Public Economics: What Governments Can and Can't Fix

Look at your last pay slip, or at a shop receipt. Part of every price you pay and every wage you earn goes to a government, and the road you walked on, the water you drank and the vaccine your grandparents took were paid for that way. In Denmark that share is about 45% of what the whole economy produces; in Mexico, 18%. In Brazil the richest tenth gets close to 60% of income; in Sweden, under 30%. Nobody voted to make these numbers exactly what they are, yet they shape everything from how long you wait for a doctor to whether your child can climb out of poverty.

A public economics graduate learns to ask two questions of any policy. Does it fix a real failure of markets, and who ends up paying and gaining once everybody has reacted? The first is a question about efficiency, the second about fairness, and the discipline's honesty comes from keeping them separate and keeping a third, awkward one in view: governments fail too.

Why governments are in the economy at all: public goods

Markets are good at things that can be bought, one buyer at a time. They are bad at things whose benefits spill over to everyone. A public good is non-excludable (you can't keep non-payers out) and non-rival (my use doesn't reduce yours): clean air, a lighthouse, defence, a vaccination campaign. Each person would prefer that someone else pays, and the result is that a private market supplies too little. This is the free-rider problem, and it is the oldest justification for taxation: a way to make everyone pay for something everyone wants.

The game below is the classic experiment. Four players each hold 20 tokens. Whatever goes into the shared pot is multiplied by 1.6 and split equally, so each token you give returns 0.4 to you and 0.4 to each of the others.

Whatever the others do, you always do better by giving nothing: every token you give costs you 1 and returns 0.4. But if all four give nothing, each ends with 20, while if all four give everything, each ends with 32. The best private choice and the best group result point in opposite directions. In real experiments people usually start by giving around half, and contributions drift down over repeated rounds, though a core of givers remains; allowing players to punish free riders keeps contributions higher. Governments do the "punishment": they make paying compulsory. Elinor Ostrom (Nobel 2009) added that communities can often solve the problem themselves, so tax is one solution, not the only one.

Insurance and information: why some markets need a mandate

Insurance is a market for sharing risk. It can fall apart when buyers know more about their own risk than the seller does: adverse selection, the problem George Akerlof described for used cars in 1970 and which won him a share of the 2001 Nobel Prize. If the insurer charges the average price, the low-risk customers find it too dear and leave; the pool gets sicker; the price rises; more leave. Governments respond with mandates (everyone must be in), public insurance, or subsidies.

If people value cover at exactly their expected cost (multiple 1), a voluntary market collapses to almost nobody. At 1.3 the premium settles at 812 and only 37.5% buy. At 2 it settles at about 666 and two thirds buy. Even a keen market never covers everyone. A mandate fixes the premium at the pool average, 500, and covers everyone, but it forces in those who value cover at less than that price: 38% at multiple 1.3. Mandates trade a market failure for a compulsion, which is why the argument over them (Switzerland and the Netherlands require everyone to buy private health cover; the UK and Canada fund care from taxes instead) is fierce.

Who really pays a tax

The law says who must send the money. Tax incidence asks who ends up poorer. Put a tax on sellers and they raise the price; put it on buyers and they bid less. In both cases the price buyers pay and the price sellers keep move apart by the tax, and the split depends only on who can walk away more easily. The side that is less responsive to price carries more of the burden.

With demand elasticity 0.5 and supply 1.5 buyers pay 75% of the tax, whichever side the law names. That is why economists are suspicious of a payroll tax "paid half by the employer": the split on the form is a legal fiction, and the usual finding is that workers bear most of it through lower wages. And it is why a tax on something people cannot easily give up, like fuel in the short run, raises revenue and mostly falls on the buyer.

Efficiency and equity: the leaky bucket

Taxes that move money from richer to poorer lose some on the way, through administration and, more importantly, because people change what they do. The economist Arthur Okun called this the leaky bucket (1975): carry a bucket of money from rich to poor and some leaks out. How big is the leak? It depends on how much people cut work, move income or avoid tax when the rate rises, which economists summarise as the elasticity of taxable income, e. In a simple model where the tax base shrinks by (1 − t)^e, revenue t(1 − t)^e peaks at a rate of 1 ÷ (1 + e): beyond that, a lower rate would collect more. This is the Laffer curve.

With e = 0.5 revenue peaks at a rate of 67%; with e = 1, at 50%. Most of the argument is not about the curve, which almost nobody denies, but where real countries sit on it and how large e is for high earners. Equity-minded economists answer that a leak does not mean the bucket should stay empty; efficiency-minded ones that growth is the best antipoverty tool. Both statements are true. The disagreement is over weights and measured responses, so ask for both.

Inequality, and how it is measured

Inequality is easy to feel and hard to summarise. The standard picture is the Lorenz curve: line everyone up from poorest to richest and plot the share of income held by the bottom 10%, 20%, and so on. Perfect equality is a straight diagonal; the more it sags, the less equal. The Gini coefficient (Corrado Gini, 1912) is the area between the diagonal and the curve, doubled, so that 0 means everyone has the same and 1 means one person has everything. It is one number, and it hides shapes: two very different distributions can have the same Gini. For example, a society where half the people have nothing and the other half share equally has a Gini of 0.5, exactly like one where the bottom three quarters hold a quarter of the income and the top quarter three quarters. Top shares tell the other half of the story.

