Chapter 7 The Government Sector

Chapter Objectives In this chapter we’ll be looking at these topics: Government spending. The graphing of the C + I + G line. Types of taxes. The average and marginal tax rates. Sources of government revenue. The economic role of government.

Introduction: The Growing Economic Role of Government Most of the growth over the past 7 decades was due to the Depression and WWII. Since 1945 the roles of government at the federal, state, and local levels have expanded. The seeds of that expansion were sown during the Roosevelt administration. The government exerts 4 basic influences: It spends more than $3.0 trillion. It levies even more in taxes. It redistributes hundreds of billions of dollars. It regulates the economy.

Government Revenues and Spending, Fiscal Year 2009 Estimate Source: Economic Report of the President, 2008; www.budget.gov.

Spending: Past, Present, and Future ** 2009 figures are from President George W. Bush’s 2009 budget. They are projected estimates of actual spending. Source: Congressional Budget Office.

State and Local Government Spending Main expenditures: Education Health Welfare Spending is a little more than half the level of federal spending. Police protection and prisons are now straining state and local budgets.

Government Purchases versus Transfer Payments The federal, state, and local governments spends over $3.0 trillion a year. GDP = C + I + G + Xn Approximately half are “transfer payments.” The largest transfer payment is social security. These payments end up in the “C” part GDP. Approximately half are “government purchases.” The largest government purchase is defense. These end up in the “G” part of GDP.

Graphing the C + I + G Line If we assume government spending is constant across all levels of disposable income at $167 billion, we see how it shifts the function up and results in a new equilibrium at $10.8 trillion. The slope of the function is determined by the MPC. The impact of spending on the new equilibrium is determined by a multiplier that we will learn about later.

Questions for Thought and Discussion How did the Great Depression encourage the growth of government? Do future forecast make the government’s present role appear to be sustainable?

The Average Tax Rate and the Marginal Tax Rate The Average Tax Rate (ATR) is the overall rate you pay on your entire income. The Marginal Tax Rate (MTR) is the rate you pay on the last dollars you earned.

The Average Tax Rate and the Marginal Tax Rate: A Hypothetical Illustration Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 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 %

Types of Taxes Direct tax Indirect tax A tax with your name on it A tax on things

Types of Taxes Progressive taxes Proportional taxes Regressive taxes Places a greater burden on those best able to pay and little or no burden on the poor Proportional taxes Places an equal burden on the rich, the middle class, and the poor Regressive taxes Places a heavier burden on the poor than on the rich

Nominally Progressive, Proportional, & Regressive Taxes

Sources of Federal Revenue Personal Income Tax The personal income tax is the largest source of federal revenue. Accounts for 44% of all federal tax revenue. Low income people pay little or no federal income tax. This means in general the middle class and the rich pay nearly all federal taxes.

Federal Personal Income Tax:The Top Marginal Tax Rate, 1993–2008

Top Marginal Combined Income Tax Rates in 11 Leading Wealthy Nations, 2006* *Combined federal, state, and local income taxes. Source: OECD.

Sources of Federal Revenue The Personal Income tax Individual personal income taxes account for 44% of all federal tax revenue. In general, the middle class and the rich pay nearly all federal income taxes. The federal personal income tax is considered progressive because the burden falls mainly on the upper middle class and the rich.

Sources of Federal Revenue (continued) The Social Security and Medicare taxes are the Payroll Tax. What you pay is matched by your employer. The Social Security tax by law is set at 6.2% with a wage based limitation of $94,200. The inflation rate of the previous year raises the wage base. The Medicare tax of 1.45% applies to all wages and salaries. There is no wage based limitation. Income such as rental income, interest, dividends, and profit is exempt.

Sources of Federal Revenue You pay 6.2% in payroll tax on wages up to $94,200 and 1.45% on all wages and salaries. This means the rich whose income is primarily from rental income, interest, dividends, and profits pay no payroll taxes on money from these sources. The Payroll Tax is the fastest growing source of federal revenue. Today, 3/4th of all taxpayers pay more in social security taxes than in federal income tax. Think about it. . .only a tiny fraction of the income of the rich goes to payroll taxes.

The Incidence of the Social Security Tax at Various Income Levels Level of Earned Income Taxes Paid Average Tax Rate $ 10,000 $ 620.00 6.2% 94,200 5,840.40 6.2% 100,000 5,840.40 5.84% 1,000,000 5,840.40 0.58% Note: The current social security tax by law is set at 6.2% with a wage based limitation of $94,200.

The Corporate Income Tax The corporate income tax is a tax on a corporation’s profits. The maximum rate is 35%, however loopholes allow most corporations to pay significantly lower rates than the maximum rate. Corporate income taxes are just 3% of all federal tax revenue. All corporations earning profits of at least $335,000 are to pay an average tax rate of 35%. But loopholes in the tax law allow many corporations to pay much lower taxes.

