Jonathan gruber public finance and public policy worth publishers

Public Finance and Public Policy This page intentionally left blank Jonathan Gruber Massachusetts Institute of Technology Worth Publishers Public Finance and Public Policy THIRD EDITION To Andrea, Sam, Jack, and Ava Senior Publisher Craig Bleyer Senior Acquisitions Editor Sarah Dorger Development Editor Jane Tufts Media Development Editor Marie McHale Senior Marketing Manager Scott Guile Assistant Supplements Editor Tom Acox Associate Managing Editor Tracey Kuehn Project Editor Leo Kelly, Macmil.

and Public Policy

This page intentionally left blank

To Andrea, Sam, Jack, and Ava

Senior Publisher:Craig Bleyer

Senior Acquisitions Editor:Sarah Dorger

Development Editor:Jane Tufts

Media Development Editor:Marie McHale

Senior Marketing Manager:Scott Guile

Assistant Supplements Editor:Tom Acox

Associate Managing Editor:Tracey Kuehn

Project Editor:Leo Kelly, Macmillan Publishing Solutions

Production Manager:Barbara Anne Seixas

Art Director:Babs Reingold

Cover Design:Kevin Kall

Interior Design:Lissi Sigillo

Photo Editor:Cecilia Varas

Composition:MPS Limited, A Macmillan Company

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ISBN-13: 978-1-4292-1949-5

ISBN-10: 1-4292-1949-1

Library of Congress Control Number: 2006937926

© 2011, 2007, 2005 Worth Publishers

All rights reserved

Printed in the United States of America

Dr Jonathan Gruber is a Professor of Economics at the MassachusettsInstitute of Technology, where he has taught since 1992 He is also theDirector of the Health Care Program at the National Bureau of Economic

Research, where he is a research Associate He is a co-editor of the Journal of Public Economics and an Associate Editor of the Journal of Health Economics.

Dr Gruber received his B.S in Economics from MIT and his Ph.D

in Economics from Harvard He has received an Alfred P Sloan tion Research Fellowship, a FIRST award from the National Institute onAging, and the Kenneth Arrow Award for the Best Paper in Health Eco-nomics in 1994 He was also one of 15 scientists nationwide to receivethe Presidential Faculty Fellow Award from the National Science Foun-dation in 1995 Dr Gruber was elected to the Institute of Medicine in

Founda-2005, and in 2006, he received the American Society of Health omists’ Inaugural Medal for the best health economist in the nationaged 40 and under Dr Gruber’s research focuses on the areas of publicfinance and health economics He has published more than 125 researcharticles and has edited six research volumes

Econ-During the 1997–1998 academic year, Dr Gruber was on leave fromMIT, serving as Deputy Assistant Secretary for Economic Policy at theU.S Treasury Department He was a key architect of Massachusetts’sambitious health reform effort, and in 2006, he became an inauguralmember of the Health Connector Board, the main implementing bodyfor that effort In that year, he was named the nineteenth-most powerful

person in health care in the United States by Modern Healthcare Magazine.

He acted as a consultant on several presidential campaigns and is

consid-ered by the Washington Post to be one of the “most influential” health

care experts in America

Brief Contents

Preface .xxvii

PART I Introduction and Background 1 Why Study Public Finance? 1

2 Theoretical Tools of Public Finance 25

3 Empirical Tools of Public Finance 63

4 Budget Analysis and Deficit Financing 91

PART II Externalities and Public Goods 5 Externalities: Problems and Solutions 121

6 Externalities in Action: Environmental and Health Externalities 149

7 Public Goods 181

8 Cost-Benefit Analysis 205

9 Political Economy 227

10 State and Local Government Expenditures 261

11 Education 289

PART III Social Insurance and Redistribution 12 Social Insurance: The New Function of Government 319

13 Social Security 353

14 Unemployment Insurance, Disability Insurance, and Workers’ Compensation 389 15 Health Insurance I: Health Economics and Private Health Insurance 419

16 Health Insurance II: Medicare, Medicaid, and Health Care Reform 453

17 Income Distribution and Welfare Programs 489

PART IV Taxation in Theory and Practice 18 Taxation in the United States and Around the World 523

19 The Equity Implications of Taxation: Tax Incidence 557

20 Tax Inefficiencies and Their Implications for Optimal Taxation 589

21 Taxes on Labor Supply 623

22 Taxes on Savings 647

23 Taxes on Risk Taking and Wealth 675

24 Corporate Taxation 701

25 Fundamental Tax Reform 737

Glossary .G-1 References .R-1 Name Index .NI-1 Subject Index .SI-1

vi

Preface .xxvii

CHAPTER 1 Why Study Public Finance? .1

1.1 The Four Questions of Public Finance 3

When Should the Government Intervene in the Economy? 3 Application:The Measles Epidemic of 1989–1991 5 How Might the Government Intervene? 6 What Are the Effects of Alternative Interventions? 7 Application:The Congressional Budget Office: Government Scorekeepers 8 Why Do Governments Do What They Do? 9 1.2 Why Study Public Finance? Facts on Government in the United States and Around the World 10

The Size and Growth of Government 10 Decentralization 12 Spending, Taxes, Deficits, and Debts 12 Distribution of Spending 13 Distribution of Revenue Sources 17 Regulatory Role of the Government 19 1.3 Why Study Public Finance Now? Policy Debates over Social Security, Health Care, and Education .20

Social Security 20 Health Care 21 Education 21 1.4 Conclusion 22

Highlights .22

Questions and Problems .23

Advanced Questions .24

CHAPTER 2 Theoretical Tools of Public Finance .25

2.1 Constrained Utility Maximization .26

Preferences and Indifference Curves 27

Utility Mapping of Preferences 29

Budget Constraints 31

Putting It All Together: Constrained Choice 33

The Effects of Price Changes: Substitution and Income Effects 35

vii

P A R T I Introduction and

Background

2.2 Putting the Tools to Work: TANF and Labor

Supply Among Single Mothers .37

Identifying the Budget Constraint 38 The Effect of TANF on the Budget Constraint 39 2.3 Equilibrium and Social Welfare .43

Demand Curves 44 Supply Curves 46 Equilibrium 48 Social Efficiency 49 Competitive Equilibrium Maximizes Social Efficiency 50 From Social Efficiency to Social Welfare: The Role of Equity 52 Choosing an Equity Criterion 54 2.4 Welfare Implications of Benefit Reductions: The TANF Example Continued .55

2.5 Conclusion .57

Highlights .57

Questions and Problems .58

Advanced Questions .59

APPENDIX TO CHAPTER 2 The Mathematics of Utility Maximization .60 CHAPTER 3 Empirical Tools of Public Finance .63

3.1 The Important Distinction Between Correlation and Causality .64

The Problem 65 3.2 Measuring Causation with Data We’d Like to Have: Randomized Trials .66

Randomized Trials as a Solution 67 The Problem of Bias 67 Randomized Trials of ERT 69 Randomized Trials in the TANF Context 69 Why We Need to Go Beyond Randomized Trials 70 3.3 Estimating Causation with Data We Actually Get: Observational Data .71 Time Series Analysis 72

