Public finance and public policy

1 2 Theoretical Tools of Public Finance 27 3 Empirical Tools of Public Finance 65 4 Budget Analysis and Deficit Financing 93 5 Externalities: Problems and Solutions 123 6 Exter

A Tour Through the Book

PArT I Introduction and Background

1 Why Study Public Finance?

The goal of studying public finance is to understand the proper role of the government in the economy The changing role of government and exciting current policy debates motivate the study of this field

2 Theoretical Tools of Public Finance

We review the microeconomic tools necessary to understand the effects of government intervention in the economy

3 Empirical Tools of Public Finance

We review the main issues in empirical public finance, the use of data and statistical methods to measure the impact of government policy on individuals and markets

4 Budget Analysis and Deficit Financing

We delve into the complexity of budgetary issues that arise as governments consider their revenue and expenditure policies

PArT II Externalities and Public Goods

A major role of government is to address market failures caused by goods that have external costs and benefits or public benefits In this part we discuss when the private market can and cannot solve these problems and the prospects for government success in addressing the problems

5 Externalities: Problems and Solutions

When do externalities cause private markets to fail, and what tools does government have to combat this failure?

6 Externalities in Action: Environmental and Health Externalities

We use theoretical tools to examine examples of environmental and health externalities (such as acid rain, global warming, cigarette smoking, and obesity)

10 State and Local Government Expenditures

We discuss the local provision of public goods and the question of whether competition across localities can solve the problem of underprovision of public goods

11 Education

We review the public finance issues involved in providing education, one of the most important public goods in the United States

PArT III Social Insurance and redistribution

The increased nature and scope of government spending on social insurance programs is one of the most fundamental changes in U.S public policy over the past fifty years

13 Social Security

14 Unemployment Insurance, Disability Insurance, and Workers’ Compensation

We apply the principles of social insurance from Chapter 12 to the study of the nation’s largest social insurance programs We discuss the institutional features of these programs, their benefits and costs, and prospects for program reform

15 Health Insurance I: Health Economics and Private Health Insurance

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

The largest and most rapidly growing government expenditure is on health care We discuss the nature of health economics and the functioning of private health insurance markets, the role of the nation’s two largest public health insurance programs, and the structure and impacts of the Affordable Care Act

17 Income Distribution and Welfare Programs

We review the facts on income distribution in the United States, the theoretical and empirical effects of welfare policy, and the impacts of fundamental welfare reform

PArT IV Taxation in Theory and Practice

In this part we move from the study of government expenditures to the study of how the government raises revenue through taxation

18 Taxation: How It Works and What It Means

We provide the institutional and theoretical bases for understanding tax policy and its effects, focusing in particular on the appropriate base for individual income taxation

19 The Equity Implications of Taxation: Tax Incidence

20 Tax Inefficiencies and Their Implications for Optimal Taxation

Markets do not take taxes lying down In these chapters, we discuss how market reactions affect both the equity implications of tax (tax incidence) and the efficiency costs of taxation We use this theory to model the optimal design of taxes on goods and on income, and discuss evidence

on the distribution of tax burdens

21 Taxes on Labor Supply

22 Taxes on Savings

23 Taxes on Risk Taking and Wealth

In these chapters we explore the effect of income taxation on individual behavior and the resulting implications for tax policy How do taxes affect labor supply, and what has been the effect of the Earned Income Tax Credit? How do taxes affect savings, and what has been the effect of tax-subsidized retirement savings? How do taxes affect the distribution of asset holdings, and what has been the effect of the capital gains, estate, and property taxes?

24 Taxation of Business Income

We discuss the structure of the corporate income tax and its implications for a firm’s investment and financing decisions

25 Fundamental Tax Reform and Consumption Taxation

Fundamental tax reform in the United States focuses on moving to a low-rate, broad-based tax system We discuss the benefits of this reform, the political and economic barriers it faces, and possible reforms such as a consumption or flat tax

and Public Policy

Jonathan Gruber

Massachusetts Institute of Technology

FiFth edition

A Macmillan Education Imprint

New York

Vice President, Content Management: Catherine Woods Vice President, Editorial, Sciences, & Social Sciences: Charles Linsmeier Publisher: Shani Fisher

Executive Editor: Carlise Stembridge Executive Development Editor: Sharon Balbos Development Editor: Jane Tufts

Associate Media Editor: Lindsay Neff Media Producer: Andrew Vaccaro Editorial Assistant: Carlos Marin Marketing Manager: Tom Digiano Marketing Assistant: Alex Kaufman Director of Content Management Enhancement: Tracey Kuehn Managing Editor: Lisa Kinne

Project Editor: MPS North America LLC Project Editor Liaison: Julio Espin Photo Editor: Cecilia Varas Director of Design, Content Management: Diana Blume Cover and Text Designer: Vicki Tomaselli

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Printing and Binding: RR Donnelley Photo Cover Credit: Robert Dodge/E+/Getty Images

Library of Congress Control Number: 2015951239 ISBN-13: 978-1-4641-4333-5

ISBN-10: 1-4641-4333-1

© 2016, 2013, 2011, 2007 by Worth Publishers All rights reserved.

Printed in the United States of America First Printing

Worth Publishers One New York Plaza Suite 4500 New York, NY 10004–1562 www.worthpublishers.com

dr Jonathan Gruber is a Professor of

Economics at the Massachusetts Institute

of Technology (MIT), where he has taught since 1992 He is also the Director of the Health Care Program at the National Bureau

of Economic Research, where he is a Research Associate, and President Elect of the American Society of Health Economists He is also a member of the Institute of Medicine, the American Academy of Arts and Sciences, and the National Academy of Social Insurance

Dr Gruber received his B.S in Economics from MIT and his Ph.D in Economics from Harvard University Dr Gruber’s research focuses

on the areas of public finance and health nomics He has published more than 150 research articles, has

eco-edited six research volumes, and is the author of Health Care Reform, a graphic novel In 2006, he received the American

Society of Health Economists Inaugural Medal for the best health economist in the nation aged 40 and under

During the 1997–1998 academic year, Dr Gruber was on leave as Deputy Assistant Secretary for Economic Policy at the Treasury Department From 2003 to 2006, he was a key archi-tect of the ambitious health reform effort in Massachusetts and

in 2006 became an inaugural member of the Health nector Board, the main implementing body for that effort In 2009–2010, he served as a technical consultant to the Obama Administration and worked with both the Administration and Congress to help craft the Patient Protection and Affordable Care Act In 2011, he was named “One of the Top 25 Most Innovative and Practical Thinkers of Our Time” by the online

Con-magazine Slate In both 2006 and 2012, he was rated one of

the top 100 most powerful people in health care in the United

States by Modern Healthcare magazine.

Contents vii

Preface xvii

1 Why Study Public Finance? 1

2 Theoretical Tools of Public Finance 27

3 Empirical Tools of Public Finance 65

4 Budget Analysis and Deficit Financing 93

5 Externalities: Problems and Solutions 123

6 Externalities in Action: Environmental and Health Externalities 153

12 Social Insurance: The New Function of Government 335

13 Social Security 367

14 Unemployment Insurance, Disability Insurance, and Workers’ Compensation 403

15 Health Insurance I: Health Economics and Private Health Insurance 433

16 Health Insurance II: Medicare, Medicaid, and Health Care Reform 471

17 Income Distribution and Welfare Programs 511

18 Taxation: How It Works and What It Means 549

19 The Equity Implications of Taxation: Tax Incidence 585

20 Tax Inefficiencies and Their Implications for Optimal Taxation 619

21 Taxes on Labor Supply 657

22 Taxes on Savings 683

23 Taxes on Risk Taking and Wealth 713

24 Taxation of Business Income 739

25 Fundamental Tax Reform and Consumption Taxation 777

Preface xvii

PaRt I

Introduction and Background

1.1 The Four Questions of Public Finance 3

When Should the Government Intervene in the Economy? 4

aPPlICatIon Modern Measles Epidemics 5 How Might the Government Intervene? 8 What Are the Effects of Alternative Interventions? 9 aPPlICatIon The CBO: Government Scorekeepers 10 Why Do Governments Do What They Do? 11 1.2 Why Study Public Finance? Facts on

Government in the United States and Around

Debates over Social Security, Health Care,

and Education 21

Social Security 21 Health Care 22 Education 23 1.4 Conclusion 24

Highlights 24 Questions and Problems 25 Advanced Questions 25

2.1 Constrained Utility Maximization 28

Preferences and Indifference Curves 29 Utility Mapping of Preferences 31 Budget Constraints 33

Putting It All Together: Constrained Choice 35

The Effects of Price Changes: Substitution and Income Effects 37

2.2 Putting the Tools to Work: TANF and Labor Supply Among Single Mothers 39

Identifying the Budget Constraint 40 The Effect of TANF on the Budget Constraint 41 2.3 Equilibrium and Social Welfare 45 Demand Curves 46

Supply Curves 48 Equilibrium 49 Social Efficiency 50 Competitive Equilibrium Maximizes Social Efficiency 53

From Social Efficiency to Social Welfare:

The Role of Equity 54 Choosing an Equity Criterion 56 2.4 Welfare Implications of Benefit Reductions: The TANF Example Continued 56

