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Chapter 15 Financing Government: Taxes and Debt Economic Principles Commandeering resources Commandeering money (taxes) Regressive, proportional, and progressive tax structures Gottheil - Principles of Economics, 4e 2 Economic Principles Social Security taxes Government securities and public debt Internally and externally financing the debt Gottheil - Principles of Economics, 4e 3 EXHIBIT 1 PRODUCTION POSSIBILITIES CURVE Gottheil - Principles of Economics, 4e 4 Exhibit 1: Production Possibilities Curve What is the opportunity cost of producing the first aircraft in Exhibit 1? • The opportunity cost of producing the first aircraft is 500 houses. Gottheil - Principles of Economics, 4e 5 Commandeering Resources What is the most direct method available for a government to acquire resources? • The most direct method is to commandeer resources. Gottheil - Principles of Economics, 4e 6 Commandeering Resources What is the most direct method available for a government to acquire resources? • This is how the pharaohs built the pyramids, and how governments built roads during the Middle Ages. Gottheil - Principles of Economics, 4e 7 Commandeering Resources What is the most direct method available for a government to acquire resources? • The military draft is a modern form of commandeering resources for the military. Gottheil - Principles of Economics, 4e 8 The Tax System How is the tax system related to commandeering resources? • The tax system commandeers money, not resources. Remember that resources are land, labor, capital, and entrepreneurship. Gottheil - Principles of Economics, 4e 9 There’s More Than One Way to Levy Taxes Poll tax • A tax of a specific absolute sum levied on every person or every household. Gottheil - Principles of Economics, 4e 10 There’s More Than One Way to Levy Taxes Regressive income tax • A tax whose impact varies inversely with the income of the person taxed. Poor people have a higher percentage of their income taxed than do rich people. Gottheil - Principles of Economics, 4e 11 There’s More Than One Way to Levy Taxes 1. What is an example of a regressive income tax? • One example is a poll tax. Gottheil - Principles of Economics, 4e 12 There’s More Than One Way to Levy Taxes 1. What is an example of a regressive income tax? • Another example is a tax on consumption, such as a sales tax. Since poor people spend all of their income on consumption, while rich people save a portion of their income, a consumption tax is regressive. Gottheil - Principles of Economics, 4e 13 There’s More Than One Way to Levy Taxes Proportional income tax • A tax that is a fixed percentage of income, regardless of the level of income. Gottheil - Principles of Economics, 4e 14 There’s More Than One Way to Levy Taxes 2. What is an example of a proportionate income tax? • A flat-rate tax on personal income Gottheil - Principles of Economics, 4e 15 There’s More Than One Way to Levy Taxes Progressive income tax • A tax whose rate varies directly with the income of the person being taxed. Rich people pay a higher tax rate—a larger percentage of their income is taxed—than do poor people. Gottheil - Principles of Economics, 4e 16 There’s More Than One Way to Levy Taxes 3. What is an example of a progressive income tax? • The current system of federal income taxation is progressive. Gottheil - Principles of Economics, 4e 17 There’s More Than One Way to Levy Taxes Corporate income tax • A tax levied on a corporation’s income before dividends are distributed to stockholders. Gottheil - Principles of Economics, 4e 18 Are We Really Paying High Taxes? True or false: Taxes as a percentage of GDP are higher in the U.S. than in any other rich industrialized country. • False Gottheil - Principles of Economics, 4e 19 Are We Really Paying High Taxes? True or false: Taxes as a percentage of GDP are higher in the U.S. than in any other rich industrialized country. •Tax revenues in the U.S. were 34.3 percent of GDP. Gottheil - Principles of Economics, 4e 20 Are We Really Paying High Taxes? True or false: Taxes as a percentage of GDP are higher in the U.S. than in any other rich industrialized country. • In comparison, tax revenues as a percentage of GDP were 40.6 in the United Kingdom, 43.4 in Canada, 45.1 in Germany, and 51.1 in France. 