivered in the US.
Medicare has three main components. “Part A” pays for hospital stays, surgery, and other
medical procedures that require admission to a hospital. “Part B” covers supplementary
medical services like physician visits and procedures that do not require hospital admission.
“Part D” pays for prescription drugs. Part A is funded through payroll taxes and through
premiums paid by individual beneficiaries. Part B and Part D are funded mostly through
payroll taxes. Medicare does not employ physicians or other health care providers. It is, in
effect, a health insurance company funded by the federal government.
 Health is a broad category that covers health-related spending outside of Medicare. The
largest segment of this spending is the federal government’s contribution to state Medicaid
programs. It includes funding for public health and population health agencies like the
 National Institutes of Health (NIH) and the Centers for Disease Control and Prevention, and
for health-focused regulatory agencies like the Food and Drug Administration.
 Social Security is an income assistance program for retirees. Social Security is simple.
Individuals contribute payroll taxes while they are working, those taxes are deposited into a
fund, and when they retire, they are paid from that fund. Social Security also distributes
benefits to disabled individuals who are not able to work.
 Income security is cash and cash-like assistance programs outside of Social Security. Most of
these programs help individuals pay for specific, basic necessities. It includes
unemployment insurance, food stamps, foster care etc.
 The federal government borrows a lot of money. Some of that borrowing is to pay for “big
ticket” or capital outlays like aircraft carriers or refurbishing national parks. To purchase
these items, it borrows money and pays it back over time. It also borrows when revenue
collections fall short of spending needs. This is known as deficit spending. The federal
government borrows money by issuing three types of Treasury Obligations: Treasury bills,
Treasury notes, and Treasury bonds. Much like loans, obligations are bought by investors
and the government agrees to pay them back, with interest, over time. Treasury bills come
due – i.e., they have a maturity – of three months to one year. Treasury notes have
maturities of two years to ten years. Treasury bonds mature in ten years up to 30 years.
Each year the government pays the annual portion of the interest it owes on its Treasury
obligations, and that payment is known as net interest.
 “Everything Else” is just as it sounds. This includes federal government programs for
transportation, student loans, affordable housing, the arts and humanities, and thousands
of other programs.
We often divide federal government spending into two categories: discretionary spending and
non-discretionary or mandatory spending. Non-discretionary spending is controlled by law.
Social Security is a good example. A person becomes eligible for “full” Social Security benefits
once they are over age 65 and have paid payroll taxes for almost four years. Once they become
eligible, the benefit they receive is determined by a formula that is linked to the total wages
they earned during their last 35 years of working. That formula is written into the law that
created Social Security. Once a person becomes eligible, they are “entitled” to the benefits
determined by that formula. Other federal programs like Medicare, food stamps, Supplemental
Security Income, and many others follow a formula-based structure. If Congress and the
President want to change how much is spent on these programs, they must change the relevant
laws. Discretionary spending is the spending that Congress, and the President can adjust in the
annual budget. It includes national defense, most of the “health” spending category, and
virtually all of the “everything else” category.
The Federal Government has a substantial structural deficit. A structural deficit is when a
government’s long-term spending exceeds its long-term revenues. Why is the deficit expected
to grow so quickly? In part because federal non-discretionary spending is going to grow. More
and more of the “Baby Boomer” population will become eligible for Medicare, Social Security,
and other programs. As the eligible population grows, so too will spending. Moreover, the cost
of health care services has increased three to four times faster than all other costs across the
economy. That’s why health-related non-discretionary spending is the proverbial “double
whammy” – the number of people who need those services will increase, and so will the rate of
spending per person to deliver those services. At the same time, most economists are
projecting slower economic growth for the next several decades. Given the federal
government’s current revenue policies, that will mean slower revenue growth over time. Those
two main factors, growth in non-discretionary spending and slower revenue growth, will lead to
much larger deficits over time.
To finance those deficits, if the federal government does not collect enough revenue to cover
its spending needs, it will borrow. This rapid growth in debt is concerning for many reasons.
