Chapter 7. The Government Sector

Chapter 7The Government Sector7-1Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Chapter ObjectivesGovernment spendingThe graphing of the C + I + G lineTypes of taxesThe average and marginal tax ratesSources of government revenuePrinciples of taxationThe economic role of government7-2Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Introduction: The Growing Economic Role of GovernmentMost of the growth over the past seven decades was due to the Depression and World War IISince 1945 the roles of government at the federal, state, and local levels have expandedThe seeds of that expansion were sown during the Roosevelt administrationThe government exerts four basic influencesIt spends more than $2.5 trillionIt levies almost that amount in taxesIt redistributes hundreds of billions of dollarsIt regulates our economy7-3Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-4Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-5Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.2002 Proposed Spending by CategoryBudget of the United States Government , Fiscal Year 1999 7-6State and Local Government SpendingMain expendituresEducationHealthWelfareSpending is a little more than half the level of federal spendingPolice protection and prisons are now straining state and local budgetsCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Government Purchases versus Transfer PaymentsThe government spends $2.7 trillion a yearGDP = C + I + G + XnApproximately half is “transfer payments”The largest transfer payment is social securityThese payments end up in the “C” part GDPApproximately half is “government purchases”The largest government purchase is defenseThese end up in the “G” part of GDP7-7Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Federal and State and Local Purchases Relative to GDP, 1960-2000 7-8Total government purchases have been declining since the late 1960s and now constitute 16 percent of GDP7-9Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Federal and State and Local Transfer Payments as a Percentage of GDP, 1960-2000Federal transfer payments have risen sharply since the mid-1960s, while state and local transfer payments have also grown substantially since the early 1970s.Total government transfer payments have risen from just 6 percent of GDP in 1960 to more than 15 percent todayGraphing the C + I + G + Xn Line7-10Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.To keep the graph as simple as possible, we are assuming the government spends a constant amount of money regardless of the level of disposable incomeGraphing the C + I + G + Xn Line7-11Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.How much is G?Answer: 400The Average Tax Rate and the Marginal Tax RateIncome Marginal Total AverageLevel Tax Rate Tax Taxes Tax Rate7-12This is a hypothetical illustrationCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Average Tax Rate and the Marginal Tax RateIncome Marginal Total Average Level Tax Rate Tax Taxes Tax Rate7-13This is a hypothetical illustration0 - $100 0 % 0 $ 0 0.0 %Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Average Tax Rate and the Marginal Tax RateIncome Marginal Total AverageLevel Tax Rate Tax Taxes Tax Rate7-14This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 %$101 - $200 $10 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Average Tax Rate and the Marginal Tax RateIncome Marginal Total AverageLevel Tax Rate Tax Taxes Tax Rate7-15This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 %$101 - $200 $10 Additional Taxes Paid ( $10) MTR = -------------------------------- ---------- Additional Taxable Income ($100)Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Average Tax Rate and the Marginal Tax RateIncome Marginal Total AverageLevel Tax Rate Tax Taxes Tax Rate7-16This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 %$101 - $200 10 % $10 Additional Taxes Paid ( $10) MTR = -------------------------------- ---------- Additional Taxable Income ($100)Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Average Tax Rate and the Marginal Tax RateIncome Marginal Total AverageLevel Tax Rate Tax Taxes Tax Rate7-17This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 %$101 - $200 10 % $10 Additional Taxes Paid ( $10) MTR = -------------------------------- ---------- Additional Taxable Income ($100)The Marginal Tax Rate (MTR) is the rate you pay on the last dollars you earned Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Average Tax Rate and the Marginal Tax RateIncome Marginal Total AverageLevel Tax Rate Tax Taxes Tax Rate7-18This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 %$101 - $200 10 % $10 $10Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Average Tax Rate and the Marginal Tax RateIncome Marginal Total AverageLevel Tax Rate Tax Taxes Tax Rate7-19This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 %$101 - $200 10 % $10 $10 Total Taxes Paid ( $10) ATR = -------------------------------- ---------- Entire Income ($200)Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Average Tax Rate and the Marginal Tax RateIncome Marginal Total AverageLevel Tax Rate Tax Taxes Tax Rate7-20This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 %$101 - $200 10 % $10 $10 5.0 % Total Taxes Paid ( $10) ATR = -------------------------------- ---------- Entire Income ($200)Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Average Tax Rate and the Marginal Tax RateIncome Marginal Total AverageLevel Tax Rate Tax