Cross -Sectional Regression Analysis 75 Quasi-Experiments 80

Structural Modeling 83

viii

Questions and Problems .85

Advanced Questions .86

APPENDIX TO CHAPTER 3 Cross-Sectional Regression Analysis 88

CHAPTER 4 Budget Analysis and Deficit Financing .91

4.1 Government Budgeting .93

The Budget Deficit in Recent Years 93 The Budget Process 94 Application:Efforts to Control the Deficit 95 Budget Policies and Deficits at the State Level 97 4.2 Measuring the Budgetary Position of the Government: Alternative Approaches .98

Real vs Nominal 98 The Standardized Deficit 99 Cash vs Capital Accounting 100 Static vs Dynamic Scoring 102 4.3 Do Current Debts and Deficits Mean Anything? A Long-Run Perspective .103

Background: Present Discounted Value 103 Why Current Labels May Be Meaningless 104 Alternative Measures of Long -Run Government Budgets 105 What Does the U.S Government Do? 109 Application:The Financial Shenanigans of 2001 112 4.4 Why Do We Care About the Government’s Fiscal Position? .113

Short -Run vs Long -Run Effects of the Government on the Macroeconomy 113 Background: Savings and Economic Growth 114 The Federal Budget, Interest Rates, and Economic Growth 115 Intergenerational Equity 117 4.5 Conclusion .118

Highlights .119

Questions and Problems .119

Advanced Questions .120

ix

CHAPTER 5 Externalities: Problems and Solutions .121

5.1 Externality Theory .123

Economics of Negative Production Externalities 123 Negative Consumption Externalities 126 Application:The Externality of SUVs 127 Positive Externalities 128 5.2 Private-Sector Solutions to Negative Externalities .130

The Solution 130 The Problems with Coasian Solutions 132 5.3 Public-Sector Remedies for Externalities .134

Corrective Taxation 135 Subsidies 136 Regulation 137 5.4 Distinctions Between Price and Quantity Approaches to Addressing Externalities .137

Basic Model 137 Price Regulation (Taxes) vs Quantity Regulation in This Model 139 Multiple Plants with Different Reduction Costs 140 Uncertainty About Costs of Reduction 143 5.5 Conclusion .146

Highlights .146

Questions and Problems .147

Advanced Questions .148

CHAPTER 6 Externalities in Action: Environmental and Health Externalities .149

6.1 Acid Rain .150

The Damage of Acid Rain 150 History of Acid Rain Regulation 151 Empirical Evidence:Estimating the Adverse Health Effects of Particulates 152 Has the Clean Air Act Been a Success? 154 6.2 Global Warming .155

Application:The Montreal Protocol 157 The Kyoto Treaty 158

Can Trading Make Kyoto More Cost -Effective? 158 What Does the Future Hold? 161

Application:Congress Takes on Global Warming 162

x

P A R T I I

Externalities

and Public

Goods

Should We Care Only About Externalities, or Do “Internalities” Matter Also? 170

6.4 The Economics of Other Addictive Behaviors .173

Drinking 173 Illicit Drugs 174 Application:Public Policy Toward Obesity 174 Summary 177 6.5 Conclusion .177

Highlights .178

Questions and Problems .178

Advanced Questions .179

CHAPTER 7 Public Goods .181

7.1 Optimal Provision of Public Goods .182

Optimal Provision of Private Goods 183 Optimal Provision of Public Goods 185 7.2 Private Provision of Public Goods .187

Private-Sector Underprovision 188 Application:The Free Rider Problem in Practice 189 Can Private Providers Overcome the Free Rider Problem? 190 Application:Business Improvement Districts 190 When Is Private Provision Likely to Overcome the Free Rider Problem? 192 7.3 Public Provision of Public Goods .194

Private Responses to Public Provision: The Problem of Crowd -Out 195 Measuring the Costs and Benefits of Public Goods 197 How Can We Measure Preferences for the Public Good? 197 Empirical Evidence:Measuring Crowd -Out 198 7.4 Conclusion .199

Highlights .200

Questions and Problems .200

Advanced Questions .201

APPENDIX TO CHAPTER 7 The Mathematics of Public Goods Provision .202

xi

CHAPTER 8 Cost-Benefit Analysis .205

8.1 Measuring the Costs of Public Projects .206

The Example 207 Measuring Current Costs 208 Measuring Future Costs 209 8.2 Measuring the Benefits of Public Projects .210

Valuing Driving Time Saved 210 Application:The Problems of Contingent Valuation 213 Empirical Evidence:Valuing Time Savings 214 Valuing Saved Lives 215 Application:Valuing Life 215 Discounting Future Benefits 220 Cost-Effectiveness Analysis 220 8.3 Putting It All Together .221

Other Issues in Cost -Benefit Analysis 221 8.4 Conclusion .223

Highlights .223

Questions and Problems .224

Advanced Questions .225

CHAPTER 9 Political Economy .227

9.1 Unanimous Consent on Public Goods Levels .229

Lindahl Pricing 229 Problems with Lindahl Pricing 231 9.2 Mechanisms for Aggregating Individual Preferences .232

Application:Direct Democracy in the United States 232 Majority Voting: When It Works 234 Majority Voting: When It Doesn’t Work 236 Arrow’s Impossibility Theorem 237 Restricting Preferences to Solve the Impossibility Problem 237 Median Voter Theory 239 The Potential Inefficiency of the Median Voter Outcome 239 Summary 240 9.3 Representative Democracy .241 Vote -Maximizing Politicians Represent the Median Voter 241

Assumptions of the Median Voter Model 242 Lobbying 244

Application:Farm Policy in the United States 245 Evidence on the Median Voter Model for Representative Democracy 247

Empirical Evidence:Testing the Median Voter Model 248

xii

Problems with Privatization 250

Application:Contracting Out with Non-Competitive Bidding 251

Leviathan Theory 253

Corruption 254

Application:Government Corruption 254

Empirical Evidence:Government Failures and Economic Growth 257

The Implications of Government Failure 258

9.5 Conclusion .258

Highlights .258

Questions and Problems .259

Advanced Questions .260

CHAPTER 10 State and Local Government Expenditures .261

10.1 Fiscal Federalism in the United States and Abroad .263

Spending and Revenue of State and Local Governments 264 Fiscal Federalism Abroad 265 10.2 Optimal Fiscal Federalism .267

The Tiebout Model 267 Problems with the Tiebout Model 269 Evidence on the Tiebout Model 271 Optimal Fiscal Federalism 273 Empirical Evidence:Evidence for Capitalization from California’s Proposition 13 274 10.3 Redistribution Across Communities .275

Should We Care? 276 Tools of Redistribution: Grants 277 Redistribution in Action: School Finance Equalization 282 Empirical Evidence:The Flypaper Effect 283 Application:School Finance Equalization and Property Tax Limitations in California 285 10.4 Conclusion 285

Highlights .286

Questions and Problems .286

Advanced Questions .287

xiii

CHAPTER 11 Education .289

11.1 Why Should the Government Be Involved in Education? .292

Productivity 292 Citizenship 293 Credit Market Failures 293 Failure to Maximize Family Utility 293 Redistribution 294 11.2 How Is the Government Involved in Education? .294

Free Public Education and Crowding Out 295 Solving the Crowd -Out Problem: Vouchers 297 Problems with Educational Vouchers 300 11.3 Evidence on Competition in Education Markets .304

Direct Experience with Vouchers 304 Experience with Public School Choice 304 Empirical Evidence:Estimating the Effects of Voucher Programs 305 Experience with Public School Incentives 306 Bottom Line on Vouchers and School Choice 307 11.4 Measuring the Returns to Education .307

