Foldvary, Public Finance, John Anderson book

Chapter 1, Economics of the public sector

Public sector: government

p. 6: US economy, 1/3 GDP allocated by government.

plus: deadweight loss tax. plus: regulations such as minimum wage, $7000 per family.

About ½ the economy is allocated by government.

Positive and normative analysis.

But: positive analysis includes ethics.

p. 7: economic goals: efficiency, equity (social justice), liberty

Efficience means in the long run, thus implying sustainability also.

p. 12: public goods and the need for government.

Game theory.

An economic game: an interaction among persons, following specific rules,

with possible payoffs for winners and penalties for losers.

Game theory: a theory of decision making with incomplete information, using games.

Games can be zero-sum, positive sum, negative-sum.

Cooperative, non-cooperative (rival).

One-time or repeated.

Can have an equilibrium, such as the Nash equilibrium:

In a Nash equilibrium, given two players A and B,

A's choice is optimal, given B's choice, and B's choice is optimal, given A's choice.

Neither wants to change the choice.

A game may have several or no Nash equilibrium.

Example: driving on the right side of the road..

Prisoner’s dilemma

The usual story is that there are two thieves who get caught.

They are partners in crime, and they are both selfish.

They are questioned in separate rooms.

If one confesses and the other does not, the confessor goes free and the other 20 years in prison.

If they both confess they get 8 years.

If neither confesses, they get a lesser charge, and only 1 year in prison.

The incentive is for both to confess.

Confessing is the dominant strategy.

In the book, the example has two ranchers, X and Y.

The cooperative solution is to avoid stealing.

The non-cooperative solution is to steal, given the payoff, which evidently does not include the risk of getting caught and being punished.

In the cooperative solution, they hire a sheriff to prevent theft and enforce contracts.

The prisoner’s dilemma is used in the field of social welfare economics.

In this context, welfare means social well-being.

Market failure and government response

Rationale for governmental provision and intervention: market failure.

Implies also governmental success.

If there is also governmental failure, then it is just a problem to endure.

If one cannot do better, is it failure?

Market failure is a set of situations, with three subsets.

First, market failure exists when there is a systemic lack of provision of goods for which the demand would cover the costs.

Secondly, market failure exists when there is a systemic excessive provision of goods, greater

than the quantity for which an informed demand would cover the social costs.

These are failures to provide efficiency.

Third, market failure exists when the distribution of goods is unjust.

"Market" failure is a systemic failure, meaning a failure which is economy-wide and persists over time due to the inherent structure of the system, i.e. of free markets. Market failure is therefore distinguished from entrepreneurial failure and human failure (such as due to bounded cognition).

Why would a free market fail?

Public goods.



p. 14: Entrepreneurs cannot make a profit providing them.

Why not?

Externalities: uncompensated effects on others. Negative e.g. pollution.

Would a free market have significant externalities?

Lack of competition

Why a problem: price above marginal cost or average cost.

Natural monopolies - continuously lower long-run average costs.

The monopoly profit causes a deadweight loss.

Advancing technology is making industries such as electricity and even water provision less naturally monopolistic.

At any rate, if a resource such as water is a natural monopoly, the market does not necessarily involve a monopoly exploiting the users by charging more than average cost.

Another possibility is that homeowner associations and other private communities would jointly own the water company.

If a community is dependent on a particular natural monopoly, its incentive will be to own it. Vertical and horizontal integration prevent the problem of natural monopoly, which is why residential associations own their own streets and transit services.

House owners also own their back yards rather than rent them, to prevent paying monopoly prices. Therefore, the mere potential of monopoly does not inherently imply market failure.

Imperfect information

p. 15: Markets require perfect knowledge.

Problem of asymmetric information.

Market remedies?

Equity failure: distribution of income

P. 16: “A society” may determine that it finds [the market] allocation of income too unequal.”

Does “society” think?

Methodological individualism: only individuals think and decide.

There can be a group decision such as by voting.

But if not unanimous, it is a majority or plurality or other fraction that decides.

“A legitimate role for government.”

Implies moral legitimacy. Which morality?

Is the relevant moral criterion what the majority believes,

or an absolute moral standard?

The ethic that tells us the meaning of the market

is the same ethic that tells us the morally proper laws and policies.

Therefore, a free market cannot possibly be unjust.

(Sharing the rent is free market egalitarian if one believes the rent belongs to the community.)

U.S. Constitutional authority for taxation

            Article I: powers of Congress.

