1 Chapter 10 Introduction to Government Finance

2 Federal, State, and Local Revenue Sources: Taxes: Payroll Income (Corporate and Personal) Property Sales and Excise Estate Tariffs Fees Tuition Licenses  $3 trillion annually

3 Purpose and Consequences of Government Finance Political Equilibrium Market Equilibrium and Its Efficiency The Distribution of Income

4 Taxes Taxes are compulsory payments to government

5 Tax Basics Tax Base The item or activity that is to be taxed A general tax is one that taxes all of the components of the economic base, with no exclusions, exemptions, or deductions from the tax base. A selective tax is one that taxes only certain portions of the tax base, or it might allow exemptions and deductions from the general tax base. An excise tax is a selective tax on the manufacture or sale of a particular good or service. Tax Rate Structure The relationship between the amount that is to be paid in tax and the tax base for a given accounting period

6 Tax Basics (Continued) Marginal Tax Rate The amount by which the tax increases when the tax base increases Average Tax Rate The total amount of tax divided by the total amount of the tax base Tax bracket The range of the tax base in which the marginal rate is constant

7 Descriptors of the Tax Rate Structure A Progressive Tax has a structure where the marginal tax rate is increasing and greater than the average tax rate. A Proportional Tax has a structure where the marginal tax rate is constant and equal to the average tax rate. (Sometimes called a Flat Tax) A Regressive Tax has a structure where the marginal tax rate is decreasing and less than the average tax rate.

8 Figure 10.1 A Proportional Tax Rate Structure Tax Rate (Percent) Tax Base (Dollars per Year) 0 t ATR = MTR

9 Figure 10.2 A Progressive Tax Rate Structure Tax Rate (Percent) Tax Base (Dollars of Taxable Income per Year) MTR ATR 4,00029,00070,000

10 Figure 10.3 An Example of a Regressive Tax Structure Tax Rate (Percent) Annual Labor Earnings perWorker $100,000 MTR ATR $76,200

11 Average Tax Rates Tax Brackets (Taxable Income) Marginal Tax Rates (MTR) Beginning of Bracket End of Bracket 0-$4, $4000-$29, $29,000-$70, Above $70, * Average Tax Rates in the US

12 Average Tax Rates Throughout the World

13 How Should the Burden of Government Be Financed? Benefit Principle Those who benefit the most from a particular program should pay the most for that program (Lindahl Tax principle at work). Ability-to-Pay Principle Those who have the greatest ability to pay should be required to pay the most.

14 Criteria for Evaluating Methods of Government Finance Equity The distribution of the government finance burden should coincide with commonly held notions of fairness and ability-to-pay. Efficiency The system of government finance should raise revenues with the least loss in efficiency in the private sector. Administrative ease A government finance system should be relatively easy to administer consistently, without excessive costs to collect, enforce, and comply with taxes and tax laws.

15 Horizontal and Vertical Equity Horizontal equity is achieved when individuals of the same economic capacity (measured, for example, by income) pay the same amount of taxes per year (or over their lifetimes). Vertical equity is accomplished when individuals of differing economic ability pay annual tax bills that differ according to some collectively chosen notion of fairness. Both concepts are subjective. “Economic capacity” is difficult to measure and administer. “Ability to pay” requires value judgments on the proper income distribution.

16 Tax Compliance, Avoidance and Evasion Tax Evasion is the term for illegal ways to avoid paying taxes. It is typically the result of not declaring income or overstating otherwise legal deductions. Tax Avoidance is the term for legal ways to avoid paying taxes, typically the result of avoiding activities that are taxed, delaying the time at which taxes are owed, or taking an action designed to lower a tax burden.

17 Figure 10.4 Reducing Tax Evasion D* A MC MB = MTR Cost and Benefit Unreported Income per Year (Dollars) 0 E MB 2 E2E2 D* Cost and Benefit Unreported Income per Year (Dollars) 0D* 1 B MC 1 E MB 1 = MTR 1 2 MC 2 E D* C MC 1 Cost and Benefit Unreported Income per Year (Dollars) 0 MB = MTR E1E1 D* 1 2

18 Alternatives to Taxation Debt Finance is the means of financing expenditures by issuing bonds. Inflationary Finance is the means of financing expenditures through the printing of money.

19 Figure 10.5 Inflationary Finance T' T Guns per Year Butter per Year 0 B2B2 G2G2 C G1G1 A B1B1 I

20 More alternatives to Taxation Donations Money (but more usually time) is voluntarily given to government. Military service or work in the Peace Corps can be considered a donation when the compensation is less than the market value of the time. User Charges Users of a government service can expect to pay for that service. Examples include tuition, fees paid to enter state parks, greens fees at publicly owned golf courses. Earmarked Taxes Taxes can be implemented to fund specific public goods. Examples include gasoline taxes and tolls designed to fund road and bridge repair.

21 Figure 10.6 User Charges and Efficiency MSB = MPB + MEB MPB MSC Charges Trash Pickups per Year 0 C* C* + S* Z* Q* S* Z

22 User Charges and the Transportation Infrastructure Economists argue that voters demand better roads and airports in part because the price to use them (usually zero) is less than the true marginal cost (which should include congestion costs.)

23 User Charges and Efficiency Roads and Bridges wear out when too much weight is concentrated on too few axles. Tolls motivate the wrong behavior in that they tax per axle rather than on pounds per axle. Estimates suggest that taxing pounds per axle and using the revenue to create stronger roads would pay for itself more than eight-fold.

24 Figure 10.7 User Charges for a Congestible Government-Supplied Service 0 User Charges (Cents per Mile) Vehicles per Mile per Hour E1E1 D 1 = MSB 1 80 E2E D 2 = MSB E* MSC 100 N*

25 Government Enterprise Local Utilities Lotteries

26 State Lotteries 38 states run or participate in lotteries. State Lotteries account for more than 3% of state revenues. People of varying incomes spend approximately the same amount on lotteries, which suggests that the lottery system is a regressive means of creating government revenue. Lotteries pay out a smaller portion of revenue to winners than other forms of gaming (horse racing, casinos, etc.).