The best books on Public Finance

Let’s start by defining the term that we’re discussing. What is public finance, otherwise known as public economics?

Public finance is the study of the role of government in the economy. It is defined around four questions: When should governments intervene? How should governments intervene? What is the impact of government intervention on the economy? And why do governments intervene in the way that they do?

A common knock on economists is that you all disagree and so present everything as “on the one hand, and on the other hand”. What do all public finance economists agree on?

I would say that there is almost nothing that we all agree on, but there are areas of broad agreement. There is broad agreement that the best tax system is one that is broad and comprehensive and has relatively low tax rates. There’s broad agreement that government intervention should be proportionate to how big the market failures are – that markets which function well on their own should be left alone and there should be some intervention where there’s market failures like imperfect information or externalities but there’s lots of disagreement on the degree of that. It’s really a field where there is a lot of disagreement.

Can economics really help decide government’s optimal role in society? I thought that was the province of political philosophy or just plain partisan reflex.

I think of economics as being very good at answering relatively narrow questions precisely and less good at answering very broad questions. So a question like what’s the optimal role of the government in economy – that’s just too broad. But something like how big should the benefit for unemployment insurance be, or, should we repeal the Bush tax cuts? Those are topics that aren’t in the province of political philosophers. Those are topics on which we have a lot to offer.

Let’s get to the books.

This was hard because public economists don’t usually use books, they use articles, so choosing five books took a while – and I imagine if you polled 10 different finance economists they’d name 45 different books.

You wrote one of the most popular textbooks on the topic of public finance, Public Finance and Public Policy. So let’s begin our discussion with the textbook you trained on, Economics of the Public Sector by Nobel laureate Joe Stiglitz. Tell us about it.

Joe Stiglitz is, of course, a brilliant economist but he’s not just brilliant at solving math equations, he’s really good at abstract thinking and drawing out interesting implications of topics. Joe’s was the first textbook I read which had a lot of really funky footnotes about cool little implications you might not have thought about. It was more like reading a book than a textbook. It’s still a textbook but it’s definitely inspired.

For someone who’s really into the topic it was great. I think it was too confusing for someone who wasn’t, which is why I felt like I wanted to write my own textbook. Mine tries to explain the basic economics more simply but with a lot of interesting footnotes and explaining some interesting tangents.

Does Economics of the Public Sector cover all the major topics in economics? Do you need to be a budding PhD to read it?

It did a good job covering public economics. The textbook really was at its prime in the mid-1980s and the government has changed a lot since then. What Paul Krugman says is that we’re now a large pension fund that happens to have an army. Much more of our field is about healthcare and government spending. Joe’s book was mostly about taxation and government transfers – a third of my book is on social insurance and government transfers. An enormous shift from taxing and spending on defence to taxing and spending on health is the main change in public economics.

In economics, unlike in, say, physics, leading members of the field write leading textbooks. Joe Stiglitz made major contributions to the study of public finance. Can you describe some of them?

Joe is one of the two modern fathers of bringing rigour to studying market failures; my colleague Peter Diamond is the other one. Joe wrote a large number of articles in a wide variety of contexts. His work helped us to rigorously model markets that don’t work perfectly well and consider the implications of market failures for the economy and for government policy.

Please introduce us to your second selection, Taxing Ourselves: A Citizen’s Guide to the Debate Over Taxes.

Joel Slemrod and Jon Bakija do an excellent job of taking what we know about how taxes affect behaviour and translating it into basic lessons. There are three different kinds of reactions people can have to taxes. There are timing reactions like, “Should I realise my capital gains today or tomorrow?” There are financing reactions like, “Should I get paid in stock options or wages?” And then there are behaviour adjustments like, “How hard should I work?”

This book teaches that taxes have a large effect on timing, a moderate effect on financing and little-to-no effect on behaviour, such as how hard people work. When people talk about taxes and economic growth, they’re really talking about that third factor but that’s not really what taxes affect. Taxes don’t have much effect on how hard people work – they have more effect on things like the composition of portfolios and when they realise their capital gains. This book brought the literature together to make that point very clearly.

Tax issues – from how much we should collect to who we collect from and how – are among the most divisive issues in any political system. Is the economics profession as divided as the polity on tax issues?

