Public finance and public policy jonathan gruber

212 Valuing Driving Time Saved 213 Application: The Problems of Contingent Valuation 214 Empirical Evidence: Valuing Time Savings 216 Valuing Saved Lives 216 Application: Valuing Life 21

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Massachusetts Institute of Technology

Jonathan Gruber

Worth Publishers

A Macmillan Higher Education Company

fourth edition

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Senior Vice President, Editorial and Production: Catherine Woods Publisher: Charles Linsmeier

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Printed in the United States of America

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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 He is an Associate Editor of both the Journal

of Public Economics and the Journal of Health Economics In 2009, he was elected

to the Executive Committee of the American Economic Association 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 economics He has published more than 140

research articles, has 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 architect of the ambitious health reform effort in Massachusetts, and in 2006 became an inaugural member of the Health Connector Board, the main implementing body for that effort During the 2008 election, he was a consultant to the Clinton, Edwards, and Obama Presidential campaigns 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

Think-ers of Our Time” by the online 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.

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Contents vii

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 183

8 Cost-Benefit Analysis 207

9 Political Economy 229

10 State and Local Government Expenditures 263

11 Education 291

PART III Social Insurance and Redistribution 12 Social Insurance: The New Function of Government 321

13 Social Security 355

14 Unemployment Insurance, Disability Insurance, and Workers’ Compensation 391 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 703

25 Fundamental Tax Reform 739

Glossary G-1 References R-1 Index I-1

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Contents vii

Preface xxvii

PART I Introduction and Background 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? 7 What Are the Effects of Alternative Interventions? 8 Application: The CBO: Government Scorekeepers 9 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 13 Distribution of Spending 16 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

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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

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

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

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3.3 Estimating Causation with Data We Actually

Get: Observational Data 71

Time Series Analysis 71 Cross-Sectional Regression Analysis 74 Quasi-Experiments 79 Structural Modeling 82 3.4 Conclusion 84

Highlights 84

APPendIx To ChAPTeR 3 Cross-Sectional Regression Analysis 87

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 96 Budget Policies and Deficits at the State Level 98 4.2 Measuring the Budgetary Position of the Government: Alternative Approaches 98

Real vs Nominal 98 Economic Conditions 100 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 104 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

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Highlights 119

PART II Externalities and Public Goods 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 134 Subsidies 135 Regulation 137 5.4 Distinctions Between Price and Quantity Approaches to Addressing Externalities 137

Basic Model 138 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

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6.1 Acid Rain 150

The Damage of Acid Rain 151 Empirical Evidence: Estimating the Adverse Health Effects of Particulates 152 History of Acid Rain Regulation 152 Has the CAA Been a Success? 155 6.2 Global Warming 155

Application: The Montreal Protocol 158 The Kyoto Treaty 158 Can Trading Make Kyoto More Cost-Effective? 159 What Does the Future Hold? 162 Application: Congress Takes on Global Warming 163 6.3 The Economics of Smoking 165

The Externalities of Smoking 167 Should We Care Only About Externalities, or Do “Internalities” Matter Also? 171 6.4 The Economics of Other Addictive Behaviors 174

Drinking 174 Illicit Drugs 175 Empirical Evidence: The Effect of Legal Drinking at Age 21 176 Application: Public Policy Toward Obesity 178 Summary 180 6.5 Conclusion 181

Highlights 181

CHAPTER 7 Public Goods .183

7.1 Optimal Provision of Public Goods 184

Optimal Provision of Private Goods 185 Optimal Provision of Public Goods 187 7.2 Private Provision of Public Goods 189

Private-Sector Underprovision 189

Application: The Free Rider Problem in Practice 191

Can Private Providers Overcome the Free Rider Problem? 192

Application: Business Improvement Districts 192

When Is Private Provision Likely to Overcome the Free Rider Problem? 194

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Measuring the Costs and Benefits of Public Goods 199 How Can We Measure Preferences for the Public Good? 199

Empirical Evidence: Measuring Crowd-Out 200

Highlights 202

APPendIx To ChAPTeR 7 The Mathematics of Public Goods Provision 204

CHAPTER 8 Cost-Benefit Analysis 207

8.1 Measuring the Costs of Public Projects 208

The Example 209 Measuring Current Costs 209 8.2 Measuring the Benefits of Public Projects 212

