Lecture 01: Why Study Public Finance?

Okay, the other thing to know is about my lecture style, a couple of points. First of all, I go too fast and my handwriting is incredibly messy. So please do not hesitate to ask what the hell I just said. Okay, this is, we'll learn this semester about public goods. You all know what public goods are, which is when you provide something that helps others. If you don't understand something, chances are most of the class didn't understand it. So please don't hesitate to ask, ask to repeat or just ask a question. This class, if I don't get interrupted, I go faster and faster. And eventually my head just pops off. So you guys need to interrupt me with questions, thoughts. I understand you guys don't like to talk, you know, the joke about Harvard students and MIT students and tell a joke at Harvard, they laugh and tell a joke at MIT, they write it down. Okay, so basically, please laugh at my jokes, but more than that, please ask questions, not just what you understand, but anything. If you're just curious about anything, I'd like this class to be a discussion. Remember, you're not just serving your own interests. Any question you ask is gonna be helpful to everyone in the class. So please provide that public good and ask questions. Okay, that's point one. Point two is I have a terrible tendency to use the term guys in a gender neutral sense. So when I say guys, I mean economic agents, men and women, people, I don't mean men. Okay, so I'm sorry, it's just a sexist term that I just use in the generic sense of guys or people. When I say guys and economic agents, not particularly men or women. That's the second one of a teaching style. So that is pretty much the setup of the class. Come to class, let's discuss, do the problem sets, do the exams. Oh, problem sets, no problem at all, it's group work. I don't really, I don't think ChatGPT is yet smart enough to solve my problems, I hope it isn't. But here's the thing, the exam, the problem sets, I should have mentioned, jointly are worth 25% of the grade. The midterm is only 25% and the final is 50%. So if you cheat on the problem sets, you're only hurting yourself, because the problem sets are the very best practice for the exams, which is really where the bulk of the grades are. So please work in a team, that's great, but make sure you understand what you're doing, because at the end of the day, if you don't understand the problem sets, you're not gonna understand the exams. That's the closest proximate prediction of what'll be in the exams. So make sure that if you work in groups, you understand what your group is doing so that you're prepared when the exams come along. Okay, any questions? Okay, so I'm gonna then, the way it's gonna work, if you have the syllabus, the way this is gonna work is essentially I'm gonna do roughly a chapter or lecture with some exceptions. So today I'll do chapter one, this is on the syllabus. Chapters two, three, and four are background. Oh, that's the other thing I didn't mention in terms of pre-reqs. Pre-req is a good understanding of 14.01. And how do you tell it's a good understanding of 14.01? You look at chapter two. If chapter two is like, yeah, I remember all that stuff, I need a little brushing up, that's great. If chapter two's like, I don't know what the hell I'm looking at, you should not be taking this class. Okay, I will assume chapter two. I will assume you can handle anything that's covered in chapter two. I won't assume anything beyond that in terms of math skills or knowing models. But I will assume that chapter two can be relied on as base knowledge. So please, I'm not even gonna review it in section. So please, on your own, skim through chapter two, make sure that's stuff you kind of vaguely at least remember. If it looks foreign to you, you should not be in this class. Okay, so that's chapter two. Chapters three and four are also background chapters. We'll cover those in section. Chapter three we'll cover this Friday. Chapter four in a few weeks. So I'm gonna go today, chapter one. I'm then gonna go through from chapter five to 25 pretty linearly, pretty much a chapter or lecture except some of the chapters will take more than one lecture. Okay, we'll end up with 25 lectures in the semester. All right, so today we'll start with chapter one, which is just introduction. I'm just gonna teach out of the book. That's kind of what I wanna teach. So it makes it easy. So basically, we're gonna start with chapter one, which is sort of an introduction to what is public finance and how should you think about it, okay? So when people ask what I teach, I say I teach a course about the role of the government in the economy. And roughly speaking, that's what we'll be talking about this semester. More specifically, we focus on what we call the four questions of public finance. The four questions of public finance. And these are the questions that organize everything we do this semester, okay? The first question is, when should the government intervene in the economy? When should the government intervene in the economy? The second question is, how might the government intervene? When should the government intervene? How might it intervene? The third question is, what is the effect of these interventions? When should the government intervene? How might it intervene? What is the effect of these interventions? And the fourth is, why do governments choose to do what they do? Why do governments intervene in the way we actually see them doing, okay? So what I'm gonna do is run through these questions in the context of a specific example, which is health insurance. We'll talk a lot about healthcare and health insurance this semester. It's the largest single expenditure of the US government and many governments around the world. So it makes sense, it's the focus of this class. We'll talk about the example of health insurance to sort of guide our thinking, okay? And here is the key single guiding principle is to remember that economics, as I say, 1401, if you took, how many here took 1401 with me? Apologize at the end of the semester, he'll tell the same joke. Okay, the key, as I emphasized in 1401, economics is fundamentally right-wing science. We assume the market is correct unless proven otherwise. So the fundamental guiding principle of this class on question one is when should the government intervene is, is there a provable market failure? Is there a provable case that the market is not delivering the welfare maximizing outcome? Only then do you go on to the other