Effects of Education Levels on Productivity 308 Effect of Education Levels on Other Outcomes 309 Empirical Evidence:Estimating the Return to Education and Evidence for Screening 310 The Impact of School Quality 310 11.5 The Role of the Government in Higher Education .311

Empirical Evidence:Estimating the Effects of School Quality 312 Current Government Role 313 What Is the Market Failure and How Should It Be Addressed? 314 11.6 Conclusion .315

Highlights .316

Questions and Problems .316

Advanced Questions .317

CHAPTER 12 Social Insurance: The New Function of Government .319

12.1 What Is Insurance and Why Do Individuals Value It? 321 What Is Insurance? 321

Why Do Individuals Value Insurance? 322 Formalizing This Intuition: Expected Utility Model 323

xiv

P A R T I I I

Social

Insurance and

Redistribution

Example with Full Information 327

Example with Asymmetric Information 327

The Problem of Adverse Selection 329

Does Asymmetric Information Necessarily Lead to Market Failure? 330

Application:Adverse Selection and Health Insurance “Death Spirals” 331

How Does the Government Address Adverse Selection? 332

12.3 Other Reasons for Government Intervention

in Insurance Markets .333

Externalities 333 Administrative Costs 333 Redistribution 334 Paternalism 334 Application:Flood Insurance and the Samaritan’s Dilemma 334 12.4 Social Insurance vs Self -Insurance: How Much Consumption Smoothing? .337

Example: Unemployment Insurance 337 Lessons for Consumption -Smoothing Role of Social Insurance 341 12.5 The Problem with Insurance: Moral Hazard .342

Application:The Problems with Assessing Workers’ Compensation Injuries 343 What Determines Moral Hazard? 344 Moral Hazard Is Multidimensional 344 The Consequences of Moral Hazard 345 12.6 Putting It All Together: Optimal Social Insurance .346

12.7 Conclusion .346

Highlights .347

Questions and Problems .347

Advanced Questions .348

APPENDIX TO CHAPTER 12 Mathematical Models of Expected Utility .350

CHAPTER 13 Social Security .353

13.1 What Is Social Security and How Does It Work? .354

Program Details 355

Application:Why Choose 35 Years? 355

xv

How Does Social Security Work Over Time? 359

Application:Ida May Fuller 360 How Does Social Security Redistribute in Practice? 362

13.2 Consumption-Smoothing Benefits

of Social Security .364

Rationales for Social Security 364 Does Social Security Smooth Consumption? 365 Social Security and Private Savings 366 Living Standards of the Elderly 366 13.3 Social Security and Retirement .367

Theory 367 Empirical Evidence:Measuring the Crowd -Out Effect of Social Security on Savings 368 Evidence 369 Application:Implicit Social Security Taxes and Retirement Behavior 372 Implications 374 13.4 Social Security Reform .374

Reform Round I: The Greenspan Commission 375 Application:The Social Security Trust Fund and National Savings 376 Incremental Reforms 377 Fundamental Reforms 379 Application:Company Stock in 401(k) Plans 383 Application:Mixed Proposals for Social Security Reform 384 13.5 Conclusion .385

Highlights .385

Questions and Problems .386

Advanced Questions .387

CHAPTER 14 Unemployment Insurance, Disability Insurance, and Workers’ Compensation .389

14.1 Institutional Features of Unemployment Insurance, Disability Insurance, and Workers’ Compensation .391

Institutional Features of Unemployment Insurance 391 Institutional Features of Disability Insurance 393 Institutional Features of Workers’ Compensation 394 Comparison of the Features of UI, DI, and WC 395 Application:The Duration of Social Insurance Benefits Around the World 396 14.2 Consumption-Smoothing Benefits of Social Insurance Programs .397

xvi

Empirical Evidence:Moral Hazard Effects of Unemployment Insurance 400

Evidence for Moral Hazard in DI 402

Evidence for Moral Hazard in WC 403

Empirical Evidence:Moral Hazard Effects of DI 404

Empirical Evidence:Krueger’s Study of Workers’ Compensation 405

14.4 The Costs and Benefits of Social Insurance to Firms 406

The Effects of Partial Experience Rating in UI on Layoffs 406 The “Benefits” of Partial Experience Rating 408 Application:The “Cash Cow” of Partial Experience Rating 408 Workers’ Compensation and Firms 409 14.5 Implications for Program Reform .410

Benefits Generosity 410 Targeting 410 Experience Rating 411 Worker Self -Insurance? 411 Application:Reforming UI 412 14.6 Conclusion .413

Highlights .413

Questions and Problems .414

Advanced Questions .414

APPENDIX TO CHAPTER 14 Advanced Quasi -Experimental Analysis .416 CHAPTER 15 Health Insurance I: Health Economics and Private Health Insurance .419

15.1 An Overview of Health Care in the United States .421

How Health Insurance Works: The Basics 422 Private Insurance 423 Medicare 427 Medicaid 427 TRICARE/CHAMPVA 428 The Uninsured 428 Empirical Evidence:Health Insurance and Mobility 430 15.2 How Generous Should Insurance Be to Patients? .432

Consumption-Smoothing Benefits of Health Insurance for Patients 432

Moral Hazard Costs of Health Insurance for Patients 433

Application:The Problem with McAllen, Texas 436

xvii

How Elastic Is the Demand for Medical Care? The RAND Health Insurance Experiment 438

Empirical Evidence:Estimating the Elasticity of Demand for Medical Care 439 Optimal Health Insurance 440

Why Is Insurance So Generous in the United States? 441

Application:Health Savings Accounts 442

15.3 How Generous Should Insurance Be to Medical Providers? .445 Managed Care and Prospective Reimbursement 445

The Impacts of Managed Care 447 How Should Providers Be Reimbursed? 448

15.4 Conclusion .448

Highlights . 449

Questions and Problems . 449

Advanced Questions . 450

CHAPTER 16 Health Insurance II: Medicare, Medicaid, and Health Care Reform .453

16.1 The Medicaid Program for Low -income Mothers and Children .455

How Medicaid Works 455 Who Is Eligible for Medicaid? 456 What Health Services Does Medicaid Cover? 456 How Do Providers Get Paid? 457 16.2 What Are the Effects of the Medicaid Program? .457

How Does Medicaid Affect Health? A Framework 457 How Does Medicaid Affect Health? Evidence 458 Empirical Evidence:Using State Medicaid Expansions to Estimate Program Effects 461 16.3 The Medicare Program .462

How Medicare Works 462 Application:The Medicare Prescription Drug Debate 463 16.4 What Are the Effects of the Medicare Program? .466 The Prospective Payment System 466

Empirical Evidence on the Move to the PPS 467 Problems with PPS 467

Lesson: The Difficulty of Partial Reform 469 Medicare Managed Care 469

Should Medicare Move to a Full Choice Plan? Premium Support 472

Application:A Premium Support System for Medicare 472 Gaps in Medicare Coverage 474

xviii

16.6 Lessons for Health Care Reform in the United States 476

Rising Health Care Costs 476 The Uninsured 478 National Health Insurance 479 Application:The Massachusetts Experiment with Incremental Universalism 480 Reform Efforts in 2009 482 16.7 Conclusion .484

