The first reading assignment for Unit Two is pp. 31-38 and pp. 114-120. The new topic is the Role of Government in the Economy.

The American economy has evolved from a rural, agricultural economy to an urbanized, highly specialized economy. We’ve become urbanized because that’s where the jobs are. With this urbanization and suburbanization comes additional demands on government to furnish education, roads, water and sewer systems, law enforcement, and many other services.

Today we don’t generally grow our own food, make our own clothes, or construct our own homes. Yet one hundred or more years ago, many people did. Now we are more interdependent. Our jobs are specialized and we are paid for these narrowly defined positions. We then go out and buy the necessities and optional things we want. As we have become less independent and more specialized, we demand more from government: to provide schools for training to accommodate this specialization, libraries to help the public stay well informed, and to pass rules and laws to govern us as we live in a more congested condition. The more urbanized American society becomes, the more we give up certain individual freedoms. We can’t burn trash in the backyard or let dogs run loose. Citizens want government to pass laws that make these actions illegal.

As we have become more interdependent and specialized, people become more vulnerable to periods of unemployment. Our society decided that it wants a system of Unemployment Compensation as well as other transfer payments, such as Social Security and public assistance. If we went back 70 years, we would find there were no such programs as Social Security or Unemployment Compensation. Instead, families took care of their own when it came to income maintenance. When some families had trouble doing this, churches and charitable organizations would furnish assistance. Then came the Great Depression of the 1930s and the economy simply would not self-adjust, that is, it bottomed out and refused to go back up the business cycle. Too many families needed assistance and the churches and charities could not handle the volume. This, in conjunction with the developments discussed above, led to overwhelming demands that government participate in the income maintenance function. Many of the transfer payments (also known as entitlements or social programs, which will be presented in more detail shortly) we have today trace their beginnings to the 1930s, a totally different and much less pleasant economic environment than the one we know today.

Now what role should government play in the economy? Of course, only you can answer this question. But we can look at some possibilities. At one extreme of the political/economic spectrum, there is the libertarian approach. This is an ultra-conservative approach and involves a very minimalist role for government. There might be a role for government in national defense, in some public works, and perhaps a role in establishing a judicial system. As we move toward the middle, the next approach is conservative. This is still minimalist as free market results are favored and government handles an activity only if the private sector can’t or won’t do the job. A conservative might favor the funding of higher education by government, whereas a libertarian would say that the private sector should provide this service exclusively.

Moving toward the left side of the spectrum, the next approach to the role of government in the economy is liberal. Here, government plays a more active role and free market results are often adjusted. More government regulation and redistribution of income through transfer payments and taxes occurs under the liberal approach. Toward the far left of the political/economic spectrum is socialism. Government ownership of major industries such as banking and airline is common in socialistic systems.

In the United States, the libertarian and socialistic approaches are considered extreme and are not favored. The usual debate is between the conservative and liberal approaches.

Now we are going to be more specific in examining various areas of government involvement in our economy to find out when it is more likely that government will play a role, and why. First, we’ll deal with the distinction between private and collective (also known as public) goods. Since we live in a private sector dominated economy, most goods are private. This means that we purchase them individually and that those who do not pay can be excluded from enjoying the benefits of these goods. A loaf of bread, a CD, and a pair of shoes are all examples of private goods. If you purchase these items, you are in a position to exclude those who haven’t paid from using them.

Government typically does not play a significant role with respect to private goods. It does, however, play a large role when it comes to collective goods. These goods or services are typically provided on a group basis and nonpayers cannot easily or conveniently be excluded. National defense and police protection are common examples. Everyone who lives in the U.S. receives national defense and there is no obvious way of excluding those who haven’t paid for it. Therefore, the government provides it and tries to fund the activity through the tax collection process. Similarly, if you live in a city or town with a police department, there is no apparent way of excluding those who haven’t paid from receiving police protection. One could imagine a system in which you received a "police protection" bill in the mail each year, and if you didn’t pay it, then the next time you called 911 the police would not respond. Most people would find such a system to be unacceptable.

Suppose you decided it was too dark near your house and decided to erect a street light. Your neighbors, who didn’t pay, might also benefit from this, and therefore you have a disincentive to put up the light. It is a collective good and so the government handles the activity. What if you were boating at a nearby lake and decided to mark a concealed, rocky area with a buoy. Other boaters who did not pay might benefit from your installation and this could dissuade you from installing the buoy. It is a collective good and therefore government is more likely to provide it than an individual.

Our next topic is externalities, also known as spillover effects. Externalities may be positive or negative. A positive externality occurs when there is a spillover benefit to the community that is associated with a particular activity. A typical example is higher education. Presumably you benefit individually from the courses you are taking in terms of learning things you previously didn’t know or preparing yourself for a better job in the future. The externalities (i.e., spillover benefits to the community) include a better-trained labor force and a lower unemployment rate. For this reason, you pay only about 25% of the total cost of your education at this school. Taxpayers pay the rest.

