Muddy Points from Tuesday

1. Muddy Points from Tuesday • Basic definition of “standard of living” • The level of comfort and material goods enjoyed in everyday life by a community, class, or individual. • includes factors such as income, quality and availability of employment, class disparity, poverty rate, quality and affordability of housing, • Often use [real/inflation adjusted] gross domestic product (GDP) because most of the standard of living measures tend to rise or fall with real GDP.

2. Muddy Points from Tuesday • What order would you teach each concept in economics? • Scarcity  choice  outcomes (poverty around the world) • How do society’s choose • economic systems & broad social goals. • Market economy – how do markets work (demand/supply) • Market failure: • Price controls • Monopoly power – market structures • Externalities and public goods • Poverty – wealth activity and distribution of income • Economic growth – course summary

3. Muddy Points from Tuesday • Are the factors of production the same thing as: • Technical knowledge • Physical capital • Natural resources • Human capital? • Yes • Next two slides are taken from my introductory course

4. factors of productionavailable to produce goods & services More on Scarcity • Wants > Availability • or, • Unlimited wants > Limited resources

5. technology Create an environment that encourages the efficient development and use of these scarce resources: • institutionsof the economy: • property rights and rule of law • free and open markets Scarcity Is Not An Option! • Resources are scarce: • natural resources (land) • human resources (labor) • entrepreneurship • man-made resources (capital)

6. Muddy Points from Tuesday • “Voluntary Trade and Success in the Market” … what does this mean? • Voluntary trade: • free and open markets, with well defined and enforced property rights. • Success in the market: • Growth in GDP/capita  increasing average standard of living

7. Economics of Taxes

8. A Few Preliminaries . . . • …before discussing taxes from the PFL perspective

9. Government Expenditures (G) • Governments perform many tasks: • Define and enforce property rights • Provide rule of law • Ensure competitive markets • Provide public goods: • Infrastructure • National defense • Provide social services • Police, fire, emergency services • Provide social safety net • Medicaid

10. How Do We Pay for G? • Taxes (T) • Borrow (Treasury bonds) Government Expenditures (G) Borrow Tax Revenue (T)

11. Federal Government Taxes Total Federal Taxes (2011): ≈ $2,500,000,000,000 We are dealing with large numbers! How large are they?

12. How Much is a Trillion Dollars? • ½ inch think = $10,000

13. $1,000,000 • $1 million • $100,000,000 • $100 million

14. $1,000,000,000 • Billion $

15. 1,000,000,000,000 • $1 trillion

16. Government Spending:Big Numbers! • 1 million seconds ≈ 11.5 days • 1 billion seconds ≈ 32 years • 1 trillion seconds ≈ 32,000 years

17. In this world nothing is certain but death and taxes. • Benjamin Franklin, 1789

18. Financial Overview of U.S.Government • When Franklin made his famous statement • average American paid < 5% of income in taxes • Today, all taxes (federal, state, local): • personal income • corporate income • payroll • sales • property • 28 - 29% of GDP (income)

19. Total Government Taxes as % of GDP • Denmark 49% • Sweden 49% • Zimbabwe 49% • Brazil 39% • Germany 39% • Canada 33% • Australia 31% • S. Korea 28% • U.S. 28% • Japan 28% • S. Africa 27% • India 18% • China 17% • Chile 17% • Singapore 13% • Hong Kong 13%

20. Total Receipts of the Federal Government* 2011 * Economic Report of the President, 2012

21. Total Receipts of the Federal Government 2011

22. Other Federal Taxes • Payroll tax: • Tax on wages (employer pays same as employee) • FICA: Social Security: 6.20% (2013: up to $113.7K) Medicare: 1.45% (on all income) Total FICA 7.65% • Corporate income tax: tax on corporate profit • “double taxation” • Tax on corporate profit • Individual income tax on dividends (distribution of profit) • Excise tax: • Taxes on specific goods – gasoline, cigarettes, alcohol

23. Total Receipts of the State & Local Governments*2011 **$1,592 billion does not include the federal government grants * Economic Report of the President, 2012

24. The Fiscal Challenge • Longer life expectancy • Lower fertility •  Fewer workers paying taxes to support aging population . . . working age per > 65 year old: • 1940: 8.6 • 2000: 4.7 • Rising cost of Social Security and Medicare

25. U.S. Federal Spending & Revenues CBO (2002): A 125-Year Picture of the Federal Government’s Share of the Economy, 1950 – 2075.

26. Main Culprit: Health Care

27. The Fiscal Challenge • Longer life expectancy • Lower fertility •  Fewer workers paying taxes to support old • 1940: 8.6 • 2000: 4.7

28. Present Tax & Spending Policies Are Unsustainable • Solution? • Raise taxes and/or • Reduce promises

29. Yoram BaumanPh.D. EconomistUniversity of WashingtonA Little Humor . . . on the Fiscal Crisis

30. Regardless of What Form the Eventual Reforms Take … Our students will face greater responsibility for their own retirement!

