Gerald J. Lynch Purdue University West Lafayette, Indiana Gerald Lynch is a professor of economics and associate director of the Center for Economic Education at Purdue University in West Lafayette, Indiana.

With the recent inauguration of George W. Bush as president of the United States and the lingering memories of the campaign promises of both candidates still relatively fresh in our minds, it is an opportune time to think about the role of the government in the economy. As was obvious from the campaign rhetoric, the government plays a large role in the economy. Government is a provider of services, a tax collector (in order to pay for those services), a provider of a safety net for income, an agent to stimulate economic growth (or perhaps retard it, depending on your economic view), an agent to attempt to provide stability in the economy, and a regulator of various industries. Given that resources, print space, and time are all scarce, we cannot address each and every role that government plays in the economy. An interesting and not often addressed question about the role of government is why government should provide services at all. Let's explore that question and then address the principles of taxation.

Exclusionary and Non-Exclusionary Goods
As a first principle, we should remember that individuals consume goods as long as the marginal value of each good, as they see it, exceeds its marginal cost. If a Big Mac costs $1.50 and I value it $1.50, I will consume it. If, after I have consumed one Big Mac, my marginal value falls below $1.50, I will not consume a second Big Mac. Non-economists might say, "I am full;" an economist would say, "The marginal value of another Big Mac is less than marginal cost, and I choose not to consume." Because of this simple principle, consumers send producers powerful market signals. If they are willing to pay a price for some good, they are making a statement about the relative values and costs of that good. If they choose not to consume it, then they are also sending an important signal, and the producer knows it is in his or her best interest to reallocate resources to some other pursuit. Under certain conditions, simple weighing of marginal costs and marginal benefits allows the market to allocate resources to their highest-valued use. These conditions are related to a distinction between exclusionary and non-exclusionary goods.

Many goods are called exclusionary goods. Exclusionary goods are goods that individuals cannot use unless they pay for such use. Exclusionary goods reflect clearly defined property rights. Most goods that people consume are exclusionary goods. For example, suppose that a local concert promoter decides to bring a series of favorite rock groups to town. The promoter rents an arena and, through the use of tight security, excludes all those without tickets. Only people who pay for tickets will be able to enjoy the concerts, and they express how much they value the concerts by how much they are willing to pay. Those who do not like the rock groups will not pay the price charged. The groups that attract many ticket buyers will be asked back, and the others will not. In this sense, the economy has done its job sending signals about consumer preferences.

Suppose, however, that the student concert board at the local college decides the promoter is charging too high a price, and some people who would like to listen to the music can't afford it. They decide to compete with the promoter by bringing groups to campus and having a different kind of pay scheme for concerts. The concerts will be held in the common ground in the center of campus. Instead of charging an individual price, there will be buckets scattered about the commons, and people will place an amount of money in the bucket equal to the value they place on the rock group. Because some people can walk onto the commons and listen to the concert without paying, this concert is an example of what we call a non-exclusionary good. Because the student concert board is asking for a voluntary contribution, it cannot exclude those who do not pay. The problem with this type of scheme arises because some people who would be willing to pay, attend the concert without paying. The nonpayers are called free riders, and their actions reflect the absence of clearly defined property rights. The problem that a market economy faces when there are non-exclusionary goods and free riders is that, under these conditions, the providers of goods will no longer be sent proper signals about the public's demand for their goods.

An underlying assumption here is that the student concert board still wants to make a profit and wants to bring in the groups that the students most want to hear. Suppose the student concert board brings in a band they thought was a big attraction, but when they count up the receipts at the end of the night (which won't take long), they learn that it was a mistake to bring this group to campus. They therefore decide not to promote any more concerts, because there is not a large enough student demand for them. Is there a large student demand? We do not really know because in the absence of clearly defined property rights, where we cannot exclude those who do not pay, we get incorrect signals about the public's demand for a good. When this happens, we tend to underprovide that good.

How does the concert example help us understand the role of government in the economy? There is a class of goods that are by nature non-exclusionary. We cannot exclude those who do not pay, and if we try to provide such a good privately, we will not provide enough of it as long as there are some free riders. Thus non-exclusionary goods have to be provided publicly. What goods fit this class? National defense is one. Once we have a strong national defense, even those who do not pay enjoy the umbrella of defense. Once people see that they can have national defense without paying, there will be some free riders; then, if we attempt to provide national defense privately, we will not provide as much as the public wants. Police protection is another example. Just the presence of a police cruiser in your neighborhood deters criminals, whether you have helped pay for the cruiser or not. If we provided for police protection privately, there would be some free riders and we would not provide the level of police protection the public wants; thus we provide it publicly. Similarly, it would be very difficult to exclude those people who do not pay for roads, so we provide for roads publicly. Of course, if we have a limited-access road, the simple use of a toll booth excludes those who do not pay. Some libertarians believe the interstate highway system should be sold to a private concern, which would charge tolls and run the roads privately.

Once we start to apply this test to whether or not the government should provide a good, we start to question some of the publicly provided goods taken for granted in this country. For a long time, first-class postal service was under a government monopoly. No one but the federal government was allowed to deliver mail, and the service was completely government provided. But a thoughtful analysis of this issue leads us to realize that we can clearly exclude those people who do not pay, and there is no reason for the government to provide all postal service. The postal service now has competition for certain lines of its business.

