S O L U T IO N M AN U AL FO R
P U BL I C F I NAN CE A CO N T E M P O RARY
AP P L I CAT I O N O F T H EO R Y T O P O L I CY 1 2 T H
E DI T I O N DAVI D N H Y M A N
CH AP T E R 1
Individuals and Government
INSTRUCTIONAL OBJECTIVES
Chapter 1 is a general introduction to the field of public finance, emphasizing the relationship between
individuals and government. The functions of government are outlined, and the importance of taxes in
household budgets is highlighted. The chapter seeks to develop an understanding of the economic role of
government as a supplier of useful goods and services. Students are also expected to digest data on the
actual extent of government activity in the United States and other nations. They should know the current
structure of government expenditures and revenues in the United States, how government has grown
since 1920, and how the structure of federal government spending has changed since 1960.
In addition, the chapter seeks to demonstrate that the problem of scarcity implies that an increase in
resources devoted to government goods and services decreases availability of resources for nongovern-
ment uses. It is also made clear to students how government provision of goods and services differs from
market provision of goods and services.
CHANGES IN THIS EDITION
Chapter 1 discusses the growth in government spending, the impact of slow economic growth on
public finance on the federal, state and local government levels, and health care issues.
All data on government spending and revenues have been updated to the latest available year. Public
expenditure data have been revised using the latest National Income and Product Account (NIPA)
figures for government consumption and investment, documenting the rise in the share of the public
sector as a share of GDP since 2001.
The International View on government spending has been revised and updated with the latest data.
Discussion of mandatory versus discretionary federal government spending has been added.
Graphs have been redone to reflect the latest available observations.
1
,2 | Part One | The Economic Basis of Government Activity
The discussion of the mix between transfer payments and government consumption has been revised.
The growth in health care spending by government has been documented, showing that it is now the
largest and fastest growing category of federal government expenditure.
The analysis of the implications of aging populations for public finance has been updated based on
empirical analysis of the latest UN projections of changing world demographics. There is more
discussion of European aging and implications for pension systems. The impact the aging population
on health care spending in the United States is discussed.
CHAPTER OUTLINE
Individuals, Society, and Government
Governments and Political Institutions
The Allocation of Resource between Government and Private Use
The Mixed Economy, Markets, and Politics
Government Expenditures in the United States
International View: How Much Government? The Share of Government Expenditure in Modern
Economies
The Structure of State and Local Government Expenditure
Financing Government Expenditure in the United States
Market Failure and the Functions of Government: How Much Government Is Enough?
Aging Populations: Implications for Public Finance
MAJOR POINTS AND LECTURE SUGGESTIONS
1. My objective in the first lecture is to make it clear to students how economic analysis of the func-
tions and activities of governments fits in with their other courses. Since most students have already
had at least one course in microeconomics, I point out how governments can be thought of as
agents for supplying goods and services whose quantities have been determined through political,
as opposed to market, interaction. The role of government in the mixed economy is schematically
illustrated with a modified circular flow diagram. Figure 1.2 represents a useful starting point for
illustrating how the economic analysis of government fits in with previous analyses of markets to
which most students will have already been exposed. I usually draw the diagram on the board and
show how both households and business firms have economic relations with governments.
2. The tradeoff between government goods and services, and private goods and services is illustrated
with the production possibility curve. Figure 1.1 is familiar to most students, and its application to
analysis of government goods and services usually captures their attention. It helps to use the graph
in class to discuss reallocation of resources from military to nonmilitary uses. Another interesting
use of the graph is to show how increased environmental quality improvement services supplied by
government will require the sacrifice of material goods and services, as the prices of such products
as fuel, electricity, and automobiles rise.
, 3. Emphasize that government goods and services are usually made available through nonprice
rationing:
a. Government goods are often available for collective use at no direct charge, as is the case for
roads, national defense, police services, fire protection, and environmental protection.
b. Eligibility for obtaining the benefits of government services is determined by criteria other
than ability and willingness to pay. Politically determined criteria, such as age, income, family
status, and location of residence, often determine a person’s eligibility to receive government
transfers such as food stamps and services such as public schooling.
