1. 17 CHAPTER D YNAMIC P OWER P OINT ™ S LIDES BY S OLINA L INDAHL The Federal Budget: Taxes and Spending

2. CHAPTER OUTLINE Tax Revenues Spending Will the U.S. Government Go Bankrupt? Revenues and Spending Undercount the Role of Government in the Economy For applications, click herehere To Video To Video

3. Some good blogs and other sites to get the juices flowing: Food for Thought….

4. B ACK TO Introduction The federal government spends over 18% of GDP. Taxes collected are just under 17%. In this chapter we will answer the following questions: Where does all that money come from? Where does it go? How long can the government keep spending more than it raises in taxes?

5. B ACK TO Tax Revenues Sources of Government Revenue (2010)

6. B ACK TO Tax Revenues The Individual Income Tax Marginal tax rate Marginal tax rate: the tax rate paid on an extra dollar of income. Example: If the marginal tax rate is 10%, tax owed on an additional $100 will be (.10) x $100 = $10. Marginal tax rate: important (it affects incentives).

7. B ACK TO Tax Revenues U.S. Marginal and Average Tax Rates (2010)

8. B ACK TO Tax Revenues The Individual Income Tax Average tax rate Average tax rate: total tax payment divided by total income. Example: If income is $50,000 and tax owed is $7,500, the average tax rate is… Marginal tax rates are set by government (the average tax rate is calculated after tax owed is known).

9. In the simple land of Rabushka, there is only one tax rate, 20 percent, but workers don't have to pay tax on the first $10,000 of their income. For every dollar they earn above $10,000, they pay 20 cents on the dollar to the Lord High Mayor of Rabushka. What is the average income tax rate in Rabushka if a worker's income is $1,000,000? a)20% b)19.8% c)22% d)16%

10. B ACK TO Tax Revenues The Individual Income Tax Exemptions and Deductions: not all income is taxed. Exemptions : reduce taxable income Spouse, Dependents Each exemption reduces taxable income by $3,650. Deductions : also reduce taxable income. Apply only to specific expenses. Example: mortgage interest The Mortgage Interest Deduction: encouraging home buying since 1913

11. B ACK TO Tax Revenues Taxes on Capital Gains, Interest, and Dividends All of these are taxes on investment income. Dividends —stockholders’ share of the profits. Marginal Tax Rate = 15% for most people. Marginal Tax Rate = 5% for low income people. Capital Gains —the difference between the price an asset was purchased at and its selling price. Marginal Tax Rate = 15%. Capital losses can offset income from capital gains.

12. B ACK TO Tax Revenues Taxes on Capital Gains, Interest, and Dividends Political debate about how investment income should be taxed. Democrats —favor higher tax rates. Why?: Rich people (who invest more than the poor) should bear a higher share of the burden. Republicans —favor lower tax rates. Why?: Lower taxes provide incentive to invest and create economic growth. The Capital Gains Tax: an appropriate tax on lazy fatcats? Or stifling the engine of growth?

13. B ACK TO Tax Revenues The Alternative Minimum Tax (AMT) Designed in 1969 to make it impossible to avoid all income tax. Requires taxpayers to do two calculations: Compute taxed owed under standard tax code. Compute what they owe based on a flat rate of 26% or 28% with no deductions. Pay the higher of the two. Because the AMT is not adjusted for inflation, more people pay than originally intended.

14. B ACK TO Tax Revenues Social Security and Medicare Taxes FICA (Federal Insurance Contributions Act) Payroll tax. Employees pay 6.2% on earnings up to $106,800. Employers pay 6.2% on the same earnings. The larger share of the burden is on workers because… employers are able to shift some of the tax back on workers by paying lower wages. Chile (1981): privatization of social security-employers no longer had to pay payroll taxes for their employees. Result? Wages rose.

15. B ACK TO Tax Revenues Social Security and Medicare Taxes Medicare taxes —special payroll tax to finance Medicare. 1.45% deducted from workers’ paychecks. 1.45% deducted paid by employers. Again, workers pay much of the employers’ premium in the form of lower wages.