2.5 Conclusion 58 Highlights 59 Questions and Problems 59 Advanced Questions 60

Randomized Trials of ERT 71 Randomized Trials in the TANF Context 71 Why We Need to Go Beyond Randomized Trials 72 3.3 Estimating Causation with Data We Actually Get: Observational Data 73 Time Series Analysis 73

Cross-Sectional Regression Analysis 77 Quasi-Experiments 81

The Budget Deficit in Recent Years 95

The Budget Process 97

aPPlICatIon Efforts to Control the

Deficit 98

Budget Policies and Deficits at the

State Level 100

4.2 Measuring the Budgetary Position

of the Government: Alternative

Approaches 101

Real Versus Nominal 101

Economic Conditions 102

Cash Versus Capital Accounting 103

Static Versus Dynamic Scoring 105

4.3 Do Current Debts and Deficits

Mean Anything? A Long-Run

Perspective 106

Background: Present Discounted Value 107

aPPlICatIon Present Discounted Value and

Interpreting Sports Contracts 107

Why Current Labels May Be Meaningless 108

Measuring Long-Run Government Budgets 109

What Does the U.S Government Do? 111

aPPlICatIon The Financial Shenanigans

of 2001 113

4.4 Why Do We Care About the Government’s

Fiscal Position? 114

Short-Run Versus Long-Run Effects of the

Government on the Macroeconomy 115

Background: Savings and Economic

Externalities and Public Goods

5.1 Externality Theory 125 Economics of Negative Production Externalities 125 Negative Consumption Externalities 128

aPPlICatIon The Externality of SUVs 129 Positive Externalities 130

5.2 Private-Sector Solutions to Negative Externalities 132

The Solution 132 The Problems with Coasian Solutions 134 5.3 Public-Sector Remedies for Externalities 136

Corrective Taxation 136 Subsidies 137

Regulation 139 5.4 Distinctions Between Price and Quantity Approaches to Addressing Externalities 139 Basic Model 140

Price Regulation (Taxes) Versus Quantity Regulation

in This Model 141 Multiple Plants with Different Reduction Costs 142 Uncertainty About Costs of Reduction 145 5.5 Conclusion 148

Highlights 148 Questions and Problems 149 Advanced Questions 150

Environmental and Health

6.1 The Role of Economics in Environmental Regulation: The Case of Acid Rain 155 The Damage of Acid Rain 156

History of Acid Rain Regulation 157 EmPIRICal EvIdEnCE Estimating the Adverse Health Effects of Particulates 158

Has the CAA Been a Success? 160 6.2 Global Warming 161

aPPlICatIon The Montreal Protocol 163 The Kyoto Treaty 164

Can Trading Make Environmental Agreements More Cost-Effective? 164

What Does the Future Hold? 167 aPPlICatIon Congress Takes on Global Warming 169 6.3 The Economics of Smoking 171

The Externalities of Smoking 173 Should We Care Only About Externalities, or Do

“Internalities” Matter Also? 176 6.4 The Economics of Other Addictive

Behaviors 180

Drinking 180 Illicit Drugs 181 EmPIRICal EvIdEnCE The Effect of Legal Drinking

at Age 21 182 aPPlICatIon Public Policy Toward Obesity 184 Summary 187

6.5 Conclusion 188

Highlights 188 Questions and Problems 188 Advanced Questions 189

7.1 Optimal Provision of Public Goods 192

Optimal Provision of Private Goods 193 Optimal Provision of Public Goods 195 7.2 Private Provision of Public Goods 197

Private-Sector Underprovision 198 aPPlICatIon The Free Rider Problem in Practice 199 Can Private Providers Overcome the Free Rider Problem? 200

aPPlICatIon Business Improvement Districts 200 When Is Private Provision Likely to Overcome the Free Rider Problem? 201

7.3 Public Provision of Public Goods 204

Private Responses to Public Provision: The Problem

of Crowd-Out 205 EmPIRICal EvIdEnCE Measuring Crowd-Out 206 The Right Mix of Public and Private 208

aPPlICatIon The Good and Bad Sides of Contracting Out 208

Measuring the Costs and Benefits of Public Goods 211 How Can We Measure Preferences for Public Goods? 211

7.4 Conclusion 212

Highlights 212 Questions and Problems 213 Advanced Questions 213

Provision 215

8.1 Measuring the Costs of Public Projects 220

The Example 221 Measuring Current Costs 221 8.2 Measuring the Benefits of Public Projects 224

Valuing Driving Time Saved 224 aPPlICatIon The Problems of Contingent Valuation 226

Valuing Saved Lives 227 EmPIRICal EvIdEnCE Valuing Time Savings 228 aPPlICatIon Valuing Life 229

EmPIRICal EvIdEnCE How Much Does It Cost to Avoid a Traffic Fatality? 234

Discounting Future Benefits 234 Cost-Effectiveness Analysis 235 8.3 Putting It All Together 235 Other Issues in Cost-Benefit Analysis 236 8.4 Conclusion 237

Highlights 238 Questions and Problems 238 Advanced Questions 239

9.1 Unanimous Consent on Public Goods Levels 243

Lindahl Pricing 243 Problems with Lindahl Pricing 245 9.2 Mechanisms for Aggregating Individual Preferences 246

aPPlICatIon Direct Democracy in the United States 246

Majority Voting: When It Works 248 Majority Voting: When It Doesn’t Work 250 Arrow’s Impossibility Theorem 251 Restricting Preferences to Solve the Impossibility Problem 251

Median Voter Theory 253 The Potential Inefficiency of the Median Voter Outcome 253

Summary 254 9.3 Representative Democracy 255 Vote-Maximizing Politicians Represent the Median Voter 255

Assumptions of the Median Voter Model 256 Lobbying 258

ApplicAtion Farm Policy in the United

States 259

Evidence on the Median Voter Model

for Representative Democracy 261

EmpiricAl EvidEncE Testing the Median Voter

ApplicAtion Government Corruption 266

The Implications of Government Failure 269

Fiscal Federalism Abroad 280

10.2 Optimal Fiscal Federalism 281

The Tiebout Model 281

Problems with the Tiebout Model 283

Evidence on the Tiebout Model 286

Optimal Fiscal Federalism 287

EmpiricAl EvidEncE Evidence for Capitalization from

California’s Proposition 13 288

10.3 Redistribution Across

Communities 290

Should We Care? 290

Tools of Redistribution: Grants 291

Redistribution in Action: School Finance

Equalization 296

EmpiricAl EvidEncE The Flypaper Effect 298

ApplicAtion School Finance Equalization and

Property Tax Limitations in California 299

Citizenship 309 Credit Market Failures 309 Failure to Maximize Family Utility 310 Redistribution 310

11.2 How Is the Government Involved in Education? 310

Free Public Education and Crowding Out 311

Solving the Crowd-Out Problem:

Vouchers 313 Problems with Educational Vouchers 315 11.3 Evidence on Competition in Education Markets 320

Direct Experience with Vouchers 320 Experience with Public School Choice 320

EmpiricAl EvidEncE Estimating the Effects

of Voucher Programs 321 Experience with Public School Incentives 322 Bottom Line on Vouchers and School Choice 323

11.4 Measuring the Returns to Education 323 Effects of Education Levels on Productivity 323 Effect of Education Levels on Other

Outcomes 325 The Impact of School Quality 325 EmpiricAl EvidEncE Estimating the Return to Education 326

11.5 The Role of the Government in Higher Education 327

EmpiricAl EvidEncE Estimating the Effects of School Quality 328

Current Government Role 328 What Is the Market Failure, and How Should It Be Addressed? 330

11.6 Conclusion 331 Highlights 332 Questions and Problems 332 Advanced Questions 333

12.1 What Is Insurance and Why Do

Individuals Value It? 337

What Is Insurance? 338 Why Do Individuals Value Insurance? 338 Formalizing This Intuition: Expected Utility Model 339 12.2 Why Have Social Insurance? Asymmetric

Information and Adverse Selection 342

Asymmetric Information 342 Example with Full Information 343 Example with Asymmetric Information 344 The Problem of Adverse Selection 345 Does Asymmetric Information Necessarily Lead to Market Failure? 346

aPPlICatIon Adverse Selection and Health Insurance

“Death Spirals” 347 How Does the Government Address Adverse Selection? 348

12.3 Other Reasons for Government

Intervention in Insurance Markets 349

Externalities 349 Administrative Costs 349 Redistribution 349 Paternalism 350 aPPlICatIon Flood Insurance and the Samaritan’s Dilemma 350

12.4 Social Insurance Versus Self-Insurance:

How Much Consumption Smoothing? 352

Example: Unemployment Insurance 353 Lessons for Consumption-Smoothing Role of Social Insurance 355

12.5 The Problem with Insurance: Moral

Hazard 355

aPPlICatIon The Problems with Assessing Workers’

Compensation Injuries 356 What Determines Moral Hazard? 357 Moral Hazard Is Multidimensional 358 The Consequences of Moral Hazard 358 12.6 Putting It All Together: Optimal Social

