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Unformatted text preview: This material may be protected by Copyright Law (,Tttie 17 . . Learning Guide Watch for answers to these important questions What Is the role of government in our economy? How do we distinguish toe- tween the diflerent types of goods that government provides? Can government provide goods effi- ciently? What concepts can help us analyze and evaluate the provision of goods by the publlo sector? How does the government raise money? How does it spend money? What methods can be used to achieve greater eifiolency in budgeting? What is the nature of our tax system? What principles are used to evaluate particular taxes and their attests? Who was John Stuart Mill? What views did he have of the role of gov- ernment In the economy? The Public Sector— Governmenl: Public Choice and Taxation Economic Scope and Functions at Government Spillovers. Market Failure, and Public Choice Public-Sector Budgeting Our Tax System Theories oi Taxation Completing the Circular-Flow Model Origins: Government in the Economy One of the most remarkable trends in contempomrv history has been the growth in the importance of gov. ' ; emmem in economic life. As measured by govern. ment purchases of goods and services, the public sec. tor bought 10 percent of the nation's toral Output in 1930. Today the public sector purchases approxi. mately twice that percentage of the nation's total our- put. These facts raise many questions concerning the economic functions of government in our mixed economy. This chapter examines a few of the more im- portant ones and provides some basic tools for under- standing them. Any serious discussion of government is bound to raise questions about taxes. Taxes, you may recall from your study of history, have sometimes been a major cause of wars and revolutions. Moreover. in our society today, taxes affect economic activity in many different ways. When we speak of government. we ordinarily mean the federal government. But this chapter will also say some things about government at the state level and the local level. The local level includes coun— ties, cities, villages. townships. school districts, and so OI]. A “1...”... n The Public Sector—Government: Public Choice and Taxation C ha pier 4 8 9 Economic Scope and Functions of Government For centuries. political scholars have theorized about the purposes and functions of government. In The wealth ofN'atiom, Adam Smith said that government’s role should be limited to national defense, the admin. istration of justice, the facilitation of commerce, and me provision of certain public works. Many people today would agree with Smith, although some might add a few items to his list. For present purposes, the' economic role of government can be considered to consist of two broad functions: (1) the promotion and regulation of the private sector, and (2) the provision of social goodS- Promotion and Regulation of the Private Sector Government promotes and regulates the private sec: tor in many ways. Sometimes it does this to the net ad: vantage, and sometimes to the net disadvantage, of so- cietv as a whole. A complete analysis of the public sector's economic functions is impossible here. How- ever, five major activities can be identified. Providing a Stable Economic Environment Government fa- cilitates the production, distribution, and consump- tion of goods and services. It does this by defining property rights, upholding contracts, adjudicating dis- putes, setting standards for weights and measures, en- forcing law and order, and maintaining a monetary system. These activities are so fundamental to organ»- nized society that they existed even in ancient civiliza- tions. The Code of Hammurabi (circa 2100 B.C.) and Lhelater laws of ancient Egypt and Rome, for example, went into considerable detail in defining property rights and related matters pertaining to commerce. Panning the Public Welfare Government establishes health and safety standards in industry and regulates minimum wages for certain classes of workers. It also Provides old-age, disability, sickness. and unemploy- ment benefits for those who qualify. Of course, these sOdal welfare measures are enacted primarily for hu- manitarian reasons. Nevertheless, some of the mea- ‘um "13‘! be tacit admissions that the private sector has failed to fulfill human wants in a manner that soci- ety regards as equitable. Granting Economic Privileges Through selective subsi- dies, tariffs. taxes, and other legal provisions. govern- ment favors particular consumers, industries, unions, and other segments of the economy. This elaborate network of privileges and controls results as much from political pressures as from economic logic. To a large extent, therefore, government privileges cause reduced efficiencies, higher prices, and misallocations of society's resources. Maintaining Competition Specific laws forbid unreguc laced monopolies and unfair trade and labor practices. If government enforces these laws vigorously, it helps ensure the perpetuation of a strong private sec to r. Encouraging Elliciency, Equity, Stability, and Growth Through appropriate tax, expendittxe, and regulatory policies, government seeks to'attain certain objectives. These include high employment, an equitable distribution of income. stable prices, and a steady rate of eco- nomic growth. The government’s efforts are not al. ways successful, however, for political reasons as well as for economic ones. Much of the study of econom- ics is concerned with learning to understand these reasons. This brief sketch of the economic activities of gov" ernment leads to an important observation: The promotional and regulatory activities of gov- ernment are complex and widespread. Some of these activities are undertaken to correct for market fail- ures. That is, they address the inability of the private sector, if left to itself, to achieve the goals of effi- ciency, equity, stability, and growth to the degree that society seeks. However, as you will see. the extent to which government activities contribute to the realiza— tion of these goals is often debatable. Provision of Social Goods All economic systems are concerned with the three fundamental questions: What will be produced? How will it be produced? and Who will receive the final one put? ln mixed capitalistic economies such as ours, these questions are answered primatin by the market 90 Pa rt 1 Overview: The EconomicSystem system. But if certain types of goods and services are not, in the public's opinion, adequately provided by a free market, supplying them usually becomes a func- tion of government. In this book we’ll refer to such products as social goods. For present purposes, they may be classified into two groups—apublic goods and merit goods. Public Goods Public goods are sometimes called “collective” goods. Examplesinclude national defense, street lighting, dis— ease control, the administration of justice through the courts, airtraffic control, and public safety. An essen- tial characteristic of public goods is that you cannoc be excluded from reaching their benefits whether you pay for them or not. Public goods can thus be distinguished from non- public goods. Nonpublic goods are private goods (such as food, automobiles, appliances, clothing, and ser- vices) thatpeople buy in the market and certain social goods, known as merit goods, which are described below. Someone who docsn ’I pay for nonpublic goods can conceivably be excluded from using them. There- fore: The distinction between public and nonpublic goods rests on what is called the mlwion