IntroductionPUBLIC FINANCE

PUBLIC FINANCE

What Is Public Finance?Public Finance, field of economics concerned with how governments

raise money, how that money is spent, and the effects of these activities on the economy and on society

What Is Public Finance?Public finance studies how governments at all levels—national, state, and local—provide the public with desired services and how they secure the financial resources to pay for these services.

What Is Public Finance?In many industrialized countries, spending and taxation by the government form a large portion of the nation's total economic activity.

For example, total government spending in the United States equals about 40 percent of the nation's gross domestic product

Why Public Finance Is Needed?Governments provide public goods—government-financed items and services such as roads, military forces, lighthouses, and street lights.

Private citizens would not voluntarily pay for these services, and therefore businesses have no incentive to produce them.

Why Public Finance Is Needed?Public finance also enables governments to correct or offset undesirable side effects of a market economy.

These side effects are called spillovers or externalities.

Example: households and industries may generate pollution and release it into the environment without considering the adverse effect pollution has on others.

Why Public Finance Is Needed?Pollution is a spillover because it affects people who are not responsible for it.

To correct a spillover, governments can encourage or restrict certain activities.

For example, governments can sponsor recycling programs to encourage less pollution, pass laws that restrict pollution, or impose charges or taxes on activities that cause pollution.

Why Public Finance Is Needed?Public finance provides government programs that moderate the incomes of the wealthy and the poor.

These programs include social security, welfare, and other social programs.

For example, some elderly people or people with disabilities require financial assistance because they cannot work.

Why Public Finance Is Needed?Governments redistribute income by collecting taxes from their wealthier citizens to provide resources for their needy ones.

The taxes fund programs that help support people with low incomes.

Public SpendingEach year national, Provincial, and local governments create a budget to determine how much money they will spend during the upcoming year.

The budget determines which public goods to produce, which spillovers to correct, and how much assistance to provide to financially disadvantaged people.

Public SpendingThe chief administrator of the government—such as the prime minister, governor, or mayor—proposes the budget.

The legislature—such as the parliament, Provincial council, or Municipality council—ultimately must pass the budget.

The legislature often changes the size and composition of the budget, but it must not make changes that the chief administrator will reject and veto.

Government SpendingGovernment spending takes two forms:

Exhaustive spending

Transfer spending.

Government SpendingExhaustive spending: refers to purchases made by a government for the production of public goods.

For example, to construct a new harbor the government buys and uses resources from the economy, such as labor and raw materials.

Government SpendingTransfer spending when government transfers income to people to help them support themselves.

Transfers can be one of two kinds:

cash or in-kind.

Cash transfers are cash payments, such as social security checks and welfare payments.

In-kind transfers involve no cash payments but instead transfer goods or services to recipients. Examples of in-kind transfers include food stamp coupons and Medicare.

Public Revenue Governments must have funds, or revenue, to pay for their activities.

Governments generate some revenue by charging fees for the services they provide, such as entrance fees at national parks or tolls for using a highway.

However, most government revenue comes from taxes, such as income taxes, capital taxes, and sales and excise taxes.

Public Revenue An important source of tax revenue in most industrialized countries is the income or payroll tax, also known as the personal income tax.

Income taxes are imposed on labor or activities that generate income, such as wages or salaries.

In the United States, income taxes account for about half of the total revenue of local, state, and federal governments combined.

Public Revenue Another important source of government revenue is the capital tax.

Capital includes items or facilities that generate profits, such as factories, business machinery, and real estate.

Some types of capital taxes are known as “profits” taxes.

One kind of capital tax used by the federal government in the United States is the corporate income tax.

A property tax is a capital tax used by state and local governments. Property taxes are levied on items such as houses or boats.

Public Revenue Sales and excise taxes are also a major source of government tax revenue.

Many state and local governments levy a sales tax on the purchase of certain items.

Consumers usually pay a percentage of the sales price as the tax.

Excise taxes are used by all levels of government.

An excise tax is levied on a specific product, such as alcohol, cigarettes, or gasoline.

In Canada and many European, South American, and Asian countries, a value-added tax (VAT) provides significant revenue.

The VAT is levied on the value added to a product during production as its components are assembled into final goods.

For example, a clothing manufacturer might spend $500 on fabric, thread, zippers, and other goods required to make dresses. The manufacturer then adds $1000 to cover the costs of labor and the use of machines and equipment and sells the dresses for a total of $1500. The value-added tax is paid on this $1000.

Public Revenue

How Public Finance Affects the Economy?

Government spending and taxation directly affect the overall performance of the economy.

For example, if the government increases spending to build a new highway, construction of the highway will create jobs. Jobs create income that people spend on purchases, and the economy tends to grow.

The opposite happens when the government increases taxes. Households and businesses have less of their income to spend, they purchase fewer goods, and the economy tends to shrink.

Fiscal PolicyA government's fiscal policy is the way the government spends and taxes to influence the performance of the economy.

Government Deficits When the government spends more than it receives, it runs a deficit.

