Ch. 14: Government Revenue and Spending

1. Ch. 14: Government Revenue and Spending

2. Sec. 1: How Taxes Work

3. Government Revenue • Govt. provides goods generally not provided by the market • ex – street lighting, highways, law enforcement, court system • Tax – • Revenue – • Nontax sources – • rights of govt. to tax are set down in the US Constitution and in state Constitutions

4. Principles of Taxation certain principles and criteria to evaluate whether or not taxes should be paid and who should pay them most often based on the benefits taxpayers receive from taxes and their ability to pay

5. -BENEFITS-RECEIVED PRINCIPLE- • Holds that • ex – financing road construction & maintenance with gas tax • Difficult to assess how much different taxpayers benefit from national defense, national parks, local police & fire protection, public education

6. -ABILITY-TO-PAY PRINCIPLE- • Holds that • people with higher income will pay more than people with lower incomes • level of benefits received not a consideration • income alone not completely determine ability to pay taxes • Should everyone pay the same % of income, • should those with higher incomes pay a higher % of their income in taxes

7. Criteria for Taxation tax systems attempt to meet 3 criteria: the criteria are sometimes in conflict and a given tax may not meet all of the criteria equally well

9. Tax Bases and Structures tax base – 4 most common tax bases are:

10. Tax Bases INDIVIDUAL INCOME TAX SALES TAX -is a tax based on an individual’s income from all sources: wages, interest, dividends, tips -all taxes ultimately come from income – but using that as a tax base means amount of tax is directly linked to person’s earnings -for most – income comes from wages or tips & could come from investments and savings in form of interest & dividends -corporate income tax – is a tax based on a corporation’s profits -is a tax based on the value of designated goods or services at the time of sale -generally imposed on a wide range of goods and services -is usually a % of the price of the good or service & is included in final price customer pays -seller then passes the tax revenue on to govt.

11. Tax Bases-PROPERTY TAX- • Is a tax based on the value of an individual’s or business’s assets, generally real estate • Home & business owners pay based on value of buildings and land on which buildings stand • Growing and shrinking tax base – wealth that is available to be taxed • personal income rises – • If fewer homes or businesses in a locality or value declines – tax base shrinks – less wealth for govt. to tax

12. Tax Structure 3 different tax structures –

14. -PROPORTIONAL TAX- -PROGRESSIVE TAX- • Sometimes called a flat tax – • ex- all taxpayers might have a flat 15% tax on their income no matter how much income is • ex – earn $20,000 – pay $3,000 in taxes • ex – earn $50,000 – pay $7,500 in taxes • Some states & local govt. have proportional taxes in individual income • Michigan – flat income tax rate of 3.9% • Massachusetts – flat income tax rate of 5.3% • Tax in which the tax rate increases as a person’s income increases • high income person pays more in amount of taxes but also pays a higher % of income in taxes • see figure 14.1 – progressive tax is most closely linked to the ability to pay principle • in US – federal income tax is a progressive tax – tax rate increases as income increases • may states have progressive income taxes: Cal., Kansas, NY, South Carolina

15. -REGRESSIVE TAX- • The % of income paid in taxes decreases as income increases • some taxes are regressive b/c they are applied to sales not income • ex – a sales tax is applied equally to all items subject to the tax, the tax as a % of income is regressive • this is b/c low income earners tend to spend a higher proportion of income than do high income earners • EX – state charges 5% sales tax • Jones- earn $20,000, spend $15,000 on taxable goods, pay $750 in sales taxes, (5% of 15,000) or 3.75% of income • Smith – earn $50,000, spend $25,000 on taxable goods, pay$1,250 in sales tax (5% of $25,000) or 2.5% of income • Property taxes on homes also considered regressive • low income usually spend higher % of their income on housing than high income • therefore – property taxes take a higher % of their income • poorer communities often charge a higher tax rate b/c property has a lower value then tax base is smaller • even non-home owners are subject to the regressive tax

16. Who Pays the Tax? incidence of a tax – impact of a tax on a taxpayer ex –

17. Effect of Elasticity on Taxes • Govt. imposed a $1 tax on a product – demand elasticity influences the incidence of this tax • if elastic demand – • if inelastic demand – • Seller recognizes that quantity demanded will go down only slightly for goods and services that have elastic demand b/c hey are less price sensitive

18. Impact of Taxes on the Economy taxes have impact on govt. chooses what to tax based on amount of income it wants to raise and the other economic effects it wants to achieve

19. Impact 1: Resource Allocation • Tax placed on a good or service will increase the costs of production and therefore shift the supply curve to the left • if demand remains the same – price will go up • will likely cause a shift is resources • If a supplier not able to pass increased costs to consumer in form of higher prices – may choose to shift production to another good that is more profitable • ex – govt. imposed 10% tax on luxury yachts – producer not able to raise prices enough to cover entire tax – no longer profitable – shift to small fishing boats or new business

