Chapter 6 Taxes, Transfers, and Public Spending

Slide 6-2 Public school students often must pay supplemental fees in order to participate in sports or other extra-curricular activities. What accounts for this change in the way school operations are financed? Introduction

Slide 6-3 Understand the key factors influencing the relationship between tax rates governments assess and the tax revenues governments collect. Explain how the taxes governments levy on purchases of goods and services affect market prices and equilibrium quantities. Learning Objectives

Slide 6-4 Analyze how Medicare affects the incentives to consume medical services. Explain why increases in government spending on public education have not been associated with improvements in measures of student performance. Understand how the Social Security system works and explain the nature of the problems it poses for today’s students. Learning Objectives

Slide 6-5 Chapter Outline Taxation from the Government’s Point of View Taxation from the Government’s Point of View Taxation from the Point of View of Producers and Consumers Taxation from the Point of View of Producers and Consumers Public Spending and Transfer Programs Public Spending and Transfer Programs Social Security

Slide 6-6 Public schools were not widespread in the U.S. until the 1870’s? State and local governments collect tax revenue from a variety of sources in order to subsidize public education? Did You Know That...

Slide 6-7 Taxation from the Government’s Point of View Three sources of government funding –Fees, or user charges –Taxes –Borrowing

Slide 6-8 Taxation from the Government’s Point of View The Government Budget Constraint –The sum of public spending on goods, services, and transfer payments during a given period cannot exceed tax and fee revenues plus borrowed funds. –Because borrowed funds must be paid from later taxes, the ability to collect tax revenue defines current spending limits.

Slide 6-9 The Tax Base Tax Base –The value of wealth or transactions subject to taxation

Slide 6-10 Tax Rates and Tax Revenues Static tax analysis –Based on the assumption that changes in the tax rate leave the tax base unaffected Dynamic tax analysis –Recognizes that higher tax rates may shrink the tax base

Slide 6-11 Tax Rates and Tax Revenues If the disincentive effects of higher tax rates are small, static analysis may give a fairly accurate estimate of the change in tax revenues resulting from a tax rate change. As tax rates escalate, members of the public have a greater incentive to remove their activities from the tax base. A dynamic analysis would be necessary to determine the overall effect on government revenues.

Slide 6-12 Maximizing Sales Tax Revenue Figure 6-2

Slide 6-13 Taxation form the Point of View of Producers and Consumers Excise taxes on gasoline become added costs of production. This shifts the supply curve up by the amount of the unit tax. Consequently, the equilibrium price of gasoline rises and the equilibrium quantity declines.

Slide 6-14 Effects of Excise Taxes on the Market for Gasoline Figure 6-3

Slide 6-15 Who Pays the Tax? The shapes of the supply and demand curves determine how the burden of a tax is split between producers and consumers. In this example, consumers pays 30 cents of the tax and producers absorb the remaining 10 cents.

Slide 6-16 Public Spending and Transfer Programs How taxes are spent –Funding public goods –Subsidize the consumption of merit goods –Finance transfer payment programs such as Medicare

Slide 6-17 Medicare is a program that heavily subsidizes the medical expenses of those over 65. –Currently the Medicare tax is 2.9 percent of earnings –Retirees are guaranteed that the majority of their doctor’s and hospital bills will be paid with public monies Publicly Subsidized Health Care: Medicare

Slide 6-18 Figure 6-5 The Economic Effects of Medicare Subsidies When the government pays a per-unit subsidy M for medical care, consumers pay the price P d and providers receive P s. S Q0Q0 QmQm PdPd D P0P0 PsPs M

Slide 6-19 To increase the quantity of medical care, the government pays a subsidy –The price per unit paid to medical service providers increases –The price per unit paid by consumers falls –More medical services are consumed The Economic Effects of Medicare Subsidies

Slide 6-20 Problems plaguing Medicare include –rising physician incomes, –the spread of private for-profit hospitals, –and many new tests and procedures due to the rise in the price of medical services. Expenditures are higher than projected because of rising prices and consumption. Medicare Incentives at Work

Slide 6-21 Medicare Incentives at Work Total spending on medical services consumes far more income than expected –14 percent of GDP in the United States –The highest percent in the world Patients consume many relatively low- value services that are very costly to provide

Slide 6-22 Today’s Challenge: Containing Medicare Spending –Reimbursement caps limit total spending on specific procedures –Patients are often discharged too soon –Drugs are often withheld to cut costs –Elderly patients are sicker than they otherwise would be –Costs are often higher

Slide 6-23 Today’s Challenge: Containing Medicare Spending Recent government policy has been to limit Medicare reimbursement to physicians. As a result, a growing number of physicians now refuse to treat any Medicare patients.

