ECON 132 · Public Economics
Chapter 2 · Stiglitz / Rosengard

Measuring Public Sector Size

How big is "the government" really? Which activities count? And why is there no single answer?

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One of the central political debates in the US and other mixed economies is the question of the appropriate size of government — some believe it is too large, others too small. Before answering the question normatively, you have to clarify it positively: How do you even measure?

1 · What or who is the government?

In mixed economies, the line between private and public is often blurry. Two features distinguish the state from private institutions:

  1. Democratic accountability: In representative democracies, those responsible are elected directly or indirectly by the people.
  2. Coercive power: The state can compel activities that would not happen voluntarily — e.g., levying taxes, taking property through eminent domain.
Important The line is fluid. Is Fannie Mae (a government-backed mortgage company) private or public? What about the Federal Reserve? Public universities? What if the state is a major shareholder in a company but does not control it? Such hybrids make measuring size difficult.

2 · Five types of government activity

Stiglitz distinguishes five main categories of government activity:

  1. Providing a legal system (property rights, contract enforcement).
  2. Own production (electricity, education, mail).
  3. Influence on private production (subsidies, taxes, regulation, credit).
  4. Purchase of goods and services (roads, defense, education).
  5. Redistribution of income (transfer payments).

These categories are a practical organizing scheme — reality is often ambiguous. A program like Medicare is simultaneously a purchase (hospital services), a subsidy (for older citizens), and redistribution.

The most fundamental function. Without clear and enforceable property rights and contracts, a market economy cannot function — a lesson that transition countries like Russia learned painfully in the 1990s.

Example: Property Rights In Peru, many slum dwellers effectively had houses but no registered property rights. Hernando de Soto showed: as long as this "dead capital" was not legalized, owners could not take out loans against their homes or start businesses — the reform created hundreds of millions of dollars in economic activity.

4 · Government production

Which industries are public or private varies across countries and over time. Examples:

  • Electricity: mixed in the US; historically state-owned in France (EDF); privatized in Germany.
  • Rail: mostly private in the US for freight, state-subsidized passenger service (Amtrak); long state-owned in Europe.
  • Mail: USPS as a "government corporation" in the US; privatized in Germany since 1995.

The best measure of government production is the number of public employees (about 15% of the US workforce). Unlike private firms, agencies rarely sell their outputs at market prices, which makes measuring their value difficult.

5 · Influence on private production

The state influences private production without running it itself — through five instruments:

A · Subsidies & Taxes

The largest US subsidy historically goes to agriculture. The tax system also works as a hidden subsidy: tax preferences (e.g., research tax credits, mortgage interest deduction) do not appear in any spending statistic, but they are tax expenditures.

B · Government credit

Federal Direct Student Loans, Small Business Administration Loans, FHA mortgage guarantees — all channel capital into areas the market considers too risky. The costs of these programs usually appear in the budget only when borrowers default.

C · Regulation

Cross-sector (FTC, EPA, OSHA) or sector-specific (FCC for telecom, FAA for aviation). The budgetary cost of regulation is small; its economic effect is enormous.

Smart Regulation Modern regulatory philosophy: balance between protective function and economic burden. Market-like mechanisms (emissions trading instead of strict limits, performance standards instead of design standards) are often more efficient.

6 · Regulation in detail

Four types of regulation:

  • Antitrust: Prevents monopoly formation (Sherman Act, Clayton Act).
  • Consumer protection: Food and drug safety (FDA), product liability.
  • Environmental protection: Air, water, soil (EPA, Clean Air Act).
  • Financial market regulation: Banks, securities (SEC, FDIC) — dramatically expanded after 2008 (Dodd-Frank).

7 · Purchases of goods and services

When the state spends money, part of it goes to direct purchases (roads, school buildings, weapons, civil servant salaries). These purchases make up about 20% of US GDP.

To be distinguished from these are transfer payments — money that is simply redistributed from one group to another (Social Security, Medicaid).

8 · Redistribution

Transfer payments in the US have grown substantially in recent decades — today the largest item in the federal budget:

  • Social Security (retirement) — ~24% of the budget.
  • Medicare (health insurance for seniors) — ~15%.
  • Medicaid (health insurance for low-income people) — ~10%.
  • SNAP (Food Stamps) and other public assistance — ~8%.

Two main forms:

  • Cash transfers: direct money (SNAP, EITC, TANF).
  • In-kind transfers: benefits in kind (Medicare, public education, housing vouchers).

