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DYNAMIC POWERPOINT™ SLIDES BY SOLINA LINDAHL

The Federal Budget:The Federal Budget:Taxes and SpendingTaxes and Spending

CHAPTER OUTLINE

Tax Revenues

Spending

Will the U.S. Government Go Bankrupt?

Revenues and Spending Undercount the Role of Government in the Economy

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Some good blogs and other sites to get the juices flowing:

Food for Food for Thought….Thought….

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Introduction

The federal government spends over 18% of GDP.Taxes collected are just under 17%.In this chapter we will answer the following questions:

Where does all that money come from?Where does it go?How long can the government keep spending more than it raises in taxes?

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Tax Revenues

Sources of Government Revenue (2010)

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Tax Revenues

The Individual Income Tax

Marginal tax rateMarginal tax rate: the tax rate paid on an extra dollar of income.

Example: If the marginal tax rate is 10%, tax owed on an additional $100

will be (.10) x $100 = $10.

Marginal tax rate: important (it affects incentives).

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Tax Revenues

U.S. Marginal and Average Tax Rates (2010)

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Tax Revenues

The Individual Income Tax

Average tax rateAverage tax rate: total tax payment divided by total income.

Example: If income is $50,000 and tax owed is $7,500, the average tax rate is…

Marginal tax rates are set by government (the average tax rate is calculated after tax owed is known).

(15%) 0.15$50,000$7,500

Try it!Try it!In the simple land of Rabushka, there is only one tax rate, 20 percent, but workers don't have to pay tax on the first $10,000 of their income. For every dollar they earn above $10,000, they pay 20 cents on the dollar to the Lord High Mayor of Rabushka. What is the average income tax rate in Rabushka if a worker's income is $1,000,000?

a)20%b)19.8%c)22%d)16%

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Tax Revenues

The Individual Income TaxExemptions and Deductions: not all income is taxed.

Exemptions: reduce taxable incomeSpouse, DependentsEach exemption reduces taxable

income by $3,650.

Deductions: also reduce taxable income.Apply only to specific expenses.Example: mortgage interest

The Mortgage Interest Deduction: encouraging home buying since 1913

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Tax Revenues

Taxes on Capital Gains, Interest, and Dividends

All of these are taxes on investment income.Dividends—stockholders’ share of the profits.

Marginal Tax Rate = 15% for most people.Marginal Tax Rate = 5% for low income people.

Capital Gains—the difference between the price an asset was purchased at and its selling price.

Marginal Tax Rate = 15%.Capital losses can offset income from capital

gains.

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Tax Revenues

Taxes on Capital Gains, Interest, and Dividends

Political debate about how investment income should be taxed.

Democrats—favor higher tax rates.Why?: Rich people (who invest more

than the poor) should bear a higher share of the burden.

Republicans—favor lower tax rates.Why?: Lower taxes provide incentive

to invest and create economic growth.

The Capital Gains Tax: an appropriate tax on lazy fatcats? Or stifling the engine of growth?

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Tax Revenues

The Alternative Minimum Tax (AMT)Designed in 1969 to make it

impossible to avoid all income tax.Requires taxpayers to do two

calculations:Compute taxed owed under standard

tax code.Compute what they owe based on a flat

rate of 26% or 28% with no deductions.Pay the higher of the two.

Because the AMT is not adjusted for inflation, more people pay than originally intended.

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Tax Revenues

Social Security and Medicare TaxesFICA (Federal Insurance Contributions

Act) Payroll tax.Employees pay 6.2% on earnings up to

$106,800.Employers pay 6.2% on the same earnings.

The larger share of the burden is on workers because…

employers are able to shift some of the tax back on workers by paying lower wages.

Chile (1981): privatization of social security-employers no longer had to pay payroll taxes for their employees.

Result? Wages rose.

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Tax Revenues

Social Security and Medicare TaxesMedicare taxes—special payroll tax to finance Medicare.

1.45% deducted from workers’ paychecks.1.45% deducted paid by

employers.Again, workers pay much of the

employers’ premium in the form of lower wages.