20. Impact 2: Productivity and Growth • When taxes on interest & dividends are high, people tend to save less than when taxes on this source of income are low • taxes have impact on • economists say high taxes reduce incentives to work • People may spend more time of things other than work if large % of income goes to taxes • others suggest underground economy is result of high taxes • Underground economy – • ex- Bob’s landscaping business – work weekends – charges less than large firms – insists on being paid in cash – difficult for govt. to tax income

21. Impact 3: Economic Behavior • Tax incentive – • providing tax credits or rebates – govt. may encourage behavior it believes is good for the economy and society • ex- tax rebates for businesses opening new factories, offices & stores in economically depressed areas • ex – govt. give tax credits to consumers for recycling or using energy more efficiently • Positive tax credit with widest impact –

22. Impact 3: Economic Behavior • Sin taxes – • gambling, alcohol, cigarettes • Taxes are generally levied on products or activities for which there is relatively inelastic demand – • but – demand is relatively inelastic – the decline in quantity demanded will not cause tax revenues to decrease dramatically • demand for sin-tax products becomes somewhat more elastic as tax increases get steeper • ex – in Washington – cigarette sales fell 19% year after imposed $.60 per pack tax – but revenue went up 40%

23. Sec. 2: Federal Taxes

24. Individual Income Tax • Federal govt. takes in $2.5 trillion in revenue each year • comes from many sources: individual income tax, social insurance taxes, corporate income taxes, estate taxes, gift taxes, excise taxes, customs taxes • largest source – • started using after • prior – excise taxes and customs duties main source • social insurance taxes are • workers and employers share the burden of these taxes

25. Example: Paying Your Taxes • If taxpayers had to pay at end of year in one lump sum – would be difficult • would be difficult for govt. getting revenue once a year • drawing up a budget, developing a sound economic plan for future impossible • To make it easier – • Withholding – • ex – Scott – works part-time during school, full-time during summer - $6 hr. • b/c of withholdings – • pays taxes as he earns income – govt. has steady stream of revenue • employer forwards withholdings to IRS

26. Example: Paying Your Taxes • IRS – • federal income tax is a progressive tax based on the ability to pay principle of taxation • people with higher incomes not pay more in total taxes but also a higher % of their income in taxes • Taxable income – • under federal income tax laws – taxpayers can take certain exemption & deductions from total earned income to reduce amount of their taxable income • exemptions for each individual adult and child – larger family reduce more than smaller family • may take standard deductions or itemized deductions – interest paid on a home mortgage, state & local taxes, charitable contributions, certain portion of medical expenses

27. Tax return – • Federal tax return shows – • state & local tax return show similar but less detailed information • if too much tax withheld – receive a refund for overpayment • if not enough withheld – then owe a payment to the IRS or state or local revenue dept.

28. Example: Indexing • The level of income that causes someone to pay a higher rate of taxis the dividing point between tax brackets • the tax bracket is IDed by the tax rate for that income span • 2006 tax schedule – see p. 422 • ex – Scot has taxable income of $7,000 – in 10% tax bracket & pays 10% or $700 • if earned $8,000 of taxable income – would be in 15% tax bracket – would pay 10% on first $7,550 of earnings – then 15% on remaining $450 • total would be $822.50 – or 10.3% of income

29. Example: Indexing • Indexing is • ex- Scott’s income increases to $8,320 – 4% increase – due to inflation • w/o indexing - $770 of income is taxed at 15% and pays $870.50 or 10.5% • w/indexing – beginning level of 15% bracket is adjusted by 4% to $7,852 so he still pays 10.3% of income in taxes • Indexing combats the

30. FICA: Taxes to Ease Hardships -FICA – also known as social insurance – encompasses Social Security & Medicare both employers & employees make contribution

31. -SOCIAL SECURITY- -MEDICARE- • Is a • began during the Great Depression of the 1930s • employer & employee each pay 6.2 % of employee’s income up to an annual max • limit generally rises each year • Is a • started in 1966 • employers & employees each pay 1.45% of employee income • no limit on amount of income subject to the tax for Medicare

32. -UNEMPLOYMENT TAXES- • Is a program • provides benefits for a certain period of time to employees who lose their jobs through no fault of their own • tax applies to first $7,000 earned by an employee and for most part is paid only by employers

33. Corporate Income and Other Taxes -govt. also uses corporate income, estate, gift, and excise taxes as well as customs duties and user fees to finance operations

34. Corporate Income Taxes • Corporate income tax is • 3rd largest sources of revenue • 1941-1968 – • corporate income tax receipts have increased in total dollars since mid-1900s, but have decreased relative to total federal income tax revenues and overall size of economy