Valuing Driving Time Saved 213 Application: The Problems of Contingent Valuation 214 Empirical Evidence: Valuing Time Savings 216 Valuing Saved Lives 216 Application: Valuing Life 217 Discounting Future Benefits 222 Cost-Effectiveness Analysis 222 8.3 Putting It All Together 223

Other Issues in Cost-Benefit Analysis 223 8.4 Conclusion 225

Highlights 225

CHAPTER 9 Political Economy 229

9.1 Unanimous Consent on Public Goods Levels 231 Lindahl Pricing 231

Problems with Lindahl Pricing 233

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Majority Voting: When It Works 235

Majority Voting: When It Doesn’t Work 237

Arrow’s Impossibility Theorem 238

Restricting Preferences to Solve the Impossibility Problem 239

Median Voter Theory 241

The Potential Inefficiency of the Median Voter Outcome 241

Summary 242

9.3 Representative Democracy 242

Vote-Maximizing Politicians Represent the Median Voter 243 Assumptions of the Median Voter Model 244 Lobbying 246 Application: Farm Policy in the United States 247 Evidence on the Median Voter Model for Representative Democracy 249 Empirical Evidence: Testing the Median Voter Model 250 9.4 Public Choice Theory: The Foundations of Government Failure 251

Size-Maximizing Bureaucracy 251 Problems with Privatization 252 Application: Contracting Out with Noncompetitive Bidding 253 Leviathan Theory 255 Corruption 256 Application: Government Corruption 256 The Implications of Government Failure 259 9.5 Conclusion 259

Empirical Evidence: Government Failures and Economic Growth 260 Highlights 261

CHAPTER 10 State and Local Government Expenditures 263

10.1 Fiscal Federalism in the United States and Abroad 265

Spending and Revenue of State and Local Governments 266 Fiscal Federalism Abroad 268 10.2 Optimal Fiscal Federalism 269

The Tiebout Model 269

Problems with the Tiebout Model 271

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Proposition 13 276

10.3 Redistribution Across Communities 276

Should We Care? 278 Tools of Redistribution: Grants 279 Redistribution in Action: School Finance Equalization 284 Empirical Evidence: The Flypaper Effect 285 Application: School Finance Equalization and Property Tax Limitations in California 287 10.4 Conclusion 287

Highlights 288

CHAPTER 11 Education 291

11.1 Why Should the Government Be Involved in Education? 294

Productivity 294 Citizenship 295 Credit Market Failures 295 Failure to Maximize Family Utility 295 Redistribution 296 11.2 How Is the Government Involved in Education? 296

Free Public Education and Crowding Out 297 Solving the Crowd-Out Problem: Vouchers 299 Problems with Educational Vouchers 301 11.3 Evidence on Competition in Education Markets 306

Direct Experience with Vouchers 306 Experience with Public School Choice 306 Empirical Evidence: Estimating the Effects of Voucher Programs 307 Experience with Public School Incentives 308 Bottom Line on Vouchers and School Choice 308 11.4 Measuring the Returns to Education 309 Effects of Education Levels on Productivity 309

Empirical Evidence: Estimating the Return to Education 311 Effect of Education Levels on Other Outcomes 312

The Impact of School Quality 312

Empirical Evidence: Estimating the Effects of School Quality 313

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What Is the Market Failure, and How Should It Be Addressed? 316

Highlights 317

PART III Social Insurance and Redistribution CHAPTER 12 Social Insurance: The New Function of Government 321

12.1 What Is Insurance and Why Do Individuals Value It? 323

What Is Insurance? 323 Why Do Individuals Value Insurance? 324 Formalizing This Intuition: Expected Utility Model 325 12.2 Why Have Social Insurance? Asymmetric Information and Adverse Selection 328

Asymmetric Information 328 Example with Full Information 329 Example with Asymmetric Information 329 The Problem of Adverse Selection 331 Does Asymmetric Information Necessarily Lead to Market Failure 331 Application: Adverse Selection and Health Insurance “Death Spirals” 333 How Does the Government Address Adverse Selection? 334 12.3 Other Reasons for Government Intervention in Insurance Markets 335

