Ch. 14: Government Revenue and Spending

Sec. 1: How Taxes Work

Government Revenue

Govt. provides goods generally not provided by the market ex – street lighting, highways, law enforcement, court

systemTax – Revenue – Nontax sources –

rights of govt. to tax are set down in the US Constitution and in state Constitutions

CERTAIN PRINCIPLES AND CRITERIA TO EVALUATE WHETHER OR NOT TAXES SHOULD BE PAID AND WHO SHOULD PAY THEM

MOST OFTEN BASED ON THE BENEFITS TAXPAYERS RECEIVE FROM TAXES AND THEIR ABILITY TO PAY

Principles of Taxation

-BENEFITS-RECEIVED PRINCIPLE-

Holds that ex – financing road construction & maintenance with

gas taxDifficult to assess how much different

taxpayers benefit from national defense, national parks, local police & fire protection, public education

-ABILITY-TO-PAY PRINCIPLE-

Holds that people with higher income will pay more than people

with lower incomes level of benefits received not a consideration income alone not completely determine ability to pay

taxesShould everyone pay the same % of income,

should those with higher incomes pay a higher % of their income in taxes

TAX SYSTEMS ATTEMPT TO MEET 3 CRITERIA:

THE CRITERIA ARE SOMETIMES IN CONFLICT AND A GIVEN TAX MAY NOT MEET ALL OF THE CRITERIA EQUALLY WELL

Criteria for Taxation

•-fairness of a tax is established by how uniformly the tax is applied•-equity requires that people in similar situations pay a similar amount of

taxes•-some believe it requires that people with higher incomes pay more than

people with lower incomes

EQUITY

•-is determined by how easy it is for the taxpayer to understand and how easy it is for the govt. to collect

•-should be no confusion about the time the tax is due and the amount to be paid•-sales tax meets the criterion of simplicity

•-a set % of the price of a taxed item is collected every time that item is purchased

SIMPLICITY

•-can be judged by how well the tax achieves the goal of raising revenue for the govt. with the least cost in terms of administration

•-from taxpayer view – can be judged by the amount of effort and expense it takes to pay the tax•-individual income tax – best meets the criterion of efficiency

EFFICIENCY

TAX BASE –

4 MOST COMMON TAX BASES ARE:

Tax Bases and Structures

INDIVIDUAL INCOME TAX

SALES TAX

-is a tax based on an individual’s income from all sources: wages, interest, dividends, tips

-all taxes ultimately come from income – but using that as a tax base means amount of tax is directly linked to person’s earnings

-for most – income comes from wages or tips & could come from investments and savings in form of interest & dividends

-corporate income tax – is a tax based on a corporation’s profits

-is a tax based on the value of designated goods or services at the time of sale

-generally imposed on a wide range of goods and services

-is usually a % of the price of the good or service & is included in final price customer pays

-seller then passes the tax revenue on to govt.

Tax Bases

Tax Bases-PROPERTY TAX-

Is a tax based on the value of an individual’s or business’s assets, generally real estate

Home & business owners pay based on value of buildings and land on which buildings stand

Growing and shrinking tax base – wealth that is available to be taxed personal income rises –

If fewer homes or businesses in a locality or value declines – tax base shrinks – less wealth for govt. to tax

3 DIFFERENT TAX STRUCTURES –

Tax Structure

Proportional tax

Progressive tax

•

Regressive tax

•takes a larger % of income from people with low incomes than from people with high incomes

-PROPORTIONAL TAX- -PROGRESSIVE TAX-

Sometimes called a flat tax – ex- all taxpayers might have a flat

15% tax on their income no matter how much income is

ex – earn $20,000 – pay $3,000 in taxes

ex – earn $50,000 – pay $7,500 in taxes

Some states & local govt. have proportional taxes in individual income Michigan – flat income tax rate of

