Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 18 Taxation and Public Expenditure

Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

Chapter 18

Taxation and Public Expenditure

18-2Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

In this chapter you will learn to

3. Describe the main categories of government spending.

2. Explain why a tax can lead to allocative inefficiency.

5. Describe the factors that determine the scope and nature of government’s role in the economy.

4. Explain why transfer payments for the elderly are an increasing proportion of government spending.

1. Describe the main sources of government revenue in the United States.


Tax Expenditures

Tax Expenditures: Tax revenues returned to taxpayers who take actions that the government deems desirable

Taxation

Example: health insurance


Figure 18.1 International Comparison of Government Tax Revenues, 2004


Average Tax Rate: % of income that individual pays in taxes

An income tax is:- progressive if the ATR rises as income rises- regressive if the ATR falls as income rises- proportional if the ATR is constant as income rises

Most income-tax systems achieve their progressivity by having marginal tax rates that rise with income

– “tax brackets”

Progressivity


The U.S. Tax System

Sources of federal government revenues:

• personal income taxes

• payroll taxes

• corporate Income taxes

• excise and sales taxes


Tax bracket: A range of taxable income for which there is a constant marginal tax rate.

Tax Brackets


Figure 18.2 Sources of Government Revenues, 2005


APPLYING ECONOMIC CONCEPTS 18.1

How Federal Taxes Affect Your Paycheck

Income Taxes


Taxation and Equity

Evaluating the Tax System

Equity is normative. Two principles are helpful in assessing equity:

1. the ability-to-pay principle

2. the benefits-received principle

- vertical and horizontal equity

Problems:

- ability to pay is not the same as income.

- how to measure benefits received?


A modern government relies on many kinds of taxes. Assessing the entire tax system is complicated by two factors:

1. the progressivity of the system depends on the mix of the different taxes (federal taxes tend to be progressive; property taxes are slightly regressive)

2. income from different sources are taxed at different rates

How Progressive is the U.S. Tax System?


APPLYING ECONOMIC CONCEPTS 18.2

Poverty Traps and the Negative Income Tax

Negative Income Tax


Taxation and Efficiency

Taxes often generate allocative inefficiency.

Two burdens of taxation:

1. direct burden is the amount paid by taxpayers

2. excess burden is the allocative inefficiency generated by a tax


Most taxes impose both burdens:

- by taking resources from market participants, they impose a direct burden

- by changing behaviour, they generate a deadweight loss — the excess burden

The government’s tax policy should strive to minimize allocative inefficiency for a given amount of tax revenues.

Taxation and Efficiency


Figure 18.3 Direct and Excess Burdens of an Excise Tax

Case 1: Only a direct burden, no excess burden.

Case 2: No direct burden (no sales), some excess burden.

Case 3: Both direct and excess burdens.


The same principle applies with an income tax...

Figure 18.4 Direct and Excess Burdens of an Income Tax


Figure 18.5 A Laffer Curve

Along a Laffer curve:

- increases in the tax rate beyond some level (t0) lead to disincentive effects, and decrease tax revenues.


Public Expenditure

There are two broad categories of government expenditure:

1. purchases of goods and services

2. transfer payments (including payments made to other governments)

Federal, state and local governments spend an amount equal to about one-third of the nation’s annual output.


Figure 18.6 Spending by Governments as a Share of National Income,1960–2005


Figure 18.7 Federal, State, and Local Spending, 2005


Purchases of Goods and Services

Because public goods are underprovided by private markets due to the free rider problem, government spending tends to be concentrated on providing public goods.

- national defense is 2/3 of federal government spending

- education is about 20% of state and local government spending

- policy and fire services are about 15% of the state and local government spending


Transfer Payments

The largest category of transfer payments by the federal government is made to individuals.

Federal government transfer payments include transfers to:

– elderly persons (Social Security and Medicare)

– needy persons (welfare and Medicaid)

– other governments (grants-in-aid)


Evaluating the Role of Government

Public Versus Private Sector

Government activities reallocate resources between the private and public sectors

- a different mix of goods and services from what would otherwise exist

What is the appropriate mixture of public and private expenditures?


John Kenneth Galbraith (1908-2006) lamented the reallocation away from the public sector, especially in the United States

- “private affluence and public squalor”

His classic 1958 book The Affluent Society discussed his views of the appropriate role of government in the economy.

Evaluating the Role of Government


Scope of Government Activity

It is important to maintain an appropriate perspective about the role of government in the economy.

One pitfall is to become overwhelmed by the government’s role, and forget that people are mostly free to make decisions in their own ways.

Another pitfall is to fail to recognize that a significant share of of taxes is used to finance goods and services that add to the welfare of individuals — such as education, health care, and roads.


Evolution of Policy

In a democratic society, the majority’s view on the amount of intervention that is desirable will have a considerable influence on the amount of intervention that actually occurs.

The economist’s job is to continue analyzing and explaining the effects of alternative policies.

Only then will the electorate and policymakers be able to make informed choices.

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Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 18 Taxation and Public Expenditure