1. Macroeconomics ECON 2301 May 2010 Marilyn Spencer, Ph.D. Professor of Economics Chapter 6

2. Chapter 6: Funding the Public Sector

3. Learning Objectives: After studying this chapter, you should be able to: 1. Distinguish between average tax rates and marginal tax rates 2. Explain the structure of the U.S. income tax system 3. Understand the key factors influencing the relationship between tax rates & the tax revenues governments collect 4. Explain how the taxes governments levy on purchases of goods and services affect market prices and equilibrium quantities 5. Understand how the Social Security system works and explain the nature of the problems it poses for today’s students

4. Paying for the Public Sector 4 Three sources of government funding: 1.Fees, or user charges 2.Taxes 3.Borrowing

5. Paying for the Public Sector (cont'd) 4 Government Budget Constraint ÜThe limit on government spending and transfer payments ÜImposed by the fact that every dollar spent must be provided for by taxes, fees, debt and/or printing money* *States and local governments are limited to taxes, fees and debt.

6. Systems of Taxation (starting with definitions) 4 Tax Base ÜThe value of goods, services, wealth, or incomes subject to taxation 4 Tax Rate ÜThe proportion of a tax base that must be paid to a government as taxes

7. Marginal tax rate = Change in taxes due Change in taxable income Systems of Taxation (cont'd) 4 Marginal Tax Rate ÜThe change in the tax payment divided by the change in income

8. Systems of Taxation (cont'd) 4 Tax Bracket ÜA specified interval of income to which a specific and unique marginal tax rate is applied 4 Average Tax Rate ÜThe total tax payment divided by total income

9. Systems of Taxation (cont'd) 4 Proportional Taxation ÜA tax system in which, regardless of an individual’s income, the tax bill comprises exactly the same proportion Marginal tax rate = Average tax rate Income RateTax liability $10,00020%$2,000 $100,00020%$20,000

10. Systems of Taxation (cont'd) 4 Progressive Taxation (as with our income tax system) ÜA tax system in which, as income increases, a higher percentage of the additional income is paid as taxes Marginal tax rate > Average tax rate Income Rate Tax liability $0–$10,000 5%$500 $10,001–$20,000 10%$1,000 $20,001–$30,000 30%$3,000 $4,500

11. Systems of Taxation (cont'd) 4 Regressive Taxation (as with Social Security) ÜA tax system in which as more dollars are earned, the percentage of tax paid on them falls Marginal tax rate < Average tax rate Income RateTax liability $50,000 10% $5,000 $100,000 5%$5,000

12. Sources of Government Tax Receipts 4 Question ÜWhat types of taxes do federal, state and local governments collect? 4 Answers ÜFederal government: individual income taxes, corporate income taxes, Social Security taxes, import and excise taxes ÜState and local governments: sales taxes, property taxes, personal and corporate income taxes

13. Figure 6-1 Sources of Government Tax Receipts

14. The Most Important Federal Taxes 4 The federal personal income tax ÜAccounts for about 43.6% of all federal revenue ÜAll U.S. citizens, resident aliens, and most others required to pay (includes income earned abroad) ÜRates paid rise as income increases

15. Table 6-1 Federal Marginal Income Tax Rates

16. Most Important Federal Taxes (cont'd) 4 Arguments for the progressive tax ÜRedistribution of income ÜAbility to pay ÜBenefits received 4 Counterargument ÜNo strong evidence of redistribution

17. Most Important Federal Taxes (cont'd) 4 Capital Gain: The positive difference between the purchase price and the sale price of an asset You buy a share of stock for $5 and sell for $15: you have a capital gain of $10 4 Capital Loss: The negative difference between the purchase price and the sale price of an asset You buy a share of stock for $15 and sell for $5: you have a capital loss of $10.

18. The Most Important Federal Taxes (cont'd) 4 The corporate income tax ÜAccounts for 12% of federal tax revenue and 2% of all state and local taxes collected ÜCorporations are generally taxed on the difference between total revenues and expenses. 4 Double taxation ÜCorporation pays taxes on its profits ÜCorporation declares a dividend on after-tax profits ÜDividend income is taxed

19. Table 6-2 Federal Corporate Income Tax Schedule

20. The Most Important Federal Taxes (cont'd) 4 Retained Earnings ÜEarnings that a corporation saves, or retains, for investment in other productive activities ÜEarnings that are not distributed to stockholders 4 Tax Incidence ÜThe distribution of tax burdens among various groups in society

21. The Most Important Federal Taxes (cont'd) 4 Who really pays the corporate income tax? ÜTax incidence is distributed among Consumers Stockholders Employees

22. The Most Important Federal Taxes (cont'd) 4 Social Security taxes ÜSocial Security rates today are imposed on earnings up to roughly $98,000. ÜContributions are 6.2% for employers and 6.2% for employees. ÜBut who REALLY PAYS???

