[MUSIC]. Hello. Today we will be discussing the political aspects of public economics. Public economics is one of the most political, or for that matter, politicized subject areas, fields of economics. And that comes as no surprise, because public economic decisions, they are in the public, in the involvement, in fact, multiple individuals, households, firms in a similar fashion. That produces conflicts because individuals have different preferences, different needs, and different opportunities. And, as a result, their views of public policies are different as well. Public policies, however, are the same for every individual. Everyone is subject to the same tax rules, everyone has access to the same public goods, everyone has to comply with the same laws and regulations. Private decisions are taken by individuals in accordance to their preferences, and they make best use of the available opportunities. As far as public decisions are concerned, as I just said, individuals might have vastly different preferences over what this decision should be, and this generates political conflicts. Such conflicts are reconciled and settled by political systems and processes, hence, the political angle of public economics. When we talk about politics of public economics, the key divide that we have to discuss first and foremost - about different types of political systems and how these political systems affect public economic decisions. Primarily, we need to discuss the difference between public economic decisions - taxes, and public expenditures - in democracies and autocracies. In the case of democracy, as you should remember from the first lecture, governments are agencies set by societies to take care of market failures, to support markets, and otherwise to increase the wealth of the nation. That means that there is a principal-agent relationship between government and society. And in democracies governments are agents, and the society is the principal. In the case of autocracies, the principal-agent relationship is put in reverse. In this case, the principal is the government, or rather the ruling class. And the society, well, they might not be agents - they're subjects - and the purpose of public economic policies is quite different. In the case of democracies, once again the purpose of taxes is to generate revenues to fund government's operations, and in particular to fund public goods and services. Taxes are instrumental, they are means, they're not ends. In a case of autocracy, it's quite different because the purpose of taxes is to generate rent for the ruling class. And oftentimeы, there are ends, not means. That suggests that in case of autocracies we should see much higher taxes and much less of public goods than in the case of democracies. Well, that does not necessarily have to be the case. Autocracies also have some incentives to moderate their taxation and to supply public goods, services, and production inputs. They do so, however, not because they want to serve the society, but because they want to take good care of the economy viewing the economy as their "privately owned asset". And this asset has to be kept in good shape. Excessively high taxes would excessively shrink the tax base, and, as a result, the economy will not generate maximum tax revenues for the autocratic regime. And for the very same reason, this regime might have some incentives to supply public goods and production inputs because they want to expand, enlarge the tax base and to reap fiscal benefits of this expansion and enlargement. All of that that suggests that the attitude to public economic policies of the society and of the autocrat are not necessarily that much antagonistic to each other. This is not necessarily a zero sum game and, as I said, one can expect some sensible and reasonable economic policies for an autocratic regime, as well. And then, of course, the question is how far this logic can take us? Can we suggest that political systems have little or no impact on public economic decision making? And the answer is no, that is not true. And to make this discussion and this analysis more explicit and more rigorous I suggest to have a look at the simple model which was proposed by two American economists McGuire and Olson in 1996. This model gives us a good opportunity to visualize the difference in our public economic decision making between democracies and autocracies. First of all, let's discuss the basic setup of this model. Suppose there is an economy, and this economy is taxed at the flat tax rate t between zero and one. Let's talk first about the income that this economy generates. Well, this income depends on the availability of public goods and production inputs. And this is government's responsibility to supply these public goods and production inputs. This graph shows how the income, and it's called potential income, why I call it potential you will understand in just a second, how this income depends on the availability of public goods and production inputs. The higher level of public goods and production inputs... By the way, by production inputs I mean public goods which are used in the private sector, such as infrastructure, access to markets, rule of law, so on and so forth. And this is something that has to be supplied by governments and paid by from public revenues. So if G is the available stock of public goods or public production inputs, and this stock rises, the potential income rises as well. And we assume that this association, this production function is neoclassical in that higher levels of public production inputs generates higher income, but the marginal returns to public production inputs declines as the stock of public production input rises. Okay, now we need to tax the economy to generate funds to fund public production inputs. And, as I said, we do so by using tax, a tax with a flat tax rate t. Now, if you remember from the second lecture, taxes cause deadweight losses. They cause deadweight losses because they suppress market incentives, because they distort market signals, so on and so forth. And, as a result, taxes usually reduce the tax base. As you remember, there is one notable exception from this said rule and this is lump-sum taxes, but we agreed that lump-sum taxes, for the reasons that we also discussed in lecture two, are rarely used in practice. So, flat tax rate and, as a result, deadweight losses. What is the deadweight loss? Let's suppose that if the tax rate is steep, then the tax base is decreased by the share of (1-r(t)) And this is the proportional deadweight loss caused by taxes and the rate t. Let's talk a little bit about how this function r of t behaves. It depends on the tax rate. And when t equals 0 r(t) equals 1 And that means that there is, if there are no taxes, then, quite obviously, there are no deadweight losses. And, at the other extreme, when t equals 1, in other words, if all the income is taxed away, certainly, there wouldn't be any economic activity, and in this case the dead weight loss is 100%. Now you should be able to understand why I called Y(G) potential income. This is the income that the economy would generate - if it has access to public production input G - if there are no taxes. If, for example, there is man that funds this public production equal G, then that would be the potential income. But if public revenues to fund G have to be generated by the very same economy, then you have to tax this economy. And, as we just agreed, taxation reduces the tax base and what survives taxation what is left in the tax base is r(t)Y(G) This is actual pretax income. This is what we call tax base, and, of course, this tax base will be taxed at the rate t and, therefore, tax revenues would by tr(t)Y(G), and net social welfare, what the society ends up having, is the actual output r(t)Y(G) minus expenditures, and this is net social welfare. Consider the economy or the society as a big enterprise. In this case, G would be the input used in this enterprise and r(t)Y(G) would be the output, so this is "profit" which is net social welfare. Now let's consider two problems. The first one is the one which we use to determine public economic decisions in the case of democracy. And the second one is a similar problem that is used to determine public economic decisions in the case of autocracy. In both cases, we have to find two variables. Our decisions involve two parameters. The first one is tax rate t, and the second is the is public expenditures G. And in both cases, the democracy and autocracy are subject to the same budget constraint. Public revenues, public coffers is the one that serves to fund public production inputs. And I forgot to mention, but let me do it now, that we measure public production inputs in monetary terms, it's the amount of money spent to fund this inputs. So a budget constraint, therefore, tells us that public production inputs should not exceed public revenues, that makes perfect sense, and this rule has to be observed both in democracy and autocracy, so same constraints. But different maximands, different functions to be maximized. Let me start with autocracy. In the case of autocracy, what the autocrat strives to maximize is the balance between gross tax revenues, tr(t)Y(G), net of the revenue spent to support to fund public production inputs. So, it's net tax revenues which are maximized in the case of autocracy. In the case of democracy, it's social welfare. And social welfare, as we've just agreed, is the difference between the actual income generated by the economy, which is r(t)Y(G), and a portion of that income which is spent to fund the public production input. So, same constraints, same restrictions on public policy variables, different objective functions. And it should come as no surprise that optimal solutions in the case of democracy and autocracy will also be quite different from each other, although they will have some similarities as well. So let's discuss those. [SOUND]