The World Inequality Report 2026 (Dec 2025) puts the global top 10% at about 53% of income and the bottom half at about 8%. By country, it reports South Africa's top 10% near 66% and Brazil, Mexico, Chile and Colombia near 60%, India, Thailand and Türkiye above 50%, and Sweden and Norway under 30%. A caution on the other measure: the World Bank's Gini for South Africa is 54.1 (2022), Brazil 50.3 (2024), Mexico 42.6 (2024), the United States 41.8 (2024), Germany 33.7 (2022), Sweden 29.3 (2023), Slovenia 24.7 (2023). These measure income or consumption per person from household surveys, which tend to miss the very top; the report's figures use tax and national accounts to see more of it. The two kinds of number will not agree and neither is wrong.

The welfare state across countries

The modern welfare state grew from Bismarck's social insurance laws in 1880s Germany and from Britain's 1942 Beveridge Report, which named five "giants" to slay: want, disease, ignorance, squalor and idleness. Today governments differ in how large they are and in how they spend: through cash for pensions and the unemployed, services like health and school, or tax breaks. The OECD (rich-country club) measures the size of the state's take as tax revenue as a share of GDP: 34.1% on average in 2024, from 18.3% in Mexico to 45.2% in Denmark.

The same OECD database measures inequality before taxes and transfers ("market income") and after ("disposable income"). The gap is what the tax-and-benefit system does. Pick a country.

Nordic and continental European countries start with market-income Ginis around 0.43 to 0.52 and end at 0.28 to 0.33, a cut of a third or more. The United States starts about as unequal as the UK and France (0.51) and ends at 0.39. Mexico barely moves: 0.416 to 0.400, a cut of 4%, consistent with its small tax take. Notice also that the rich-country spread is mostly in how much they redistribute, not in how unequal the market leaves them. The sociologist Gøsta Esping-Andersen's Three Worlds of Welfare Capitalism (1990) sorted rich states into liberal, conservative and social-democratic types; most scholars now use more families, and regard the groups as tendencies.

Government failure: the same logic, pointed the other way

If markets can fail, so can the people who fix them. Public choice economics (James Buchanan, Nobel 1986, and Gordon Tullock) applies the same assumptions to voters, politicians and civil servants as to shoppers: they respond to incentives. Mancur Olson's The Logic of Collective Action (1965) explained why small groups with a lot at stake organise better than large groups with a little each. A subsidy that gives each of 50 firms 2 million and costs each of 100 million taxpayers 1 will be lobbied for by the firms and ignored by the taxpayers (illustrative numbers). Anne Krueger called the effort spent winning such favours rent-seeking (1974).

Other failures are about knowledge: planners seldom know what local people know; programmes outlast their purpose; and well-meant rules cause side effects. The sound reply is not "government never works", which smallpox (declared eradicated by WHO in 1980) refutes, but Harold Demsetz's warning against the "nirvana fallacy" (1969): comparing a real market with an ideal government, or the reverse, instead of one real option with another. A graduate asks, for each policy, who gains, who pays, who is watching, and what happens after the first round of reactions.

What a graduate just sees

• Public goods go unsupplied because everyone prefers to free-ride; compulsion or good rules fix that.
• When buyers know less than sellers, or the reverse, markets can unravel. Insurance is the case study.
• The law says who sends the cheque; elasticities say who pays. The less flexible side bears more.
• Redistribution has a leak, and the size of the leak is an empirical question, not an ideology.
• A Gini is one number. Ask for top shares, the bottom half and the time frame.
• Rich countries differ less in market inequality than in how much their taxes and benefits change it.
• Governments fail from incentives, not just stupidity: concentrated gains beat diffuse costs.
• Compare real policies, not a flawed market with a perfect state or the reverse.

Where it shows up next

• Macroeconomics (34/43): the budget deficit, the debt ratio and the multiplier are this subject at the scale of the whole economy.
• Development Economics (34/48): why many poorer countries collect far less tax (Nigeria 8% of GDP, Kenya 16%, Mexico 18%, in the OECD's global series) and what that does to schools and roads.
• Behavioral Economics (34/46): defaults and nudges in pension and tax design.
• In the world: a sugar tax, a carbon price, a minimum pension, a budget speech, the debate over a wealth tax or a universal income.

If you want to go deeper

• 📘 Textbook. Jonathan Gruber, Public Finance and Public Policy (Worth/Macmillan). The usual undergraduate text, strong on evidence from natural experiments.
• 📘 Textbook. Harvey Rosen and Ted Gayer, Public Finance (McGraw-Hill). Another standard choice, a bit more theory.
• 📘 Gentler. Anthony Atkinson, Inequality: What Can Be Done? (Harvard University Press, 2015), or Branko Milanovic, Global Inequality (Harvard University Press, 2016): clear on the data, with proposals set out for and against.
• 🌐 Free course. MIT OpenCourseWare 14.41 Public Finance and Public Policy (Fall 2024). Also World Inequality Report 2026, free online.