1. Chapter 7 The Government Sector 7-1 Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Objectives Government spending The graphing of the C + I + G line Types of taxes The average and marginal tax rates Sources of government revenue Principles of taxation The economic role of government 7-2 Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

3. Introduction: The Growing Economic Role of Government Most of the growth over the past seven decades was due to the Depression and World War II Since 1945 the roles of government at the federal, state, and local levels have expanded –The seeds of that expansion were sown during the Roosevelt administration The government exerts four basic influences –It spends more than $3.0 trillion –It levies even more in taxes –It redistributes hundreds of billions of dollars –It regulates the economy 7-3 Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

4. 7-4 Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

5. 7-5 State and Local Government Spending Main expenditures –Education –Health –Welfare Spending is a little more than half the level of federal spending Police protection and prisons are now straining state and local budgets Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

6. Government Purchases versus Transfer Payments The federal, state, and local governments spends over $3.0 trillion a year –GDP = C + I + G + X n –Approximately half are “transfer payments” The largest transfer payment is social security These payments end up in the “C” part GDP –Approximately half are “government purchases” The largest government purchase is defense These end up in the “G” part of GDP 7-6 Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

7. Graphing the C + I + G + X n Line 7-7 Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved. To keep the graph as simple as possible, we are assuming the government spends a constant amount of money regardless of the level of disposable income

8. Graphing the C + I + G + X n Line 7-8 Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved. How much is G? Answer: 400

9. The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-9 This is a hypothetical illustration Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

10. The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-10 This is a hypothetical illustration 0 - $100 0 % 0 $ 0 0.0 % Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

11. The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-11 This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 % $101 - $200 $10 Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

12. The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-12 This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 % $101 - $200 $10 Additional Taxes Paid ( $10) MTR = -------------------------------- ---------- Additional Taxable Income ($100) Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

13. The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-13 This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 % $101 - $200 10 % $10 Additional Taxes Paid ( $10) MTR = -------------------------------- ---------- Additional Taxable Income ($100) Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

14. The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-14 This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 % $101 - $200 10 % $10 Additional Taxes Paid ( $10) MTR = -------------------------------- ---------- Additional Taxable Income ($100) The Marginal Tax Rate (MTR) is the rate you pay on the last dollars you earned Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

15. The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-15 This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 % $101 - $200 10 % $10 $10 Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

16. The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-16 This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 % $101 - $200 10 % $10 $10 Total Taxes Paid ( $10) ATR = -------------------------------- ---------- Entire Income ($200) Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

17. The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-17 This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 % $101 - $200 10 % $10 $10 5.0 % Total Taxes Paid ( $10) ATR = -------------------------------- ---------- Entire Income ($200) Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

18. The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-18 This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 % $101 - $200 10 % $10 $10 5.0 % Total Taxes Paid ( $10) ATR = -------------------------------- ---------- Entire Income ($200) Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

19. The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-19 This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 % $101 - $200 10 % $10 $10 5.0 % Total Taxes Paid ( $10) ATR = -------------------------------- ---------- Entire Income ($200) The Average Tax Rate (ATR) is the overall rate you pay on your entire income Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

20. The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-20 This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 % $101 - $200 10 % $10 $10 5.0 % $201 - $300 12 % $12 $22 7.3 % Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

21. The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-21 This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 % $101 - $200 10 % $10 $10 5.0 % $201 - $300 12 % $12 $22 7.3 % $301 - $400 15 % $15 $37 9.3 % Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

22. The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-22 This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 % $101 - $200 10 % $10 $10 5.0 % $201 - $300 12 % $12 $22 7.3 % $301 - $400 15 % $15 $37 9.3 % $401 - $500 28 % $28 $65 13.0 % Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

23. The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-23 This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 % $101 - $200 10 % $10 $10 5.0 % $201 - $300 12 % $12 $22 7.3 % $301 - $400 15 % $15 $37 9.3 % $401 - $500 28 % $28 $65 13.0 % $501 - $600 50 % $50 $115 19.2 % Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

24. The Average Tax Rate and the Marginal Tax Rate Income Marginal Total Average Level Tax Rate Tax Taxes Tax Rate 7-24 This is a hypothetical illustration 0 - $100 0 % $ 0 $ 0 0.0 % $101 - $200 10 % $10 $10 5.0 % $201 - $300 12 % $12 $22 7.3 % $301 - $400 15 % $15 $37 9.3 % $401 - $500 28 % $28 $65 13.0 % $501 - $600 50 % $50 $115 19.2 % > $600 80 % Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

25. Types of Taxes Direct tax –A tax with your name on it Indirect tax –A tax on things 7-25 Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

26. Types of Taxes Progressive taxes –Places a greater burden on those best able to pay and little or no burden on the poor Proportional taxes –Places an equal burden on the rich, the middle class, and the poor Regressive taxes –Places a heavier burden on the poor than on the rich 7-26 Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

27. Nominally Progressive, Proportional, and Regressive Taxes Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved. 7-27

28. 7-28 Sources of Federal Revenue Personal Income Tax –The personal income tax is the largest source of federal revenue –Accounts for 44 percent of all federal tax revenue –Low income people pay little or no federal income tax Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

