Public Spending, Public Choice, Need for Government, and Taxation Systems

1. Public Spending, Public Choice, Need for Government, and Taxation Systems Lecture

2. Test terms for Thursday, May 1 • Market failure • Externality • Medicaid • Medicare • Private good • Public good • Rival consumption • Government sponsored good • Government inhibited good • Collective decision making • Theory of public choice • Tax base • Tax rate proportional tax • Progressive tax • Regressive tax • Capital gain • Capital loss • Tax incidence • Dynamic tax analysis • Static tax analysis

3. What a Price System Can and Cannot Do • Price system lets resources move from low-valued uses to high value uses • Consumers decide this • Sometimes too many or too few resources move to specific economic activities • This is called a market failure

4. Market failure: negative externality • Externality; consequence of economic activity that spills over to third party • Example: steel mill moves into town • Charges market price for steel • Mill doesn’t have to pay cost of dirtier air, dirtier clothes, or more respiratory diseases

5. How does government correct for negative externalities? • Special taxes: • In steel mill example government could tax steel mill(pollution or effluent tax) • Ultimate aim to place real cost of steel on mill itself: prices would rise—supply fall • Regulation: • Government could set maximum allowable rate of pollution • Mill would have to install abatement equipment or reduce rate of output

6. How does government correct positive externalities? • Idea of positive externality can be seen with inoculations against communicable diseases • If it wants more inoculations than the market is producing: it could finance them • It could subsidize them • It can regulate them: require that you must have them to work, attend school, etc.

7. Other Functions of Government • Provide a Legal System • A market system relies on contracts (good legal system is necessary) • Must have a good system of protecting property rights • Having a good police system is necessary

8. Other Functions of Government • Promote Competition • We want to preserve our competitive economic system(anti-trust legislation) • Reduce and eliminate monopolies • Answer this questions with your partner: • Can small businesses continue to exist in America? Which ones?

9. Other Functions of Government • Provide Public Goods • Private Good: • Goods that can be consumed by only one individual at time. Private goods are subject to principle of rival consumption • Rival consumption: individuals are rivals in consuming private goods because each persons consumption reduces amount available for others to consume

10. Public Goods • Public Goods: • Principle of rival consumption does not apply • Can be consumed by many individuals simultaneouslyat no additional cost & no reduction in quality or quantity • One who does not pay for the good cannot be denied benefit of good • Example of public good: national defense

11. Other Functions of Government • Ensure Economy-wide Stability • Stabilize rising prices • Eliminate unemployment • Examples: FDR’s program; bank bailouts; stimulus packages; control of interest rates

12. Political Functions of Government • Promote and restrict goods • Government-sponsored good: something deemed socially desirable: museums & parks • Government-inhibited good: something deemed undesirable through political process: heroin

13. Political Functions of Government • Provide Income Redistribution • This is a more recent function of government • Two systems used for this: • Progressive income tax • Transfer payments

14. Public Spending & Transfer Programs

15. Public Spending

16. Public Spending & Transfer Programs • Publicly Subsidized Health: Medicare • In fewer than 40 years Medicare became our second-biggest domestic government spending program • In first 20 years of Medicare: • Huge upswing in physician's incomes & med-school applications + • Huge increase of prices of medical services • Each year government expenditures on Medicare exceed budget projections

17. Public Spending & Transfer Programs • Why do projections of expenditures fall short? • Bureaucratic planners don’t often see the effects of incentives of government programs • Demand side: Huge incentive to use program when government is paying for it • Supply side: Huge incentive to use expensive procedures when government is paying

18. Public Spending & Transfer Programs • Health Care Subsides Continue to Grow • Medicare cost has risen from 0.7 % of national income in 1970 to 2.8% today • Medicare spending is growing faster than employer & employee contributions • Currently Medicare tax is 2.9% on wages with 1.45% paid by employer & 1.45% paid by employee • Currently unfunded guarantees for Medicare estimated at $25 trillion

19. Public Spending & Transfer Programs • Increased guaranteed costs do not include Medicaid • Medicaid provided for low income people • Combination of state and federal payments • Currently, 50 million people have Medicaid or one in six Americans • Federal government currently pays for 57% • Medicaid expenditures have grown more rapidly than Medicare (75% since 2000 alone) • From 2010 forward increases have expanded at rate at more than $100 billion per year

20. Obamacare????? The major questions in Obamacare are 1) whether it will be less expensive for consumers and 2) how will the funding work in insuring 40 million new people?

21. Economic Issues of Public Education • State and local governments assume primary responsibility for public education • Annual expenditures are $900 billion • In excess of 6% of national income • Education funded by • State & local sales, excise, property, and income taxes • Federal government, also, provides billions of dollars in grants & transfers • Question: Should education be funded by local communities or federal government?

22. Economic Issues of Public Education • Currently state & local education is subsidized by federal government • Education is provided for below market price • Think of cost of private schools • Trade-offs occur with federal government subsides • St. Gregory tuition: $16,675 • AZ State payment per student: $7,468 • AZ Charter school per student: $6,777 • National payment per student: $10,615

23. Economic Issues of Public Education • What is the problem with subsidized public education? • Schools don’t have to compete with each other • Schools provide inefficient programs for student learning & achievement • How are charter schools able to operate at income levels 25% under public schools?