4. A general listing of the functions of government, as discussed in the text, is useful to students.
These functions are as follows:
a. Provision of useful goods and services, including the establishment of property rights and the
underlying legal system
b. Redistribution of income and economic opportunity among citizens
c. Stabilization (Note that this is not covered in the text.)
d. Regulation of private action
5. Note that the discussion of government finance in the chapter briefly outlines the fact that the con-
sequences of alternative means of finance differ in terms of the impact on incentives to produce and
on the distribution of well-being.
6. I usually photocopy the tables in Chapter 1 and bring them to class for the second lecture. I believe
that it is important for students to have some appreciation of the current extent of government and
the growth of expenditures and revenues in recent years.
7. In addition to illustrating the growth of government, I seek to show how the structure of federal
government expenditure has changed significantly since 1960. First, point out to students the spec-
tacular growth in the relative importance of transfers from 1960 to 1980. You can also point out
that transfers stabilized at close to 40 percent of federal spending in the 1970s. After declining
slightly as a share of federal spending in the 1980s, they rose again in the 1990s and now account
for about 43 percent of federal spending. Federal government purchases of goods and services for
consumption and investment has declined from over 60 percent of federal spending in 1960 to 27
percent in 1999. Since the end of the Cold War, purchases have declined as defense spending has
been cut back. However, the terrorist attacks of September 11, 2001, resulted in both increased
government spending and a shift away from transfers toward government consumption.
8. In discussing actual expenditures, use Table 1.3 and the accompanying pie chart to show the impor-
tance of Social Security, income security, Medicare, and health for the federal government; and
point out that these programs account for about 63 percent of federal government expenditures.
Also point out that about 32 percent of state and local government expenditure is accounted for by
education. Health care spending by state and local governments, mainly for Medicaid, has been
growing rapidly and now accounts for about 24 percent of state and local government spending.
9. Use the data and accompanying pie charts in the chapter to show students how income taxes,
including payroll taxes and corporate profits taxes, account for more than 90 percent of federal
government revenue. Also point out that sales and property taxes account for nearly half of state
and local government revenues and that one in five dollars of receipts received by state and local
governments comes from federal grants-in-aid.
10. Many instructors are now spending more time in class discussing state and local government fiscal
problems. A section in Chapter 1 discusses the structural problems that are underlying state
, 4 | Part One | The Economic Basis of Government Activity
government budgets and discusses the situation and impact on budgets for selected states that have
been particularly hard hit by revenue shortfalls.
11. Aging of populations has implications for public finance, especially for Social Insurance
programs. A section in this chapter provides information on aging of the population,
dependency ratios worldwide, along with implications for government spending.
ANSWERS TO TEXT PROBLEMS
1. Given a point on the old production possibility curve, the outward shift allows movement in the
northeast direction to a point on the new production possibility curve corresponding to an increase
in production of both private and government goods and services.
2. The increased allocation of resources to government provision of health services implies that fewer
resources can be used for other goods and services. The student should plot health care services on
one of the axes and ―all other goods and services‖ on the other axis. As production of health care
services increases, given fixed resources and technology, production of other goods and services
must decline.
3. Social Security pensions are government transfers. Except for a small amount of purchases for
personnel and other resources to administer the transfer, no government purchases are required.
4. The debt accumulated by past budgets amounts to many times more than the amount of federal
spending. It will take many years to retire the outstanding debt. The interest on the outstanding
debt will have to be paid for many years until the debt is retired. Running a budget surplus would
accelerate the rate of debt repayment.
5. Even though many programs are federally funded, such as, Medicare, programs such as Medicaid
are partially state funded. Consequently, the aging population will increase state expenditures as
Medicaid and other health care programs become more expensive due to increased demand. The
aging population will also impact state government revenue as the population leaves the workforce
and contributes less and less in the form of personal income tax, sales tax, and property tax.
A NOTE ON THE APPENDIX TO CHAPTER 1
The appendix to Chapter 1 is a concise review of basic microeconomic principles used throughout the
text. The material is designed to aid students with weak backgrounds in basic economic theory. It also
provides a convenient reference for students who wish to review basic concepts as they are needed. I
advise my students to read the appendix, but I do not cover any of the material in class.