First, federal government borrowing “crowds out” borrowing by small businesses,
homeowners, state and local governments, and others who need to borrow to invest in their
own projects. Since there are only so many investors with money to invest, if the federal
government takes a larger share of that money, there’s less for everyone else. Many
economists and finance experts have also warned that if the federal government’s debt grows
too high, then investors might be less willing to loan it money in the future. If investors are less
willing to loan the government money, the government must offer higher interest rates to
increase investors’ return on investment. As the federal government’s interest rates rise,
interest rates rise for everyone else. Occasional increases to interest rates are not necessarily a
bad thing, but prolonged high interest rates mean less investment by people and business, and
that leads to lower productivity and slower economic growth.
What is a “Fair” Tax?
Governments tax many different types of activity with many different types of revenue
instruments (i.e., taxes, fees, charges, etc.). Each instrument is fair in some ways, but less fair in
other ways. In public finance we typically define fairness along several dimensions:
 Efficiency. Basic economics tells us that if a good or service is taxed, then consumers will
purchase or produce less of it. An efficient tax minimizes these market distortions. For
instance, most tax experts agree the corporate income tax is one of the least efficient.
Most large corporations are willing and able to move to the state or country where they
face the lowest possible corporate income tax burden. When they move, they take jobs,
capital investments, and tax revenue with them. Property taxes, by contrast, are one of
the most efficient. The quantity of land available for purchase is fixed, so taxing it cannot
distort supply the same way that taxing income might discourage work, or that taxing
investment might encourage near-term consumption.
 Vertical Equity. Vertical equity means the amount of tax someone pays increases with
their ability to pay. Most income tax systems impose higher tax rates on individuals and
businesses with higher incomes. This is meant to ensure taxpayers who have greater
ability to pay will contribute a higher share of their income through taxes. A tax with a
high degree of vertical equity, like the income tax, is known as a progressive tax. A
regressive tax is a tax where those who have less ability to pay ultimately pay a higher
share of their income in taxes.
 Horizontal Equity. Horizontal equity – sometimes called “tax neutrality” – means that
people with similar ability to pay contribute a similar amount of taxes. The property tax
is a good example of a tax that promotes horizontal equity. With a properly
administered property tax system, homeowners or business owners with similar
properties will pay similar amounts of property taxes. Income taxes are quite different.
 Because of tax preferences, it’s entirely possible for two people with the same income to
pay very different amounts of income tax.
 Elasticity. An elastic tax responds quickly to changes in the broader economy. If the
economy is growing and consumers are spending money, collections of elastic taxes
increase, and overall revenue grows. This is quite attractive to policymakers. With elastic
taxes, they can see growth in tax collections without increasing the tax rate. Of course,
the opposite is also true. If the economy is in recession, consumer spending decreases,
and so do revenue collections. Sales taxes and income taxes are the most elastic
revenues.
 Stability. A stable – or “inelastic” – tax does not respond quickly to changes in the
economy. Property taxes are among the most inelastic taxes. Property values don’t
typically fluctuate as much as prices of other goods, so property tax collections don’t
increase or decrease nearly as fast as sales or income taxes. They’re more predictable,
but they can only grow so fast.
 Administrative Costs. Some taxes require a lot of time and resources to administer.
Property taxes are a good example. Tax assessors go to great lengths to make certain
the appraised value they assign to a home or business is as close as possible to its actual
market value. To do this they perform a lot of spatial analysis. That analysis demands
time and expertise.
The chart below illustrates a basic fact about taxation: all taxes come with trade-offs. For
instance, the property tax is stable and promotes horizontal equity, but it’s costly to administer
and generally non-responsive to broader trends in the economy. The sales tax is cheap to
administer and produces more revenue during good economic times, but it’s also quite
regressive. Also note that for many of these instruments the evidence is mixed. That is, tax
policy experts disagree on whether that characteristic is a strength or weakness for that
particular revenue instrument.