Governments finance deficits by borrowing money.

Deficit spending—that is, spending funds obtained by borrowing instead of taxation—can be helpful for the economy.

Examplewhen unemployment is high, the government can undertake projects that use workers who would otherwise be idle.

The economy will then expand because more money is being pumped into it.

However, deficit spending also can harm the economy.

When unemployment is low, a deficit may result in rising prices, or inflation. The additional government spending creates more competition for scarce workers and resources and this inflates wages and prices

INTRODUCTION

CHAPTER 1

Defining the Field of StudyPublic Finance – Field of economics that analyzes government taxation and spending activities.

Public Sector Economics or Public Economics

◦Terms that better capture the fundamental issues of this field of economics - government’s role in the allocation of real resources - that includes, but is not limited to, government’s financial behavior.

Focus on microeconomic functions of government.

1

Public Finance and IdeologyOrganic view of government

◦Society is a natural organism ◦Government is the heart.

◦Individuals are parts of the organism that have significance only as part of the community, which is stressed above the individual.

Mechanistic view of government◦Government is not an organic part of society, but created by individuals for

individuals. ◦Libertarians vs. Social Democrats: Role of government

1

Government at a Glance:The Legal Framework

State Governments

◦Federal Constitution gives state governments board autonomy to spend and tax.

◦Federal Constitution 10th Amendment controls states’ international economic policy.

◦States’ Constitutions vary in spending and taxing restrictions and the economic issues with which they deal.

Local Governments

◦Derive power to tax and spend from the States.◦Fiscal independence of local governments.

1

Government at a Glance:The Size of Government

How to measure the extent to which society’s resources are subject to control by government.

Annual expenditures◦Types of government expenditure

◦Purchases of goods and services

◦Transfers of income

◦Interest payments

◦Budget documents ◦Unified budget: Itemized list of federal government revenues and

expenditures.

◦Regulatory budget: Economic costs of government regulations.

1

The Size of GovernmentState, Local, and Federal Government Expenditures (selected

years)

1

1 2 3 4

Total Expenditures

(billions)

2011 Dollars (billions)*

2011 Dollars per capita

Percent of GDP

1970 295 1,375 6,703 28.4%

1980 847 2,007 8,815 30.4%

1990 1,880 2,948 11,784 32.4%

2000 2,906 3,712 13,155 29.2%

2011 5,410 5,410 17,362 35.9%

*Conversion to 2011 dollars done using the GDP deflatorSource: Calculations based on Economic Report of the President, 2012 [pp. 316, 320, 359, 415].

Adjusting for

Inflation

Adjusting for

PopulationRelative to

Economy

The Size of Government Government Expenditures as a % of GDP (2011)

1Source: Organization for Economic Cooperation and Development [2011b].

United

States

The Size of Government Composition: 2011 Federal Expenditures & Revenues

1Source: Economic Report of the President, 2012 [p. 413].

The Size of Government Composition: 2011 State & Local Expenditures & Revenues

1Source: Economic Report of the President 2012 [p. 419].

The Size of Government Revenues

At the Federal level, the personal income tax is the single most important source of revenue.

At the State and Local levels:◦Grants from the federal government are over 20% of revenues

◦Sales taxes and Property taxes are each about 18% of revenues.

Changes in the Real Value of Debt is also an important source of government revenue.

1

Chapter 1 SummaryPublic Finance/Public Sector Economics focuses on government’s role in the allocation of real resources - that includes, but is not limited to, taxing and govt spending.

•The Mechanistic view vs. Organic view of government.◦The U.S. embraces the mechanistic view, which nevertheless

leads to disagreements on the appropriate size of the government.

◦Evidence shows that the impact of the U.S. government on the allocation of national resources has increased over time.

•The U.S. Constitution outlines the roles of and constraints placed on state, and federal government economic activity.

1

Doing Research in Public Finance

Public Finance data available on Internet◦Resources for Economists on the Internet (www.rfe.org)

◦U.S. Census Bureau (www.census.gov)

◦University of Michigan’s Office of Tax Policy Research (www.otpr.org)

◦Urban-Brookings Tax Policy Center (www.taxpolicycenter.org)

1

TOOLS OF POSITIVE ANALYSIS

CHAPTER 2

Public Finance and Positive Analysis

One goal of Public Finance is to estimate how government policy affects individuals’ behavior.

The Role of TheoryEconomic models

◦Provide frameworks for thinking about the factors that might influence behavior.

◦Generate hypotheses whose validity can be assessed through empirical work.

◦Virtue of simplicity: reduces a problem to its essentials.

Empirical analysis: Analysis based on observation and experience. ◦Used to test hypotheses.

Causation vs. CorrelationConditions required for government action X to cause societal effect Y rather than just correlate(move together) with effect Y.

◦X must precede Y◦X and Y must be correlated

◦Other explanations for any observed correlation must be eliminated

The importance of the distinction for policy.◦Example: There is a positive correlation between being

married and wages…Does that mean government should enact a policy encouraging marriage as a way of increasing wages?