No, not as divided. I would say that if you surveyed the economics profession they would be much more uniform than the polity about the need for a broad tax base, which means no mortgage deduction and no health insurance exemption. If you surveyed public finance economists they would advocate moving away from income taxation toward consumption taxation because of the belief that that would encourage savings.

And how about on the basics: How much we should collect, from whom and how?

A common argument you’ll hear is that high taxes distort economic behaviour. This book would say that factor is not as big a deal as it’s made out to be. How much we should collect is really about your underlying philosophy about the proper role of government. From whom and how – you want a system that collects taxes in some proportion to how much people consume and how much they earn. Some would say only based on what people consume, others are worried that would hit the poor too hard. Most public finance economists believe in progressive taxation – the rich paying more than the poor – but I think there would be a lot of difference on how progressive.

Is there a hope that more economic research will help resolve these debates? Do you think economists will be as divided 20 years from now?

You have to separate out economists doing economics from economists as political advocates. In terms of economists doing economics, I think we will probably be less divided. In the mainstream economics profession there is a growing consensus that although taxes can affect the timing of transaction and that complexities in the code can be a drag, taxes are not a major driver of economic growth.

What do you think of President Obama’s proposed Buffett Rule for tax reform? And how would a book like Taxing Ourselves help someone form an intelligent view on that question?

What a book like Taxing Ourselves would say is the whole “don’t tax millionaires, they’re job creators” point is crap. The idea that people who make a million a year will create fewer jobs or start fewer businesses or any of that if they’re taxed, that’s not right. There is pretty strong consensus in the public finance community on this right now.

But the authors might point out a problem with the Buffett Rule – it’s difficult to tax the top 1% because they’re very able to evade taxes. If you tax people who make a million a year, they’ll hire accountants to avoid taxation. That’s the point of Taxing Ourselves. What we should be thinking about when we tax billionaires is not, “Will it harm economic growth?” I think it won’t. But, “What do we do about the fact that those who earn a million a year are much better than average Americans at avoiding taxation.”

What do you think the prospects are for tax reform in America? How important do you think that would be for the economy?

The prospects, over the long run, are pretty good. In 1986 we did a lot to fix the tax code. After the reforms of 86 the code looked very much like public economists say it should look. That recent history is encouraging. I think we will be able to get back there again.

The alternative minimum tax is a real timebomb that’s right down the road. Eventually it’s going to be clear to everyone that we need to raise taxes. And we can probably only do that in the context of broader reform, something like the “grand bargain” that Obama proposed. Republicans will realise they have to raise revenues and Democrats will realise that broadening the tax base may be the best way to do it. Maybe we’ll get some agreement about raising revenues in a way that reforms the income tax system.

Next, The Green Book. Not the once-required reading for Libyans written by Muammar Gaddafi, but the one published by the House of Representatives’ Ways and Means Committee. Please tell us about it and why it makes your list.

We have an incredibly complicated set of social welfare programmes in the United States. We sort of know what food stamps are, we sort of know what welfare is and what Medicare does but there’s hundreds of thousands of rules that affect how these programmes are implemented. Those rules are important to understand, as policy makers and students of public finance. To understand the effects of these programmes on groups over time is incredibly important. The Green Book brought all that together.

It’s about 1,600 pages of incredibly small print, which goes through all the details on all the major social welfare programmes administered by the Ways and Means Committee. So you could learn about exactly what happened when you went from two kids to three kids on TANF [Temporary Assistance for Needy Families, otherwise known as welfare]. Or exactly what happens when you went above the ceiling for the earnings tax and Social Security. I don’t think I ever sat down and read The Green Book but I referenced it thousands of times to figure out exactly how does this programme work. It was a great resource to get if you wanted to understand these programmes and how they worked.

Are you recommending the 2004 edition or will the 2008 edition, which was published online, do equally well?

Sure. This is just the ultimate tool for anyone who wants to get away from the polemics and really understand how these programmes work. It’s not for everyone but it can enable any real student of public policy to puzzle through these programmes and answer questions like, “How exactly are rich people vs poor people treated in terms of the Medicare premiums they pay?” It’s just the ultimate resource for questions like that.