3.9% Massachusetts – flat income tax rate

of 5.3%

Tax in which the tax rate increases as a person’s income increases high income person pays more in

amount of taxes but also pays a higher % of income in taxes

see figure 14.1 – progressive tax is most closely linked to the ability to pay principle

in US – federal income tax is a progressive tax – tax rate increases as income increases

may states have progressive income taxes: Cal., Kansas, NY, South Carolina

-REGRESSIVE TAX-

The % of income paid in taxes decreases as income increases some taxes are regressive b/c they

are applied to sales not income ex – a sales tax is applied equally to

all items subject to the tax, the tax as a % of income is regressive

this is b/c low income earners tend to spend a higher proportion of income than do high income earners

EX – state charges 5% sales tax Jones- earn $20,000, spend

$15,000 on taxable goods, pay $750 in sales taxes, (5% of 15,000) or 3.75% of income

Smith – earn $50,000, spend $25,000 on taxable goods, pay$1,250 in sales tax (5% of $25,000) or 2.5% of income

Property taxes on homes also considered regressive low income usually spend

higher % of their income on housing than high income

therefore – property taxes take a higher % of their income

poorer communities often charge a higher tax rate b/c property has a lower value then tax base is smaller

even non-home owners are subject to the regressive tax

INCIDENCE OF A TAX –

IMPACT OF A TAX ON A TAXPAYER

EX –

Who Pays the Tax?

Effect of Elasticity on Taxes

Govt. imposed a $1 tax on a product – demand elasticity influences the incidence of this tax if elastic demand – if inelastic demand –

Seller recognizes that quantity demanded will go down only slightly for goods and services that have elastic demand b/c hey are less price sensitive

TAXES HAVE IMPACT ON

GOVT. CHOOSES WHAT TO TAX BASED ON AMOUNT OF INCOME IT WANTS TO RAISE AND THE OTHER ECONOMIC EFFECTS IT WANTS TO ACHIEVE

Impact of Taxes on the Economy

Impact 1: Resource Allocation

Tax placed on a good or service will increase the costs of production and therefore shift the supply curve to the left if demand remains the same – price will go up will likely cause a shift is resources

If a supplier not able to pass increased costs to consumer in form of higher prices – may choose to shift production to another good that is more profitable ex – govt. imposed 10% tax on luxury yachts – producer not

able to raise prices enough to cover entire tax – no longer profitable – shift to small fishing boats or new business

Impact 2: Productivity and Growth

When taxes on interest & dividends are high, people tend to save less than when taxes on this source of income are low taxes have impact on

economists say high taxes reduce incentives to workPeople may spend more time of things other than

work if large % of income goes to taxes others suggest underground economy is result of high taxes

Underground economy – ex- Bob’s landscaping business – work weekends – charges

less than large firms – insists on being paid in cash – difficult for govt. to tax income

Impact 3: Economic Behavior

Tax incentive – providing tax credits or rebates – govt. may encourage

behavior it believes is good for the economy and society

ex- tax rebates for businesses opening new factories, offices & stores in economically depressed areas

ex – govt. give tax credits to consumers for recycling or using energy more efficiently

Positive tax credit with widest impact –

Impact 3: Economic Behavior

Sin taxes – gambling, alcohol, cigarettes

Taxes are generally levied on products or activities for which there is relatively inelastic demand – but – demand is relatively inelastic – the decline in

quantity demanded will not cause tax revenues to decrease dramatically

demand for sin-tax products becomes somewhat more elastic as tax increases get steeper

ex – in Washington – cigarette sales fell 19% year after imposed $.60 per pack tax – but revenue went up 40%