Pitfalls of Experimental StudiesEthical issues

Technical problems

Response bias

Impact of limited duration of experiment

Generalization of results to other populations, settings, and related treatments

Black box aspect of experiments

Empirical Work:Observational Studies

Observational study – empirical study relying on observed data not obtained from experimental study

Sources of observational data

◦Surveys◦Administrative records

◦Governmental data

Econometrics: statistical techniques to establish and estimate causal relationships in absence of randomization.

Chapter 2 SummaryEconomic theory provides a framework for analyzing the causal relationship between government policy and individuals’ behavior.

Empirical work tests hypothesis arising from economic theory to determine if it is consistent with real-world phenomena.

Various methods for conducting empirical work exist.

TOOLS OF NORMATIVE ANALYSIS

CHAPTER 3

Welfare EconomicsConcerned with the social desirability of alternative economic states.

3-44

Consumption EconomyEdgeworth Box - an analytical device used to model welfare economic theory

◦Depicts distribution of goods in a 2-good/2-person economy

Pareto Efficiency – an allocation of resources such that no person can be made better off without making another person worse off

Pareto Improvement – a reallocation of resources that makes at least one person better off without making anyone else worse off

3-45

Pareto Efficiency in Consumption

MRSaf = MRSaf

Where MRS:

-is the rate at which an individual is willing to trade one good for another

3-46

Adam Eve

Production EconomyAnalysis when supplies of 2 goods (applies and figs) are variable rather than fixed

Production Possibilities Curve◦Graph to model production economy

◦Maximum quantity of one output that can be produced given the amount of the other output

3-47

Production Possibilities Curve

3-48

Apples per year

Fig

leaves p

er

year

C

C0

w

y

x z

│Slope│ =

marginal rate of

transformation

The First Fundamental Theorem of Welfare Economics

Given:◦All producers and consumers are perfect competitors

◦A market exists for every commodity

Then a Pareto Efficient allocation of resources emerges◦A competitive economy allocates resources efficiently out any need for centralized

direction

3-49

Fairness and Second Fundamental Theory of Welfare Economics

Addresses equity concerns in allocations of goods

Second Fundamental Theory of Welfare Economics states that society can attain any Pareto efficient allocation of resources – one that is more equitable – by redistributing the initial allocation of resources and then letting people freely trade

Interference with market prices, which impairs efficiency, is unnecessary

3-50

Market Failures: Causes of Inefficiency

Market Power◦Monopoly

Nonexistence of Markets◦Asymmetric information

◦Externality

◦Public good

3-51

Chapter 3 SummaryWelfare economics is the study of the desirability of different economic states

◦Based on individualist social philosophy

Pareto efficiency occurs when no person can be made better off without making another person worse off

◦MRSixy = MRTxy i=persons i….n

First Fundamental Theory of Welfare Economics: Competitive markets result in Pareto efficiency

Second Fundamental Theory of Welfare Economics: Society can attain any Pareto Efficient outcome with reassignment of initial endowments and free trade

3-52

PUBLIC GOODSCHAPTER 4

Characteristics of GoodsExcludable vs. Nonexcludable

◦Excludable – preventing anyone from consuming the good is relatively easy

◦Nonexcludable – preventing anyone from consuming the good is either very expensive or impossible

Rival vs. Nonrival◦Rival – once provided, the additional resource cost of

another person consuming the good is positive

◦Nonrival – once provided, the additional resource cost of another person consuming the good is zero

4-54

Types of Goods

4-55

EXCLUDABLE

RIVAL

YES NO

YES

NO

PRIVATE

GOODS

PUBLIC

GOODS

COMMON

RESOURCES

NATURAL

MONOPOLY

Noteworthy Aspects of Public Goods

Even though everyone consumes the same quantity of the good, it need not be valued equally by allClassification as a public good is not absolute; it depends on market conditions and the state of technology

◦A commodity can satisfy one part of the definition of a public good but not the other

◦Impure public good: rival or excludable

Some things that are not conventionally thought of as commodities have public good characteristicsPrivate goods are not always provided only by the private sector

◦publicly provided private goods: rival and excludable goods provided by govt

Public provision of a good does not necessarily mean that it is also produced by the public sector (e.g. garbage collection)

4-56

Some Public GoodsBasic research

Programs to fight poverty

Uncongested non-toll roads

Fireworks display

Honesty

National Defense

4-57

Efficient Provision of Private Goods

4-58

Price Adam (Df

A)Eve (Df

E)Market (Df

A+E)

$11 5 1 6

$9 7 3 10

$7 9 5 14

$5 11 7 18

$3 13 9 22

$1 15 11 26

0

1

2

3

4

5

6

7

8

9

10

11

12

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26

DfA

DfE

DfA+E

Sf

$

Quantity of Pizza4-59

Efficient Provision of Public Goods

4-60

Units of Fireworks

1 2 3 4

Adam (DrA) $300 $250 $200 $150

Eve (DfE) 250 200 150 100

Market(Df

A+E)$550 $450 $350 $250

0

50

100

150

200

250

300

350

400

450

500

550

600

650

700

750

800

1 2 3 4

DrA

DrE

DrA+E

Sr

Quantity of Fireworks

$

4-61

Problems Achieving EfficiencyThe Free-Rider Problem

Solutions to the free-rider problem◦Perfect price discrimination

Policy Perspective: GPS is non-rival but excludable since technology exist to scramble signals

4-62

Laboratory Experiments: Do People Free-Ride?

