1. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 18 Taxation and Public Expenditure

2. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-2 In this chapter you will learn to 3. Describe the main categories of government spending. 2. Explain why a tax can lead to allocative inefficiency. 5. Describe the factors that determine the scope and nature of government’s role in the economy. 4. Explain why transfer payments for the elderly are an increasing proportion of government spending. 1. Describe the main sources of government revenue in the United States.

3. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-3 Tax Expenditures Tax Expenditures: Tax revenues returned to taxpayers who take actions that the government deems desirable Taxation Example: health insurance

4. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-4 Figure 18.1 International Comparison of Government Tax Revenues, 2004

5. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-5 Average Tax Rate: % of income that individual pays in taxes An income tax is: - progressive if the ATR rises as income rises - regressive if the ATR falls as income rises - proportional if the ATR is constant as income rises Most income-tax systems achieve their progressivity by having marginal tax rates that rise with income – “tax brackets” Progressivity

6. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-6 The U.S. Tax System Sources of federal government revenues: personal income taxes payroll taxes corporate Income taxes excise and sales taxes

7. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-7 Tax bracket: A range of taxable income for which there is a constant marginal tax rate. Tax Brackets

8. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-8 Figure 18.2 Sources of Government Revenues, 2005

9. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-9 APPLYING ECONOMIC CONCEPTS 18.1 How Federal Taxes Affect Your Paycheck Income Taxes

10. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-10 Taxation and Equity Evaluating the Tax System Equity is normative. Two principles are helpful in assessing equity: 1. the ability-to-pay principle 2. the benefits-received principle - vertical and horizontal equity Problems: - ability to pay is not the same as income. - how to measure benefits received?

11. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-11 A modern government relies on many kinds of taxes. Assessing the entire tax system is complicated by two factors: 1.the progressivity of the system depends on the mix of the different taxes (federal taxes tend to be progressive; property taxes are slightly regressive) 2.income from different sources are taxed at different rates How Progressive is the U.S. Tax System?

12. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-12 APPLYING ECONOMIC CONCEPTS 18.2 Poverty Traps and the Negative Income Tax Negative Income Tax

13. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-13 Taxation and Efficiency Taxes often generate allocative inefficiency. Two burdens of taxation: 1. direct burden is the amount paid by taxpayers 2. excess burden is the allocative inefficiency generated by a tax

14. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-14 Most taxes impose both burdens: - by taking resources from market participants, they impose a direct burden - by changing behaviour, they generate a deadweight loss — the excess burden The government’s tax policy should strive to minimize allocative inefficiency for a given amount of tax revenues. Taxation and Efficiency

15. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-15 Figure 18.3 Direct and Excess Burdens of an Excise Tax Case 1: Only a direct burden, no excess burden. Case 2: No direct burden (no sales), some excess burden. Case 3: Both direct and excess burdens.

16. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-16 The same principle applies with an income tax... Figure 18.4 Direct and Excess Burdens of an Income Tax

17. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-17 Figure 18.5 A Laffer Curve Along a Laffer curve: - increases in the tax rate beyond some level (t 0 ) lead to disincentive effects, and decrease tax revenues.

18. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-18 Public Expenditure There are two broad categories of government expenditure: 1. purchases of goods and services 2. transfer payments (including payments made to other governments) Federal, state and local governments spend an amount equal to about one-third of the nation’s annual output.

19. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-19 Figure 18.6 Spending by Governments as a Share of National Income, 1960–2005

20. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-20 Figure 18.7 Federal, State, and Local Spending, 2005

21. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-21 Purchases of Goods and Services Because public goods are underprovided by private markets due to the free rider problem, government spending tends to be concentrated on providing public goods. - national defense is 2/3 of federal government spending - education is about 20% of state and local government spending - policy and fire services are about 15% of the state and local government spending

22. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-22 Transfer Payments The largest category of transfer payments by the federal government is made to individuals. Federal government transfer payments include transfers to: – elderly persons (Social Security and Medicare) – needy persons (welfare and Medicaid) – other governments (grants-in-aid)

23. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-23 Evaluating the Role of Government Public Versus Private Sector Government activities reallocate resources between the private and public sectors - a different mix of goods and services from what would otherwise exist What is the appropriate mixture of public and private expenditures?

24. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-24 John Kenneth Galbraith (1908-2006) lamented the reallocation away from the public sector, especially in the United States - “private affluence and public squalor” His classic 1958 book The Affluent Society discussed his views of the appropriate role of government in the economy. Evaluating the Role of Government

25. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-25 Scope of Government Activity It is important to maintain an appropriate perspective about the role of government in the economy. One pitfall is to become overwhelmed by the government’s role, and forget that people are mostly free to make decisions in their own ways. Another pitfall is to fail to recognize that a significant share of of taxes is used to finance goods and services that add to the welfare of individuals — such as education, health care, and roads.

26. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-26 Evolution of Policy In a democratic society, the majority’s view on the amount of intervention that is desirable will have a considerable influence on the amount of intervention that actually occurs. The economist’s job is to continue analyzing and explaining the effects of alternative policies. Only then will the electorate and policymakers be able to make informed choices.