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Tax Revenues

The Corporate Income Tax35% in the U.S.—one of the highest in the world.Tax code lets a good accountant reduce the legal measure of income.Example: Boeing—a large and profitable airplane manufacturer.

Over a recent period of 5 years paid an average tax rate of 0.7%.

Who pays the corporate income tax?Shareholders and bondholdersWorkers (in the form of lower wages)Consumers (in the form of higher prices)

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Tax Revenues

The Bottom Line on the Distribution of Federal Taxes

Note: Includes all deductions, exemptions, corporate taxes, payroll taxes,excise taxes, AMT, and assumptions about incidence.

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Tax Burden: Who Pays What?

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Tax Revenues

The Bottom Line on the Distribution of Federal Taxes

Conclusion: Overall, the U.S. tax code is progressive

Progressive tax rates Progressive tax rates are higher on people with higher incomes.

Effective tax rate ranges from 4.1% - 31.2%

Flat tax:Flat tax: constant average tax rate on all income levels.

Regressive tax: Regressive tax: higher average tax rate on people with lower incomes.

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SEE THE SEE THE INVISIBLEINVISIBLE HANDHAND

SEE THE SEE THE INVISIBLEINVISIBLE HANDHAND

What are the political chances for a flat tax?

Eliminating the mortgage deduction would result in lower house prices and other side effects…… What do you think?

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Tax Revenues

State and Local TaxesOverall: smaller burden (half the level of federal taxes)States raise more of their revenues from sales taxes.Less progressive than the federal income tax.

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Spending

Where does our tax money go?

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Spending

Social SecurityAt $721.5 billion in 2010—the single largest government program in the world.Run on a “pay as you go” basis

Current contributions pay for benefits of current retirees.No one has a social security

account in their name.

Ida May Fuller, receiving the first ever Social Security check in 1940: She paid lived to age 100, paid $24.75 in Social Security Taxes and received $22,888.92 in benefits.

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Net Benefits of Social Security

(Single male assuming various retirement years and average wages)

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Spending

Social SecuritySome people advocate raising the full retirement age.Net benefits are declining over time.

Higher taxes on today’s workers funds larger benefits for yesterday’s workers.

President Franklin D. Roosevelt, signing the Social Security Bill into law.

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Spending

Defense2010—Spending on defense was $719,200,000,000 ($719.2 billion.)

Excludes most spending on the wars in Iraq and Afghanistan.

The U.S. spends more on its military than any other country.

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Top Ten Countries by MilitaryExpenditure (Billions of U.S. Dollars)

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Spending

Medicare and MedicaidMedicare—reimburses the elderly for medical spending.

With Social Security, amounts to the largest federal spending program.

Medicaid—Covers the poor and the disabled.

Paid for jointly by federal and state governments.Expenditures are half that of Medicare.

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Spending

Unemployment Insurance and WelfareCommon myth: most money spent by the federal government goes to welfare programs.Truth? Welfare is 9% of federal budget.Two important categories of welfare:

Temporary Assistance for Needy Families (TANF):Assistance for poor households with children.Benefits are limited to 5 years in a lifetime.Housing vouchers are given to subsidize a

portion of rent.

Earned Income Tax Credit (EITC): is a direct cash payment based on income.

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Spending

Everything elseNo other programs are large compared to Medicare, Social Security and defense spending.Earmarks have received a lot of attention.

When a congressman puts an expenditure for his/her district into a broader bill.While often wasteful, cutting them out

will not save enough to fund significant new spending programs.

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Spending

National Debt, Interest on the National Debt, and Deficits

National Debt held by the publicNational Debt held by the public: All federal debt held outside the United States government.

As of 2011 equaled around $13.5 trillion.Debt-to-GDP Ratio = over 60%

May be high for an individual but not necessarily for the U.S. government.Debt-to-GDP ratio has been much higher in

the past.