OUTLINE OF THE APPENDIX TO CHAPTER 1
Indifference Curve Analysis
Analysis of Production and Cost
Profit Maximization, Competition, and Supply
P U BL I C F I NAN CE A CO N T E M P O RARY
AP P L I CAT I O N O F T H EO R Y T O P O L I CY 1 2 T H
E DI T I O N DAVI D N H Y M A N
CH AP T E R 1
Individuals and Government
INSTRUCTIONAL OBJECTIVES
Chapter 1 is a general introduction to the field of public finance, emphasizing the relationship between
individuals and government. The functions of government are outlined, and the importance of taxes in
household budgets is highlighted. The chapter seeks to develop an understanding of the economic role of
government as a supplier of useful goods and services. Students are also expected to digest data on the
actual extent of government activity in the United States and other nations. They should know the current
structure of government expenditures and revenues in the United States, how government has grown
since 1920, and how the structure of federal government spending has changed since 1960.
In addition, the chapter seeks to demonstrate that the problem of scarcity implies that an increase in
resources devoted to government goods and services decreases availability of resources for nongovern-
ment uses. It is also made clear to students how government provision of goods and services differs from
market provision of goods and services.
CHANGES IN THIS EDITION
Chapter 1 discusses the growth in government spending, the impact of slow economic growth on
public finance on the federal, state and local government levels, and health care issues.
All data on government spending and revenues have been updated to the latest available year. Public
expenditure data have been revised using the latest National Income and Product Account (NIPA)
figures for government consumption and investment, documenting the rise in the share of the public
sector as a share of GDP since 2001.
The International View on government spending has been revised and updated with the latest data.
Discussion of mandatory versus discretionary federal government spending has been added.
Graphs have been redone to reflect the latest available observations.
1
,2 | Part One | The Economic Basis of Government Activity
The discussion of the mix between transfer payments and government consumption has been revised.
The growth in health care spending by government has been documented, showing that it is now the
largest and fastest growing category of federal government expenditure.
The analysis of the implications of aging populations for public finance has been updated based on
empirical analysis of the latest UN projections of changing world demographics. There is more
discussion of European aging and implications for pension systems. The impact the aging population
on health care spending in the United States is discussed.
CHAPTER OUTLINE
Individuals, Society, and Government
Governments and Political Institutions
The Allocation of Resource between Government and Private Use
The Mixed Economy, Markets, and Politics
Government Expenditures in the United States
International View: How Much Government? The Share of Government Expenditure in Modern
Economies
The Structure of State and Local Government Expenditure
Financing Government Expenditure in the United States
Market Failure and the Functions of Government: How Much Government Is Enough?
Aging Populations: Implications for Public Finance
MAJOR POINTS AND LECTURE SUGGESTIONS
1. My objective in the first lecture is to make it clear to students how economic analysis of the func-
tions and activities of governments fits in with their other courses. Since most students have already
had at least one course in microeconomics, I point out how governments can be thought of as
agents for supplying goods and services whose quantities have been determined through political,
as opposed to market, interaction. The role of government in the mixed economy is schematically
illustrated with a modified circular flow diagram. Figure 1.2 represents a useful starting point for
illustrating how the economic analysis of government fits in with previous analyses of markets to
which most students will have already been exposed. I usually draw the diagram on the board and
show how both households and business firms have economic relations with governments.
2. The tradeoff between government goods and services, and private goods and services is illustrated
with the production possibility curve. Figure 1.1 is familiar to most students, and its application to
analysis of government goods and services usually captures their attention. It helps to use the graph
in class to discuss reallocation of resources from military to nonmilitary uses. Another interesting
use of the graph is to show how increased environmental quality improvement services supplied by
government will require the sacrifice of material goods and services, as the prices of such products
as fuel, electricity, and automobiles rise.
, 3. Emphasize that government goods and services are usually made available through nonprice
rationing:
a. Government goods are often available for collective use at no direct charge, as is the case for
roads, national defense, police services, fire protection, and environmental protection.
b. Eligibility for obtaining the benefits of government services is determined by criteria other
than ability and willingness to pay. Politically determined criteria, such as age, income, family
status, and location of residence, often determine a person’s eligibility to receive government
transfers such as food stamps and services such as public schooling.