23. The Most Important Federal Taxes (cont'd) 4 Unemployment taxes ÜPaid by employer Ü0.8% of first $7,000 of wages for employees earning more than $1,500 ÜStates may levy an additional tax up to 3% based on record of the employer ÜBut who REALLY PAYS?

24. Tax Rates and Tax Revenues 4 State and local governments ÜTaxes imposed on goods and services yield more revenues than income taxes ÜA fundamental issue is how to set tax rates to extract the largest possible payments

25. Tax Rates and Tax Revenues (cont'd) 4 Sales Taxes ÜTaxes assessed on the prices paid on a large set of goods and services 4 Ad Valorem Taxation ÜAssessing taxes by charging a tax rate equal to a fraction of the market price of each unit purchased

26. Tax Rates and Tax Revenues (cont'd) 4 Static Tax Analysis ÜBased on the assumption that changes in the tax rate leave the tax base unaffected 4 Dynamic Tax Analysis ÜRecognizes that higher tax rates may shrink the tax base ÜDynamic tax analysis predicts ever-higher tax rates bring about declines in the tax base.

27. Primer on Average v. Marginal Tax Rates 4 Looking at average & marginal tax rates is a lot like looking at changes in your GPA from semester to semester: ÜFor your GPA up to now, you know the average over all semesters. For any new semester by itself, that's the marginal GPA. If you get straight A's this term in 14 credit hours, your marginal GPA this term is 4.0. ÜSuppose your average GPA over the past 63 credit hours is 3.18: You earned 200 points, with A=4, B=3, C=2, D=1, and 200 divided by 63 credit hours is approx. 3.18. ÜAfter this semester of straight A's, your GPA is 3.32. You have now accumulated a total of 200 + 56 = 256 points (adding 4.0 x 14 = 56 to the 200 points). You divide 256 by your new total number of SCH, 63 + 14 = 77. And 256/77 = approx. 3.32.

28. Tax Rates and Tax Revenues (cont'd) 4 If the disincentive effects of higher tax rates are small, static analysis may give a fairly accurate estimate of the change in tax revenues resulting from a tax rate change. 4 As tax rates escalate, members of the public have a greater incentive to remove their activities from the tax base; a dynamic analysis would be necessary to determine the overall effect on government revenues.

29. Figure 6-2 States with the Highest and Lowest Sales Tax Rates

30. E-Commerce: Even During a Revenue Boom, States Seek Internet Sales Tax 4 State governments seek to expand their sales tax bases by taxing items shipped from other states ordered online. 4 State governments have been less than successful collecting, even though tax forms have a line item for such reporting. 4 Why wouldn’t states just audit all taxpayers?

31. Tax Rates and Tax Revenues (cont'd) 4 Maximizing tax revenues ÜAt sufficiently high rates the government’s tax revenues begin to fall off. ÜBut studies of the income tax indicate that this occur when tax rates are in much higher ranges than we’ve seen since 1969.

32. Taxation from the Point of View of Producers and Consumers 4 Excise Tax: A tax levied on purchases of a particular good or service 4 Unit Tax: A constant tax assessed on each unit of a good that consumers purchase

33. Taxation from the Point of View of Producers and Consumers (cont'd) 4 Excise taxes on gasoline become added costs of production. 4 This shifts the supply curve up by the amount of the unit tax. 4 Consequently, the equilibrium price of gasoline rises and the equilibrium quantity declines.

34. Figure 6-4 Effects of Excise Taxes on Gasoline Supply & Equilibrium P & Q 4 Who pays the tax? In this example, consumers pay three- fourths of the excise tax and producers absorb the remainder. – This is the tax incidence.