Insurance 359

12.7 Conclusion 360

Highlights 361 Questions and Problems 361

Advanced Questions 362

Utility 364

13.1 What Is Social Security, and How Does It Work? 369

Program Details 369 aPPlICatIon Why Choose 35 Years? 371 How Does Social Security Work over Time? 373 aPPlICatIon Ida May Fuller 375

How Does Social Security Redistribute in Practice? 376 13.2 Consumption-Smoothing Benefits of Social Security 379

Rationales for Social Security 379 Does Social Security Smooth Consumption? 380 Social Security and Private Savings 381 Living Standards of the Elderly 381 EmPIRICal EvIdEnCE Measuring the Crowd-Out Effect

of Social Security on Savings 382 13.3 Social Security and Retirement 383 Theory 383

Evidence 384 aPPlICatIon Implicit Social Security Taxes and Retirement Behavior 387

Implications 389 13.4 Social Security Reform 389 Reform Round I: The Greenspan Commission 390 aPPlICatIon The Social Security Trust Fund and National Savings 391

Incremental Reforms 391 Fundamental Reform: Privatization 395 aPPlICatIon Company Stock in 401(k) Plans 397 aPPlICatIon Mixed Proposals for Social Security Reform 399

13.5 Conclusion 400 Highlights 400 Questions and Problems 400 Advanced Questions 401

Disability Insurance, and

14.1 Institutional Features of Unemployment Insurance, Disability Insurance, and Workers’

Compensation 405 Institutional Features of Unemployment Insurance 405

Institutional Features of Disability Insurance 407

Institutional Features of Workers’ Compensation 408

Comparison of the Features of UI, DI, and WC 410

ApplicAtion The Duration of Social Insurance

Benefits Around the World 410

14.2 Consumption-Smoothing Benefits of

Social Insurance Programs 412

14.3 Moral Hazard Effects of Social Insurance

Evidence for Moral Hazard in DI 416

EmpiricAl EvidEncE Disability Insurance Screening

and Labor Supply 418

Evidence for Moral Hazard in WC 420

EmpiricAl EvidEncE Moral Hazard Effects of

The “Benefits” of Partial Experience Rating 423

ApplicAtion The “Cash Cow” of Partial Experience

Rating 424

Workers’ Compensation and Firms 425

14.5 Implications for Program Reform 425

Economics and Private

15.2 How Generous Should Insurance

Be to Patients? 450 Consumption-Smoothing Benefits of Health Insurance for Patients 451

Moral Hazard Costs of Health Insurance for Patients 452

How Elastic Is the Demand for Medical Care? The RAND Health Insurance Experiment 455

EmpiricAl EvidEncE Estimating the Elasticity of Demand for Medical Care 456

Optimal Health Insurance 458 Why Is Insurance So Generous in the United States? 459

ApplicAtion Health Savings Accounts 460 15.3 How Generous Should Insurance

Be to Medical Providers? 463 Managed Care and Prospective Reimbursement 463 The Impacts of Managed Care 465

How Should Providers Be Reimbursed? 466 15.4 Conclusion 466

Highlights 467 Questions and Problems 467 Advanced Questions 468

Medicaid, and Health Care

16.2 What Are the Benefits of the Medicaid Program? 475

Does Medicaid Provide Financial Protection? 475 Does Medicaid Improve Health? 476

How Does Medicaid Affect Health? Evidence 477 EmpiricAl EvidEncE Using State Medicaid Expansions to Estimate Program Effects 479 16.3 The Medicare Program 480

How Medicare Works 480 aPPlICatIon The Medicare Prescription Drug Debate 482

16.4 What Are the Effects of the Medicare

Program? 484

The Prospective Payment System 485 Empirical Evidence on the Move to the PPS 485 Problems with PPS 486

EmPIRICal EvIdEnCE Short Stays in Long-Term Care Hospitals 488

Lesson: The Difficulty of Partial Reform 488 Medicare Managed Care 490

Should Medicare Move to a Full Choice Plan?

Premium Support 492 aPPlICatIon A Premium Support System for Medicare 493

Gaps in Medicare Coverage 495 16.5 Long-Term Care 495

Financing Long-Term Care 496 16.6 Health Care Reform in the United

States 497

The Historical Impasse 497 The Massachusetts Experiment with Incremental Universalism 499 The Affordable Care Act 500 aPPlICatIon Rising Health Care Costs and Cost Control Efforts in the ACA 502

Projected Impacts of the ACA and Early Evidence

on Its Effects 505 16.7 Conclusion 506

Highlights 507 Questions and Problems 507 Advanced Questions 508

17.1 Facts on Income Distribution in the

United States 514

Relative Income Inequality 514 Absolute Deprivation and Poverty Rates 516 aPPlICatIon Problems in Poverty Line Measurement 518

What Matters—Relative or Absolute Deprivation? 519

17.2 Welfare Policy in the United States 520

Cash Welfare Programs 521 In-Kind Programs 522 17.3 The Moral Hazard Costs of Welfare

aPPlICatIon An Example of Ordeal Mechanisms 534

Increasing Outside Options 534 EmPIRICal EvIdEnCE The Canadian Self-Sufficiency Project 537

EmPIRICal EvIdEnCE Child Care, Preschool, and Child Outcomes 538

aPPlICatIon Evaluating the 1996 Welfare Reform 541

17.5 Conclusion 544 Highlights 545 Questions and Problems 545 Advanced Questions 546

PaRt Iv

Taxation in Theory and Practice

18.1 Types of Taxation 551 Taxes on Earnings 551 Taxes on Individual Income 551 Taxes on Corporate Income 551 Taxes on Wealth 551

Taxes on Consumption 552 Taxation Around the World 552 18.2 Structure of the Individual Income Tax in the United States 553

Computing the Tax Base 554 Tax Rates and Taxes Paid 555 aPPlICatIon Fixing the AMT 557 18.3 Measuring the Fairness of Tax Systems 558

Average and Marginal Tax Rates 559 Vertical and Horizontal Equity 560 Measuring Vertical Equity 561 aPPlICatIon The Political Process of Measuring Tax Fairness 561

18.4 Defining the Income Tax Base 562

The Haig-Simons Comprehensive Income

Definition 563

Deviations due to Ability-to-Pay Considerations 564

Deviations due to Costs of Earning Income 564

aPPlICatIon What Are Appropriate Business

Deductions? 565

18.5 Externality/Public Goods Rationales

for Deviating from Haig-Simons 566

Charitable Giving 566

Spending Crowd-Out Versus Tax Subsidy Crowd-In 567

Consumer Sovereignty Versus Imperfect

Information 569

Housing 570

EmPIRICal EvIdEnCE The Social Benefits

of Homeownership 572

Tax Deductions Versus Tax Credits 573

aPPlICatIon The Refundability Debate 574

Bottom Line: Tax Expenditures 576

18.6 The Appropriate Unit of Taxation 577

The Problem of the “Marriage Tax” 577

Marriage Taxes in Practice 579

18.7 Conclusion 581

Highlights 581

Questions and Problems 581

Advanced Questions 582

19.1 The Three Rules of Tax Incidence 587

The Statutory Burden of a Tax Does Not Describe

Who Really Bears the Tax 587

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

Irrelevant to the Distribution of the Tax Burdens 589

Parties with Inelastic Supply or Demand Bear

Taxes; Parties with Elastic Supply or Demand Avoid

Them 592

Reminder: Tax Incidence Is About Prices, Not

Quantities 595

19.2 Tax Incidence Extensions 596

Tax Incidence in Factor Markets 596

Tax Incidence in Imperfectly Competitive Markets 599

Balanced Budget Tax Incidence 601

19.3 General Equilibrium Tax Incidence 602

Effects of a Restaurant Tax: A General Equilibrium

Example 602

Issues to Consider in General Equilibrium Incidence

Analysis 605

19.4 The Incidence of Taxation

in the United States 607 EmPIRICal EvIdEnCE The Incidence of Taxation: Real- World Complications 608

CBO/TPC Incidence Assumptions 608 Results of CBO/TPC Incidence Analysis 610 Current Versus Lifetime Income Incidence 612 19.5 Conclusion 613

Highlights 613 Questions and Problems 614 Advanced Questions 614

Implications for Optimal

aPPlICatIon The Deadweight Loss of Taxing Wireless Communications 633

20.2 Optimal Commodity Taxation 633 Ramsey Taxation: The Theory of Optimal Commodity Taxation 634

Inverse Elasticity Rule 635 Equity Implications of the Ramsey Model 635 aPPlICatIon Price Reform in Pakistan 636 20.3 Optimal Income Taxes 639

A Simple Example 640 General Model with Behavioral Effects 640

An Example 643 20.4 Tax-Benefit Linkages and the Financing

of Social Insurance Programs 644 The Model 644

Issues Raised by Tax-Benefit Linkage Analysis 647 EmPIRICal EvIdEnCE A Group-Specific Employer Mandate 648

20.5 Conclusion 649 Highlights 649 Questions and Problems 649 Advanced Questions 650

ChaPtER 21 Taxes on Labor Supply 657

21.1 Taxation and Labor Supply—Theory 659

Basic Theory 659 Limitations of the Theory: Constraints on Hours Worked and Overtime Pay Rules 662