Sec. 2: Federal Taxes

Individual Income Tax

Federal govt. takes in $2.5 trillion in revenue each year comes from many sources: individual income tax,

social insurance taxes, corporate income taxes, estate taxes, gift taxes, excise taxes, customs taxes

largest source – started using after

prior – excise taxes and customs duties main source social insurance taxes are workers and employers share the burden of these

taxes

Example: Paying Your Taxes

If taxpayers had to pay at end of year in one lump sum – would be difficult would be difficult for govt. getting revenue once a year drawing up a budget, developing a sound economic plan for

future impossibleTo make it easier – Withholding –

ex – Scott – works part-time during school, full-time during summer - $6 hr. b/c of withholdings – pays taxes as he earns income – govt. has steady stream of

revenue employer forwards withholdings to IRS

Example: Paying Your Taxes

IRS – federal income tax is a progressive tax based on the ability to

pay principle of taxation people with higher incomes not pay more in total taxes but also

a higher % of their income in taxesTaxable income –

under federal income tax laws – taxpayers can take certain exemption & deductions from total earned income to reduce amount of their taxable income

exemptions for each individual adult and child – larger family reduce more than smaller family

may take standard deductions or itemized deductions – interest paid on a home mortgage, state & local taxes, charitable contributions, certain portion of medical expenses

Tax return – Federal tax return shows –

state & local tax return show similar but less detailed information

if too much tax withheld – receive a refund for overpayment

if not enough withheld – then owe a payment to the IRS or state or local revenue dept.

Example: Indexing

The level of income that causes someone to pay a higher rate of taxis the dividing point between tax brackets the tax bracket is IDed by the tax rate for that income

span 2006 tax schedule – see p. 422 ex – Scot has taxable income of $7,000 – in 10% tax

bracket & pays 10% or $700 if earned $8,000 of taxable income – would be in 15%

tax bracket – would pay 10% on first $7,550 of earnings – then 15% on remaining $450

total would be $822.50 – or 10.3% of income

Example: Indexing

Indexing is ex- Scott’s income increases to $8,320 – 4% increase –

due to inflation w/o indexing - $770 of income is taxed at 15% and

pays $870.50 or 10.5% w/indexing – beginning level of 15% bracket is

adjusted by 4% to $7,852 so he still pays 10.3% of income in taxes

Indexing combats the

-FICA –

ALSO KNOWN AS SOCIAL INSURANCE – ENCOMPASSES SOCIAL SECURITY & MEDICARE

BOTH EMPLOYERS & EMPLOYEES MAKE CONTRIBUTION

FICA: Taxes to Ease Hardships

-SOCIAL SECURITY- -MEDICARE-

Is a began during the

Great Depression of the 1930s

employer & employee each pay 6.2 % of employee’s income up to an annual max

limit generally rises each year

Is a started in 1966 employers &

employees each pay 1.45% of employee income

no limit on amount of income subject to the tax for Medicare

-UNEMPLOYMENT TAXES-

Is a program provides benefits for a certain period of time to

employees who lose their jobs through no fault of their own

tax applies to first $7,000 earned by an employee and for most part is paid only by employers

-GOVT. ALSO USES CORPORATE INCOME, ESTATE,

GIFT, AND EXCISE TAXES AS WELL AS CUSTOMS DUTIES

AND USER FEES TO FINANCE OPERATIONS

Corporate Income and Other Taxes

Corporate Income Taxes

Corporate income tax is 3rd largest sources of revenue

1941-1968 – corporate income tax receipts have increased in total

dollars since mid-1900s, but have decreased relative to total federal income tax revenues and overall size of economy

Corporate Income Taxes

Only certain types of corporations are subject to corporate income tax

Corporations make up about 8% of all businesses that file tax returns Tax rate for most is 35% of

profits – most pay about 26% of profits in taxes

Corporations can deduct certain expenses from profits to reduce taxable income Deductions for investments in

buildings, equipment, and research & rules that benefit multinational corporations

Common criticism – profits are taxed at

corporate level and again at individual level

b/c shareholders pay taxes on income received in form of dividends or capital gains