principle. Ac- cording to this principle, a good is nonpublic if some- one who doesn’t pay can be excluded from its use. Otherwise, it’s a public good. Merit (Quasi-Public) Goods In addition to public goods, government provides men"! goods. These are goods that_government deems meritorious, or intrinsically worthy of production. Merit goods share. to different degrees, some of the properties of both public and private goods. There fore, merit oods are also sometimes called “ uasi— .. q public goods." Some examples of merit goods pro— vided by the federal and state gOVernrnents are parks,_ public housing, and public hospitals. Some examples‘ of merit goods pron'clcd by local governments are mu- 4 nicipal libraries. tennis courts, golf courses, and muse- ours. in contrast to public goods, merit goods are sub ject lo the exclusion principle, even though thepn'nciple may rial always be invoked. Therefore, merit goods are not pure public goods. People could be charged for the use- of merit goods instead of being given them “free” or at reduced prices. As you will see. this raises interesting questions about efficiency and equity. problems that are among the fundamental Concerns of economics. Conclusion: Achieving Efficiency Through the Market Throughout the nation’s history, government has served as a rescuer, subsidizer, owner, and regulator of special interests. It has saved failing companies, ii- nanced roads and canals, subsidized industries, shel- tered workers, protected consumers and businesses, stabilized credit, refereed competition, and regulated markets. Government has also become the chief producer) of social goods, both public and merit goods. Every- one receives the benefits of the former. The benefits of the latter are widely available and, in most cases, are provided at reduced prices. How does this affect the allocation of such goods? In a free market, prices perform the allocative function. A resource is always allocated to its highest- valued use, as determined by the prices that buyers offer. But the situation is different with most social goods. Because many are made available “free” or at reduced prices, it is impossible to know the value peo- ple place on the goods. How, then, should governmenl decide what and how much to produce? A reasonable answer to this question is that gov- ernment should seek ways of making more effective use of market mechanisms. This can be done through the use of special taxes, grants. and pricing strategies designed to test the demand for certain social goods. In this way, as you’ll see below, officials can be guided in learning how to improve efficiency in the provision of these goods. Equally important, legislators can con- sider whether certain social goods might better be pro- vided through the private sector. Something to Think About 1. Radio and network television broadcasting are public goods. Why? What about cable television broad- casting? 2. In the United States (but not in most other coun- tries). the great majority of radio and television broad- casts are profided by the private sector. Why do comv l r l l l a i l l t l a 3 The Public Sector—Government: Public Choice and Taxation C h a p l er 4 91 panics incur the costs of producing such goods if peo— ple can consume them without paying? Can you think of any other public goods that are provided by the pri- vate sector? 3. Aretha government’s postal services a public good? Why? Spillovers, Market Failure, and Public Choice Many social goods (as well as private goods) create “fallout” effects, or These are external bene- fits or Costs for which no compensation is made. Spillovers are also called The two terms are used interchangeably. so you should be familiar with both. For example, in the public sector, air—traffic con— trol at busy airports reduces noise for some nearby res- idents while increasing it for others. This is an unpaid- for benefit to the former and an uncompensated “cost” to the latter. In the private sector. similarly. a factory may provide income and employment to a com- munity while polluting its environment. Thus. spill— over benefits and costs exist with some private goods as Well as with some social goods. Spillovers are an indication of market failure. That is, their occurrence in a competitive free market is a Sign that the market hasn‘t allocated its resources effi- ciently. As you will recall from your study of demand and supply. resource misallocation occurs if a good‘s costs and/or benefits are not fully reflected by its equi- librium price. When that happens, it is because the EOOd's demand and supply curves do not incorporate the full value of society's sacrifices and preferences. The values that are not incorporated are externalities 01' spillovers. Their existence accounts for the failure of Competitive free markets to provide outputs that are soCially ideal. Redresstng Splllovers what can be done to correct for the effects of sPillovers? Because they are associated with private-sec- ‘01' market {allure. corrective action to eliminate or Offsel them can come only from government. Two major approaches may be considered—market mea- sures and nonmarket'measures. Market Measures: lnternalizing the Exiernalities One way of correcting for the effects of spillovers is to look for ways to incorporate them into a good’s mar— ket demand and market supply curves. This is illus- trated in Exhibit 1. Thus: In Figure (2) , any point on the normal market de- mand curve D expresses the demand price. This is the highest price that buyers are willing to pay for a given quantity of the good. The demand curve thus reflects only private benefits to buyers, not spillover benefits to nonbuyers or to society. Similarly, any point on the normal market supply curve S expresses the supply price. This is the least price necessary to bring forth a given output. That is, it is the lowest price that sellers are willing to accept in order to supply a given quantity of the good. The sup— ply curve thus reflects only private costs to producers, not spillover costs to anyone else. The diagram assumes that all benefits and costs are incorporated in the demand and supply curves—- there are no spillovers. Accordingly. the equilibrium quantity at Q is socially ideal because it represents an optimum allocation of society‘s resources. However, if i all benefits and costs are not included inthe demand and supply curves, then spillovers exist. The equilib— rium quantity is not socially ideal. In that case, govern- ment can undertake either of two sets of policy mea- sures to correct the situation: internalize Spillover Costs by Incorporating Them into the Mar- kel Supply Curve The effect of this approach is shown in Figure (b). It illustrates the case of an industry that pollutes its environment. thereby externalizing some costs of production to others. As a result. the supply curve S is “too low” because it does not include all of the costs of producing the product. Because of this, the equilibrium quantity is at Q rather than at Q'. One measure that government can adopt to cor. rect the situation is to require sellers to pay a specific tax. This is a per-unit payment on a good. That is, sell- ers would pay the tax Ton each unit of the good pro- duced. This would increase its costs of production by the amount of the tax, causing the supply corve to shift from 510 S'. if the tax is large enough. it can com- pensate for any spillover costs that were not included in the original supply curve. The tax will thus reduce output from the level at Q to the socially optimum level at (2', (Question: Can you show how the ideal out- put may also be achieved by imposing a specific tax on buyers?) 