Highlights .484

Questions and Problems .485

Advanced Questions .486

CHAPTER 17 Income Distribution and Welfare Programs 489

17.1 Facts on Income Distribution in the United States .491

Relative Income Inequality 491 Absolute Deprivation and Poverty Rates 492 Application:Problems in Poverty Line Measurement 494 What Matters—Relative or Absolute Deprivation? 496 17.2 Welfare Policy in the United States .496

Cash Welfare Programs 497 In-Kind Programs 498 17.3 The Moral Hazard Costs of Welfare Policy .499

Moral Hazard Effects of a Means -Tested Transfer System 500 Solving Moral Hazard by Lowering the Benefit Reduction Rate 503 The “Iron Triangle” of Redistributive Programs 505 17.4 Reducing the Moral Hazard of Welfare .505

Moving to Categorical Welfare Payments 505 Using “Ordeal Mechanisms” 508 Application:An Example of Ordeal Mechanisms 510 Increasing Outside Options 511 Empirical Evidence:The Canadian Self -Sufficiency Project 513 17.5 Welfare Reform .517

Changes Due to Welfare Reform 517

Effects of the 1996 Welfare Reform 517

Empirical Evidence:Estimating the Impact of Welfare Reform 518

xix

17.6 Conclusion .519

Highlights .520

Questions and Problems .520

Advanced Questions .521

CHAPTER 18 Taxation in the United States and Around the World .523

18.1 Types of Taxation .524

Taxes on Earnings 524 Taxes on Individual Income 525 Taxes on Corporate Income 525 Taxes on Wealth 525 Taxes on Consumption 525 Taxation Around the World 525 18.2 Structure of the Individual Income Tax in the United States .527

Computing the Tax Base 527 Tax Rates and Taxes Paid 529 Application:The Coming AMT Timebomb 531 18.3 Measuring the Fairness of Tax Systems .532

Average and Marginal Tax Rates 532 Vertical and Horizontal Equity 533 Measuring Vertical Equity 534 Application:The Political Process of Measuring Tax Fairness 534 18.4 Defining the Income Tax Base .536

The Haig -Simons Comprehensive Income Definition 536 Deviations Due to Ability -to-Pay Considerations 537 Deviations Due to Costs of Earning Income 538 Application:What Are Appropriate Business Deductions? 538 18.5 Externality/Public Goods Rationales for Deviating from Haig -Simons .539 Charitable Giving 540

Spending Crowd -Out Versus Tax Subsidy Crowd -In 540 Consumer Sovereignty Versus Imperfect Information 542 Housing 543

Empirical Evidence:The Social Benefits of Homeownership 545 Tax Deductions Versus Tax Credits 546

Application:The Refundability Debate 547 Bottom Line: Tax Expenditures 549

xx

P A R T I V

Taxation in

Theory and

Practice

Marriage Taxes in Practice 552

19.1 The Three Rules of Tax Incidence .559

The Statutory Burden of a Tax Does Not Describe Who Really

Bears the Tax 559

The Side of the Market on Which the Tax Is Imposed Is Irrelevant to the

Distribution of the Tax Burdens 561

Parties with Inelastic Supply or Demand Bear Taxes;

Parties with Elastic Supply or Demand Avoid Them 564

Reminder: Tax Incidence Is About Prices, Not Quantities 567

19.2 Tax Incidence Extensions .568

Tax Incidence in Factor Markets 568

Tax Incidence in Imperfectly Competitive Markets 572

Balanced Budget Tax Incidence 574

19.3 General Equilibrium Tax Incidence .575

Effects of a Restaurant Tax: A General Equilibrium Example 575

Issues to Consider in General Equilibrium Incidence Analysis 577

19.4 The Incidence of Taxation in the United States .580

CBO Incidence Assumptions 580

Empirical Evidence:The Incidence of Excise Taxation 581

Results of CBO Incidence Analysis 581

Current Versus Lifetime Income Incidence 584

CHAPTER 20 Tax Inefficiencies and Their Implications for Optimal Taxation .589

20.1 Taxation and Economic Efficiency .590 Graphical Approach 590

Elasticities Determine Tax Inefficiency 592

Application:Tax Avoidance in Practice 593 Determinants of Deadweight Loss 594 Deadweight Loss and the Design of Efficient Tax Systems 595

Application:The Deadweight Loss of Taxing Wireless Communications 600

20.2 Optimal Commodity Taxation .601 Ramsey Taxation: The Theory of Optimal Commodity Taxation 601

Inverse Elasticity Rule 602 Equity Implications of the Ramsey Model 603

Application:Price Reform in Pakistan 603

20.3 Optimal Income Taxes .607

A Simple Example 607 General Model with Behavioral Effects 608

An Example 610

20.4 Tax -benefit Linkages and the Financing

of Social Insurance Programs .611 The Model 611

Issues Raised by Tax -benefit Linkage Analysis 613

Empirical Evidence:A Group -Specific Employer Mandate 615

20.5 Conclusion .616

Highlights .616

Questions and Problems .617

Advanced Questions .617

APPENDIX TO CHAPTER 20 The Mathematics of Optimal Taxation 619

CHAPTER 21 Taxes on Labor Supply .623

21.1 Taxation and Labor Supply—Theory .625 Basic Theory 625

Limitations of the Theory: Constraints on Hours Worked and Overtime Pay Rules 627

21.2 Taxation and Labor Supply—Evidence .628

Empirical Evidence:Estimating the Elasticity of Labor Supply 629 Limitations of Existing Studies 630

xxii

Impact of EITC on Labor Supply: Theory 633

Impact of EITC on Labor Supply: Evidence 634

Empirical Evidence:The Effect of the EITC on Single Mother Labor Supply 636

Summary of the Evidence 637

Application:EITC Reform 637

21.4 The Tax Treatment of Child Care and

Its Impact on Labor Supply .639

The Tax Treatment of Child Care 639

Empirical Evidence:The Effect of Child Care Costs on Maternal

Labor Supply 640

Options for Resolving Tax Wedges 642

Comparing the Options 643

21.5 Conclusion .643

Highlights .644

Questions and Problems .644

Advanced Questions .645

CHAPTER 22 Taxes on Savings .647

22.1 Taxation and Savings—Theory and Evidence .648

Traditional Theory 648

Evidence: How Does the After -Tax Interest Rate Affect Savings? 653

Inflation and the Taxation of Savings 653

22.2 Alternative Models of Savings .655

Precautionary Savings Models 655

Self-Control Models 656

Empirical Evidence:Social Insurance and Personal Savings 657

22.3 Tax Incentives for Retirement Savings .658

Available Tax Subsidies for Retirement Savings 659

Why Do Tax Subsidies Raise the Return to Savings? 660

Theoretical Effects of Tax -Subsidized Retirement Savings 662

Application:The Roth IRA 666

Implications of Alternative Models 668

Private vs National Savings 669

Empirical Evidence:Estimating the Impact of Tax Incentives for Savings on

Savings Behavior 670

Evidence on Tax Incentives and Savings 671

xxiii

22.4 Conclusion .672

Highlights .673

Questions and Problems .673

Advanced Questions .674

CHAPTER 23 Taxes on Risk Taking and Wealth .675

23.1 Taxation and Risk Taking .677 Basic Financial Investment Model 677

Real-World Complications 678 Evidence on Taxation and Risk Taking 680 Labor Investment Applications 680