How a typical experiment works

Typical results◦People contribute about 50% of resources to provision of

public good

◦Contributions fall the more often the game is repeated

◦Cooperation fostered by prior communication

◦Contribution rates decline when opportunity cost of giving goes up

“Warm-glow” giving

4-63

The Privatization DebatePrivatization – taking services supplied by government and turning them over to the private sector

Public Sector v Private Sector Provision: What is the right mix?◦Relative wage and materials costs: less expensive sector

preferred on efficiency grounds◦Administrative costs: large fixed adm costs can be spread over

a large group under public sector◦Diversity of tastes: larger diversity better handled by private

sector◦Commodity egalitarianism: some commodities ought to be

made available to everyone better achieved under public sector

4-64

Public vs Private Production DebateWhich sector is more efficient?

◦Theory that public sector managers have little incentive to be efficient◦However, problems in comparing cost differences since quality of services

offered by public and private sectors can differ. (e.g., hospitals)◦Incomplete contracts

◦Competition to supply good or service◦Reputation building

Ultimately depends on Market Environment facing the providers

4-65

Chapter 4 SummaryPublic goods are nonrival and nonexcludable in consumption

◦Impure public goods exhibit some qualities of private and public goods

Efficient provision of public goods:◦∑MRSi

xy= MRTxy i=person i…..n

An incentive exists to free-ride in the payment of public goods

Public goods can be provided privately; private goods can be provided publicly

4-66

Appendix: Preference Revelation Mechanisms for Public Goods

∆TEve = MRTra – (MRSraTotal – MRSra

Eve)

Eve’s choice: ∆TEve = MRSraEve

By substitution: MRTra – (MRSra

Total – MRSraEve) = MRSra

Eve

Add (MRSraTotal – MRSra

Eve) to both sides:MRTra = MRSra

Total

4-67

COST-BENEFIT ANALYSISCHAPTER 8

Projecting Present Dollars into the FutureR=$ T=years r=interest rate

How much will $1000 earn in 2 years at an interest rate of 10%?

R0 = $1000

R1 = $1000*(1+.01) = $1010

R2 = $1010*(1+.01) = $1020.10

R2 = $1000*(1+.01)2 = $1020.10

RT = R0*(1+r)T

Projecting Future Dollars into the PresentHow much will $1000 earned in 2 years at an

interest rate of 10% be worth today?

Since RT = R0*(1+r)T

R0 = RT/(1+r)T Present Value

discount ratediscount factor

Low r – more future-oriented and benefits projects in which returns are concentrated further into the futureHigh r – more present-oriented and benefits projects in which returns are concentrated closer into the future

Present Value of a Stream of Money

PV RR

r

R

r

R

r

T

T

0

1 2

21 1 1( ) ( )...

( )

Inflation

PV RR

r

R

r

R

r

T

T

T T

0

1

2

2

2 2

1

1 1

1

1 1

1

1 1

( )

( )( )

( )

( ) ( )...

( )

( ) ( )

How to incorporate inflation – price level increases – into the procedure?

Given: ∏ = inflation rate

However, (1+∏) terms cancel out, leaving the PV equation from previous slide!

CAUTION: $ values and r values must be measured consistently – if real values are used for R, the r must be measured in real terms

Private Sector Project Evaluation

The Present-Value Criterion is the most reliable evaluation guide◦Both IRR and Benefit-Cost Ratio Criteria can lead to incorrect inferences

What is the Appropriate Discount Rate for Government Projects

Based on Returns in Private Sector: the market rate

Social Discount Rate: the rate at which society is willing to trade off present consumption for future consumption

◦Arguments for SDR:◦Paternalism

◦Market Inefficiency

◦Example: Discounting and the Economics of Climate Change

Government Discounting in Practice

U.S. Office of Management and Budget (OMB) requires federal agencies to use a variety of discount rates, depending on the agency and the type of project

◦One using real discount rate of 7%◦One using real discount rate of 3%

Evidence shows that government’s incorrect use of discounting has favored policies that increase revenue in the short run, but reduce it in the long run

Valuing Public Benefits and CostsInferences from Economic Behavior

How to place a value on the time saved by a proposed project like a new highway?

◦Earnings?

◦Other methods

How to place a value on a life saved by a proposed project such as a 4-lane divided highway?

◦Lost earnings?