Taxes Tax Rate7-21This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 %$101 - $200 10 % $10 $10 5.0 % Total Taxes Paid ( $10) ATR = -------------------------------- ---------- Entire Income ($200)Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Average Tax Rate and the Marginal Tax RateIncome Marginal Total AverageLevel Tax Rate Tax Taxes Tax Rate7-22This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 %$101 - $200 10 % $10 $10 5.0 % Total Taxes Paid ( $10) ATR = -------------------------------- ---------- Entire Income ($200)The Average Tax Rate (ATR) is the overall rate you pay on your entire incomeCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Average Tax Rate and the Marginal Tax RateIncome Marginal Total AverageLevel Tax Rate Tax Taxes Tax Rate7-23This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 %$101 - $200 10 % $10 $10 5.0 %$201 - $300 12 % $12 $22 7.3 % Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Average Tax Rate and the Marginal Tax RateIncome Marginal Total AverageLevel Tax Rate Tax Taxes Tax Rate7-24This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 %$101 - $200 10 % $10 $10 5.0 %$201 - $300 12 % $12 $22 7.3 %$301 - $400 15 % $15 $37 9.3 % Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Average Tax Rate and the Marginal Tax RateIncome Marginal Total AverageLevel Tax Rate Tax Taxes Tax Rate7-25This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 %$101 - $200 10 % $10 $10 5.0 %$201 - $300 12 % $12 $22 7.3 %$301 - $400 15 % $15 $37 9.3 % $401 - $500 28 % $28 $65 13.0 % Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Average Tax Rate and the Marginal Tax RateIncome Marginal Total AverageLevel Tax Rate Tax Taxes Tax Rate7-26This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 %$101 - $200 10 % $10 $10 5.0 %$201 - $300 12 % $12 $22 7.3 %$301 - $400 15 % $15 $37 9.3 % $401 - $500 28 % $28 $65 13.0 %$501 - $600 50 % $50 $115 19.2 % Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Average Tax Rate and the Marginal Tax RateIncome Marginal Total AverageLevel Tax Rate Tax Taxes Tax Rate7-27This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 %$101 - $200 10 % $10 $10 5.0 %$201 - $300 12 % $12 $22 7.3 %$301 - $400 15 % $15 $37 9.3 % $401 - $500 28 % $28 $65 13.0 %$501 - $600 50 % $50 $115 19.2 % > $600 80 % Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Types of TaxesDirect taxesA tax with your name on itIndirect taxesTaxes on things 7-28Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Types of Taxes (Continued)Progressive taxesPlaces a greater burden on those best able to pay and little or no burden on the poorProportional taxesPlaces an equal burden on the rich, the middle class, and the poorRegressive taxesPlaces a heavier burden on the poor than on the rich7-29Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-30Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-31Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-32Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-33Sources of Federal RevenuePersonal Income TaxThe personal income tax is the largest source of federal revenueMost of the poor pay little or no federal income taxCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-34Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Federal Personal Income Tax:The Top Marginal Tax Rate, 1954-20017-35Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Top Marginal Tax Rates in 15 Leading Wealthy Nations, 20007-36Sources of Federal RevenueThe Social Security and Medicare taxes are the Payroll TaxWhat you pay is matched by your employerThe social security tax by law is set at 6.2% with a wage based limitation of $80,400 The inflation rate of the previous year raises the wage baseThe Medicare tax of 1.45% applies to wages and salaries only. Income such as rental income, interest, dividends, and profit is exemptCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-37Sources of Federal RevenueYou pay 6.2% in payroll tax on wages up to $80,400 and 1.45% on all wages The Payroll Tax is the fastest growing source of federal revenueCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-38Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Level of Earned Income Taxes Paid Average Tax Rate $ 10,000 $ 620.00 6.2% 68,400 4,240,80 6.2% 100,000 4,240.80 4.24% 1,000,000 4,240.80 0.424%The Incidence of the Social Security Tax at Various Income Levels in 1998Note: The current social security tax by law is set at 6.2 % with a wage based limitation of $80,400 The Corporate Income TaxThe corporate income tax is a tax on a corporation’s profitsThe maximum rate is 35%All corporations earning profits of at least $335,000 pay an average of tax rate of 35%Loopholes in the tax law allow many corporations to pay much lower taxes 7-39Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Excise TaxesAn excise tax is a sales tax aimed at specific goods and servicesMost excise taxes are levied by the federal governmentState and local governments also often levy taxes on the same items7-40Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Excise Taxes (Continued)Excise taxes tend to reduce consumption of certain products of which the federal government takes a dim view (e.g., cigarettes)Excise taxes are usually regressive7-41Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Estate TaxThe estate tax is a tax on the estates of people who dieIt is a graduated tax that rises to 55%It is levied only on estates valued at $675,000 or moreMore than 90% of estate taxes are