questions. This is the threshold question. If there's no provable case that the government, that the market isn't welfare maximizing, you're done. You don't have to worry about these other things, okay? You need a provable case that the market outcome is not welfare maximizing. We'll talk about many, many of such provable cases, but you need one, okay? So for example, and this is what's proved, as we prove in 1401 and prove again quickly in chapter two, the first fundamental welfare theorem of economics says the market outcome's efficient under certain conditions. And we wanna ask which of those conditions might be violated. So essentially, there's essentially two types of reasons why we say the government might want to intervene, or two types of answers to the one question. The first is market failures, market failures, okay? The market does not meet the conditions that are required for an efficiently operating economy, okay? So let's take the market for health insurance. At first glance, this should be a pretty well-functioning market. I mean, there are something like 160 million, there's something like 200 or 300 million Americans or more buying health insurance, okay? There is a price of health insurance. There's many, there's a price and quantity of health insurance. There's many firms delivering health insurance. At first, this might seem like any other market. Now, you might say, well, of course, it's not like a market because people aren't insured. Indeed, before the Affordable Care Act, about 50 million Americans weren't insured. Now, almost 30 million are. You might say, gee, well, clearly the market's broken because there's uninsured people, but that would be wrong. Just because someone doesn't buy something doesn't mean the market's broken. There are people in America without large screen TVs. That doesn't mean the market for large screen TVs is broken. It just means some people have chosen not to buy them. It's the existing price. So the fact there's uninsured does not mean the market is broken. We need an actual reason why the market is not functioning efficiently, okay? That is, we need some kind of market failure. So a classic example would be an externality. So for example, and we learned about this in 1401, for example, imagine that I get sick and because with a communicable disease and because I don't have health insurance, I don't get vaccinated or take the medicine that I need to fix that communicable disease, and I come to class and I get you all sick, okay? COVID obviously is fresh on our minds here. We all live through that, okay? That is a classic externality, an example of when one party's actions affect another party. In such situations, we'll cover in depth in chapter five and beyond in the class, this is a reason why the social value of health insurance exceeds the private value of health insurance. Market failures arise whenever social benefits and costs do not align with private benefits and costs. Once again, we'll go over this in detail next lecture. But that's where market failure is gonna arise. A classic example would be if I am not accounting for the fact that I'm making you sick, then my private incentives are not aligned, my private benefit is not aligning with the social benefit, okay, and this is a classic externality. And in the book, I talk about vaccination as a classic example of government policies to fight this kind of externality. Measles used to be an incredibly deadly disease, about three to four million Americans used to get them with about 500 people dying every year from measles. A measles vaccine was invented and measles largely went away as a problem. By the 1980s, there were fewer than 3,000 cases. But then in the 1990s, there was a burst of measles cases. And it turned out that basically, what happened was that basically a bunch of patients had stopped getting vaccinated. And enough patients stopped getting vaccinated that kids were starting to catch measles again and dying from it. So immunization rates fell dramatically and deaths increased from measles. In response, the federal government made vaccination for measles free for everyone. And that caused immunization rates to go back up. Immunization rates went back up into the 90s. But then a new problem happened, which is, I'm trying to be too judgmental in this class, but one of the world's biggest assholes. Okay, there's a guy named Andrew Wakefield. Andrew Wakefield wrote an article in the Lancet, actually a reputable medical journal, claiming the vaccines gave you autism. Now, if you look at his study, I swear to God, this is true. His study, and we don't have to be empirical scientists to understand this. His study was, he went to a birthday party and collected data from like eight kids and two of them had autism. And it was correlated whether they've been vaccinated or not. And somehow got published in this reputable medical journal and it became the basis for this view that vaccines are bad for you and cause damage. Of course, it's false. There's never been any evidence that's true. But it's become a basis. It was sort of the kicking off point for a massive anti-vaccination movement we all know about by now. Okay, we all know about the anti-vax movement. We know that it led to a massive spread in the lack of vaccination for things like measles and explosion in measles cases. These were often concentrated in particular areas like, do we have any Minnesotans here? No, no Minnesotans, my wife's from Minnesota, so I focus on Minnesota a lot in my examples. They have a large immigrant Somali community. For some reason, the word got around that community vaccines were bad. Immunizations rates fell to less than 50%. And they had the largest measles outbreaks in more than 30. Okay, so that led to other reactions. Like for example, the state of California started saying we will kick kids out of school if they're not immunized. And we won't accept any exemptions. Some states said we have to be immunized, but if you tell us your religion forbids it, we'll let you not be immunized. California said, no, you're not immunized, you're not going to school. Is that a good policy? That's what we wanna talk about. That's what we wanna think about. Does that make sense? Is that a sensible way to fight this? And obviously, COVID brings it to the fore. We all know about the vaccine sketches and problems in COVID. We may have seen the facts that death rates in red counties, counties that typically vote Republican, during COVID were dramatically higher than death rates in blue