21 There’s More Than One Way to Levy Taxes Property tax • A tax levied on the value of physical assets such as land, or financial assets such as stocks and bonds. Gottheil - Principles of Economics, 4e 22 There’s More Than One Way to Levy Taxes Unit tax • A fixed tax in the form of cents or dollars per unit, levied on a good or service. Gottheil - Principles of Economics, 4e 23 There’s More Than One Way to Levy Taxes Sales tax • A tax levied in the form of a specific percentage of the value of the good or service. Gottheil - Principles of Economics, 4e 24 There’s More Than One Way to Levy Taxes Customs duty • A sales tax applied to a foreign good or service. Gottheil - Principles of Economics, 4e 25 There’s More Than One Way to Levy Taxes Excise tax • Any tax levied on a good or service, such as a unit tax, a sales tax, or a customs duty. Gottheil - Principles of Economics, 4e 26 There’s More Than One Way to Levy Taxes 5. Which of the following is a unit tax? a. A 7% tax on gasoline sales. b. A $10 tax on fishing rods. c. A 20% flat tax on income. Gottheil - Principles of Economics, 4e 27 There’s More Than One Way to Levy Taxes 5. Which of the following is a unit tax? a. A 7% tax on gasoline sales. b. A $10 tax on fishing rods. c. A 20% flat tax on income. Gottheil - Principles of Economics, 4e 28 EXHIBIT 2 2003 TAX RATE SCHEDULE FOR MARRIED PERSONS FILING JOINTLY Source: Internal Revenue Service, Instructions for Form 1040 (Washington, D.C.: Department of the Treasury, 2003), p. 13. Gottheil - Principles of Economics, 4e 29 Exhibit 2: 2003 Tax Rate Schedule for Married Persons Filing Jointly Suppose that a married couple filing jointly had $100,000 in taxable income. According to Exhibit 2, how much federal income tax must this couple pay? • On the first $7,000 they pay 10%, which equals $700. Gottheil - Principles of Economics, 4e 30 Exhibit 2: 2000 Tax Rate Schedule for Married Persons Filing Jointly Suppose that a married couple filing jointly had $100,000 in taxable income. According to Exhibit 2, how much federal income tax must this couple pay? • On the next $21,400 they pay 15%, which equals $3,200. Gottheil - Principles of Economics, 4e 31 Exhibit 2: 2000 Tax Rate Schedule for Married Persons Filing Jointly Suppose that a married couple filing jointly had $100,000 in taxable income. According to Exhibit 2, how much federal income tax must this couple pay? 10100 • On the next $40,400 they pay 25%, which equals $10,100. Gottheil - Principles of Economics, 4e 32 Exhibit 2: 2000 Tax Rate Schedule for Married Persons Filing Jointly Suppose that a married couple filing jointly had $100,000 in taxable income. According to Exhibit 2, how much federal income tax must this couple pay? 10100 • On the final $31,100 they pay 28%, which equals $10,296. Gottheil - Principles of Economics, 4e 33 Exhibit 2: 2000 Tax Rate Schedule for Married Persons Filing Jointly Suppose that a married couple filing jointly had $100,000 in taxable income. According to Exhibit 2, how much federal income tax must this couple pay? • Thus the married couple pays a total of $(700 + $3210 + $10,100 + 8,736) = $22,746. Gottheil - Principles of Economics, 4e 34 EXHIBIT 3 FEDERAL, STATE, AND LOCAL GOVERNMENT REVENUES: 2002 ($ BILLIONS) Source: Survey of Current Business (Washington, D.C.: U.S. Department of Commerce, October 2003). Gottheil - Principles of Economics, 4e 35 Exhibit 3: Federal, State, and Local Government Revenues: 2002 ($ billions) Income taxes are the largest single source of combined government tax revenues. Gottheil - Principles of Economics, 4e 36 Financing Government Spending Through Debt Public debt • The total value of government securities— Treasury bills, notes, and bonds—held by individuals, businesses, other government agencies, and the Federal Reserve. Gottheil - Principles