16. B ACK TO Tax Revenues The Corporate Income Tax 35% in the U.S.—one of the highest in the world. Tax code lets a good accountant reduce the legal measure of income. Example: Boeing—a large and profitable airplane manufacturer. Over a recent period of 5 years paid an average tax rate of 0.7%. Who pays the corporate income tax? Shareholders and bondholders Workers (in the form of lower wages) Consumers (in the form of higher prices)

17. B ACK TO Tax Revenues The Bottom Line on the Distribution of Federal Taxes Note: Includes all deductions, exemptions, corporate taxes, payroll taxes, excise taxes, AMT, and assumptions about incidence.

18. B ACK TO Tax Burden: Who Pays What?

19. B ACK TO Tax Revenues The Bottom Line on the Distribution of Federal Taxes Conclusion: Overall, the U.S. tax code is progressive Progressive tax rates Progressive tax rates are higher on people with higher incomes. Effective tax rate ranges from 4.1% - 31.2% Flat tax: Flat tax: constant average tax rate on all income levels. Regressive tax: Regressive tax: higher average tax rate on people with lower incomes.

20. B ACK TO SEE THE INVISIBLE HAND What are the political chances for a flat tax? Eliminating the mortgage deduction would result in lower house prices and other side effects… … What do you think?

21. B ACK TO Tax Revenues State and Local Taxes Overall: smaller burden (half the level of federal taxes) States raise more of their revenues from sales taxes. Less progressive than the federal income tax.

22. B ACK TO Spending Where does our tax money go?

23. B ACK TO Spending Social Security At $721.5 billion in 2010—the single largest government program in the world. Run on a “pay as you go” basis Current contributions pay for benefits of current retirees. No one has a social security account in their name. Ida May Fuller, receiving the first ever Social Security check in 1940: She paid lived to age 100, paid $24.75 in Social Security Taxes and received $22,888.92 in benefits.

24. B ACK TO Net Benefits of Social Security (Single male assuming various retirement years and average wages)

25. B ACK TO Spending Social Security Some people advocate raising the full retirement age. Net benefits are declining over time. Higher taxes on today’s workers funds larger benefits for yesterday’s workers. President Franklin D. Roosevelt, signing the Social Security Bill into law.

26. B ACK TO Spending Defense 2010—Spending on defense was $719,200,000,000 ($719.2 billion.) Excludes most spending on the wars in Iraq and Afghanistan. The U.S. spends more on its military than any other country.

27. B ACK TO Top Ten Countries by Military Expenditure (Billions of U.S. Dollars)

28. B ACK TO Spending Medicare and Medicaid Medicare —reimburses the elderly for medical spending. With Social Security, amounts to the largest federal spending program. Medicaid —Covers the poor and the disabled. Paid for jointly by federal and state governments. Expenditures are half that of Medicare.

29. B ACK TO Spending Unemployment Insurance and Welfare Common myth : most money spent by the federal government goes to welfare programs. Truth? Welfare is 9% of federal budget. Two important categories of welfare: Temporary Assistance for Needy Families (TANF): Assistance for poor households with children. Benefits are limited to 5 years in a lifetime. Housing vouchers are given to subsidize a portion of rent. Earned Income Tax Credit (EITC): is a direct cash payment based on income.

30. B ACK TO Spending Everything else No other programs are large compared to Medicare, Social Security and defense spending. Earmarks have received a lot of attention. When a congressman puts an expenditure for his/her district into a broader bill. While often wasteful, cutting them out will not save enough to fund significant new spending programs.

31. B ACK TO Spending National Debt, Interest on the National Debt, and Deficits National Debt held by the public National Debt held by the public : All federal debt held outside the United States government. As of 2011 equaled around $13.5 trillion. Debt-to-GDP Ratio = over 60% May be high for an individual but not necessarily for the U.S. government. Debt-to-GDP ratio has been much higher in the past.