CHAPTER 2
Types of Government Activity
A primary role of government is to provide the legal framework within which all economic
transactions occur. Beyond that, the activities of government fall into four categories: (a) the
production of goods and services; (b) the regulation and subsidization of private production; (c)
the purchase of goods and services, from missiles to the services of street cleaners; and (d) the
redistribution of income, that is, payments, such as unemployment benefits, to particular group
of individuals that enable them to spend more than they could otherwise. Payments that
transfer money from one individual to another – but not in return for the provision of goods or
services – are called transfer payments.
These four categories do not correspond to the way the federal government organizes its
budget or divide responsibilities between its various departments. Moreover, government
activities are undertaken at the state and local levels as well as at the federal level, with the
relative importance of state, local, and federal expenditures of various types having changed
over time. A final complication is that the nature of some government expenditures is
ambiguous. For example, government subsidies to small farmers could be considered a
production subsidy or a redistributive (transfer) payment.
Government Production
The line between public and private production shifts overtime. During the past 15 years in
Europe, many countries have converted public enterprises into private enterprise, a process
called privatization. The process of converting private enterprises to government enterprises is
called nationalization. For technical reasons, the best way to measure the size of government
production is to look at employment. In 1997 public employees represented almost 16% of
total employment. This was almost double the percentage in 1929. The figure shows a marked
increase in the ratio of public employment from 1929 through 1936, a burst of public
employment during World War II, and return to pre-War levels by 1952. It is important to bear
in mind though reductions that reductions in federal expenditures or employment do not of
themselves necessarily imply or reduction in government expenditures or employment. More
of a burden may simply be placed on states and localities.
Government’s Influence of Private Production
In industries in which the government is neither a producer nor a consumer, it may
nevertheless have a pervasive effect on the decisions of private producers. This influence is
exercised through subsidies and taxes – both direct and indirect – and through regulations.
There are many motives for such government influence. There may be dissatisfaction with
particular actions of firms, such as pollution. There may be concerns about the monopoly
power of some firms. Special interest groups may convince Congress that they’re particularly
deserving of help. Private markets may fail to provide certain goods and services that are felt to
be important.
SUBSIDIES AND TAXES. Government subsidizes private production in three broad ways: direct
payments to producers, indirect payments through the tax system, and other hidden
expenditures. The tax system also sometimes serves to subsidize production. If the government
gives a grant to a producer to assist her in buying a machine, it appears as an expenditure. But
suppose the government allows her to take a tax credit on her expenditures on machines.
Though it’s not accounted as such, for all intents and purposes the tax credit is equivalent to
government expenditures and is thus referred to as a tax expenditure. Finally, many
government subsidies show up neither in the statistics on the government expenditures nor in
those on tax expenditures. For instance, when the government restricts the import of some
foreign good or imposes a tariff on its import, this raises the prices of that good in the US.
American producers of competing goods are helped. In effect, there is a subsidy to American
producers, paid not by the government but directly by consumers.
GOVERNMENT CREDIT. A special type of subsidy is government provision of credit below
market interest rates, in the form of low-interest loans and loan guarantees. Government
subsidies tend to lead to the expansion of the subsidized industry, by lowering its cost of doing
business. This is as true for subsidies to credit as it is for other forms of subsidies. In addition to
loan subsidies, other government programs affect the allocation of credit and thus of
productive resources. In the US, the subsidies are often to buy particular goods and services.
For instance, government-sponsored enterprises (GSEs) encourage lending to enable people to
buy homes and go to school.
REGULATING BUSINESS. Government regulates business activity in an attempt to protect
workers, consumers, and the environment, to prevent anti-competitive practices, and to
prevent discrimination.
Government Purchases of Goods and Services
Every year the government buys billions of dollars’ worth of goods and services. It does this to
provide for national defense, to maintain a network of highways, to provide education, police
protection, fire protection, and parks. What we characterized as government purchases are
amounts spent for goods and services made available to the public, such as national defense,
public schools, and highways. Government payments to the aged through the Medicare
program to finance their hospital expenses or to the poor through the food stamp program
categorized as transfer payments, not as direct government purchases.