Externalities 335 Administrative Costs 335 Redistribution 335 Paternalism 336 Application: Flood Insurance and the Samaritan’s Dilemma 336 12.4 Social Insurance vs Self-Insurance: How Much Consumption Smoothing? 339

Example: Unemployment Insurance 339

Lessons for Consumption-Smoothing Role of Social Insurance 343

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What Determines Moral Hazard? 346 Moral Hazard Is Multidimensional 346 The Consequences of Moral Hazard 347

12.6 Putting It All Together: Optimal Social Insurance 348

Highlights 349

APPendIx To ChAPTeR 12 Mathematical Models of Expected Utility 352

CHAPTER 13 Social Security 355

13.1 What Is Social Security, and How Does It Work? 357

Program Details 357 Application: Why Choose 35 Years? 358 How Does Social Security Work Over Time? 361 Application: Ida May Fuller 363 How Does Social Security Redistribute in Practice? 364 13.2 Consumption-Smoothing Benefits of Social Security 367

Rationales for Social Security 367 Does Social Security Smooth Consumption? 368 Social Security and Private Savings 368 Living Standards of the Elderly 369 Empirical Evidence: Measuring the Crowd-Out Effect of Social Security on Savings 370 13.3 Social Security and Retirement 370

Theory 371 Evidence 371 Application: Implicit Social Security Taxes and Retirement Behavior 375 Implications 376 13.4 Social Security Reform 376 Reform Round I: The Greenspan Commission 378

Application: The Social Security Trust Fund and National Savings 378 Incremental Reforms 379

Fundamental Reforms 382

Application: Company Stock in 401(k) Plans 385

Application: Mixed Proposals for Social Security Reform 386

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CHAPTER 14 Unemployment Insurance, Disability Insurance, and Workers’ Compensation 391

14.1 Institutional Features of Unemployment Insurance, Disability Insurance, and Workers’ Compensation . 393

Institutional Features of Unemployment Insurance 393 Institutional Features of Disability Insurance 395 Institutional Features of Workers’ Compensation 396 Comparison of the Features of UI, DI, and WC 397 Application: The Duration of Social Insurance Benefits Around the World 398 14.2 Consumption-Smoothing Benefits of Social Insurance Programs 399

14.3 Moral Hazard Effects of Social Insurance Programs 400

Moral Hazard Effects of Unemployment Insurance 400 Empirical Evidence: Moral Hazard Effects of Unemployment Insurance 402 Evidence for Moral Hazard in DI 404 Evidence for Moral Hazard in WC 405 Empirical Evidence: Moral Hazard Effects of Disability Insurance 406 Empirical Evidence: Moral Hazard Effects of Workers’ Compensation 407 14.4 The Costs and Benefits of Social Insurance to Firms 408

The Effects of Partial Experience Rating in UI on Layoffs 408 The “Benefits” of Partial Experience Rating 410 Application: The “Cash Cow” of Partial Experience Rating 410 Workers’ Compensation and Firms 411 14.5 Implications for Program Reform 412

Benefits Generosity 412 Targeting 412 Experience Rating 413 Worker Self-Insurance? 413 Application: Reforming UI 413 14.6 Conclusion 414

Highlights 415

APPendIx To ChAPTeR 14 Advanced Quasi-Experimental Analysis 417

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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 431 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 How Elastic Is the Demand for Medical Care? The RAND Health Insurance Experiment 438 Empirical Evidence: Estimating the Elasticity of Demand for Medical Care 440 Optimal Health Insurance 440 Why Is Insurance So Generous in the United States? 441 Application: Health Savings Accounts 443 15.3 How Generous Should Insurance Be to Medical Providers? 445

Managed Care and Prospective Reimbursement 446 The Impacts of Managed Care 448 How Should Providers Be Reimbursed? 449 15.4 Conclusion 449

Highlights 449

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

16.1 The Medicaid Program for Low-Income Mothers and Children 454 How Medicaid Works 455

Who Is Eligible for Medicaid? 455

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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 460 16.3 The Medicare Program 461

