State and Local Spending

There are approximately 90,000 state and local governments operating in the United States. State and local governments tend to spend tax receipts and other revenues on local needs. Table 7.6 shows several major categories of spending by state and local governments in 2008.^[1]

The 50 state governments spent $1.5 trillion in 2008. The largest single category of state government spending was for intergovernmental transfers, which accounted for nearly onethird of all state spending. Intergovernmental transfer refers to money that state governments distribute to local governments. In recent years the lion's share of these financial transfers has been used by local governments to fund public education. State governments also spent heavily on public welfare, education, health and hospitals, and highways. Combined, these five categories accounted for 83 percent of all state spending, as shown in Table 7.6. The remaining 17 percent of state spending paid for other important services such as housing and community development, the general operation of government, and interest on state debt.^[2]

Local governments spent about $1.6 trillion on local services and goods in 2008. The largest categories of local government spending were education, health and hospitals, and police and corrections. Spending on these three categories accounted for about one-half of all local spending, as shown in Table 7.6. Local governments also spent money on public goods such as highways and waste disposal systems, public welfare programs, parks and recreation programs, the administration of local governments, and interest on local government debt.^[3]

Table 7.6 Spending by State and Local Governments, 2008

Cost-Benefit Analysis

Government at the federal, state, and local levels provides trillions of dollars in public goods, services, and other assistance to people each year. With this level of spending it would seem as though the government could provide unlimited assistance to people. Yet this is not the case. The government has limited resources and must choose between alternative wants and needs. One way governments decide which public goods, services, and programs to provide is through a cost-benefit analysis.

A cost-benefit analysis is a process by which the costs of providing certain public goods are weighed against the likely benefits these goods will provide to society. Like most economic decisions the provision of public goods or services is rarely an all-or-nothing proposition. Instead, decisions in the public sector, like decisions made in the private sector, are typically made at the margin. That is, a cost-benefit analysis helps determine whether the government should provide the next or additional unit of a good.

Consider a hypothetical cost-benefit analysis. Microtown seeks to improve its traffic flow by building additional roads and wants to make a rational spending decision on this road-building project. Microtown determines that each additional mile of road would cost the town $1 million. In the language of the economist, each mile of new road represents the marginal social cost (MSC) to the town, in this case $1 million per mile. The MSC is shown in Column 1 of Table 7.7. Note that the first, second, third, fourth, and fifth mile of new road would each cost Microtown $1 million. Microtown also determines that each additional mile of road would contribute some additional benefit to society, ranging from $1.5 million in additional benefit from the first new mile of road to just $500,000 in additional benefit from the fifth mile of road. Economists call the additional benefit gained from each new mile of road the marginal social benefit (MSB), as shown in Column 2 of Table 7.7.

How many miles of road should Microtown build? The quick answer to this question is three miles of road. Assuming Microland has the financial resources to build roads, the first and second miles of new road would be built. This is because the additional benefit each mile of new road is greater than the additional cost to the town. The first new mile of road contributes $1.5 million in additional benefits but costs the town only $1 million to build. Similarly, the second new mile of road contributes $1.25 million in additional benefits but costs the town only $1 million to build. In other words, the town's cost-benefit analysis indicates that the benefits derived from the first and second miles of road outweigh the costs. But should the third, fourth, and fifth miles of road be built? For the third mile of road, the MSC ($1 million) and MSB ($1 million) are equal. Economists generally agree that this mile of road should be built as long as the additional benefits match the additional

Table 7.7 A Cost-Benefit Analysis for Microtown

costs. The fourth and fifth miles of road, on the other hand, would not be built because in each case the MSC is greater than the MSB. The bottom line is that rational public sector decision makers will provide a public good or service if the MSB is greater than or equal to the MSC but will not provide a public good or service if the MSC is greater than the MSB.

• [1] U.S. Bureau of the Census, U.S. Department of Commerce, State and Local Government Finances Summary: 2009 (prepared by Jeffrey L. Barnett), October 2011, 1–4; U.S. Bureau of the Census, “Table 454: State Governments, Expenditures and Debt by State, 2008,” “Table 456: Local Governments, Expenditures and Debt by State, 2008,” Statistical Abstract of the United States: 2012 (Washington, DC: U.S. Government Printing Office), 2011, 290-291, 294-295
• [2] Ibid
• [3] Ibid.