Public Finance and Fiscal Policy
Public Finance and Fiscal Policy tests the economic rationale for government, the design and incidence of taxes, and the sustainability of fiscal policy. The exam expects you to connect market failure to policy tools, and to distinguish legal from economic tax incidence.
Core rules and concepts
- Public goods are non-rival and non-excludable, so markets underprovide them and free-riding is rational. The Samuelson condition is ΣMRS = MRT: the sum of marginal rates of substitution equals the marginal rate of transformation.
- Externalities: a Pigouvian tax equal to marginal external cost at the efficient output internalizes a negative externality; a subsidy addresses a positive externality.
- Tax principles: equity includes ability-to-pay and benefit principles; efficiency minimizes excess burden. Economic incidence depends on relative elasticities, not on the statutory payer.
- Fiscal stance: distinguish the actual balance, the cyclical balance, and the structural balance. Automatic stabilizers cushion demand without discretionary action.
- Debt dynamics: the debt-to-GDP ratio tends to rise when the interest rate exceeds growth and the primary balance is in deficit.
Worked example
Demand is Qd = 120 − 2P and supply is Qs = 3P. The free-market equilibrium is 120 − 2P = 3P, so P = 24 and Q = 72. Marginal external cost is 10 per unit. A Pigouvian tax of 10 on sellers changes supply to Qs = 3(P − 10) = 3P − 30. The new equilibrium is 120 − 2P = 3P − 30, so P = 30 and Q = 60. Tax revenue is 10 × 60 = 600. Pre-tax deadweight loss is ½ × 10 × (72 − 60) = 60. The tax raises revenue and reduces output toward the efficient level.
Traps that cost marks
Do not confuse public goods with common resources; only public goods are both non-rival and non-excludable. Legal incidence is not economic incidence. A deficit is a flow and debt is a stock. Do not treat the cyclical balance as a measure of discretionary policy. Not all government spending has the same multiplier, and debt sustainability depends on r versus g as well as on the primary balance.