92 Part 1 Overview:lheEconomicSystern Spillover Effects in a Competitive Market FIGURE-(a) No S'ijillo’v‘ers When the demand and supply curves include all costs and benefits. there are no spillover effects. The equilibrium quantity at Ole optimum, or ideaL FIGURE (b) Spillover Costs Because some costs are exter- nallzed.'resources are overallocated. and 'too much" of the good (equal to 0'0) is produced. To achieve the ideal output at 0'. government can impose a specific tax of T per unit on sellers. This will raise the supply curve from S to S’. FtGURE (c) Spillover Benefits Because some benefits are externalized. resources are underallocated and 'too little" of the good (equal to 00') is produced. Government can achieve the ideal output at O’ by giving buyers at specific subsidy of U per unit, This will shift the demand curve upward from Dto D'. internalize Spillover Benefits by incorporating Them into the Market Demanil Curve The effect of this approach is shown in Figure (c). It illustrates the case of an indus- try, such as private higher education that externalizes some benefits by providing society with a more in— formed and concerned citizenry. As a result, the demand curve D is “too tow" because it doesn't in- clude all of the benefits obtained from the product. Bertrand and supply curves. I assuming no spillovers Spillover Because of this, the equilibrium quantityis at Qrather than at Q’. To correct this, government can bring about an increased OUIpUl of the product by giving buyers a spe- cific subsidy. This is a per unit grant on a commodity. As shown in the graph. buyers would receive the subsidy U on each unit of the good purchased. This would inv crease the consumption of the good, causing the de— The Public Sector—Government: Public Choice and Taxation Ch a plot 4 93 Inand curve to shift from D to D’. If the subsidy is large enough, it can compensate for any spillover benefits “(weren't included in the original demand curve. Thus, the subsidy will increase output from the level at Q to the socially optimum level at (2'. (Question: Can you demonstrate that government can also achieve the ideal output by granting a specific subsidy to sellers?) Nonmarkel Measures: Government Regulation and Provision in addition to the foregoing market devices, govern- ment can employ various nonmarket measures to in. fluence output and resource allocation. This is ac- complished by enacting appropriate legislation. For instance: Through government regulation, the outputs of some products (and by-products) for which spillovers are deemed to be undesirable can be reduced. Examples are industrial-waste disposal, smoke emission, and water pollution. In terms of Figure (b), in Exhibit 1, the purpose of such regu- lation is to shift the supply curve upward to achieve results similar to those attained by market measures {such as taxing sellers). Through government provision the output of some goods for which spillovers are deemed to be desirable can be enlarged. You will recall that when government makes available such products, they are called “merit goods.” Examples include public recreation, public housing, and public higher education. In terms of Figure (c), the pur— pose of such provision is to shift the supply curve downward, to achieve the same ideal output at- tained by market measures (such as subsidizing buyers) . Thus, government regulation and provision, by their very nature, focus on influencing the supply of goods. not the demand for them. Dealing with International Spillovers National governments can addre55 the domestic sPillmers created by production within their own Countries. But in many cases international spillovers OCCur. These result in external costs for some coun- mfis and external benefits for others. Examplesof international spillover costs are easy [0 find. Global warming, caused by heat-trapping gases b(fiched out of power plants and cars. can melt polar ice caps. flood coastal cities, and turn farmland into deserts. Stratospheric erosion, caused by chemicals and gases that eat away Earth's protective ozone layer, may subject people to excessive ultraviolet radiation. Pollution of the oceans and destruction of rainforests can alter food chains and organic systems. Examples of international spillover benefits are also apparent. National defense helps provide protec- tion to neighboring friendly countries. Thus, Canada and Mexico are more secure when the United States is wellwprotected. Improvements in education make for a more enlightened world citizenry. And advances in disease control, technology, and information systems create benefits that accrue to all nations. The ability to redress international spillovers lies beyond the scope and authority of a single national government. in view of this, is efficient resource allo- cation possible? The answer, in principle, is yes. Coun- tries often join global agencies or negotiate agree- ments to deal with international spillovers. The United Nations is the most obvious example of a world organization established to address issues created by global externalitjes—-including defense, disease pre- vention, and environmental pollution. Other exam- ples include the North Atlantic Treaty Organization, the World Bank, the European Community, and the Association of Southeast Asian Nations. Redressing spillovers is more difficult when they reach beyond national boundaries. However, the exis- tence of international spillovers helps explain why na- tional governments extend the scope of their activities into the global economy. Conclusion: Efficiency and Public Choice The analysis of spillovers leads to three important gen- eralizations. 1. Referring back to Figure (b) of Exhibit 1, a com- petitive free market overallocazes resources to the production of a good that has spillover costs. Con- sequently “too much" of the good is produced rel- ative to its ideal output. 2. Referring back to Figure (c) of Exhibit 1,3 com- petitive free market underallacatzs resources to the production of a good that has spillover benefits. Because of this, “too little” of the good is pro- duced relative to its ideal output. 3. Government alters the outputs of many goods that have spillover costs and benefits. The alterations 94 Part 1 Overview: ‘lheEconomicSystem are accomplished both by market mechanisms such as taxes and subsidies, and by nonmarket mechanisms such as regulation, provision, and in— ternational agreement- The analysis of spillover costs and benefits is part ofa larger branch of economics known as public choice. This may be defined as the study of nonmarket collec- tive decision making, or the application of economics to political science. Public choice seeks to explain how and why government does what it does. The hope is that this will lead to developing ways of improving effi- ciency in the public sector—in the provision of social goods. Public-Sector Budgeting In the past few decades, the US. public sector has been characterized by a remarkable growth of expen~ ditures at all levels of government—federal, state, and local. This means that a rising volume of the nation’s output is being allocated by collective (rather than pri- vate) decision making. The long-run trends can be seen in Exhibit 2. There are four major reasons for the growth of government spending: 1. Increased Bertrand tar Social Goods and Senate: The public sector has increased its expenditures on so- cial goods, including education, transportation, social security, housing, and consumer protection. 