counties, correlated with the fact that vaccination rates were much lower in red counties than blue counties. And in general, the estimates are that the availability of the COVID vaccine saved about 2 million lives worldwide. We're saved by the vaccine. And yet, vaccination rates, even for the first COVID shot, never got much above 70% in the US and for boosters are well below 50% and diminished. Okay? So basically, this notion that kind of, well, there's an externality to get a vaccine is clearly not percolating through and other things are coming in. This raised the question of what should the government's role be? So that's the first kind of market failure. The second kind of market failure, the first kind of answer the when question. The second kind of answer the when question is redistribution. We learned in 1401 that we have a social welfare function and the goal of government is not to maximize the size of the pie, but to maximize social welfare, which accounts for both the size of the pie and its distribution, or at least some would say. Some people might say the goal is solely to maximize the size of the pie. That's a particular social welfare function. Okay? But other social welfare functions would say, no, distribution matters. In that case, even with a well-functioning market, you may want to engage in government intervention for your distribution. Now, the trick here is that typically, this is gonna lead to what we call an efficiency equity trade-off. Typically, when you redistribute and intervene in the economy to distribute, you cause inefficiencies. So distribution is rarely free. There are a few cases where it is, where actually you get a win-win solution of both solving market failures and redistributing. But by and large, there's a trade-off. And that's sort of the core of a lot of what we'll talk about this year, this semester, is basically, how do you think about that trade-off between efficiency and redistribution? Okay? So that's the first, this is the first threshold. Is there either a market failure or redistribution argument for what you want to do? If not, go home. Okay? We are gonna trust the market unless you have one of those reasons. If you have those reasons, you can then turn to the how question. If the government sees a market failure, it wants to redistribute, how can it do so? Well, the government has a lot of different tools to do so. I'll just give a sort of an overview here. For example, the government could tax or subsidize private purchase. The government could say, look, we think there should be more vaccination, so we're gonna make it free. We think there should be more health insurance to offer you a tax credit. Indeed, the Affordable Care Act includes massive tax credits for health insurance exactly in the argument the health insurance market is not working well. So as a result, we need to subsidize the provision of health insurance. Okay? So that's one way the government could intervene. A second way a government could intervene is to restrict or mandate purchase. The government could say, well, we're not gonna change the price, but we're gonna either not allow you to sell it. For example, we think cigarettes have negative externalities, we could ban the sale of cigarettes, or mandate you have to buy it. If we think that health insurance, not having health insurance is negative externalities, we could mandate health insurance, which is once again what the Affordable Care Act did, although it's subsequently been repealed. Okay? That's a second thing you could do. The third thing you could do is public provision. You could say, look, we think this is a problem that's solved by the government literally providing the good. So the government could literally say, as they do in Canada, we're gonna have government-provided health insurance. We think people are not buying enough health insurance, we're not gonna mess with the private market stuff, we're just gonna have a government-provided health insurance. Okay? That is another way you could approach a problem like that. And then finally, the last category here is public financing. Of private provision. So you can, public financing. So you can say, look, I'll let the private sector provide it, but I'm gonna pay them to do so. Okay? So an example here is in 2003, as we'll talk about in a number of lectures, the government had a prescription drug benefit to the Medicare program for our nation's elders. Okay, you need to write no about this now, we'll cover it later. But instead of just giving them a government-provided drug option, they paid, they reimbursed private health insurance companies to provide the drugs. So they said, you're gonna buy it in a private market, but the government's gonna pay for it. Okay? So that's another way that you can go. So there's lots of options, yeah. Three and four is the difference is, is the private market involved. In three, the private market's not involved, the government just provides the insurance. So the debate, as we'll cover about Medicare Part D, which, the other parts of Medicare are literally government just provides the insurance. This was no, instead of the government providing the insurance, we're gonna hire private insurance companies to provide it and we'll just pay them. It is, the difference is that basically, it is a form of a subsidy. These are all sort of related. It is a form of a subsidy. The difference is the government sort of organizes the market more and more, but they're related. Good point, good question. Okay, so that's the second question. The third question is the, the third question is the what question? Okay, you've decided that the government should intervene. Okay, you said there's a justification. You're considering ways the government might. Well, how do you choose between them? Well, the way you choose between them is by understanding what effect these different interventions will have. To help choose, you need evidence on how these different interventions might work. And that is the area of what we call empirical public finance, which is actually trying to assess what effect different types of government policies actually have, okay? And here, of course, we have direct and indirect effects. The direct effects aren't fun. That's accounting, accounting for, okay? The indirects are fun. That's economics. That's the effect of the policy that's unintended, but yet can have a critical impact on the outcome. So for example, let's say before the ACA, the government said there's 50 million uninsured people, 50 million uninsured