Introduction to Government Finance Chapter 10 Introduction to Government Finance

Federal, State, and Local Revenue Learning Objectives Alternative means of financing government expenditures Analysis of tax impacts on the economy and its criteria for evaluation Alternative taxation methods

Alternative Means of Financing Government Expenditure Alternatives are influenced by the following factors: Political Equilibrium (e.g. voting) Market Equilibrium and Its Efficiency (e.g. subsidies & taxation) The Distribution of Income (e.g. equity)

Alternative Means of Financing Government Expenditure Sources: Taxes: Payroll Income (Corporate and Personal) Property Sales and Excise Estate Tariffs Fees Tuition Licenses $3 trillion annually!!

Alternative Means of Financing Government Expenditure What are taxes? Taxes are compulsory payments to government Tax Base Tax Rate Structure Marginal vs. Average Progressive, Proportional & Regressive

Tax Basics Tax Base The item or activity that is to be taxed General – no exclusions or exceptions Selective – allows exceptions or deductions Excise - selective tax on targeted goods What are some examples?

Tax Basics Tax Rate Structure The relationship between the amount that is to be paid in tax and the tax base for a given accounting period Marginal Tax Rate - The amount by which the tax increases when the tax base increases

Tax Basics Tax Rate Structure The relationship between the amount that is to be paid in tax and the tax base for a given accounting period Average Tax Rate - The total amount of tax divided by the total amount of the tax base

Tax Basics Tax Rate Structure The relationship between the amount that is to be paid in tax and the tax base for a given accounting period Tax bracket - The range of the tax base in which the marginal rate is constant Current Tax Code

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

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

Figure 10.2 A Progressive Tax Rate Structure MTR 35 ATR 25 Tax Rate (Percent) Income Tax (Current Structure) 15 4,000 29,000 70,000 Tax Base (Dollars of Taxable Income per Year)

Figure 10.3 An Example of a Regressive Tax Structure 15.30 Social Security Payroll Tax 12.35 Tax Rate (Percent) AT R 2.9 MTR $76,200 $100,000 Ann ual Labor Earnings per W ork er

Average Tax Rates Throughout the World

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. Equity vs. Efficiency

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 (Efficiency) A government finance system should be relatively easy to administer consistently, without excessive costs to collect, enforce, and comply with taxes and tax laws.

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.

Figure 10.4 Reducing Tax Evasion MC MB = MTR Cost and Benefit Unreported Income per Year (Dollars) E Cost and Benefit Unreported Income per Year (Dollars) D* 1 B MC E MB1 = MTR1 2 MB2 E2 D* C MC1 Cost and Benefit Unreported Income per Year (Dollars) MB = MTR E1 D* 1 2 MC2 E D* Reduce tax evasion by increasing its MC or reduce its MB!

Alternatives to Taxation Debt Finance is the means of financing expenditures by issuing bonds. Intergenerational Inflationary Finance is the means of financing expenditures through the printing of money. Winners vs.Losers

More Alternatives to Taxation 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.

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

User Charges and the Transportation Infrastructure (Group Discussion) Why voters always demand better roads and airports (even though their tax will go up)…. MPB > MPC ?

Figure 10.7 User Charges for a Congestible Government-Supplied Service User Charges (Cents per Mile) Vehicles per Mile per Hour MSC 100 N* What if the toll is $0? Given D1 shifts to D2 20 D2 = MSB2 120 E* E1 D1 = MSB1 80 E2 150

Why Not 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.).