21.2 Taxation and Labor Supply—Evidence 662

Limitations of Existing Studies 663 EmPIRICal EvIdEnCE Estimating the Elasticity of Labor Supply 663

21.3 Tax Policy to Promote Labor Supply:

The Earned Income Tax Credit 666

Background on the EITC 667 Impact of EITC on Labor Supply: Theory 668 Impact of EITC on Labor Supply: Evidence 670 EmPIRICal EvIdEnCE The Effect of the EITC on Single-Mother Labor Supply 672

Summary of the Evidence 673 aPPlICatIon EITC Reform 673 21.4 The Tax Treatment of Child Care and Its

Impact on Labor Supply 675

The Tax Treatment of Child Care 675 EmPIRICal EvIdEnCE The Effect of Child Care Costs

on Maternal Labor Supply 676 Options for Resolving Tax Wedges 678 Comparing the Options 678

21.5 Conclusion 679

Highlights 680 Questions and Problems 680 Advanced Questions 681

22.1 Taxation and Savings—Theory

and Evidence 685

Traditional Theory 685 Evidence: How Does the After-Tax Interest Rate Affect Savings? 688

Inflation and the Taxation of Savings 690 22.2 Alternative Models of Savings 692

Precautionary Savings Models 692 Self-Control Models 693

EmPIRICal EvIdEnCE Social Insurance and Personal Savings 694

22.3 Tax Incentives for Retirement

Highlights 710 Questions and Problems 710 Advanced Questions 711

23.1 Taxation and Risk Taking 715 Basic Financial Investment Model 715 Real-World Complications 716 Evidence on Taxation and Risk Taking 718 Labor Investment Applications 718 23.2 Capital Gains Taxation 719 Current Tax Treatment of Capital Gains 719 What Are the Arguments for Tax Preferences for Capital Gains? 721

What Are the Arguments Against Tax Preferences for Capital Gains? 726

aPPlICatIon Capital Gains Taxation of “Carried Interest” 726

23.3 Transfer Taxation 727 Why Tax Wealth? Arguments for the Estate Tax 729

Arguments Against the Estate Tax 730 23.4 Property Taxation 732 Who Bears the Property Tax? 733 Types of Property Taxation 734 aPPlICatIon Property Tax Breaks to Businesses 735

23.5 Conclusion 737 Highlights 737 Questions and Problems 737 Advanced Questions 738

aPPlICatIon Executive Compensation and the

Agency Problem 742

Firm Financing 745

Why Do We Have a Corporate Tax? 746

24.2 The Structure of the

Corporate Tax 747

Revenues 747

Expenses 747

aPPlICatIon What Is Economic Depreciation? The

Case of Personal Computers 749

Corporate Tax Rate 750

Negative Effective Tax Rates 757

Policy Implications of the Impact of the Corporate

Tax on Investment 757

Evidence on Taxes and Investment 758

24.5 The Consequences of the Corporate Tax

for Financing 758

The Impact of Taxes on Financing 758

Why Not All Debt? 760

EmPIRICal EvIdEnCE How Do Corporate Taxes Affect

a Firm’s Financial Structure? 763

The Dividend Paradox 763

How Should Dividends Be Taxed? 764

aPPlICatIon The 2003 Dividend Tax Cut 765

Corporate Tax Integration 766

24.6 Treatment of International Corporate

Income 767

How to Tax International Income 767

aPPlICatIon A Tax Holiday for Foreign Profits 768

aPPlICatIon The A(pple) B(urger King) C(aterpillar)s of

Avoiding Corporate Taxes in a Global System 771

24.7 Conclusion 773

Highlights 773

Questions and Problems 774

Advanced Problems 775

25.1 Why Fundamental Tax Reform? 779 Improving Tax Compliance 779

aPPlICatIon Tax Evasion 779 aPPlICatIon The 1997 IRS Hearings and Their Fallout for Tax Collection 783

Making the Tax Code Simpler 784 Improving Tax Efficiency 786 Summary: The Benefits of Fundamental Tax Reform 789

25.2 The Politics and Economics of Tax Reform 789

Political Pressures for a Complicated Tax Code 790 Economic Pressures Against Broadening the Tax Base 790

aPPlICatIon Grandfathering in Virginia 793 The Conundrum 794

aPPlICatIon TRA 86 and Tax Shelters 794 25.3 Consumption Taxation 795 Why Might Consumption Make a Better Tax Base? 795

Why Might Consumption Be a Worse Tax Base? 798 Designing a Consumption Tax 801

Backing into Consumption Taxation: Cash-Flow Taxation 803

25.4 The Flat Tax 804 Advantages of a Flat Tax 805 Problems with the Flat Tax 805 aPPlICatIon The Camp Tax Reform Proposal 807 25.5 Conclusion 808

Highlights 809 Questions and Problems 809 Advanced Questions 810

Glossary G-1

References R-1

Index i-1

When I began writing this book 12 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 in the media every day By presenting rigorous

theory, cutting-edge empirical evidence, and abundant policy-relevant

appli-cations, I hoped that students would find the main lessons of public finance

accessible and appealing—perhaps even enjoyable

With the success of the first four 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

evi-dence, Public Finance and Public Policy has enabled instructors to better engage

their students Whenever a major theoretical concept is discussed, the

discus-sion is augmented by examples of the policy relevance of the topic and, where

available, evidence about the key relationships highlighted by the theory

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

in three ways

Updated Selection of Topics

Any public finance textbook must pay a great deal of attention to issues of

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

this book is no exception Yet I also cover in detail the transfer and social

insurance programs that dominate government activity The text is organized

around four key areas:

n Introduction and Background The first section of the book is devoted

to motivating the study of public finance, beginning in Chapter 1 with

a timely discussion of the debate over health care reform and the Affordable Care Act, as well as other major public policy debates

of the day

The book then reviews background skills in Chapter 2 (micro- economic theory), Chapter 3 (empirical methodology), and Chapter 4 (government budgeting) I recognize that students come to their pub-lic finance courses with highly varying levels of skill in economics

This course requires familiarity with introductory microeconomics, but no more than that All other required skills are reviewed in these background chapters Chapter 3, on empirical methods, provides stu-dents with all the background they need to interpret the Empirical Evidence boxes throughout the text The early discussion in Chapter 4

of the budget’s role in policy debates allows the presentation of other

topics (such as Social Security and tax policy) throughout the book to incorporate the importance of budgetary concerns.

n Externalities and Public Goods The discussion of externalities begins

in Chapter 5 with a discussion of private and public solutions to the problem of externalities I then continue in Chapter 6 by focusing on the two major public policy issues involving externalities: environ-mental externalities, such as acid rain and global warming, and health externalities, such as smoking and obesity

The section on public goods begins in Chapter 7 with a discussion

of private and public solutions to the public goods problem and then highlights two of the major issues in public provision: cost-benefit anal-ysis (Chapter 8) and political economy (Chapter 9)

Chapter 10 examines the role of state and local governments as viders of public goods, highlighting the potential efficiencies and costs

pro-of decentralization Chapter 11 expands on these ideas by discussing education, one of the most important public goods in the United States

n Social Insurance and Redistribution I have been gratified that tors have responded positively to this book’s expanded discussion of social insurance and redistribution, the largest and fastest-growing function of government This section begins with a novel chapter on the theory of social insurance: Chapter 12 highlights the reasons we have social insurance, its role in crowding out private self-insurance, and the problems of moral hazard

instruc-I then include a separate chapter on the nation’s largest social ance program, Social Security (Chapter 13), and another on the three other nonhealth social insurance programs: unemployment insurance, disability insurance, and workers’ compensation (Chapter 14)

insur-Given the enormous and growing role of government in the sion of health care, I devote two chapters to this topic, first discussing the nature of health insurance and health economics in Chapter 15 and then focusing on the government’s role in Chapter 16, in particular highlight-ing the development, structure, and impacts of the Affordable Care Act

provi-Finally, Chapter 17 discusses the role of government as a tive agent through welfare programs

redistribu-n Taxation in Theory and Practice The feedback on my presentation

of taxation has been very positive The coverage begins in Chapter

18 with the key institutional features and theoretical concepts (such

as vertical equity and the Haig-Simons tax base) that are central to understanding tax policy The next two chapters cover the theoretical underpinnings of tax incidence (Chapter 19) and tax efficiency analysis (Chapter 20)

The next three chapters focus on the behavioral responses of viduals to income taxation and discuss key tax policies that affect those behaviors: labor supply and the EITC (Chapter 21); savings and tax-subsidized retirement savings (Chapter 22); and the distribution of asset holdings and capital gains, estate, and property taxes (Chapter 23)

indi-Chapter 24 presents an overview of the corporate income tax and reviews the key equity and efficiency issues that are the focus of cor-porate tax debates Finally, Chapter 25 concludes by discussing the motivations for, barriers to, and approaches to fundamental reform

of taxation policies in the United States, including the possibility of replacing income with consumption taxation