people, and let's say we think we can insure each of them for $2,500 each. So that means that we could insure all the uninsured for $125 billion. Now, when I was a kid, that was a big number. In the era of COVID, were you guys hearing lots of trillions thrown around like they're nothing? That's not that big a number, 125 billion. After all, our spending in healthcare in the US is three and a half trillion. That's a pretty small number, if you think about it. We'd cover all the uninsured. That's the direct effect. What does that miss? Why is that number wrong? No, I'm just doing the cost for now. Just the cost, yeah. Yeah, what that misses is being uninsured is not stamped on our forehead at birth and irremovable. It's a choice. And if you change relative prices, choices change, okay? So if you change the relative price of being uninsured by going for something bad to something that's good, because you get free health insurance, you could create a lot of people who then announce themselves uninsured to get this free care. So for example, imagine that basically, imagine half of everyone who has private insurance dropped it and said, well, gee, why should I pay for my private insurance? I'll just buy, I'll just get this free public, this free insurance for the uninsured. That would cause the cost to rise from 125 billion to 340 billion a year. That's, now we're talking real money. On the other hand, if only 10% of those with private insurance decide to drop it and join the program, that raises the cost to only 165 billion a year. So this is if half the privately insured say I'm gonna take advantage of this free program, this is 10% do. That's a huge difference. What's the right answer? How many will? That's what we think, try to think we get at with the what of public finances. Try to understand these, measure these indirect effects. We can understand what effect government interventions will actually have. We'll get to the benefits later. This is just the cost, okay? So that's the what. And here, we're gonna come to the heroes of our story. The people, the unsung, not all heroes wear capes, the youngsters story, which is the Congressional Budget Office, the CBO. The Congressional Budget Office is fundamentally the last thing between us and the total collapse of democracy. And I'm only slightly exaggerating. Why do I say that? Because the Congressional Budget Office is a truly, hard to imagine this word still exists in America, but a truly nonpartisan institution that is in charge of what's called scoring government policies. So let's say you've got a bill and you wanna do something, you wanna provide free healthcare to veterans or whatever. CBO takes your bill, takes the bill language, and estimates what it's gonna cost. They have models of the type we'll discuss this semester, and they form estimates, including both direct and indirect effects, of what it's gonna cost. And that becomes the official word for Congress. And basically, what that means is that if you wanna do some policy that's fiscally responsible, CBO is going to call you out on it. So let me give a simple example of why this matters. In 1965, Lyndon Johnson wanted to use the Medicare program, which is universal coverage for the elderly. He knew it was gonna cost X. He announced it would cost 1 10th X. And he passed it. And no one could really say like he was wrong. Okay, now, I like we have Medicare, I'm not saying that was the wrong decision, but it's no way to make a decision, okay? We wanna know, we want our eyes open when we go in and think about government policy, we're eyes wide open on what we're getting into. And that's gonna mean actually having objective scoring of what that is, and that's what the CBO does. So they really are sort of the truth tellers in Washington about what government policies are gonna cost and what they're gonna do. And we'll refer to them with great reverence throughout the semester. Now, to be clear, if they're projecting a number, it is by definition never right, okay? It's impossible to project these things correctly. All you want is that the errors are symmetric, okay? You just want an organization which is not gonna get it right. You can't hold them by how right they get it. Just wanna make sure their errors are not too large and symmetric. One way to see that they achieve that goal is both parties hate them equally. That is a good sign. If any party ever starts defending CBO a lot compared to the other, then that's a problem. So we'll talk about that more this semester. And then the final question of public finance is the why. Why do governments do the crazy ---- they do, okay? Why does Canada have single payer coverage and we have this mixed private public system? This is at least the field of what's called political economy. Now, this is really an entire subfield of economics. You can take entire classes on that. In fact, we have the world's leading political economists right here at MIT. Okay, you can take entire classes on that. We will unfortunately devote a lecture to it, which is really unfair. It's just, it's kind of not fun and depressing. Because it's basically about how every, basically we're gonna spend the semester talking about what a benevolent government should do. And then we'll spend a lecture talking about why governments aren't benevolent and they screw everything up. And I'll say, oh, well, let's go back and assume what a benevolent government's gonna do. That's not quite right, because throughout the semester, I'll talk about some political realities that intervene in doing the right thing. But political economy is fascinating. It's really important. It's increasingly important. And we'll spend some time on it this semester, but not nearly as much as it deserves. Okay? Questions about the four questions. Yeah. Well, no, we have economists. We have many. We have Daronis Simoglu, Ben Olkin, Abhijit Banerjee. We just hired a guy named Jacob Moscona. We have a ton of, really, we have by far the best group doing that in the world. And probably the signal book in political economy, it's a book called Why Nations Fail by Daronis Simoglu. Sold like a million copies. It's like probably the central book of political economy today. All right? Other questions? Okay. So now, let's go on to the next thing I wanna cover in this lecture, which is why should we care? What's going on? Why did this matter? And to do that, I wanna motivate. We're at MIT, I wanna motivate that with some facts. So let's go to the handout. You should all grab the handout from up front. By the