Public finance studies the role of the government in the economy. It is the definitive branch of Economics which assesses the government revenue and government expenditure of the public authorities and the adjustment of one or the other to achieve desirable effects and avoid undesirable ones. Public finance is a subject which has the distinction of intimate interaction between theory and practice.

1. Introduction to Public
Budgeting and Finance

2. 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

3. 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.

4. What is Public Budgeting?
 How governments strategically plan a
budget
 Manage ongoing activities
 Control spending

5. 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

6. 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

7. The Role of Government: Ideology

8. 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

9. 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.”

10. 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

11. The Role of Government: Objective Analysis
 Complexity theory and systems thinking
 Government in a market economy

12. 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

13. 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.

14. Legal Framework

15. 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

16. Federal Government: Revenue
 Duties, imposts and excises must be
uniform throughout US
 Constitutional amendment (16th) required
for federal income tax
 5th amendment– can’t take away property
without due process of law, compensation
required
 Can’t tax articles exported from states
 Empowered to borrow money

17. State and local governments
 States have power not explicitly relegated
to federal government
 Can’t impose duties on imports or exports
 Power of local governments granted by
states

18. The Size of Government

19. Historical context
 What was the highest
marginal tax rate
 Under Eisenhower?
•Under Kennedy?
•Today?
•Highest tax bracket currently applies to single people earning $54,000/yr

20. What has happened to the deficit?

21. What has happened to the size of
government as a share of GDP?

22. 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%

23. How does the federal government
spend its money?

24. How do state governments spend
money?
 Miscellaneous (~43%, +)
 Education (~35%, -)
 Public welfare (~17%, +)
 Highways (~5%, -)

25. Where does the government get its
money?
 Federal
 Individual income tax
(+)
 Social insurance (++)
 Corporate tax (--)
 Other (-)
 State and local
 Other (+)
 Sales tax
 Grants from federal
government (+)
 Property tax (-)
 Individual income tax
(+)
 Corporation tax

26. How do we Objectively Measure
Government Performance?

27. Role of Theory
 Observe, form hypotheses
 Test hypotheses through continued
observation, measurement and
experiments
 Confirm hypotheses repeatedly and you
have theory
 Reject hypotheses and you’re back to the
drawing board
 Theory tells us what questions to test

28. If we fail to test our theories and
their assumptions, or continue
to believe them when they fail
the tests, they become
ideology, not theory

29. Neoclassical Economic Theory
 Assumes humans are rational, self interested
utility maximizers
 Empirical studies reject this
 Assumes perfect market competition
 Empirical studies reject this
 Assumes in perfect markets invisible hand leads
to efficient allocation: greatest good for greatest
number
 Can’t be tested in practice, because
governments always intervene with perfect
functioning of market

30. Ecological Economic Theory
 Assume economy is subset of ecosystem
 Ecologically sustainable scale is first
priority
 Socially just distribution 2nd
 Efficient allocation 3rd

31. 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

32. 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

33. 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

34. How do we normatively measure
government Performance?

35. 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

36. 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

37. Indifference curves in Edgeworth box

39. Contract curve

40. 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
Eve
af
Adam
af MRS
MRS 

41. Production possibilities frontier

42. Marginal cost
 Marginal cost of figs is the number of apples
you have to give up to get one more fig
f
a
af
MC
MC
MRT 

43. Efficiency demands that
Eve
af
Adam
af
af
f
a
MRS
MRS
MRT
MC
MC



across all goods and all people in the economy

44. 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

45. 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

46. 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 we’ll learn in next
lecture