Introduction
131 Undergraduate Public Economics
Emmanuel Saez
UC Berkeley
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PUBLIC ECONOMICS DEFINITION
Public Economics (or public finance) = Study of the Role of
the Government in the Economy
Government is instrumental in most aspects of economic life:
1) Government in charge of huge regulatory structure
2) Taxes: governments in advanced economies collect 30-
45% of GDP in taxes
3) Expenditures: tax revenue funds traditional public goods
(infrastructure, public order and safety, defense) and welfare
state (Education, Retirement benefits, Health care, Income
Support)
4) Macro-economic stabilization through central bank (inter-
est rate, inflation control), fiscal stimulus, bailout policies
2
Four questions of public finance
1) When should the government intervene in the economy?
2) How might the government intervene?
3) What is the effect of those interventions on economic out-
comes?
4) Why do governments choose to intervene in the way that
they do?
3
When should the government intervene
in the economy?
1) Market Failures: Market economy sometimes fails to de-
liver an outcome that is efficient ⇒ Government intervention
may improve the situation
2) Redistribution: Market economy generates substantial in-
equality in economic resources across individuals ⇒ Govern-
ment intervention may help reduce inequality by redistributing
resources through taxes and transfers
First part of the class focuses on Market Failures
Second part of the class focuses on Redistribution
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Main Market Failures
1) Externalities: (example greenhouse emissions) ⇒ require
govt interventions (Pigouvian taxes/subsidies, public good pro-
vision)
2) Imperfect competition: (example monopoly) ⇒ requires
regulation (typically studied in Industrial Organization)
3) Imperfect or Asymmetric Information: (example, ad-
verse selection in health insurance may require mandatory in-
surance)
4) Individual failures: People are not always rational (ana-
lyzed in behavioral economics, field in huge expansion): ex-
ample myopic or hyperbolic people may not save enough for
retirement
5
Inequality and Redistribution
Even if market outcome is Pareto efficient, society might not
be happy with the market outcome because market equilibrium
might generate very high economic disparity across individuals
Governments use taxes and transfers to redistribute from from
rich to poor and reduce inequality
Redistribution through taxes and transfers might reduce in-
centives to work
⇒ create inefficiencies Redistribution creates an equity-efficiency
trade-off
Pre-tax, pre-transfer income inequality has soared in the United
States in recent decades, and has moved to the forefront in
the public debate on taxes (e.g., Fiscal Cliff deal for ’13)
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Top 10% Income Share, 1917-2010
50%
Top 10% Income Share
45%
40%
35%
30%
25%
1917
1922
1927
1932
1937
1942
1947
1952
1957
1962
1967
1972
1977
1982
1987
1992
1997
2002
2007
Source: Piketty and Saez, 2003 updated to 2010. Series based on pre-tax cash market income including realized capital
gains and excluding government transfers.
Decomposing Top 10% into 3 Groups, 1913-2010
25%
Share of total income for each group
20%
15%
10%
Top 1% (incomes above $352,000 in 2010)
5%
Top 5-1% (incomes between $150,000 and $352,000)
Top 10-5% (incomes between $108,000 and $150,000)
0%
1913
1918
1923
1928
1933
1938
1943
1948
1953
1958
1963
1968
1973
1978
1983
1988
1993
1998
2003
2008
Source: Piketty and Saez, 2003 updated to 2010. Series based on pre-tax cash market income including realized
capital gains and excluding government transfers.
How Might the Government Intervene?
1) Tax or Subsidize Private Sale or Purchase:
One way that the government can try to address failures in
the private market is to use the price mechanism, whereby
government policy is used to change the price of a good in
one of two ways:
a) Through taxes, which raise the price for private sales or
purchases of goods that are overproduced (example is carbon
tax), or
b) Through subsidies, which lower the price for private sales
or purchases of goods that are underproduced (example is
subsidized flu shots).
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How Might the Government Intervene?
2) Restrict or Mandate Private Sale or Purchase: The
government can directly restrict the private sale or purchase of
goods that are overproduced, or mandate the private purchase
of goods that are underproduced and force individuals to buy
that good (example is auto insurance)
3) Public Provision: The government can provide the good
directly, in order to potentially attain the level of consumption
that maximizes social welfare (example is defense)
4) Public Financing of Private Provision: Governments
may want to influence the level of consumption but may not
want to directly involve themselves in the provision of a good
(example is privately provided health insurance paid for by
government in Medicare-Medicaid)
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What Are the Effects of Alternative Interventions?
