The role of government in society


Hyman, D. N. (2014). Public finance: A contemporary application of theory to policy (11th ed.). Cengage Learning.

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Chapter 1

The role of government in society has been and will always be controversial. Some believe government does too much while others believe it needs to do more. Many look to government to solve problems they believe to be important to them but would rather not have it engage in activities that benefit others. No matter what your view of government, it is clear that its programs and scope have grown significantly from a small share of the economy in the early 1900s to between 30 and 60 percent of the economy in modern industrial nations today. Citizens give up substantial amounts of their income each year to pay the taxes necessary to finance government expenditures. This book is about the government sector of the economy. A framework for analyzing the role of government will be developed. That framework will be used understand why government has grown and the consequences of future growth. We will study both the economic and political aspects of government. Major gov- ernment expenditure programs will be analyzed. Alternative mechanisms for financ- ing government activity and their economic effects will be discussed, as will issues relating to the government budget deficits and debt. Since 2000, government spending in the United States as a share of gross domestic product (GDP) has increased. Federal expenditures for national defense and health care by governments have both gone up as a share of the economy. The recession of 2007–2009 and its aftermath of slow economic growth and high unemployment in the United States resulted in increased federal government spend- ing to stabilize the economy. The recession and anemic economic growth from 2009 through 2011 has adversely affected tax collections for the federal, state, and local governments. Many state and local governments have been forced to curtail spending and raise taxes to balance budgets from 2008 to 2011. The federal gov- ernment’s budget deficit and debt outstanding has been soaring. Some of the growth in federal spending and the increase in government bor- rowing is due to the extraordinary circumstances resulting from the financial crisis and recession. The federal government has provided assistance to state and local governments to help them cope with the effect of the recession on their budgets and has also acquired ownership shares in struggling businesses in the banking, financial, and automotive sectors of the economy. Although these shares can be sold in the future, they do pose the risk that economic losses could be borne by tax- payers. The federal government’s budget deficit in 2010 was the largest as a share of GDP since the end of the World War II. As federal deficits have increased, so has the level of federal debt as a share of GDP. Rising levels of government debt both in the United States and nations in Europe using the euro as their currency has been a factor of concern in financial markets. In the United States, political bickering between the president and Congress about the ceiling on federal debt caused one leading credit rating agency to down- grade its rating for U.S. government securities in 2011. And the risk of default on sovereign debt in such euro zone nations as Greece, Italy, Spain, Portugal, Ireland, and even France has caused interest rates to rise on government securities in those nations. Many of these European nations have embarked on “austerity” programs to cut government spending and raise tax revenues that could adversely affect their economic growth rates. A major factor influencing the growth of government spending in the United States is the expanding role of governments in financing health care. Government expenditures for health care have been rising rapidly in recent years. If current trends continue federal government spending on health care through its two major health insurance programs, Medicare and Medicaid, could account for more than 50 percent of federal government spending by 2080 as the population ages. State government expenditures for health care have also been increasing significantly. Either tax rates will increase in the future to finance growth in government spend- ing or increased federal budget deficits could impact the economy in ways that either slow economic growth or cause inflation. Of course, another alternative would be to attempt to reduce the rate of growth of federal government spending. Given the projected importance of health care spending in the budget, this is unlikely to be possible without some curbs on spending for health care by govern- ments and significant changes in the health care system in the United States. The government’s role in health care is likely to remain a divisive issue. Between 2000 and 2010, total government spending in the United States increased significantly from 30 to 38 percent of GDP. Since 2007 much of that increase resulted from extraordinary expenditure to stabilize the economy while slow growth in GDP also contributed to increased share of government spending in the economy. However, because of rising levels of federal debt and concern about the negative impact of chronic federal budget deficits on the economy, politi- cal pressure has now emerged to reduce the share of government in the economies of both the United States and other major industrial nations—particularly those in western Europe. INDIVIDUALS, SOCIETY, AND GOVERNMENT What would it be like to live in a nation without government? There would be no system of courts to administer justice. Provision of national defense and homeland security would be difficult or disorganized with no central government to maintain and supply the armed forces. You could forget about such programs as Social Secu- rity, unemployment insurance, and welfare that provide income support to the elderly, the unemployed, and the poor or disabled. How would police and fire pro- tection be provided? Driving on roads and over bridges that we take for granted could also be a problem because virtually all the highways, streets, and other public transportation infrastructure we use every day are supplied and maintained by gov- ernments or their agencies. There would be no publicly funded elementary and sec- ondary schools. Higher education, which is heavily subsidized by both the federal and state governments, also would be in trouble. Our system of health care depends on government programs to pay the medical bills of many of the poor, the elderly, and veterans. Institutions ranging from medical schools to public clinics and hospi- tals would have their operations impaired without government support. Now that you have finished reflecting on what your life would be like without governments, you can better appreciate how much you rely on government services each day. We all benefit from government activities and expenditures. Since 1980, annual government expenditures in the United States averaged one third of GDP. In economics, we study the ways individuals make choices to use scarce resources to satisfy their desires. If you have taken an introductory economics course, you studied the role of markets as a means of establishing prices that influ- ence individual choices to use resources. In this book, you will study the role gov- ernments play in allocating resources and how individual choices influence what governments do. You also will study how government policies affect the incentives of workers, investors, and corporations to engage in productive activities.