9 · Hidden redistribution

Not every form of redistribution appears in the budget. Examples of hidden redistribution:

  • Tax preferences: The Mortgage Interest Deduction costs the US government ~$70 billion per year — and mostly benefits wealthy homeowners.
  • Loan guarantees: When the state guarantees mortgages, interest rates fall for the beneficiaries. The costs only become visible when loans default.
  • Regulation: Protective tariffs favor domestic producers at the expense of consumers — without any budget line item.
Key Insight Anyone who measures the state by its budget spending alone dramatically underestimates its impact. The tax system, regulation, and loan guarantees are often just as powerful as direct spending — but statistically invisible.

10 · Social insurance

Social insurance sits conceptually between redistribution and insurance:

  • Social Security: against loss of income in old age.
  • Medicare: against high health costs in old age.
  • Unemployment Insurance: against unemployment.
  • Workers' Compensation: against work-related injuries.

Unlike pure welfare, contributions are tied to employment — the programs enjoy broader political support because they are seen as "earned."

11 · Measuring the state

The two classic measures:

  • Spending as % of GDP — sums up all activities in one number. US ~34%, Germany ~45%, France ~55%.
  • Public sector employment — measures government production directly. US ~15%, France ~22%.

Both measures have weaknesses:

  • Tax expenditures are missing.
  • Regulation barely shows up.
  • Loan guarantees only appear at default.
  • International comparisons are complicated by different definitions.

12 · Growth & composition over time

Three trends in the US data:

  1. Growth: Federal, state, and local spending has risen from <10% of GDP (1913) to ~34% today.
  2. Shift in composition: Defense has fallen massively as a share (from ~60% of the federal budget in 1960 to ~15% today). Social programs (Social Security, Medicare, Medicaid) now dominate.
  3. Demographic pressure: As the population ages, Medicare and Social Security keep growing — the "entitlement crunch" will be the central fiscal challenge of the coming decades.
Chapter Take-away "How big is the government?" has no simple answer. Direct spending (~34% of US GDP) is only part of it. The tax system, regulation, and loan guarantees are just as powerful, but statistically hidden. Anyone who wants to discuss government size honestly has to consider all five types of activity — not just the budget.

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Quiz — Chapter 2

12 multiple-choice questions. After each answer you see an explanation.

Problem Set — Chapter 2

Six open-ended exam-style questions. Click on a question to reveal the model answer.

1 France's government spending is around 55% of GDP, the US's around 34%. Does that mean the French state is 60% "bigger"? Discuss why the question is more complicated.

Direct comparison of spending ratios

Yes, measured by direct spending/GDP, France is considerably "bigger." This mainly reflects a more extensive welfare state (health, pensions, family policy).

Why the number is misleading

  • Tax expenditures: The US runs massive social policy through the tax system (EITC, Mortgage Interest Deduction). These "hidden expenditures" are not included in the 34% figure.
  • Regulation: The US regulates more strongly in some areas (antitrust, financial supervision after Dodd-Frank); the budgetary cost of this regulation is small.
  • Loan guarantees: Federal mortgage guarantees (FHA, Fannie/Freddie) are a massive subsidy that remains statistically invisible.
  • Private mandatory insurance: US employers must offer health insurance — the "state" forces private actors to take on a task. In France, this appears as government spending.

Conclusion

The difference is real, but smaller than the headline numbers suggest. The decisive point is not who spends more, but how efficiently and fairly the respective systems work — those are separate questions.

2 Classify each of the following programs as (a) Providing a legal system (b) Government production (c) Influence on private production (d) Direct purchase (e) Redistribution. Justify multiple classifications.
1. SNAP (Food Stamps) 2. Medicare 3. Public universities 4. Department of Defense 5. EPA emissions regulation 6. Research tax credit

1. SNAP: Primarily redistribution (e). Low earners receive an in-kind benefit. Small allocation component (stimulates food demand).

2. Medicare: A mix: redistribution (e — from younger to older), but also a purchase (d — the state purchases hospital services). On top of that, an allocation aspect: correcting an insurance market failure.

3. Public universities: Government production (b) — the state produces educational services directly. Implicit redistribution (e), since subsidized.

4. Department of Defense: A mix: purchase (d — weapons, services) and production (b — military service itself). Provision of a public good (national defense).

