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COPYRIGHT © 2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. 16-1 How Does the Government Acquire Revenue? • Taxing the public – Federal taxes – State and local taxes • Government borrowing – Government borrows when it issues government securities • Government bonds • Treasury notes • Treasury bills 16-2 Federal Taxes 16-3 Federal Personal Income Taxes • Most important tax levied by federal government – Personal income tax brings in roughly 44 percent of total federal tax revenue – Different tax rate is applied to different increments of income • In this case, taxable income is called the tax base – Tax rate » Percentage of tax base that must be paid to government as tax – Tax base » Income, earnings, sales, property, or other valued items that have tax rate applied to them 16-4 Capital Gains • Net income received when asset is bought at particular price and subsequently sold at higher price – One continual political issue is whether capital gains should be taxed in same way as other forms of income • Since higher-income people tend to receive by far more capital gains than low-income people, cutting capital gains tax would largely benefit high-income people 16-5 Tax Breaks • Exemptions – Amounts of money for each household member that can be deducted from household income before personal income tax rates are applied • Standard deduction – Fixed amount of money that taxpayers can deduct from taxable income when calculating personal income taxes, if other deductions are not claimed • Tax credits – Amounts of money by which income taxes payable to government can be directly reduced • Person or business must meet certain criteria to be eligible for credit 16-6 Social Insurance • Second-largest federal category of taxes is for social insurance – Also called payroll taxes; deducted directly from paycheck or paid by employer to fund various social insurance programs • Social Security • Medicare 16-7 Excise Taxes and Estate Taxes • Excise taxes – Applied to purchase of specific goods or services • Estate taxes – Until recently, were levied only on highly valued estates that were passed on to others as inheritance • Because wealthy people own bulk of taxable estates, most of benefit goes to nation’s wealthiest individuals – President Bush proposed elimination of estate tax on highly valued property, thereby returning billions of dollars to the public 16-8 State and Local Taxes 16-9 Sales Taxes • Bring in second-largest share of state and local tax revenue • Levied on goods and services sold within state, locality, or both – Some states exempt some certain items; others do not • Tax base is market value of purchased item 16-10 Personal Income Taxes • Usually levied at state (and sometimes local) level – In some states, different tax brackets and rates, as at federal level – In other states, one tax rate applies to all people’s taxable income • Often referred to as flat-rate tax – Various exemptions, deductions, and credits may apply to state personal income tax systems as well as those at federal level 16-11 Property Taxes • Levied by local governments and bring in highest percent of combined state and local tax revenue • Levied directly on owners of houses and land; depend on value of this property • Used to fund local public schools 16-12 Effects of Taxes on the Macroeconomy 16-13 Effects of Taxes on the Macroeconomy (cont.) • If government finances increased expenditures through increased taxes, moderate expansion of economy will occur – Moderate expansion may be appropriate if economy is operating at high level of capacity • Too much expansion would put undesired upward pressure on price level • If goal of government is to substantially expand economy, raising taxes to finance increased expenditures is not most effective way to proceed – Preferable to finance increased expenditures by government borrowing 16-14 Effects of Taxes on the Income Distribution • When economists consider redistributive effect of taxes, usually classify taxes according to three basic types: – Progressive tax • Takes greater percentage of income from high-income people than from low-income people – Proportional tax • Takes same percentage of income from people of all income levels – Regressive tax • Takes greater percentage of income from low-income people than from high-income people 16-15 Progressive Taxes • Prime example is rate structure of federal personal income tax – Progressive tax rate structure relies on different income brackets • Higher the person’s income, higher are the tax rates applied to increments of income – Higher-income individual pays larger percentage of his or her income to government; lower-income individual pays smaller percentage of his or her income 16-16 Proportional Taxes • Example of flat-rate personal income tax levied by various state governments • Some have proposed that flat rate income tax be used at federal level as well – Because flat-rate tax takes same percentage of income from people of all income levels, it does not redistribute income – Bear in mind that proportionality of actual flat-rate taxes will depend on existence of various exemptions, deductions, and credits combined with taxes • Overall result may well be regressive tax 16-17 Regressive Taxes • Most taxes in our country are regressive • Include: – – – – Sales taxes Most excise taxes Property taxes Social Security tax • Because some of these taxes are not levied directly on income, seeing why they are regressive is sometimes difficult 16-18 Sales Taxes 16-19 Sales Taxes (cont.) • Although numbers are made up, provide realistic results – Low-income family spends larger percent of income on taxable consumer goods • Low-income families must spend income on necessities and have little income left over for saving • Higher-income families can afford to save larger share of income, thereby “consuming” smaller share – Because higher-income family does spend more money on taxable goods, in absolute terms, it will also spend more money on state sales tax, again in absolute terms – When tax amounts are expressed as percentages of family incomes, however, we see that lower-income family pays higher percent of income on tax » 5 percent sales tax results in lower-income family paying higher percent of its income on tax 16-20 Property Taxes and Excise Taxes • Regressive for very similar reasons – Low-income families tend to spend larger percentage of income on goods covered by excise taxes and on housing (either owned housing or rental housing) than do higherincome families • Assuming that property taxes are passed on to renters in form of higher rent, low-income families end up paying larger percentage of incomes on excise and property taxes than do higher-income families 16-21 Social Security Tax • Also highly regressive, but for different reasons – Levied only on income earned by working: that is, on wages and salaries • Because lower-income families earn most income in form of wages and salaries, all of this income is taxed • Most income of