Chapter 16 The Federal Budget: Taxes and Spending

1. Chapter 16 The Federal Budget: Taxes and Spending

2. Introduction • The federal government spends over 18% of GDP. • Taxes collected are just under 17%. • In this chapter we will answer the following questions: • Where does all that money come from? • Where does it go? • How long can the government keep spending more than it raises in taxes?

3. Tax Revenues • 2007--Federal Government Revenue was about $2.4 trillion. • Major Sources of Revenue • Individual income tax • Social Security and Medicare taxes • Corporate income tax • The following figure helps us see the magnitudes and relative values of these sources.

4. Tax Revenues • Sources of Government Revenue (2007)

5. Tax Revenues • The Individual Income Tax • Marginal tax rate (MTR)—thepercent paid in taxes on an extra dollar of income. • Example: If the marginal tax rate is 10%, tax owed on an additional $100 will be (.10) x $100 = $10. • MTR is important because it affects incentives. • Changes in the marginal tax rate cause two effects: • Revenue effect • Incentive effect

6. Tax Revenues • The Individual Income Tax (cont.) • Average tax rate (ATR)—totaltax payment divided by total income. • Example: If income is $50,000 and tax owed is $7,500, the average tax rate is… • Marginal tax rates are set by government, while the average tax rate is calculated after tax owed is known.

7. Tax Revenues • The Individual Income Tax (cont.) • U.S. tax rates—2007 • Six marginal tax rates, if… • Income < $15,650 → MTR = 10% • $15,650 < Income < $63,700 → MTR = 15% • $63,700 < Income < $128,500→ MTR = 25% • $128,500 < Income < $195,850→ MTR = 28% • $195,850 < Income < $349,700→ MTR = 33% • Income > $349,700 = 35% • The following figure helps us see the relationship between the MTR and ATR.

8. Tax Revenues

9. Tax Revenues • The Individual Income Tax (cont.) • Exemptions and Deductions—not all income is taxed. • Exemptions: reduce taxable income. • Spouse, Dependents • Each exemption reduces taxable income by $3,500. • Deductions: also reduce taxable income. • Apply only to specific expenses. • Example: mortgage interest • We are now ready to look at a specific case.

10. Tax Revenues • The Individual Income Tax (cont.) • Family of four – 4 exemptions; Mortgage interest = $10,000. Before tax income = $75,000 • Taxable income = $75,000 - 4 x $3,300 - $10,000 = $51,800 • Tax owed = 0.1 x $15,650 + 0.15 x ($51,800 - $15,650) = $8,773 • ATR = $8,773/$75,000 = .117 (11.7%)

11. Tax Revenues • The Individual Income Tax (cont.) • What is the value of the mortgage deduction? • It depends on the level of income. • Higher income individuals benefit more. • This is shown in the next slide.

12. Tax Revenues • The Individual Income Tax (cont.) • What is the value of the mortgage deduction? Notes: If the mortgage deduction doesn’t move the taxpayer into a lower tax bracket, the benefit is equal to the MTR x mortgage interest deduction (I.e. 0.15 x $10,000 = $1,500). If the mortgage deduction moves the taxpayer into a lower tax bracket, the benefit will be a little less than the MTR x mortgage interest deduction (i.e. 0.28 x $10,000 = $2,800 compared to $2,749)

13. Tax Revenues • Taxes on Capital Gains, Interest, and Dividends • All of these are taxes on investment income. • Dividends—stockholders’ share of the profits. • MTR = 15% for most people. • MTR = 5% for low income people. • Capital Gains—the difference between the price an asset was purchased at and its selling price. • MTR = 15%* • Capital losses can offset income from capital gains.

14. Tax Revenues • Taxes on Capital Gains, Interest, and Dividends (cont.) • Political debate about how investment income should be taxed. • Democrats—favor higher tax rates. • Why?: Rich bear a higher share of the burden. • Republicans—favor lower tax rates. • Why?: Lower taxes provide incentive to invest and create economic growth.

15. Tax Revenues • Taxes on Capital Gains, Interest, and Dividends (cont.) • The Alternative Minimum Tax(AMT) • Requires taxpayers to do two calculations: • Compute taxed owed under standard tax code. • Compute what they owe based on a flat rate of 26% or 28% with no deductions. • Pay the higher of the two. • Because the AMT is not adjusted for inflation, more people pay than originally intended.