23.2 Capital Gains Taxation .681 Current Tax Treatment of Capital Gains 681

What Are the Arguments for Tax Preferences for Capital Gains? 683 What Are the Arguments Against Tax Preferences for Capital Gains? 688

23.3 Transfer Taxation .688 Why Tax Wealth? Arguments for the Estate Tax 690

Arguments Against the Estate Tax 691

23.4 Property Taxation .694 Who Bears the Property Tax? 695

Types of Property Taxation 696

Application:Property Tax Breaks to Businesses 696

23.5 Conclusion .698

Highlights .699

Questions and Problems .699

Advanced Questions .700

CHAPTER 24 Corporate Taxation .701

24.1 What Are Corporations and Why Do We Tax Them? .703 Ownership vs Control 704

Application:Executive Compensation and the Agency Problem 705 Firm Financing 707

Why Do We Have a Corporate Tax? 708

24.2 The Structure of the Corporate Tax .709 Revenues 709

Expenses 709

xxiv

24.3 The Incidence of the Corporate Tax .713

24.4 The Consequences of the Corporate Tax for Investment 714

Theoretical Analysis of Corporate Tax and Investment Decisions 714

Negative Effective Tax Rates 719

Policy Implications of the Impact of the Corporate Tax on Investment 719

Application:The Impact of the 1981 and 1986 Tax Reforms on Investment

Incentives 720

Evidence on Taxes and Investment 721

24.5 The Consequences of the Corporate

Tax for Financing .722

The Impact of Taxes on Financing 722

Why Not All Debt? 723

The Dividend Paradox 726

How Should Dividends Be Taxed? 727

Application:The 2003 Dividend Tax Cut 728

Corporate Tax Integration 729

24.6 Treatment of International Corporate Income .730

How to Tax International Income 730

Application:A Tax Holiday for Foreign Profits 731

24.7 Conclusion .734

Highlights .734

Questions and Problems .735

Advanced Questions .736

CHAPTER 25 Fundamental Tax Reform .737

25.1 Why Fundamental Tax Reform? .738

Improving Tax Compliance 739

Application:Tax Evasion 739

Application:The 1997 IRS Hearings and Their Fallout for Tax Collection 742

Making the Tax Code Simpler 743

Improving Tax Efficiency 745

Summary: The Benefits of Fundamental Tax Reform 748

25.2 The Politics and Economics of Tax Reform .748

Political Pressures for a Complicated Tax Code 749

Economic Pressures Against Broadening the Tax Base 749

xxv

Application:Grandfathering in Virginia 752 The Conundrum 752

Application:TRA 86 and Tax Shelters 753

25.3 Consumption Taxation .754 Why Might Consumption Make a Better Tax Base? 754

Why Might Consumption Be a Worse Tax Base? 757 Designing a Consumption Tax 760

Backing Into Consumption Taxation: Cash -Flow Taxation 762

25.4 The Flat Tax .763 Advantages of a Flat Tax 763

Problems with the Flat Tax 764

Application:The 2005 Panel on Tax Reform 765

Name Index .NI-1

Subject Index .SI-1

xxvi

When I began writing this book six years ago, I hoped that my text

would bring the excitement and enthusiasm that I have for the

study of public finance to the students taking this important course

I believe that a public finance text should help students understand the public

finance issues that are discussed on the front page of the newspaper every day

By presenting rigorous theory, cutting-edge empirical evidence, and abundant

policy-relevant applications, I hoped that students would find the main lessons

of public finance accessible and appealing—perhaps even enjoyable

With the success of the first two editions of this text, I am gratified and happy

to say that my approach has found wide acceptance among instructors and their

students across the country By augmenting the traditional approach of public

finance texts with a true integration of theory, application, and evidence, Public

Finance and Public Policy has enabled instructors to better engage their students.

Whenever a major theoretical concept is discussed, the discussion is augmented

by examples of the policy relevance of the topic and, where available, evidence

on the key relationships highlighted by the theory

For example, when discussing the impact of individual income taxation on

labor supply in Chapter 21, I present the traditional theoretical analysis, discuss

the available evidence on the responsiveness of labor supply to taxation, and

then apply those insights to the discussion of the major tax subsidy to labor

supply in the United States, the Earned Income Tax Credit (EITC) And in

the discussions of externalities in Chapters 5 and 6, the theoretical analysis of

private and public solutions to externalities is followed by application of those

solutions to the major environmental externalities, such as global warming,

that face policy makers today, and an examination of the empirical evidence

on the effects of existing U.S regulatory interventions in those areas

Features

Public Finance and Public Policy improves on previous texts in public finance in

three ways

Updated Selection of Topics

Any public finance textbook must devote extensive discussion to issues of

externalities and public goods, taxation, and direct government spending, and

this book is no exception Yet I also devote increased attention to the transfer

and social insurance programs that dominate government activity The text is

organized around four key areas:

왘 Introduction and Background The first section of the book is

devoted to motivating the study of public finance, beginning in

xxvii

Chapter 1 with a timely discussion of the debates over the proper sizeand mix of government spending and tax relief in the recent stimulusbill, as well as other major public policy debates of the day The bookthen reviews background skills in Chapter 2 (microeconomic theory),Chapter 3 (empirical methodology), and Chapter 4 (governmentbudgeting) I recognize that students come to their public financecourses with highly varying levels of skill in economics This courserequires familiarity with introductory microeconomics, but no more:All other required skills are reviewed in these background chapters.Chapter 3, on empirical methods, provides students with all the back-ground they need to interpret the empirical evidence boxes throughoutthe text In addition, by moving the discussion of government budget-ing from its traditional “orphan” spot at the end of textbooks, I allowthe discussion of other topics throughout the book, such as SocialSecurity and tax policy, to draw on the insights developed in Chapter 4about the role of the budget in policy debates.

왘 Externalities and Public Goods The discussion of externalitiesbegins in Chapter 5 with a discussion of private and public solutions tothe problem of externalities, and then continues in Chapter 6 by focus-ing on the two major public policy issues involving externalities:environmental externalities, such as acid rain and global warming, andhealth externalities The section on public goods begins in Chapter 7with a discussion of private and public solutions to the public goodsproblem, and then highlights two of the major issues in public provision:cost/benefit analysis (Chapter 8) and political economy (Chapter 9)

I then turn to the role of state and local governments as providers ofpublic goods, highlighting the potential efficiencies and costs of decen-tralization in Chapter 10, before discussing education, one of the mostimportant public goods in the United States, in Chapter 11

왘 Social Insurance and Redistribution I have been gratified thatinstructors have responded positively to this book’s major innovation:the expanded discussion of social insurance and redistribution, thelargest and fastest-growing function of government This section beginswith a novel chapter on the theory of social insurance: Chapter 12highlights the reasons we have social insurance, its role in crowding outprivate self-insurance, and the problems of moral hazard I then include

a separate chapter on the nation’s largest social insurance program,Social Security (Chapter 13), and another on the three other non-health social insurance programs: unemployment insurance, disabilityinsurance, and workers’ compensation (Chapter 14) Given the enor-mous and growing role of government in the provision of health care,