◦Probability of death

Valuing Public Benefits and CostsIntangibles

Intangibles can subvert cost-benefit exercises

C/B tools can reveal limits on valuing intangibles

Cost-effectiveness analysis might be best in the presence of intangible benefits

◦Comparing the costs of various alternatives that attain similar benefits to determine which one is the cheapest

Distributional ConsiderationsShould who gains and who loses be taken into account? Should benefits and costs be weighted?

NO: Hicks-Kaldor Criterion – a project should be undertaken if it has positive net present value, regardless of distributional consequences

NO: Let the government costlessly correct any undesirable distributional aspects

NO: Relies too much on value judgments and politics

An Application: Are Reductions in Class Size Worth It?

Discount rate

Costs

Benefits

The Bottom Line and Evaluation

Chapter 8 SummaryCost-Benefit analysis is used to evaluate potential public sector projects

Present value of future expected costs and benefits must be calculated in order to allow correct comparisons

Although the IRR and B-C Ratio are used to evaluate projects, the NPV criterion has fewer biases and problems

Choice of the discount rate is critical

The costs and benefits of public projects can be measured using market prices in the absence of market failures. Otherwise, shadow prices or consumer surplus can be used

CONT

Chapter 8 Summary (cont)Quantifying the value of time and life, is necessary in measuring benefits, but using earnings as a proxy has limitations

Whether the distribution of future costs and benefits on various groups of people should be included in C-B analysis is under debate

Uncertainty of future costs and benefits can be included through the use of certainty equivalents

SOCIAL SECURITYCHAPTER 11

Social Security Expenditures(1939-2011)

11-83

Source: Social Security Trustees [2012].

Why Have Social Security?Consumption Smoothing and the Annuity Market

◦How Social Security works

◦Annuity

◦Consumption smoothing

Adverse Selection and the Annuity Market◦Asymmetric information

◦Adverse selection

11-84

Other JustificationsLack of foresight and paternalism

Moral hazard

Economize on decision-making and administrative costs

Income Redistribution

Improve the Economic Status of the Aged

11-85

AdjustmentsFamily Status

◦+50% for spouse or dependent child◦If covered worker dies spouse receives 100% of worker’s

benefit or spouse’s own benefit (whichever is higher)◦Divorced spouse married at least 10 years gets spouse benefit

if not remarried while covered worker alive

Earnings test and taxing benefits◦Benefits reduced $1 for every $2 earned above $14,160

◦Individuals losing benefits may have later benefits increased◦Up to 85% of benefits taxed for recipients with income above a

base amount ($25,000 for single and $32,000 for married taxpayers)

11-86

Maintain the Current SystemRaise the payroll tax

Raise the Maximum Taxable Earnings Level

Raise the Retirement Age

Reducing the Cost-of-Living Adjustment

Change the Benefit Formula

Comparing the Options

11-87

TAXATION AND INCOME DISTRIBUTION

CHAPTER 14

Vocabulary

Statutory Incidence

Economic Incidence

Tax Shifting

Partial Equilibrium Models

Tax Incidence: General Remarks

Only people can bear taxes◦Functional distribution of income

◦Size distribution of income

Both sources and uses of income should be considered

Incidence depends on how prices are determined

Incidence depends on the disposition of tax revenues◦Balanced-Budget tax incidence

◦Differential tax incidence◦Lump-sum tax

◦Absolute tax incidence

Tax Progressiveness Can Be Measured in Several Ways

Average tax rate versus marginal tax rate

Proportional tax system

Progressive tax system

Regressive tax system

Tax Liabilities under a hypothetical tax system

Income Tax Liability

Average Tax Rate

Marginal Tax Rate

$2,000 -$200 -0.10 0.2

3,000 0 0 0.2

5,000 400 0.08 0.2

10,000 1,400 0.14 0.2

30,000 5,400 0.18 0.2

Taxes on FactorsStatutory vs. Economic Incidence

The Payroll Tax◦Tax on labor that finances Social Security

Tax on Capital in a Global Economy

Profits TaxesEconomic profit

Perfect competition

Monopoly

Measuring economic profit

An Applied Incidence Study

Average Federal Tax Rates and Share of Federal Taxesby Income Quintile (2009)

Income Category Average Federal Tax Rate Share of Federal Taxes

Lowest Quintile 1.0% 0.3%

Second Quintile 6.8% 3.8%

Third Quintile 11.1% 9.4%

Fourth Quintile 15.1% 18.3%

Highest Quintile 23.2% 67.9%

All Quintiles 17.4% 100.0%

Top 1% 28.9% 22.3%

Source: Congressional Budget Office (2012a)

Chapter 14 SummaryWho bears the burden of a tax? It depends on price changes, which, in turn, depend on:

◦Time frame◦Disposition of tax revenue

◦Market structure◦Elasticities of supply and demand

◦Mobility of factors of production◦Tax salience

Partial equilibrium incidence and general equilibrium incidence analyses are used to determine burdens of unit and ad-valorem taxes

THE PERSONAL INCOME TAXCHAPTER 17

Computation of Federal Personal Income Tax Liability

17-97

• Start with Tax Base• Wages and compensation, interest, dividends, capital gain (or loss), business income (or loss),

pensions, farm income (or loss), rents, royalties, Social Security benefits, etc.• Subtract by “Above-the-line” deductions

• Trade or business expenses, moving expenses, educator expenses, self-employed health insurance premium payments, student loan payments, tuition and fees, alimony paid, etc.

