1. The national accounts treat all government purchases of goods and services, G, as part of real GDP. But suppose that the public services derived from government purchases are an input to private production, say:
Y=F(kK,L,G)
In this case, public services are an intermediate product – a good that enters into a later stage of production. Hence, we ought not to include these services twice in real GDP – once when the government buys them and, again, when the services contribute to private production.
a. Suppose that businesses initially hire private guards. Subsequently, the government provides free police protection, which substitutes for the private guards. Assume that the private guards and public police are equally efficient and receive the same wage rates. How does the switch from private to public protection affect measured real GDP?
b. How would you change the national accounts to get a more accurate treatment of government purchases of goods and services? Is your proposal practical? (These issues are discussed by Simon Kuznets, 1948, pp. 156–157, and Richard Musgrave, 1959, pp. 186–188.)
a. If public and private security guards are perfect substitutes in production, there
should be no impact on GDP. However, because national income accounts treat
government purchases of labour as a final good, the measured GDP will increase.
This is a case of “double counting”.
b. Various answers are possible, but the obvious one would be to classify government purchases according to whether they are used to purchase inputs or outputs of the production process. Such a classification system would be far from objective. For example, if an employer provides a free lunch for its employees it is treated as an input to the production process, just as much as the labour itself. When the individual buys their lunch at a restaurant, it is treated as a final good. Consider education, health care, and a variety of other services, and the same ambiguity appears.
2. Suppose that people learn in the current year that government purchases, Gt, will increase in some future year. Current government purchases, G1, do not change.
a. What happens in the current year to real GDP, Y, consumption, C, and investment, I?
b. Can you think of some real-world cases to which this question applies?
a. Based on the assumptions of the model used in this chapter, we will treat the government purchase as a reduction in future income. If the capital and labour supply is fixed, there will be no change in GDP. Because of consumption smoothing, people will reduce current consumption, and investment will increase.
b. This could occur during election years when the leading candidate is proposing a significant expansion of government programs.
3. Distinguish between the average tax rate and the marginal tax rate. Must the two be equal for a flat-rate tax?
4. Could an increase in the tax rate on labour income reduce real tax revenue? How does the answer depend on the responsiveness of labour supply to the after-tax real wage rate?
5. Some economists advocate shifting from the graduated individual income tax to a flat-rate tax. Under the new system, there would be few deductions from taxable income, and the marginal tax rate would be constant. Because of the elimination of the deductions, the average marginal tax rate would be lower than that under the current system. What are the economic effects from a shift to a flat-rate tax on labour income?
6. Briefly compare the conventional view of government debt and the Ricardian view. What are the main differences in the assumptions and the conclusions?
7. Under what circumstances is an open-market operation neutral?
8. Suppose that the government announces a reduction in next year’s tax rate on labour income. What intertemporal-substitution effect will this announcement have on the current quantity of labour supplied?
