12 Public Finance: Expenditures and Taxes This chapter addresses the main sources of government revenue and categories of government spending. We discuss and summarize the different philosophies regarding the distribution of a nation’s tax burden. We explain the principles relating to tax shifting, tax incidence, and the efficiency losses caused by taxes. The chapter concludes with a demonstration of how the distribution of income between the rich and poor is affected by government taxes, transfers, and spending.

Government and the Circular Flow (1) Costs (1) Money income (rents, wages, interest, profits) RESOURCE MARKET (2) Resources (2) Land, labor, capital Entrepreneurial Ability (7) Expenditures (8) Resources (10) Goods and services (9) Goods and services BUSINESSES GOVERNMENT HOUSEHOLDS Net taxes (11) Net taxes (12) We integrate government as a decision maker into the circular flow model. Note that government employs resources from the resource market and buys goods and services from the product market. Government then provides goods and services to households and businesses. This is all financed through the net taxes (taxes minus transfer payments) that they receive from households and businesses. (5) Expenditures (6) Goods and services (4) Goods and services (4) Goods and services PRODUCT MARKET (3) Consumption expenditures (3) Revenues LO1

Borrowing and deficit spending Government Finance Government purchases Exhaustive Transfer payments Nonexhaustive Borrowing and deficit spending Opportunity cost is low during recession, high during growth Government purchases are exhaustive and directly absorb resources. The goods and services purchased by the government are a part of GDP. Transfer payments do not contribute to GDP because recipients don’t make any contributions to current GDP. Social security, welfare payments, veterans’ benefits, and unemployment compensation are examples of transfer payments. Government spending and the tax revenues needed to finance it are equivalent to 35 percent of GDP. The funds used to pay for government purchases and transfers come from taxes, proprietary income, and borrowed funds secured by selling government securities. Government can maintain a high level of spending during a recession by borrowing and creating deficits. The opportunity cost of borrowing during a recession is low because otherwise the funds would have sat idle, but during growth, deficit spending can crowd out private investment. LO1

Government Finance Government purchases, transfers, and total spending as percentages of U.S. output 40 35 30 25 20 15 10 5 15% Government transfer payments 5% Percentage of U.S. output 22% 20% In 2010 government purchases declined to 20 percent from 22 percent in 1960, while government transfer payments rose from 5 percent in 1960 to 15 percent in 2009. Total government spending (purchases plus transfers) rose from 27 percent of U.S. GDP in 1960 to 36 percent in 2010. Government Purchases 1960 2010 Year LO1

Global Snapshot This table shows the tax revenue, or a nation’s “tax burden,” as a percent of GDP for selected industrialized nations. LO1

Pensions & income security Federal Expenditures Federal expenditures: $3456 billion Federal tax revenues: $2162 billion National defense 20% Pensions & income security 38% Payroll taxes 40% Health 24% These pie charts show the sources of revenues and expenditures for the federal government, 2010. All other 12% Corporate income tax 9% Interest on public debt 6% Excise taxes 3% All other 6% LO1

Federal Tax Revenues Personal income tax Progressive tax Marginal tax rate Payroll taxes Corporate income tax Excise taxes Personal income taxes are the backbone of the U.S. federal tax system. A tax is levied on taxable incomes of households and unincorporated businesses after certain deductions. A progressive tax means that higher tax rates are applied to higher brackets of income. Marginal tax rate is the tax rate paid on additional income. Payroll taxes are taxes on wages and income that finance Social Security and Medicare for retirees. The corporate income tax is a tax on a corporation’s profit and for most firms it is 35 percent. Excise taxes include sales taxes where sales taxes are placed on a large range of goods and services and excise taxes are imposed on specific goods. LO1

Average Tax Rate on Highest Income in Bracket % (3) / (1) Federal Tax Revenues Federal Personal Tax Rates, 2011* (1) Total Taxable Income (2) Marginal Tax Rate % (3) Total Tax on Highest Income in Bracket (4) Average Tax Rate on Highest Income in Bracket % (3) / (1) $1–$17,000 10 $ 1700 $17,001–$69,000 15 9500 14 $69,001–$139,500 25 27,125 19 $139,501–$212,300 28 47,509 22 $212,301–$379,150 33 103,570 27 Over $379,150 35 This table shows the tax rates for a married couple filing a joint return, 2011. * For a married couple filing a joint return LO1

State and Local Finance State revenues 48 percent from sales and excise taxes 40 percent from personal and corporate taxes License fees and other taxes make up the rest The primary source of state tax revenues comes from sales and excise taxes. Personal and corporate income taxes are the second most significant source and license fees and other taxes make up the remainder. LO1

State and Local Finance State expenditures 37 percent on education 28 percent on public welfare 8 percent on health and hospitals 7 percent on highway maintenance and construction 4 percent on public safety 20 percent on other purposes The biggest expenditure for states tends to be for education. Public welfare programs take the next largest chunk, followed by health and hospitals, highways, and public safety. LO1

State and Local Finances 71 percent of revenues from property taxes 17 percent of revenues from sales and excises taxes 44 percent of expenditures on education 12 percent on welfare, health, and hospitals 11 percent on public safety 11 percent on housing, parks, and sewerage 6 percent on streets and highways The tax revenues of local government cover less than one-half of their expenditures. The remaining funds come from intergovernmental grants from the federal and state governments. They also receive considerable income from government-owned utilities providing services such as water and electricity. LO1

Local, State, and Federal Employment State and local jobs 50 percent in education 9 percent in hospitals or health care 10 percent in police and corrections Federal jobs 50 percent in national defense or postal service 12 percent in hospitals or health care 4–7 percent in natural resources, police, and financial administration U.S. governments employed about 19.4 million workers in 2008, representing 13% of the workforce. These jobs vary depending on whether it is a federal job or at the state and local level. At the federal level, the largest category of worker is in the area of national defense or the postal services. At the state and local level, the largest category is education. LO1