I devote two chapters to this topic, first discussing the nature of healthinsurance and health economics in Chapter 15 and then focusing onthe government’s role in Chapter 16, in particular highlighting thecurrent debates over reforming the nation’s health care system Finally,

xxviii

왘 Taxation in Theory and Practice The feedback on the novel

organ-ization of the tax-related chapters has been very positive The coverage

of taxation begins with the key institutional features and theoretical

con-cepts (such as vertical equity and the Haig-Simons tax base) that are

cen-tral to understanding tax policy (discussed in Chapter 18) Next are

two chapters that cover the theoretical underpinnings of tax incidence

(Chapter 19) and tax efficiency analysis (Chapter 20) These chapters

include applications to measure the incidence of taxation in the United

States and to design optimal commodity taxes The next three chapters

focus on the behavioral responses of individuals to income taxation, and

discuss key tax policies that affect those behaviors: labor supply (and the

EITC) in Chapter 21, savings (and tax-subsidized retirement savings) in

Chapter 22, and the distribution of asset holdings (and capital gains,

estate, and property taxes) in Chapter 23 Chapter 24 presents an

overview of the corporate income tax and reviews the key equity and

efficiency issues that are the focus of corporate tax debates Finally,

Chapter 25, a chapter that has received an overwhelmingly positive

response from those teaching from the book, concludes by discussing

the motivations for, barriers to, and approaches to fundamental reform

of taxation policies in the United States

Integration of Policy Applications

The theoretical analysis that is at the core of public finance is most compelling

if students can see the real-world applications that are informed by that theory

This book provides a multitude of policy applications and examples to help

students appreciate the insights of public finance Whenever a new topic is

discussed, it is placed in the policy environment in the surrounding text In

addition, there are 54 separate policy applications spread throughout the book

to help emphasize the importance of the material These applications cover topics

such as the difficulties policy makers face in valuing human life in cost/benefit

analysis, the implementation of a universal health insurance coverage plan in

Massachusetts, appropriate and inappropriate business deductions under the

income tax, and a detailed discussion of the recommendations of the 2005

presidential panel on tax reform Finally, several chapters in the text are devoted

exclusively to policy applications such as global warming and education

Integration of Empirical Evidence

Theoretical development is central to the presentation of core public finance

concepts But the presentation of theory is greatly enhanced by a careful

pres-entation of the empirical evidence that supports, or does not support, these

theoretical models In this book, empirical evidence is presented in two ways

to provide flexibility for instructors with different tastes for this material

xxix

Throughout the text, whenever a major theoretical point is made, I discuss therelevant empirical findings on this same question, as well as the certainty that

we have about particular empirical findings In addition, for those who want

to teach a more empirically oriented course, Chapter 3 carefully explains how

to interpret empirical results to students of public finance who may not havebeen exposed to sophisticated empirical methods I have also included 27Empirical Evidence boxes, which discuss in more detail the studies thatunderlie the empirical results presented in the text and illustrate for studentsthe process of research and the methods by which empirical economistsanswer central policy questions I am gratified that the inclusion of these boxeshas been so widely applauded by users of the book

Improved Presentation and Pedagogy

As inherently interesting as this material is, student interest in any text criticallydepends on the exposition and presentation I have endeavored throughout thetext to use a student-friendly, conversational style that emphasizes the intuition,graphics, and mathematics of theory Instructors using the book have reported

that their students have found Public Finance and Public Policy to be an

accessi-ble, illuminating, and engaging read

Several features make this book appealing to potential users:

왘 Integrated Applications As noted earlier, the 54 applications in this text allow students to step back from the main text and appreci-ate the policy relevance of the material These applications are inte-grated directly with the text, rather than set aside, so that studentsunderstand the importance of applying the material they arelearning

왘 Empirical Evidence Boxes For instructors who wish to explore inmore depth the nature of the empirical findings mentioned in the text,Empirical Evidence boxes are set aside from the main text to explaincarefully the research process that generates the major empirical find-ings in public finance

왘 Integration of Relevant Statistics Throughout the text, and in anumber of graphs and tables, I present the statistics about the role of thegovernment that emphasize the importance of this course It is mucheasier to explain to students why they should care about social insur-ance, for example, when they clearly see graphics that illustrate the rise

in that activity as a share of the U.S government

왘 Quick Hints Throughout the text are a variety of highlighted QuickHints to emphasize the intuition of key theoretical points that studentsoften find difficult: How does one decide where to draw deadweight losstriangles (see page 52)? Why is the subsidy to employer-provided healthinsurance a subsidy to employees and not to employers (see page 426)?How can the income effect actually lead higher wages to cause lowerlevels of labor supply (see page 626)?

xxx

make key points about tax incidence, public goods provision, adverse

selection in insurance markets, optimal taxation, and other topics Five

appendices develop the mathematics of these topics Two additional

appendices focus on the details of empirical analysis

왘 Marginal Definitions Key terms are boldfaced throughout the text,

and marginal definitions allow students to focus on the key concepts

왘 Full-Color Graphics This is the first public finance text to use

full-color graphics, allowing the students to better understand the graphical

analysis that is so often confusing to them

왘 Highlights At the end of each chapter is a summary of the key themes

and concepts from the material in that chapter

왘 Questions and Problems At the end of each chapter are an average

of 15 questions and problems Questions on empirical analysis that draw

on material in Chapter 3 are denoted separately with an e, and there is

a careful delineation between basic and more advanced problems The

questions throughout the text have been reviewed, revised, updated, and

augmented with additional problems for the third edition

What’s New in the Third Edition

The dynamic public policy environment of the past few years required a

thor-ough updating of most aspects of the book All statistics, data-related tables and

figures, and applications have been updated completely to reflect the most recent

available data In addition, a number of major changes were made throughout

the book, including new applications, updating of existing applications and

empirical examples, and a number of new text discussions Highlights of the

changes include:

왘 Chapter 1: A new introduction focuses on the contentious debate

between Democrats and Republicans over the proper size and

composition of the major stimulus package passed in the spring of

2009

왘 Chapter 4: This chapter contains an updated discussion of the

enor-mous deficits currently faced by the federal government

왘 Chapter 6: A new application on “Congress Takes On Global Warming”

discusses the most significant legislative initiative to tackle this

external-ity to date: the Waxman-Markey bill passed out of the House of

Representatives in 2009 Another new application, “Public Policy

Toward Obesity,” extends the shorter coverage in the previous edition

into a longer discussion that addresses a variety of policy options for

combating the most important public health problem facing the United

States in the long run

xxxi

왘 Chapter 7: The Empirical Evidence box on “Measuring Crowd-Out”has been updated to reflect exciting new studies on this topic.

왘 Chapter 9: The application on “Farm Policy in the United States” hasbeen updated and includes a new discussion of the successful approach

to ending agricultural subsidies in New Zealand The application called

on “Government Corruption” has been extended to include the recentcase of Governor Rod Blagojevich in Illinois An interesting new exam-ple included in the chapter discusses the unintended consequences ofproviding public information on Congressional “pork.”

