ECL1105 – PUBLIC SECTOR ECONOMICS

CHAPTER 2: MEASURING PUBLIC SECTOR SIZE

WHAT OR WHO IS THE GOVERNMENT? --------------------------------------------------------------------------------

What precisely is the government? We all have some idea about what institutions are included:
- Congress
- State
- Local legislatures
- The President
- Governors and Mayors
- The courts, and a host of alphabet-soup agencies, such as the DOH, DepEd, DTI, NEDA, etc.

The United States has a federal governmental structure—that is, governmental activities take place at
several levels: federal, state, and local. The federal government is responsible for national defense, the
post office, the printing of money, and the regulation of interstate and international commerce, whereas
the states and localities have traditionally been responsible for education, police and fire protection, and
the provision.

Even though the Constitution asserts that all rights not explicitly delegated to the federal government
reside with the states and the people, commonly referred to as subsidiarity, the Constitution has proven
to be a sufficiently flexible document that the exact boundaries are ambiguous. Although education is
primarily a local responsibility, the federal government has become increasingly involved in its support.

A primary role of government is to provide the legal framework within which all economic transactions
occur. Beyond that, the activities of government fall into four categories:

1. The production of goods and services.

2. The regulation and subsidization or taxation of private production.
3. The purchase of goods and services, from missiles to the services of street cleaners.
4. The redistribution of income—that is, payments like unemployment benefits to particular
groups of individuals that enable them to spend more than they could otherwise.
Payments that transfer money from one individual to another—but not in return for the provision of
goods or services—are called transfer payments.

TYPES OF GOVERNMENT ACTIVITY -------------------------------------------------------------------------------------

Providing a Legal System

An important activity of the government, but one that accounts for very little expenditure, is the
establishment of the legal framework within which firms and individuals can engage in economic
interactions. Economists and philosophers often try to imagine what life would be like in the
complete absence of government. Without laws defining property rights, for instance, only the
exercise of force would stop one individual from stealing from another. Without the ability to
protect property, individuals would have little incentive to accumulate assets. Needless to say,
economic activities would be severely restricted.
Government Production

The U.S. government undertakes certain types of production directly. Much of this is similar to
corresponding activities carried out by private firms. For instance, both private and government
enterprises produce and sell electricity (the most famous of the latter is, perhaps, the Tennessee
 Valley Authority). In addition, under the Constitution, the federal government takes responsibility
for running the postal service and for printing money.

Moreover, the line between public and private production shifts over time. During the past two
decades in Europe, many countries have converted public enterprises into private enterprises, a
process called privatization. (The process of converting private enterprises to government
enterprises is called nationalization.) For instance, the British government has privatized
enterprises in industries ranging from telecommunications to energy, automobiles, aerospace, and
steel.

Government’s Influence on Private Production

In industries in which the government is neither a producer nor a consumer, it may nevertheless
have a pervasive effect on the decisions of private producers. This influence is exercised through
subsidies and taxes—both direct and indirect—and through regulations. There are many motives
for such government influence. There may be dissatisfaction with particular actions of firms, such
as pollution. There may be concern about the monopoly power of some firms. Special interest
groups may convince Congress that they are particularly deserving of help. Private markets may
fail to provide certain goods and services that are felt to be important.
Subsidies and taxes. Government subsidizes private production in three broad ways: direct
payments to producers, indirect payments through the tax system, and other hidden expenditures.

Government credit. A special type of subsidy is government provision of credit below market
interest rates, in the form of low interest loans and loan guarantees.

Regulating business. Government regulates business activity in an attempt to protect workers,

consumers, and the environment; to prevent anticompetitive practices; and to prevent
discrimination.

Government Purchases of Goods and Services

Every year the government buys billions of dollars’ worth of goods and services to support our
national defense, maintain a network of highways, and provide education, police protection, fire
protection, and parks. These purchases of goods and services amount to nearly one-fifth of the
total production in the United States. In 2010, total government purchases were $3 trillion. Of
these purchases, 17 percent was for investments in infrastructure such as roads and bridges that
increase the economy’s future productivity.

Government Redistribution of Income

The government takes an active role in redistributing income; that is, in taking money away from
some individuals and giving it to others. There are two major categories of explicit redistribution
programs: public assistance programs, which provide benefits to those poor enough to qualify;
and social insurance, which provides benefits to the retired, disabled, unemployed, and sick.