Integration of Policy Applications

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

compel-ling 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 58 separate policy applications spread throughout the

book to emphasize the importance of the material These applications cover

topics such as the difficulties that policy makers face in valuing human life in

cost-benefit analysis, the problem of rising health care costs and attempts to

address them in the Affordable Care Act, appropriate and inappropriate

busi-ness deductions under the income tax, and recent efforts by multinational

corporations to evade taxation of profits 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

pre-sentation 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

Throughout the text, whenever a major theoretical point is made, I discuss the

relevant 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 have

been exposed to sophisticated empirical methods

I have also included 32 Empirical Evidence boxes, which discuss in

more detail the studies that underlie the empirical results presented in the

text and illustrate for students the process of research and the methods by

which empirical economists answer central policy questions I am gratified

that the inclusion of these boxes has 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 cally depends on the exposition and presentation I have endeavored through-out the text to use a student-friendly, conversational style that emphasizes the intuition, graphics, and mathematics of theory Instructors using the book have

criti-reported that their students have found Public Finance and Public Policy to be

an accessible, illuminating, and engaging read Several features make this book appealing to potential users:

n Questions to Keep in Mind New to this edition, these questions, found at the start of each chapter, alert students to the chapter’s “big ideas,” thus helping them organize the many ideas presented in the chapter

n Integrated Applications As noted earlier, the 58 Applications in this

text allow students to step back from the main text and appreciate the policy relevance of the material These applications are integrated directly with the text, rather than set aside, so that students understand the importance of applying the material they are learning

n Empirical Evidence Boxes For instructors who wish to explore in

more depth the nature of the empirical findings mentioned in the text, Empirical Evidence boxes are set aside from the main text to explain carefully the research process that generates the major empirical find-ings in public finance

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

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

n Quick Hints Throughout the text are a variety of highlighted Quick Hints to emphasize the intuition of key theoretical points that students often find difficult: How does one decide where to draw deadweight loss triangles (see page 54)? Why is the subsidy to employer-provided health insurance a subsidy to employees and not to employers (see page 445)? How can the income effect of higher wages cause lower levels of labor supply (see page 660)?

n Mathematical Appendices The text explains the material primarily

through intuition and graphics, with relatively little reliance on ematics Nevertheless, many instructors want to use mathematics to 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

math-n Marginal Definitions Key terms are boldfaced throughout the text, and marginal definitions allow students to focus on the key concepts

n Full-Color Graphics Full-color graphics allow students to better

understand the graphical analysis that is so often confusing to them

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

and concepts from the material in that chapter

n 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 fifth edition

What’s New in the Fifth 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 This has involved the updating of hundreds of facts and

figures In addition, a number of major changes were made throughout the

book, including new applications, updating of existing chapter introductions,

applications and empirical examples, and a number of new and thoroughly

updated text discussions Of particular note is the large number of new or

updated Empirical Evidence boxes, reflecting the exciting recent

develop-ments in empirical work in public finance and incorporating more graphical

evidence to illustrate directly how the methodologies are applied

Highlights of the changes include the following:

n All chapters now begin with “questions to keep in mind,” which

high-light the key issues raised in the chapter

n To complement the text’s thorough revision, the end-of-chapter

prob-lems have been significantly revised and updated

n Chapter 1: An updated introduction focuses on the ongoing debate

over the Patient Protection and Affordable Care Act (ACA), and the application on the externalities of measles has been updated to reflect the role of recent outbreaks

n Chapter 4: This chapter contains an updated discussion of political

efforts to balance the budget, an updated discussion of dynamic ing (to reflect the increased emphasis on this topic at the Congressional Budget Office), and a new Application that uses a sports contract to illustrate the calculation of present discounted value The chapter has also been streamlined by removing the specific discussion of generation-

scor-al accounting and focusing more broadly on the intertemporscor-al budget constraint

n Chapter 6: An updated chapter introduction focuses on major

develop-ments in government regulation of greenhouse gases in recent years

The discussion of global warming includes a number of policy updates (including U.S.–China negotiations) and a new discussion of alterna-tive approaches to mediating global warming The section on illicit drugs includes a discussion of recent evidence on marijuana legaliza-tion And the Application on obesity incorporates new evidence on which policy tools work and which do not in this important public health arena.

n Chapter 7: This chapter features a new discussion about Wikipedia in the Application entitled “The Free Rider Problem in Practice.” The materials on privatization of public services have been moved from Chapter 9 to this chapter and expanded to incorporate exciting new examples of failure (halfway houses) and success (health insurance contracting)

n Chapter 8: This chapter features a new introduction focused on the benefit analysis behind recent decision of California to expand its high-speed rail system It also includes a new Empirical Evidence box that discusses the use of a state police layoff to value the cost of saving a life

cost-n Chapter 9: The chapter includes updates on lobbying and farm policy

in the United States as well as a major update to the Empirical dence box on testing the median voter model The discussion of privatization has been moved to Chapter 7 and has been replaced by another example and expanded discussion of government failure

Evi-n Chapter 10: The introduction has been updated to follow recent policy debates over the No Child Left Behind law

n Chapter 11: The updated introduction incorporates the recent versy over the educational Common Core, and the evidence on public school choice and private vouchers has also been substantially updated

contro-The section on higher education has been augmented with a sion of the exploding burden of student loan interest (a topic near and dear to the heart of many students)

discus-n Chapter 12: The Application on flood insurance has been extensively updated, and the discussion of consumption smoothing has been streamlined The moral hazard discussion includes the recent example

of the star of National Geographic’s TV show Wicked Tuna.

n Chapter 13: The section on Social Security reform has been nized to highlight the distinct issue of privatization and to update that discussion

reorga-n Chapter 14: The introduction has been updated to follow ployment insurance policy in recent years, and the discussion of

unem-UI durations around the world reflects recent international policy developments The discussion of consumption smoothing includes exciting new evidence on disability insurance, and the Empirical Evidence box on disability insurance has been completely rewritten

to highlight important recent work, including a new graphical presentation

n Chapter 15: There is a new Application on finding the inefficiency in

U.S health care that emphasizes international comparisons of health care spending and proposes theories for the difference This Applica-tion includes new graphs that compare international health care out-comes and prices All institutional details and facts have been updated

to reflect the early impacts of the ACA And the Empirical Evidence box on estimating the elasticity of medical care has been expanded to incorporate new findings and present them graphically

n Chapter 16: The introduction has been rewritten to highlight the

ongoing debate over the ACA, and the institutional features of the Medicaid and Medicare programs are updated to reflect the effects of health reform The section on Medicaid includes a more sophisticated discussion of consumption-smoothing benefits and coverage of recent evidence on health impacts A new Empirical Evidence box discusses and presents graphical evidence on how long-term care hospitals manipulate length of stay to maximize reimbursement And there is a brand new discussion of early evidence on the impacts of the ACA

n Chapter 17: A new introduction uses the recent protests in Baltimore

as motivation to look at inequality in that city and the nation as a whole The chapter features updated data on and discussion of the measurement of income and wealth inequality And there is a new Empirical Evidence box focused on the policy-relevant topic of child care, pre-school, and child outcomes

n Chapter 18: The chapter introduction updates the debates over tax

policy, and the chapter includes an updated discussion of consumer sovereignty in charitable donations

n Chapter 19: There is a complete revision and expansion of the

Empirical Evidence box on the incidence of taxation to highlight recent interesting work on the relevance of the statutory incidence

of taxation

n Chapter 20: A new Empirical Evidence box on the British “Window

Tax” vividly illustrates the distortionary effects of public policies in eighteenth-century England

n Chapter 21: The Empirical Evidence box on estimating the elasticity of

labor supply has been extended to incorporate and graphically strate exciting new developments in kinked budget constraint estimation

demon-n Chapter 22: The Empirical Evidence box entitled “Estimating the

Impact of Tax Incentives on Savings” has been completely revised to reflect and graphically illustrate exciting advances in this area

n Chapter 24: There is a new Empirical Evidence box highlighting

recent research on how corporate taxes affect firm financial structure, while the Empirical Evidence box on the 2003 dividend tax cut has been extended to incorporate new evidence on investment responses

There is a (cleverly titled and very policy relevant) new Application on the efforts of multinational corporations to avoid U.S corporate taxes

n Chapter 25: The new chapter title reflects the important role that sumption taxation plays in the discussion The tax evasion discussion includes updated evidence from Greece, while a new figure illustrates the growing complexity of the U.S tax code over time The final poli-

con-cy Application has been completely updated to focus on a recent prehensive tax reform proposal by former Congressman Dave Camp

com-Supplements and Media Package

For instructors, the catalog site (http://macmillanhighered.com/Catalog/

product/publicfinanceandpublicpolicy-fifthedition-gruber) provides the lowing downloadable resources:

fol-n Test Bank The Test Bank, revised this edition by Susan Dadres (University

of North Texas), provides a range of questions appropriate for assessing your students’ comprehension, interpretation, analysis, and synthesis skills

The Test Bank offers multiple-choice and short-answer questions designed for comprehensive coverage of the text concepts Questions are catego-rized according to difficulty level (easy, medium, and challenging) and skill descriptor (fact-based, definitional, concept-based, critical thinking, analyti-cal thinking) and are tagged to their appropriate textbook section

n Lecture Slides A series of lecture slides, revised by Heather Luea (Kansas State University), provides comprehensive coverage of the material in each chapter The slides are designed to assist with lecture preparation and presentations by incorporating key graphs from the textbook with detailed outlines of key concepts The slides can be customized to suit instructors’ individual needs and serve as a fantastic resource when building a lecture presentation

n Images from the Textbook Instructors have access to every figure and table in the new edition in high-resolution JPEG format and in the form of PowerPoint slides

n Solutions Manual Instructors have access to the files for the detailed solutions to the text’s end-of-chapter problems

