1. Chapter 7 The Government Sector 7-1 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Chapter Objectives Government spending The graphing of the C + I + G line Types of taxes The average and marginal tax rates Sources of government revenue Principles of taxation The economic role of government 7-2 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

3. Introduction: The Growing Economic Role of Government Most of the growth over the past seven decades was due to the Depression and World War II Since 1945 the roles of government at the federal, state, and local levels have expanded –The seeds of that expansion were sown during the Roosevelt administration The government exerts four basic influences –It spends more than $2.5 trillion –It levies almost that amount in taxes –It redistributes hundreds of billions of dollars –It regulates our economy 7-3 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

4. 7-4 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

5. 7-5 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2002 Proposed Spending by Category Budget of the United States Government, Fiscal Year 1999

6. 7-6 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 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

7. Government Purchases versus Transfer Payments The government spends $2.7 trillion a year –GDP = C + I + G + X n –Approximately half is “transfer payments” The largest transfer payment is social security These payments end up in the “C” part GDP –Approximately half is “government purchases” The largest government purchase is defense These end up in the “G” part of GDP 7-7 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

8. Federal and State and Local Purchases Relative to GDP, 1960-2000 7-8 Total government purchases have been declining since the late 1960s and now constitute 16 percent of GDP

9. 7-9 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Federal and State and Local Transfer Payments as a Percentage of GDP, 1960-2000 Federal transfer payments have risen sharply since the mid-1960s, while state and local transfer payments have also grown substantially since the early 1970s. Total government transfer payments have risen from just 6 percent of GDP in 1960 to more than 15 percent today

10. Graphing the C + I + G + Xn Line 7-10 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. To keep the graph as simple as possible, we are assuming the government spends a constant amount of money regardless of the level of disposable income

11. Graphing the C + I + G + Xn Line 7-11 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. How much is G? Answer: 400

12. The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-12 This is a hypothetical illustration Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

13. The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-13 This is a hypothetical illustration 0 - $100 0 % 0 $ 0 0.0 % Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

14. The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-14 This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 % $101 - $200 $10 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

15. The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-15 This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 % $101 - $200 $10 Additional Taxes Paid ( $10) MTR = -------------------------------- ---------- Additional Taxable Income ($100) Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

16. The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-16 This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 % $101 - $200 10 % $10 Additional Taxes Paid ( $10) MTR = -------------------------------- ---------- Additional Taxable Income ($100) Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

17. The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-17 This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 % $101 - $200 10 % $10 Additional Taxes Paid ( $10) MTR = -------------------------------- ---------- Additional Taxable Income ($100) The Marginal Tax Rate (MTR) is the rate you pay on the last dollars you earned Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

18. The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-18 This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 % $101 - $200 10 % $10 $10 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19. The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-19 This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 % $101 - $200 10 % $10 $10 Total Taxes Paid ( $10) ATR = -------------------------------- ---------- Entire Income ($200) Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

20. The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-20 This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 % $101 - $200 10 % $10 $10 5.0 % Total Taxes Paid ( $10) ATR = -------------------------------- ---------- Entire Income ($200) Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

21. The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-21 This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 % $101 - $200 10 % $10 $10 5.0 % Total Taxes Paid ( $10) ATR = -------------------------------- ---------- Entire Income ($200) Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

22. The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-22 This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 % $101 - $200 10 % $10 $10 5.0 % Total Taxes Paid ( $10) ATR = -------------------------------- ---------- Entire Income ($200) The Average Tax Rate (ATR) is the overall rate you pay on your entire income Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

23. The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-23 This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 % $101 - $200 10 % $10 $10 5.0 % $201 - $300 12 % $12 $22 7.3 % Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

24. The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-24 This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 % $101 - $200 10 % $10 $10 5.0 % $201 - $300 12 % $12 $22 7.3 % $301 - $400 15 % $15 $37 9.3 % Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

25. The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-25 This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 % $101 - $200 10 % $10 $10 5.0 % $201 - $300 12 % $12 $22 7.3 % $301 - $400 15 % $15 $37 9.3 % $401 - $500 28 % $28 $65 13.0 % Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

26. The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-26 This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 % $101 - $200 10 % $10 $10 5.0 % $201 - $300 12 % $12 $22 7.3 % $301 - $400 15 % $15 $37 9.3 % $401 - $500 28 % $28 $65 13.0 % $501 - $600 50 % $50 $115 19.2 % Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

27. The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-27 This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 % $101 - $200 10 % $10 $10 5.0 % $201 - $300 12 % $12 $22 7.3 % $301 - $400 15 % $15 $37 9.3 % $401 - $500 28 % $28 $65 13.0 % $501 - $600 50 % $50 $115 19.2 % > $600 80 % Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

28. Types of Taxes Direct taxes –A tax with your name on it Indirect taxes –Taxes on things 7-28 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

29. Types of Taxes (Continued) Progressive taxes –Places a greater burden on those best able to pay and little or no burden on the poor Proportional taxes –Places an equal burden on the rich, the middle class, and the poor Regressive taxes –Places a heavier burden on the poor than on the rich 7-29 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

