1. Public Finance: Expenditures and Taxes
Chapter 18
This chapter addresses the main sources of government revenue and categories of government spending. We discuss and summarize the different philosophies regarding the distribution of a nation’s tax burden. We explain the principles relating to tax shifting, tax incidence, and the efficiency losses caused by taxes. It also discusses how the distribution of income between the rich and poor is affected by government taxes, transfers, and spending.
Public Finance: Expenditures and Taxes
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2. Government and the Circular Flow
(1) Costs
RESOURCE
MARKET
(2) Resources
(2) Land, labor, capital
Entrepreneurial Ability
(7)
Expenditures
(8)
Resources
(10)
Goods and services
(9)
Goods and services
BUSINESSES
GOVERNMENT
HOUSEHOLDS
Net taxes
(11)
Net taxes
(12)
We integrate government as a decision maker into the circular flow model. Note that government employs resources from the resource market and buys goods and services from the products market. Government then provides goods and services to households and businesses. This is all financed through the net taxes (taxes minus transfer payments) that they receive from households and businesses.
(5) Expenditures
(6) Goods and services
(4)
Goods and services
(4)
Goods and services
PRODUCT
MARKET
(3) Consumption expenditures
(3) Revenues
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3. Government Finance Government purchases Exhaustive Transfer payments
Nonexhaustive
Borrowing and deficit spending
Opportunity cost is low during recession; high during growth
Government purchases are exhaustive and directly absorb resources. The goods and services purchased by the government are a part of GDP. Transfer payments do not contribute to GDP because recipients don’t make any contributions to current GDP. Social security, welfare payments, veterans’ benefits, and unemployment compensation are examples of transfer payments. Government spending and the tax revenues needed to finance it are equivalent to 35% of GDP. The funds used to pay for government purchases and transfers come from taxes, proprietary income, and borrowed funds secured by selling government securities. Government can maintain a high level of spending during a recession by borrowing and creating deficits. The opportunity cost of borrowing during a recession is low because otherwise the funds would have sat idle, but during growth, deficit spending can crowd out private investment.
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4. Government Finance
Government purchases, transfers, and total spending as percentages of U.S. output, 1960 and 2012 40 35 30 25 20 15 10 5
Government
transfer payments
15.3% 5%
Percentage of U.S. output
22%
19.6%
In 2009 government purchases declined to 20 percent from 22 percent in 1960, while government transfer payments rose from 5 percent in 1960 to 15.3% in Total government spending (purchases plus transfers) rose from 27 percent of U.S. GDP in 1960 to about 35 percent in 2012.
Government
Purchases
1960
2012
Year
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5. Global Perspective
This table shows the tax revenue or a nation’s “tax burden,” as a percent of GDP for selected industrialized nations.
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6. Federal Expenditures LO3
These pie charts show the sources of revenues and expenditures for the Federal government, 2012.
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7. Federal Tax Revenues Personal income tax Progressive tax
Marginal tax rate
Payroll taxes
Corporate income tax
Excise taxes
Personal income taxes are the backbone of the U.S. Federal tax system. A tax is levied on taxable incomes of households and unincorporated businesses after certain deductions. A progressive tax means that higher tax rates are applied to higher brackets of income. Marginal tax rate is the tax rate paid on additional income. Payroll taxes are taxes on wages and income that finance Social Security and Medicare for retirees. The corporate income tax is a tax on a corporation’s profit and for most firms it is 35%. Excise taxes include sales taxes where sales taxes are placed on a large range of goods and services and excise taxes are imposed on specific goods.
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8. Average Tax Rate on Highest Income in Bracket % (3) / (1)
Federal Tax Revenues
Federal Personal Tax Rates, 2013*
(1)
Total Taxable
Income
(2)
Marginal Tax
Rate, %
(3)
Total Tax
on Highest
Income in
Bracket
(4)
Average Tax Rate on Highest Income in Bracket % (3) / (1)
$1-$17,850 10 $
$17,851-$72,500 15
9983 14
$72,501-$146,400 25
28,458 19
$146,401-$223,050 28
49,920 22
$223,051-$398,350 33
107,769 27
$398,351-$450,000 35
125,847
$450,001 and above
39.6
This table shows the tax rates for a married couple filing a joint return, 2013.
* For a married couple filing a joint return
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9. State Finances
The pie charts show the sources of revenues and expenditures for the state governments, State and local governments have different mixes of revenues and expenditures than Federal government, as shown on this slide.
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10. Local Finances
Tax revenues cover less than half of local government expenditures. Grants from federal and state governments make up the rest of the funding. These pie charts show the sources of revenues and expenditures for the local governments, 2010.
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11. Local, State, and Federal Employment
Local, state, and Federal government employment represents 16% of the U.S. labor force. The pie charts show the percentages of government employees assigned to different tasks at the Federal, state, and local levels. In 2011, U.S. governments (local, state, and Federal) employed about 21.9 million workers, about 16% of the U.S. labor force.
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12. Apportioning the Tax Burden
Size, distribution, and impact of the costs that taxes impose on society
Benefits-received principle
Ability-to-pay principle
Taxes are the major source of funding for goods and services provided by government and the wages and salaries paid to government workers. Without taxes, there would be no public and quasi-public goods provided. Who should pay and how much taxes one should pay continue to stir controversy. Some leading philosophical approaches to splitting the tax burden are based on the benefits-received principle and ability-to-pay principle. Based on the benefits-received principle, those who benefit from the taxes should pay for them. This includes taxes on gas to fund highway construction and repair since these are the individuals using the highways. However, this principle becomes much more difficult to apply to things like public education and defense. Imposing taxes based on the ability-to-pay principle means that the taxes are based upon a person’s income and wealth where individuals with greater income/wealth pay more taxes.
