Eco 440_PS1_Soln

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Eco 440: Public Economics and Ethics Problem Set 1 (Gruber, Ch 1) - Solution Instructor: Christopher Cruz, PhD DDue date: Sep 9, 2023, 11:59PM Name: 1. Many states have language in their constitutions that requires the state to provide for an “adequate” level of education spending. What is the economic rationale for such a requirement? (Q1 in Gruber)  There are two economic rationales for government provision of a good or service: market failure and redistribution. A market failure argument for state provision of education would be that an educated population benefits society generally because, for example, well-educated individuals have better job prospects and are therefore less likely to commit crimes. Each person who receives an education receives a private benefit (e.g., higher wage rate) and also confers a positive externality on the community (e.g., lower crime rate). In the absence of public provision of education, self-interested people would acquire less-than-optimal levels of education because they would not take into account its external benefit. Public education can correct this market failure. An argument can also be made that public education is redistributive because it increases the human capital of all students regardless of their individual economic status. 2. How has the composition of federal, state, and local government spending changed since 1960? What social and economic factors might have contributed to this change in how governments spend their funds? (Q2 in Gruber)  Since 1960, there has been a marked shift of federal spending away from defense spending and toward spending on education, welfare, housing, Social Security, and health. In 1960, defense spending accounted for approximately half of the federal budget, while education, welfare, housing, Social Security, and health accounted for about 20% of the budget. In 2019, Social Security and health care spending each exceeded defense spending, which accounted for only 15% of total spending. Health spending was $1.16 trillion, or nearly double the $676 billion spent on defense spending, and accounted for over one-quarter of total government expenditures of $4.4 trillion!  Health spending has also increased as a fraction of state and local spending, with growth dominated by increased spending on the Medicaid program. A report from the Multistate Tax Commission found that in 2016, health spending constituted 13.4 percent of state and local government expenditures; this contrasted to 8.5 percent of spending in 1967. (https://www.mtc.gov/getattachment/The-Commission/News/Trends-in-State-and-Local- Finances-1967-to-2017/UPDATED-Trends-1967-2018_EJD-Comments-(2)_Final.pdf.aspx) Otherwise, the composition of the state and local spending has been relatively stable over that time.  The increases in expenditures on Social Security and health care reflect the aging of the population. As the baby boom generation has aged, there is a greater need for these kinds of spending. Furthermore, this generation has played an increasingly important role in the political process, which has allowed them to win increases in spending directed toward their interests.

 The relative decrease in defense spending may have been influenced by the collapse of the Soviet Union and the end of the Cold War. 3. How did the composition of the federal budget change in 2020, in comparison to 2019? What were the most notable changes, and what factors drove those changes? (Q3 in Gruber)  A quick search of the federal budget would lead you to these infographic: https://www.cbo.gov/system/files/2020- 04/56324-CBO-2019-budget-infographic.pdf https://www.cbo.gov/system/files/2021- 04/57170-budget-infographic.pdf  Between 2019 and 2020, federal spending increased by 50%, driven by the cost of Covid-19 relief programs. Specifically, total federal outlays increased from $4.4 trillion in 2019 to $6.6 trillion in 2020. In 2019, a total of $642 billion was spent on “Other spending,” which included unemployment compensation, the EITC, SNAP benefits, etc. The 2020 budget reported $473 billion on unemployment compensation alone, as well as $526 billion for the Paycheck Protection Program (PPP), a subsidy program that made forgivable loans to businesses to cover payroll and other expenses during Covid-19. $275 billion was spent on Recovery Rebates, which are direct payments to individuals under the CARES act. $988 billion was spent on “Other,” including EITC and SNAP benefits. Nondefense discretionary spending increased from $661 to $914 billion. Finally, spending on Medicare and Medicaid also increased from $1.053 trillion to $1.227 trillion. Covid-19 related relief spending, most of which was enabled by the $2 trillion CARES Act, had a broad and large impact on most components of federal outlays.  Federal revenues, by contrast, barely changed from 2019 to 2020. In 2019 they were $3.5 trillion and in 2020 they were $3.4 trillion.  Finally, federal outlays on interest payments dropped from $375 billion to $345 billion, despite the increase in the size of the federal debt. This decrease in interest owed was driven by historically low interest rates.

4. Consider the arguments for and against the passage of a follow up stimulus package to the CARES Act in response to the Covid-19 pandemic. Specifically, consider arguments for and against additional expanded unemployment benefits and business assistance like the Paycheck Protection Program. Do you think Speaker of the House Nancy Pelosi arguments were more about efficiency or redistribution? What about the arguments made by Senate Majority Leader Mitch McConnell? Is there an efficiency case for expanded unemployment benefits, the PPP, and other Covid-19 relief? (Q4 in Gruber)  Speaker of the House Nancy Pelosi seems focused on redistribution and equity, expressing concern about people falling into poverty while Congress delayed. By contrast, Republicans are focused on efficiency and concerns about inefficiently deterring people from working, with McConnell stating that “we need to discontinue paying people, in effect, a bonus not to work."  When businesses and individuals in industries like hospitality and retail felt economic pressure to return to work during the Covid-19 pandemic, they risked exerting a negative externality on others, creating venues for disease transmission, that in turn prolonged the economic damages of the pandemic as it lasted longer than it might have otherwise. Thus paying individuals and businesses to remain shuttered during the worst months of early spread could have been the most efficient option. 5. Why does redistribution cause efficiency losses? Why might society choose to redistribute resources from one group to another when doing so reduces the overall size of the economic pie? (Q6 in Gruber)  Redistribution can cause efficiency losses if there are behavioral responses to the redistribution system. The government might raise money to fund redistribution by imposing a tax on labor income, and this might cause a reduction in the labor supply. Similarly, generous unemployment benefits might induce some who are out of work to remain unemployed. Despite these possible efficiency losses, we (collectively) choose to redistribute wealth. Some reasons for redistribution are that people have a taste or preference for a certain degree of economic equity; that the existence of a large or visible underclass is somewhat discomforting or threatening; that people are risk averse and so are willing to pay for a “safety net” in case they or their families ever need assistance; and that humans are naturally empathetic. In a country with many very poor people, redistribution from the few rich to the many poor may make the majority of people better off, even if it reduces the overall size of the pie. A democratic process may therefore lead to the occurrence of this sort of redistribution.

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