1) Direct Effects: The effects of government interventions
that would be predicted if individuals did not change their
behavior in response to the interventions.
Direct effects are relatively easy to compute
2) Indirect Effects: The effects of government interventions
that arise only because individuals change their behavior in
response to the interventions (sometimes called unintended
effects)
Empirical public finance analysis tries to estimate indirect ef-
fects to inform the policy debate
Example: increasing top income tax rates mechanically raises
tax revenue but top earners might work less and earn less,
reducing tax revenue relative to mechanical calculation
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A P P L I C A T I O N
The Congressional Budget Office:
Government Scorekeepers
Chapter 1 Why Study Public Finance?
The methods and results derived from empirical economics
are central to the development of public policy at all levels
of government.
The Congressional Budget Office (CBO) provides Congress
with the objective, timely, nonpartisan analyses needed for economic and budget
decisions.
The CBO increasingly plays a critical role as a “scorekeeper” for government
policy debates.
Legislative spending proposals that are to become law must first have their costs
estimated by the analysts at the CBO.
It is not an overstatement to say that the economists who work at the CBO frequently
hold the fate of a legislative proposal in their hands. The large price tag that the CBO
assigned to the Clinton administration’s plan to reform health care in the United
States in 1994 is often cited as a key factor in the defeat of that proposal.
© 2007 Worth Publishers Public Finance and Public Policy, 2/e, Jonathan Gruber 10 of 28
Why Do Governments Do What They Do?
Political economy: The theory of how the political process
produces decisions that affect individuals and the economy
Example: Understanding how the level of taxes and spending
is set through voting and voters’ preferences
Public choice is a sub-field of political economy from a Liber-
tarian perspective that focuses on government failures (=sit-
uations where the government does not act in the benefit of
society).
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Normative vs. Positive Public Economics
Normative Public Economics: Analysis of How Things Should
be (e.g., should the government intervene in health insurance
market? how high should taxes be?, etc.)
Positive Public Economics: Analysis of How Things Really
Are (e.g., Does govt provided health care crowd out private
health care insurance? Do higher taxes reduce labor supply?)
Positive Public Economics is a required 1st step before we can
complete Normative Public Economics
Positive analysis is primarily empirical and Normative analysis
is primarily theoretical
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Paternalism vs. Individual Failures
In many situations, individuals may not or do not seem to act
in their best interests [e.g., many individuals are not able to
save for retirement]
Two Polar Views on such situations:
1) Paternalism [Libertarian Chicago View] Individual fail-
ures do not exist and govt wants to impose its own preferences
against individuals’ will
2) Individual Failures [Behavioral Economics View] Indi-
vidual Failures exist: Self-control problems, Cognitive Limita-
tions
Key way to distinguish those 2 views: Under Paternalism, indi-
viduals should be opposed to govt interventions. If individuals
understand they have failures, they will tend to support govt
interventions.
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Key Facts on Taxes and Spending
1) Government Growth: Size of government relative to GDP
grows dramatically over the process of development from less
than 10% in less developed economies to 30-50% in most
advanced economies
2) Government Size Stable in richest countries after 1980
3) Government Growth is due to the expansion of the wel-
fare state: public education, public retirement benefits, public
health insurance, income support programs
4) Spending > Taxes: Most rich countries have significant
public debt (relative to GDP), particularly after Great Reces-
sion of 2008
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2A. Tax revenue/GDP in the US, UK, and Sweden
60%
50% United States
Total Tax Revenue/GDP
United Kingdom
40%
Sweden
30%
20%
10%
0%
1868
1878
1888
1898
1908
1918
1928
1938
1948
1958
1968
1978
1988
1998
2008
Source: Kleven-Kreiner-Saez NBER WP 2009
CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
1.2
Why Study Public Finance? Facts on Government in the
United States and around the World
The Size and Growth of Government
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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
1.2
Spending, Taxes,
Deficits, and Debts
Federal Revenues and
Expenditures, Surplus or
Deficit, and Debt, 1930–
2008 • For most of the
twentieth century, except
for the World War II period,
federal government tax
receipts have kept pace
with expenditures. But
expenditures have
exceeded receipts by
several percentage points
of GDP on average since
the 1970s. The resulting
federal government debt is
now at about 40% of GDP.
