July 31, 2010

Why does the government spend money?

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The Congress shall have Power to lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defence and general Welfare of the United States.

The Constitution of the United States, Article I, Section 8

There are two types of government expenditure: transfers and the purchases of goods and services.

Transfers

One thing government can do with tax revenue is transfer it to people in the economy. “Transfers” are the product of complex political and social negotiations and are promulgated and defended on the grounds that the government has a social responsibility to support certain people or encourage certain behaviors.  Examples of transfer programs include Social Security, Medicare, Medicaid, Transitional Assistance to Needy Families (welfare), Food Stamps, and Unemployment Insurance.

Purchases of goods and services

The argument for government production of particular goods or services is that private markets do not produce enough of those goods or services. Economists offer two reasons why such “market failures” might occur: public goods and externalities.

Public Goods

Public goods are ones that markets undersupply because one person’s consumption of the good does not diminish anyone else’s consumption of that good and because it is difficult to exclude anyone from the benefits of the good—even people who have not paid for its use—once it has been produced.

The classic example of a public good is national defense. If one person or group hires an army to protect the country from attack, this safeguards everyone, but the private supplier has no easy way to charge those who benefit from the protection. Thus the incentive for a private party to supply national defense is limited. Government can solve this public goods problem by producing national defense and compelling everyone to pay via taxation.

Externalities

Externalities occur when the actions of a consumer or firm affect the consumption or production possibilities in some other part of the economy in a way that is not transmitted via price. Pollution is a standard example. A factory that dumps toxic wastes in a river will typically not consider the costs this behavior imposes on others and will therefore manufacture more waste than is socially desirable. The same is true of the commuter whose car generates noxious air emissions. In these cases government can potentially improve economic efficiency through regulation or other interventions.

Externalities can also be positive—for example, spillovers from education. Each person who acquires education derives some benefit, but others may benefit as well if each person’s productivity depends not just on his own training and skill levels but also on that of his co-workers. Under this condition, the amount of education chosen privately by each individual or family does not lead to the socially desirable level of education. Expenditure that increases education beyond the privately chosen amount could therefore increase an economy’s overall productivity.

Thus some kinds of government expenditure can generate benefit in excess of costs because private markets do not always work efficiently. The question for the U.S. fiscal outlook, however, is which current expenditure has a convincing public good or externality justification.