왘 Chapter 11: A more thorough discussion of empirical research oncompetition between private and public schools has been added to thesection on vouchers

왘 Chapter 12: The application on “Flood Insurance and the Samaritan’sDilemma” has been updated to discuss recent legislative actions toreform the problematic flood insurance program

왘 Chapter 14: The discussion of the moral hazard effects of disabilityinsurance (DI) is augmented through a discussion of evidence on theimpact of program-screening stringency on labor force and DIapplication decisions

왘 Chapter 15: A new section discusses the distribution of medical ing in the United States, a new section discusses in more depth thereasons that individuals end up uninsured, and a new application on

spend-“The Problem with McAllen, Texas” highlights the important role ofgeographic disparities in health care spending and their implications forcost control efforts

왘 Chapter 16: A new introduction highlights the debate over health reform

in the 2008 presidential elections The application on “The MedicarePrescription Drug Debate” has been updated to reflect the experiencesince 2006 with this major new government program, including the mostrecent health economics research And the entire final section on healthcare reform has been updated to reflect both recent developments inhealth economics and recent policy developments A new application on

“The Massachusetts Experiment with Incremental Universalism” discussesthe innovative health care reform in Massachusetts that has been the basis for ongoing health care reform efforts in the U.S Congress

왘 Chapter 18: In addition to a thorough updating of all facts about taxcollections and the tax code in the United States, a new EmpiricalEvidence box on “The Social Benefits of Homeownership” discussesthe difficult issue of convincingly measuring these benefits

왘 Chapter 20: I have reintroduced the section on the potential cies of progressive tax systems from the first edition and excised thediscussion of simulated evidence on the optimal income tax Thischange allows students to focus more on the important theoreticalissues in this area

inefficien-xxxii

capital gains during the 2008 presidential election.

왘 Chapter 24: A new introduction focuses on President Barack Obama’s

proposed reforms of the taxation of international income for U.S

busi-nesses The application on “Executive Compensation and the Agency

Problem” has been updated to reflect the renewed focus on executive

compensation during the financial meltdown of 2008–2009

Supplements and Media Package

For Students and Instructors

The book’s Companion Web Site (www.worthpublishers.com/gruber) has

been created to help students learn more effectively and to provide valuable

tools for professors teaching the course

For students, the Web site provides the following features:

왘 Self-Test Quizzes Students can test their knowledge of the material

in the book by taking a multiple-choice quiz about each chapter in the

text Students receive immediate feedback, including a hint to the

cor-rect response and a page number in the text where they can study

further All student answers are saved in an online database that can be

accessed by instructors

왘 Flashcards Students may review their knowledge of key terms by

studying the definitions and testing themselves with these electronic

flashcards

왘 Research Center This tool allows students to easily and effectively

locate outside resources and readings on the Web that relate to topics

covered in the textbook Each URL is accompanied by a description of

the site and its relevance to the chapter

왘 Student PowerPoint Slides This version of the PowerPoint

presen-tation created by Fernando Quijano of Dickinson State University is ideal

for students who need extra help in understanding the concepts in each

chapter This resource enables students to review and independently

prepare for classroom lectures The PowerPoint presentation for each

chapter comes complete with notes, summaries, and graphics

For instructors, the Web site provides the following features:

왘 Quiz Gradebook All student answers to the self-test quizzes are saved

in an online database that can be accessed by instructors Instructors can

view and export reports of their students’ practice activity

왘 Lecture PowerPoint Presentations A series of PowerPoint slides,

created by Fernando Quijano of Dickinson State University, provides

comprehensive coverage of the material in each chapter The slides are

xxxiii

designed to assist with lecture preparation and presentations by porating key graphs from the textbook with detailed outlines of keyconcepts The slides can be customized to suit instructors’ individualneeds and serve as a fantastic resource when building a lecturepresentation

incor-왘 Images from the Textbook Instructors have access to every figureand table in the new edition in high-resolution JPEG format and in the

form of PowerPoint Slides.

왘 Solutions Manual Instructors have access to the files for the detailedsolutions to the text’s end-of-chapter problems

For Instructors

Computerized Test Bank CD-ROM The computerized test bank is vided using Diploma software It includes a complete set of multiple-choiceand short-answer questions created to effectively test student analysis, inter-pretation, and comprehension of the concepts covered in the textbook Eachquestion is identified by level, text topic reference, and key concepts The TestBank is available in CD-ROM format for both Windows and Macintosh users.WebCT- and Blackboard-formatted versions of the test bank are also available

pro-on the CD-ROM With Diploma, instructors can easily write and edit tions, as well as create and print tests Questions can be sorted according tovarious information fields and questions can be scrambled to create differentversions of tests Tests can be printed in a wide range of formats The software’sunique synthesis of flexible word-processing and database features creates aprogram that is extremely intuitive and capable

ques-Acknowledgments

This book is the product of the efforts of an enormous number of people.While I’ll try my best to acknowledge them all, I apologize in advance tothose I have forgotten

My initial debts are to the teachers and colleagues who taught me publicfinance: Peter Diamond, Marty Feldstein, Jim Poterba, and especially LarrySummers, on whose 1990 public finance course this text is very loosely based!

I was very fortunate to have been able to learn at the feet of the giants of myfield, and I hope that I can do them justice in passing on their insights to thenext generation of public finance economists I am also grateful to LarrySummers for making it possible for me to work at the Treasury Department in1997–1998, which gave me an appreciation of the power of public financeanalysis and the importance of educating our future generations of policy-makers in the right way so that they can think about all aspects of publicfinance in a thorough manner

I also owe a debt of gratitude to the generations of undergraduate students

at MIT who suffered through the development of the material in this book I

am embarrassed at how much more complete my understanding is of this

xxxiv

itself, and I am grateful in particular to Liz Ananat, Alan Bengtzen, David Seif,

and Chris Smith for their assistance I am also grateful to my secretary, Jessica

Colon, for her invaluable assistance in finding me materials I needed for this

book, often at the last minute!

I am also extremely grateful to the hard-working and enthusiastic team at

Worth Publishers who made this book possible Sarah Dorger, senior

acquisi-tions editor, planned this revision, got it under way, provided helpful feedback

from the market, and kept things moving along at a brisk pace In these tasks

she was helped by the able efforts of Marie McHale, senior development editor,

and Tom Acox, assistant editor, who worked tirelessly, quickly, and efficiently

to ensure that things went smoothly once the manuscript was in Worth’s hands

Thanks to Scott Guile, senior marketing manager Thanks also to Worth’s

production group: Tracey Kuehn, associate managing editor, Barbara Seixas,

production manager, Babs Reingold, art director, Kevin Kall, designer, and

Cecilia Varas, photo editor

This entire project was feasible because of the assistance of several

col-leagues who generously devoted their time to checking the text carefully and

to rounding out the package of materials Matthew Schurin (University of

Connecticut) was kind enough to take the time to pass along several

sugges-tions for the third edition Thank you to Michael Reksulak (Georgia

South-ern University) for his accurate checking of work that often went well into

the night to ensure that we made our deadlines David Figlio (University of

Florida) and Casey Rothschild (MIT) provided the wonderful questions and

problems that are found at the end of each chapter, and Kate Krause

(Univer-sity of New Mexico) and Casey Rothschild provided the elegant solutions to

the end-of-chapter problems

A huge number of colleagues were very receptive when pestered for

questions, insights, and informal reviews of the text A

less-than-comprehensive list, impressive in both its quantity and quality, includes