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 to those I have forgotten

My initial debts are to the teachers and colleagues who taught me public finance: Peter Diamond, Marty Feldstein, Jim Poterba, and especially Larry Summers, 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 my field, and I hope that I can do them justice in passing on their insights to the next generation of public finance economists I am also grate-

ful to Larry Summers for making it possible for me to work at the Treasury

Department in 1997–1998, which gave me an appreciation of the power of

public finance analysis and the importance of educating our future

genera-tions of policy makers in the right way so that they can think about all aspects

of public finance 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 of this

material is because of the hard questions they asked over the years, and I only

wish I could have done them the service of teaching the material as well as

I am now able to do Several of my students also helped in working on the

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

Seif, and Chris Smith for their assistance

I am also extremely grateful to the hardworking and enthusiastic team at

Worth Publishers who made this book possible Carlise Stembridge,

execu-tive 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 Carlos Marin, editorial assistant

Sha-ron Balbos, executive development editor, worked creatively, tirelessly, quickly,

efficiently, and with good humor and intense attention to detail to ensure that

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

Lindsay Neff for developing the supplements package Thanks to Tom

Digia-no, marketing manager

I am fortunate to have had such a talented production and design group

working on this edition Susan Wein, Senior Production Supervisor, coordinated

the entire production process with the help of Lisa Kinne, Managing Editor, and

Julio Espin, Project Editor Liaison A special thanks goes to Lauren Hill at MPS

North America LLC, who was an excellent partner in the production process and

who helped us to publish the book on time Vicki Tomaselli created the beautiful

cover and interior design, and Cecilia Varas helped with photos Finally, thanks to

Edgar Doolan, who helped finalize content for the book’s supplements

This entire project was feasible because of the assistance of several colleagues

who generously devoted their time to checking the text carefully and to

round-ing out the package of materials Thank you to Matthew Rutledge (Boston

College) and Daniel Sacks (the Wharton School, University of Pennsylvania)

for their accurate checking of work 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 (University of New Mexico) and Casey Rothschild provided

the elegant solutions to the end-of-chapter problems Thank you to Dean Jens

(Rutgers University) for his suggested revisions to many of the text problems

A huge number of colleagues were very receptive when pestered for

ques-tions, 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 tute), Ricardo Caballero (MIT), Chris Carroll (Johns Hopkins University), Amitabh Chandra (Dartmouth College), Gary Claxton (Kaiser Family Foun-

Insti-dation), Robert Coen (Northwestern University), 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 University), Esther Duflo (MIT), Jae Edmonds (Pacific Northwest National Laboratory), Gary Engelhardt (Syracuse University), Roger Feldman (University of Minnesota), Martin Feldstein (Harvard University), David Figlio (University of Florida), Amy Fin-kelstein (Harvard University), Alan Garber (Stanford University), Bill Gentry (Williams College), David Green (University of British Columbia), Michael Greenstone (MIT), Jerry Hausman (MIT), Vivian Ho (Rice University), Caroline Hoxby (Harvard University), Hilary Hoynes (University of California

at Berkeley), Paul Joskow (MIT), Larry Katz (Harvard University), Melissa Kearney (Wellesley College), Barrett Kirwan (Cornell University), Wojciech Kopczuk (Columbia University), Botond Koszegi (University of California

at Berkeley), Jeff Leibman (Harvard University), Phil Levine (Wellesley lege), Larry Levitt (Kaiser Family Foundation), Brigitte Madrian (University

Col-of Pennsylvania), Kathleen McGarry (UCLA), Bruce Meyer (University Col-of Chicago), Kevin Milligan (University of British Columbia), Sendhil Mullaina-than (Harvard University), Robert Moffitt ( 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 Institution), Leslie Papke (Michigan State Universi-ty), Franco Perrachi (Tor Vegatta University), Jim Poterba (MIT), Matt Rabin (University of California at Berkeley), Joshua Rauh (University of Chicago), Craig Ridell (University of British Columbia), Casey Rothschild (MIT), Ceci Rouse (Princeton University), Emmanuel Saez (Berkeley), Jesse Shapiro (Har-vard University), Karl Scholz (University of Wisconsin), Kosali Simon (Cor-nell University), Jon Skinner (Dartmouth College), Joel Slemrod (University

of Michigan), Kent Smetters (University of Pennsylvania), Jim Snyder (MIT), Rob Stavins (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 rific colleagues who were willing to give their time and energy to for-mal reviews of the textbook They include Kathleen Adams (Emory University), David Agrawal (University of Georgia), 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), Michael Cote (Uni-versity of Southern Maine), Susan Dadres (University of North Texas), Arlene Geiger ( John Jay College), Seth Giertz (University of Nebraska–

ter-Lincoln), Ronald Ginsberg (University at Albany, State University of

New York), Jessica Hennessey (University of Maryland), Gary Hoover

(Univer-sity of Alabama), Michael Jerison (SUNY Albany), Janet L Johnson (Georgia

State University), Kyoungrae (Jeah) Jung (The Pennsylvania State University),

Shawn D Knabb (Western Washington University), Paul Koch (Olivet Nazarene

University), Marc Law (University of Vermont), Lee Lockwood

(Northwest-ern University), Robert McComb (Texas Tech University), Mikhail Melnik

(Niagara University), Paul Menchik (Michigan State University), Erin Moody

(University of Maryland), Robert L Moore (Occidental College), Ramiro

Malaga Ortega (Stony Brook University), Florenz Plassmann

(Bingham-ton University-SUNY), Nirupama Rao (New York University), Deborah

A Savage (Southern Connecticut State University), Mark Scanlan (Stephen

F Austin State University), Atindra Sen (Miami University), John Straub (Tufts

University), Michael Stroup (Stephen F Austin State University), Mehmet

S Tosun (University of Nevada, Reno), Roberta W Walsh (Florida Gulf Coast

University), Gregory Wassall (Northeastern University), Joann Weiner (George

Washington University), James A Willde (University of North Carolina–

Chapel Hill), and Janine Wilson (University of California, Davis)

Several individuals stand out above the others in facilitating the book as you

see it now: My development editor, Jane Tufts, has worked on all five editions

of this book and is responsible for taking my sometimes-incoherent babble and

turning it into helpful exposition Her ability to understand what I am

try-ing to say, even when I’m not exactly saytry-ing it, and translate it into clear 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 examples and

applications, in most cases turning up the ideal case study to illustrate the point

that 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 Gina Li and Tiffany Li for

helping provide background research for this edition, and I want to especially

thank Siena Harlin, who worked long hours to update the hundreds 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 pay her back for that

On March 23, 2010, President Barack Obama signed into law the

Patient Protection and Affordable Care Act, commonly known as the ACA This law proposed to transform the system of health care cover-age and financing in the United States

Under the ACA, the government was projected to spend nearly $1 trillion

on public health insurance and subsidies to private health insurance coverage

between 2010 and 2019 This spending would be offset by spending

reduc-tions on existing public insurance programs and new taxes on the medical

sector and the wealthy

As a result of the ACA, insurance companies can no longer discriminate

against sick patients, and individuals who can afford health insurance must

pur-chase it or pay a penalty In addition, dozens of new initiatives are being

under-taken in an attempt to control runaway health care spending in the United

States The Congressional Budget Office (CBO) projected that, when the ACA

was fully implemented in 2017, 26 million more Americans would have health

insurance and that the government’s deficit would fall by more than $100 billion

from passage in 2010 through 2019 On the other hand, the Centers for

Medi-care and Medicaid Services projected that the law would, at the same time,

raise health care spending in the United States by 1–2% by 2019.1

1 Gruber (2010) and CBO (2014).

Why Study Public

Finance?

Questions to keep in mind

■ What is public finance, and what are the key questions that the field

addresses?

■ What are the key facts about the size and growth of government

and the distribution of taxes and spending?

■ What are some of the most important policy debates in the United States?