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 16.5 Long-term Care 475

Financing Long-term Care 475 16.6 Health Care Reform in the United States 476

The Historical Impasse 476 The Massachusetts Experiment with Incremental Universalism 478 The Affordable Care Act 480 Application: Rising Health Care Costs and Cost Control Efforts in the ACA 481 16.7 Conclusion 485

Highlights 485

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 494

Application: Problems in Poverty Line Measurement 495

What Matters—Relative or Absolute Deprivation? 496

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Using “Ordeal Mechanisms” 509

Application: An Example of Ordeal Mechanisms 510 Increasing Outside Options 511

Empirical Evidence: The Canadian Self-Sufficiency Project 514

17.5 Welfare Reform 517 Changes Due to Welfare Reform 517

Empirical Evidence: Estimating the Impact of Welfare Reform 518 Effects of the 1996 Welfare Reform 518

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

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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 540

Charitable Giving 540

Spending Crowd-Out Versus Tax Subsidy Crowd-In 541

Consumer Sovereignty Versus Imperfect Information 543

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

18.6 The Appropriate Unit of Taxation . 550

The Problem of the “Marriage Tax” 550

Marriage Taxes in Practice 552

Highlights 554

CHAPTER 19 The Equity Implications

of Taxation: Tax Incidence 557

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

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Issues to Consider in General Equilibrium Incidence Analysis 577

19.4 The Incidence of Taxation in the United States 579

Empirical Evidence: The Incidence of Excise Taxation 580 CBO/TPC Incidence Assumptions 580

Results of CBO/TPC Incidence Analysis 581 Current Versus Lifetime Income Incidence 583

Highlights 584

Advanced Questions 585 APPendIx To ChAPTeR 19 The Mathematics of Tax Incidence 587

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 596

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 604

20.3 Optimal Income Taxes 607

A Simple Example 607 General Model with Behavioral Effects 608

An Example 610

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The Model 612

Issues Raised by Tax-Benefit Linkage Analysis 614

Empirical Evidence: A Group-Specific Employer Mandate 616

Highlights 617

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

21.3 Tax Policy to Promote Labor Supply: The Earned

Income Tax Credit 631

Background on the EITC 631

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 641

Comparing the Options 642

Highlights 644

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Traditional Theory 649 Evidence: How Does the After-Tax Interest Rate Affect Savings? 653 Inflation and the Taxation of Savings 654

22.2 Alternative Models of Savings 656 Precautionary Savings Models 656

Self-Control Models 657

Empirical Evidence: Social Insurance and Personal Savings 658

22.3 Tax Incentives for Retirement Savings 659 Available Tax Subsidies for Retirement Savings 659

Why Do Tax Subsidies Raise the Return to Savings? 661 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

Highlights 673

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

Application: Capital Gains Taxation of “Carried Interest” 688

23.3 Transfer Taxation 690 Why Tax Wealth? Arguments for the Estate Tax 691

Arguments Against the Estate Tax 692

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Types of Property Taxation 697

Application: Property Tax Breaks to Businesses 698

Highlights 700

CHAPTER 24 Corporate Taxation 703

24.1 What Are Corporations and Why Do We Tax Them? 705

Ownership versus Control 706

Application: Executive Compensation and the Agency Problem 707

Firm Financing 709

Why Do We Have a Corporate Tax? 710

24.2 The Structure of the Corporate Tax 711

24.3 The Incidence of the Corporate Tax 715

24.4 The Consequences of the Corporate Tax for Investment 716

Theoretical Analysis of Corporate Tax and Investment Decisions 716

Negative Effective Tax Rates 721

Policy Implications of the Impact of the Corporate Tax on Investment 722

Application: The Impact of the 1981 and 1986 Tax Reforms

on Investment Incentives 722

Evidence on Taxes and Investment 724

24.5 The Consequences of the Corporate Tax for Financing 724

The Impact of Taxes on Financing 724

Why Not All Debt? 726

The Dividend Paradox 728

How Should Dividends Be Taxed? 729

Application: The 2003 Dividend Tax Cut 730

Corporate Tax Integration 731

24.6 Treatment of International Corporate Income 732

How to Tax International Income 732

Application: A Tax Holiday for Foreign Profits 733

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CHAPTER 25 Fundamental Tax Reform 739