Negative externalities occur when an individual or a business firm fails to internalize (i.e., fully pay for) all of the costs of an activity. An easy example of a negative externality is air or water pollution. If you drive your vehicle down the street emitting black and blue smoke because you’re too miserly to pay for repair and maintenance on your vehicle, then you are dumping bad air into the community. This may exacerbate the medical problems of those with asthma, emphysema, etc. If a paper mill located on a river dumps effluent into it, then the firm is not fully paying for the costs of its production and may be causing damaging to fish and recreation. You can tell that when positive or negative externalities are involved, then government is more likely to play a role in the economy.

What if the state or federal government decides to build a new interstate highway or turnpike? Private residences or businesses may be in the way. Although the concept is unpleasant, the constitution provides for the taking of private property if a legitimate public purpose is involved so long as the government pays fair market value for the property. We can’t imagine that the private sector would be allowed to do the taking.

There are some instances where a monopolist would better serve consumers even though our usual preference is for competition. In businesses such as electric or natural gas service, the fixed costs tied up in transformers, piping and the like make it uneconomical for multiple providers to serve one area. Consumers would actually pay more for their electricity and gas if a competitive system was used. Therefore, the government grants a monopoly franchise to a company to provide electric or gas service to a particular area and in return, the government’s public utility (or corporation) commission must approve requests for rate increases.

Long distance telephone service used to be considered a natural monopoly and consumers had no choice. But in 1984 Congress decided that competition would be in the best interest of the public, so the industry was converted from monopoly to oligopoly, an industry dominated by a few sellers. Right now, a similar process is underway regarding local telephone service. Congress wants competition, but the legislation is complicated and it is taking some time for this to develop.

Just about everyone wants low unemployment rates, low inflation rates, and economic growth so that we can continue to improve our standard of living. Back in 1946 Congress stated that government should play a role in assisting the economy to achieve them.

When unemployment is too high, government may give the economy a boost by using an expansionary fiscal policy, that is, either a tax cut or an increase in government spending, or a combination of both. Congress handles these actions. An alternative approach is an interest rate cut by the Federal Reserve System, the U.S. Central Bank. The Fed could choose to cut the Federal Funds Rate or the Discount Rate, either of which would serve to stimulate the economy. We will study both of these areas in more detail later in the course.

If inflation heated up and we began to lose our price stability, then government could try to cool off the economy by embarking upon a contractionary fiscal policy, that is, a tax increase or a cut in government spending, or a combination of both. In addition, the Fed could raise either the Federal Funds Rate or the Discount Rate to stem the inflation. Whether a stimulative or contractionary action is called for, both liberals and conservatives agree that government will play a role in this area. They may disagree over the specifics of policies that are being considered, but they agree that there is a place for government to participate.

Many products we purchase are different as a result of laws or regulations. Congress decided a long time ago that it would be sound policy to encourage home ownership. Therefore, the tax code was changed to include a deduction for mortgage interest paid by a homeowner. The effect is to reduce the income tax exposure, at least for those owners who qualify for this deduction. Even if they qualify, the value of the deduction is the difference between the standard deduction that always could have been taken and the itemized deduction amount that includes the mortgage interest paid. Still, this is a benefit that is unavailable to renters.

Think of the many ways in which automobiles are regulated, particularly safety regulations. Seatbelts, airbags, the third brake light in the rear window, and fuel efficiency are several ways in which cars are regulated. Clearly these regulations have the effect of modifying the product we get when we purchase a new vehicle. Again, there are disputes about specific regulatory requirements, but most citizens seem to think that government should play a role when it comes to automobile safety requirements.

Both liberals and conservatives now accept the proposition that there will be some redistribution of income and that government must play a role in this process. The disagreement is over the number and extent of the transfer programs we should have.

A transfer payment by government may be defined as a payment for which government receives nothing in return at the time the payment is made. Note that this is different from a government purchase, where the government does receive something in return at the time the payment is made. Examples of government purchases include buying jet fighter planes for the military and buying computers to be used in various government agencies.

When a Social Security check is mailed or deposited into an account, nothing is received in return at the time of the payment, so it is classified as a transfer even though a retiree may have contributed heavily to the Social Security system over many years. The same is true for unemployment compensation payments. One must have worked in order to qualify and employers must pay into this system, but at the time of the payment nothing is received in return for it, so unemployment compensation is classified as a transfer. These types of payments may also be though of as social insurance. Social Security may be considered an insurance system because it is possible to pay into it for many years and then die without a spouse or other dependents. If one had not yet started drawing benefits, then a $255 death benefit is all that would be available. On the other hand, if one retires and draws benefits for twenty or thirty years, it is very likely that one would receive more than was contributed into the system, even after adjusting for inflation and present value.

The other type of transfer payment is a welfare benefit. Clearly the government receives nothing in return for these payments at the time they are made. The Temporary Assistance to Needy Families program (TANF) and Supplemental Security Income (SSI) as well as Food Stamps and Medicaid (medical welfare, by far the most expensive public assistance program) are examples of these types of benefits.

