Public Spending, Public Choice, Need for Govern-

ment, and Taxation Systems Lecture

Test terms for Thursday, May 1

• Market failure• Externality• Medicaid• Medicare• Private good• Public good• Rival consumption• Government sponsored

good• Government inhibited

good

• Collective decision mak-ing

• Theory of public choice• Tax base• Tax rate proportional

tax• Progressive tax• Regressive tax• Capital gain• Capital loss• Tax incidence• Dynamic tax analysis• Static tax analysis

What a Price System Can and Cannot Do

• Price system lets resources move from low-valued uses to high value uses– Consumers decide this

• Sometimes too many or too few re-sources move to specific economic activities– This is called a market failure

Market failure: negative externality

• Externality; consequence of economic activity that spills over to third party

• Example: steel mill moves into town– Charges market price for

steel– Mill doesn’t have to pay

cost of dirtier air, dirtier clothes, or more respira-tory diseases

How does government correct for negative externalities?

• Special taxes: – In steel mill example government could

tax steel mill (pollution or effluent tax)– Ultimate aim to place real cost of steel

on mill itself: prices would rise—supply fall

• Regulation: – Government could set maximum allow-

able rate of pollution– Mill would have to install abatement

equipment or reduce rate of output

How does government correct pos-itive externalities?

• Idea of positive externality can be seen with inocula-tions against communicable diseases– If it wants more inoculations

than the market is producing: it could finance them

– It could subsidize them– It can regulate them: require

that you must have them to work, attend school, etc.

Other Functions of Government

• Provide a Legal System– A market system relies on contracts

(good legal system is necessary)– Must have a good system of protecting

property rights• Having a good police system is neces-

sary

Other Functions of Government

• Promote Competition– We want to preserve our competitive

economic system (anti-trust legislation)– Reduce and eliminate monopolies

• Answer this questions with your partner:– Can small businesses continue to exist

in America? Which ones?

Other Functions of Government

• Provide Public Goods• Private Good:

– Goods that can be consumed by only one individual at time. Private goods are subject to principle of rival consumption

– Rival consumption: individuals are rivals in consuming private goods because each persons consumption reduces amount available for others to consume

Public Goods

• Public Goods: – Principle of rival consumption does not

apply– Can be consumed by many individuals

simultaneously at no additional cost & no reduction in quality or quantity

– One who does not pay for the good cannot be denied benefit of good

– Example of public good: national de-fense

Other Functions of Government

• Ensure Economy-wide Stability– Stabilize rising prices– Eliminate unemployment– Examples: FDR’s program; bank

bailouts; stimulus packages; control of interest rates

Political Functions of Government

• Promote and restrict goods– Government-sponsored good: some-

thing deemed socially desirable: muse-ums & parks

– Government-inhibited good: something deemed undesirable through political process: heroin

Political Functions of Government

• Provide Income Redistribution– This is a more recent function of gov-

ernment– Two systems used for this:

• Progressive income tax• Transfer payments

Public Spending & Transfer Pro-grams

Public Spending

Public Spending & Transfer Programs

• Publicly Subsidized Health: Medicare– In fewer than 40 years Medicare became

our second-biggest domestic govern-ment spending program

– In first 20 years of Medicare: • Huge upswing in physician's incomes &

med-school applications + • Huge increase of prices of medical ser-

vices– Each year government expenditures on

Medicare exceed budget projections

Public Spending & Transfer Programs

• Why do projections of expenditures fall short?– Bureaucratic planners don’t often see the

effects of incentives of government programs

– Demand side: Huge incentive to use pro-gram when government is paying for it

– Supply side: Huge incentive to use ex-pensive procedures when government is paying

Public Spending & Transfer Programs

• Health Care Subsides Continue to Grow– Medicare cost has risen from 0.7 % of

national income in 1970 to 2.8% today– Medicare spending is growing faster than

employer & employee contributions– Currently Medicare tax is 2.9% on wages

with 1.45% paid by employer & 1.45% paid by employee

– Currently unfunded guarantees for Medi-care estimated at $25 trillion

Public Spending & Transfer Programs

• Increased guaranteed costs do not in-clude Medicaid– Medicaid provided for low income people– Combination of state and federal payments– Currently, 50 million people have Medicaid

or one in six Americans– Federal government currently pays for 57%– Medicaid expenditures have grown more

rapidly than Medicare (75% since 2000 alone)

– From 2010 forward increases have ex-panded at rate at more than $100 billion per year

Obamacare?????

The major questions in Obamacare are 1) whether it will be less expensive for consumers and 2) how will the funding work in insuring 40 million new people?

Economic Issues of Public Educa-tion

• State and local governments assume pri-mary responsibility for public education

• Annual expenditures are $900 billion– In excess of 6% of national income

• Education funded by– State & local sales, excise, property, and in-

come taxes– Federal government, also, provides billions of

dollars in grants & transfers • Question: Should education be funded by

local communities or federal government?

Economic Issues of Public Educa-tion

• Currently state & local education is subsidized by federal govern-ment– Education is provided for below market

price– Think of cost of private schools– Trade-offs occur with federal government

subsides– St. Gregory tuition: $16,675– AZ State payment per student: $7,468– AZ Charter school per student: $6,777– National payment per student: $10,615

Economic Issues of Public Educa-tion

• What is the problem with subsidized public education?– Schools don’t have to compete with

each other– Schools provide inefficient programs for

student learning & achievement

• How are charter schools able to op-erate at income levels 25% under public schools?