2. National Delense A large part of the increase in federal spending can be attributed to expendi- tures on defensorelated activities. These include both military personnel and military equipment. 3. interest on the Fedrral Debt The last few decades have witnessed a huge rise in the interest pay- ments made on our growing national debt. (The national debt is also called the public debt or the government debt.) 4. Lagging ProductivityrlGovernmemEmpluyaes Produc- tivity in the delivery of government services has frequently lagged behind rising costs. Conse— quently, government has found that the salaries and fringe benefits it pays its employees often grow faster than the efficiency of the services they perform. ' As you might guess. anydiscussion of public—sector expenditures is bound to raise quEstions about public- st‘ctor revenues. The methods used by governments to manage their revenues and expenditures constitute Growth of Government Expenditures axis is expressed in constant dollars of a previous year. This I removes the effects of inflation so that the data are not exaggerated by rising prices. ,3? Government Expandtninjta (billions of 1972 dollars) what is known as “public budgeting.” Exhibit 3 de- scribes and illustrates some trends of government bud- gets- lt’s important that you read the explanations aC- companying the graphs in order to gain a better understanding of the role of government in our econ- omy. Budgeting for a government. like budgeting for a family, is an activity dealing with hopes and daydreams as well as hard facts- Whatis a budget? It is an itemized estimate of expected revenues and expenditures for a given period in the future. The federal budget covers a fiscal year. (A fiscal year is any 12-month period for which a business, government, or other organization plans the use of its revenues.) The budgets of some state and local governments cover a fiscal period that is longer than a year (typically 2 years). Public Overspending and Public Choice One of the notable trends that can be seen in Exhibit 3 is the persistent tendenq' of government outlays to exceed government receipts. Virtually all of the world’s democracies have had similar experiences. JThe size of the public sector. measured by government?" ‘ expenditures. has expanded steadily. Note that the venture“ l a“..........-.u-m _._. at. $$é_aesassase‘§“ FIG ind: ['80 our lane dis; Soul; Kill 30111 The Public Sector—Govemment: Public Choice and Taxation Cita pt e r 4 9 5 Federal, State, and Local Budgets: What Happens to Your Tax Dollars? FlGUFtE (a) The government's total revenues and expendi- tures for any given year are rarely equal. When they are, the budget is said to be balanced. When total revenues exceed total expenditures in any given year. the budget is said to have a surplus. When total revenues are less than total expenditures. the budget is said to have a deficit. to) Federal Budget Receipts and 0utlays: 1950-1990 (trillions of donors) 1960 1965 1970 1975 1980 1985 1990 FIGURE (1:) For the federal government. income taxes, both eoividual and corporate, constitute the largest source of 'E'CelptS. Income security payments, including social se- curity benefits. unemployment compensation. public assis- tance (welfare). and federal employment retirement and disability benefits. constitute the largest category of outlays. (hiArinual Fodorat Budget: Average, 1990-1992 WHERE [I COMES FROM: RECEIPTS WHERE 1T GOES: DUTUWS :' 13:59am: Individual Heat!" ‘ interest . cuties income and 15% National 1 7 [3,35 education demise 5% heal insurance taxes Corporate income ind contributions taxes 10% income security, social security. medicare Sou: - u’ “'5- Depaflmem oi Commerce preliminary data and estimates. FIGURE (c) For state and tocal governments combined, property taxes (such as on land and buildings) and sales taxes make up the chief single sources of tax income. Education is the largest single category of expenditure. it) Stats and Local Government Budgets: Average. 1990—1992 WHERE iT COMES FROM: HECEIFYS WHERE IT GOES: OUTUVS individual income Other genial taxes 10% expenditures utilities and Highways 7% Government gross SBIHWI'IEG Pub" . c weliare. 17% ",me [axes liquosrétores “93mm: and health FIGURE (d) Over the long run, state and local governments have received a rising percentage share of total tax rev— enues. in contrast. the federal government has received a declining percentage share. These trends reflect the need of state and local governments to finance their growing public functions. (d) For Gap": Tax Revenue. by Love! at Government 58.000 7.500 7.000 6500 6.000 5.500 5.000 4,500 4.000 3.500 3.000 2.500 2.000 1.500 1.000 - Total - Federal E State and tacit Dollars 3 Li 3; 3 1 “5. If at Percent: 96 Part 1 Overview: TheEconumicSystem They have found it nearly impossible to achieve long- run reductions in government spending, and they have found it equally difficult to raise taxes sufficiently to cover their spending. The result has been recurrent and, in many cases, mounting budget deficits. These occur because government (like many individuals) borrows in order to finance expenditures beyond its means. Why has public overspendng become chroaic and seemingly uncontrollable? Public~choice experts offer an answer: - just as producers operate through the market sys~ tern to satisfy consumers, elected politicians oper- ate through the voting syszern to satisfy con- stitucnts. - To an extent, politicians, as well as voters, act in pursuit of what they genuinely consider to be the “public interest.” But also, to an extent, they act in pursuit of what they see as their own material in- terests. For most politicians these include enlarg- ing their benefits and getting reelected. - Politicians therefore respond to voters by enacting spending programs that benefit constituents while refraining from enacting the tax legislation needed to finance the programs. Public—choice scholars thus emphasize a funda— mental distinction between public service and the public interesL The failure of society to recognize this distinction, they say, has been a major cause of the growth of big government. What can be done to reverse this trend? Legisla- tion is not sufficient, because histOry shows that politi- cal leaders can change the laws to fit their needs. Therefore: According to public~choice experts, spending con- straints must be imposed on politicians. The surest wayof doing this is a constitutional amendment to bal» ance the budget annually. This would require Con, g'ress to finance spending with taxes (rather than bor- rowing}. thus making the public aware of the price it is paying for benefits received. Scope of Government in Different Countries Any discussion of government is likely to raise ques- tions about its size. This in turn raises further ques- tions about the cost to taxpayers of maintaining gov- ernment, and its role in the economic system. History and experience show that, the larger the size of gov. eminent, the more costly it is to maintain and the greater its involvement in the economy. Three mea. sures—size, cost, and involvement—5mm gmnd in hand in reflectingthe overall scope of government One Way of measuring scope is to'estirnate govern— ment’s tax revenues as a percentage” of thevalue of the economy’s-iota] The Legit can then be com- tannin {been}: one 9f,petcenteges_strongman other nations. This is done in Exhibit 4. It shows fifiBitElééEibfax revenues as a percentage of total out- put for a number of countries. As you can see, in the United States tax revenues are approximately 30 per- cent of total output But for the majority of other na— tions, tax revenues average between 