high-income people may be in form of interest, capital gains, dividends, and so on – Therefore, most of their income may not be taxed for Social Security purposes – Also regressive in that they are assessed on earnings only up to certain limit • Beyond this limit, earnings are not taxed – All income of low-income earners may be taxed, whereas some of income of high-income earners may not be 16-22 Social Security Tax (cont.) • As result of earnings limit and taxation of only work-earned income, lowincome families pay much larger share of income on Social Security tax than do high-income families 16-23 Effects of an Excise Tax in the Microeconomy 16-24 Effects of an Excise Tax in the Microeconomy (cont.) • As consequence of imposition of excise tax, smaller quantity of product is produced and sold, price is higher, and both consumers and suppliers share burden of the tax – Impact of tax that is felt by producers and consumers • Consumers bear burden in form of higher prices paid for product • Producers bear burden in form of lower profits – Burden need not be shared equally by these two groups » If price of product upon which excise tax is imposed rose substantially, perhaps even full amount of tax, consumers would bear entire brunt of tax 16-25 Effects of the Property Tax in the Microeconomy 16-26 Effects of Government Borrowing on the Macroeconomy • If government is financing expenditures by borrowing, taxes will not increase – Significant economic expansion will occur • Whether this result is desirable depends on state of economy – If economy is operating at high capacity, expansion is most likely to bring unwanted price rises in its wake – If economy is operating well below capacity and perhaps is in recession, expansion is exactly what doctor ordered 16-27 Effects of Government Borrowing on the Income Distribution • Redistribution of income that occurs when people buy government bonds may cause greater income inequality in our country – Bond owners tend to be middle- to upperincome people; rarely do low-income people have means to participate in this type of investment activity • To extent that low-income people bear greater burden of tax payments, and high-income people receive greater benefit from interest receipts, income redistribution occurs from poor to rich 16-28 Effects of Government Borrowing on Interest Rates • Interest rate – Percentage of borrowed funds that must be paid to lender (or investor) for privilege of using funds • Can analyze impact of government borrowing on interest rates if we view market interest rates as simply price of loanable funds – Money that is borrowed and lent 16-29 Effects of Government Borrowing on Interest Rates (cont.) 16-30 Effects of Government Borrowing on Interest Rates (cont.) • As result of government borrowing, interest rates go up – Amount depends on state of economy and market for loanable funds • Most serious concern about rising interest rates is impact on business and consumer spending – When interest rates are high, less willing and able to pay higher costs of borrowing • Economists refer to this situation as crowding out – Government spending, financed by borrowing, causes interest rates to rise, which results in less spending by private economy 16-31 Effects of Government Borrowing on the Government Budget and the National Debt • Budget deficit – Difference between federal government spending and federal government tax revenue in any one year • Budget surplus – Difference between federal government tax revenue and federal government spending in any one year • National debt – Total amount of money owed by federal government – Represents accumulation of all funds borrowed by federal government that have not yet been repaid • Budget deficit in any one year will increase size of national debt (whereas budget surplus will decrease national debt) • Government can continue to borrow indefinitely – With no limit on borrowing, government can continually “roll over” its debt; that is, it can continue to borrow money to repay previously borrowed money 16-32 The Size of the National Debt • When considering size of budget deficit, as well as size of national debt, inflation must be considered 16-33 The Size of the National Debt (cont.) • If we wish to accurately consider growing size of budget deficit or national debt, we must consider size of variable relative to GDP 16-34 Who Owns the National Debt? 16-35 A Balanced Budget • • • Annually balanced budget would mean no government borrowing, hence no addition to national debt Would mean that all government expenditures must be financed by tax revenue and that any government spending increase must be matched by increase in tax revenue Economists see many problems with requirement that federal government balance its budget: 1. Too many variables are unknown 2. No way to comply with balanced budget amendment if recession were to occur • Only way government can correct recession is to increase its spending or decrease taxes 16-36 The Economic Left and the Economic Right • THE ECONOMIC LEFT (Liberal) – More comfortable with government taxes and spending, as long as taxes do not heavily burden poor and middle class – Like to use tax credits to support what they consider worthwhile activity, such as spending on higher education or care of elderly people – Prefer spending for domestic social programs – Tend to be uncomfortable with government borrowing to support large defense spending and tax cuts • THE ECONOMIC RIGHT (Conservative) – Generally favor reductions in government taxes – Concerned that attendant increases in interest rates will crowd out private spending – Worry about increased government spending that government borrowing permits – Have strongly and publicly argued in favor of legislation or constitutional amendment that requires balanced budget – Seem relatively untroubled by budget deficits as long as they are caused by defense spending and tax cuts 16-37 Appendix: The Impact of Excise Taxes with Perfectly Inelastic Demand • Perfectly inelastic demand – Demand in which buyers are completely unresponsive to changes in price 16-38 Appendix: The Impact of Excise Taxes with Perfectly Inelastic Supply • Perfectly inelastic supply – Supply in which producers are completely unresponsive to changes in price 16-39 Appendix: The Impact of Excise Taxes with Perfectly Inelastic Demand and Supply • Results of these two cases can be generalized in a number of respects: 1. Group—be it consumers or producers—that is more unresponsive (inelastic) to price changes bears greater burden of any excise tax 2. Applies to any situation in which production costs increase • When rising costs of production cause decrease in supply, price will rise by some amount that depends on relative elasticity of demand and supply – More inelastic the demand, more the increased cost will be passed on to consumers in form of increased prices – More inelastic the supply, more the cost will be borne by producers in form of lower profits, and the less probably it is that prices will rise very much 16-40