Control of the Ways and Means Committee shifts from Democrats to Republicans, depending on who is the majority party in the House. Do you see ideological shifts in The Green Book – for example, in the way it describes hot button issues like Social Security?

I haven’t spent a lot of time with The Green Book in a while. All the time I spent with it was during periods of Democratic control of the Ways and Means Committee so I guess I don’t know the answer to that question.

You have worked in government and much of your research is steeped with institutional knowledge. Would the field of economics benefit if more academics gained experience with the inner workings of government?

Yeah, but more importantly, the government would benefit. I think it’s a benefit for the government to have someone like me be there and a benefit to me to have been there. I don’t know that it would vastly improve the quality of the economic research but it might help us be better able to turn the research we do into something useful for the world.

Can you be explicit about the benefit to the public from having economists in government?

Policymakers face a lot of hard problems every day. Economists, particularly public finance economists, are trained to think logically about the trade-offs involved in government policy.

Let’s turn to Losing Ground by Charles Murray. Please tell us about it.

Charles Murray took the economic concept of moral hazard – the concept that if you reward people for bad behaviour then they behave badly – and turned it into prose. Reading the book moved me a notch to the right. It posed a challenge to liberals – to get more rigorous in our analysis. It showed the simple facts didn’t look so good for us and that we needed to address questions like, “Is welfare causing women to become single mothers?” Murray really challenged the way I thought.

It turned out his facts were largely wrong, so it’s really more a book to read for an example of how someone can shift the debate with potent use of clear arguments.

When it was written, liberals were very resistant to the idea that social programmes discourage work or have bad side effects. Has this shifted? How much of Losing Ground actually became embodied in reforms or proposals that many liberals would now support?

Losing Ground was the intellectual basis of the push to reform welfare in the United States, not in terms of the actual ideas but just in terms of challenging the orthodoxy. And, of course, welfare was reformed in 1996.

Next, Free For All? It certainly sounds good. Please tell us about it.

Health is the single most important topic in public finance today and this is the single most important book written about health – that’s why I chose it. The book is by Joseph Newhouse, who led the group that designed the RAND Health Insurance Experiment.

In the 1970s people tried to figure out how much of the cost of healthcare consumers should bear and how much insurance should pay. They were trying to answer the questions: “How big should the deductible be on an insurance policy? And when we raise an insured’s deductible will it really affect how much healthcare people use? Could higher deductibles make people sicker because they won’t go to the doctor?”

Joe Newhouse and his colleagues put together this incredible social experiment, funded by what was then called the Department of Health Education and Welfare. They essentially established an insurance company and randomly assigned individuals to plans with a variety of cost-sharing provisions, to determine how health was affected when people paid more for healthcare. This was the premier use of a social experiment of this magnitude and quality.

The results were profound because, not only did the study show that people are price sensitive in their health decisions and if you charge more for healthcare they’ll use less but it also showed that, at least back then, higher deductibles didn’t matter much for health. People in the study used less healthcare but weren’t less healthy. So it emphasised that we’re excessively using healthcare, as shown by the fact that when people cut back, their health wasn’t worse. Those are probably the single best-known findings in all health economics. It is just an incredibly influential study.

The RAND study was conducted from 1971 to 1982. Healthcare has changed enormously in the 30 to 40 years since then. Why are we still referring to something that is so old? Do you think the results are still relevant? Have we got new evidence since then?

It is really old but it’s still the gold standard. There have been studies since that have tried to follow up, but not that many because RAND is so dominant. Subsequent studies, including a number of mine, have generally found similar conclusions, but no study has ever been as good as this one.

So this study is really an example of what public finance can do?

Yeah. Good, solid scientific methods can really influence our understanding of our economy and the impact of government policy.

Have the findings in Free for All? affected health reform, either the Affordable Care Act or other efforts? Have people listened enough to the results?

There’s still a lot of cognitive dissonance around the study but I think it has dramatically impacted our understanding of health. People all over the political spectrum talk about how we need to have patients pay some portion of the cost of their healthcare – that’s largely because of RAND. That’s why the Affordable Care Act includes a “Cadillac tax”, to stop excessive use of healthcare. That’s just one example. But basically the public policy debate was hugely influenced by the evidence in RAND.