Recent years –

• is a tax on property that is transferred to others on the death of the owner•most estates not subject b/c govt. only taxes large

estates•2006 – estates larger than $2 million not subjectestat

e tax

•– is a tax on money or property given by one living person to another•-there are exemptions – allow family members to

give money to other family members tax-freegift tax

•– is a tax on the production or sale of a specific product (ex – gas or telephone service)•-ex – sin tax•-govt. places excise tax on goods or services

for which there is relatively inelastic demand in order to maintain a steady stream of revenue

excise tax

•– is a tax on goods imported into the US from another country•-basically excise taxes on imports also called

tariffscustoms duty

•– is money charged for the use of a good or service•-as based on benefits received principle of

taxation•-ex – govt. charges entrance, parking and

camping fees for national parks•-people enjoying the park pay for the

benefits

user fee

Economic Pacesetter: Maya MacGuineas: Reforming the Tax System

Says current system is complicated, inefficient, unfair, & doesn’t raise funds to fund all programs new system should be

based on simplicity, efficiency, equity & responsible budgeting

says income tax should be simplified by ending most tax deduction and exemptions

Would make the system more equitable – taxpayers in higher marginal tax bracket gain greatest benefit believes corporate tax

should be phased out supports environmental

taxes, different approach to how estate tax is levied

restructuring of nation’s entitlement programs

Most revolutionary idea is about FICA taxes – should be replaced with progressive consumption tax would be tied to spending rather

than income – rates rising as spending levels rise

ex – spending between $0 - $20,000 – no tax

spending between $20,000 - $50,000 – taxed at 10%

spending between $50,000 - $175,000 – taxed at 15% then so on

would be simpler & fairer & provides tremendous incentives to save

Sec. 3: Federal Government Spending

Federal Expenditures

Programs & services federal govt. funds with revenues are divided into to categories:

Mandatory spending – spending that is required by current law ex –

Discretionary spending – ex- funding for highway construction or maintenance

of national parks govt. has required funding and cover everything else

with what is left over

Type 1: Mandatory Spending

Makes up well over half of all federal spending

Entitlements – Social Security & Medicare –

many not “means tested” – anyone who meets the eligibility requirements receives the benefits regardless of income level

for other programs – income level is part of the requirements

-SOCIAL SECURITY-

Takes largest amount of federal spendingProvides benefits to older retired workers,

disabled workers with limited incomes & survivors of workers who have died is financed through payroll tax

Workers must have worked a certain period of time before they are eligible to receive full benefits with older population and more retired people – costs

have increased

To help – govt. has raised the age of full retirement – the point at which a worker is eligible to receive max benefits retirement benefits are not means tested if retiree has additional income – benefits may be

subject to withholdings ex – 2006 – if earn more –

-MEDICARE- -MEDICAID-

Induced in 1966 as additional old-age benefit under Social Security

Originally – provided hospital insurance for those over 65(funded by payroll taxes) & optional medical coverage for items such as doctor bills(funded by premiums paid by those choosing the coverage & general tax revenues) b/c of increasing # of retirees & health

care costs – costs have risen dramaticallyStarting 2006 –

means testing added for all but lowest income group of senior citizens

some coverage added for prescription drugs

Is a joint federal-state medical insurance program for low-income people federal govt. funds

about 63% & states pay about 37%

recently – states tighten eligibility requirement to control costs

-OTHER MANDATORY SPENDING PROGRAMS

Variety of other mandatory spending programs that define eligibility requirements then funded based on an estimate of how many people must meet those requirement Food Stamp program provides funds for 26 million low-income people

to purchase foodVeterans’ benefits include health care coverage, disability

payments for service-related illness or injury also eligible for education assistance govt. spends about $50 billion on veterans’ benefits payments for federal portion of unemployment insurance part of this

Federal govt. pays its workers some retirement benefits Federal employees hired after 1983 eligible for some Social Security

retirement benefits

Type 2: Discretionary Spending

More than 1/3 of federal revenue is devoted to discretionary spending

Several categories: interstate highway system & transportation programs

(Amtrak) natural resources and the environment – education – science, space, technology, and other research

programs justice administration, including enforcement

agencies (FBI & federal court system)

Type 2: Discretionary Spending

Largest category – national defense – takes up 50% of total discretionary budget includes large amount of nation’s military spending –