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13. Apportioning the Tax Burden
Progressive tax – average tax rates increase as income increases
Regressive tax – average tax rate declines as income increases
Proportional tax – average rate stays the same as income increases
Taxes are classified into one of the above categories based upon the relationship between average tax rates and the taxpayer incomes.
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14. Apportioning the Tax Burden
Applications
Personal income tax: progressive
Sales tax: regressive
Corporate tax: proportional
Payroll tax: regressive
Here we show a general application using the tax classification. Personal income taxes are progressive with marginal tax rates rising as incomes increase. A sales tax is regressive relative to income because a larger portion of a low incomes household’s income is paid to sales taxes. Corporate taxes are proportional because they are a flat percentage on income. Payroll taxes are regressive because Social Security tax has a limit where once an individual has reached the income limit, he will no longer have to pay Social Security taxes for the year.
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15. Tax Incidence and Efficiency Loss
Who really pays the tax?
Excise tax
Tax burden depends on elasticity
Inelastic vs. elastic
Efficiency loss/deadweight loss
Transfer of surplus to government
Determining the classification of a particular tax is complicated because those on whom taxes are levied do not always pay the tax. We therefore need an understanding of tax incidence: the degree to which a tax burden falls on a person or group.
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16. Elasticity and Tax Incidence
Price (Per Bottle)
Quantity
(Millions of Bottles Per Month)
Tax $2
Suppose the government levies an excise tax of $2 per bottle at the winery. Who will pay the tax? An excise tax of $2 shifts the supply curve left (up). As a result, the equilibrium price rises from $8 to $9. The price to consumers rises from $8 to $9. The consumer pays $1 of the $2 excise tax. The producer receives an after-tax price of $7, which is $1 less than the $8 before-tax price. So, in this case, consumers and producers share the burden of the tax equally. D
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17. Elasticity and Tax IncidenceP P St
Tax St
Tax S a S P1 b a P Pe Pb c P1 b De Pa
This figure contrasts the cases where demand is either relatively elastic or relatively inelastic in the relevant price range, and we can clearly see the difference in the tax burden. c Di Q2 Q1 Q2 Q1
Elastic Demand
Inelastic demand
Smaller efficiency loss with inelastic demand
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18. Elasticity and Tax IncidenceP P St S
Tax
Tax St a Pe S a b Pi P1 P1 b Pa c Pb c
In this figure, we contrast what would happen with a specific demand. The more inelastic the supply, the larger the portion of the tax borne by producers. When supply is elastic, the consumer will pay a larger portion of the tax. D D Q2 Q1 Q Q2 Q1 Q
Elastic Supply
Inelastic Supply
Smaller efficiency loss with inelastic supply
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19. Efficiency Loss of a Tax5 10 15 20 25 Q P 14 12 8 6 4 2
Tax paid
by consumers St S
Price (Per Bottle)
Quantity
(Millions of Bottles Per Month)
Tax $2
We have observed that producers and consumers typically each bear part of an excise tax levied on products. This figure takes a closer look at the overall economic effect of the excise tax, showing the portion paid by consumers and the portion paid by producers. We can also see the amount of deadweight loss that is created from the tax.
Efficiency
loss (or
deadweight loss)
Tax paid
by producers D
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20. Global Perspective
A number of advanced industrial nations rely much more heavily on consumption taxes, sales taxes, specific excise taxes, and value-added taxes, than the United States. A value-added tax, which the United States does not have, applies only to the difference between the value of a firm’s sales and the value of its purchases from other firms. As a percentage of GDP, the highest tax rates on consumption are in countries that have value-added taxes.
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21. Probable Incidence of U.S. Taxes
Type of tax
Probable Incidence
Personal income tax
The household or individual on which it is levied
Payroll taxes
Workers pay the full tax levied on their earnings and part
of the tax levied on their employers
Corporate income tax
Short Run: Full tax falls on owners of the businesses
Long Run: Some of the tax may be borne by workers through
lower wages
Sales tax
Consumers who buy the taxed products
Specific excise taxes
Consumers, producers or both, depending on elasticities of supply and demand
Property Taxes
Owners in the case of land and owner-occupied residences,
tenants in the case of rented property, consumers in the
case of business property
This table looks at the probable outcome of taxes on each of the major sources of tax revenue in the United States.
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22. The U.S. Tax Structure The Federal tax system is progressive.
The state and local tax structures are largely regressive
The overall U.S. tax system is progressive
Overall, higher-income groups pay larger percentages of their income as Federal taxes than do lower-income groups.
As a percentage of income, property taxes and sales taxes fall as income rises; and state income taxes are generally less progressive than the Federal income tax.
Higher-income people carry a substantially larger tax burden, as a percentage of their income, than do lower-income people.
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23. Redistribution vs. Recycling
Distribution of income
Taxes taken from the rich
Do they to flow to the poor?
Shows income is transferred to the poor
Bottom 40% received more government spending than they paid in taxes
Top 40% paid more in taxes than they received in government spending
The Last Word article was written by two economists from the nonpartisan Tax Foundation. The question they attempt to answer is “Does the government transfer significant amounts of income from the rich to the poor through taxation and spending?” There are concerns that the large taxes government collects merely get recycled back to the rich, but data from 2004 shows that the poor do receive more government spending than they pay in taxes.

24. Redistribution vs. Recycling
Source: Tax Foundation Working Paper No. 1, 2007