Introduction to Public

Budgeting and Finance

 Administrative Stuff
Use of WebCT
Any problems so far?
Organization of course
Each session = 4 weeks, with corresponding number
of readings
Syllabus is rough guide only
Not all reading materials will be covered in lecture,
but all should be read carefully
Group projects
Homework assignments due by following session
Take home final due week after course
 Objectives of the course
Survey the dominant theories in budgeting and finance,
compare practice and trends
Learn how to strategically plan a budget, how to
manage ongoing activities, and how to control spending;
Understand the role of public organizations in a market
economy
Understand social security, public health and other major
categories of public expenditure
Understand the theory and practice of the redistribution
of wealth and resources
Understand the impact of taxes on social welfare.
Learn from practitioners in the field.
 What is Public Budgeting?
How governments strategically plan a
budget
Manage ongoing activities
Control spending
 What is Public Finance?
The study of how governments collect and
spend money and real resources
How do governments collect/spend
money? Positive analysis
How should governments collect/spend
money? Normative analysis
We are studying public finance in a market
economy
 What is the Role of Government?
To maintain and improve the welfare of
the people
To protect the people from harm
To provide the institutions that allow market
to function (e.g. protection of property rights)
To provide the essential goods and services
that markets fail to adequately provide
The Role of Government: Ideology
 Current Trends
Reagan tax cuts
Shrink government down to the size
where we can drown it in a bathtub
Grover Norquist
The era of big government is over
Bill Clinton
Bush tax cuts
Free market ideology
 Organic view of government
Society is a natural organism
Goals of society set by state
Actions of individual are judged by the
contribution they make to the state
Ask not what your country can do for
you; ask what you can do for your
country.
Mechanistic view of government
Individuals are paramount, government
created to meet the needs of individuals
Big debate over importance of individual
freedom
Two types of freedom:
Freedom to do as you like
Freedom not to suffer from activities of others
As society grows more crowded, second type
of freedom becomes more important
The Role of Government: Objective Analysis

Complexity theory and systems thinking

Government in a market economy
 Complexity theory and
Systems thinking
Bringing together many, many simple
components leads to emergence of spontaneous
order, complex system:
2 H and 1 0 atoms form water molecule, molecules
form cell, cells form organs, organs make up humans,
humans make up society
Complex systems greater than the sum of their
parts
Characterized by non-linearities, feedback loops,
emergent properties, unpredictable surprises,
etc.
Government is a complex system
 Government in a market economy
Economics is the allocation of scarce resources
among alternative desirable ends
What are the desirable ends?
To maintain and improve the welfare of the people
Government and economics have the same desirable ends
What are the scarce resources?
What are the characteristics of the scarce resources?
Whether resources should be allocated by
government or the market depends on the physical
nature of the scarce resources
Once we agree on the desirable ends, deciding on the
role of government moves towards objective science
and away from ideology.
Legal Framework
 Federal Government: Expenditure
Constitution empowers government to
pay the debts and provide for the
common defense and general welfare of
the United States.
Bills to appropriate expenditures can be
initiated in either house, must be
approved by both houses and President
Federal Government: Revenue
Duties, imposts and excises must be
uniform throughout US
Constitutional amendment (16th) required
for federal income tax
5th amendment cant take away property
without due process of law, compensation
required
Cant tax articles exported from states
Empowered to borrow money
 State and local governments
States have power not explicitly relegated
to federal government
Cant impose duties on imports or exports
Power of local governments granted by
states
The Size of Government
 Historical context
What was the highest
marginal tax rate Under Kennedy?
Under Eisenhower? Today?

Highest tax bracket currently applies to single people earning $54,000/yr

What has happened to the deficit?
What has happened to the size of
government as a share of GDP?
 How does size of US government
compare with other countries (2001)?
USA 29.3% of GDP
Australia 31%
Canada 37.4%
Japan 38.3%
UK 38.8%
France 49.4%
Sweden 53.1%
How does the federal government
spend its money?
 How do state governments spend
money?
Miscellaneous (~43%, +)
Education (~35%, -)
Public welfare (~17%, +)
Highways (~5%, -)
Where does the government get its
money?
Federal State and local
Individual income tax Other (+)
(+) Sales tax
Social insurance (++) Grants from federal
Corporate tax (--) government (+)
Other (-) Property tax (-)
Individual income tax
(+)
Corporation tax
 Ecological Economic Theory
Assume economy is subset of ecosystem
Ecologically sustainable scale is first
priority
Socially just distribution 2nd
Efficient allocation 3rd
 Georgist Economic Theory
Ownership of land leads to poverty
Value of land is created by nature and
society, not hard work of individual
Land tax could finance all government
expenditure, prevent land speculation and
concentration of ownership, end poverty
Land tax could be extended to include all
value created by nature and society
 Empirical methods for Testing
theories
Interviews
Subjective, hard to interpret
Experiments
Ethical issues, self selection, etc.
Sample size
Econometrics (statistics)
Torture the data and it will confess
Theories can be very hard to test
Measurement in a complex system
Very hard to isolate cause and effect
E.g. feedback loops
Rarely have adequate baseline data
Systems evolve over time
Values matter
How do we normatively measure
government Performance?
 Why do we need normative
measures?
We need some way to measure social
welfare, and choose between alternative
states
Economic theory provides some guidelines
Theory can be very incomplete
Different theories make different ethical
assumptions
The most commonly taught approach is
neoclassical welfare economics
 Pareto Efficiency
Pareto improvement-- Any change in
allocation that makes at least one person
better off without making anyone worse
off
Pareto optimum an allocation where no
further Pareto improvements are possible
We always want to be at a Pareto
optimum
Indifference curves in Edgeworth box
Contract curve
 Marginal rate of substitution
If you lose one fig, how many apples would you
need to remain just as happy?
Determined by slope of indifference curve
Pareto optimum occurs when

MRS Adam
af MRS Eve
af
 Marginal cost
Marginal cost of figs is the number of apples
you have to give up to get one more fig

MCa
MRTaf
MC f
 Efficiency demands that

MCa
MRTaf MRSaf MRSaf
Adam Eve

MC f

across all goods and all people in the economy

 First Fundamental Theorem of
Welfare Economics
Assumptions:
If all producers receive the same price
And there is a perfect market for every commodity
And people are perfectly rational,
Then, the free market automatically leads to a
Pareto Efficient allocation
If assumptions hold and all we care about is
Pareto efficiency, then government should be
minimized
But some Pareto optimums may be better for
society than others
 Second Fundamental Theorem of
Welfare Economics
We can attain any point on the contract
curve by changing initial endowments and
letting market take over.
So initial distribution matters, big time
 Conclusions
If markets functioned according to theory,
the major role of government would focus
on initial distribution
Markets unfortunately do not function
according to theory, as well learn in next
lecture