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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
1.2
Spending, Taxes, Deficits, and Debts
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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
1.2
Why Study Public Finance? Facts on Government in the
United States and around the World
Decentralization
A key feature of governments is the
degree of centralization across local
and national government units—that
is, the extent to which spending is
concentrated at higher (federal) levels
or lower (state and local) levels.
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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
1.2
Spending, Taxes, Deficits, and Debts
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DISTRIBUTION OF SPENDING
Public goods: Goods for which the investment of any one
individual benefits everyone in a larger group (examples: de-
fense, police, roads).
Social spending programs: Government provision of insur-
ance against adverse events to correct inequality and address
failures in the private insurance market (examples: education,
retirement benefits, public health insurance, unemployment
insurance, disability insurance)
Growth in government since 1900 mostly due to expansion
of social spending: public education, public health benefits,
retirement benefits, and income support programs
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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
1.2
Distribution of
Spending
The Distribution of
Federal and State
Expenditures, 1960 and
2007 • This figure shows
the changing composition
of federal and state
spending over time, as a
share of total spending.
(a) For the federal
government, defense
spending has fallen and
Social Security and
health spending have
risen. (b) For the states,
the distribution has been
more constant, with a
small decline in education
and welfare spending and
a rise in health spending.
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DISTRIBUTION OF TAXES
US Federal govt raises about 20% of GDP in taxes, State+Local
govt raises about 10% of GDP in taxes.
Main Federal taxes: (1) Individual income tax (40%), (2) pay-
roll taxes on earnings (40%), (3) corporate tax (15%)
Main State taxes: (1) real estate property taxes (30%), (2)
sales and excise taxes (30%), (3) individual and corporate
state taxes (30%)
Key questions: who bears the burden of those taxes (tax in-
cidence), what impact do they on the economy?
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CHAPTER 1 ■ WHY STUDY PUBLIC ECONOMICS?
1.2
Distribution of
Revenue Sources
The Distribution of Federal
and State Revenues, 1960
and 2008 • This figure
shows the changing
composition of federal and
state revenue sources over
time, as a share of total
revenues. (a) At the federal
level, there has been a large
reduction in corporate and
excise tax revenues and a
rise in payroll tax revenues.
(b) For the states, there has
been a decline in property
taxes and a rise in income
taxes and federal grants.
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REGULATORY ROLE OF THE GOVERNMENT
Another critical role the government plays in all nations is that
of regulating economic and social activities. Examples:
1) The Food and Drug Administration (FDA) regulates
the labeling and safety of nearly all food products and bottled
water, tests cosmetics to ensure their safety, and approves
drugs and medical devices to be sold to the public.
2) The Occupational Safety and Health Administration
(OSHA) is charged with regulating the workplace safety of
the 115 million Americans employed at 7.2 million job sites.
3) The Environmental Protection Agency (EPA) is charged
with minimizing dangerous pollutants in the air, water, and
food supplies.
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PUBLIC DEBATES OVER SOCIAL SECURITY,
HEALTH CARE AND EDUCATION
Social Security, health care, and education are each the subject
of debate, with both the “liberal” and “conservative” positions
holding differing views in their approach to each problem.
Social Security: Social Security is the single largest govern-
ment expenditure program. The financing structure of this
program is basically that today’s young workers pay the retire-
ment benefits of today’s old.
Health Care: There are currently about 50 million Americans
without any health insurance, about 20% of the non-elderly
U.S. population. Obamacare will reduce this number substan-
tially but health care costs are increasing very quickly
Education: There is an enormous dissatisfaction with current
US educational system, highlighted by the poor performance
of US students on international tests.
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CONCLUSION
It is clear from the facts presented here that the government
plays a central role in the lives of all Americans.
It is also clear that there is ongoing disagreement about whether
that role should expand, stay the same, or contract.
The facts and arguments raised in this chapter provide a back-
drop for thinking about the set of public finance issues that
we explore in the remainder of the lectures.
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PROFESSOR SAEZ’ RESEARCH
Most of my research (available on my webpage) is in public
economics:
1) Design of optimal tax policies and optimal transfer pro-
grams (theory, normative)
2) Analysis of the effects of taxes and transfers on individual
behavior (empirical, positive)
3) Analysis of inequality overtime and across countries (em-
pirical, descriptive)
I will discuss some of my research in this course when we cover
the relevant topics
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