The Government Sector Chapter 07 Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

7-2 Learning Objectives  After this chapter you should be able to: 1. Define and discuss federal, state, and local government spending. 2. Analyze the graph of the C + I + G line. 3. Define and compute the average and marginal tax rates. 4. Identify and discuss the types of taxes. 5. List and discuss the sources of federal government revenue. 6. Summarize recent federal tax legislation. 7. List and discuss the sources of state and local government revenue. 8. Explain and discuss the economic role of government.

7-3 Introduction: The Growing Economic Role of Government  Most of the growth over the past 7 decades was due to the Depression and WWII (1929 – 1945).  After 1945, the roles of government at the federal, state, and local levels continued to expand. Americans were determined to avoid another Depression or another military attack.  When Ronald Reagan was elected in 1980, there was a political swing in favor of shrinking the size of government. Reagan promised to “get the government off the backs of the American people.”  In 2008 – 2009, as the economy sank into recession, voters demanded the government do something. $700 billion financial bailout and $787 billion stimulus

7-4 How Government Influences the Economy  The government exerts 4 basic influences over the economy: 1. It spends trillions of dollars.  Public goods and services 2. It levies trillions of dollars in taxes. 3. It redistributes hundreds of billions of dollars.  To the poor, retirees, and the holders of government bonds 4. It regulates the economy.  Laws regulate how business may be conducted.

7-5 Federal Government Spending  The federal government’s financial, or fiscal, year begins on October 1 and runs through September 30 of the following year. Preparation of the budget begins about two years before the beginning of the fiscal year.  President and the Office of Management and Budget (OMB) work with departments and agencies on budget plans.  The President submits the final budget message in February of prior fiscal year.  By May 15, both houses of Congress have to pass a concurrent budget resolution.  Appropriations bills are passed between May and October.  The 13 spending bills that are the heart of the budget are often passed late. In fiscal year 2011 the federal government plans to spend about $3.9 trillion.

7-6 Government Revenues and Spending, Fiscal Year 2009 Source: Economic Report of the President, 2010;

7-7 Spending: Past, Present, and Future Figures are from President Barack Obama’s 2011 budget. They are projected estimates of actual spending. Source: Congressional Budget Office. As a share of federal spending, Social Security, Medicare, and Medicaid have more than doubled in 40 years and will continue to grow, according to the Congressional Budget Office’s “intermediate” projections.

7-8 Does the US spend too much on foreign aid? This is less than 1% of the federal budget. Source: OECD.

7-9 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.

7-10 Government Purchases versus Transfer Payments  The federal, state, and local governments spends over $5.0 trillion a year. Approximately half are “government purchases.”  The largest government purchase is defense.  These end up in the “G” part of GDP.  GDP = C + I + G + Xn Approximately half are “transfer payments.”  The largest transfer payment is social security.  These payments end up in the “C” part GDP.

7-11 Graphing the C + I + G Line  Assume government spending is constant across all levels of disposable income at $2,000 billion (or $2 trillion).  We see how it shifts the function up to the new C + I + G line.  This new line crosses the 45- degree line at a new equilibrium of $10 trillion.  We will add X n in chapter 8.

7-12 Questions for Thought and Discussion  How did the Great Depression encourage the growth of government?  Which categories of government spending would you like to see decreased? Which would you like to see increased?  Why do transfer payments show up in Consumption rather than Government Purchases?

7-13 The Average Tax Rate and the Marginal Tax Rate  The Average Tax Rate (ATR) is the overall rate you pay on your entire income.  The Marginal Tax Rate (MTR) is the rate you pay on the last dollars you earned. Once again, “marginal” refers to the response to a change.

7-14 The Average Tax Rate and the Marginal Tax Rate: A Hypothetical Illustration Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 0 – $100 0 % $ 0 $ % $101 – $ % $10 $105.0 % $201 – $ % $12 $ % $301 – $ % $15 $ % $401 – $ % $28 $ % $501 – $ % $50 $ %

7-15 Types of Taxes  Direct tax A tax with your name on it Examples: personal income tax, social security payroll tax Another example: corporate income tax on profits  Indirect tax A tax on goods and services that we purchase. Examples: sales taxes, excise taxes

7-16 Types of Taxes  Progressive taxes As your income increases, the percentage that you pay increases. Places a greater burden on those best able to pay and little or no burden on the poor. Example: federal income tax  Proportional taxes Flat tax (same percent with no deductions) It would be much harder for a family with an income of $10,000 to pay $1,500 in income tax (15 percent of $10,000) than it would be for a family with an income of $100,000 to pay $15,000 (15 percent of $100,000).  Regressive taxes Places a heavier burden on the poor than on the rich Example: social security tax

7-17 Nominally Progressive, Proportional, & Regressive Taxes

7-18 Sources of Federal Revenue  Personal Income Tax The largest source (44%) of federal revenue. Considered progressive because the burden falls mainly on the upper middle class and the rich.  Payroll Tax Social Security and Medicare taxes  Corporate Income Tax Accounts for only 12% of federal tax revenue.  Excise Taxes Sales tax aimed at specific goods and services. May be intended to reduce consumption. Examples: tires, cigarettes, liquor, gasoline, phone calls  Estate Tax Tax on estates left to people other than spouse. Phased out by end of 2009 but set to come back in 2011.