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Spending

National Debt, Interest on the National Debt, and Deficits

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Spending

National Debt, Interest on the National Debt, and Deficits

Interest on the national debtPayment of interest to bond

holders in 2007 was $244 billion.Does it matter if a large amount

of the debt is owed to foreigners? From a purely economic point of

view the answer is no.What matters is how the borrowed

dollars are spent.

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Spending

National Debt, Interest on the National Debt, and Deficits

DeficitDeficit:: the annual difference between federal spending and revenues.

The deficit is…The difference between revenues and spending.The annual change in the national debt.

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U.S. Spending, Revenues and Deficit

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Will the U.S. Government Go Bankrupt?

The Congressional Budget Office (CBO): “under any plausible scenario, the federal budget is on an unsustainable path…”

Main forces driving the projectionsDemographics

The population is aging resulting in...

Higher Social Security and Medicare payments.

Rising health costs per personRising more than twice as

fast as GDP per capita.

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Will the U.S. Government Go Bankrupt?

Actual Projected

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19601970198019902000201020202030204020502060

Source: Congressional Budget Office, Long Term Budget Outlook 2007

The Debt to GDP Ratio is Projected to SoarGiven Current Spending and Tax Trends

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If the generation of new ideas has caused the Solow curve to shift to the right (with no other changes) then the debt-to-GDP ratio would

a)increase.b)remain constant.c)decrease.d)be impossible to calculate.

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Spending and Revenue Projections by Category as a Percentage of GDP

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Will the U.S. Government Go Bankrupt?

The Future is Hard to PredictThe U.S. has a history of relatively low taxes.

The American Revolution was in part about taxes in spite of one of the lowest tax burdens in the world.The income tax is fairly new: began

in 1913.Taxes and federal spending increased

dramatically during WWI and WWII.Since then, as a percent of GDP they

have remained fairly stable around 18%.

Take a look…..Take a look…..

How will raising the debt ceiling impact U.S. bond markets? Via PBS’s “Making Sen$e” series, Paul Solman gives a balanced overview with clips, interviews and analysis. (7:51 minutes)

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http://www.youtube.com/watch?v=wNv__bi-AVw

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Will the U.S. Government Go Bankrupt?

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0 20 40 60

SwedenDenmark

FranceFinlandAustria

BelgiumNetherlands

ItalyGermany

United KingdomCanada

SpainJapan

United StatesAustralia

SwitzerlandIreland

Total government spending includes spending by federal, state and local governments.Source: OECD in Figures, 2005

Total Government Spending (as a Percentage of GDP)

U.S. government spends a lower fraction of GDP than most other developed countries.

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Will the U.S. Government Go Bankrupt?So what will happen: will spending be cut or will taxes be raised? No one knows.

Spending could increase substantially and U.S. spending would be on par with German, Italy, and the Netherlands today.Cutting total spending substantially will require cuts in Social Security benefits.

This will be politically difficult.

Other countries spend a smaller fraction of GDP on health care but…

The growth in health care costs is similar throughout the world.

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Revenues and Spending UndercountRevenues and Spending Undercountthe Role of Government in the Economythe Role of Government in the Economy

The government’s influence on The government’s influence on resources goes beyond simple budget resources goes beyond simple budget measurements….measurements….

The EPA has a small-ish budget but a The EPA has a small-ish budget but a large amount of regulatory influence over large amount of regulatory influence over the economy’s resources.the economy’s resources.

And when the military is filled by draft, And when the military is filled by draft, the opportunity cost to society is larger the opportunity cost to society is larger than with a volunteer army.than with a volunteer army.

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Which of the following statements about the Social Security program is correct?

a)The earlier you retire, the greater the benefits you receive from the Social Security system.

b)Your Social Security withholdings from your paychecks are deposited into an account for you.

c)On average, retirees in the United States receive about $8,000 per month in Social Security payments.

d)Women, who generally live longer than men, benefit more from the system.

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The annual difference between federal spending and revenues is called:a)a deficit.b)the debt held by the public.c)the national debt.d)the debt to GDP ratio.

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