Slide 6-24 Example: The Doctor is In, But Insurance is Out A new type of health care clinic has emerged in response to the high costs of administering insurance claims. These clinics do not accept any third- party payments, so they avoid all the paperwork associated with Medicare and insurance.

Slide 6-25 Example: The Doctor is In, But Insurance is Out With overall costs much lower at these clinics, patients who are willing to pay out of their own pocket can purchase medical services at rates far below those charged by health care providers accepting third-party payments.

Slide 6-26 Economic Issues of Public Education State and local governments provide primary, secondary, and post- secondary education at prices well below those that would otherwise prevail in the marketplace.

Slide 6-27 Economic Issues of Public Education The performance of U.S. students compared with those in other countries declines at higher grade levels. Subsidies, which drive a wedge between the cost of providing education and the price paid by the student, may account for this relatively poor performance.

Slide 6-28 Policy Example: Government Education Subsidies and Tuition Hikes As the federal government subsidizes college students, each student is willing to pay a higher level of tuition. This increase in demand for higher education has led to an increase in the average college tuition.

Slide 6-29 Social Security was created in 1935 to: –Prevent retirees and those soon to retire from being destitute as a result of the Great Depression –Transfer wealth between generations –Guarantee minimum level of pension benefits to all persons Social Security

Slide 6-30 The Ticking Social Security Time Bomb The current Social Security payroll tax rate is 12.4 percent. For Social Security and Medicare to be maintained at current levels, the payroll tax rate will have to rise to 25 percent within the first half of the 21st century.

Slide 6-31 Source: Social Security Administration and author’s estimates Figure 6-5 Private Rates of Return on Social Security Contributions

Slide 6-32 Social Security’s rate of return –These were high to begin with because current retirees were paid benefits from growing membership. –Later retirees collected less because membership growth slowed down. –For today’s college students, negative returns are likely. Social Security

Slide 6-33 Social Security’s rate of return –High for low-income people –Low for blacks –Two-income earner families now get a much lower rate of return than one- income earner families Social Security

Slide 6-34 The pre-funding myth –Supporters of the current system argue that the system has built up assets –The obligations of the system: Benefits the system promises to pay Taxes levied on the public over time Social Security

Slide 6-35 Question –Given the promised level of benefits, does it matter whether taxes required to pay the benefits are levied before, during, or after the benefits are paid? Answer –No. The economic value of taxes now or later must be exactly equivalent. Social Security

Slide 6-36 How Social Security became the largest taxpayer drain and the most important domestic policy problem: –In the 1970s the trust fund became very large. –The World War II generation began to retire and Congress expanded benefits. Social Security

Slide 6-37 Raise taxes –Either increase the tax rate or expand the tax base What Will it Take to Salvage Social Security?

Slide 6-38 What Will it Take to Salvage Social Security? Reduce benefit payouts –Increase the eligibility age –Cut benefits to nonworking spouses –Introduce means testing

Slide 6-39 What Will it Take to Salvage Social Security? Reform immigration policies Find a way to increase the rate of return on Social Security

Slide 6-40 Issues and Applications: Paying for School Activities The amount of public subsidies to schools has dwindled in recent years. Schools now seek to provide a lower level of service, because the “price” they receive for each service is lower. Consequently, they have sought to remove the least valued services, unless those who use the services are willing to contribute.

Slide 6-41 Summary Discussion of Learning Objectives The Relationship between Tax Rates and Tax Revenues –Dynamic tax analysis reveals how an increase in the tax rate causes the tax base to decline. How Taxes on Purchases of Goods and Services Affect Market Prices and Quantities –A tax collected from the seller of a good will shift the supply curve up. –To the extent that the price rises, the consumer bears a burden.

Slide 6-42 Summary Discussion of Learning Objectives The Effect of Medicare on the Incentives to Consume Medical Services –Medicare subsidizes the consumption of medical care. –This subsidy encourages the use of medical services that are low in marginal value.

Slide 6-43 Summary Discussion of Learning Objectives Why Bigger Subsidies for Public Schools Do Not Necessarily Translate into Improved Student Performance –The last unit of educational services provided is likely to cost more than the benefit provided.

Slide 6-44 How Social Security Works and Why It Poses Problems for Today’s Students –Social Security benefits are paid from current taxes. –The current schedule of benefits for retirees will be an overwhelming tax burden for future generations. Summary Discussion of Learning Objectives

End of Chapter 6 Taxes, Transfers, and Public Spending