Longwood University Personal Finance Scott Wentland Longwood University 201 High Street Farmville, VA 23901

Longwood University Government and the Economy Part 1: Basic Functions

Longwood University Government and the Economy What role does the government play in the economy? – Government and the rule of law – Federal Budget Government revenue (taxes) Government budget and deficits

Longwood University Basic Role of Government Ensure Property rights: the right to benefit from one’s effort. How? A well developed legal system and rule of law –Provides incentives to work hard. –Encourage investment in physical and human capital. –Are important for encouraging technological innovation. –Without property rights: Effort is divorced from payment → ↓incentive to work Free riders become a problem

Longwood University Basic Role of Government A good legal system facilitates contracts and protects property from others including government. Poorly protected property rights can result from too much government or too little government. –The legal system in some governments is so poor that no one knows who owns what. Example: In India, residents who purchase land have to do so more than once because of lack of proper record keeping.

Longwood University Basic Role of Government Other fundamental roles – Provide a good defense – Provide basic public goods (roads and infrastructure) – Besides the legal system, set the “rules of the game” via some regulation Up to this point, there is little debate on whether government should provide these – Beyond this, there is more (healthy) debate at each step toward additional roles of the government in the economy

Longwood University Government and the Economy Part 2: Federal Budget

Longwood University Government Budget and Revenue Overview The federal government spends over 18% of GDP. During the most recent recession, it was as high as 24% of GDP, about ¼ of the economy. – All govt. spending is closer to 1/3 of GDP Taxes collected are around 17% of GDP.

Longwood University Sources of Government Revenue (2007)

Longwood University Taxes The U.S. tax code is progressive: tax rates are higher on people with higher incomes. – Effective tax rate ranges from 4.1% % 85.6% of all federal taxes are paid by the top 40% of earners. State and Local Taxes – Overall: half the level of federal taxes – States raise more of their revenues from sales taxes. – Less progressive than the federal income tax.

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Budget Two thirds of the U.S federal budget is spent on… – Social Security – Defense – Medicare – Medicaid The following figure gives a better picture of where our tax money is spent.

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Social Security – At $586 billion in 2007—the single largest government program in the world. – Runs on a “pay as you go” basis. Current contributions pay for benefits of current retirees. No one has a Social Security account in their name. – Benefits are modest so don’t count on living solely on Social Security when you retire. – Sometimes called a transfer because it redistributes income from workers to retirees

Longwood University Defense – 2007: Spending on defense was $549 billion. Excludes most spending on the wars in Iraq and Afghanistan. – The U.S. spends more on its military than any other country. The next table shows the top ten countries listed by military expenditure.

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Healthcare Spending Medicare and Medicaid – Medicare: reimburses the elderly for medical spending. With Social Security, amounts to 36.5% of federal spending. Covers individuals over 65 who have paid into the system for at least 10 years. Does not pay all medical bills. – Medicaid: Covers the poor and the disabled. Paid for jointly by federal and state governments. Expenditures are half that of Medicare.

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Deficits Deficits: the annual difference between federal spending and revenues. – The deficit is… The difference between revenues and spending. The annual change in the national debt. – The following figure allows us to see the level of deficit-to-GDP ratio and how it has changed over time. National Debt held by the public—All federal debt held outside the United States government. Approximately $12 trillion in 2013 – Nearly $45,000 per person – Nearly $91,500 for every person working

Longwood University Deficits The Congressional Budget Office (CBO): “under any plausible scenario, the federal budget is on an unsustainable path…” – Main forces driving the projections: Demographics – The population is aging resulting in... » Higher Social Security and Medicare payments. – Rising health costs per person » Rising more than twice as fast as GDP per capita.

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What will happen? So what will happen; will spending be cut or will taxes be raised?—no one knows.  Spending could increase substantially and U.S. spending would be on par with Germany, Italy, and the Netherlands today.  Cutting total spending substantially will require cuts in Social Security benefits and Medicare. This will be politically difficult.  Other countries spend a smaller fraction of GDP on health care but… the growth in health care costs is similar throughout the world. Other countries are facing major crises It is up to this generation to fix this problem

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