ECONOMICS OF THE PUBLIC SECTOR (4TH EDITION, 2015) by Joseph Stiglitz & Jay Rosengard PDF

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ECONOMICS OF THE PUBLIC SECTOR FOURTH EDITION FOURTH EDITION ECONOMICS OF THE PUBLIC SECTOR JOSEPH E. STIGLITZ | JAY K. ROSENGARD n W. W. NORTON & COMPANY, INC . NE W YORK • LONDON W. W. Nor ton & Company has been independent since its founding in 1923, when William Warder Nor ton and Mar y...

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ECONOMICS OF THE PUBLIC SECTOR FOURTH EDITION

FOURTH EDITION

ECONOMICS OF THE PUBLIC SECTOR JOSEPH E. STIGLITZ

n W. W. NORTON & COMPANY, INC . NE W YORK • LONDON

|

JAY K. ROSENGARD

W. W. Nor ton & Company has been independent since its founding in 1923, when William Warder Nor ton and Mar y D. Her ter Nor ton first published lec tures delivered at the People’s Institute, the adult education division of New York Cit y’s Cooper Union. The firm soon expanded its program beyond the Institute, publishing books by celebrated academic s from America and abroad. By midcentur y, the t wo major pillars of Nor ton’s publishing program —trade books and college text s — were firmly established. In the 1950s, the Nor ton family transferred control of the company to its employees, and today—with a staf f of four hundred and a comparable number of trade, college, and professional titles published each year—W. W. Nor ton & Company stands as the largest and oldest publishing house owned wholly by its employees. Copyright © 2015 by W. W. Nor ton Company, Inc. Copyright © 20 0 0, 1988, 1986 by Joseph E. Stiglit z, the Trus tee of Edward Hannaway Stiglit z Trus t, the Trus tee of Julia Hannaway Stiglit z Trus t, and the Trus tee of the Trus t for the Benef it of Joseph E. Stiglit z’s Children All right s reser ved Printed in the United St ates of Americ a Editor: Jack Repcheck Editorial A s sis tant: Theresia Kowara Projec t Editor: Sujin Hong Managing Editor, College Digital Media: Kim Yi Produc tion Manager: Vanessa Nuttry Marketing Manager, Economic s: Janise Turso Design Direc tor: Jillian Burr Permis sions Manager: Megan Jackson Composition: Cenveo ® Publisher Ser vices Manufac turing: Quad/Graphics —Taunton Librar y of Congres s Cataloging -in- Public ation Data. Stiglit z, Joseph E. Economic s of the public sec tor / Joseph E. Stiglit z, Jay K . Rosengard.— Four th edition. pages cm Includes bibliographic al references and index. ISBN 978 - 0 -393 -92522-7 (pbk.) 1. Finance, Public— United States. 2. Fiscal policy— United States. I. Rosengard, Jay K. II. Title. HJ257.2.S84 2015 336.73 — dc 23 2014048383 W. W. Nor ton & Company, Inc., 50 0 Fif th Avenue, New York, NY 10110 - 0 017 w w nor ton.com W. W. Nor ton & Company Ltd., Cas tle House, 75/ 76 Wells Street, London W1T 3QT 1 2 3 4 5 6 7 8 9 0