35 and 50 percent of total output. Thus, byphisnteasuteo£5cope,.thc.Q.S. publicrfiskector isolasiargerelatiyemme totalemnomy the public sector in other major countries. This suggests that, in other capitalistic nations, government involvement in the economy is consider— ably greater than it is in the United States. The evi- dence supports this belief. In Australia, Canada, New Zealand. and western European countries, partial or complete government ownership of industries deemed “essential” is common. Some of the major ones in- clude airlines, railroads, television, communications. and health care. In japan, South Korea, Taiwan, and other Asian capitalistic countries, private ownership prevails. However, selective government direction and assistance in the form of subsidies, tax favors. and im- port protection are frequently provided. And in Latin American, African. and some eastern European capi- talistic eounuies, private owuership mixed with vary- ing but substantial doses of government ownership, di- rection, and assistance are typical. Thus: Government occupies an important position in all capitalistic economies. However, the US. government appears to play a relatively smaller role in the Ameri- can economy than the governments of other capitalis- tic countries play in their economies. Our Tax System Government budgets deal not only with expenditures but also with revenues. Governments raise revenues through taxation. In view of this, we must ask: What is the nature of our tax system? ; i - —--w—-~.~.u-t . i i i i ,l a ! 3 i i no rcrzm ' . _ . , The Public Sector—Government: Public Choice and Taxation C hat: 1 e r 4 97 Scope of Government in Different Amiga Ia Countries: Tax Revenues as a Q serum. Canada Percent of Output, 1990 Denmark Taxes collected by all levels of government in the United Finland States average about 30 percent of the value of total output. France This percentage is among the lowest of capitalistic coun- Germany tries. where tax collections average between 35 and 50 “all percent of output m: u.s. Department of meneroe. A tax is a compulsory payment to government. Taxes can be levied and classified in many ways. In our own country and in many other nations, there are three principal types of taxes: 1. Taxes on income I. Personal income taxes lt. Corporate income taxes 2. Taxes on Wealth (including its ownership and transfer) I. Property taxes ll. Death (aware and inheritance) and gift taxes 1 Taxes on activities (consumption, production, em- ployment. and so forth) t Sales and excise taxes 3. Soda] security taxes some of these taxes are levied by the federal govern- ment. some by state and local governments, and some 3“ three. Although various other less important ‘13 of mites exist, nearly all can be placed in one of PmEdlng three categoncs. b! 5n the Japan Netherlands New Zealand Nanny Portugal Spain Sweden Switzerland .United Kingdom United Slates 0 to 20 30 40 50 60 Tax Revenues (percent of national output) Taxes on Income Income taxes are based on net income—what remains after certain items are deducted from gross income. The items that can be deducted and the tax rates that are applied are specified bylaw. Personal Income Tax In poetry, spring is a time when young people's fancies turn to thoughts of love. But in economics, spring is a much more mundane and certainly less romantic pe— riod. It is the season when millions of Americans begin to sort their previous year's income and expense records. As shown in Exhibit 5. this is the first step in determining your personal income tax. in calculating this tax, you are allowed to take spe— cific types of deductions and exemptions. Some de— ductions that may be made (within limits) from your income are donations to various nonprofit organiza- tions such as the Red Cross, the Salvation Army, and your alma mater. You may also deduct (subject to cer- tain previsions) some payments for doctor‘s bills, taxes paid to state and local governments. interest paid on some loans, and various other outlays. In addition, lim-r 98 Pa rt 1 Overview: The Economic System Structure of the Federal Personal incorne Tax mfivfiflmvzvv9vm2 -; Z'YDBI Tohl Income”: I;._*-oa.;| {—4 hum = to ‘aa-A‘JMM ' ited exemptions are permitted for support of yourself and your dependents. In this way, the government ac- knowledges that larger families require more funds than smaller ones do to meet their living costs. The mount of income tax you must pay at a given income level depends on several things. These include Whether you are single or married and what the partic- ular tax rates happen to be at the time. The rates are usually revised by the government every few years, as you can see from Exhibit 6. Nevertheless. certain gen- eral principles underlying a tax-rate schedule never change. The most important involve a distinction be- tween two types of rates—average and marginal. Federal Tax Brackets Change Frequently for Individuals Income tax rates are based on taxable income, which is total income less deductions and exemptions. 352.150 49.300 Taxable lncama 34.000 20.350 Married, Single filing joinily Tax Rate. 1991 Brackets Scum: Internal Revenue Sewioe. U.S. Depamnem of the Treasury. Average Tax Hale This is the proportion of total taxable income that you pay in taxes. That is: Average tax rate x total taxable income = total personal income tax Income. for tax purposes, is always expressed in an- nual terms. Thus, suppose you get a job at. a salary which, after deductions and exemptions, leaves you with a total taxable income of $25,000 annually. lfthe tax laws are such that your average tax rate on that in- come is 20 percent, your total personal income tax will be $5,000. In most cases we‘re more interested in the tax rate than in the amount of the tax. The average to: rate in the above equation can therefore be expressed by the formula: tonal personal income rat; average tax r (e : ————--——--——«-——--——-— total taxable income Marginal Tax Rate If your taxable income increases, the amount of the increase is called “marginal income." But an increase in your taxable income will also result in an increase in the tax you pay—called “marginal tax," The marginal tax rate is the ratio of marginal tax to marginal income. Thus, suppose your total taxable income for a particular year increases by $4.000. If. as a result, you pay an additional tax 0f$1,000. your mar~ ginai tax rate is 25 percent. Stated in terms of a formula: Marginal _ marginal tax taxrate ‘ marginal income change in total personal income tax W taxable income ll The marginal tax rate is the fraction, or percent- age, of each additional dollar of income that is paid in mes. However, because income tax rates are gradu- ated according to income, the marginal tax rate is greater at higher income levels than at lower ones. You can now see why two controversial aspects of the personal income tax are especially worth noting. They are incentives and loopholes. Incentives The degree of graduation—or steepness—- of the marginal tax—rate schedule undergoes frequent revision by Congress. These changes can have serious economic consequences. Rates must be high enough at all income levels to yield the desired amounts of rev- cnues. However, rates that are too high at the upper income levels may discourage investment and risk tak- ing. Correspondingly. rates that are too high at the lower income levels may reduce the incentive for tak- ing on overtime work or second jobs. In view of this. is there a “best” or optimum tax-rate schedule for the economy as a whole? There probably is. But it changes as conditions change. reflecting political as well as eco- nomic circumstances of the times. loopholes Legal methods of on: avoidance enable,- "WW taxpayers to reduce their average rates. This is because our tax system contains various legal "loop holes“ that permit relative tax advantages for people In almost every income class. For example, some types Or mm!