            Section 8 on taxes.

            Parag. 1: “The Congress shall have Power

            To lay and collect Taxes, Duties, Imposts and Excises, “


            ”To lay” means to impose, by force.

            “Imposts” are tariffs. “Duties” are taxes on goods, including tariffs.

            That is the Constitutional authority for taxation.

            Congress has the Constitutional power to force people to pay taxes.

There is only one type of tax that is prohibited by the Constitution.

A restriction on taxation in Article I, Section 9, is a prohibition of taxes on exports.

There are also sources of federal government revenue besides taxation:

1) Voluntary user fees, such as for a passport or entry into a national park.

2) Donations

3) Borrowing (authorized by Article I, Section 8).

            The next part authorizes the spending:

            [“The Congress shall have Power...]

            “to pay the Debts

            and provide for the common Defense

            and general Welfare of the United States;


            “Provide” means spending.

            Note: it is the general welfare,

which implies not the welfare of specific persons or groups,

such as subsidies to farmers or local public works projects.

            But the Supreme Court has interpreted “general welfare” to mean almost any spending.

            But the taxing power is not “anything goes.” There are restrictions:

            “but all Duties, Imposts and Excises

            shall be uniform throughout the United States.”

            They must have a uniform rate throughout the USA.

            Article I, Section 2, parag. 3

            “Representatives and direct Taxes shall be apportioned among the several States which may be included within this Union, according to their respective Numbers.”

            Article I, Section 9 states: “No Capitation, or other direct Tax shall be laid, unless in Proportion to the Census or Enumeration ...”

            The requirement that direct taxes be proportional to population applies to the states but not the territories of the US, such as the District of Columbia.

            Bottom of p. 16: Anderson is incorrect.

            Two categories of taxes: direct and indirect.

            A direct tax is one which is

1) imposed directly on a person or property, rather than on a privilege or activity, and

2) is paid directly to the government by the owner of the item being taxed

            All other taxes are indirect.

Examples of direct taxes: lump-sum (capitation), property (such as real estate)

Examples of indirect (excise) taxes: sales, tariffs, the privileges such as corporations.

A tax on corporate profit is legally a tax on the privilege of operating as an artificial legal person.

Taxes on "income" have to be on profits, not just receipts or revenue.

Is a tax on personal income a direct or indirect tax?

The Revenue Act of 1862 included the first US federal income tax.

It expired in 1872.

Congress brought back the federal income tax in 1894.

The Supreme Court declared it unconstitutional in 1895

in Pollock v. Farmers' Loan & Trust Assn., 158 US 601

because it taxed income from real estate, which is a direct tax,

and it was not apportioned by state population.

The 16th Amendment was then adopted in 1913:

“The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”

Stanton v. Baltic Mining Co., 240 US 103

"The 16th Amendment conferred no new power of taxation but simply prohibited the previous complete and plenary power of income taxation possessed by Congress from the beginning from being taken out of the category of indirect taxation to which it inherently belonged.

“Taxes on incomes from some sources had been held to be ‘direct taxes’ within the meaning of the constitutional requirement as to apportionment.

The Amendment relieved from that requirement and obliterated the distinction in that respect between taxes on income that are direct taxes and those that are not, and so put on the same basis all incomes ‘from whatever source derived.’”

State, Indian, and local governments.

There are three parallel governments in the U.S.

Federal, States, Indian nations, all officially sovereign

10th Amendment: powers not delegated to the US nor prohibited to the states are reserved to the states or the people.

Local governments are agencies of the states.

Cities are municipal corporations whose powers are granted by the state.

In practice, cities have some autonomy.

As sovereign governments, states have the power to tax anything except:

1) foreign trade (imports or exports)

2) taxing goods from other states differently than its own goods.

            State taxes are subject to the constitutions of the state.

For example, in California, the constitution limits the ad-valorem taxation of real estate to one percent of the market value when bought, with annual increases of no more than two percent.

Local assessments and taxes can be approved by the voters in the cities and counties if they are not ad valorem.

2. Measurement and methods in public finance

Nominal data are in current dollars.

Real data are in constant dollars, using a base year.

For the economy, the relevant index is the GDP deflator.

How can we measure the size of government?

Relative to GDP or per-capita.

Taxes per capita do not necessarily indicate the relative burden.

Alaska has oil revenue.

Lowest per-capita tax state: New Hampshire. No income or sales tax.