Public assistance programs. Public assistance programs take two forms. Some provide cash,
whereas others provide payment only for specific services or commodities. The latter are referred
to as in-kind benefits.
Social insurance programs. Social insurance differs from public assistance in that an individual’s
entitlements are partly dependent on his or her contributions, which can be viewed as insurance
premiums.
 Hidden redistribution programs. The government affects the distribution of income not only
through direct transfers but also through the indirect effects of the tax system and other
government programs. One could imagine the government taxing everyone at the same rate but
then giving grants to those whose income fell below a certain level. This would have the same
effect as taxing the lower-income individuals at a lower rate. Thus, there is a certain arbitrariness
in distinguishing between transfer payments through spending programs and the implicit
transfers through the tax system.

In summary:

- Providing a legal system: required if a market economy is to function

- Producing goods: defense, education, mail
- Affecting what the private sector produces, through subsidies, taxes, credit, and regulation
- Purchasing goods and services from the private sector, which are then supplied by the government
to firms and households
- Redistributing income

GAUGING THE SIZE OF THE PUBLIC SECTOR --------------------------------------------------------------------------

Because the government’s impact on the private economy depends on its regulatory and tax policies as
well as on its outlays, no single number can provide an accurate indicator of the government’s effect on
the economy. Nonetheless, one indicator that economists have found particularly convenient to use is the
size of public expenditures relative to the size of the total economy. A standard measure of the size of the
total economy is gross domestic product (GDP), which is a measure of the value of all the goods and
services produced in the economy during a given year.

- The size of the U.S. government today is much larger than it was a hundred years ago.
- During the past eighty years, public expenditures as a share of GDP have grown rapidly. In 1930,
they were 9 percent of GDP. In 2010, they represented 36 percent of GDP.
- Growth in expenditures for Social Security, Medicare, Medicaid, and interest account for much of
the increase in public expenditures since 1950.
- The size of government relative to the economy is much smaller in the United States than in most
European countries.

GOVERNMENT REVENUES --------------------------------------------------------------------------------------------------

Taxes and The Constitution

The Congress shall have power to levy and collect Taxes, Duties, Imposts, and Excises, to pay the
Debts and provide for the Common Defense and General Welfare of the United States.

Three restrictions were imposed: the government could not levy taxes on exports; all Duties,
Imposts, and Excises had to be uniform throughout the United States (referred to as the
uniformity clause); and no capitation or other direct tax shall be laid, unless in proportion to the
Census or Enumeration herein before directed to be taken (referred to as the apportionment
clause). (A capitation tax is a tax levied on each person. These taxes are also called head taxes or
poll taxes. They are no longer levied by any state.)

Federal Taxation Today

The federal government currently relies on five major forms of taxation: (1) the individual
income tax, (2) payroll tax (to finance Social Security and Medicare benefits), (3) corporate
income tax, (4) excise tax (taxes on specific commodities, such as gasoline, cigarettes, airline
tickets, and alcohol), and (5) customs tax (taxes levied on selected imported goods).
State and Local Government Revenues

Unlike the federal tax system, state and local tax systems rely heavily on sales and property taxes.
Until the 1970s property taxes were their major source of revenue. Today, property and sales taxes
each contribute about 20% of their total revenue. State and local individual income taxes amount
to only 15% of the total, whereas corporate income taxes are between 2% and 3%.

Comparison of Taxation Across Countries

Outside the United States, the value-added tax (a tax imposed on the value of the output of a firm
less the value of goods and services purchased from other firms) is a major source of revenue.
Social Security taxes comprise about the same share of government revenues in the United States
and other OECD countries. In contrast to high-income countries, lower-income countries tend to
rely more on indirect than direct taxes, as the small size of their formal economies make it very
difficult to collect payroll-based income and social security taxes.

DEFICIT FINANCING ---------------------------------------------------------------------------------------------------------

The major source of financing of government expenditures is taxes. But many governments, especially in
recent years, have found tax revenues insufficient to pay for their expenditures. A deficit in any period is
the excess of spending over revenues. A deficit is financed by borrowing. The cumulative value of
borrowing by a firm, household, or government is its debt.

A firm or household that runs a deficit cannot continue to borrow indefinitely but will be forced into
bankruptcy once its debt gets too large. Because of the federal government’s ability to tax, and the huge
potential revenue sources it can tap, its deficits do not cause the same kinds of problems that large debts
incurred by private firms or individuals would. Lenders will continue to willingly finance the federal
government’s debt, provided the interest rate is high enough.