25.1 Why Fundamental Tax Reform? 741 Improving Tax Compliance 741

Application: Tax Evasion 741

Application: The 1997 IRS Hearings and Their Fallout for Tax Collection 744 Making the Tax Code Simpler 746

Improving Tax Efficiency 747 Summary: The Benefits of Fundamental Tax Reform 750

25.2 The Politics and Economics of Tax Reform 750 Political Pressures for a Complicated Tax Code 751

Economic Pressures Against Broadening the Tax Base 751

Application: Grandfathering in Virginia 754 The Conundrum 755

Application: TRA 86 and Tax Shelters 755

25.3 Consumption Taxation 756 Why Might Consumption Make a Better Tax Base? 757

Why Might Consumption Be a Worse Tax Base? 759 Designing a Consumption Tax 762

Backing into Consumption Taxation: Cash-Flow Taxation 765

25.4 The Flat Tax 765 Advantages of a Flat Tax 766

Problems with the Flat Tax 767

Application: The 2005 Panel on Tax Reform 768

Highlights 769

Advanced Questions 770Glossary G-1References R-1Index I-1

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W hen I began writing this book nine 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 three editions of this text, I am gratified and

happy to say that my approach has found wide acceptance among

instruc-tors and their students across the country By augmenting the traditional

approach of public finance texts with a true integration of theory,

applica-tion, 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 about the key relationships

high-lighted 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

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:

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

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theory), Chapter 3 (empirical methodology), and Chapter 4 ment budgeting) I recognize that students come to their public 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 students with all the background they need to interpret the Empirical Evidence boxes throughout the text In addition, by moving the discussion of govern-ment budgeting from its traditional “orphan” spot at the end of text-books, I allow the discussion of other topics throughout the book, such

(govern-as Social Security and tax policy, to draw on the insights developed in Chapter 4 about the role of the budget in policy debates

in Chapter 5 with a discussion of private and public solutions to the problem of externalities, and then continues in Chapter 6 by focusing

on the two major public policy issues involving externalities: mental externalities, such as acid rain and global warming, and health externalities 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/

environ-benefit analysis (Chapter 8) and political economy (Chapter 9) I then turn to the role of state and local governments as providers of public goods, highlighting the potential efficiencies and costs of decentral-ization in Chapter 10, before discussing education, one of the most important public goods in the United States, in Chapter 11

instruc-tors have responded positively to this book’s major innovation: the 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 I then include a sepa-rate chapter on the nation’s largest social insurance program, Social Security (Chapter 13), and another on the three other nonhealth social insurance programs: unemployment insurance, disability insurance, and workers’ compensation (Chapter 14) Given the enormous and growing role of government in the provision of health care, I devote two chapters to this topic, first discussing the nature of health insur-ance and health economics in Chapter 15 and then focusing on the government’s role in Chapter 16, in particular highlighting the cur-rent debates over reforming the nation’s health care system Finally, Chapter 17 discusses the role of government as a redistributive agent through welfare programs

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concepts (such as vertical equity and the Haig-Simons tax base) that are central 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 tion 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 behav-iors: labor supply (and the EITC) in Chapter 21, savings (and tax-sub-sidized retirement savings) in Chapter 22, and the distribution of asset holdings (and capital gains, estate, and property taxes) in Chapter 23

taxa-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, 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

dis-cussed, it is placed in the policy environment in the surrounding text In

addi-tion, there are 57 separate policy applications spread throughout the book to

help 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 ACA, 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

con-cepts But the presentation of theory is greatly enhanced by a careful

presenta-tion 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

flex-ibility for instructors with different tastes for this material Throughout the text,

whenever a major theoretical point is made, I discuss the relevant empirical

find-ings 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

xxix

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cuss 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 inclu-sion 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 critically depends on the exposition and presentation I have endeavored throughout the text

to use a student-friendly, conversational style that emphasizes the intuition, ics, and mathematics of theory Instructors using the book have reported that their

graph-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:

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

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

num-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

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

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 52)? Why is the subsidy to employer-provided health insurance a subsidy to employees and not to employers (see page 426)? How can the income effect actually lead higher wages to cause lower levels of labor supply (see page 626)?