Not all of this is discretionary spending some - homeland security (border protection and

enforcement of immigration laws) falls into mandatory expenditure

certain military spending falls outside the basic federal budget – wars in Iraq & Afghan

The Federal Budget and Spending

Federal budget – Fiscal year –

federal budget is prepared for a fiscal year the fiscal year runs from Oct. 1 to Sept. 30

President’s budget is prepared by the Office of Management and Budget (OMB) and takes into account estimated tax receipts and requests by all federal departments and agencies

Congress Acts on the Budget

Congressional Budget Office helps House and Senate develop guidelines for different appropriations appropriations – members of Congress often make deals to gain votes

for appropriations they supportCongress votes of final budget and send to

pres. for approval if not approved by beginning of fiscal year –

Methods of Federal Spending

After approval – funds spent in several ways one way – direct spending – by which the govt. buys

goods and services that it needs to operate ex – military equipment & office supplies & salaries of

govt. employees second way – transfer payments – money distributed

to taxpayers who do not provide goods or services in return

Grant-in-aid –

-TRANSFER PAYMENTS- -GRANTS-IN-AID-

Generally part of mandatory spending ex – Social Security

retirement or disability benefits and health care benefits from Medicare or veterans’ programs

taxpayers do not provide specific goods or services in exchange for these govt. funds

Transfer payments between levels of govt. federal govt. makes

grants to states, local govt., and regions

grants designated for specific categories of activities

ex – highway construction, certain school services, Medicaid funding

FEDERAL GOVT. INFLUENCES THE ECONOMY IN 3 WAYS:

-PRIVATE SECTOR –

The Impact of Federal Spending

-RESOURCE ALLOCATION-

Federal govt. makes choices concerning where to spend money and on what to spend it influences how resources are allocated ex – if money goes to urban transit – cannot go to fix

rural roads

-INCOME REDISTRIBUTION-

Govt. spending affects the incomes of families, individuals, & businesses transfer payments for health care, retirement, Food

Stamp benefits – how govt. awards work contracts can also influence

distribution of income ex –

-COMPETITION WITH THE PRIVATE SECTOR-

Govt. may produce goods or services that are also produced in the private sector ex – ex –

Sec. 4: State and Local Taxes and Spending

State Revenue

Comes from a variety of sources –

Also raise funds from state sales taxes & state income tax on individuals & corporations

Type 1: Sales and Excise Taxes

All states except Alaska, Delaware, New Hampshire, Montana, & Oregon levy a state sales tax rates range from 2.9% in Colo. To 7.25% in Cali. generally applied to most goods & services sold within the state many states exempt food and prescription drugs

Some states tax these goods and over-the-counter-drugs and other medical supplies at a lower rate charitable, religious, and educational organizations often exempt all states have excise taxes on cigarettes, alcohol, gas, & diesel fuel

Certain govt. organizations, volunteer fire-fighting companies, & farmers may be exempt from fuel taxes

Many states have special sales taxes that mostly affect tourists (car rentals, hotels & motel rates)

Type 2: Income Tax and Other Revenue Sources

Income tax accounts for most states levy on both individual & corporate

income Alaska, Florida, & Texas have no individual income tax

Nevada, South Dakota, Washington, Wyoming levy neither individual nor corporate income taxes most states have progressive tax rate on individual &

flat tax rate on corporate rate vary from 0.36% for lowest tax bracket in Iowa to

9.5% for highest tax bracket in Vermont

Average state corporate tax rate is 6.8% low of 1% for lowest bracket in Alaska & Arkansas to Pennsylvania’s

flat rate of 9.99% many state govt. structure corporate tax rates to attract businesses govt. use tax cuts & incentives for businesses to promote economic

developmentStates receive benefits from these tax practices in

increased economic activity revenue from other sources estate taxes and user fees – same as federal govt. levy property taxes

Charge fees related to business operations – registration fees for certain types of businesses and license fees for doctors, dentists, lawyer and accountants