One who favored a purely efficient, survival of the fittest approach might want to eliminate public assistance and certain other transfers. A 100% private, free market system would yield this result. But most citizens believe there should be some so-called safety net for reasons of fairness or equity. Those who are permanently and totally disabled require some type of assistance. That is one example of why taxes are needed.

Although social insurance, welfare payments, and the progressively structured income tax system are the primary methods of redistribution, other forms of transfer take place throughout our system. We noted earlier that homeowners receive the mortgage interest deduction. This is a redistribution of income toward homeowners and away from renters. If you pay about 25% of the total cost of your education at this institution, then that is a redistribution in favor of you. If farmers are paid money to not plant a certain amount of acreage, then that is a redistribution in favor of certain farmers. These are only a few examples.

It is impossible to discuss the role of government in the economy without considering taxation. This section is intended to be an introduction to public finance.

A starting point is the concept of the tax base. This refers to the objects or activities that are to be taxed. Income is part of the tax base. So is the sale of a personal property item (the sales tax). Real property and the sale of liquor or tobacco products (excise taxes) are also included in the base. So are many other things. The U.S. uses a wide tax base system as opposed to a narrow tax base. An example of a narrow tax base would be to use just one tax such as a cigarette tax or a real property tax. Most people would say that such a system would be unfair, that a wider tax base produces a fairer tax system. With a wide base, everyone is stuck paying some taxes whereas with a narrow system, some would pay nothing at all.

Note that deciding upon a tax base says nothing about what the tax rates should be. A wide tax base could be used with very low tax rates and this would produce a tax system in which the tax burden on citizens was quite low. An opposite approach would be to use a narrow base with high tax rates. This would be extremely burdensome for those with the tax exposure.

This old taxation concept says that if we can identify on an individual basis those persons who are benefiting from a governmental activity, then they should be taxed individually or assessed a user fee. An example of this would be a toll road system, although some would argue against this on the theory that everyone benefits whether or not they actually drive on toll roads. Still, a turnpike is an example of the beneficiary principle. If you visit a state or national park and camp overnight, you will pay a user fee since you are identified individually as benefiting from using the facility.

Economists favor the beneficiary principle and the associated user fees. Obviously, there are many instances in which it is not possible or practical to determine who is benefiting on an individual basis and user fees cannot be assessed in these cases.

Sometimes a tax is aimed at one target but the target may shift the tax and make others pay for it. Suppose corporate profits tax rates were increased. Corporations might shift this tax in several ways:

• Reduce the amount of dividend distributions
• Cut back on raises for employees
• Raise the prices of its products

So before a tax is put in place or raised, those working in public finance should address whether the incidence of the tax will fall on a someone other than the intended target.

This is a very old principle of taxation. As you would guess, it says that those who are able to pay more should in fact pay more and those who are less able to pay should pay less. This applies to all taxes, not just to federal and state income taxation. By itself, however, this principle does not tell us whether taxes are or should be progressive, regressive, or proportional. I'll address that now.

If a tax is progressive, then there is a direct, positive relationship between income and the percentage of income paid to the tax. As income increase, a larger percentage of income is paid to the tax and as income declines, a smaller percentage of income is paid to the tax. As a practical matter, most economists would say that the federal (and some state) income tax system is just about the only example of a progressive tax. Consider the following table:

This mini-table is an example of a progressive tax. As income rises from $10,000 to $20,000, both the dollars and the percentage of income paid to the tax increase. As income drops from $20,000 to $10,000, both the dollars and the percentage of income paid to income taxes decline.

A regressive tax features an inverse relationship between income and the percentage of income paid to the tax. If income increases, the percentage of income paid to the tax decreases and as income declines, the percentage of income paid to the tax rises. Most taxes in our system are classified as regressive. As an example, consider a state sales tax of 10% on the sale or lease of all items of tangible personal (movable) property. The following table illustrates a possible outcome:

Note that as income goes up, the percentage of income paid to the sales tax drops, classifying it as regressive. It is also true that as income rises, the total dollar amount paid in sales taxes also increases, but the dollar amount of taxes paid does not determine whether a tax is progressive or regressive. The key is the percentage of income that is paid to the tax.

A strong suggestion that the sales tax is in fact regressive is that many state legislatures have chosen to exempt food purchases from this tax. When income doubles, we don't double our food purchases and so the sales tax on food hits especially hard on lower income families. Some states also exempt clothing purchases up to a certain amount for the same reason. Once basic needs such as food and clothing have been taken care of, then there is more scope for saving and personal financial investing. These expenditures are not subject to the sales tax

A third type of tax is known as a proportional (or "flat") tax. In this situation, as income rises or falls, the percentage of income paid to the tax remains the same. About the only tax that immediately comes to mind as proportional is the Medicare tax. It is defined as 1.45% times all wage and salary income. The following table illustrates this relationship:

Note that the Social Security tax of 6.2% is different because there is a cutoff at just below $90,000 gross income per year. Therefore, Social Security tax would be classified as regressive if incomes above $90,000 per year are considered. It is also true that there is a cap on the maximum monthly Social Security benefit.

You are now ready to work on the Problems and Exercises for Unit Two, Assignment One.