through intuition and graphics, with relatively little reliance on matics Nevertheless, many instructors will 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

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full-color graphics, allowing the students to better understand the graphical analysis that is so often confusing to them

and concepts from the material in that chapter

aver-age 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 fourth edition

What’s New in the Fourth 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

appli-cations and empirical examples, and a number of new text discussions

High-lights of the changes include the following:

E Chapter 1: A new introduction focuses on the contentious debate over

the Patient Protection and Affordable Care Act (ACA), which passed in the spring of 2010

E Chapter 3: All of the empirical data that forms the basis of this chapter

have been completely updated for the first time since the First edition

This includes figures, text, and the appendix, as well as updated data posted to the textbook website

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

efforts to balance the budget, a revision of the section on cyclical ments to the budget that reflects current government methodology, and

adjust-an updated discussion of the impacts of dynamic scoring on the budget

E Chapter 5: The chapter now includes a discussion of the problems with

using subsidies to address negative externalities

E Chapter 6: A new chapter introduction focuses on the first major

fed-eral rules designed to address global warming, the 2012 Environmental Protection Agency (EPA) regulations restricting greenhouse gas emis-sions from new power plants in the United States The chapter also includes a new empirical application focusing on the cutting edge empirical work on the effect of the legal drinking age on drinking and mortality, as well as updated discussions of global warming legislation and efforts to combat obesity around the world

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software like Maze to reduce “free-riding.”

E Chapter 8: This chapter features a new discussion of the variation in the value of life used by different government agencies

E Chapter 9: The chapter includes updates on the farm policy in the United States as well as a new example of the hazards of contracting out with non-competitive bidding

E Chapter 11: This chapter has been thoroughly updated to reflect ing new research in the economics of education, such as findings on competition between public and private schools and the effects of public school choice through magnet and charter schools

excit-E Chapter 12: this chapter has an extended discussion of the politics and policies around flood insurance, as well as a fun new example of the moral hazard arising from workers’ compensation insurance

E Chapter 13: This chapter has an all new introduction focused on the debate over Social Security that took place during the 2012 Republi-can Presidential Primaries

E Chapter 14: The chapter offers new material on the Unemployment Compensation Extension Acts of 2009 and 2010 and the Middle Class Tax Relief and Job Creation Act of 2012

E Chapter 16: A completely new introduction highlights the debate over the Patient Protection and Affordable Care Act (ACA) This is paired with a completely rewritten last third of the chapter which discusses the history, structure and future of the ACA, a new application on ris-ing health care costs and efforts made in the ACA to control those costs, and an updated discussion of the Massachusetts experiment with health care reform that formed the basis of the ACA The chapter also updates the application on the Medicare Part D program to reflect the exciting new research in this area

E Chapter 17: This chapter features new data on the growing gap between the top 1% and bottom 99% of the U.S income distribution,

as well as an updated discussion of the implications of welfare reform

E Chapter 18: The chapter presents a thorough updating of all facts about tax collections and the tax code in the United States as well as a fun new example of an inappropriate business deduction!

E Chapter 22: This chapter features an updated introduction which trasts the approaches of the Bush and Obama Administrations to pro-moting retirement savings

con-E Chapter 23: This chapter features a new application on the exciting debate around capital gains taxation of carried interest income

E Chapter 24: The application on executive compensation and the

agen-cy problem has been updated with interesting new examples, and there

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E Chapter 25: A new introduction focuses on Herman Cain’s “9-9-9

plan” as an example of fundamental tax reform

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:

in the book by taking a multiple-choice quiz about each chapter in the text Students receive immediate feedback, including a hint to the correct 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

studying the definitions and testing themselves with these electronic flashcards

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

presentation created by Fernando Quijano of Dickinson State versity 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 presen-tation for each chapter comes complete with notes, summaries, and graphics

Uni-For instructors, the Web site provides the following features:

in an online database that can be accessed by instructors Instructors can view and export reports of their students’ practice activity

created by Fernando Quijano of Dickinson State University, vides comprehensive coverage of the material in each chapter The slides are designed to assist with lecture preparation and presenta-tions by incorporating key graphs from the textbook with detailed outlines of key concepts The slides can be customized to suit