35. Financing Social Security 4 Today’s seniors are beneficiaries of rapidly increasing levels of federal spending. 4 Probably half of all federal spending will go to the elderly by 2025, unless Congress & the President make changes. ÜMedicare ÜSocial Security

36. Financing Social Security (cont'd) 4 Social Security was founded in 1935, as the United States was recovering from the Great Depression. ÜMeans of guaranteeing a minimum level of pension benefits ÜEarly recipients had high rates of return on their Social Security contributions.

37. Financing Social Security (cont'd) 4 Social Security Contributions: Mandatory taxes paid out of workers’ wages and salaries 4 Rate of Return: Proportional annual benefit that results from making an investment 4 Inflation-Adjusted Return: Measured in terms of real goods and services, after effects of inflation taken out

38. Figure 6-5 Private Rates of Return on Social Security Contributions, by Year of Retirement

39. Financing Social Security (cont'd) 4 Social Security faces ÜSlow growth in membership ÜFewer workers per retiree (though this recession is changing the ratio somewhat) ÜNegative rates of return for some ÜBenefits exceeding taxes

40. What Will it Take to Salvage Social Security? 4 There are five options to consider: 1.Raise taxes  Either increase the tax rate or expand the tax base 2.Reduce retirement benefit payouts 3.Reduce disability payments 4.Reform immigration policies 5.Find a way to increase the rate of return

41. What Will it Take to Salvage Social Security? (cont'd) 2. Reduce benefit payouts  Increase the eligibility age  Cut benefits to nonworking spouses  Introduce means testing 3. Reduce disability benefits  Tighten requirements, or separate the disability benefit from the Social Security system 4. Reform immigration policies  Changes in laws could offer hope of dealing with tax burdens and workforce shrinkage

42. What Will it Take to Salvage Social Security? (cont'd) 4 Increase Social Security’s rate of return ÜInflation-adjusted return available on stocks 7–9% since the 1930s – BUT this is generally over a 10-12 year period. Issues with privatization: Uncertainty of returns Political pressure

43. Figure 6-6 Projected Social Security Rates of Return for Future Retirees

44. Issues and Applications: Can Social Security Learn from the Private Sector? 4 Social Security is similar to a pay-as-you-go pension, which is not fully funded when employees retire. 4 Policymakers suggest that reforming the system will require it to function more like a terminally funded pension.

45. Issues/Applications: Can Social Security Learn from Private Sector? (cont'd) 4 Terminally funded pensions receive interest and capital gains from stock and bond investments. 4 Private Social Security accounts, like terminally funded plans, would also allow for investing in securities.

46. Summary Discussion of Learning Objectives 4 Average tax rates versus marginal tax rates ÜAverage tax rate is the ratio of total tax payments to total income ÜMarginal tax rate is the change in tax payments, induced by a change in total taxable income: applies to the last dollar earned

47. Summary Discussion of Learning Objectives (cont'd) 4 The U.S. income tax system taxes personal and business income. ÜA tax system is progressive when marginal tax rate increases as income rises. ÜContrasts with regressive system, in which higher- income earners pay lower marginal tax rates ÜUnder proportional taxation, the marginal and average rate are equal.

48. Summary Discussion of Learning Objectives (cont'd) 4 The relationship between tax rates and tax revenues ÜStatic tax analysis assumes that the tax base does not respond significantly to an increase in the tax rate ÜDynamic tax analysis reveals how an increase in the tax rate causes the tax base to decline

49. Summary Discussion of Learning Objectives (cont'd) 4 How taxes on purchases of goods and services affect market prices and quantities ÜA tax collected from the seller of a good will shift the supply curve up. ÜTo the extent that the price rises, consumers pay a portion of the tax and sellers pay the remainder.

50. Summary Discussion of Learning Objectives (cont'd) 4 How Social Security works and why it poses problems for today’s students ÜSocial Security benefits are paid from current taxes. ÜThe current schedule of benefits for retirees will be an overwhelming tax burden for future generations.

51. Summary Discussion of Learning Objectives (cont'd) 4 What will it take to salvage Social Security? 1.Raise taxes 2.Reduce retirement benefit payouts 3.Reduce disability payments 4.Reform immigration policies 5.Find a way to increase the rate of return

52. Assignment to be completed before class May 20: Pre-read Chapter 7 & also read end-of- chapter Problems 14 th ed: 7-2, 7-7, 7-8, 7-9, 7-13 & 7-14 on pp. 182-183 15 th ed: 7-2, 7-7, 7-8, 7-9, 7-13 & 7-14 on pp. 182-183