One good that is typically provided publicly (although it need not be) is fire protection. Unlike the police cruiser that deters crime in the neighborhood, the presence of a firehouse in the neighborhood does not deter fires. Also, it is easy to exclude people who do not pay. In some small and rural communities, a force to which people must subscribe provides fire protection. For anyone who calls to report a fire, the department can quickly check to see if the caller is up-to-date on his or her subscription. There are tales of fire departments letting houses burn because the occupant had refused to pay. While that may seem harsh, think what would happen if someone called and said his house was on fire and the check is in the mail. If the fire department put the fire out for this person, then people would know they could get fire service without paying in advance, and subscriptions would fall. Less money would be collected under this scheme than if the fire department made fire service truly exclusionary and refused to help those who did not pay. Because we find this a harsh outcome, and because those who do pay benefit from the fire department putting out fires before they spread to other houses, we typically provide fire protection publicly.

Adam Smith, the founder of modern economics, did not see an expansive role for the government in the economy. He thought it should provide national defense, police protection, and public works. In his comments on the last area, he addresses the principles we have discussed here. "The third and last duty of the sovereign or commonwealth," he says, "is that of erecting and maintaining those public institutions and those public works which ... are of such a nature, that the profit could never repay the expense to any individual or small number of individuals.¹ The reason no individual could make a profit in these cases is not that the public doesn't value those goods, but that the builder would have a difficult time excluding those who do not pay and thus collecting enough revenue to make a profit.

We have not exhausted the examples or the reasons why government provides goods, but this analysis allows us to see a decision rule for whether or not government should be providing a service. The application of this decision rule has led many communities to privatize the provision of goods that were formerly provided by the government. Once the government does start to provide public goods, it needs to raise revenue in order to pay for those goods. That leads to an analysis of taxation.

Taxation
Governments collect many different taxes for the purpose of raising revenue. Income taxes are the largest source of revenue for the U.S. federal government. Federal income taxes are a relatively recent phenomenon. It took the 16th Amendment to the Constitution, passed in 1913, to give Congress the "power to lay and collect taxes on income from whatever source derived." Just as there are principles involved in whether or not the government should provide services, there are also some principles involved in taxation. In general, we would like to see a tax raise the maximum amount of revenue with the minimum amount of disruption of output. There are also opposing philosophies on how the government should distribute the tax burden. One is the benefits-received principle of taxation, which asserts that individuals should be taxed according to the benefits they receive from government expenditures. A good example of such a tax is the gasoline tax that is used to fund the maintenance of highways. Those who actually use the highways pay the tax. Contrasting with a benefits-received principle is the ability-to-pay principle, which is almost self-defining. Those who have the ability to pay the tax should do so regardless of who receives the benefit of the expenditures. The income tax is an example of this principle in action.

The ability-to-pay principle played a part in the campaign debates in the recent election, although neither candidate necessarily addressed it with that term. The issue that the rich should pay their "fair share" comes up often in election debates. Yet there is really no definition of who the rich are or what their fair share ought to be. Around 80 percent of total tax revenue is collected through income taxes and the payroll tax that funds Social Security. While both of these tax a percentage of income, they actually are different in terms of how they tax.

Taxes can either be progressive or regressive, based on the proportion of income that is paid as a tax. With a progressive tax, the proportion of income paid as a tax, increases as income increases. If the government taxed our income at a flat rate with no deductions or exemptions, that would not be a progressive tax; while the rich would pay more, they would not pay a higher proportion. That is why the income tax, as it is currently structured, is a progressive tax: the percentage of income paid increases as income increases. If the percentage paid decreases as income increases, then a tax is said to be regressive. The Social Security tax is a regressive tax. Individuals pay a certain percentage of their income (currently 7.65 percent) into the Social Security fund, but they pay it only on the first $82,000 (according to current law; the number changes periodically as the law is revised). As someone's income goes above $82,000, the proportion of income he or she will pay as a Social Security tax decreases. To a certain extent, the Social Security tax reflects the benefits-received principle, because the payment one makes is in line with what one receives. There is actually an element of income transfer in the Social Security system. The lower income earners will receive a better return on the investment than the wealthy, but the system does scale payments received according to payments made. Thus, even Bill Gates will receive Social Security checks when he retires.

Many taxes that seem either progressive or proportional turn out to be regressive. The sales tax is a regressive tax. It taxes a fixed percentage of retail sales, but the rich typically spend a smaller proportion of their income on consumption goods and hence pay a smaller percentage of their income in sales taxes. Some states attempt to make their sales tax less regressive by exempting food and medicine from the tax. Various excise taxes on particular goods may also be regressive.

Another principle of taxation that determines where government places taxes has to do with the output disruption. If government places a tax on a good, it would like both to raise revenue and to minimize output disruption. Since an excise tax results in an increase in price, a government is more likely to achieve the aforementioned two goals if it taxes a good for which there is an inelastic demand.

One of the rallying cries for the Colonies during the Revolutionary War was, "Taxation without representation is unjust." This stemmed from the Townshend Acts (1767), also known as the Stamp Act, since a stamp was placed on items taxed. Great Britain sought to extract revenue from the Colonies without disrupting commerce in the Colonies too much. At the time the taxes were levied, Adam Smith had not yet written The Wealth of Nations (that came in 1776), and no one had yet drawn the first demand curve or identified the concept of elasticity. Nonetheless, Great Britain knew enough to put a tax on such items as tea, tobacco, and newspapers, for which demand was relatively inelastic. Lawmakers in England knew such taxes would have the least effect on the quantity of goods exchanged and thus extract the most revenue. They did not know that the Stamp Act would lead to the Boston Tea Party and the war that eventually gave freedom to the Colonies.

The size of government, the functions of government, the role of government in raising revenue through taxes — these issues have long been controversial among the voting taxpayers.

¹Smith, Adam, An Inquiry into the Nature and Causes of the Wealth of Nations, Random House, 1985, p.388.