5. EPA regulation: Clearly (c) influence. No budget purchase, no transfer — just rules that change private production.

6. Research tax credit: Clearly (c) — through the tax system. A "tax expenditure," does not appear in the spending budget, but is a subsidy.

3 Explain the difference between a cash transfer and an in-kind transfer. What are the advantages and disadvantages of each?

Cash transfer

Direct money payment (EITC, cash TANF). The recipient decides how to spend it.

Advantages: Maximizes consumer sovereignty, minimizes administrative costs, no black market for "wrong" goods.

Disadvantages: No protection against allegedly "wrong" behavior (e.g., money for alcohol instead of food). Political support tends to be lower.

In-kind transfer

An in-kind benefit (SNAP cards for food, Medicare services, housing vouchers).

Advantages: Ensures the money goes where it is socially desired. Higher political support (self-selection: anyone willing to deal with the SNAP card is genuinely in need).

Disadvantages: Efficiency loss — the recipient would have valued cash more highly (unless externalities or paternalistic arguments justify the restriction). Higher administrative costs.

Economic consensus

If there are no externalities or paternalistic reasons, cash transfers are more efficient. In-kind transfers are justified for goods with positive externalities (education) or for protection against bad decisions (e.g., for people with addiction issues).

4 What are tax expenditures? Name three examples from the US system and explain why they are often criticized economically.

Definition

Tax expenditures are tax preferences (deductions, credits, exclusions) that economically work like subsidies, but do not appear in the spending budget — instead they show up as "forgone revenue."

Examples

  • Mortgage Interest Deduction: Mortgage interest is deductible. Cost: ~$70 billion/year. Beneficiaries: mainly high earners with expensive houses.
  • Employer-Sponsored Health Insurance Exclusion: Employer health insurance contributions are tax-free. Cost: over $250 billion/year — the largest US tax preference.
  • 401(k) and IRA retirement accounts: Contributions to retirement accounts are deductible. Encourages saving, but also distributionally regressive.

Criticism

  • Non-transparent: They do not appear in the budget; they escape the annual political review.
  • Often regressive: Deductions are worth more to high earners (with higher marginal tax rates).
  • Complex: They make the tax system inefficient (compliance costs, distortions).
  • Path-dependent: They are politically almost impossible to remove — beneficiaries defend them fiercely.
5 Which two features distinguish a government institution from a private one? Why are some institutions (Fannie Mae, USPS, Federal Reserve) borderline cases?

Two main differences

  1. Democratic accountability: Those in charge are elected directly or indirectly by the people — not by shareholders or owners.
  2. Coercive power: The state can compel activities (taxes, eminent domain) that would not happen voluntarily.

Borderline cases

Fannie Mae & Freddie Mac: Before 2008 formally private (publicly listed), but with an implicit government guarantee. After 2008 under government conservatorship. Hybrids: privately benefited from profits, socialized losses.

USPS: An "independent agency" — formally public, but financially autonomous (lives off postage fees, not taxes). Has a government monopoly on letter delivery, but no subsidies.

Federal Reserve: Quasi-public. The Regional Banks are formally private corporations with member banks as shareholders. The Board of Governors, however, is a federal agency. Democratic accountability exists (presidential nomination of the governors, Senate confirmation) — but it is highly independent.

Such borderline cases arise because certain tasks require advantages of both worlds: governmental credibility + private efficiency/independence.

6 The biggest items in the US federal budget are Social Security and Medicare. Why is it not a political administrative failure that these programs are so large? Why will they keep growing?

Not an administrative failure

These programs address specific market failures that serious economists recognize:

  • Social Security: Capital/insurance market failure for long-term retirement saving. Private insurers face adverse selection problems, and many people save too little (behavioral bias).
  • Medicare: The private market would only offer older citizens insurance at unaffordable prices (extreme adverse selection given known health risks).

Why they will keep growing

  • Demographics: The Baby Boomer cohort is now retiring. The share of those over 65 is rising from ~15% to >25% by 2050.
  • Medical progress: More treatment options = higher health care costs (Baumol's disease: productivity gains in services are hard).
  • Political lock-in: The scheduled beneficiaries are a massive voting bloc — cuts are politically almost impossible.

Implications

The "entitlement crunch" will be the central fiscal challenge of the coming decades. Either taxes rise, benefits get cut, or other spending (defense, education, infrastructure) gets squeezed out. Politically the answer will probably be a mix — but rarely at the right time.