Chapter 7 The Government Sector 7-1 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Objectives Government spending The graphing of the C + I + G line Types of taxes The average and marginal tax rates Sources of government revenue Principles of taxation The economic role of government 7-2 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Introduction: The Growing Economic Role of Government Most of the growth over the past seven decades was due to the Depression and World War II 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 four 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 7-3 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

7-4 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

7-5 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

7-6 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 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Government Purchases versus Transfer Payments The federal, state, and local governments spends over $3.0 trillion a year –GDP = C + I + G + X n –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 7-7 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Graphing the C + I + G Line 7-8 Copyright  2008 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 income

Graphing the C + I + G Line 7-9 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. How much is G? Answer: 2000

The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-10 This is a hypothetical illustration Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-11 This is a hypothetical illustration 0 - $100 0 % 0 $ % Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-12 This is a hypothetical illustration 0 - $100 0 % $ 0 $ % $101 - $200 $10 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-13 This is a hypothetical illustration 0 - $100 0 % $ 0 $ % $101 - $200 $10 Additional Taxes Paid ( $10) MTR = Additional Taxable Income ($100) Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-14 This is a hypothetical illustration 0 - $100 0 % $ 0 $ % $101 - $ % $10 Additional Taxes Paid ( $10) MTR = Additional Taxable Income ($100) Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-15 This is a hypothetical illustration 0 - $100 0 % $ 0 $ % $101 - $ % $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  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-16 This is a hypothetical illustration 0 - $100 0 % $ 0 $ % $101 - $ % $10 $10 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-17 This is a hypothetical illustration 0 - $100 0 % $ 0 $ % $101 - $ % $10 $10 Total Taxes Paid ( $10) ATR = Entire Income ($200) Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-18 This is a hypothetical illustration 0 - $100 0 % $ 0 $ % $101 - $ % $10 $ % Total Taxes Paid ( $10) ATR = Entire Income ($200) Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-19 This is a hypothetical illustration 0 - $100 0 % $ 0 $ % $101 - $ % $10 $ % Total Taxes Paid ( $10) ATR = Entire Income ($200) Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-20 This is a hypothetical illustration 0 - $100 0 % $ 0 $ % $101 - $ % $10 $ % Total Taxes Paid ( $10) ATR = Entire Income ($200) The Average Tax Rate (ATR) is the overall rate you pay on your entire income Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-21 This is a hypothetical illustration 0 - $100 0 % $ 0 $ % $101 - $ % $10 $ % $201 - $ % $12 $ % Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-22 This is a hypothetical illustration 0 - $100 0 % $ 0 $ % $101 - $ % $10 $ % $201 - $ % $12 $ % $301 - $ % $15 $ % Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-23 This is a hypothetical illustration 0 - $100 0 % $ 0 $ % $101 - $ % $10 $ % $201 - $ % $12 $ % $301 - $ % $15 $ % $401 - $ % $28 $ % Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-24 This is a hypothetical illustration 0 - $100 0 % $ 0 $ % $101 - $ % $10 $ % $201 - $ % $12 $ % $301 - $ % $15 $ % $401 - $ % $28 $ % $501 - $ % $50 $ % Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-25 This is a hypothetical illustration 0 - $100 0 % $ 0 $ % $101 - $ % $10 $ % $201 - $ % $12 $ % $301 - $ % $15 $ % $401 - $ % $28 $ % $501 - $ % $50 $ % > $ % Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Types of Taxes Direct tax –A tax with your name on it Indirect tax –A tax on things 7-26 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Types of Taxes Progressive 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 7-27 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Nominally Progressive, Proportional, and Regressive Taxes Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 7-28

7-29 Sources of Federal Revenue Personal Income Tax –The personal income tax is the largest source of federal revenue –Accounts for 44 percent 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 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

7-30 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. Federal Personal Income Tax:The Top Marginal Tax Rate,

7-31 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. Top Marginal Tax Rates

7-32 Sources of Federal Revenue The Personal Income tax Individual personal income taxes account for 44 percent 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 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

7-33 Sources of Federal Revenue 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 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

7-34 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, 3/4 th 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 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

7-35 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. Level of Earned Income Taxes Paid Average Tax Rate $ 10,000 $ % 94,200 5, % 100,000 5, % 1,000,000 5, % The Incidence of the Social Security Tax at Various Income Levels 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 7-36 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Excise Taxes An excise tax is a sales tax aimed at specific goods and services Accounts for about 4 percent of federal revenue Most excise taxes are levied by the federal government –State and local governments often levy taxes on the same items 7-37 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Excise Taxes Excise taxes tend to reduce consumption of certain products of which the federal government takes a dim view Excise taxes are usually regressive 7-38 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

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 7-39 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

7-40 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. Top Marginal Income Tax Rates in 9 Leading Wealthy Nations, 2003

7-41 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 percent of all local tax revenue –Can influence business decisions about where to locate Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The State and Local Fiscal Dilemma Since World War II, 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 7-42 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

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 7-43 The State and Local Fiscal Dilemma Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

7-44 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 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

7-45 Copyright  2008 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, 2004 Organization for Economic Cooperation and Development

Economic Role of Government 7-46 Provision of Public Goods and Services Redistribution of Income Stabilization Economic Regulation Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Provision of Public Goods and Services Some examples –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 7-47 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

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 7-48 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

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 7-49 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

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 7-50 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

7-51 Adam Smith’s Dos and Don’ts Do –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 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

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 seven decades It will probably continue to grow into an even more monolithic all-powerful colossal Big- Brother in the coming years 7-52 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

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 – How ever, the surplus is spent by the government each year to off set its deficits –The US 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) 7-53 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Will Social Security be There for You? 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! 7-54 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Will Social Security be There for You? The Looming Crises –The government will borrowing hundreds of billions of dollars by selling the government securities in the trust fund (I.O.U.s) to pay social security recipients Selling government securities is simply borrowing money from the people who buy them These I.O.U.s will be gone by 2042 –Financing the social security system by borrowing money will be on top of financing an already huge and growing federal budget deficit –This will push up interest rates and possibly precipitate a financial collapse of unprecedented proportions unless strong measures are taken now to raise social security taxes and lower benefits 7-55 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

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 7-56 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Big government, like rock ‘n’ roll, is here to stay. But can the politician’s song and dance match Medicare & Social Security’s tunes? 7-51 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.