way, every lecture will be a handout to pick up. Make sure you pick it up. I mean, also, if you have the book online, you can look on your laptop. It's not a problem. You don't have to look at it on paper. But if you don't have your laptop, you don't have access to the chapters. The handouts will always just be tables and figures from every chapter. The access to the chapters online, great. If not, you can grab a handout. Okay, so this is from section 1.2 of the book, which is the facts about the government. Let's go through facts about the government. Figure 1.2 is the growth in the size of the US government, the percent of GDP that is spending by the federal government over time. What you see is that when we started collecting this data around the Great Recession, the federal government was very small. It's about 5% of GDP was government expenditures. It then exploded during World War II, then settled back to a slowly rising trend, really peaking in about the 1980s, then went back up to 2010. If this graph went into COVID, you'd see a big peak in 2021. 2021 was government spending went up to over 30% of the economy, the biggest since World War II. And now it's back down to about 25% of GDP, okay? So basically, if you want to extend this line, it goes up to about 30% in 2021, and today it's back down to about 24%, I think, of the economy. So this raises natural questions such as, well, what is the right percent of the economy for the government? And why did it grow? And is it good that it grew or bad that it grew? These are sort of the, you should be looking at graphs like this. That's the central question you want to ask yourself, is what does this all mean for what the US government's doing, both what it's done and what it should be doing? So that's one sort of facts we'll look at it. Comparatively, you can look at figure one, two. This shows the growth of government spending. Now, let me be clear. Sometimes these figures look contradictory. If you note the US line, this figure is higher than the previous figure. That's because this includes all of government, federal and state and local. I'll come to that in a minute. This is total size of government. And what you see here is, you can see the US growth in the sort of orangish line, I guess. And you compare that to the average among developed countries. Our indicator of developed countries is called the OECD, the Organization of Economic, I don't know what it stands for. But OECD is for Organization, I know that. And that's sort of our set of sort of developed country counterparts. You see, actually, we started about the same place as OECD in 1960. OECD countries have grown somewhat more than the US over time, although they've come back in line. You see two or three different patterns in Sweden and Greece. Just two examples. Sweden, spending by the government exploded in the 1970s. To the point where by 1980, two thirds of all activity in the Swedish economy was government. That was a huge number that persisted for a while, but it started to fall again over time. Sweden then started reducing that over time, and it's actually come back down to about 50%. Compare that to Greece, which for many, many years was well below the OECD average, and then exploded in the 1990s, ultimately leading to, we know it's the Greek debt crisis about a decade ago, and is now spending at a level that's comparable to Sweden, above the OECD average. So once again, lots of different patterns. Why did Sweden explode in the 70s, then come back down? Why did Greece explode later? These are the kind of things we want to try to understand, and what were the effects of all those. Fact number three, figure 1.3, the highly technical figure 1.3, shows the division of what the U.S. government does between federal and state and local expenditures, or what we might call the central and the decentralized part of the U.S. government. Now, what you see here is federal expenditures are about 2 3rds of total government expenditure. Now, that actually is pretty steady over time, but changed dramatically during COVID, when the federal share went much, much higher, before now it's slowly returning back to that long one steady state, and differently enormously across countries. We'll see in chapter 10, we'll discuss this. The U.S. government's relatively unusual in how little is done by the central government. Most other countries have a much larger share of the government expenditures run through the central government than the U.S. does. We have a relatively decentralized government, okay? Relatively large share of our spending goes through states and localities, as opposed to the federal government. This raises a set of questions you probably haven't thought a lot about, but which are really interesting, that go in the name of fiscal federalism, which is what should be done at what level of government? Why is defense done by the federal government and education done by towns? Why are roads and police done by towns, but welfare programs like Medicaid and FTC are run by states? Does it make sense? Is it done for some random historical reason, or is there actually a strong theoretical basis behind how large there is, actually, and that actually there's a solid explanation for why we distribute things the way we do? And that's the purview of what we call fiscal federalism, which is what we'll cover in chapter 10, okay? So that's the third fact I want you to focus on. The fourth set of facts are around the government's budget balance. Now, this course is distinctly a microeconomics course. We'll do incredibly little macro. Basically, the only macro in the book is contained in chapter four, which we'll cover in section in a few weeks, okay? But this sort of notion that deficits are bad sort of lies behind a lot of what we'll talk about throughout this semester. Now, is that notion correct? You'll talk about it in section in chapter four. But nonetheless, it's a focus of a lot of what we'll talk about as sort of an underlying. In other words, we're gonna sort of talk about throughout this notion the government doesn't have an unlimited budget. It's gotta eventually pay its bills. In chapter four, we talk about why that's a framework that makes sense and where it comes from, okay? But for the rest of the book, we'll just sort of take that as given. Now, what are the facts on the government budget? Well, it's rather interesting. Once again, you see that expenditures we saw before, this is now back to the federal level only, you see revenues except for World War II were