4. A general listing of the functions of government, as discussed in the text, is useful to students.
These functions are as follows:
a. Provision of useful goods and services, including the establishment of property rights and the
underlying legal system
b. Redistribution of income and economic opportunity among citizens
c. Stabilization (Note that this is not covered in the text.)
d. Regulation of private action
5. Note that the discussion of government finance in the chapter briefly outlines the fact that the con-
sequences of alternative means of finance differ in terms of the impact on incentives to produce and
on the distribution of well-being.
6. I usually photocopy the tables in Chapter 1 and bring them to class for the second lecture. I believe
that it is important for students to have some appreciation of the current extent of government and
the growth of expenditures and revenues in recent years.
7. In addition to illustrating the growth of government, I seek to show how the structure of federal
government expenditure has changed significantly since 1960. First, point out to students the spec-
tacular growth in the relative importance of transfers from 1960 to 1980. You can also point out
that transfers stabilized at close to 40 percent of federal spending in the 1970s. After declining
slightly as a share of federal spending in the 1980s, they rose again in the 1990s and now account
for about 43 percent of federal spending. Federal government purchases of goods and services for
consumption and investment has declined from over 60 percent of federal spending in 1960 to 27
percent in 1999. Since the end of the Cold War, purchases have declined as defense spending has
been cut back. However, the terrorist attacks of September 11, 2001, resulted in both increased
government spending and a shift away from transfers toward government consumption.
8. In discussing actual expenditures, use Table 1.3 and the accompanying pie chart to show the impor-
tance of Social Security, income security, Medicare, and health for the federal government; and
point out that these programs account for about 63 percent of federal government expenditures.
Also point out that about 32 percent of state and local government expenditure is accounted for by
education. Health care spending by state and local governments, mainly for Medicaid, has been
growing rapidly and now accounts for about 24 percent of state and local government spending.
9. Use the data and accompanying pie charts in the chapter to show students how income taxes,
including payroll taxes and corporate profits taxes, account for more than 90 percent of federal
government revenue. Also point out that sales and property taxes account for nearly half of state
and local government revenues and that one in five dollars of receipts received by state and local
governments comes from federal grants-in-aid.
10. Many instructors are now spending more time in class discussing state and local government fiscal
problems. A section in Chapter 1 discusses the structural problems that are underlying state
, 4 | Part One | The Economic Basis of Government Activity
government budgets and discusses the situation and impact on budgets for selected states that have
been particularly hard hit by revenue shortfalls.
11. Aging of populations has implications for public finance, especially for Social Insurance
programs. A section in this chapter provides information on aging of the population,
dependency ratios worldwide, along with implications for government spending.
ANSWERS TO TEXT PROBLEMS
1. Given a point on the old production possibility curve, the outward shift allows movement in the
northeast direction to a point on the new production possibility curve corresponding to an increase
in production of both private and government goods and services.
2. The increased allocation of resources to government provision of health services implies that fewer
resources can be used for other goods and services. The student should plot health care services on
one of the axes and ―all other goods and services‖ on the other axis. As production of health care
services increases, given fixed resources and technology, production of other goods and services
must decline.
3. Social Security pensions are government transfers. Except for a small amount of purchases for
personnel and other resources to administer the transfer, no government purchases are required.
4. The debt accumulated by past budgets amounts to many times more than the amount of federal
spending. It will take many years to retire the outstanding debt. The interest on the outstanding
debt will have to be paid for many years until the debt is retired. Running a budget surplus would
accelerate the rate of debt repayment.
5. Even though many programs are federally funded, such as, Medicare, programs such as Medicaid
are partially state funded. Consequently, the aging population will increase state expenditures as
Medicaid and other health care programs become more expensive due to increased demand. The
aging population will also impact state government revenue as the population leaves the workforce
and contributes less and less in the form of personal income tax, sales tax, and property tax.
A NOTE ON THE APPENDIX TO CHAPTER 1
The appendix to Chapter 1 is a concise review of basic microeconomic principles used throughout the
text. The material is designed to aid students with weak backgrounds in basic economic theory. It also
provides a convenient reference for students who wish to review basic concepts as they are needed. I
advise my students to read the appendix, but I do not cover any of the material in class.
OUTLINE OF THE APPENDIX TO CHAPTER 1
Indifference Curve Analysis
Analysis of Production and Cost
Profit Maximization, Competition, and Supply