Collective Decision Making:The Theory of Public Choice

• Collective decision making: how voters, politicians, and other in-terested parties influence non-market decisions

• Theory of Public Choice: study of collective decision making– Theory states individuals will act within

political process to maximize their individual, not collective well-being.

• Do you agree with this theory?

The Theory of Public Choice• Opportunity cost:

– Everything spent in private sector plus public sector must add up to total in-come available

– Government then has an opportunity cost; they face choices

• Competition: – Appointed officials are in competition for

available government funds– Government officials will do what is in

the best interest of themselves

The Theory of Public Choice

• Differences of individuals & public sectors– Governmental officials face a different

incentive structure– Compare USPS & UPS: profitability incen-

tives– Public sector is not that concerned with

cost- benefits (how many units to ex-pand or how many hours to operate)

– Difference in use of force: don’t pay your taxes wages are seized; don’t pay your bills-- declare bankruptcy

The Theory of Public Choice

• Voting vs. spending– Political system: one person-one vote– Political system: majority rule– Market system: each dollar a person

spends counts– Market system: proportional rule (if 10%

of votes cast vote for blue cars 10% will be made)

Funding the Public Sector

• Three sources of funding for govern-ment– 1) Explicit fees or charges for gov.-ser-

vices– 2) Taxes– 3) Borrowing

Government Budget Con-straint

• Each dollar of public spending on goods, services, transfer payments, and repayment of borrowed funds –must be provided by tax rev-enues

Systems of Taxation

• Tax Base– Value of good, services, wealth, or in-

come subject to taxation

• Tax rate– Proportion of tax base that must be paid

to a government

Three types of taxation sys-tems

1. Proportional Taxation• Regardless of income everyone’s tax

rate is the same—everyone pays the same %

2. Progressive Taxation• As a person’s taxable income increases

the % paid increases (our current sys-tem)

3. Regressive Taxation• A smaller % of taxable income is taken

as taxable income increases

Sources of Government Tax Re-ceipts

Treatment of Capital Gains

• Capital gain: positive difference be-tween the purchase price & sale price of an asset

• Miscalculation????– Are capital gains always real gains?

• Example: if you sold an asset for $100,000 after 10 years and your original purchase price was $50,000 (pay on $50,000)

• What if there was 10% inflation, your real gain would be $0.00 (fair????)

Treatment of Capital Gains

• Capital Loss: a negative difference between the purchase price and sale price

• Can you deduct the full amount of a capital loss on your income tax?– Ten Important Facts About Capital Gains

and Losses

Corporate Income Tax

• Corporate Taxable Income

• $0-50,000• $50,001-75,000• $100,000-335,000• $335,001-

10,000,000• $10,000,001-

15,000,000• $15,000,001-

18,333,333• $18,333,334-and

up

Corpo-rate

Tax Rate

15%25%39%34%35%38%35%

More on Cooperate Income Tax

• Corporate income taxes account for– 12% of federal taxes– 2% of state & local taxes

More on Corporate Income Tax

• Double taxation– Stockholders pay taxes on dividends– Dividends are paid out of after tax profits– Prior to issuing dividends, it paid taxes on all

its profit, including any it put back into the company

– Retained earnings (any earnings put back into invest-ments) have helped raise the value of the company

– When you sell your stock for a capital gain, you pay tax on the capital gains

– Either way, dividends or retained earnings you are double taxed (Since 2003 dividends are taxed at lower rates)

Who Really Pays the Corporate Income Tax?

• Tax Incidence: – the distribution of tax burdens among

various groups in society

• So who really pays the corporate taxes? – Discuss with your partner!

So who really pays the corporate taxes?

• Do corporations simply pass on their tax burden to customers by charging higher prices?

• Are stockholders bearing the cost of the tax? (price of stock has to reflect cost)

• Are employees of the corporation paying the cost by taking lower wages than might be offered without the tax?

• Point: it is people who pay the tax!

Social Security & Unem-ployment Taxes

• Social Security Tax on earnings up to $106,800– 6.2% on employees & 6.2% on employ-

ers

• Social Security taxes were passed in 1935– More people paid into it than drew bene-

fits– Within next few years outflow will ex-

ceed inflow – Solutions include; later start date, in-

creased taxes, lower COL adjustments

Tax Rates & Tax Revenues• Sales taxes, gross receipts taxes, &

excise taxes generate one-fifth of most state and local governments– Sales tax is a proportional tax

• Static tax analysis– Assumption of no effect on tax base with

tax rate increases

• Dynamic tax analysis– Recognizes tax base will eventually de-

cline as tax rate increases

How to maximize tax rev-enue

• Maryland example of “millionaires” tax– Extra-high bracket created for incomes

exceeding $1,000,000– Many millionaires changed residences to

other states (made second home – pri-mary)

– Maryland collected $100 million less with this tax

– Gerry Swanson: most important consid-eration in taxing is that those taxed feel it is fair. (Tax avoidance can set in)

Can we wipe out the annual federal deficit with taxes?

• Yes, annual deficit is about $1.3 tril-lion– Taxes should be raised by $9,000 for ev-

ery worker (that covers one year)

• Shouldn’t we tax the rich more?– There are fewer than 100,000 who make

more than $1,000,000– Raise the marginal tax rate from 35% to

45% we would raise $35 billion or less than 3% of federal budget

Last call on taxing the rich!

• Let’s tax that top 1% at 100%!– So that would cover one year at $1.3 tril-

lion– Our national debt is over $17 trillion

• Let’s take 100% of everyone who makes at least $75,000!– So that would cover about $4 trillion or

one-third of the net public debt

Components of Federal Expenditures as Percent of Total Federal Spending

With your partner

• What is your solution for eliminating the national public debt?