“ are exempt from taxes, such as income “fr?” from certain types of financial investments. ,S'm'larll'l some types of payments are deductible from "Rome for 93‘ Purposes, such as interest paid on a pri- m'l’ home mortgage. Although changes in the tax . . The Public Sector—Government: Pubtic Choice and Taxation Cha pie I 4 59 laws have. over the years, closed many loopholes, it is not likely that they will ever be entirely eliminated. (By contrast, illegal methods of escaping taxes. such as lying about income or expenses, come under the gen: eral heading of tax evasion.) Nearly all taxpayers. rich and poor alike, benefit from tax loopholes of one form or another. However. the greatest share of benefits from tax loopholes tends to benefit taxpayers with above—average incomes. Although many people do not realize it. this group also pays more than half the total personal income tax bill. Corporate Income Tax A significant source of revenue to the federal gavern- ment is the corporate income tax. (Many states also tax corporate incomes, but at lower rates.) The corpo— rate income tax is based on profit—the difference be- tween a company’s total income and its total expenses. The tax rate has varied over the years. During recent decades, it has averaged substantially less than 50 per- cent. The corporate income tax raises some important issues. Among them: - Some authorities argue that lower rates would leave corporations with more funds to use for ex‘ panding their operations, thereby creating more jobs. Others. however, contend that the rates should be higher, enabling government to reduce other taxes. especially personal income taxes. - There is considerable controversy over who ulti- mately bears the burden of the corporate income tax. Some economists believe that the tax is shifted “forward” to consumers in the form of higher prices. Others contend that much of the tax is shifted “backward” to resource owners in the form of lower wages, rents, etc. Still other authori- ties believe that the tax is borne by the owners (stockholders) of the corporation because the tax is imposed on corporate profit. That is. the money the shareholders would receive as dividends is re- duced because the corporation must pay income tax. . The corporate income tax involves a form of dou- ble taxation. The corporation pays a tax on its prof- its, and the stockholder pays a personal income tax on the dividends received from those profits. Because of this multilevel impact of the corporate income tax, as well as its shiftability. it is widely be lieved to be both inefficient and inequitable. 1 00 Pa r l 1 overview: The Economic System There are no simple resoluuons for these contro- versial issues. Each has valid aspects that are subject to frequent debate. The remaining two categories that make up the structure of the American tax system are taxes on wealth and taxes on activities. Taxes on Wealth Properly taxesare levied almost exclusively on land and buildings to help pay for public services. The taxes vary from relatively low rates in some rural areas to rel- atively high rates in localities vvith expensive public services. Death taxes are levied. at the Lime of death, on es tates by the federal government and on inheritances by some state governments. A11 estate is the value of everything that someone owns; an inheritance is an amount that someone receives. Like income taxes, death taxes exempt smaller estates and inheritances but tax the unexempt portions at progressive rates. Many wealthy people might try to avoid these taxes by distributing most of their property before death. Therefore. gt]? taxes are imposed on the transfer of as- ' sets beyond certain values. However, various legal de- viceS, most notably trust funds, have enabled many people to lighten the burden of these taxes. Taxes on Activities Sales taxes are imposed by many state and local govern- ments. These taxes are flat percentage levies on the re- tail prices of many goods and services. In some states or cities, food, medicine, and certain services are ex- empt from sales taxes. In other places, they are not. The federal government imposes no general sales tax on the final sale of goods. However, itdoes impose spe- cial sales taxes, called ease-tire taxes, on the manufacture, sale, or consumption of specific commodities such as liquor, tobacco products, gasoline, and certain other goods. Social security taxes are federal payroll taxes on wages and salaries, The taxes finance compulsory so— cial programs that provide benefits to retired and dis— abled persons and to dependents of deceased workers. The taxes are imposed both on employees and on em— ployers and are based on the incomes of the former. After a person has earned a certain amount each year, his or her income above that level is exempt fi'om the tax. -_ Consumpiiun An International Comparison of Tax Systems The American tax system is a complex mixture of vari— ous types of taxes. Are they similar to those employed in other advanced nations? The answer is yes. All of the advanced countries rely primarily on four types of taxes—personal income, corporate profits, social 5e- curity, and consumption. However, although the kinds of taxes employed are alike, the proportion of rer— enues that governments derive from each can differ considerably. The proportions are shown for a number of ad- vanced countries in Exhibit 7. As you can see, Canada, Sweden, and the United States rely relatively heat-ii}- on personal income taxes- japan depends less on per- sonal income taxes and more on corporate profits taxes. The governments of these four countries obtain International Comparison of Taxes, 1988 (latest comparable data) yr. l;::’ Nations finance most of their government expenditures with four kinds of taxes-personal income. corporate profit. social security. and consumption. The proportion of total tax rev- enues derived from each tax varies considerably between countries. Percenl Distrihuliun ol Tax Receipts By Me or Tax—Selected Countries ,- ---wm-—e'—<s . «so. cos. n W I "'— ’"F ' — ' ' . .. —'.£k.d “at”. “WWW” _ '- mi ' .a w”). .. .. 7W . ‘1‘?"qu unwr- “co...— 7 n -- cm. _I United Kingdom ’2;- Canada France Germany ltaly Japan Netherlands Sweden United States 0 20 4O 60 80 100 Percentage of Total Taxes - Corporaleprolil ;-_;. Social security - Ollter Source: Organization lor European Cooperation and Development. a: Personal income The Public Sector—Government: Public Choice and Taxation C h a pie r 4 1 01 roughly the same proportion of their total revenues from personal income and corporate profits taxes to- gather. In contrast, the governments of the other na- Lions shown rely more strongly on social security taxes and on consumption taxes. Why do these differences exist? Are there underly- ing principles that can account for the differences? Unfortunately, there is no simple answer. In‘ each nation, complex mixtures of tradition, cul- ture, politics, and economics all play a role in influenc— ing the types of taxes that are employed. As a result, it isn’t possible to give any general reasons as to why cer- tain types of taxes are relatively more important in some countries than in Others. Theories of Taxation Tm power (a tax is not only the power to desnvy but also the power to keep alive. so stated the US. Supreme Court in a famous case in 1899. Today hardly anyone would disagree. Because we power to tax is so weighty a matter, economists have developed several broad standards for judging the merits of a tax: 1, Equity Tax burdens should be distributedjusdy. 