Apportioning the Tax Burden Size, distribution, and impact of the costs that taxes impose on society Benefits-received principle Ability-to-pay principle Taxes are the major source of funding for goods and services provided by government and the wages and salaries paid to government workers. Without taxes, there would be no public and quasi-public goods provided. Who should pay and how much taxes one should pay continue to stir controversy. Some leading philosophical approaches to splitting the tax burden are based on the benefits-received principle and ability-to-pay principle. Based on the benefits-received principle, those who benefit from the taxes should pay for them. This includes taxes on gas to fund highway construction and repair since these are the individuals using the highways. However, this principle becomes much more difficult to apply to things like public education and defense. Imposing taxes based on the ability-to-pay principle means that the taxes are based upon a person’s income and wealth where individuals with greater income/wealth pay more taxes. LO2

Apportioning the Tax Burden Progressive tax—average tax rates increase as income increases Regressive tax—average tax rate declines as income increases Proportional tax—average rate stays the same as income increases Taxes are classified into one of the above categories based upon the relationship between average tax rates and the taxpayer incomes. LO2

Apportioning the Tax Burden Applications Personal income tax: progressive Sales tax: regressive Corporate tax: proportional Payroll tax: regressive Here we show a general application using the tax classification. Personal income taxes are progressive with marginal tax rates rising as incomes increase. A sales tax is regressive relative to income because a larger portion of a low-income household’s income is paid to sales taxes. Corporate taxes are proportional because they are a flat percentage on income. Payroll taxes are regressive because Social Security tax has a limit where once an individual has reached the income limit, he will no longer have to pay Social Security taxes for the year. LO2

Tax Incidence and Efficiency Loss Who really pays the tax? Excise tax Tax burden depends on elasticity Inelastic versus elastic Efficiency loss Deadweight loss Transfer of surplus to government Determining the classification of a particular tax is complicated because those on whom taxes are levied do not always pay the tax. We therefore need an understanding of tax incidence: the degree to which a tax burden falls on a person or group. LO3

Elasticity and Tax Incidence 14 12 10 8 6 4 2 5 15 20 25 Q P St S Price (per bottle) Quantity (millions of bottles per month) Tax $2 Suppose the government levies an excise tax of $2 per bottle at the winery. Who will pay the tax? An excise tax of $2 shifts the supply curve left (up). As a result, the equilibrium price rises from $8 to $9. The price to consumers rises from $8 to $9. The consumer pays $1 of the $2 excise tax. The producer receives an after-tax price of $7, which is $1 less than the $8 before-tax price. So, in this case, consumers and producers share the burden of the tax equally. D LO3

Elasticity and Tax Incidence P P St Tax Tax St S a S P1 P b a Pe Pb c P1 b De Pa c This figure contrasts the cases where demand is either relatively elastic or relatively inelastic in the relevant price range, and we can clearly see the difference in the tax burden. Di Q2 Q1 Q2 Q1 Elastic Demand Inelastic Demand Smaller efficiency loss with inelastic demand LO3

Elasticity and Tax Incidence P P St S Tax Tax St a Pe S a b Pi P1 P1 b Pa c Pb c D D In this figure, we contrast what would happen with a specific demand. The more inelastic the supply, the larger the portion of the tax borne by producers. When supply is elastic, the consumer will pay a larger portion of the tax. Q2 Q1 Q Q2 Q1 Q Elastic Supply Inelastic Supply Smaller efficiency loss with inelastic supply LO3

Efficiency Loss of a Tax 5 10 15 20 25 Q P 14 12 8 6 4 2 Tax paid by consumers St Tax $2 S Price (per bottle) Quantity (millions of bottles per month) Efficiency loss (or deadweight loss) We have observed that producers and consumers typically each bear part of an excise tax levied on products. This figure takes a closer look at the overall economic effect of the excise tax, showing the portion paid by consumers and the portion paid by producers. We can also see the amount of deadweight loss that is created from the tax. . Tax paid by producers D LO3

Global Snapshot A number of advanced industrial nations rely much more heavily on consumption taxes, sales taxes, specific excise taxes, and value-added taxes than the United States. A value-added tax, which the United States does not have, applies only to the difference between the value of a firm’s sales and the value of its purchases from other firms. As a percentage of GDP, the highest tax rates on consumption are in countries that have value-added taxes. LO3

Probable Incidence of U.S. Taxes Type of tax Probable Incidence Personal income tax Tax falls on the household or individual on which it is levied Payroll taxes Workers pay the full tax levied on their earnings and part of the tax levied on their employers Corporate income tax Short run: Full tax falls on owners of the businesses Long run: Some of the tax may be borne by workers through lower wages Sales tax Tax falls on consumers who buy the taxed products Specific excise taxes Taxes fall on consumers, producers, or both, depending on elasticity of supply and demand Property Taxes Taxes fall on owners in the case of land and owner-occupied residences, tenants in the case of rented property, consumers in the case of business property This table looks at the probable outcome of taxes on each of the major sources of tax revenue in the United States. LO3

Federal tax system is progressive U.S. Tax Structure Federal tax system is progressive State and local tax structures are largely regressive Overall U.S. tax system is progressive The question of whether the overall U.S. tax structure is progressive, regressive, or proportional is difficult to answer. The majority of economists who study taxes feel that the federal system tends to be progressive while the state and local systems are regressive, but overall higher-income people carry a substantially larger tax burden, resulting in an overall progressive system. LO3