Have we seen other large-scale economic experiments like this in the United States or around the world? If you could design just one new experiment, what would it be?

There haven’t been that many. There’s another famous one called the Negative Income Tax Experiment – it’s also very old [from 1968 to 1979]. In that experiment they changed people’s tax rate and saw how hard they worked. That one has been influential.

The equivalent of the RAND healthcare experiment would cost tens of millions of dollars today. There were two things about RAND that made it so influential. The first was it was truly a randomised trial – the kind that’s done in medicine – so it’s very convincing. Second, they got detailed data on individuals – not just how subjects felt but their actual blood pressure and other objective measures of health.

I was fortunate enough to be part of the closest thing we’ve seen to RAND – a study we just did in the state of Oregon, with my colleague Amy Finkelstein at MIT and Katherine Baicker and Joe Newhouse at Harvard. A bunch of other people in Oregon ran the experiment for us. They only had enough money to fund health insurance for 10,000 people but 100,000 applied so they ran a lottery and the winners got health insurance and the losers didn’t. So while in RAND they carefully randomised the subjects, in the Oregon study the lottery did the randomisation for us. RAND was about what happens when you pay more or less. The Oregon study is about what happens when you’re insured vs uninsured.

We just spent a huge amount of money studying the data. The first finding, which just came out and got a lot of attention, is that people who won the lottery and got the health insurance were hugely better off. Their utilisation went up but, more importantly, their health went up, their wellbeing improved and their odds of financial distress were reduced. This was a neat initial finding and now we’re gathering data from people in household surveys on objective measures of health like their blood pressure and blood glucose and things like that. This is, in my mind, the biggest study since RAND.

You were an architect of Mitt Romney’s Massachusetts health programme and an instrumental adviser in the design of the Obama administration’s health reforms. So please settle the question of the year: How similar are they?

They are very, very similar. You can think of the Affordable Care Act as a more ambitious version of the Massachusetts reform. Both reforms have the same core principles: Non-discrimination in insurance markets, health insurance mandates and subsidies so insurance is affordable. In Massachusetts, we stopped there.

The national bill – the Affordable Care Act – has two additional features. One is it’s paid for and two, it takes on cost controls. Romney’s reform was paid for with funding from the federal treasury. The Affordable Care Act is paid for through offsets in the federal budget. And the Affordable Care Act tackles the increase in costs in a serious way, which the Massachusetts bill didn’t do. So you can think of the Affordable Care Act as the Massachusetts bill-plus.

Where did the idea for a mandate come from?

I associate it with Stuart Butler from the Heritage Foundation and Mark Pauly, an academic at Wharton. I first heard about it as the conservative alternative to the Clinton healthcare reform of the early 1990s. At the time, most economists thought an individual mandate made more sense than the employer mandate proposed by the Clinton administration. Over time the idea became more popular and then Massachusetts adopted it as the right way to go.

Tell us about this graphic book you’ve just published. What inspired it?

I use the comic book format to explain what’s wrong with our healthcare system, how we solved this in Massachusetts and how the Affordable Care Act will do so at the national level. The book aims to dispel myths about the Affordable Care Act and explain clearly what the bill does and doesn’t do.

Given how important public finance is to understanding tax, healthcare and welfare policy, which all seem very fundamental to our day-to-day lives and the major debates in our political system, should students be required to learn about the role of government in the economy?

Public finance is a hugely important topic and I think most students would find it very interesting.

What are the two or three most important questions that public finance economists have not answered but need to? And how optimistic are you that they will be answered?

The single most important question that we need to answer is how government behaviour, not merely taxation, affects capital formation. I think we still don’t really have a good handle on what government can do to best promote capital formation and what it does that most dissuades capital formation. The biggest issue in dollar terms is just how to control healthcare costs. The Affordable Care Act makes a start but more must be done.

I like to say there are only two problems we have to worry about in America – healthcare spending and global warming because either one puts us underwater. How we control healthcare costs is probably the number one problem public finance economists and everyone in the world has to grapple with, because if we don’t control healthcare costs we’ll be bankrupt. Capital formation would be number two, and then if I had to pick a third – well, those two are difficult enough. I’ll just stick with two.