of Economics, 4e 37 EXHIBIT 5 OWNERSHIP OF THE U.S. PUBLIC DEBT: 2002 (PERCENTAGE OF TOTAL) *Savings and loan associations, nonprofit institutions, credit unions, certain U.S. Treasury deposit accounts, and federally sponsored agencies. Source: Federal Reserve Bulletin (Washington, D.C., October 2003). mutual savings Gottheil - Principles of Economics, 4e banks, corporate pension trust funds, 38 EXHIBIT 6A THE FEDERAL DEBT Source: Statistical Abstract of the United States, 2000 (Washington, D.C.: U.S. Department of Commerce, 2000). Gottheil - Principles of Economics, 4e 39 EXHIBIT 6B THE FEDERAL DEBT Source: Statistical Abstract of the United States, 2000 (Washington, D.C.: U.S. Department of Commerce, 2000). Gottheil - Principles of Economics, 4e 40 Exhibit 6: The Federal Debt 1. During what time period did the gross federal debt grow most rapidly? • During the period between approximately 1980 and 2000. Gottheil - Principles of Economics, 4e 41 Exhibit 6: The Federal Debt 2. Based on the data in panel b of Exhibit 6, in what year was federal debt as a percentage of GDP the largest? • 1945. Spending on the war effort caused federal debt to be 125 percent of GDP. Gottheil - Principles of Economics, 4e 42 Exhibit 6: The Federal Debt 3. True or false: Gross federal debt as a percentage of GDP has increased sharply during the 1990s. • False. Gross federal debt as a percentage of GDP flattened out and then declined in the 1990s. Gottheil - Principles of Economics, 4e 43 Exhibit 6: The Federal Debt 4. Compare panels a and b in Exhibit 6. What caused debt as a percentage of GDP to flatten out and then decline in the 1990s? • Panel a shows that the gross federal debt increased through 1996. Gottheil - Principles of Economics, 4e 44 Exhibit 6: The Federal Debt 4. Compare panels a and b in Exhibit 6. What caused debt as a percentage of GDP to flatten out and then decline in the 1990s? • In order for debt as a percentage of GDP to flatten out when debt is still growing, GDP must grow as fast as debt. Gottheil - Principles of Economics, 4e 45 Exhibit 6: The Federal Debt 4. Compare panels a and b in Exhibit 6. What caused debt as a percentage of GDP to flatten out and then decline in the 1990s? • In the late-1990s gross federal debt actually began to decline. Gottheil - Principles of Economics, 4e 46 EXHIBIT 7 GROSS PUBLIC DEBT AS A PERCENT OF GDP FOR SELECTED ECONOMIES: 1998 Source: Statistical Abstract of the United States, 2000 (Washington, D.C.: U.S. Department of Commerce, 2000), p. 847. Gottheil - Principles of Economics, 4e 47 Does Debt Endanger Future Generations? In one sense the answer is no. While the interest on future government debt must be paid by taxing the future economy, people in the future who own government bonds receive that interest as income. Gottheil - Principles of Economics, 4e 48 Does Debt Endanger Future Generations? In another sense the answer is yes. For example, if future bondholders are rich, then the rich receive the interest income while the poor only bear the burden of higher taxes. Gottheil - Principles of Economics, 4e 50 Does Debt Endanger Future Generations? In addition, increased government debt purchased by the Fed will increase the money supply, which can be inflationary. Gottheil - Principles of Economics, 4e 51 Does Debt Endanger Future Generations? Another problem with increased government debt is that it tends to crowd out private investment, which slows the rate of economic growth. Debt promotes overconsumption since bond holders are not aware the source of interest is from the tax they pay. Gottheil - Principles of Economics, 4e 52 Does Debt Endanger Future Generations? External debt • Public debt held by foreigners. Gottheil - Principles of Economics, 4e 53 Does Debt Endanger Future Generations? Recall from Exhibit 5 that foreigners are a major owner of U.S. public debt. In this case, future generations of U.S. citizens bear the burden of higher taxes to pay the interest that flows to foreigners. Gottheil - Principles of Economics, 4e 54 Gottheil - Principles of Economics, 4e 55