31. Before continuing with taxes, an important footnote . . . Another key concept in the economic way of thinking …

32. MB(X) MC(X) Example: College Decision • You are considering: • college or no college? • B(X)? (X = go to college) • higher lifetime earnings • greater fulfillment • addedfun in college • C(X)? • Books and fees • Tuition • Foregone earnings • Room and board • Ignore this sunk cost!

33. Total Benefit (B) go to college Earnings w/ college degree suppose $50,000 per yr. Total Benefit (B) not go to college Earnings: HS diploma suppose $30,000 per yr. College Decision: Benefit Side What is the relevant benefit to weigh against the cost of college? Added benefit of college = “Marginal benefit” = MB(X) MB(X) = $20,000 Ignore the “Sunk benefit” = $30,000

34. Total Cost (C) go to college Books and fees Tuition Foregone earnings Housing Food All other life costs Total Cost (C) not go to college Housing Food All other life costs MC of choice These costs do not vary with decision -- thus, “sunk costs” College Decision: Cost Side

35. Some Practice Problems

36. Cinema & Get Money’s Worth? • Suppose the movie is making both of you sick. You say, “Let’s go.” • Friend says, “We’ve got to get our money’s worth!” • TC (exit)TC (stay) $8.00$8.00 MC of time Thus, likely that MC > MB, exit the theatre Don’t throw good money [or time] after bad!

37. Drive for Discount? • Alarm clock: $20 local store • On sale for $10 across town • Refrigerator: $2510 local store • On sale for $2,500 across town • Typical consumer? • Drive across town for 50% discount, • Do not drive across town for half-percent discount • Economic perspective of marginalism? • MB in both cases is: $10 • MC in both cases is: time & gas • Since MB & MC in both cases is the same, decision should be same!

38. Key Concept: Economic Way of Thinking • Rational people think at the margin. • “marginalism” • If MB > MC, do it • If MC > MB, not do it

39. How Does This Relate to Taxes? • Common failure: not understand the distinction between: • Average tax rate • Marginal tax rate • Average tax rate: • Marginal tax rate:

40. Example • Government tax: • 20% of first $50,000 income • 50% of all income > $50,000 • Consider person who makes $60,000: • (0.20) $50,000 + (0.50) $10,000 = $15,000 • Average tax rate? $15/$60 = 25% • Marginal tax rate: $5/$10 = 50%

41. Example • Government tax: • 20% of first $50,000 income • 50% of all income > $50,000 • Consider person who makes $50,000: • (0.20) $50,000 = $10,000 • “I’m considering earning another $1,000, • but, I don’t want to because I will move into higher bracket and actually make less net income.” • Net income when earning $50K = $40,000 • Net income when earning $51K? = $40,500

42. Which Measure Would You Use . . . • . . . if you wanted to gauge: • the sacrifice made by a taxpayer? • Average tax rate: measures the fraction of income paid in taxes • how much tax system distorts incentives? • Marginal tax rate measures how much taxes discourage people from working

43. 1926 1936 1946 1956 1966 1976 1986 1996 2006 Comparison of Highest & Lowest Marginal Tax Rates1926–2012 100% marginal tax rate •Highest rate •Lowest rate > 90% 80 60 40 35% 22% 20 10% 0

44. Overview of the Tax System • Taxes paid (T) = Tax Rate (t) x Tax Base (B) = tB • e.g., if t = 8% & B = P paid for something (B = $100) • T = tB = 0.08($100) = $8.00 • Taxes can differ: B, t, & how t changes with B Base (B) • Tax rate, t, is applied to some base • e.g., income, property value, purchase price • where taxes paid = T = t(B) Structure • Specifies how the tax depends on the base

45. Base of Important Taxes • Tax . • Income tax • Payroll tax • Sales tax (excise tax) • Profits tax (corporate tax) • Property tax • Wealth tax Tax Base • Income of an individual or family from wages and investments • e • Earnings an employer pays to an employee • Value of the goods sold • Corporate profit • Value of property (e.g., home value) • Individual’s wealth

46. Tax Structure:How Tax Depends on Base • Proportional (or flat) tax • Same % of base regardless of income or value • e.g., 15% tax whether $1M or $50K income • Progressive tax • Rises more than in proportion to income • High-income taxpayers pay larger % of income in tax • Regressive tax • Rises less than in proportion to income • High-income taxpayers pay smaller % of income in tax

47. Tax Principles • Benefits Principle: • Pay taxes based on benefits received • similar to private goods • Examples: • Gasoline tax used to pay road maintenance (use charge) • drive more, benefit more from roads, pay more tax • Wealthy have more to protect • benefit more from tax policy, pay more tax (progressive?)

48. Tax Principles • Ability-to-Pay Principle: • Pay taxes based on how well can shoulder burden • “equal sacrifice” • Corollary 1: • Vertical equity: • greater ability to pay  pay more • but how much more?

49. How Much More Should the Rich Pay? • Consider three different tax systems: In all three systems: higher income person pays more taxes Which most fair? No obvious answer: Like beauty – in the eye of the beholder!

50. Tax Burden Distribution • Policy debate focused on: • Do the wealthy pay their fair share? • No objective way to make the judgment • but, might be useful to know how much families with different incomes currently pay