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 simultaneously at 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 % 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 Tax rate
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 Income Tax Corporate Taxable Income $0-50,000 $50,001-75,000
$100, ,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%

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?