Daron Acemoglu (MIT), Joe Aldy (Harvard University), Josh Angrist (MIT),

David Autor (MIT), Steve Ansolebehere (MIT), Kate Baicker (Dartmouth

College), Olivier Blanchard (MIT), Becky Blank (University of Michigan),

Len Burman (Urban Institute), Ricardo Caballero (MIT), Chris Carroll

( Johns Hopkins University), Amitabh Chandra (Dartmouth College), Gary

Claxton (Kaiser Family Foundation), Robert Coen (Northwestern

Univer-sity), Jonathan Cohn (New Republic), Miles Corak (UNICEF), Julie Cullen

(University of California at San Diego), David Cutler (Harvard University),

Susan Dadres (Southern Methodist University), Angus Deaton (Princeton

University), Peter Diamond (MIT), David Dranove (Northwestern

Univer-sity), Esther Duflo (MIT), Jae Edmonds (Pacific Northwest National

Labo-ratory), Gary Engelhardt (Syracuse University), Roger Feldman (University

of Minnesota), Martin Feldstein (Harvard University), David Figlio

(Univer-sity of Florida), Amy Finkelstein (Harvard Univer(Univer-sity), Alan Garber (Stanford

xxxv

University), Bill Gentry (Williams College), David Green (University ofBritish Columbia), Michael Greenstone (MIT), Jerry Hausman (MIT ),Vivian Ho (Rice University), Caroline Hoxby (Harvard University), HilaryHoynes (University of California at Berkeley), Paul Joskow (MIT ), LarryKatz (Harvard University), Melissa Kearney (Wellesley College), Barrett Kir-wan (Cornell University), Wojciech Kopczuk (Columbia University), BotondKoszegi (University of California at Berkeley), Jeff Leibman (Harvard Uni-versity), Phil Levine (Wellesley College), Larry Levitt (Kaiser Family Foun-dation), Brigitte Madrian (University of Pennsylvania), Kathleen McGarry(UCLA), Bruce Meyer (University of Chicago), Kevin Milligan (University

of British Columbia), Sendhil Mullainathan (Harvard University), RobertMoffitt ( Johns Hopkins University), Casey Mulligan (University of Chicago),Joe Newhouse (Harvard University), John Nyman (University of Minnesota),Ted O’Donoghue (Cornell University), Peter Orszag (Brookings Institu-tion), Leslie Papke (Michigan State University), Franco Perrachi (Tor VegattaUniversity), Jim Poterba (MIT), Matt Rabin (University of California atBerkeley), Joshua Rauh (University of Chicago), Craig Ridell (University ofBritish Columbia), Casey Rothschild (MIT), Ceci Rouse (Princeton Uni-versity), Emmanuel Saez (Berkeley), Jesse Shapiro (Harvard University), KarlScholz (University of Wisconsin), Kosali Simon (Cornell University), JonSkinner (Dartmouth College), Joel Slemrod (University of Michigan),Kent Smetters (University of Pennsylvania), Jim Snyder (MIT), RobStavins (Harvard University), John Straub (Texas A&M), Chris Taber(Northwestern University), Richard Thaler (University of Chicago),Ebonya Washington (Yale University), and Ivan Werning (MIT)

In addition to this gargantuan list, there was also a large number of terrificcolleagues who were willing to give their time and energy to formal reviews

of the textbook They include Olugbenga Ajilore (University of Toledo),Pedro H Albuquerque (University of Minnesota Duluth), Mauro C Amor(Northwood University), Kevin Balsam (Hunter College), Gregory Burge(University of Oklahoma), Susan Dadres (University of North Texas), ArleneGeiger ( John Jay College), Seth Giertz (University of Nebraska–Lincoln),Jessica Hennessey (University of Maryland), Janet L Johnson (Georgia StateUniversity), Shawn D Knabb ( Western Washington University), Marc Law( University of Vermont), Mikhail Melnik (Niagara University), Paul Menchik(Michigan State University), Robert L Moore (Occidental College), GaryHoover (University of Alabama), Florenz Plassmann (Binghamton University–SUNY), Deborah A Savage (Southern Connecticut State University), MarkScanlan (Stephen F Austin State University), Atindra Sen (Miami University),John Straub (Tufts University), Mehmet S Tosun (University of Nevada, Reno),Roberta W Walsh (Florida Gulf Coast University), Gregory Wassall (North-eastern University), Joann Weiner (George Washington University), James A.Willde (University of North Carolina–Chapel Hill), and Janine Wilson (Uni-versity of California, Davis)

Several individuals stand out above the others in facilitating the book asyou see it now: My development editor, Jane Tufts, has worked on all three

xxxvi

text is uncanny She has been a pleasure at all times to work with, and my ability

to write has been immeasurably improved for the experience of working with

her Josh Goodman (now assistant professor of public policy at the Kennedy

School of Government at Harvard) was my research assistant on the first edition

of this book, and his contribution is no less than the roughly one-half of this

book that is examples, anecdotes, statistics, and graphs He worked tirelessly for

more than a year to meet my most demanding and esoteric requests for

exam-ples and applications, in most cases turning up the ideal case study to illustrate

the point I was trying to make He turned my chicken-scratch diagrams into

beautiful PowerPoint presentations And he was a master at finding any statistic

or fact, no matter how obscure I am also extremely grateful to Maggie Liu,

Anna Radinova, and Andy Wu, who worked long hours to update the

hun-dreds of facts in this edition, to expand on existing applications, and to provide

new ones as well

Finally, my greatest debt is to my family I am grateful to my parents, Marty

and Ellie, for providing me with the education and skills that allowed me to

pursue this project I hope my children, Sam, Jack, and Ava, can find some

small solace for the time I spent away from them and on this book in their

prominent place as examples throughout the text And I am most of all

grate-ful to my wondergrate-ful wife, Andrea, whose sacrifice throughout this project was

the largest of all Her unending support, from the initial decision process

through the last page proof, was the backbone on which this effort was built,

and I hope that someday I can make it up to her

xxxvii

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When Barack Obama was inaugurated as the 44th President of the

United States on January 20, 2009, he faced an economic crisis

that was the worst that the United States had seen in at least a

quarter century The unemployment rate, which had been at 4.8% less than

one year earlier, had risen to 7.6%—over 3.6 million jobs were estimated to

have been lost since the start of the recession in December 2007 The Dow

Jones stock market index had fallen 34.27% since January 22, 2008, and

78.19% from its peak on October 9, 2007 As President Obama said in a

meet-ing with nine Democratic and Republican leaders at the White House three

days after taking office, “We are experiencing an unprecedented economic crisis

that has to be dealt with and dealt with rapidly.”1

Leaders from both parties agreed on the importance of taking action to

deal with the faltering economy, and they looked to pass a stimulus package of

some sort Senate Minority Leader Mitch McConnell called the potential

stimulus package “a critical piece of legislation”2and Senator Majority Leader

Harry Reid warned that if Congress failed to pass a stimulus package, “our

entire country will suffer and the world will suffer.”3

Unfortunately, this consensus ended once the debate began over how to

stimulate the economy Democratic proposals for a stimulus package centered

around increased spending, primarily for expanded health benefits for

low-income families and the uninsured, increased aid to state and local governments,

and increased educational spending A second part of the stimulus (about

one-third of the total) would come from tax cuts, primarily for middle- and

lower-class taxpayers As the Democratic Speaker of the House, Nancy Pelosi, said,

“[President Obama] said he wanted action, bold and swift, and that is exactly

what we’re doing today.”4

Republicans disagreed Rep Eric Cantor of Virginia, the second-ranking

House Republican, called the stimulus bill “ a spending bill beyond anyone’s

Why Study Public Finance?

1

1

Finance? Facts on Government

in the United States and Around the World

1.3 Why Study Public Finance Now? Policy Debates over Social Security, Health Care, and Education