largely in line with expenditures. And therefore, except for World War II, until about the early 70s, we had a zero surplus or deficit. That is government spending was about the same as government revenues. Then starting in the 1970s, we started building up large deficits. That's the negative, the second panel, the numbers going below zero. And you see the gap between the red and blue lines growing. Okay, we started to build up large deficits. Then in the 1990s, there was a boom in tax collections and actually we closed the deficit and actually briefly went into surplus. Okay, I was very excited. I was in the White House. I was in the Clinton administration. I got to be in the White House when Clinton did this big celebration about how we're gonna move to surplus and we're gonna end the national debt. And then what happened was, of course, what always happens, which is once President Bush got elected, we went back into deficit. That deficit got significant during both Bush and Obama handling the Great Recession of the late 2008, 2009 period. And we'll talk some about why the Great Recession led to such a boom in the deficit. It then started to close and then COVID hit. And once again, this graph stops at an early point. You'll see there, the deficit explodes during COVID again because of the massive federal spending on the economy. And we'll talk about what that federal spending was. And now it's starting to close again, okay? So basically, if you extend this graph, you'll see sort of the red line going way up. Like I said, we went up to about 30% of GDP in 2021. The blue line stays pretty much the same. And eventually now the red line's coming back towards the blue line, but we've got very large deficits. The result is the national debt. Deficit's a flow measure. Debt is a stock measure. The debt is the accumulation of all past national deficits. And what you see is we had a modest national debt till World War II. World War II caused the national debt to spike at about 120% of GDP. It then fell over time. Now, here's the clear thing. Here's the key thing. When you're talking about aggregate concepts like debt or deficit, never talk about them in dollars. Politicians are very good at this. When they want to make a number sound big, they'll talk about it in dollars. When a number sounds small, they'll talk about it as a percent of something, okay? We aren't politicians. We care about things right. The dollar amount doesn't matter. Dollars are worth different times at different periods of time. We know that. We review present discounted value in chapter four. What matters is the share of the economy. How big is the debt? And what you see is from the end of World War II all the way to 1980, the debt shrunk enormously the share of the economy, not because the debt fell, because the economy grew and the debt didn't grow as fast. So we basically grew out of our debt, okay, in that period. Then deficit started to rise and the debt accumulated again. It flattened out a bit in the 2000s because we had gotten to small deficits. Now it's exploded. Now we're currently at about, approximately where we were at the end of World War II, about 125% of GDP. Okay, the debt's the largest it's been now in, you know, in 70 years, 80 years. So once again, how do we feel about that? Yeah. Well, that's a great point. We nominally grew out of our debt with that. Once again, you cover this in chapter four. What that means is the debt is denominated in nominal dollars. The nominal economy grew massively. Some of that was inflation. A lot of it was underlying growth. Good question. So where does that put us in national context? Well, if you look at figure one, five, that shows where our debt levels are relative to other countries. We were right in the middle. I'm now revising the textbook. We currently have the second biggest debt in the world. So we've gone from being right in the middle in this graph to about second in the world with our debt. So we're large. There is, as I said, what you cover in chapter four, there's a constant debate about whether it's too large, how worried we should be. We don't need to get in that debate, other than to say, in general, we're gonna operate in the concept that all is equal. It's better to not spend money than to spend money. Okay, all is equal. We don't wanna burn money, okay? That that's kind of the underlying principle with which we'll operate, okay? Now, let's now turn to, oh, that one's interesting. If you look at figure one, six, that's interesting. This is state and local. Note the difference in the way state and local governments operate. State and local governments are generally in surplus and never in deficit. Why is that? Well, because it's the law. States have what's called balanced budget requirements that mandate that they can never be in deficit. And I think, well, that's a good idea. Why didn't the federal government have that? Well, that's a great question that will be part of what we discussed in chapter four and we'll discuss elsewhere. But the answer is because of the macro stuff we don't cover that basically a standard way to fight macroeconomic cyclical fluctuations through government spending, that's the standard Keynesian model, and you wouldn't want the government not to be able to spend in bad times, which is why even if a state-level balanced budget requirement makes sense, federal level one does not. Now, the next thing we're gonna talk about is what does the government actually do with all this money? And that's in figure one, seven, okay? This shows, figure one, seven, there's four panels. The left panels are for 1960, the right panels for 2019. The upper is federal government, the lower state and local government. And this, I think, will have a lot of facts you may not have known. For example, in 1960, the federal government basically spent about half its dollars on defense. And other stuff was small in particular. Education, housing, and welfare was about 3.6%. And healthcare spending was 2.7%. Today, healthcare spending is the single largest thing the government does. It's gone up tenfold. So over the 60 years, from 1960 to 2019, healthcare spending went from 2.6% of the government budget to 30% of the government's budget. Defense shrunk from 47% to 14%. Social security's gone up some. Net interest is comparable. And basically, as economist Paul Krugman wrote, the US government has become a large social pension fund with a small army attached, okay? It's kind of where we are. We've changed massively in how we spend our dollars compared