paid by people with incomes above $200,000 a year7-42Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-43Sources of State and Local Tax RevenueSales TaxIs a source of over half of all taxes collected by the statesIs a highly regressive taxProperty taxesProvides 80% of all local tax revenueCan distort business decisions about where to locateCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The State and Local Fiscal DilemmaSince World War II, state and local governments have been expected to provide an increasing number of servicesMost notable are health, welfare, education, and police protectionPrograms dropped at the Federal level must often be picked up at the state or local level7-44Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.During the 1960s and 1970s the federal government helped states with increasing grants-in-aid and general revenue sharingThe Reagan administration not only stemmed this increase, but strongly reversed it The State and Local Fiscal Dilemma (Continued)7-45Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Neighboring states and local governments are in direct competition with one another for tax dollarsIf one government’s tax rates rise too far above the levels of its neighbors, it citizens will vote with their feetThe 1998 Internet Tax Freedom Act declared a three-year moratorium for online sales7-46The State and Local Fiscal Dilemma (Continued) Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-47Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Government Tax Rates as a Percentage of GDP, 1929 and 2000Tax Rates are almost three times as high as they were in 19297-48Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Tax Receipts as a Percentage of GDP in the United States and Selected Western European Countries, 1999 Two Principles of Taxation: IAbility to pay principleAbility to payRich people would pay a much higher proportion of their incomes than the middle classMiddle class would pay a higher proportion of their incomes than the poor Is this fair?Possibly, but only if you are solely concerned with people’s incomesIt also depends on how you define the rich and middle class7-49Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Two Principles of Taxation: IIBenefits received principleSome people receive more benefits than othersApplying the benefits received principle strictly could end up with absurd resultsWe are not always clear about the value of any benefits received7-50Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.An example of the ability to pay principle is the federal personal income taxAn example of the benefits received principle is the federal and state tax on gasoline, which is geared to the number of miles drivenA tax based on both principles cannot be devised because they appear to be mutually exclusiveTherefore, some taxes are based on the ability to pay principle while others are based on the benefits received principle 7-51Two Principles of Taxation(Continued)Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Economic Role of Government7-52Provision of Public Goods and ServicesRedistribution of IncomeStabilizationEconomic RegulationCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Provision of Public Goods and ServicesSome examplesDefense of the countryMaintenance of internal orderProvision of a nationwide highway networkProvision of a money supplyProvision of public educationRunning the criminal justice systemEnvironmental protection7-53Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Redistribution of IncomeThe government redistributes hundreds of billions of dollars every yearSocial security redistributes money from those currently working to those who have retiredWelfare for the poorExamples are food stamps, Medicaid, disability payments and unemployment benefits Welfare for the richExamples are subsidies to corporate farmers and tax breaks for defense contractors, oil companies, and other large corporations7-54Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.StabilizationTwo basic goals of economic stabilization by the federal governmentStable prices with little or no inflationLow unemploymentAn economic rate of growth high enough to keep the unemployment rate to a minimum7-55Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Economic RegulationThe government provides the economic rules of the gameThis must be done within the social and political context in which the economy operatesThe government must allow individuals and business firms to operate with the maximum degree of freedomThere is little agreement as to how far economic freedom may be extended without interfering with society as a whole or the economic rights of specific individuals or business firms7-56Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.7-57Adam Smith’s Dos and Don’tsDoProtect society from the violence and invasion of other countriesEstablish an exact administration of justiceErect and maintain certain public works and institutions where private enterprise could not profit from doing soDon’t – Do anything elseCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.ConclusionUntil the 1930s, the federal government more or less followed the role prescribed by Adam SmithThe government’s economic role has expanded tremendously these last seven decadesIt will continue to grow in the coming years7-58Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Big government, like rock ‘n’ roll, is here to stay7-59Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.