35. Corporate Income Taxes • Only certain types of corporations are subject to corporate income tax • Corporations make up about 8% of all businesses that file tax returns • Tax rate for most is 35% of profits – most pay about 26% of profits in taxes • Corporations can deduct certain expenses from profits to reduce taxable income • Deductions for investments in buildings, equipment, and research & rules that benefit multinational corporations • Common criticism – • profits are taxed at corporate level and again at individual level • b/c shareholders pay taxes on income received in form of dividends or capital gains • Recent years –

38. Economic Pacesetter: Maya MacGuineas: Reforming the Tax System • Says current system is complicated, inefficient, unfair, & doesn’t raise funds to fund all programs • new system should be based on simplicity, efficiency, equity & responsible budgeting • says income tax should be simplified by ending most tax deduction and exemptions • Would make the system more equitable – taxpayers in higher marginal tax bracket gain greatest benefit • believes corporate tax should be phased out • supports environmental taxes, different approach to how estate tax is levied • restructuring of nation’s entitlement programs

39. Most revolutionary idea is about FICA taxes – should be replaced with progressive consumption tax • would be tied to spending rather than income – rates rising as spending levels rise • ex – spending between $0 - $20,000 – no tax • spending between $20,000 - $50,000 – taxed at 10% • spending between $50,000 - $175,000 – taxed at 15% then so on • would be simpler & fairer & provides tremendous incentives to save

40. Sec. 3: Federal Government Spending

41. Federal Expenditures • Programs & services federal govt. funds with revenues are divided into to categories: • Mandatory spending – spending that is required by current law • ex – • Discretionary spending – • ex- funding for highway construction or maintenance of national parks • govt. has required funding and cover everything else with what is left over

42. Type 1: Mandatory Spending • Makes up well over half of all federal spending • Entitlements – • Social Security & Medicare – • many not “means tested” – anyone who meets the eligibility requirements receives the benefits regardless of income level • for other programs – income level is part of the requirements

43. -SOCIAL SECURITY- • Takes largest amount of federal spending • Provides benefits to older retired workers, disabled workers with limited incomes & survivors of workers who have died • is financed through payroll tax • Workers must have worked a certain period of time before they are eligible to receive full benefits • with older population and more retired people – costs have increased

44. To help – govt. has raised the age of full retirement – the point at which a worker is eligible to receive max benefits • retirement benefits are not means tested • if retiree has additional income – benefits may be subject to withholdings • ex – 2006 – • if earn more –

45. -MEDICARE- -MEDICAID- • Induced in 1966 as additional old-age benefit under Social Security • Originally – provided hospital insurance for those over 65(funded by payroll taxes) & optional medical coverage for items such as doctor bills(funded by premiums paid by those choosing the coverage & general tax revenues) • b/c of increasing # of retirees & health care costs – costs have risen dramatically • Starting 2006 – • means testing added for all but lowest income group of senior citizens • some coverage added for prescription drugs • Is a joint federal-state medical insurance program for low-income people • federal govt. funds about 63% & states pay about 37% • recently – states tighten eligibility requirement to control costs

46. -OTHER MANDATORY SPENDING PROGRAMS • Variety of other mandatory spending programs that define eligibility requirements then funded based on an estimate of how many people must meet those requirement • Food Stamp program provides funds for 26 million low-income people to purchase food • Veterans’ benefits include health care coverage, disability payments for service-related illness or injury • also eligible for education assistance • govt. spends about $50 billion on veterans’ benefits • payments for federal portion of unemployment insurance part of this • Federal govt. pays its workers some retirement benefits • Federal employees hired after 1983 eligible for some Social Security retirement benefits

47. Type 2: Discretionary Spending • More than 1/3 of federal revenue is devoted to discretionary spending • Several categories: • interstate highway system & transportation programs (Amtrak) • natural resources and the environment – • education – • science, space, technology, and other research programs • justice administration, including enforcement agencies (FBI & federal court system)

48. Type 2: Discretionary Spending • Largest category – national defense – takes up 50% of total discretionary budget • includes large amount of nation’s military spending – • Not all of this is discretionary spending • some - homeland security (border protection and enforcement of immigration laws) falls into mandatory expenditure • certain military spending falls outside the basic federal budget – wars in Iraq & Afghan

49. The Federal Budget and Spending • Federal budget – • Fiscal year – • federal budget is prepared for a fiscal year • the fiscal year runs from Oct. 1 to Sept. 30 • President’s budget is prepared by the Office of Management and Budget (OMB) and takes into account estimated tax receipts and requests by all federal departments and agencies

50. Congress Acts on the Budget • Congressional Budget Office helps House and Senate develop guidelines for different appropriations • appropriations – • members of Congress often make deals to gain votes for appropriations they support • Congress votes of final budget and send to pres. for approval • if not approved by beginning of fiscal year –