7. Efficiency, Stability. anti Growth A tax should con- tribute toward improving resource allocation, eco- nomic stabilization, and growth in the total output of goods and services. 1 Eniarcaahilily A tax should be adequate for its pur- pose and acceptable to the public, or else it will be impossible to enforce. These criteria are simple and persuasive. But im— plementation, especially of equity. has caused much controversy. Let’s see why. Principles of Tax Equity A good tax system should be fair. If people believe it is unfair-41m too many loopholes benefit some people 211d not others-wmxpayers' morale and the effective- ?“ 0f the tax system will deteriorate. Therefore, an Emil ‘31 System imposes an equal tax burden—the Pam“ 0f paying taxes—on everyone. To help achieve this “blCCliVe. two standards of tax equity have evolved 0"" the years. Horizontal Equity The doctrine of horizontal equity is that “equals should be treated equally. " This means that people who are economically equal should “bear equal tax burdens. That is, if people have the same income, wealth, or other taxpayng ability. they should pay the same amount of tax. Vertical Equity The doctrine of verticalequity is that “unequals should be treated unequally." This means that people who are economically unequal should bear equal tax burdens. That is, people with different incomes, wealth, or other taxpayng abil- ities should pay different amounts of tax so that everyone sacrifices equally. Horizontal and vertical equity are standards for judging the fairness of a tax. Efforts to apply these standards have resulted in two fundamental principles of taxation-«he benefit principle and the ability-t0— pay principle. Benefit Principle The benefit principle holds that people should be taxed according to the benefits they receive. For example, the tax you pay on gasoline reflecu the benefit you re- ceive from driving on public roads. The more you drive, the more gasoline you use and the more taxcs you pay. These tax revenues are typically set aside for financing highway construction and maintenance. Similarly, local governments pay for at least part of the construction of streets and sewers by taxing those resi- dents who benefit directly from them. What is wrong with the benefit principle as a gen- eral guide for taxation? There are two major difficul— ties: - Relatively few publicly provided goods and ser- vices exist for which all benefits and beneficiaries can be readily determined. For many goods and services, the benefits would be impossible to de— termine. The entire nation benefits from social goods, such as public education. health and sani~ tation facilities, police and fire protection, and na- tional defense. How can we decide which groups should pay the taxes for these things and which should not? - Those who receive certain benefits may not be able to pay for them. For instance, it would be im- possible to finance public welfare aid or unem- ployment compensation by taxing the recipients. 102 Part 1 Overview: The Economic System Ability-to-Pay Principle The Milly-£01m); states that the fairest tax is one that is based on the ability of the taxpayer to pay it, regardless of who derives the benefits from the tax. Therefore, the more Wealth a person has or the higher his or her income, the higher the tax rate should be. This is based on the assumption that each dollar of taxes paid by a rich person “hurts” less than each dol- lar paid by a poor one. The personal income tax in the United States is structured on this principle. There are two major difficulties in the use of this ’ principle as a general guide for taxation: . Ability to pay is a debatable concept—difficult to determine and impossible to measure. How can we really know thatan additional thousand dollars a year in income means lesx to a rich person than to a poor person? The concept involves psycholog- ical and philosophical issues that economics is not equipped to explore. . Even if we assume that certain taxes should be based on ability to pay, how can we distinguish be- tween degrees of ability among different individu~ als? You may feel that a person who earns $50,000 a year is able to pay a higher tax rate than some— one who earns $25,000. But how much higher? There is no simple answer, and no answer that is unarguahly “just.” Real-World Compromises: Three Classes of Tax Rates As a result of these difficulties, it has become neces— sary to adopt methods of implementing the benefit and ability-tovpay principles. The methods may not al- ways be ideal, butthey have proven to be practical. Thus. three major classes of tax rates—propor— tional. progressive, and regressive—have evolved over the years. These types of rates differ from each other according to the way in which the amount of the tax is related to the tax base. This is the item being taxed. The value of property is the tax base for a property tax. Income is the tax base for an income tax. The value of goods sold is the tax base for a sales tax. When the total tat is divided by the tax base. the resulting figure. expressed as a percentage, is called the tax rate. Thus, a $10 tax on a tax base of$l 00 represents a tax rate of 10 percent. It follows that the tax base times the tax rate equals the tax yield to the government. This prin- Clplt‘ applies to all types of taxes. Proportional Tax A proportional 1a.: is one whose per. centage rate remains constant as the tax base increases. Consequently, the amount of the tax paid is propor. tional to the tax base. The property tax is an example_ If the tax rate is constant at 5 percent, someone who owns property valued at $10,000 pays $500 in taxes_ ‘Someone who owns property valued at $100,000 pays $5,000 in taxes. Progressive Tax A progressive tax is one whose percent. age rate increases as the tax base increases. in the United States, the federal personal income tax is the best example. The tax is graduated so that. theoreti- cally, a person with a higher income pays a greater per- centage in tax than a person with a lower income. We say “theoretically” because in reality certain loopholes in the tax structure reduce the progressive effect of the tax- Regressive Tax A We tax is one whose percentage rate deaeasesas the tax base increases. In this narrow. technical sense, there is no regressive tax in the United States. In practice, however, the term “regres- sive” is applied to any tax that takes a larger share of income from the low-income taxpayer than from the high-income taxpayer. Most proportional taxes, such as sales taxes, are considered to have regressive effects. For instance, a 6 percent sales tax is the same rate for everyone, rich and poor alike. But people with smaller incomes spend on average a larger percentage of their incomes. Therefore, the sales taxes they pay are a greater proportion of their incomes. To summarize: In the narrow, technical sense, definitions of pro- portional, progressive, and regressive taxes are ex- pressed in terms of their actual tax bases. These an: the things that are taxed, such as income, property, or value of goods said. For equity purposes, however, the base chosen for comparison is always taxpayers’ in— Comeswregardless of the actual tax base. The equity disunctions among the three types of tax rates are illustrated with brief explanations in Ex— hibit 8. Take a few moments to study them