29. 7-29 Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved. Federal Personal Income Tax:The Top Marginal Tax Rate, 1954-2003

30. 7-30 Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved. Top Marginal Tax Rates

31. 7-31 Sources of Federal Revenue The Social Security and Medicare taxes are the Payroll Tax What you pay is matched by your employer The social security tax by law is set at 6.2% with a wage based limitation of $87,000 The inflation rate of the previous year raises the wage base The Medicare tax of 1.45% applies to wages and salaries only. Income such as rental income, interest, dividends, and profit is exempt Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

32. 7-32 Sources of Federal Revenue You pay 6.2% in payroll tax on wages up to $87,000 and 1.45% on all wages and salaries The Payroll Tax is the fastest growing source of federal revenue Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

33. 7-33 Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved. Level of Earned Income Taxes Paid Average Tax Rate $ 10,000 $ 620.00 6.2% 87,000 5,394.00 6.2% 100,000 5,394.00 5.4% 1,000,000 5,394.00 0.54% The Incidence of the Social Security Tax at Various Income Levels Note: The current social security tax by law is set at 6.2% with a wage based limitation of $87,000

34. The Corporate Income Tax The corporate income tax is a tax on a corporation’s profits –The maximum rate is 35% All corporations earning profits of at least $335,000 pay an average tax rate of 35% –Loopholes in the tax law allow many corporations to pay much lower taxes 7-34 Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

35. Excise Taxes An excise tax is a sales tax aimed at specific goods and services Accounts for about 4 percent of federal revenue Most excise taxes are levied by the federal government –State and local governments often levy taxes on the same items 7-35 Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

36. Excise Taxes Excise taxes tend to reduce consumption of certain products of which the federal government takes a dim view Excise taxes are usually regressive 7-36 Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

37. The Estate Tax The estate tax is a tax on the estates of people when they die –It is a graduated tax that rises to 55% It is levied only on estates valued at $675,000 or more –More than 90% of estate taxes are paid by people with incomes above $200,000 a year 7-37 Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

38. 7-38 Sources of State and Local Tax Revenue Personal income tax –Accounts for about half of all state revenue Sales Tax –Is a source of almost half of all taxes collected by the states –Is a highly regressive tax Property taxes –Provides 80 percent of all local tax revenue –Can influence business decisions about where to locate Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

39. The State and Local Fiscal Dilemma Since World War II, state and local governments have been expected to provide an increasing number of services –Most notable are health, welfare, education, police protection and prisons In 2003 states increased tuition at public colleges, cut Medicaid eligibility and benefits, and laid off state employees –In addition localities spent billions of dollars on new security measures without receiving any federal assistance Unfunded mandates –The Federal government often places obligations on states without providing the money to pay for them 7-39 Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

40. Neighboring states and local governments are in direct competition with one another for tax dollars –If one government’s tax rates rise too far above the levels of its neighbors, it citizens will vote with their feet The 1998 Internet Tax Freedom Act declared a three-year moratorium for online sales 7-40 The State and Local Fiscal Dilemma Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

41. 7-41 Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved. Government Tax Rates as a Percentage of GDP, 1929 and 2003 Economic Report of the President, 2003 Tax Rates are almost three times as high as they were in 1929

42. 7-42 Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved. Tax Receipts as a Percentage of GDP in the United States and Selected Western European Countries, 1999 Organization for Economic Cooperation and Development

43. Economic Role of Government 7-43 Provision of Public Goods and Services Redistribution of Income Stabilization Economic Regulation Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

44. Provision of Public Goods and Services Some examples –Defense of the country –Maintenance of internal order –A nationwide highway network –Provision of a money supply –Public education –Running the criminal justice system –Environmental protection 7-44 Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

45. Redistribution of Income The government does redistribute hundreds of billions of dollars every year –Social security redistributes money from those currently working to those who have retired –Welfare for the poor Examples are food stamps, Medicaid, disability payments, and unemployment benefits – Welfare for the rich Examples are subsidies to corporate farmers and tax breaks for defense contractors, oil companies, and other large corporations 7-45 Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

46. Stabilization Two basic goals of the federal government –Stable prices with little or no inflation –Low unemployment An economic rate of growth high enough to keep the unemployment rate to a minimum 7-46 Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

47. Economic Regulation The government provides the economic rules of the game –This must be done within the social and political context in which the economy operates The government must allow individuals and business firms to operate with the maximum degree of freedom There is little agreement as to how far economic freedom may be extended without interfering with society as a whole or the economic rights of specific individuals or business firms 7-47 Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

48. 7-48 Adam Smith’s Dos and Don’ts Do –Protect society from the violence and invasion of other countries –Establish an exact administration of justice –Erect and maintain certain public works and institutions where private enterprise could not profit from doing so Don’t do anything else Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

49. Conclusion Until the 1930s, the federal government more or less followed the role prescribed by Adam Smith The government’s economic role has expanded tremendously these last seven decades It will probably continue to grow in the coming years 7-49 Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.

50. Big government, like rock ‘n’ roll, is here to stay. 7-50 Copyright  2005 by The McGraw-Hill Companies, Inc. All rights reserved.