Chapter 6 Funding the Public Sector

1. Chapter 6Funding the Public Sector

2. Introduction During the past few years, federal government spending has increased at the same time that revenues collected from taxes and other sources have declined. To cover its expenditures, the federal government has resorted to borrowing. As you will learn in this chapter, however, the government budget constraint indicates that ultimately spending and revenues must be equalized.

3. Learning Objectives • Distinguish between average tax rates and marginal tax rates • Explain the structure of the U.S. income tax system • Understand the key factors influencing the relationship between tax rates and the tax revenues governments collect

4. Learning Objectives (cont'd) • Explain how the taxes governments levy on purchases of goods and services affect market prices and equilibrium quantities

5. Chapter Outline • Paying for the Public Sector • Systems of Taxation • The Most Important Federal Taxes • Tax Rates and Tax Revenues • Taxation from the Point of View of Producers and Consumers

6. Did You Know That ... • More than a dozen U.S. states have sold bonds promising annual payments based on projected revenues from a legal settlement with the tobacco industry? • To obtain the funds required to finance their operations, state and local governments collect taxes from many different sources such as property tax, sales tax, income tax, and hotel occupancy tax. • At the federal level, there are Social Security taxes, Medicare taxes, and income taxes.

7. Paying for the Public Sector • Three sources of government funding • Fees for government services, or user charges • Taxes • Borrowing

8. Paying for the Public Sector (cont'd) • Government Budget Constraint • The limit on government spending and transfer payments • Imposed by the fact that every dollar spent must be provided for by taxes

9. Example: State Tuition Rates Jump – Even at the Last Moment • To continue operations with limited budgets during the recession of the late 2000s, more than half of the states have cut spending on higher education. • In turn, state universities have responded by raising tuition. • At a number of state universities, tuition rates have increased as late as the final course registration date.

10. Systems of Taxation • Tax Base • The value of goods, services, wealth, or incomes subject to taxation • Tax Rate • The proportion of a tax base that must be paid to a government as taxes

11. Policy Example: Is It Time to Replace Gasoline Taxes with Mileage Taxes? • Taxes on gasoline are a major source of funds for road construction and repair. • Yet, with more battery-powered vehicles on the road, the gasoline tax base has been shrinking. • The Congressional Budget Office has suggested using a mileage tax base. • Vehicle owners would be taxed based on the number of miles driven, as recorded by a mileage meter on the vehicle.

12. Systems of Taxation (cont'd) change in taxes due change in taxable income Marginal tax rate = • Marginal Tax Rate • The change in the tax payment divided by the change in income

13. Systems of Taxation (cont'd) • Tax Bracket • A specified interval of income to which a specific and unique marginal tax rate is applied • Average Tax Rate • The total tax payment divided by total income

14. Systems of Taxation (cont'd) • Proportional Taxation • A tax system in which, regardless of an individual’s income, the tax bill comprises exactly the same proportion • Taxpayers at all income levels pay the same percentage of their income in taxes

15. Systems of Taxation (cont'd) Proportional taxation Marginal tax rate = Average tax rate IncomeTax RateTaxes $10,000 20% $2,000 $100,000 20% $20,000

16. Systems of Taxation (cont'd) • Progressive Taxation • A tax system in which, as income increases, a higher percentage of the additional income is paid as taxes

17. Systems of Taxation (cont'd) Progressive taxation Marginal tax rate > Average tax rate IncomeTax RateTaxes $0–$10,000 5% $500 $10,001–$20,000 10% $1,000 $20,001–$30,000 30% $3,000

18. Policy Example: Calculating the Top U.S. Marginal Tax Rate • In the progressive tax system of the federal government and most states, the highest income earners pay the highest overall tax rates. • The highest U.S. income earners are able to keep for their own use just over half of the last dollar they earn.

19. Systems of Taxation (cont'd) • Regressive Taxation • A tax system in which as more dollars are earned, the percentage of tax paid on them falls • A smaller percentage of income is taken in taxes as income increases

20. Systems of Taxation (cont'd) Regressive taxation: Social Security* Marginal tax rate < Average tax rate IncomeTax RateTaxes $100,000 10% $10,000 $200,000 5% $10,000 * No social security tax after $100,000 in income

21. The Most Important Federal Taxes • Question • What types of taxes do federal, state and local governments collect? • Answers • Federal government: individual income taxes, corporate income taxes, Social Security taxes, import and excise taxes • State and local governments: sales taxes, property taxes, personal and corporate income taxes

22. Figure 6-1 Sources of Government Tax Receipts Source: Economic Report of the President, Economic Indicators

23. The Most Important Federal Taxes • The federal personal income tax • Accounts for almost 44% of all federal revenue • All U.S. citizens, resident aliens, and most others required to pay (includes income earned abroad) • Rates paid rise as income increases

24. Table 6-1 Federal Marginal Income Tax Rates

25. The Most Important Federal Taxes (cont'd) • Arguments for the progressive tax • Redistribution of income • Ability to pay • Benefits received • Counterargument • No strong evidence of redistribution

26. Policy Example: Figuring Out How Much to Pay In Income Taxes Is Not Cheap • The Internal Revenue Service has estimated that U.S. taxpayers spend nearly $200 billion per year to determine how much they owe in income taxes. • In addition, taxpayers devote 7.6 billion hours to this process. • Using an opportunity cost of $16 per hour, this amounts to a total cost of roughly $325 billion per year.