Government Redistribution of Income
The government takes an active role in redistributing income, that is, and taking money away
from some individuals and giving it to others. There are two major categories of explicit
redistribution programs: public assistance programs, which provide benefits to those poor
enough to qualify; and social insurance, which provides benefits to the retired, disabled,
unemployed, and sick.
Outlays for explicit redistribution programs are called transfer payments. These expenditures
are qualitatively different from government spending on roads or bombers. Transfer payments
are simply changes in who has the right to consume goods. In contrast, a government outlay for
a road or a bomber reduces the amount of other good (e.g., private consumption goods) that
society can enjoy. Transfer payments affect the way in which society’s total income is divided
among its members, but (neglecting here losses of output due to distorted incentives
associated with transfers) transfers do not affect the total amount of private goods that can be
enjoyed.
PUBLIC ASSISTANE PROGRAMS. Public assistance programs take two forms. Some provide cash,
while others provide payment only for specific services or commodities. The latter are referred
to as in-kind benefits (Medicaid, which covers the medical costs of the poor, and accounts for
about one half of total public assistance).
SOCIAL INSURANCE PROGRAMS. Social insurance differs from public assistance in that an
individual’s entitlements are partly dependent on his or her contributions, which can be viewed
as insurance premiums. To the extent that what individuals receive is commensurate with their
contributions, social insurance can be viewed as a government “production activity” not a
redistribution activity. But since what some receive is far in excess of what they contribute (on
an actuarial basis) there is a large element of redistribution involved in government social
insurance programs.
The social security and Medicare programs are sometimes referred to as middle-class
entitlement programs because the main beneficiaries are the middle class, and benefits are
provided not on the basis of need but because the beneficiaries satisfy certain other eligibility
standards (e.g., age). As soon as they satisfy these criteria, they become entitled to receive the
benefits.
HIDDEN REDISTRIBUTION PROGRAMS. The government affects the distribution of income not
only through direct transfers but also through the indirect effects of the tax system and other
government programs. One could imagine the government taxing everyone at the same rate
but then giving grants to those whose income fell below a certain level. This would have the
same effect as taxing the lower income individuals at a lower rate. Thus, there is a certain
arbitrariness in distinguishing between transfer payments through spending programs and
implicit transfers through the taxes. The government also redistributes income in the guise of
subsidy programs and quotas. Spending for goods and services also has its redistributive
consequences: subsidies to urban bus transport may help the poor, while subsidies to suburban
rail lines may help the middle class.
Government Revenues
Governments raise revenue to pay for their expenditures by levying a variety of taxes. When
the revenues that it receives from taxes are less than its planned expenditures, it must either
cut back expenditures or borrow the difference.
The federal government currently relies on the five major forms of taxation: (1) the individual
income tax, (2) payroll taxes (to finance Social Security and Medicare benefits), (3) corporate
income taxes, (4) excise taxes (taxes on specific commodities, such as gasoline, cigarettes,
airline tickets, and alcohol), and (5) customs taxes (taxes levied on selected imported goods).
Unlike the federal tax system, state and local tax systems rely heavily on sales and property
taxes. Competition among states for industry discourages the use of some state and local taxes,
especially corporate income taxes. The federal government provides substantial aid to state
and local governments, much of it directed at specific programs like road construction, mass
transit, bilingual education, vocational education, and libraries.
Outside the US, the value-added tax (a tax imposed on the value of the output of a firm less the
value of goods and services purchased from other firms) is a major source of revenue.
Deficit Financing
The major source of financing of government expenditures is taxes. But many governments,
especially in recent years, have found tax revenues insufficient to pay for their expenditures. A
deficit in any period is the excess of spending over revenues. A deficit is financed by borrowing.
The cumulative value of borrowing by a firm, household, or government is its debt.
A firm or household that runs a deficit cannot continue to borrow indefinitely, but will be
forced into bankruptcy once its debt gets too large. Because of the federal government’s ability
to tax, and the huge potential revenue source is can tap, its deficits do not cause the same kinds
of problems that large debts incurred by private firms or individual would. Lenders will continue
to willingly finance the federal government’s debt, provided the interest rate is high enough.