To our f irst teachers, Nat and Charlot te Jordan and Bet t y

BRIEF CONTENTS

Preface

x x vii

PART 1

ROLE AND SIZE OF THE PUBLIC SECTOR 1

PART 2

PART 3

1

DEFINING PUBLIC SECTOR RESPONSIBILITIES 3

2

MEASURING PUBLIC SECTOR SIZE

26

FUNDAMENTALS OF WELFARE ECONOMICS 59 3

MARKET EFFICIENCY

61

4

MARKET FAILURE

5

PUBLIC GOODS AND PUBLICLY PROVIDED PRIVATE GOODS 101

6

EXTERNALITIES AND THE ENVIRONMENT

7

EFFICIENCY AND EQUIT Y

81

129

163

PUBLIC EXPENDITURE THEORY 8

PUBLIC PRODUCTION OF GOODS AND SERVICES 199

9

PUBLIC CHOICE

197

230

vii

viii

BRIEF C O NT E NTS

PART 4

PART 5

PART 6

PART 7

PUBLIC EXPENDITURE IN PR ACTICE 10

FRAMEWORK FOR ANALYSIS OF EXPENDITURE POLICY 269

11

EVALUATING PUBLIC EXPENDITURE

296

12

DEFENSE, RESEARCH, AND TECHNOLOGY

13

HEALTH CARE

14

EDUCATION

15

WELFARE PROGRAMS AND THE REDISTRIBUTION OF INCOME 428

16

SOCIAL INSURANCE

329

357 394

470

TA X ATION IN THEORY

503

17

INTRODUCTION TO TA X ATION

18

TA X INCIDENCE

19

TA X ATION AND ECONOMIC EFFICIENCY

20

OPTIMAL TA X ATION

21

TA X ATION OF CAPITAL

505

538

636

665

22

THE PERSONAL INCOME TA X

23

THE CORPORATION INCOME TA X

24

A STUDENT’S GUIDE TO TA X AVOIDANCE

25

REFORM OF THE TA X SYSTEM

FURTHER ISSUES

574

606

TA X ATION IN PR ACTICE

667 709

762

799

26

INTER GOVERNMENTAL FISCAL REL ATIONS 801

27

SUBNATIONAL TA XES AND EXPENDITURES 832

28

FISCAL DEFICITS AND GOVERNMENT DEBT 851

References 880 Index 893

267

746

CONTENTS

Preface

PART 1

x x vii

ROLE AND SIZE OF THE PUBLIC SECTOR 1 1

DEFINING PUBLIC SEC TOR RESPONSIBILITIES 3 The Economic Role of Government 4 The Mixed Economy of the United States 4 Different Perspectives on the Role of Government 6 An Impetus for Government Action: Market Failures 7 Achieving Balance between the Public and Private Sectors 10 The Emerging Consensus 11 Thinking Like a Public Sector Economist

13

Analyzing the Public Sector 15 Economic Models 17 Case Study Musgrave’s Three Branches 18 Normative versus Positive Economics 19 Disagreements among Economists 21 Differences in Views on How the Economy Behaves Disagreement over Values 23 Case Study Public Sector Economics and the Global Economic Crisis 23 Review and Practice

21

24

Summary 24 Key Concepts 24 Questions and Problems

25

ix

x

C ONT ENT S

2

MEASURING PUBLIC SEC TOR SIZE

26

What or Who Is the Government? 27 Types of Government Activity 29 Providing a Legal System 30 Government Production 30 Government’s Influence on Private Production 33 Government Purchases of Goods and Services 36 Government Redistribution of Income 36 Overview of Government Expenditures 40 Gauging the Size of the Public Sector

42

Growth in Expenditures and Their Changing Composition 42 Case Study Estimating the Full Budgetary and Economic Costs of War 43 Comparison of Expenditures across Countries 45 Government Revenues

47

Taxes and the Constitution 47 Federal Taxation Today 48 State and Local Government Revenues 49 Comparison of Taxation across Countries 50 Deficit Financing

51

Playing Tricks with the Data on Government Activities 55 Review and Practice 56 Summary 56 Key Concepts 57 Questions and Problems

PART 2

57

FUNDAMENTALS OF WELFARE ECONOMICS 59 3

MARKET EFFICIENCY

61

The Invisible Hand of Competitive Markets Welfare Economics and Pareto Efficiency

61 63

Case Study On the Prowl for Pareto Improvements 64 Pareto Efficiency and Individualism 65 The Fundamental Theorems of Welfare Economics 66 Efficiency from the Perspective of a Single Market 68 Analyzing Economic Efficiency The Utility Possibilities Curve 69 Exchange Efficiency 70 Production Efficiency 74 Product Mix Efficiency 78

69

C ONTE NTS

Review and Practice

79

Summary 79 Key Concepts 80 Questions and Problems

4

MARKET FAILURE

80

81

Property Rights and Contract Enforcement 82 Case Study Property Rights and Market Failures: The Tragedy of the Commons Revisited 82 Market Failures and the Role of Government

83

1. Failure of Competition 83 2. Public Goods 86 3. Externalities 86 4. Incomplete Markets 87 Case Study Student Loans: Incomplete Reform of an Incomplete Market 89 5. Information Failures 91 6. Unemployment, Inflation, and Disequilibrium 93 Interrelationships of Market Failures 93 Case Study Market Failures: Explanations or Excuses?

94

Redistribution and Merit Goods 95 Two Perspectives on the Role of Government

97

Normative Analysis 97 Positive Analysis 98 Review and Practice

99

Summary 99 Key Concepts 99 Questions and Problems

5

100

PUBLIC GOODS AND PUBLICLY PROVIDED PRIVATE GOODS 101 Public Goods

102

Public Goods and Market Failures 103 Paying for Public Goods 103 The Free Rider Problem 105 Case Study Economists and the Free Rider Problem Pure and Impure Public Goods 107 Case Study Property Rights, Excludability, and Externalities 110 Publicly Provided Private Goods

106

111

Rationing Devices for Publicly Provided Private Goods Efficiency Conditions for Public Goods Demand Curves for Public Goods 117 Pareto Efficiency and Income Distribution