27. The Most Important Federal Taxes (cont'd) • Capital Gain • The positive difference between the purchase price and the sale price of an asset • You buy a share of stock for $5 and sell for $15: you have a capital gain of $10 • Capital Loss • The negative difference between the purchase price and the sale price of an asset

28. The Most Important Federal Taxes (cont'd) • The corporate income tax • Accounts for 12% of federal tax revenue and 2% of all state and local taxes collected • Corporations are generally taxed on the difference between total revenues and expenses

29. Table 6-2 Federal Corporate Income Tax Schedule

30. The Most Important Federal Taxes (cont'd) • Double taxation • Corporation pays taxes on its profits • Corporation declares a dividend on after-tax profits • Dividend income is taxed

31. The Most Important Federal Taxes (cont'd) • Retained Earnings • Earnings that a corporation saves, or retains, for investment in other productive activities • Earnings that are not distributed to stockholders • Tax Incidence • The distribution of tax burdens among various groups in society

32. The Most Important Federal Taxes (cont'd) • Who really pays the corporate income tax? • Tax incidence is distributed among • Consumers • Stockholders • Employees

33. The Most Important Federal Taxes (cont'd) • Social Security taxes • Social Security rates today are imposed on earnings up to roughly $106,800 • Contributions are 6.2% for employers and 6.2% for employees

34. The Most Important Federal Taxes (cont'd) • Unemployment taxes • Paid by employer • 0.8% of first $7,000 of wages for employees earning more than $1,500 • States may levy an additional tax up to 3% based on record of the employer

35. Tax Rates and Tax Revenues • State and local governments • Taxes imposed on goods and services yield more revenues than income taxes • A fundamental issue is how to set tax rates to extract the largest possible payments

36. Tax Rates and Tax Revenues (cont'd) • Sales Taxes • Taxes assessed on the prices paid on a large set of goods and services • Ad Valorem Taxation • Assessing taxes by charging a tax rate equal to a fraction of the market price of each unit purchased

37. Policy Example: States Seek to Apply Sales Taxes to Internet Retailers’ Sales • In an attempt to increase tax revenues, some states have targeted Internet retailers who are linked to other sellers, known as affiliates, who have a physical presence within the state. • Whenever state governments have tried to tax these retailers, the affiliate programs have been eliminated. • Thus, these states have not succeeded in expanding their sales tax base.

38. Tax Rates and Tax Revenues (cont'd) • Static Tax Analysis • Based on the assumption that changes in the tax rate leave the tax base unaffected • Dynamic Tax Analysis • Recognizes that higher tax rates may shrink the tax base

39. What If . . . The government seeks to collect higher taxes by increasing capital gains tax rates? • When people learn about upcoming increases in the capital gains tax rate, they can attempt to sell their assets immediately. • Alternatively, asset sales can be postponed if the tax rate is expected to fall. • Indeed, there is considerable evidence of an inverse relationship between capital gains tax rates and realized capital gains.

40. Tax Rates and Tax Revenues (cont'd) • If the disincentive effects of higher tax rates are small, static analysis may give a fairly accurate estimate of the change in tax revenues resulting from a tax rate change • As tax rates escalate, members of the public have a greater incentive to remove their activities from the tax base; a dynamic analysis would be necessary to determine the overall effect on government revenues

41. Figure 6-2 States with the Highest and Lowest Sales Tax Rates

42. Tax Rates and Tax Revenues (cont'd) • Maximizing tax revenues • Dynamic tax analysis predicts ever-higher tax rates bring about declines in the tax base • At sufficiently high rates the government’s tax revenues begin to fall off

43. Figure 6-3 Maximizing the Government’s Sales Tax Revenues

44. Taxation from the Point of View of Producers and Consumers • Excise Tax • A tax levied on purchases of a particular good or service • Unit Tax • A constant tax assessed on each unit of a good that consumers purchase

45. Taxation from the Point of View of Producers and Consumers (cont'd) • Excise taxes on gasoline become added costs of production • This shifts the supply curve up by the amount of the unit tax • Consequently, the equilibrium price of gasoline rises and the equilibrium quantity declines

46. Figure 6-4 The Effects of Excise Taxes on the Market Supply and Equilibrium Price and Quantity of Gasoline

47. Taxation from the Point of View of Producers and Consumers (cont'd) • Who Pays the Tax? • In our example, the price that each consumer pays is $0.30 per gallon higher • Therefore, consumers pay three-fourths of the excise tax and producers absorb the remainder

48. You Are There: How to Keep Social Security in Business • Nancy Altman is co-director of Social Security Works, a group dedicated to preserving the Social Security programs that provide benefits to the elderly and disabled. • Altman proposes two ways of preserving both programs: • 1) Combine both programs, so that tax dollars originally intended to provide benefits for the elderly would be diverted to disability benefits • 2) Increase the Social Security tax rate

49. Issues & Applications: What Determines the U.S. Long-Run Average Tax Rate? • Figure 6-5 on the next slide displays the average U.S. federal tax rate for each year since 1934. • Since the early 1950s, this overall average tax rate has ranged between 15 and 21 percent. • The greater instability of the average individual income tax rate reflects both changes in marginal tax rates and variations in the amount of income subject to taxation. • The current ratio of federal spending to national income of about 24 percent is well above the overall tax rate of 15 percent.

50. Figure 6-5 The Overall Average Federal Tax Rate and Its Components and Federal Spending as a Percentage of National Income