24. Collective Decision Making:The Theory of Public Choice • Collective decision making: how voters, politicians, and other interested parties influence nonmarket decisions • Theory of Public Choice: study of collective decision making • Theory states individuals will act within political process to maximize their individual, not collective well-being. • Do you agree with this theory?

25. The Theory of Public Choice • Opportunity cost: • Everything spent in private sector plus public sector must add up to total income available • Government then has an opportunity cost; they face choices • Competition: • Appointed officials are in competition for available government funds • Government officials will do what is in the best interest of themselves

26. The Theory of Public Choice • Differences of individuals & public sectors • Governmental officials face a different incentive structure • Compare USPS & UPS: profitability incentives • Public sector is not that concerned with cost- benefits (how many units to expand or how many hours to operate) • Difference in use of force: don’t pay your taxes wages are seized; don’t pay your bills-- declare bankruptcy

27. The Theory of Public Choice • Voting vs. spending • Political system: one person-one vote • Political system: majority rule • Market system: each dollar a person spends counts • Market system: proportional rule (if 10% of votes cast vote for blue cars 10% will be made)

28. Funding the Public Sector • Three sources of funding for government • 1) Explicit fees or charges for gov.-services • 2) Taxes • 3) Borrowing

29. Government Budget Constraint • Each dollar of public spending on goods, services, transfer payments, and repayment of borrowed funds • must be provided by tax revenues

30. Systems of Taxation • Tax Base • Value of good, services, wealth, or income subject to taxation • Tax rate • Proportion of tax base that must be paid to a government

31. Three types of taxation systems • Proportional Taxation • Regardless of income everyone’s tax rate is the same—everyone pays the same % • Progressive Taxation • As a person’s taxable income increases the % paid increases (our current system) • Regressive Taxation • A smaller % of taxable income is taken as taxable income increases

32. Sources of Government Tax Receipts

33. Treatment of Capital Gains • Capital gain: positive difference between the purchase price & sale price of an asset • Miscalculation???? • Are capital gains always real gains? • Example: if you sold an asset for $100,000 after 10 years and your original purchase price was $50,000 (pay on $50,000) • What if there was 10% inflation, your real gain would be $0.00 (fair????)

34. Treatment of Capital Gains • Capital Loss: a negative difference between the purchase price and sale price • Can you deduct the full amount of a capital loss on your income tax? • Ten Important Facts About Capital Gains and Losses

35. Corporate Taxable Income $0-50,000 $50,001-75,000 $100,000-335,000 $335,001-10,000,000 $10,000,001-15,000,000 $15,000,001-18,333,333 $18,333,334-and up Corporate Tax Rate 15% 25% 39% 34% 35% 38% 35% Corporate Income Tax

36. More on Cooperate Income Tax • Corporate income taxes account for • 12% of federal taxes • 2% of state & local taxes

37. More on Corporate Income Tax • Double taxation • Stockholders pay taxes on dividends • Dividends are paid out of after tax profits • Prior to issuing dividends, it paid taxes on all its profit, including any it put back into the company • Retained earnings (any earnings put back into invest-ments) have helped raise the value of the company • When you sell your stock for a capital gain, you pay tax on the capital gains • Either way, dividends or retained earnings you are double taxed (Since 2003 dividends are taxed at lower rates)

38. Who Really Pays the Corporate Income Tax? • Tax Incidence: • the distribution of tax burdens among various groups in society • So who really pays the corporate taxes? • Discuss with your partner!

39. So who really pays the corporate taxes? • Do corporations simply pass on their tax burden to customers by charging higher prices? • Are stockholders bearing the cost of the tax? (price of stock has to reflect cost) • Are employees of the corporation paying the cost by taking lower wages than might be offered without the tax? • Point: it is people who pay the tax!

40. Social Security & Unemployment Taxes • Social Security Tax on earnings up to $106,800 • 6.2% on employees & 6.2% on employers • Social Security taxes were passed in 1935 • More people paid into it than drew benefits • Within next few years outflow will exceed inflow • Solutions include; later start date, increased taxes, lower COL adjustments

41. Tax Rates & Tax Revenues • Sales taxes, gross receipts taxes, & excise taxes generate one-fifth of most state and local governments • Sales tax is a proportional tax • Static tax analysis • Assumption of no effect on tax base with tax rate increases • Dynamic tax analysis • Recognizes tax base will eventually decline as tax rate increases

42. How to maximize tax revenue • Maryland example of “millionaires” tax • Extra-high bracket created for incomes exceeding $1,000,000 • Many millionaires changed residences to other states (made second home – primary) • Maryland collected $100 million less with this tax • Gerry Swanson: most important consideration in taxing is that those taxed feel it is fair. (Tax avoidance can set in)

43. Can we wipe out the annual federal deficit with taxes? • Yes, annual deficit is about $1.3 trillion • Taxes should be raised by $9,000 for every worker (that covers one year) • Shouldn’t we tax the rich more? • There are fewer than 100,000 who make more than $1,000,000 • Raise the marginal tax rate from 35% to 45% we would raise $35 billion or less than 3% of federal budget

44. Last call on taxing the rich! • Let’s tax that top 1% at 100%! • So that would cover one year at $1.3 trillion • Our national debt is over $17 trillion • Let’s take 100% of everyone who makes at least $75,000! • So that would cover about $4 trillion or one-third of the net public debt

45. Components of Federal Expenditures as Percent of Total Federal Spending

46. With your partner • What is your solution for eliminating the national public debt?