If you have completed an introductory economics course, one lesson you have been taught already is that nothing of value can be obtained without some sacrifice. There are costs as well as benefits associated with the activities of governments. The role of government in society is so hotly disputed because we differ in our assessments of the costs and benefits of government programs. Many people think the role of government in the economy needs to be expanded and look to government to help solve their own problems. Others think the role of government in the economy is already excessive and would like to see its scale of influence reduced. Government expenditures are financed mainly by taxes. U.S. taxpayers give up more of their income each year to support government activities than they do to satisfy their desires for such basic items as food, clothing, and shelter. Taxes col- lected by governments in the United States are nearly three times the annual expen- ditures on food, nearly eight times the annual expenditures on clothing, and more than three times the annual expenditures on housing. The average U.S. household devotes nearly four months of annual earnings to meet its total yearly federal, state, and local government tax obligations. Citizens benefit from the many goods and services made available by governments, but they also pay the costs of these services. We differ in our views about what governments should and should not be doing in part because our valuations of the benefits we get from government dif- fer. We also disagree because of variation in the amount of taxes and other costs each of us pay. GOVERNMENTS AND POLITICAL INSTITUTIONS Public finance is the field of economics that studies government activities and the alternative means of financing government expenditures. As you study public finance, you will learn about the economic basis for government activities. A crucial objective of the analysis is to understand the impact of government expenditures, regulations, taxes, and borrowing on incentives to work, invest, and spend income. This text develops principles for understanding the role of government in the econ- omy and its impact on resource use and the well-being of citizens. Governments are organizations formed to exercise authority over the actions of people who live together in a society and to provide and finance essential services. Many citizens and resources are employed in the production of government ser- vices. Individuals pay taxes and, in many cases, are recipients of income financed by those taxes. For example, Social Security pensions, unemployment insurance compensation, and subsidies to the poor are financed by taxes. The extent to which individuals have the right to participate in decisions that determine what governments do varies from society to society. What governments do, how much they spend, and how they obtain the means to finance their func- tions reflect political interaction of citizens. Political institutions constitute the rules and generally accepted procedures that evolve in a community for determining what government does and how government outlays are financed. Through these mediums, individual desires are translated into binding decisions concerning the extent and functions of government. Such democratic institutions as majority rule and representative government offer citizens an opportunity to express their desires through voting and through attempts to influence the voting of others. Under majority rule, one alternative

(such as a political candidate or a referendum to increase spending for education) is chosen over others if it receives more than half the votes cast in an election. Just as economic theory is usefully applied to analysis of market interaction and individual choice, so can it be applied to political interaction and choices. Modern economics bases the study of government activity on a theory of individual behavior. THE ALLOCATION OF RESOURCES BETWEEN GOVERNMENT AND PRIVATE USE Government provision of goods and services requires labor, equipment, buildings, and land. The real cost of government goods and services is the value of private goods and services that must be sacrificed when resources are transferred to govern- ment use. When citizens pay taxes, their capacity to purchase goods and services for their own exclusive use (such as automobiles, clothing, housing, cameras, and din- ing out) is reduced. Resources that are thereby diverted from private use are pur- chased or otherwise obtained by government. Taxes also have indirect costs because they distort choices. Taxes affect prices of goods and services and the incentive to work, save, and allocate expenditures among goods and services. Taxes impair the operation of the economy by inducing individuals to make choices based not only on the benefits and costs of their actions but also on the tax advan- tages or disadvantages of their decisions. The distortion in resource use and loss in output that results from the effect of taxes on incentives is also part of the cost of government activity. The resources governments obtain are used to provide citizens with goods and services, such as roads, police and fire protection, and national defense. These gov- ernment goods and services are shared by all; they cannot be used by any one citi- zen exclusively. Other goods and services provided by government are limited in availability to certain groups, such as the aged or children, as with Social Security pensions and public primary and secondary schooling. The trade-off between government and private goods and services can be illus- trated with the familiar production-possibility curve. As shown in Figure 1.1, this curve gives the alternative combinations of government goods and services and pri- vate goods and services that can be produced in an economy, given its productive resources and technology and assuming that resources are fully employed. Private goods and services are those items, such as food and clothing, that are usually made available for sale in markets. Government goods and services, such as roads, schooling, and fire protection, usually are not sold in markets. At point A in Figure 1.1, MX1 units of private goods and services are forgone by individuals so that government can provide 0G1 units of goods and services. Resources that would have been employed in producing private goods and services are used by the government to provide services and exercise its functions. An increase in the amount of government goods and services provided per year from 0G1 to 0G2 requires a reduction in the amount of private goods avail- able per year. In Figure 1.1, the annual amount of private goods available declines from 0X1 to 0X2 as the economy moves from point A to point B on the production-possibility curve. For example, suppose that individuals demand more environmental protection services. To make these services available, governments Copyright 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require


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