16. Tax Revenues • Social Security and Medicare Taxes • Social Security Taxes • FICA: Payroll tax. • Employees pay 6.2% on earnings up to $106,800. • Employers pay 6.2% on same earnings. • The larger share of the burden is on workers because… • employers are able to shift some of the tax back on workers by paying lower wages.

17. Tax Revenues • Social Security and Medicare Taxes (cont.) • Who actually pays the payroll tax? • Research shows that the employer’s payment is mostly taken out of the workers’ prospective wages. • Implication: If the employer didn’t have to pay the tax, wages would be higher. • Chile (1981)—employers no longer had to pay payroll taxes for their employees. • Result: wages rose.

18. Tax Revenues • Social Security and Medicare Taxes (cont.) • Medicare taxes: special payroll tax to finance Medicare. • 1.45% deducted from workers’ paychecks. • 1.45% deducted paid by employers. • Again, workers pay much of the employers’ premium in the form of lower wages.

19. Tax Revenues • The Corporate Income Tax • 35% in the U.S.—one of the highest in the world. • Tax code lets a good accountant reduce the legal measure of income. • Example: Boeing—a large and profitable airplane manufacturer. • Over a recent period of 5 years paid an ATR of 0.7%. • Who pays the corporate income tax? • Shareholders and bondholders. • Workers in the form of lower wages. • Consumers in the form of higher prices.

20. Tax Revenues • The Bottom Line on the Distribution of Federal Taxes Note: Includes all deductions, exemptions, corporate taxes, payroll taxes, excise taxes, AMT, and assumptions about incidence.

21. Tax Revenues • The Bottom Line on the Distribution of Federal Taxes (cont.) • Conclusions: • The U.S. tax code is progressive: tax rates are higher on people with higher incomes. • Effective tax rate ranges from 4.1% - 31.2% • 85.6% of all federal taxes are paid by the top 40% of earners. • What are the implications of such a narrow tax base? • What is a regressivetax?

22. Tax Revenues • The Bottom Line on the Distribution of Federal Taxes (cont.) • Flat Tax: Proposedto replace current tax code • MTR is the same for all income levels. • If almost all deductions were eliminated, a flat rate of 19% would raise the same revenue as the current code. • Advantages: • Less complexity. • Lower compliance cost. • Greater incentive to save and invest.

23. Tax Revenues • The Bottom Line on the Distribution of Federal Taxes (cont.) • Flat Tax(cont.) • What are the political chances for a flat tax? • Eliminating the mortgage deduction would result in lower house prices. • What do you think?

24. Tax Revenues • The Bottom Line on the Distribution of Federal Taxes (cont.) • Flat Tax(cont.) • Disadvantages: • MTR for the bottom 80% of taxpayers would rise. • Proponents (Steve Forbes-Republican, Jerry Brown-Democrat) counter argue that… • Higher incomes resulting from greater saving and investment would mean that even people whose MTR rose would pay a smaller fraction of their income.

25. Tax Revenues • State and Local Taxes • Overall: half the level of federal taxes • States raise more of their revenues from sales taxes. • Less progressive than the federal income tax.

26. In the early 1830s most tax revenue came from taxes on trade. What percent of federal revenue comes from customs duties? • Individual income taxes and payroll taxes represent what percent of federal revenue? • Calculate the tax owed for an individual making $80,000 pretax and $160,000 pretax. Compare total taxes paid by each and the ATR for each. Is there evidence of a progressive tax?

27. Spending • Two thirds of the U.S federal budget is spent on… • Social Security • Defense • Medicare • Medicaid • The following figure gives a better picture of where our tax money is spent.

28. Spending • Where does our tax money go?

29. Spending • Social Security • At $586 billion in 2007—the single largest government program in the world. • Runs on a “pay as you go” basis. • Current contributions pay for benefits of current retirees. • No one has a Social Security account in their name. • Benefits are modest so don’t count on living solely on Social Security when you retire.

30. Spending • Social Security (cont.) • Some people advocate raising the full retirement age—you might want to keep an eye on that. • Benefits are indexed to the level of wages. • Net benefits are declining over time. • Higher taxes on today’s workers funds larger benefits for yesterday’s workers. • Using the present value calculations discussed in Chapter 8, the following table shows that net benefits get smaller for later generations.

31. Spending • Social Security (cont.)

32. Spending • Social Security (cont.) • Conclusions • Benefits are getting less generous over time. • Redistributes wealth across income classes. • Net benefits for wage earners retiring in 2030… • Low wage earner—$3,062 • High wage earner— - $193,874 • Social Security is also a welfare system.