1.1 The Four Questions

of Public Finance

1.2 Why Study Public 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

1.4 Conclusion

1

The ACA is likely the most important piece of social policy legislation enacted in the United States in the past 40 years Yet, despite its passage, the ACA continues to be debated ferociously in Congress, in the states, and in campaigns at all levels of government Supporters argue that the bill corrects failed insurance markets, reduces the economic burden on the uninsured, and moves to control health care costs in the long run Representative Nancy Pelosi, a Democrat who was Speaker of the House of Representatives during the initial debates over the ACA in 2009–2010, said the law was

personal for millions of families who’ve gone into bankruptcy under the weight of rising health care costs And it’s personal for 45,000 Americans and their families who have lost a loved one each year because they didn’t and couldn’t get health insurance Today, we have the opportunity to complete the great unfinished business of our society and pass health insur-ance reform for all Americans that is a right and not a privilege.2

President Obama made his argument that

This law will cut costs and make coverage more affordable for families and small businesses It’s reform that brings—that begins to bring down our gov-ernment’s long-term structural deficit It’s reform that finally extends the opportunity to purchase coverage to the millions who currently don’t have it—and includes tough new consumer protections to guarantee greater stability, security, and control for the millions who do have health insurance.3

Opponents of the legislation viewed the ACA as an unwarranted expansion

of government power into the health care sector—and an enormous sion of government spending at a time of record deficits Representative John Boehner, a Republican who succeeded Nancy Pelosi as Speaker of the House, issued a press release entitled “ObamaCare ‘Will Increase Spending, Increase Taxes, & Destroy Jobs in America,’ ” and said that,

expan-Between reports from the Kaiser Family Foundation and the Seattle Times

indicating that health care costs will skyrocket under ObamaCare, the ocrats’ claims that their government takeover of health care will make health insurance more affordable doesn’t pass the straight-faced test.4

Dem-After the vote to pass the ACA in 2010, Republican Representative Ron Paul said,

It was truly a sad weekend on the House floor as we witnessed further mantling of the Constitution, disregard of the will of the people, explosive expansion of the reach of government, unprecedented corporate favoritism, and the impending end of quality healthcare as we know it.5

2 Pelosi quotes available at http://www.democraticleader.gov/blog/?p=2209 and http://pelosi.house.gov /news/press-releases/2010/04/releases-April10-hos.shtml (2010).

3 Obama remarks at the Annual Conference of the American Medical Association, June 15, 2009; available

at http://www.whitehouse.gov/the-press-office/remarks-president-annual-conference-american-medical -association.

4 Boehner comments available at http://www.politifact.com/ohio/statements/2011/mar/31/john-boehner /house-speaker-john-boehner-labels-money-health-car/ (2011) and http://healthcarereform.procon.org/view answers.php?questionID=001526 (2015).

5 Paul comments available at http://2012election.procon.org/view.answers.election.php?questionID=1706 (2012).

The debate over the ACA has not slowed with the implementation of the

major provisions of the law in 2014 Significant problems in the roll-out of the

federal website that was the public face of the ACA and numerous complaints

of disruption among existing insurance relationships led to a further erosion in

public support for the law This low public support has been reflected in more

than 50 votes in the House of Representatives to repeal the law At the same time,

in the first year of the law’s implementation, it has been estimated that it reduced

the number of uninsured people by more than one-third, with more than

16 million Americans gaining coverage.6 Premiums for health insurance

pur-chased through the new health insurance exchanges were 15% below levels

pro-jected by the CBO in 2014 and grew at historically low rates in 2015 Thus, as

of 2015, the budgetary costs of the ACA were 20% below original projections.7

The controversies over the proper role of the government in dealing with

health care coverage and costs raise the fundamental questions addressed by the

branch of economics known as public finance The goal of public finance is to

understand the proper role of the government in the economy On the expenditures

side of public finance, we ask: What kind of services should the government

provide, if any? Why should the government be spending hundreds of billions of

dollars to provide health insurance to the uninsured (to cite just one example)?

More generally, why is the government the primary provider of goods and

services such as highways, education, and transfers to the unemployed, while

the provision of goods and services such as clothing, entertainment, and

prop-erty insurance is generally left to the private sector? On the revenue side of

public finance, we ask: How much should the government tax its citizens, and

how should that amount be related to the economic circumstances of those

individuals? What kinds of activities should be taxed or be given tax relief in

difficult times? What effect do taxes have on the functioning of the economy?

In the simplest terms, public finance is the study of the role of the

gov-ernment in the economy This is a very broad definition This study involves

answering the four questions of public finance:

■ When should the government intervene in the economy?

■ How might the government intervene?

■ What is the effect of those interventions on economic outcomes?

■ Why do governments choose to intervene in the way that they do?

In this section, we explore these four questions within the context of a specific

example: the market for health insurance, in which individuals pay a monthly

premium to insurance companies, in return for which insurance companies

pay the individuals’ medical bills if they are ill This is only one of many

mar-kets in which the government is involved, but it is a particularly useful example

public finance The study

of the role of the government

on economic outcomes? Why do governments choose to inter­

vene in the way that they do?

6 Enrollment details found at http://obamacarefacts.com/sign-ups/obamacare-enrollment-numbers (2015).

7 Kliff and Klein (2015).

because health care spending is the single largest and fastest-growing part of the U.S government’s budget.

When Should the Government Intervene in the Economy?

To understand the reason for government intervention, think of the economy

as a series of trades between producers (firms) and consumers A trade is cient if it makes at least one party better off without making the other party

effi-worse off The total efficiency of the economy is maximized when as many efficient trades as possible are made

The fundamental lesson of basic microeconomics is that, in most cases, the

competitive market equilibrium is the most efficient outcome for society—that is, it

is the outcome that maximizes the gains from efficient trades As discussed

in much more detail in Chapter 2, the free adjustment of prices guarantees that, in competitive market equilibrium, supply equals demand When supply equals demand, all trades that are valued by both producers and consumers are being made Any good that consumers value above its cost of production will

be produced and consumed; goods that consumers value at less than their cost

of production will not be produced or consumed

If the competitive market equilibrium is the most efficient outcome for society, why do governments intervene in the operation of some of these mar-kets? There are two reasons governments may want to intervene in market economies: market failures and redistribution

Market Failures The first motivation for government involvement in the

economy is the existence of market failures, problems that cause a market

economy to deliver an outcome that does not maximize efficiency out this book, we discuss a host of market failures that impede the operation

Through-of the market forces you learned about in basic microeconomics Here we briefly explore a failure in the health insurance market that may cause its equilibrium outcome to be inefficient

At first glance, the market for health insurance seems to be a standard book competitive market Health insurance is supplied by a large number of insurance companies and demanded by a large number of households In the market equilibrium where supply equals demand, social efficiency should be maximized: anyone who values health insurance above its cost of production

text-is able to buy insurance

In 2010, before the Affordable Care Act, there were 49 million persons without health insurance in the United States, or 18.5% of the non-elderly population (as we’ll discuss in Chapter 15, the elderly are provided univer-sal health coverage in the United States under the Medicare program).8 The existence of such a large number of uninsured does not, however, imply that the market doesn’t work After all, there are many more Americans who don’t have a large-screen TV, or a new car, or a home of their own That a small minority of the population is uninsured does not by itself prove that there is a

market failure A problem that

causes the market economy to

deliver an outcome that does

not maximize efficiency.

8 Employee Benefit Research Institute (2011).

problem in the market; it just implies that those without insurance don’t value

it enough to buy it at existing prices

Is this equilibrium outcome, which leaves 49 million people without health

insurance, the most efficient outcome for society? It may not be, as the

fol-lowing example shows Suppose that I am uninsured and, as a result, do not

get my yearly vaccination for influenza By not getting my flu shot, I increase

my risk of getting the flu and increase the risk of passing it on to all of the

students who come into contact with me and have not had flu shots If these

students become ill, their medical costs will rise, and their performance in class

will worsen Thus, the total or social value of health insurance is not just the

improvement it causes in my health but also the improvement it causes in my

students’ health, which lowers their medical costs and improves class

perform-ance Thus, I should have insurance if the total social value, both to myself and

to others with whom I have contact, exceeds the cost of that insurance

When I make my insurance decision, however, I don’t consider that total

social value, only the value to myself Suppose that I value the insurance at less

than its cost because I don’t mind getting the flu but that society values the

insurance at more than its cost because it is very costly for my students to go

to the doctor and to perform poorly in class if they get sick In this situation,

I won’t buy insurance, even though society (which includes me and my

stu-dents) would be better off if I did In this case, the competitive outcome has

not maximized total social efficiency

This is an example of a negative externality, whereby my decision imposes

on others costs that I don’t bear As a result of this negative externality,

I am underinsuring myself from society’s perspective because I don’t take into

account the full costs that my medical decisions impose on others We discuss

externalities in much more detail in Chapters 5 and 6, but this example

illus-trates the type of market failure that can cause the competitive equilibrium to

deliver a socially inefficient outcome Later chapters in the book discuss other

types of market failure as well

If the competitive equilibrium does not lead to the efficiency-maximizing

outcome, there is the potential for efficiency improvement through

govern-ment intervention Because the governgovern-ment can take into account not only

my costs and benefits but also the costs and benefits to others, the government

can compare the social costs to the social benefits more accurately and induce

me to buy insurance if the total benefits exceed the total costs As we

emphas-ize in answering the fourth question, however, the fact that the private market

outcome is not efficiency-maximizing does not imply that government

inter-vention will necessarily improve efficiency

Modern Measles Epidemics

One of the illnesses for which all children are supposed to be immunized is

measles Measles is transmitted from person to person by respiratory droplets

and is characterized by a high fever and severe rash that lasts five to six days

APPlICATIoN

In the early 1960s, there were thought to be 3–4 million cases annually in the United States, resulting in 500 reported deaths each year Other costs associ-ated with measles infection included medical expenditures and work time lost for parents in caring for sick children.