to 1960. Now, compared to the state level, at the state level, things haven't changed as much. Health spending's also grown at the state level. Education spending shrunk a little bit. Other whatever it is is about comparable. What's more interesting is less the growth. It's more interesting the comparison from up versus down. Look at the fundamentally different things that the federal government and state and local government spend their money on. The federal government spending is more on health and social security and defense, but education, welfare, and housing together are 8%. Well, a third of what state and local governments spend their money is education, okay? And they spend nothing on defense and comparable somewhat less on health. So that raises question I already asked, which is why are these different spending done in such different ways at the levels of government? Does it make sense? What are the effects of that? That's a really fascinating question that would cover the fiscal federalism. Now, that's how the government spends its money. How's the government raise its money, okay? Well, figure 1.8 gives the source of federal receipts. Now, here what's interesting is, once again, 1960 versus now 2020, top is federal, bottom is state and local. What you can hear is, first of all, the share of federal revenues from income taxes basically not changed. We sort of consistently get slightly less than half of our federal revenues from income taxes. Now, we'll talk about what income taxes are later. Okay, we'll talk about different kinds of taxes. Basically, we have different kinds of taxes. We tax income taxes and your whole income. On the other hand, we have what we call social insurance contributions, or also payroll taxes, which are that FICA line and Medicare line and your pay stub. Those are collected just on your pay, but not other income, okay? That's where the real change is. And then we also have corporate taxes, which is taxes on the profits made by corporations. And here's the fundamental change. We've gone from corporate taxes being 23% and social insurance being 17% to corporate taxes being 6% and social insurance being 39%. We've basically massively shifted from corporations paying taxes to workers paying taxes. How do we feel about that? Well, at first, that sounds bad. Corporations should pay taxes, not workers. But then you realize that, like, corporations pay the workers, and if they pay taxes, maybe they'll have less money to pay the workers, and maybe it's not such a big deal at the end of the day. If it's corporate tax or worker tax, it's all the same pot. There's a bunch of money firms pay. They either pay it to workers or keep it in profits. Doesn't really matter if it's taxed. Which view is right? That's what we'll cover in chapter 19. We talk about tax incidents or the question of who actually bears the taxes. Okay, think about what does it mean that our economy's gone from one which collects a large share of its revenues from corporations to one which collects a large share of its revenue from payroll. Now, that's spending and taxes, but it turns out most of what, or much of what the government does does not involve much money, and that's the regulatory role of the government. So, for example, the FDA, the Food and Drug Administration, approves all the food you eat, all the beverages you drink, and all the drugs you take. Now, the FDA, their budget is only 0.025% of the federal government budget, but their regulations affect on the order of $3 trillion of goods annually, okay? So, they have an outsized effect. Not a lot of spending, but a huge regulatory effect. Likewise, if you think about work and think about safety at work, the OSHA, the Occupational Safety Hazard Administration, regulates the safety of workplaces. Once again, the agency only has 1,850 employees, but it's responsible for the safety of over 10 million worksites in America, okay? They regulate work safety. If you listen to radio or watch TV, that's regulated by the Federal Communication Commission, and they've got a massive reach. And then, of course, the water you drink, the air you breathe, that's all regulated by the Environmental Protection Agency, okay? Which has a large staff, but once again, small relative to the giant environment it's regulated. So, the government has both fiscal roles in spending and taxing, and regulatory roles as well. Now, what we'll do in this book is we will try to, we will cover both of those roles. Let me give you sort of a quick overview of where the story's going. So, what we'll do is we'll start in chapters five through 11, in talking a lot about what the government's role is in dealing with externalities and public goods. And that's largely a regulatory role. There's some spending and taxing, but that's largely a regulatory role. We'll then turn, that's sort of the first segment of the course, is externalities and public goods. We'll talk about environmental externalities, health externalities. We'll talk about education. We'll talk about state and local public finance, and we'll talk about how you do cost benefit analysis. The second third of the course is the social insurance function of the government. That's social security, health insurance, all this government does, all the stuff the government does to insure us. That's largely about spending and taxing. And that's the second third of the book. The third third of the book is how do we pay for it all, and that's taxation. And there we'll cover all the various forms of taxation, how taxation affects our behavior and the function of the government. So that's sort of where we're going in thirds. The midterm is gonna cover sort of, slightly less than the first half of the course, the first third and some of the social insurance stuff. So that's where we're going. Now, the last thing I wanna talk about today, let me see, are there any questions about this so far? Okay, the last thing I wanna talk about today, I'll let you go. I usually wanna lay out early, but I don't like going to next lectures, I like to keep it a little clean. So we'll start chapter five next time. Last thing I wanna talk about today is, why is this a particularly exciting time to be taking this class? Now, in all fairness, I say that every year, okay? But the answer changes, okay? This is a really exciting time, I would argue for two reasons. The first reason is because we have lived through the largest shock to the US probably society in 100 years, which was COVID, or at least 70 years since World War II. And COVID