33. Spending • Social Security (cont.) • Complications • More beneficial for married couples than singles. • You don’t own your account. • Your cannot borrow from the account. • You can’t make an early withdrawal even an emergency such as a terminal illness. • Your survivors to not inherit the money you have put in your account. • It’s better for females than for males because females live longer.

34. Spending • Defense • 2007: Spending on defense was $549 billion. • Excludes most spending on the wars in Iraq and Afghanistan. • The U.S. spends more on its military than any other country. • The next table shows the top ten countries listed by military expenditure.

35. Spending • Defense (cont.)

36. Spending • Medicare and Medicaid • Medicare: reimburses the elderly for medical spending. • With Social Security, amounts to 36.5% of federal spending. • Covers individuals over 65 who have paid into the system for at least 10 years. • Does not pay all medical bills. • Medicaid: Covers the poor and the disabled. • Paid for jointly by federal and state governments. • Expenditures are half that of Medicare.

37. Spending • Unemployment Insurance and Welfare • Common myth—most money spent by the federal government goes to welfare programs. • Two important categories of welfare: • Temporary Assistance for Needy Families (TANF)—are made to poor households with children. • Benefits are limited to 5 years in a lifetime. • Housing vouchers are given to subsidize a portion of rent. • Earned Income Tax Credit (EITC)—is a direct cash payment based on income.

38. Spending • Unemployment Insurance and Welfare (cont.) • Unemployment insurance: payments to people who are out of work regardless of income • Everything else: • Adds up to about $462 billion. • None are large compared to Medicare. • Earmarks have received a lot of attention. • When a congressman puts an expenditure for his/her district into a broader bill. • While often wasteful, cutting them out will not save enough to fund significant new spending programs.

39. Spending • National Debt, Interest on the National Debt, and Deficits • National Debt held by the public—Allfederal debt held outside the United States government. • As of 2009 equaled just over $7 trillion. • Debt-to-GDP Ratio= 50% • May be high for an individual but not necessarily for the U.S. government. • Debt-to-GDP ratio has been much higher in the past. • The following figure shows this.

40. Spending • National Debt, Interest on the National Debt, and Deficits (cont.)

41. Spending • National Debt, Interest on the National Debt, and Deficits (cont.) • Interest on the national debt • Payment of interest to bond holders in 2007 was $244 billion. • Does it matter if a large amount of the debt is owed to foreigners? • From a purely economic point of view the answer is no. • What matters is how the borrowed dollars are spent.

42. Spending • National Debt, Interest on the National Debt, and Deficits (cont.) • Deficits: the annual difference between federal spending and revenues. • The deficit is… • The difference between revenues and spending. • The annual change in the national debt. • The following figure allows us to see the level of deficit-to-GDP ratio and how it has changed over time.

43. Spending • National Debt, Interest on the National Debt, and Deficits (cont.)

44. When you retire, you will receive Social Security benefits as will most Americans. Right now, what percentage of federal spending is represented by Social Security and Medicare payments? • Why is it important to consider the debt-to-GDP ratio rather than just the absolute amount of the national debt? What does the ratio tell us?

45. Will the U.S. Govt. Go Bankrupt? • The Congressional Budget Office (CBO): “under any plausible scenario, the federal budget is on an unsustainable path…” • Main forces driving the projections: • Demographics • The population is aging resulting in... • Higher Social Security and Medicare payments. • Rising health costs per person • Rising more than twice as fast as GDP per capita. • The next figure shows the result.

46. Will the U.S. Govt. Go Bankrupt? • Projected Debt-to-GDP Ratio

47. Will the U.S. Govt. Go Bankrupt? • Spending and Revenue Projections by Category as a Percent of GDP • Over the past 40 years spending on programs and revenue has fluctuated around 18% of GDP. • Main cause of higher spending is greater expenditures for Social Security and Medicare. • Spending on all other programs including defense is projected to decline as a percent of GDP. • CBO is not predicting but is demonstrating that something else has to change.

48. Will the U.S. Govt. Go Bankrupt? • Spending and Revenue

49. Will the U.S. Govt. Go Bankrupt? • The Future is Hard to Predict • The U.S. has a history of relatively low taxes. • The American Revolution was in part about taxes in spite of one of the lowest tax burdens in the world. • The income tax is fairly new—started in 1913. • Taxes and federal spending increased dramatically during WWI and WWII. • Since then, as a percent of GDP they have remained fairly stable around 18%. • Compared to other countries we’re not doing so badly. Let’s look at this.

50. Will the U.S. Govt. Go Bankrupt?