• Equals Adjusted Gross Income• Subtract Exemptions

• Phaseout with income• Compare Larger of: Standard Deduction or Itemized Deductions

• Charitable contributions, home mortgage interest, state and local taxes, medical expenses in excess of 10% of AGI, casualty and theft losses, non-reimbursed employee expenses; Differs by filing status

• Phaseout with income• Equals Taxable Income• Apply Tax Rate

• Seven ordinary rates (10%, 15%, 25%, 28%, 33%, 35%, 39.6); differs by filing status; special rates for dividends and capital gains

• Equals Tax Liability Before Credits• Subtract Tax Credits

• Child tax, additional child tax, EITC, HOPE and Lifetime Learning, electric vehicles, health coverage tax, adoption, mortgage interest, retirement savings contribution, child and dependent care credit, credit for the elderly or the disabled, D.C. First-Time homebuyer’s credit, etc.

• Phaseout with income• Equals Regular Tax Liability

• Start over to determine AMT tax liability using AMT base. Pay tentative AMT liability in excess of regular tax liability

• Then Pay Tax or Claim Refund• Incur additional compliance, administration, and efficiency costs

Haig-Simons Income (Comprehensive Income)

Income = Consumption + DNet Worth

Maximum consumption taxpayers can enjoy without spending down their wealth

Anything received that can be used, either now or later, to purchase goods and services

Subtract costs of earning income

17-98

Items Included in H-S IncomeEmployer pension contributions and insurance purchases

Transfer payments, including Social Security benefits, unemployment compensation, and welfare

Capital gains◦Realized versus unrealized

Income in-kind

17-99

Some Practical and Conceptual Problems

Computing income net of business expenses

Computing capital gains and losses

Valuing in-kind services

17-100

Excluded Forms of Money Income

Interest on State & Local Bonds

Some dividends

Capital gains

Employer contributions to benefit plans

Some types of saving◦Individual retirement account (IRA)

◦Education savings account

Gifts and Inheritances

17-101

Personal ExemptionsAllowable Exemptions

◦Taxpayer and spouse◦Children under 19 (or 24 if in school)

◦Children and other relatives who pass certain tests (depend on taxpayer for support)

◦Phase out

Why are there exemptions?◦Adjust ability to pay for presence of children

◦Provide tax relief for low-income families

17-102

DeductionsImportant Itemized Deductions

◦Charitable Contributions◦Unreimbursed medical expenses > 10% AGI

◦State and Local Income and Property Taxes◦Certain Interest Expenses

◦Interest on consumer debt◦Interest on qualified education loans

◦Interest on debt incurred to purchase financial assets◦Interest on home mortgages

Interest rules in terms of H-S criterion

Tax Arbitrage

17-103

Tax ExpendituresWhat are tax expenditures?

Annual tax expenditure budget

Technical problems with measuring tax expenditures◦Incentive effects◦Defining income

◦The decision not to tax is not equivalent to a government expenditure

Why are tax expenditures to popular?

17-104

Flat Income TaxFeatures of Flat income tax

◦Applies same tax rate to everyone and each component of income◦Limited deductions

Arguments in favor◦Reduces excess burden

◦Reduces incentive to cheat◦Greater simplicity

◦Equity

Arguments against◦Shifts burden from rich to middle class

◦Simplicity an illusion

Altig et. Al. [2001]

17-105

Taxes and InflationTax Indexing

How inflation affects taxes◦Bracket creep

◦Deductions and exemptions set in nominal terms

◦Taxation of nominal capital gains

◦Taxation of nominal interest

17-106

Choice of Unit and the Marriage Tax

Three principles◦The income tax should embody increasing marginal tax rates

◦Families with equal income should, other things being the same, pay equal taxes

◦Two individuals’ tax burdens should not change when they marry; the tax system should be marriage neutral

No tax system can adhere to all three simultaneously

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Treatment of International Income

Global versus territorial systems

Equity

Efficiency◦Production decisions

◦Residential decisions

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State Income TaxesState income taxes similar to federal tax

Lower marginal tax rates

Including state tax rates when assessing overall marginal tax rates

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Chapter 17 SummaryThe Haig-Simons criterion of income is the next change in the individual’s power to consume. The U.S. federal tax system is far removed from the Haig-Simons criterion

Computing federal income tax liability involves determining the total income base, taxable income – the tax base minus deductions and exemptions - and tax liability – taxable income times a tax rate

◦Tax expenditures are forgone revenues due to preferential tax treatment

The alternative minimum tax was designed to ensure that high-income earners who use tax shelters pay some federal income tax, although it affects millions of middle-class earners

Currently, joint tax liabilities can increase or decrease upon marriage

Taxes due are roughly independent of whether the income is earned at home or abroad

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PERSONAL TAXATION AND BEHAVIOR

CHAPTER 18

Empirical FindingsEissa [2001]

◦For males aged 20-60, the effect of changes in the net wage on hours worked is small and often statistically insignificant

◦Elasticity of approximately 0.05

◦For married females, the hours of work and labor force participation decisions are quite sensitive to changes in the net wage, although it has gotten smaller over time.