Then, in 1963, a measles vaccine was introduced Measles vaccination greatly reduces, but does not eliminate, the chance of contracting measles, and the vaccine can wear off over time if you don’t get periodic “booster” shots to reactivate the immunity As a result of the vaccine, measles cases had become relatively rare in the United States by the 1980s, with fewer than 3,000 cases reported per year and very few deaths

Over the period from 1989 to 1991, however, there was a huge resurgence in measles in the United States, with more than 50,000 cases and 123 deaths from

a disease thought to be largely eradicated This outbreak resulted from very low immunization rates among disadvantaged inner-city youths One-third of all of the new cases were in Los Angeles, Chicago, and Houston, and one-half of those children who contracted measles had not been immunized, even though many had regular contact with a physician These unimmunized children were impos-ing a negative externality on other children who had received their immuniz-ations but for whom immunization may have worn off There was a negative externality because the unimmunized children raised the risk that these other children would become sick, without bearing any of the costs of raising this risk

The federal government responded to this health crisis in the early 1990s, first through publicly encouraging parents to get their children immunized and then through an initiative that paid for the vaccines for low-income fam-ilies The result was impressive Immunization rates, which had never been above 70% before the epidemic, rose to 90% by 1995.9 And from 2001 to 2011, there were, on average, only 62 cases per year

But the problem of measles epidemics was back in the news in 2014 as the number of cases reached a level not seen since the early 1990s: 644 cases in 27 states.10 Most newsworthy was a measles outbreak in Disneyland in Anaheim,

California, in the winter of 2014–2015 From December 28, 2014, to March

13, 2015, 145 people from seven states had measles linked to the outbreak at Disneyland.11

The reason for this resurgence is the refusal of a large number of parents to immunize their children, despite the expansion of public education and the availability of low-cost immunization This refusal is often linked to a widely cited (but now completely discredited) relationship between childhood vac-

cinations and autism, based on a 1998 study in the British journal The Lancet

that claimed to have found such a relationship Subsequently, however, study after study has repudiated this finding, and the article was formally retracted

in 2010, with The Lancet editors announcing that it was “utterly clear, without

any ambiguity at all, that the statements in the paper were utterly false.”12

9 Discussion of 1989–1992 epidemic comes from Wood and Brunell (1995).

10 Belluz (2014).

11 Ellis (2015).

12 Lallanilla (2014).

Nevertheless, a strong “anti-vaccine” movement had taken root, resulting in

sizable pockets of nonimmunized children in some areas For instance, on

Vas-hon Island, Washington, 17% of kindergartners—greater than nine times the

national average13—failed to receive their shots in 2013 due to a “personal/

philosophical” exemption.14 A 2012 study of vaccine exemption policies across

the country found that of the 20 states that allow personal-belief

exemp-tions, 9 states make exemptions easy to obtain by simply requiring a form to

be signed Opt-out rates in states that allow personal-belief exemptions are

2.5 times as high as rates in states that only permit religious exemptions.15

Research has found that outbreaks are far more likely to happen in these areas

with lower vaccination rates.16

This new rise in measles has raised questions of whether government policy

needs to go further than the interventions of the early 1990s For example,

California recently enacted legislation that would make it more difficult for

parents to opt out of vaccinations for their children and requires children to be

vaccinated against specific contagious diseases before enrolling in California

schools.17 The balance for the government between ensuring public health

and respecting individual preferences is one of the more significant policy

issues that we discuss throughout this book ■

Redistribution The second reason for government intervention is

redistribution, the shifting of resources from some groups in society to others

Think of the economy as a pie, the size of which is determined by the social

efficiency of the economy If there are no market failures, then the private

mar-ket forces of demand and supply maximize the size of the pie; if there are marmar-ket

failures, there is the potential for the government to increase the size of the pie

The government may care not only about the size of the pie, however, but

also its distribution, or the size of each person’s slice For reasons we discuss in

Chapter 2, society may decide that the resource allocations provided by the

market economy are unfair; for example, society may view another dollar of

consumption by a very rich person as less valuable than another dollar of

con-sumption by a very poor person The primary way to correct such

misalloca-tions is through government intervenmisalloca-tions that redistribute resources from those

groups that society has deemed “too well off ” to those groups that society has

deemed “not well off enough.” For example, in the United States in 2010, 70%

of the uninsured were in families with incomes below $50,000 Thus, society

may feel that it is appropriate to redistribute from those with insurance, who

tend to have higher incomes, to those without, who tend to have lower incomes

In some cases, society can undertake redistributions that change only the

distribution of the pieces and not the size of the pie itself Usually, however,

redistributing resources from one group to another will entail efficiency losses

These losses occur because the act of redistribution causes individuals to shift

redistribution The shifting of

resources from some groups in society to others.

13 Centers for Disease Control and Prevention (2014).

14 Raja and Mooney (2014).

15 New England Journal of Medicine (2012).

16 Atwell (2013).

17 Martinez and Watts (2015).

their behavior away from the efficiency-maximizing point For example, if

we tax the rich to distribute money to the poor, then this tax may cause the rich to work less hard (because they don’t get to take home as much money from their work) and the poor to work less hard (because they don’t have to work as hard to maintain their living standards) When these groups work less hard, they don’t produce goods that would be valued by consumers at more than they cost to produce, so social efficiency is reduced

In general, then, there will be a trade-off between the size of the pie and

the distribution of the pie, which we call an equity–efficiency trade-off Societies

typically have to choose between pies that are larger and more unequally distributed and pies that are smaller and more equally distributed

How Might the Government Intervene?

Having decided whether to intervene, the next question is how the ment should do so There are several different general approaches that the gov-ernment can take to intervention

govern-Tax or Subsidize Private Sale or Purchase One way that the government

can try to address failures in the private market is to use the price mechanism,

whereby government policy is used to change the price of a good in one of two ways:

1 Through taxes, which raise the price for private sales or purchases of

goods that are overproduced, or

2 Through subsidies, which lower the price for private sales or purchases

of goods that are underproduced

Returning to the example of health insurance, one key element of the ACA is the subsidization of health insurance costs for low-income families, although those subsidies are delivered through the tax code as a tax credit that offsets the cost of insurance

Restrict or Mandate Private Sale or Purchase Alternatively, the ment can directly restrict private sale or purchase of goods that are over-produced or mandate private purchase of goods that are underproduced and force individuals to buy that good The ACA mandates that individuals purchase health insurance or face a tax penalty Many other nations, such as Germany and Switzerland, mandate that almost all citizens have health insur-ance coverage

govern-Public Provision Another alternative is to have the government provide the good directly in order to potentially attain the level of consumption that maximizes social welfare In the United States, more than one-quarter of the population has insurance that is provided to it directly by the government; in Canada and many other developed nations, the entire population of the coun-try has insurance that is provided directly by the government

Public Financing of Private Provision Finally, governments may want to influence the level of consumption but may not want to involve themselves directly in the provision of a good In such cases, the government can finance

private entities to provide the desired level of provision For example, the 2003

legislation to add a prescription drug benefit to the U.S Medicare insurance

program for the disabled and elderly involves federal government

reimburse-ment of private insurers to provide prescription drug insurance

As you can see, there is a wide spectrum of policy options When

consider-ing how to intervene, policy makers should evaluate alternative options

care-fully before deciding which option is best This evaluation leads naturally to

the third question: How can we evaluate alternative policy options?

What Are the Effects of Alternative Interventions?

Answering this third question requires that policy makers understand the

implications of each policy option under consideration This evaluation is the

focus of empirical public finance, which involves gathering data and

develop-ing statistical models to assess how people and firms might respond to policy

interventions We discuss empirical public finance in much more detail in

Chapter 3

In assessing the effects of government interventions, policy makers must

keep in mind that any policy has direct and indirect effects.

Direct Effects The direct effects of government interventions are those

effects that would be predicted if individuals did not change their behavior

in response to the interventions For example, suppose that in 2010, the

gov-ernment had decided to address the problem of the uninsured by providing

free public health care, as is done in the United Kingdom The government

computed that, with 49 million uninsured and an average cost of treating

each uninsured person of $2,500 per year, this intervention would cost about

$125 billion per year This is a huge amount, but it was much smaller than

existing spending on health care by the U.S government ($818 billion in

2010) According to this calculation, the government could have covered all of

the uninsured for less than 3.5% of the federal budget of $3.7 trillion.18

Indirect Effects The indirect effects of government intervention are

effects that arise only because individuals change their behavior in response

to the interventions For example, being uninsured is something that people

can change about themselves; it is not a fixed personal characteristic such as

being male or African American By providing free health care to those who

are uninsured, the government provides strong incentives for those paying for

their own health insurance to drop that insurance and take part in the

govern-ment’s free health care program

Suppose that half of the non-elderly who are privately insured behaved this

way This would add another 88 million persons to the pool using this public

source of health care If each person in this group also costs $2,500 on average,

the government cost of the program would almost triple to $340 billion per

year! On the other hand, if only 10% of the privately insured behaved this way,

the government cost of the program would rise to only $165 billion per year

direct effects The effects of

government interventions that would be predicted if individuals did not change their behavior in response to the interventions.

18 Office of Management and Budget (2006a), Table 3.1.

indirect effects The effects

of government interventions that arise only because indi­

viduals change their behavior

in response to the interventions.