7-19 Federal Personal Income Tax: The Top Marginal Tax Rate, 1993–2010

7-20 Top Marginal Combined Income Tax Rates in 11 Leading Wealthy Nations, 2008* *Combined federal, state, and local income taxes. Source: OECD.

7-21 Payroll Taxes  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 $106,800.  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.

7-22 Payroll Taxes (Continued)  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.

7-23 The Incidence of the Social Security Tax at Various Income Levels in 2010 Note: The current social security tax by law is set at 6.2% with a wage based limitation of $106,800.

7-24 The Estate Tax  The estate tax is a tax on the estates of people when they die.  This tax expired on December 31,  The estates of those who died in 2010 paid no federal taxes.  But on January 1, 2011, under the snap-back tax plan, estates will once again be taxed at a rate of 55 percent of everything over $1 million.  By the time you read this, it is likely that Congress will have modified the tax to enable inheritors of farms and other businesses to carry on without having to pay such a high tax.

7-25 Recent Tax Legislation  Kemp-Roth Tax Cut of 1981  Tax Reform Act of 1986  Tax Cut of 2001  Tax Cut of 2003

7-26 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% of all local tax revenue. Can influence business decisions about where to locate.

7-27 The State and Local Fiscal Dilemma  Since WWII, state and local governments have been expected to provide an increasing number of services. Most notable are health, welfare, education, police protection and prisons.  Unfunded mandates The Federal government often places obligations on states without providing the money to pay for them. Examples: NCLB, Homeland Security  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.  In response, states have increased tuition at public colleges, cut Medicaid eligibility and benefits, and laid off state employees.

7-28 Government Tax Rates as a Percentage of GDP, 1929 and 2009 Since 1929 Federal taxes have risen much more quickly than state and local taxes as a percentage of GDP. Source: Economic Report of the President, 2010; Survey of Current Business, March 2010,

7-29 Tax Receipts as a Percentage of GDP in the U.S. and Selected Countries, 2008 Source: Organization for Economic Cooperation and Development. American taxpayers have a relatively low burden in comparison to taxpayers in other rich nations.

7-30 Questions for Thought and Discussion  Is the American income tax regressive or progressive? Are payroll taxes regressive or progressive? Are sales and excise taxes regressive or progressive?  Which tend to be more progressive, federal taxes or state and local taxes?  What are the arguments for and against raising gasoline taxes?

7-31 Economic Role of Government 1. Provision of Public Goods and Services 2. Redistribution of Income 3. Stabilization 4. Economic Regulation

7-32 Provision of Public Goods and Services  Some examples include: 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  Private enterprise would not supply these because they are not profitable. Public goods and services raise our standard of living.

7-33 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.

7-34 Stabilization  Two basic goals of the federal government: 1. Stable prices with little or no inflation 2. Low unemployment  An economic rate of growth high enough to keep the unemployment rate to a minimum.  From the day it took office, the Obama administration needed to deal with the effects of the worst economic downturn since the 1930s. Between fiscal year 2009 and fiscal year 2011 federal spending leapt from $3.2 trillion to $3.9 trillion. Taxes were cut, while U.S. Treasury and the Federal Reserve provided over $2 trillion in loans and loan guarantees to the nation’s major financial institutions and other large corporations. Policies helped end the Great Recession but fueled reaction against increased economic role of government.

7-35 Economic Regulation  The government provides the economic rules of the game. Examples: fostering competition, environmental protection, child labor laws, minimum hourly wage, consumer protection laws and a court system.  It also provides the social and political context in which the economy operates. The government allow individuals and business firms to operate with the maximum degree of freedom within this framework. 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.

7-36 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.

7-37 Will Social Security Be There for You?  For decades, the federal government has received more in Social Security Taxes than it was paying out. This surplus is deposited in the Social Security trust (trust me) fund, consisting of U.S. government securities. However, the surplus is spent by the government each year to offset its deficits. The U.S. Treasury places I.O.U.s, (government securities) in the Social Security trust fund.  In 2010, benefits are expected to exceed tax revenues because of recession. Because of unemployment, tax receipts lagged and seniors retired early. Difference is paid out of trust fund by selling government securities.

7-38 Will Social Security Be There for You? (continued)  Is a Crisis Looming? The baby boomers (born between 1946 and 1964) will start retiring in this decade. This means that benefits will continue to exceed revenues. The securities in the trust fund will continue to have to be sold to fill in the gap, but will compete in the market with new government securities issued to pay for deficits.  Interest rates could skyrocket causing a financial crisis. Current estimates are that the trust fund will run out around Does this mean there will be no funds for Social Security benefits? No!  Each year, Social Security will collect revenue to pay most of the benefits.  The problem is financing the gap once the trust fund runs out, which can be accomplished by raising payroll taxes and/or cutting benefits.

7-39 Social Security is the Good News; the Bad News is Medicare  Medicare is even more seriously under funded than Social Security. By 2028 Medicare spending will surpass Social Security spending. Remember all those retiring baby boomers? Health care costs have been rising much faster than inflation.  Medicare financing is much more complex than Social Security and harder to fix. One goal of health care reform was to reduce costs so Medicare costs will rise more slowly. Will it work?

7-40 Questions for Thought and Discussion  How does the present role of government deviate from the role envisioned by Adam Smith? Would it be possible or desirable to return to a government with a more limited role?  How can government continue to provide social security and Medicare? Should the wage limitation on social security taxes be eliminated?