◦Elasticity of approximately 0.40

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Tax Rates versus Tax Revenue–Laffer Curve

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Tax rate

Tax

reve

nu

e

t1 t2 tA t3

Debate Over the Laffer CurveThe Laffer curve and the elasticity of labor supply

Where on the Laffer curve is the economy operating?

Other ways tax rates can affect tax revenues

Determining the optimal tax rate

Is maximizing tax revenue a valid goal?

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Some Additional ConsiderationsReal net rate of return

Many assets

Private saving versus social saving

Validity of life-cycle model

Empirical evidence: effect of taxation on saving◦Problems using the regression approach

◦Specification issues

◦Measurement issues

◦Joint Committee on Taxation [2005]

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Tax-Preferred Savings AccountsTypes of tax-preferred savings accounts and how they work

Are contributions to these accounts new saving?

Administrative details and effect on saving: insights from Behavioral Economics

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Taxes and the Capital ShortageTaxes and investment

Taxes and excess burden

Closed versus open economy

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Chapter 18 SummaryThe U.S. personal income tax affects several economic decisions including labor supply, housing consumption, saving, and human capital investment

Research into these affects are among the most contentious of all areas of public policies

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THE CORPORATION TAXCHAPTER 19

I’ll probably kick myself for having said this, but when are we going to have the courage to point out that in our tax structure, the corporation tax is very hard to justify?

President Ronald W. Reagan

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CorporationsCorporation – A state-chartered form of business organization, usually with limited liability for shareholders (owners) and an independent legal status

Limited liability

Corporations are “artificial legal persons”

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Why Tax Corporations?Only real people can pay a tax

Justifications ◦Corporations are distinct entities

◦Corporations receive special privileges from society

◦Protects integrity of personal income tax

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Structure

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Revenue- Expenses incurred earning revenues

Taxable Income

* Tax rate (15% - 35%)

Tax- Credits

Total Tax

Alternative Minimum Tax

Treatment of Losses

Allowable ExpensesEmployee Compensation

◦Except compensation in excess of $1,000,000◦Options do not have to be included

Cost of Material Inputs

Taxes including employer contributions to Social Security

Repairs and advertising

Interest but not dividends

Depreciation

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ConsiderationsDepreciation

◦Economic depreciation: The extent to which an asset decreases in value during a period of time

◦Accelerated depreciation: Taking depreciation allowances faster than true economic depreciation

◦Expensing: deducting the asset’s full cost at time of acquisition

Tax life: the # of years an asset can be depreciated◦3, 5, 7, 10, 15, 20, 27.5, and 39 years

◦Most 5 years◦Intangibles

Treatment of Dividends versus Retained Earnings◦Double taxation

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Effective Tax Rate on Corporate CapitalStatutory rate versus effective rate

◦Interest deductibility

◦Depreciation allowances

◦Inflation

◦Double taxation

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Incidence and Excess BurdenA tax on corporate capital

◦Incidence in a general equilibrium model

◦Excess burden on a general equilibrium model

A tax on economic profits◦Incidence and excess burden of a tax on economic profits

◦Actual corporate profits versus economic profits

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Effects on BehaviorTypes of Assets

◦Tax system encourages purchase of assets that receive relatively generous depreciation allowances

Total Physical Investment◦Accelerator Model

◦Neoclassical Model

◦Cash Flow Model

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Effect of User Cost on InvestmentEconometric problems

◦Role of expectations

◦Elasticity of supply curve of capital goods

◦Open economy problems

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Cash Flow ModelWhat is cash flow?

Irrelevancy of cash flow in neoclassical model

Cost of internal versus external funds

Empirical results

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Effects on BehaviorCorporate Finance: How to finance and whether to retain or distribute profits

◦Why do firms pay dividends?◦Dividends as a signal of firm’s financial strength

◦Clientele effect

◦Effect of taxes on dividend policy◦Empirical evidence – Chetty and Saez [2004]

◦Effect on savings

◦Debt versus Equity Finance

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Taxation of Multinational Corporations

Structure◦U. S. corporations pay tax at standard rate on global

taxable income◦Credit for foreign taxes paid

Subsidiary status◦Deferral of taxes on income from foreign enterprise

◦Repatriation

Income allocation◦Arm’s length system

◦Transfer-pricing problem

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Corporation Tax Reform Full IntegrationIssues

◦Nature of the corporation

◦Administrative feasibility

◦Effects on efficiency

◦Effects on saving

◦Effect on distribution of income

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Chapter 19 SummaryThe U.S. Corporate Income Tax of 35%, accounting for about 10% of all federal revenues, is controversial due to double taxation arising from the dividend income tax component of the personal income tax

Economic analysis centers on the effect of the tax on amount of physical investment, dividend income payments, debt financing, state taxes, and tax avoidance, particularly concerning multinational corporations

Tax reforms include full integration of corporate and personal income taxes, and dividend relief

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DEFICIT FINANCECHAPTER 20

How Big Is the Deficit?Deficit

Surplus

On-budget deficit

Off-budget deficit

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How Big Is the Debt?

