The Public Sector

Market Failures:

Externalities and Third Party Costs

Market failures: externalities

• Market prices are supposed to reflect the benefits and costs received by producers and consumers involved in an exchange.

• A market failure occurs when the market prices fail to reflect all the costs and benefits involved.

• Market failures are called externalities• Sometimes externalities are called “third part

y” costs or benefits

Negative externalities

• Negative externalities are the costs paid by society for a private exchange.

• For example, a steel plant may produce toxic emissions while producing steel.

• The air pollution caused by the factory may lead to the increases in lung cancer and other respiratory illnesses.

• The medical and hospital costs associated with the pollution is not a private cost to the steel manufacturer, but is born by the third parties who become ill.

Correcting for Negative Externalities

• The government may step in to correct the negative externalities by establishing higher air quality standards.

• It may also tax or fine the steel company. This tax increases the costs of producing steel and lowers the supply of steel.

• Finally the government may want to give incentives (subsidies or tax breaks) to companies that create steel with less pollution.

Positive externalities

• There may be positive third party benefits, as well.(e.g. inoculations benefit public health)

• A positive externality means that a good is being under produced, therefore the government may want to finance this good (e.g. public education)

• The government may also increase the incentives by giving subsidies or tax breaks to an industry which creates positive third party benefits (e.g. alternative energy with non-renewable resources)

Characteristic of Market Economy

• Private Property

• Free Enterprise

• Self Interest

• Competition

• Markets and Prices

• Limited Government

Role of Government in a Market Economy

• Provide a legal system enforce laws and protect private property rights

• Provide Public goods that individuals or private businesses wouldn’t provide

• Correct market failures such as external costs and external benefits

• Maintain competition by regulating business• Redistribute income by taxing those with larger

incomes and helping those in need• Stabilize the economy by reducing unemployment

and inflation, while promoting economic growth

Government Sponsored or Inhibited Goods

• Our political system determines which goods are socially desirable. These goods (e.g. museums, schools, libraries) are called merit goods or government sponsored goods.

• Conversely our society may designate some goods as demerit goods (e.g.cigarettes, gambling etc.) or government inhibited goods.

• Our local, state, and national governments subsidizes merit goods, and taxes demerit goods.

Public Goods

• Public goods are consumed jointly and simultaneously.

• Public goods include national defense, police protection, and our legal system.

• Private businesses have little profit incentives to produce public goods, so government takes on this responsibility.

• Some citizens may benefit from a public good, but don’t pay for it. This is called the free rider problem.

The Federal Budget

• The government spends money on programs and takes in taxes to finances these programs.

• The Congress has budget authority. Spending bills begin the House, although the Senate and the President may present their budgets.

• Final approval is through the Congress.

Discretionary and Non-discretionary Funding

• Programs such as Social Security and Medicare are called non-discretionary items because they are mandatory payments to people who have paid in through the payroll tax.

• The rest of the budget items are discretionary items, meaning the Congress may increase or decrease their amounts.

Funding of the Public Sector

• The Public Sector is funded primarily through national, state, and local taxes.

• Our different levels of government may also charge a fee or borrow money as well.

• Each level of government has a tax base. The tax base is the level of assets, such as income and property, that can be taxed by the government.

• For example, wealthier areas have a higher tax base than poorer ones.

Federal Taxes

• The majority of revenues for the national government comes from federal income tax, paid in April.

• The national government also receives money from corporate taxes and money from capital gains (money made on the ownership of financial assets like stocks).

• Funds for Social Security derive from the payroll tax. The government also has withholding for Medicare and unemployment insurance.

Tax Philosophy

• Our national income tax is a progressive tax, which means higher income groups pay higher marginal tax rates.

• Our state sales tax is a proportional tax because all people pay the same percentage rate (e.g. 8%).

• A tax is considered regressive if it unduly burdens the poor.

Marginal tax rates

• The marginal tax rate is the tax rate on the last dollar of income earned

• In a progressive tax system the marginal rate is higher than the average tax rate

State Taxes

• States also have a variety of revenue sources.

• In California the state property tax, paid by homeowners, provides large sums of revenue and is used for big programs like schools.

• Our state also has a sales tax and a state income tax to pay for state government.

• Not all states have state income or sales tax. Nevada, for example, funds their state primarily through the taxation of gambling.

Excise Taxes

• Excise taxes are taxes on specific goods and services. For example, the state of California levies a tax on gasoline and uses the proceeds to fund the highway construction and maintenance in the state.

• Excise taxes on cigarettes and alcohol are specifically designed to make these demerit goods more expensive and discourage smoking and drinking.

• Ok, let’s try this with the handout• What is the current marginal tax rate for

people making: • $8,000• 10%• $100,000• 28%• $500,000• 39.6%

Average versus Marginal Tax rates

• Now look at the example of someone making $100, 000 per year.

• What is their marginal tax rate?

• 28%

• What is their average tax

• 22%

Taxable Income

• Taxable income is that money earned which the government can tax.

• Typically people can take deductions on their income. For example, $3650 is taken off income for each person in a family

• In addition, homeowners received a deduction on interest paid on their homeloan for a primary residence

Incentives and Loopholes

• The government uses tax policy to provide incentives to business as well.

• For example, the new healthcare law gives tax incentives to small businesses that provide healthcare plans to employees

• Corporations involved in energy: oil,natural gas, and green energy receive tax credits

• These incentives are called “loopholes” by critics who point out that many large corporation don’t pay their full tax load, and they often lobby Congress for these special tax breaks.

Limits to the government in capitalist society

• Market societies limit government from owning the majority of businesses, as the government does in a socialist society.In addition, the government does not decide what is produced and does not set basic prices for the production.

• Most capitalist societies are mixed economies. It is estimated that about 65% of all economic activity in the US takes place in the private market, with the remaining 35% of services and products occurs in all levels of the government sector.

Imagine

• A person earns $250,000 in income and $750,000 from capital gains made on stocks.

• Long term capital gains is about 15%.• What is the overall tax percentage paid by

this individual?• Is this fair or unfair? What do you think of

Warren Buffet’s proposal that wealthy American should pay a tax rate at least equal to middle class Americans?

Opposing Tax Proposals

• Many Republicans are calling for all of the Bush era tax cuts to remain, including the current 35% on the top income bracket

• Many Democrats, including President Obama, are calling for the top brackets (those making over $250,000) to jump back to the pre Bush era tax cut rate of 36% and 39%. This proposal keeps the other tax rates in place.

PBS Debate on Tax Cuts

What do you think?

• Should the tax cuts expire?• Should the highest rates be raised, with the other

tax cuts remaining?• Should all the tax cuts remain, including the

highest rates?• Should we make our national income tax more

progressive or move it to a proportional tax rate (or flat tax?)

• What about people who make most of their income from capital gains (taxed at 15%). Should this change or stay the same?