32. B ACK TO Spending National Debt, Interest on the National Debt, and Deficits

33. B ACK TO Spending National Debt, Interest on the National Debt, and Deficits Interest on the national debt Payment of interest to bond holders in 2007 was $244 billion. Does it matter if a large amount of the debt is owed to foreigners? From a purely economic point of view the answer is no. What matters is how the borrowed dollars are spent.

34. B ACK TO Spending National Debt, Interest on the National Debt, and Deficits Deficit : Deficit : the annual difference between federal spending and revenues. The deficit is… The difference between revenues and spending. The annual change in the national debt.

35. B ACK TO U.S. Spending, Revenues and Deficit

36. B ACK TO Will the U.S. Government Go Bankrupt? The Congressional Budget Office (CBO): “under any plausible scenario, the federal budget is on an unsustainable path…” Main forces driving the projections Demographics The population is aging resulting in... Higher Social Security and Medicare payments. Rising health costs per person Rising more than twice as fast as GDP per capita.

37. B ACK TO Will the U.S. Government Go Bankrupt? ActualProjected 0 100 200 300 400 Debt to GDP Ratio (%) 19601970198019902000201020202030204020502060 Source: Congressional Budget Office, Long Term Budget Outlook 2007 The Debt to GDP Ratio is Projected to Soar Given Current Spending and Tax Trends

38. If the generation of new ideas has caused the Solow curve to shift to the right (with no other changes) then the debt-to-GDP ratio would a)increase. b)remain constant. c)decrease. d)be impossible to calculate.

39. B ACK TO Spending and Revenue Projections by Category as a Percentage of GDP

40. B ACK TO Will the U.S. Government Go Bankrupt? The Future is Hard to Predict The U.S. has a history of relatively low taxes. The American Revolution was in part about taxes in spite of one of the lowest tax burdens in the world. The income tax is fairly new: began in 1913. Taxes and federal spending increased dramatically during WWI and WWII. Since then, as a percent of GDP they have remained fairly stable around 18%.

41. Take a look….. How will raising the debt ceiling impact U.S. bond markets? Via PBS’s “Making Sen$e” series, Paul Solman gives a balanced overview with clips, interviews and analysis. (7:51 minutes) B ACK TO http://www.youtube.com/watch?v=wNv__bi-AVw

42. B ACK TO Will the U.S. Government Go Bankrupt? 57.3 56.3 53.4 50.7 50.6 49.3 48.6 48.5 46.8 43.9 41.1 38.6 38.2 36.5 36.2 35.5 34.2 0204060 Sweden Denmark France Finland Austria Belgium Netherlands Italy Germany United Kingdom Canada Spain Japan United States Australia Switzerland Ireland Total government spending includes spending by federal, state and local governments. Source: OECD in Figures, 2005 Total Government Spending (as a Percentage of GDP) U.S. government spends a lower fraction of GDP than most other developed countries.

43. B ACK TO Will the U.S. Government Go Bankrupt? So what will happen: will spending be cut or will taxes be raised? No one knows. Spending could increase substantially and U.S. spending would be on par with German, Italy, and the Netherlands today. Cutting total spending substantially will require cuts in Social Security benefits. This will be politically difficult. Other countries spend a smaller fraction of GDP on health care but… The growth in health care costs is similar throughout the world.

44. B ACK TO Revenues and Spending Undercount the Role of Government in the Economy The government’s influence on resources goes beyond simple budget measurements…. The EPA has a small-ish budget but a large amount of regulatory influence over the economy’s resources. And when the military is filled by draft, the opportunity cost to society is larger than with a volunteer army.

45. Which of the following statements about the Social Security program is correct? a)The earlier you retire, the greater the benefits you receive from the Social Security system. b)Your Social Security withholdings from your paychecks are deposited into an account for you. c)On average, retirees in the United States receive about $8,000 per month in Social Security payments. d)Women, who generally live longer than men, benefit more from the system.

46. The annual difference between federal spending and revenues is called: a)a deficit. b)the debt held by the public. c)the national debt. d)the debt to GDP ratio. B ACK TO