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table in the new edition in high-resolution JPEG format and in the form of PowerPoint Slides

solutions to the text’s end-of-chapter problems

For Instructors

Computerized Test Bank CD-ROM A computerized test bank is

pro-vided using Diploma software It includes a complete set of multiple-choice and short-answer questions created to test effectively student analysis, inter-pretation, and comprehension of the concepts covered in the textbook Each question is identified by level, text topic reference, and key concepts The Test Bank is available in CD-ROM format for both Windows and Macintosh users

WebCT- and Blackboard-formatted versions of the test bank are also available

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 to various information fields and questions can be scrambled to create different versions of tests Tests can be printed in a wide range of formats The software’s unique synthesis of flexible word-processing and database features creates a program 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 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 grateful to Larry Summers for making it possible for me to work at the Treasury Depart-ment in 1997–1998, which gave me an appreciation of the power of public finance analysis and the importance of educating our future generations of policymakers 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 is of this material 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

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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 Charles Linsmeier, publisher,

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 he was

helped by the able efforts of Mary Melis, assistant editor, who worked

tire-lessly, quickly, and efficiently to ensure that things went smoothly once the

manuscript was in Worth’s hands Thanks to Stevenson Curry for his support

developing the supplements package Thanks to Scott Guile, executive

mar-keting manager Thanks also to Worth’s production group: Lisa Kinne,

associ-ate managing editor, Tracey Kuehn, director of print and digital development,

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 Thank you to Matthew

Rut-ledge (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

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 Institute),

Ricardo Caballero (MIT), Chris Carroll (Johns Hopkins University), Amitabh

Chandra (Dartmouth College), Gary Claxton (Kaiser Family Foundation),

Robert Coen (Northwestern University), Jonathan Cohn (New

Repub-lic), Miles Corak (UNICEF), Julie Cullen (University of California at San

Diego), David Cutler (Harvard University), Susan Dadres (Southern

Method-ist University), Angus Deaton (Princeton University), Peter Diamond (MIT),

David Dranove (Northwestern University), Esther Duflo (MIT), Jae Edmonds

(Pacific Northwest National Laboratory), Gary Engelhardt (Syracuse

Univer-sity), Roger Feldman (University of Minnesota), Martin Feldstein (Harvard

University), David Figlio (University of Florida), Amy Finkelstein (Harvard

University), Alan Garber (Stanford University), Bill Gentry (Williams

Col-lege), 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

Berke-ley), Paul Joskow (MIT), Larry Katz (Harvard University), Melissa Kearney

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Levitt (Kaiser Family Foundation), Brigitte Madrian (University of vania), Kathleen McGarry (UCLA), Bruce Meyer (University of Chicago), Kevin Milligan (University of British Columbia), Sendhil Mullainathan (Har-vard University), Robert Moffitt ( Johns Hopkins University), Casey Mul-ligan (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

Pennsyl-of Michigan), Kent Smetters (University Pennsyl-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 terrific colleagues 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), Michael Cote (University of Southern Maine), Susan Dadres (University of North Texas), Arlene Geiger ( John Jay College), Seth Giertz (University of Nebraska–Lincoln), Jessica Hennessey (University

of Maryland), Michael Jerison (SUNY Albany), Janet L Johnson (Georgia State University), Shawn D Knabb (Western Washington University), Marc Law (University of Vermont), Robert McComb (Texas Tech University), Mikhail Melnik (Niagara University), Paul Menchik (Michigan State Uni-versity), Erin Moody (University of Maryland), Robert L Moore (Occidental College), Gary Hoover (University of Alabama), Florenz Plassmann (Bing-hamton University-SUNY), Deborah A Savage (Southern Connecticut State University), Mark Scanlan (Stephen F Austin State University), Atindra Sen (Miami University), John Straub (Tufts University), Mehmet S Tosun (Uni-versity of Nevada, Reno), Roberta W Walsh (Florida Gulf Coast University), Gregory Wassall (Northeastern University), Joann Weiner (George Washing-ton 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 four 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 trying to say, even when I’m not exactly saying it, and translate it into

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at the Kennedy School of Government at Harvard) was my research

assis-tant 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 John Tebes, Michael Veldman, J.J Xie and Jessica Yang,

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

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