Excise Taxes An excise tax is a sales tax aimed at specific goods and services. Accounts for about 4% of federal revenue. Most excise taxes are levied by the federal government. State and local governments often levy taxes on the same items. Excise taxes tend to reduce consumption of certain products of which the federal government takes a dim view. Excise taxes are usually regressive.

The Estate Tax The estate tax is a tax on the estates of people when they die. It is a graduated tax that rises to 55%. It is levied only on estates valued at $1,000,000 or more. More than 90% of estate taxes are paid by people with incomes above $200,000 a year at the time of death.

Sources of State and Local Tax Revenue Personal income tax Accounts for about half of all state revenue. Sales Tax Is a source of almost half of all taxes collected by the states. Is a highly regressive tax. Property taxes Provides 80% of all local tax revenue. Can influence business decisions about where to locate.

The State and Local Fiscal Dilemma Since WWII, state and local governments have been expected to provide an increasing number of services. Most notable are health, welfare, education, police protection and prisons. In 2003, states increased tuition at public colleges, cut Medicaid eligibility and benefits, and laid off state employees. In addition, localities spent billions of dollars on new security measures without receiving any federal assistance. Unfunded mandates The Federal government often places obligations on states without providing the money to pay for them.

The State and Local Fiscal Dilemma Neighboring states and local governments are in direct competition with one another for tax dollars. If one government’s tax rates rise too far above the levels of its neighbors, it citizens will vote with their feet.

Government Tax Rates as a Percentage of GDP, 1929 and 2005 Economic Report of the President, 2003 Tax Rates are about two and a half times as high as they were in 1929. Source: Economic Report of the President, 2008; Survey of Current Business, March 2008, www.bea.gov.

Organization for Economic Cooperation and Development Tax Receipts as a Percentage of GDP in the U.S. and Selected Countries, 2006 Organization for Economic Cooperation and Development Source: Organization for Economic Cooperation and Development.

Questions for Thought and Discussion Is the American income tax regressive or progressive? Are payroll taxes regressive or progressive? How do high tax rates impact the quality of life of citizens in the industrialized world?

Economic Role of Government Provision of Public Goods and Services Redistribution of Income Stabilization Economic Regulation

Provision of Public Goods and Services Some examples include: Defense of the country Maintenance of internal order A nationwide highway network Provision of a money supply Public education Running the criminal justice system Environmental protection

Redistribution of Income The government does redistribute hundreds of billions of dollars every year. Social Security redistributes money from those currently working to those who have retired. Welfare for the poor Examples are food stamps, Medicaid, disability payments, and unemployment benefits. Welfare for the rich Examples are subsidies to corporate farmers and tax breaks for defense contractors, oil companies, and other large corporations.

Stabilization Two basic goals of the federal government: Stable prices with little or no inflation Low unemployment An economic rate of growth high enough to keep the unemployment rate to a minimum.

Economic Regulation The government provides the economic rules of the game. This must be done within the social and political context in which the economy operates. The government must allow individuals and business firms to operate with the maximum degree of freedom. There 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 firms.

Adam Smith’s Dos and Don’ts Protect society from the violence and invasion of other countries. Establish an exact administration of justice. Erect and maintain certain public works and institutions where private enterprise could not profit from doing so. Don’t do anything else.

Conclusion Until the 1930s, the federal government more or less followed the role prescribed by Adam Smith. The government’s economic role has expanded tremendously these last 7 decades. It will probably continue to grow into an even more monolithic all-powerful colossal Big-Brother in the coming years.

Will Social Security Be There for You? Currently, the federal government is receiving $150 million more in Social Security Taxes than it is paying out. This surplus is deposited in the Social Security trust (trust me) fund. However, the surplus is spent by the government each year to offset its deficits. The U.S. Treasury places I.O.U.s, (government securities) in the Social Security trust fund. In essence, the right hand (general fund) gives the left hand (social security trust fund) an I.O.U. and spends the money. This fund consist consists of trillions of dollars of government securities (I.O.U.s . . . they have been doing this for decades).

Will Social Security Be There for You? (continued) The Looming Crises In 2011, the baby boomers (born between 1946 and 1964) will be retiring. This means the annual Social Security surplus which is being spent by the government and replaced by an I.O.U. will disappear. Social Security checks will then have to be paid out of the government’s general fund. The government will have to make good on its I.O.U.s by selling the government securities in the Social Security trust fund (borrowing the money). However, the trust fund I.O.U.s will run out around 2042!

Social Security is the Good News; the Bad News is Medicare Medicare is even more seriously under funded than Social Security. By 2018 Medicare spending will surpass Social Security spending. Remember all those retiring baby boomers? Medicare is much more complex than Social Security.

Questions for Thought and Discussion How does the present role of government deviate from the role envisioned by Adam Smith? Would it be possible or desirable to return to a government with a more limited role? How can government continue to provide social security and Medicare? Should this be a role played by government?