before pro- ceeding. How do the foregoing principles and compro- mises apply to our tax system? Some of our taxes tend to lean more toward the benefit principle and others more toward the ability-tO-pay principle. Social secu- rity, license. and gasoline taxes are some examples of the former; income, estate, and inheritance taxes are illustrative of the latter. . .. --—-w-I-_‘ g, vi—E'F‘iw‘a... . . . -0 to Equity Terms (hypothetical data) in equity terms. the structure of a tax is always evaluated by comparing the tax rate to the taxpayer's income—regardless of the actual tax base to which the tax is applied. (a) Proportional Tax 88888238 Tax Rate (percent) 01020314050703) Annual Income (thousandsotdallars) FIGURE (3) Proportional Tax The tax takes are same percentage of income from nigh-income taxpayers as from low-in- mate taxpayers. In this example. the tax is 40._petcant of a $10,000, income, 40 The Public Sector—Government: Puntic Choice and Taxation C h a p t er 4 ; 44E... 3 . Proportional, Progressive. and Regressive Tax-Rate Structures (h) Progressive Tax Tax Rate (percent) ommmaosoerroao Annual income (thousands of dollars) FIGURE (b) Progressive Tax The tax takes a larger percentage of income from high-income taxpayers than from low- income taxpayers. in this example. the tax is 10 percent of a $10,000 income. 20 percent at a $20,000 income. etc. 103 (c) Regressive Tar Tax Rate (percent) omzoaorosomroao Annual Income (thousands of dollars) FIGURE (c) Regressive Tax The tax takes a smaller percentage of income from high—income taxpayers than from low- income taxpayers. In this example. the tax is 60 percent or a $10,000 income. 50 percent of a $20000 income. etc. percentof a $20.00!) income. etc. We can find examples of progressive, regressive, and proportional taxes in our tax system. Income and death taxes are progressive in both the technical sense and the equity sense because their percentage rates in- crease with the tax base. Property, general sales. and excise taxes are proportional in their technical struc- ture because their rates are a constant percentage of the tax base. However. they also have the effect of re- gressivc taxes because they consume a greater propor- tion of the income of lower-income taxpayers. Tax Shifting and Incidence: Direct and Indirect Taxes k You saw earlier in the discussion of corporate in- mflle taxes. the person or business firm upon whom a m i.“ iI‘itiillll’il'flposed does not always bear its burden. 5°? “Bianca, a company may be able to shifl.’ all or part :31? "Forward" to its customers by charging them " Prices fer its goods. Or it may be able to shift a to the owners of its factors of produc- m backward" tion by paying them less for their materials and sec vices. When a tax has been shifted, its burden or inci- dence is on someone else. In this connection. it is con- venient to classify taxes into two categories: direct and indirect. Direct taxes are those that are not shifted; their burden is borne by the persons or firms originally taxed. Typical examples are personal income taxes, so- cial security taxes paid by employees, homeowners' property taxes. and death taxes. Taxes on corporate income are often considered to be only partly direct. Can you suggest why? Indirect taxes are 01056 that can be shifted either partly or entirely to payers other than the person or firm originally taxed. The most familiar example is the sales tax. Contrary to popular belief, this tax is im- posed on sellers, not buyers. Sellers, how'ever. typically shift the tax burden to buyers. Other examples of indi- rcct taxes are excise taxes, taxes on business and rental property, social security taxes paid by employers, and probably, to a large extent, corporate income taxes. I 04 Pa rt 1 Overview: The Economic System In what direction will a tax be shifted, if it is shifted at all? This is a thorny problem in economic theory, and the experts do not always agree. in general: Most taxes are like an increased cost to the tax- payer. Each taxpayer will try to pass them on to some- one else. When an indirect tax is imposed, it tends— lilte lightning or water-40 follow the path of least resistance through the markets in which the taxpayer deals. That is, the taxpayer tries to shift the tax by a1- tering prices, inputs, or outputs according to the least degree of opposition encountered. This can have dif- f erent effects on efficiency and equity from those ini- tially intended. Completing the Circular-Flow Model The tax system, of course, is only one way in which the government sector is involved in the economy. Gov- ernment aifects the economy in other ways. as well. Some of these are diagrammcd in Exhibit 9 with a complete version of the circular-flow model. Notice that the model includes three familiar sectorhhouse- hold, business. and foreign. To complete the picture, the model now includes the government sector. Government needs resources to carry on its oper- ations. As Exhibit 9 shows, government acquires re- sources by purchasing factors of production (such as labor and equipment) in the resource markets. The factors that government purchases are used to pro- duce social goods such as national defense, public ed- ucation, public transportation, health care, and postal services. Government finances mosr of these secial goods with taxes and fees imposed on the household and business sectors. Some of the social goods produced by govern— ment are called “nonmarket goods, services, and grants.” This is because these goods are given away free (that is, not sold directly) to the household and business sectors. Examples include national defense, public safety, and public health. Other government-produced social goods are sold in both product and resource markets. Examples in- clude postal services, public transportation, the goods provided by state-own ed liquor stores, and the utilities provided by municipally owned electric companies and water companies. Some of these social goods are sold at below—cost or at subsidized prices. Others are sold at full cost or at above-cost prices. The receipts that governmentcollects from the sale of social goods contribute to financing its Operations. To summarize: The Circular Flow of Economic Activity: ‘7 A Four-Sector Model Inclusion of the government sector permits the circular-flow model to approximate our mixed economy more closely (see the model on page 105). Government plays an important role in all capitalistic economies. Government purchases factors of production. and uses these factors to produce both nunmarketable and salable social goods. Government finances its operations with taxes and fees collected from the household and business sectors. The chief functions of government are to (1) pro- mote and regulate the private sector, and (2) provide social goods. To fulfill these functions, government participates in the resource and product markets, and finances most of its operations by imposing “charges”— mainly taxes—on the private sector. The ways in which government conducts these activities determine the role it plays and the influence it exerts in the economy- Drigins: Government in the Economy Known equally well as a political philosopher and as an economist, the Englishman john Stuart Mill was the last of the major “mainstream” classical economists of the nineteenth century. His great two-volume trea~ rise Principles of Political Economy (1848) was a masterful synthesis of classical ideas. The book became a stan- dard text in economics for several decades. Numerous John Stuart Mill (1806-1873) ' ...
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