30. 7-30 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

31. 7-31 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

32. 7-32 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

33. 7-33 Sources of Federal Revenue Personal Income Tax –The personal income tax is the largest source of federal revenue –Most of the poor pay little or no federal income tax Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

34. 7-34 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Federal Personal Income Tax:The Top Marginal Tax Rate, 1954-2001

35. 7-35 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Top Marginal Tax Rates in 15 Leading Wealthy Nations, 2000

36. 7-36 Sources of Federal Revenue 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 $80,400 The inflation rate of the previous year raises the wage base The Medicare tax of 1.45% applies to wages and salaries only. Income such as rental income, interest, dividends, and profit is exempt Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

37. 7-37 Sources of Federal Revenue You pay 6.2% in payroll tax on wages up to $80,400 and 1.45% on all wages The Payroll Tax is the fastest growing source of federal revenue Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

38. 7-38 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Level of Earned Income Taxes Paid Average Tax Rate $ 10,000 $ 620.00 6.2% 68,400 4,240,80 6.2% 100,000 4,240.80 4.24% 1,000,000 4,240.80 0.424% The Incidence of the Social Security Tax at Various Income Levels in 1998 Note: The current social security tax by law is set at 6.2 % with a wage based limitation of $80,400

39. The Corporate Income Tax The corporate income tax is a tax on a corporation’s profits –The maximum rate is 35% All corporations earning profits of at least $335,000 pay an average of tax rate of 35% –Loopholes in the tax law allow many corporations to pay much lower taxes 7-39 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

40. Excise Taxes An excise tax is a sales tax aimed at specific goods and services Most excise taxes are levied by the federal government –State and local governments also often levy taxes on the same items 7-40 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

41. Excise Taxes (Continued) Excise taxes tend to reduce consumption of certain products of which the federal government takes a dim view (e.g., cigarettes) Excise taxes are usually regressive 7-41 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

42. The Estate Tax The estate tax is a tax on the estates of people who die –It is a graduated tax that rises to 55% It is levied only on estates valued at $675,000 or more –More than 90% of estate taxes are paid by people with incomes above $200,000 a year 7-42 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

43. 7-43 Sources of State and Local Tax Revenue Sales Tax –Is a source of over half of all taxes collected by the states –Is a highly regressive tax Property taxes –Provides 80% of all local tax revenue –Can distort business decisions about where to locate Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

44. The State and Local Fiscal Dilemma Since World War II, state and local governments have been expected to provide an increasing number of services –Most notable are health, welfare, education, and police protection –Programs dropped at the Federal level must often be picked up at the state or local level 7-44 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

45. During the 1960s and 1970s the federal government helped states with increasing grants-in-aid and general revenue sharing The Reagan administration not only stemmed this increase, but strongly reversed it The State and Local Fiscal Dilemma (Continued) 7-45 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

46. 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 The 1998 Internet Tax Freedom Act declared a three-year moratorium for online sales 7-46 The State and Local Fiscal Dilemma (Continued) Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

47. 7-47 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Government Tax Rates as a Percentage of GDP, 1929 and 2000 Tax Rates are almost three times as high as they were in 1929

48. 7-48 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Tax Receipts as a Percentage of GDP in the United States and Selected Western European Countries, 1999

49. Two Principles of Taxation: I Ability to pay principle –Ability to pay Rich people would pay a much higher proportion of their incomes than the middle class Middle class would pay a higher proportion of their incomes than the poor –Is this fair? Possibly, but only if you are solely concerned with people’s incomes It also depends on how you define the rich and middle class 7-49 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

50. Two Principles of Taxation: II Benefits received principle –Some people receive more benefits than others –Applying the benefits received principle strictly could end up with absurd results –We are not always clear about the value of any benefits received 7-50 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

51. An example of the ability to pay principle is the federal personal income tax An example of the benefits received principle is the federal and state tax on gasoline, which is geared to the number of miles driven A tax based on both principles cannot be devised because they appear to be mutually exclusive –Therefore, some taxes are based on the ability to pay principle while others are based on the benefits received principle 7-51 Two Principles of Taxation (Continued) Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

52. The Economic Role of Government 7-52 Provision of Public Goods and Services Redistribution of Income Stabilization Economic Regulation Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

53. Provision of Public Goods and Services Some examples –Defense of the country –Maintenance of internal order –Provision of a nationwide highway network –Provision of a money supply –Provision of public education –Running the criminal justice system –Environmental protection 7-53 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

54. Redistribution of Income The government redistributes 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 7-54 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

55. Stabilization Two basic goals of economic stabilization by the federal government –Stable prices with little or no inflation –Low unemployment An economic rate of growth high enough to keep the unemployment rate to a minimum 7-55 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

56. Economic Regulation The government provides the economic rules of the game –This must be done within the social and political context in which the economy operates The government must allow individuals and business firms to operate with the maximum degree of freedom 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 7-56 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

57. 7-57 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 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

58. Conclusion Until the 1930s, the federal government more or less followed the role prescribed by Adam Smith The government’s economic role has expanded tremendously these last seven decades It will continue to grow in the coming years 7-58 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

59. Big government, like rock ‘n’ roll, is here to stay 7-59 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.