fundamentally shook up the whole relationship between the government and the public, okay? Shook up the whole relationship. So think about the when question, okay? When should the government intervene? Okay, basically, under COVID, the US government sort of took charge of the US economy in a fundamental way it never had before. We spent, you know, we never did stuff in trillions before COVID, it was billions. Now we're in a land of trillions. We spent $3 trillion, essentially, trying to keep the US economy afloat during this fundamental shock between money we sent to unemployed people, between money we gave to firms to try to stay open, money we gave to schools to make sure that they could still provide their services even though there weren't, students weren't in-house, money we gave to states and localities, et cetera, money we gave to hospitals who were dealing with being overwhelmed by COVID patients, et cetera. We just gave away money on a magnitude we've never had before, okay? So the question is, was that justified? That's the fundamental when question. Should we have done this massive intervention? We fair bipartisan under both Trump and Biden, okay? Then there's the question, the when question about vaccines and about the regulatory role of the government. Should the government have mandated vaccines? Should have mandated vaccines stronger or weaker? Should the government have mandated masks? Should they have mandated earlier or later? What should the government have said about social distancing? We fundamentally, COVID is so interesting because it was the biggest sort of government intervention in our economy we've seen in my lifetime in terms of the government coming in and regulating so many aspects of our life, spending so much money. And now the dust is starting to settle, realizing we might not have done some things right and what lessons can we learn? And how can we use those to be prepared for future government intervention? Okay, pandemics are no longer gonna be once a century, they're gonna be more frequent than that. So how are we gonna be prepared to deal with that? So that's sort of the when question. What about the how question? Well, let's think about how the government dealt with COVID. The government dealt with COVID in ways that, in very different ways. On the one hand, the government provided a lot of spent money directly to people to support them and sent checks to people. It gave out a lot of unemployment insurance, Democrats like that. On the other hand, the government gave a lot of money to businesses, try to keep them afloat. Things like the Paycheck Protection Program, which was loans to small businesses to stay afloat. The Republicans proposed them like that. So very different ways the government handed out money. There are very different ways the government regulated with Republican leaning states, tending to have looser regulations on masks and social distancing than Democratic leaning states. So the how the government should intervene was also critical during COVID. The what are the effects of intervention are fascinating because we've just run the largest experiment in public finance in decades. What effect did it have? Indeed, we'll talk sometimes, there's an organization in Harvard Square called the National Bureau of Economic Research, the NBER. This is the nation's preeminent nonpartisan economic think tank. They issue working papers, which are sort of ongoing research in the field. And that basically, over the first nine months of COVID, about nine, about a quarter of all working papers issued by this group were related to COVID, okay? It's been a massive study of the effects of all these interventions. We've learned incredibly, really interesting things about the effect of more generous employment insurance, about the effect of mask mandates, about the effect of money to businesses to stay open. We've learned things from comparing the US to other countries. We've learned lots from this massive, we've run a massive experiment and we're learning from it. And then finally, there's why does government do what it do? Why did the US, so here's a fundamentally interesting question. In the US, when COVID hit, we basically let companies shut and gave people unemployment insurance. In Europe, they paid companies to stay open and didn't give unemployment insurance, which was the right approach. How do we think about that? Why did they do things so differently? That's the questions we'll tackle in political economy. So that's the first reason why this semester is particularly interesting, because we've just run this massive experiment that we're starting to learn about and we can learn from. The second reason is this course is always incredibly fun and tense to teach in election year. And there's no more fun and tense election than this one. I don't know about fun, but tense, okay? We are going to be hearing and seeing a lot of things that will bear on public finance throughout this semester. There's gonna be a lot of current topics that are related. I am eager for folks to bring them up and discuss them. My partisan leanings are well known, but I'll try to be pretty objective. I'm actually, in the scheme of things, a fairly centrist Democrat. So I'll try to be objective. I wanna hear people's opinions. I wanna hear questions you're thinking about as you're thinking about this election, regardless of whether it's determining your voting, just this election is gonna raise, should we tax tip? Both candidates now propose getting rid of the tax on tips. That turns out to be a terrible idea. I'll tell you why, okay? So I'm not gonna be shy about my opinions, but that doesn't mean that you shouldn't push back, okay? If there are things that you don't understand, if you disagree, if there's just things that have been covered in the news about this election you wanna talk about, let's talk about it, okay? This is the time when public finance is in the news, okay? Hopefully a lot, hopefully it's not all news about personal foibles and boat stealing, but rather news about public finance questions. And so it's a great semester we're discussing this. So once again, I really urge you to fight your MIT instincts, just write everything down, and instead to go ahead and ask a question, okay? And recognize that there are no stupid questions, that any question you ask, many of your classmates also have, and you're helping them out by asking them. So I hope we'll take advantage of this election season to motivate a lot of interesting discussion, okay? Okay, thanks.