Fletcher School of Law and Diplomacy, Tufts University. The Economics of Public Policy. Prof George Alogoskoufis. 1. Introduction

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1 Fletcher School of Law and Diplomacy, Tufts University The Economics of Public Policy Prof George Alogoskoufis 1. Introduction

2 The Scope of Public Economics Four major questions for public economics: 1. When should the government intervene in the economy 2. How might the government intervene in the economy 3. What are the economic effects of government actions 4. Why do governments intervene the way they do and not in other ways 2

3 When should the Government Intervene Two key justifications for government economic interventions: 1. Market failures 2. Redistribution of Income and Wealth 3

4 Example of a Market Failure: Negative Externalities and Under-provision in the Health Insurance Market In 2010, there were 49 million people without health insurance in the USA, amounting to 18.5% of the non-elderly population. In itself this is not a proof of a market failure. But when you think about it, it may be related to a market failure which calls for government intervention. People tend to underinsure themselves because they only take into account the risks to their own health, disregarding the fact that on many occasions they imply health risks to others as well. The social value of health insurance is not only related to the improvement it causes in one s own health, but also to the improvement it causes in the health of those around her. Individual decisions to buy health insurance only take into account the private benefit and not the larger social benefit. By equating the private cost of health insurance to the private benefit of health insurance, households are led to buy less health insurance than would be socially desirable. This is an example of a market failure due to a negative externality, which calls for government intervention. A competitive insurance market would not provide the socially optimal amount of health insurance, but less than the socially optimal amount. 4

5 Example of Redistribution The Size versus the Distribution of the Economic Pie Society may view the distribution of income resulting from the operation of the market as being unfair. It may view an extra dollar of consumption by a wealthy household as socially less desirable than a extra dollar of consumption by a poor household. Government interventions can redistribute income from the wealthy to the poor households in a way that improves social welfare. For example, in the USA in 2010, 70% of those without health insurance were in households with annual incomes of less than $ Society may deem it appropriate to redistribute from wealthy households with health insurance to poor households without. It is worth noting that the size of the economic pie is not independent of policies that redistribute it. Taxing the wealthy may induce them to work less and produce less. Subsidizing the poor may also induce them to work and produce less, since they now have a guaranteed income. This produces a potential tradeoff between equity and efficiency. In such cases, societies may have to chose between smaller and more equally distributed pies, and larger and more unequally distributed ones. 5

6 Forms of Government Economic Interventions Taxing or subsidizing private sales or purchases of goods and services (taxes and subsidies). e.g. Taxing cigarettes or alcohol and subsidizing health insurance. Restrict or mandate private sales or purchases (regulation) e.g. Bans on smoking or alcohol consumption and minimum health insurance purchases. Public Provision of Goods and Services (public production) e.g. public provision of health care. Public Financing of Private Provision of Goods and Services (public expenditure) e.g government expenditure for health insurance for the elderly. 6

7 Effects of Government Economic Interventions Government policies have both direct and indirect effects. Direct effects are the ones that would apply if households and firms did not change their behavior in response to government policies. Indirect effects are the ones that arise only because households and firms change their behavior in response to government policies. Example Suppose the US government in 2010 adopted a UK type system of free public health care. With 45 million uninsured, and an average cost of treatment of $2500 per annum, this policy would cost about $125 billion. Given that the federal budget is about $3,7 trillion, this is less than 3.5% of the federal budget (governemnt spending on health care is about $818 billion, so it would increase by 15,3%). This is the direct cost of the program. However, by providing free health care to everyone, the government provides strong incentives to the insured to drop their health care insurance, and use the free public health care system. Suppose that half of the insured nonelderly persons drop their health care insurance. This would add another 88 million people to the pool, costing another $340 billion per annum. This is the indirect cost of the program, which raises the total cost to $465 billion, or 12.5% of the federal budget. The key question for evaluating free public health care for the uninsured is therefore how many of the insured will drop their privately purchased coverage to join the free public program. This is an empirical question that requires expert knowledge. This expert knowledge arises from the study of public economics. 7

8 The Congressional Budget Office The organization which has the task to provide official estimates of the effects and the cost of government programs is the Congressional Budget Office (CBO). This was created in 1975 and its mission is to provide Congress with objective, timely, non-partisan analysis needed for economic and budgetary decisions. In a sense it is the scorekeeper for government policy debates. All proposals for legislative spending and tax bills have to be assessed by the CBO, which has a decisive role in the adoption or not of these proposals. Because of the expertise of the economists at the CBO, and its non-partisan nature, its analyses are usually accepted universally. 8

9 The Political Economy of Public Policy Decisions Why do governments intervene the way they do and not in other ways? To answer this question, the expertise of the economist is not enough. We cannot simply assume that government is a benign agent striving to maximize social welfare. It is even questionable is people agree on what social welfare actually is. To predict the actual behavior of governments we need to bring in political economy considerations, such as the preferences, the beliefs and the constraints of politicians, bureaucrats and the press. Such agents affect the political process and therefore decisions on public policy and the implementation of public policy itself. Even if economists agreed on what should be done (the normative question), which in any case in not usually the case, there is no guarantee that this will be done (the positive question). The variety of solutions that different political parties propose on critical public policy issues, and the variety of solutions adopted in different countries to similar public policy problems is evidence that we are far from agreement on what should be done, and also of the power of the political process itself. 9