116 122

113

xi

xii

C ONT ENT S

Limitations on Income Redistribution and the Efficient Supply of Public Goods 122 Distortionary Taxation and the Efficient Supply of Public Goods 123 Efficient Government as a Public Good Review and Practice

124

125

Summary 125 Key Concepts 125 Questions and Problems

126

APPENDIX: The Leftover Curve 127

6

EX TERNALITIES AND THE ENVIRONMENT The Problem of Externalities

130

Private Solutions to Externalities

132

Internalizing Externalities 132 The Coase Theorem 133 Using the Legal System 134 Case Study The Exxon Valdez Oil Spill Failures of Private Solutions 136 Public Sector Solutions to Externalities

135 138

Case Study Double Dividend 138 Market-Based Solutions 139 Regulation 145 Innovation 146 Information Disclosure 148 Compensation and Distribution 149 Protec ting the Environment: The Role of Government in Practice 150 Air 151 Water 155 Land 156 Concluding Remarks

159

Review and Practice

159

Summary 159 Key Concepts 160 Questions and Problems

7

160

EFFICIENCY AND EQUIT Y

163

Efficiency and Distribution Trade-Offs Analyzing Social Choices

164

Determining the Trade-Offs 166 Evaluating the Trade-Offs 169 Two Caveats 173

164

129

C ONTE NTS

Social Choices in Practice

174

Measuring Benefits 175 Ordinary and Compensated Demand Curves Consumer Surplus 179 Measuring Aggregate Social Benefits 181 Measuring Inefficiency 181 Case Study Drawing a Poverty Line 182 Quantifying Distributional Effects 184 Case Study The Great Gatsby Curve 185 Three Approaches to Social Choices

178

186

The Compensation Principle 186 Trade-Offs across Measures 186 Weighted Net Benefits 187 The Trade-Off between Efficiency and Fairness Revisited 188 Review and Practice

189

Summary 189 Key Concepts 190 Questions and Problems

190

APPENDIX: Alternative Measures of Inequality The Lorenz Curve 192 The Dalton–Atkinson Measure

PART 3

194

PUBLIC EXPENDITURE THEORY 8

192

197

PUBLIC PRODUC TION OF GOODS AND SERVICES 199 Natural Monopoly: Public Production of Private Goods 201 The Basic Economics of Natural Monopoly 202 Regulation and Taxation (Subsidies) 206 No Government Intervention 209 Government Failures 210 Case Study Rent Control and Agricultural Price Supports: Case Studies in Government Failure 211 Comparison of Efficiency in the Public and Private Sectors 213 Case Study National Performance Review Sources of Inefficiency in the Public Sector Organizational Differences 216 Individual Differences 217 Bureaucratic Procedures and Risk Aversion Corporatization

221

Case Study Privatizing Prisons

224

214 216

220

xiii

xiv

C ONT ENT S

A Growing Consensus on Government’s Role in Production 225 Review and Practice

227

Summary 227 Key Concepts 228 Questions and Problems

9

PUBLIC CHOICE

228

230

Public Mechanisms for Allocating Resources

230

The Problem of Preference Revelation 231 Individual Preferences for Public Goods 232 The Problem of Aggregating Preferences 236 Majority Voting and the Voting Paradox 237 Arrow’s Impossibility Theorem 238 Single-Peaked Preferences and the Existence of a Majority Voting Equilibrium 240 The Median Voter 243 The Inefficiency of the Majority Voting Equilibrium 243 The Two-Party System and the Median Voter 246 Case Study Social Choice Theory 248 Alternatives for Determining Public Goods Expenditures 249 Lindahl Equilibrium

249

Politics and Economics

252

Why Do Individuals Vote? 252 Elections and Special Interest Groups 253 The Power of Special Interest Groups 254 Other Aspects of the Political Process 255 Case Study Campaign Finance Reform 256 The Altruistic Politician? 257 The Persistence of Inefficient Equilibrium 258 Review and Practice

259

Summary 259 Key Concepts 260 Questions and Problems

260

APPENDIX: New Preference-Revelation Mechanisms

PART 4

PUBLIC EXPENDITURE IN PR ACTICE

267

10 FR AMEWORK FOR ANALYSIS OF EXPENDITURE POLICY 269 Need for a Program 270 Market Failures

271

Case Study Higher Education in the United States

262

272

Alternative Forms of Government Intervention 272

C ONTE NTS

The Importance of Particular Design Features

274

Private Sector Responses to Government Programs 275 Efficiency Consequences

277

Income and Substitution Effects and Induced Inefficiency 277 Distributional Consequences

281

Evaluating the Distributional Consequences 284 Case Study Incidence of Education Tax Credits 284 Fairness and Distribution 286 Equity–Ef ficiency Trade-Offs 287 Public Policy Objectives Political Process

