ECON 369
Lecture One: Notes on Public Finance and Public Choice (Introduction)
Review of Some Basic Principles: What it is, what are the basic problems we try to solve (choices and coordination).
We must make choices. Why?
We need to coordinate those choices (coordinate scarce resources with individual wants). How?
RULES – INCENTIVES – ACTIONS – OUTCOMES
Remember, often the outcomes are unintended. Why?
Spontaneous vs. Planned Orders:
Markets are spontaneous orders – they are not “organizations” like a business firm. There is no overall purpose of an order, but each individual within the order has goals or purposes. The interactions of these individuals is what gives us the order. What emerges as the order (the outcomes) depends upon the institutions or rules that people respond to.
Government is often seen as an organization, but in reality it is also an order. It has no overall purpose of its own – but individuals have goals, and their interactions create an order – the outcomes of the process of government. Therefore, according to the process economists’ view – the view we will practice in this class – governments should be studied as markets should be studied, as evolving orders. More on this later.
“Societies and markets, however, are orders and not organizations, even though their processes proceed in a generally orderly fashion. People don’t require invitations to participate in market or society, they just do it. Markets and societies don’t have goals; they are just arenas that encompass the participating individuals and organizations that do have goals. The aggregate patterns and outcomes that arise within societies and markets are not products of choice, but are the emergent by-products of interaction among the participants.” Richard E. Wagner, Fiscal Sociology and the Theory of Public Finance
In other words, individuals make decisions concerning the use of economic resources. Generally speaking there are three ways to organize (allocate, etc.) resources:
Tradition
Market
Planning (government or politics)
We will concentrate on the last two:
The rules play a large role in both. But there are many differences:
1. Simple correlation between private costs and benefits – the decisions people make in markets (I buy something if the benefits outweigh the costs) cannot exist in politics for a variety of reasons.
In markets -- taking into consideration limited knowledge -- people buy something if the private benefits outweigh the private costs. These are weighed by the individual at the time of trade and then the decision is made.
Since government does exist (and we will discuss this as well) - at some point the individual must choose how his resources will be used “collectively” (or if at all). Or choose to let others choose (which complicates things further).
And how can the private costs that the individual takes into account in such decisions be isolated and identified? How can the private "benefits" that are expected to balance off these costs be determined?
2. In markets -- there is choice, in the sense that someone is not forced (at the point of a gun) to buy something. In the political process, this is not always true. Yet another complication!!
As examples:
How do individuals make these decisions when taking into consideration their own private costs and benefits?
How does he or she do this – what roles can they play? Examples - can you think of others?
1.
2.
3.
But common sense does tell us that the institutions through which costs and benefits are presented to the private citizen may influence his decision.
For example - direct costs to the private citizen are presented to him through taxes - but how these taxes are levied may significantly affect his attitude toward the extension or the contraction of the services he receives from them.
A progressive income tax may make someone less likely to want to pay a tax for something he or she uses because they feel it is unfair -- they may be more likely to pay a sales tax, for example.
So given all of this, what we are going to do in this class?
Develop some theories or pattern predictions concerning the effects of the various fiscal institutions (rules) on the decision-making process of the individual. But also - look at how the fiscal institutions have come about in the first place.
In other words: 1. Advise the state on how it should conduct its activities and 2. Explain the responses of market participants to those activities.
We will use both the traditional approach to public finance (sometimes) and also the public choice approach:
PUBLIC FINANCE (traditionally): It studies individual behavior in the private realm of his or her activity.
EXAMPLES:
The government extends a subway in one direction when it could have extended it in another direction – this will increase land value in some places – which will lead to people buying property in different locations than they otherwise would have.
Or the government increases its taxes on alcohol and tobacco (or marijuana), while increasing personal exemptions under its income tax to try to keep revenues approximately constant. It would be reasonable for the economist to expect cross-border shopping, smuggling, etc.
PUBLIC CHOICE: Examines individual behavior in the public realm of activity or the study of individual participation in collective decision-making. So the choice is one of using income for private or public uses. The individual is in the role of voter, activist, taxpayer, beneficiary.
Or – the individual could even enter the process itself and be a politician or bureaucrat.
Here, economists explain the origins of fiscal activities and explain a government’s pattern of taxing and spending.
EXAMPLES:
The subway line didn’t extend itself, but was extended through some process of choice or interaction among some portion of the citizenry.
The higher taxes on alcohol and tobacco (or marijuana), as well as the increase in the personal exemption, didn’t just happen, but happened because some person or persons made them happen.
So – we need to explain just how those fiscal patterns come into existence and subsequently change!
As James Buchanan explained – fiscal and political institutions (rules) become central to the theory of public finance in two respects:
fiscal (political, etc.) institutions provide the framework that shapes and constrains the interactions among fiscal participants, just as property rights and contract provide the framework that shapes and constrains the interactions among market participants.
As the rules are changed in markets - for example, contracts are often constrained. An employer can't, by law, pay someone below a certain minimum wage. Does this change in the contract rule change behavior and outcomes -- yes.
So the same is true in the political realm.
those (fiscal) institutions are subject to change through processes that are capable of analytical examination.
We can examine how the fiscal rules will change behavior and outcomes just like economists do when analyzing a minimum wage law.
Can we Make Some Comparisons with Market Theory?
Self - interest axiom - Notice first - that in both cases we are going back to the individual and making the same assumptions about his behavior that we make regarding people in markets.
First - cost/benefit problem mentioned earlier. So there is more uncertainty for the individual in the political process. There is NEVER perfect information - we always make decisions under uncertainty. Markets do go a long way towards providing us with information. But what about in the political realm?
The problems that someone might face in a market are magnified in the political process (some examples)
Sometimes we will assume that individuals know their costs and benefits in the political process – and this is useful. But then we will have to be more realistic and model our individuals with more uncertainty.
In any case what we will be doing throughout this whole semester is seeing how a change in the rules of the game or institutions change individual behavior which then changes outcomes – in the political arena – which then effects the market arena.
How are we going to judge our rules or institutions?
Standard Neo-Classical Approaches to efficiency:
1. Welfare economics – (Utility Maximization, Pareto Optimal or Pareto efficient):
Sounds good but impossible in practice. Can't measure utility.
2. Standard Efficiency Criteria - Allocative and Productive Efficiency:
Again, how do we know this is happening? Knowledge problem.
3. Efficiency has no meaning outside of knowing what people value.
Alternative Approach:
Subjective Value Theory:
Seems that efficiency is gained when people become wealthier – so how do we define wealthier? Efficiency is enhanced when people get more of what they value - including money, friendship, love, nice people to work with, cleaner environment, etc.
Wealth:
But how do we measure it? We really can't. All we can do is talk in generalities -- or in pattern predictions.
So what can we do?
Examples:
We must first know how the system works - who bears the burden of taxation, how do taxes affect public choices, etc. - then maybe we can make some value judgments about them. The value judgments can happen at the stage of what should be the outcome of the rules -- but they can also enter at the process stage (is a tax fair? Is one tax more fair than another? Etc.).