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Source: Congressional Budget Office [2012b]

Interpreting Deficit, Surplus, and Debt Numbers

Government Debt held by the Federal Reserve Bank

State and Local Government

Effects of Inflation◦Inflation tax

Capital versus Current Accounting

Tangible Assets

Implicit Obligations

Summing Up

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The Burden of the DebtStatutory versus Economic Incidence

One Hand Borrows from the Other◦Internal Debt

◦External Debt

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To Tax or To BorrowBenefits-Received Principle

Intergenerational Equity

Efficiency Considerations

Deficits and Functional Finance◦Functional finance

Moral and Political Considerations◦Federal Debt and the Risk of a Fiscal Crisis

Controlling the Deficit

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Chapter 20 SummaryWhen government spending > revenues, it must borrow money: debt is the sum of past deficits & surpluses

Economic research centers on whether future generations carry the burden of government debt

Several factors influence whether government should finance expenditures through taxes or debt

◦From an efficiency point of view, the excess burden of tax vs. debt financing should be considered

Options for controlling the deficit include changing budget-making processes and a constitutional amendment

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FUNDAMENTAL TAX REFORM:TAXES ON CONSUMPTION AND WEALTH

CHAPTER 21

How a Value-Added Tax Works

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Producer Purchases SalesValue Added

VAT at 20 Percent Rate

Farmer $ 0 $400 $ 400 $ 80

Miller 400 700 300 60

Baker 700 950 250 50

Grocer 950 1,000 50 10

Total $2,050 $3,050 $1,000 $200

Efficiency and Equity of Personal Consumption Taxes

Efficiency issues◦An income tax and saving and labor supply decisions

◦A consumption tax and saving and labor supply decisions

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Efficiency and Equity of Personal Consumption Taxes

Equity issues◦Progressiveness

◦Ability to pay

◦Annual versus Lifetime Equity◦A numerical example

◦A formal model

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Rationalizations for Sales TaxesEase of administration

Defining the tax base

Tax evasion

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Efficiency and Distributional Implications of States Sales Taxes

Differential versus uniform tax rates

How to set rates◦Efficiency goal only

◦Equity goal

Externalities

Sales taxes as substitutes for user fees

“Sin” taxes

Information requirements for differential tax rates

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A National Retail Sales TaxArguments in favor

◦Simplicity

◦Ease of compliance

Arguments Against

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Value-Added TaxHow a value-added tax works

VAT as an alternative method for collecting retail sales tax

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Implementation IssuesTreatment of investment assets

◦Consumption-type VAT

Collection procedure◦Invoice method

Rate structure

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Income versus Consumption Taxation

No need to measure capital gains and depreciation

Fewer problems with inflation

No need for separate corporation tax

Administrative problems

Transitional issues

Gifts and bequests

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Advantages Disadvantages

Problems with Both SystemsDefining consumption

Choosing the unit of taxation

Choosing the rate structure

Valuing fringe benefits

Determining method for averaging over time

Taxing home production

Discouraging incentive to participate in underground economy

Real world versus ideal tax systems

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Wealth TaxesJustifications for taxing wealth

◦Large accumulations of wealth should be taxed

◦Correct problems with administration of income tax

◦Higher wealth implies higher ability to pay

◦Reduces the concentration of wealth

◦Payment for benefits received from government

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Estate and Gift TaxesRationales

◦Payment for services◦Reversion of property to society

◦Incentives

◦Recipient versus donor behavior◦Work◦Saving

◦Form of bequest◦Relation to personal income tax

◦Income distribution

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Gross EstateAll decedent’s assets at time of death, including real property, stocks, bonds and insurance policies, plus gifts made during decedent’s lifetime

Typically valued at market value at date of death; valuation may be set 6 months later if value of estate declines

Closely held businesses and farms are valued at “use value.”

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Chapter 21 SummaryArguments for substituting the income tax with a personal consumption tax include the elimination of double taxation, promotion of lifetime equity, promotion of efficiency, adjustability for progressiveness and administrative ease.

Arguments against the substitution point out that it has transition problems, it violates the of ability-to-pay rule, it is administratively burdensome, it can lead to excessive concentration of wealth, and it is regressive in nature

Sales taxes are important sources of revenues for state and local governments

◦The VAT is popular in Europe but not used in the U.S.

Wealth taxes are controversial. They are not a major source of revenue and little is known about the incentive effects or incidence of these taxes

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