290

291

Review and Practice

294

Summary 294 Key Concepts 294 Questions and Problems

294

11 EVALUATING PUBLIC EXPENDITURE

296

Private Cost–Benefit Analysis 297 Present Discounted Value

297

Social Cost–Benefit Analysis 299 Consumer Surplus and the Decision to Undertake a Project 300 Measuring Nonmonetized Costs and Benefits

303

Valuing Time 304 Valuing Life 304 Case Study Children, Car Safety, and the Value of Life Valuing Natural Resources 307 Shadow Prices and Market Prices

308

Discount Rate for Social Cost–Benefit Analysis

309

Case Study Climate Change and Discount Rates

312

The Evaluation of Risk 314 Risk Assessment 317 Distributional Considerations Cost Effectiveness

318

319

Post-Expenditure Evaluation: Assessing and Improving Government Performance 323 Case Study Taking a Bite Out of Crime in the Big Apple 324 Review and Practice

326

Summary 326 Key Concepts 327 Questions and Problems

327

305

xv

xvi

C ONT ENT S

12 DEFENSE, RESEARCH, AND TECHNOLOGY

329

Defense Expenditures 330 The Value of Marginal Analysis 333 Defense Strategy 334 Case Study Game Theory, the Arms Race, and the Theory of Deterrence 336 Case Study Converting Swords into Plowshares

338

Increasing the Efficiency of the Defense Department 339 Defense Procurement

339

Defense Conversion 343 Accounting and the Defense Department

344

Research and Technology 345 Market Failures 348 Case Study The Scope of the Patent: Can the Human Body Be Patented? 350 Government Direct Support 353 Review and Practice 354 Summary 354 Key Concepts 355 Questions and Problems

13 HEALTH CARE

355

357

The Health Care System in the United States

360

The Private Sector 364 The Role of Government 364 Other Expenditure Programs 365 Tax Expenditures 366 Rationale for a Role of Government in the Health Care Sector 367 Imperfect Information 368 Limited Competition 369 Absence of Profit Motive 370 Special Characteristics of the U.S. Market 371 The Role of the Health Insurance Industry 372 Case Study Medical Malpractice 372 Insurance and Excessive Expenditures on Health Care 374 Consequences of Inefficiencies in Health Care Markets 379 Poverty, Incomplete Coverage, and the Role of Government 381 Reforming Health Care 382 Cost Containment 383 Case Study Comprehensive Health Care Reform Extending Insurance Coverage 385

384

C ONTE NTS

Medicare Reform: Easing Long-Term Fiscal Strains 387 Reforming Medicaid 390 Review and Practice

391

Summary 391 Key Concepts 392 Questions and Problems

14 EDUCATION

392

394

The Structure of Education in the United States

397

Federal Tax Subsidies to Private and Public Schools

399

Why Is Education Publicly Provided and Publicly Financed? 401 Is There a Market Failure? The Federal Role 403

401

Issues and Controversies in Educational Policy

403

Education Outcomes 404 Do Expenditures Matter? 405 School Vouchers: Choice and Competition 407 Case Study Vouchers: The San Jose and Milwaukee Experiments 412 School Decentralization 413 Performance Standards: No Child Left Behind and Race to the Top 414 Inequality 416 Aid to Higher Education Review and Practice

418

422

Summary 422 Key Concepts 423 Questions and Problems

423

APPENDIX: How Should Public Educational Funds Be Allocated? 425

15 WELFARE PROGRAMS AND THE REDISTRIBUTION OF INCOME 428 A Brief Description of Major U.S. Welfare Programs 430 AFDC and TANF 430 Earned Income Tax Credit Food Stamps/SNAP 432 Medicaid 434 Housing 435 Other Programs 436

431

Rationale for Government Welfare Programs Dimensions of the Problem

438

437

xvii

xviii

C ONT ENT S

Analytic Issues

440

Labor Supply 440 Cash versus In-Kind Redistribution 444 Inefficiencies from In-Kind Benefits 445 Are In-Kind Benefits Paternalistic? 450 Categorical versus Broad-Based Aid 451 Is Means Testing Objectionable in Its Own Right? 453 Other Distortions 453 Case Study Conditional Cash Transfer Programs 454 Welfare Reform: Integration of Programs 456 The Welfare Reform Bill of 1996

458

Block Granting 458 Analytics of State Responses to Block Grants 459 Time Limits 461 Mandatory Work 461 The Welfare Reform Debate of 1996 462 Case Study The Person or the Place? 464 Concluding Remarks

466

Review and Practice

466

Summary 466 Key Concepts 467 Questions and Problems

468

16 SOCIAL INSUR ANCE

470

The Social Security System

472

Social Security, Private Insurance, and Market Failures 475 High Transactions Costs 476 Risk Mitigation 477 Lack of Indexing: The Inability...