1776 and the Economics of Government

Adam Smith

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This July Fourth, Americans will commemorate the 250th anniversary of the adoption of the Declaration of Independence in 1776. This year, 2026, also marks the 250th anniversary of the publication of Adam Smith’s The Wealth of Nations.The book’s official title is An Inquiry into the Nature and Causes of the Wealth of Nations. Smith’s work was foundational to economic thought on capitalism, the use of money, and the place that government and taxation occupy in the economy. Just as the U.S. has grown substantially during the past two and a half centuries—from under 3 million people in 13 colonies to over 300 million people spanning 50 states—so have economic theories on government and the economy.

In recognition of these two historic anniversaries, this blog post explores some of the theories and assumptions used by economists studying the role of government in providing goods and services in the economy.We focus on government spending in this blog post and refer readers to Louis Kaplow’s 2008 book, The Theory of Taxation and Public Economics, for an overview of the economics of taxation.

The Age-Old Question: Government or Private Sector?

Alfred Marshall

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Smith describes a relatively narrow role for government in the economy, one focused on providing national defense, establishing a legal system and providing public works. Smith defines public works as those that are beneficial to society but which may not be profitable. Similarly, the preamble of the U.S. Constitution specifies the intent for government to “establish Justice, insure domestic Tranquility, provide for the common defence, [and] promote the general Welfare.”

Over the centuries, economists have added greater detail around this role of government. For example, in 1890, economist Alfred Marshall defined the term “externality,”See Marshall’s book Principles of Economics. which is a cost or benefit to a third party from a transaction between two other, unrelated parties. Negative externalities (such as pollution) may not be priced into market transactions, leading to overconsumption and declines in social welfare, potentially justifying government intervention.

More than 60 years later, economist Paul Samuelson defined public goods (such as clean air) as space where there is a role for government.See Samuelson’s November 1954 article, “The Pure Theory of Public Expenditure,” in The Review of Economics and Statistics. In his framework, a public good is both nonexcludable, meaning a person cannot be prevented from consuming it, and nonrival, meaning one person’s consumption does not reduce that of another.For more, see Chapter 9, “Theory of Public Goods,” by William Oakland in the 1987 volume of Handbook of Public Economics. The question of provision through the government versus the private sector is rarely as clear as economic models outline. As a result, alternative solutions have been adopted, including the regulation of private industry, public-private partnerships, offerings by both government and the private sector, and government subsidies for private industry, among others.Samuelson’s work notes that the scope of government is based around the existence of market failure. As such, nonrivalrous and nonexcludable goods must fall into the domain of the public sector, as private markets are inefficient social optimizers.

Which Government: Federal, State, Local?

While basic economic models typically have a single variable for a government entity, the reality for many nations is much more complex. In the U.S., powers are divided between the federal and state governments. This division allows for a degree of local autonomy under an overarching national union. As the nation has developed, this system has gotten more complex, with additional jurisdictions at the federal, state and local levels. This opens another area of economic research in which economists study optimal provision of goods and services by governments, typically measured by maximizing social welfare.

Governments are related to one another vertically—the federal government shares authority with states, and states share authority with local governments—and horizontally—state or local governments compete to attract individuals and businesses seeking the best possible economic outcomes. This structure is referred to as fiscal federalism, which describes how taxing and spending responsibilities, as well as other functions, are distributed across different levels of government.

Economic theories introduce trade-offs in the optimal provision of goods and services by a government to better understand the choice of federal, state or local level and the welfare implications. For example, Charles Tiebout’s 1961 theory of fiscal decentralization (PDF) explores the optimal size and scope of governments. Tiebout hypothesizes that multiple local governments, as opposed to a single, consolidated government, can be the optimal providers of public goods and services because they must act like businesses and compete for residents.According to economist Richard Musgrave’s 1959 book, The Theory of Public Finance: A Study in Public Economy, designing efficient fiscal policy involves assigning the roles of allocation, distribution and stabilization across various levels of government to create a balance in which local governments focus on preference-sensitive public goods and central governments prioritize redistribution and macroeconomic stability. Two assumptions of Tiebout’s theory are that:

• Residents can move freely across jurisdictions.
• There are no externalities across jurisdictions.

Wallace Oates’ 1972 decentralization theorem suggests that public goods should be provided locally when preferences differ because local governments are able to tailor their offerings. That is, unless there are strong cost-saving benefits (economies of scale) from central provision and/or negative externalities from decentralization. Common examples are local roads and state highways, or state and local educational institutions.Intergovernmental transfers from the federal to the local level is a real-world practical compromise involving the decentralized efficiency pointed out by Tiebout and Oates. David Agrawal, William Hoyt and John Wilson’s 2022 Journal of Economic Literature article shows that local governments regularly operate on intergovernmental grants, which in turn impacts their tax collections and expenditure operations. According to Pew, federal funding accounted for 36% of total state revenue in fiscal year 2022. Similar to the public-versus-private question, the fiscal federalism answer is rarely clear in practice. As a result, alternatives have developed, such as grants and revenue-sharing programs, federal or state regulations on local policies, and special government overlay districts that span multiple municipalities, counties and even states (e.g., transit systems).

Models Meet Reality

In the 250 years since Smith’s writings, economists’ models and research have continued to provide useful insights for understanding the roles of government and the private sector and optimal governments and their policies. Nonetheless, as complex as economic models have become, they still require assumptions that can abstract from a more complex reality. Oates summed it up nicely in his 1999 essay: “My sense is that most of us working in the field feel more than a little uneasy when proffering advice on many of the decisions that must be made on vertical fiscal and political structure.”Oates’ essay, “An Essay on Fiscal Federalism,” appeared in the September 1999 issue of the Journal of Economic Literature.

Notes

1. The book’s official title is An Inquiry into the Nature and Causes of the Wealth of Nations.
2. We focus on government spending in this blog post and refer readers to Louis Kaplow’s 2008 book, The Theory of Taxation and Public Economics, for an overview of the economics of taxation.
3. See Marshall’s book Principles of Economics.
4. See Samuelson’s November 1954 article, “The Pure Theory of Public Expenditure,” in The Review of Economics and Statistics.
5. For more, see Chapter 9, “Theory of Public Goods,” by William Oakland in the 1987 volume of Handbook of Public Economics.
6. Samuelson’s work notes that the scope of government is based around the existence of market failure. As such, nonrivalrous and nonexcludable goods must fall into the domain of the public sector, as private markets are inefficient social optimizers.
7. According to economist Richard Musgrave’s 1959 book, The Theory of Public Finance: A Study in Public Economy, designing efficient fiscal policy involves assigning the roles of allocation, distribution and stabilization across various levels of government to create a balance in which local governments focus on preference-sensitive public goods and central governments prioritize redistribution and macroeconomic stability.
8. Intergovernmental transfers from the federal to the local level is a real-world practical compromise involving the decentralized efficiency pointed out by Tiebout and Oates. David Agrawal, William Hoyt and John Wilson’s 2022 Journal of Economic Literature article shows that local governments regularly operate on intergovernmental grants, which in turn impacts their tax collections and expenditure operations. According to Pew, federal funding accounted for 36% of total state revenue in fiscal year 2022.
9. Oates’ essay, “An Essay on Fiscal Federalism,” appeared in the September 1999 issue of the Journal of Economic Literature.