Ch. 18, Public Finance: Expenditures and Taxes

proprietary incomethe income that the gov’t receive from running gov’t owned enterprises such as hospitals, utilities, toll roads, and lotteries
public financethe sub-discipline of economics that studies the various ways in which governments raise and expend money
Gov’t relies on 3 sources to finance goods and services to households and businessestaxes, borrowing, and the proprietary income generated by gov’t run or gov’t sponsored businesses. Revenues from households & busin. are “net taxes” b/c vast majority comes from taxes and labels refer to net taxes to indicate they also include “taxes in reverse”
Government purchasesAre exhaustive. The products purchased directly absord (require the use of) resources and are part of domestic output. (purchase of missiles absorbs labor of physicists and engineers)
transfer paymentsare nonexhaustive. Do not directly absorb resources or create output. SS benefits, welfare, vet benefits, & unemployment compensation. Key trait is recipients make no current contribution to domestic output in return
Funds used to pay for gov’t purchases and transfers come from 3 sources:taxes, proprietary income, and funds borrowed by selling bonds to public
Government borrowingallows the gov’t to spend more than it collects. Could “crowd out” private-sector investment
deficit spendinggov’t spending that is financed by borrowing
4 areas of federal spending1. pensions and income security-many income maintained programs for aged, disabled, unemployed, retired
2. national defense
3. health- medicare (retired) medicaid (poor)
4. interest on the public debt
Personal income tax (federal)the kingpin of the federal tax system and merits special comment. Tax is levied on taxable income (incomes of households and unincorporated businesses after exemptions and deductions). Is progressive tax (higher incomes pay larger %) – apply higher tax rates to brackets of income
marginal tax ratethe rate at which the tax is paid on each additional unit of taxable income
average tax ratethe total tax paid divided by the total taxable income. (tax whose average rate rises is progressive tax)
payroll taxesSS contributions. Taxes based on wages and salaries used to finance 2 federal programs for retired workers:
1. Social Security (income enhancement)
2. Medicare (medical services)
Corporate tax incomelevied on a corporation’s profit- the difference b/w its total revenue and total expenses (for almost all, rate is 35%)
excise taxestaxes on commodities or on purchases. Sales taxes fall on wide variety of products. Sales tax- calculated by %, excise taxes based on per-unit basis) -tax alcohol, beverages, & gas, but no general sales tax
State taxes revenue:1. Sales and excise tax is primary source of revenue (49%)
2. Personal income taxes (34%)
3. Corporate income taxes and license fees
State taxes spending:1. Education expenditures
2. State expenditures on public welfare
3. Health and hospitals
4. Highway maintenance and construction
5. Public Safety

*7 states do not levy personal income tax, 43 augment tax revenue with state-run lotteries, 24% get revenue from intergovernmental grants from federal gov’t, state owned utilities and liquor stores

Local levels of gov’t include:counties, municipalities, townships, and school districts, cities and towns
Property taxeswhere 75% of local gov’t gets their tax revenue, plus sales and excise taxes. Rest of revenue comes from intergovernmental grants and proprietary income
Local gov’t expenditures:Education, welfare, health and hospitals, public safety, housing, parks, sewerage, streets and highways
Ranking of state/local jobs:1. 1/2 focused on education
2. Hospital health
3. Police and corrections
4. Highways, public welfare, & judicial
5. Other- parks and recs, fire fighting, transit, libraries
Ranking of fed. gov’t jobs:1. 1/2 national defense, postal service
2. hospitals and health care
3. Natural resources, police, financial admin.
4. “other”- workers in justice and law, corrections, air transportation, and social insurance admin.
Benefits Received Principleof taxation asserts that households should purchase the goods and services of gov’t in the same way they buy other commodities. Those who benefit most should finance them. (ex. money collected by gas used to repair roads)

1. How will gov’t determine benefits that indiv. households and businesses receive from nat’l defense, education & court system? (others also benefit-cars, but also businesses)
2. Cannot logically be applied to income redistribution programs (ask poor to finance welfare payments, tax unemployed workers to finance unemployment benefits)

Ability to Pay Principleasserts that the tax burden should be apportioned according to taxpayers’ income and wealth. In practice, means that individuals and businesses with larger incomes should pay more taxes in both absolute and relative terms than those with smaller incomes

-Each $ amount of income yields smaller amount of satisfaction- first dollars spent on goods that yield greatest marginal utility, then spent on less urgently needed goods. $ taken from poor represents greater utility tax.
Problem: no ability to measure someone’s ability to pay taxes

Tax rates are classified as:progressive, regressive, and proportional
Progressivetax is this if average rate increases as income increases. Such a tax claims not only a larger absolute ($) amount but also larger percentage of income as income increases.
regressiveif average rate declines as income increases. Taxes a smaller proportion of income as income increases. May not take a larger absolute amount of income as income increases
proportionalif average rate remains the same regardless of size of income. Often referred to as flat taxes or flat-rate taxes b/c av. rates do not vary with income levels
Personal income taxfed. income tax is progressive w/ marginal tax rates. Rules that allow indiv. to deduct from income interest on home mortgages and prop. taxes tend to make tax less progressive (av. tax rises w/income)
Sales taxWould seem proportional. But, is regressive w/income. -larger portion of poor income is exposed to tax than rich person.
Corporate income taxA proportional tax w/ flat 35% tax rate. In short run, corporate owners bear tax through lower dividends. In long run, workers may bear some of tax since it reduces return on investment. When US productivity declines, can become regressive.
Payroll taxeslevied upon wages and salaries by certain states & fed. gov’t. Know as FICA (Fed. Insurance Contributions Act)-mandated one to fund SS, one to fund Medicare. Both split b/w employer and employee. But, only Medicare tax applies to all wage and salary income w/o limit. SS tax is “capped.” Means that FICA tax is regressive. Payroll taxes are even more regressive- only apply to wage and salary. People earning higher tend to derive higher percentage of total incomes from non-wage sources like rent and dividends
Property taxesproperty taxes on building are regressive fro same reason as sales tax. First, property owners add tax to rents that tenants are charged. Second, property taxes as % of income are higher for low-income than high-income families
tax incidencethe degree to which a tax falls on a particular person or group.
Division of burdenSince gov’t imposes tax on sellers (suppliers) we can view tax as an addition to marginal cost of product. Ex.- wine tax of 2% excise tax, added to purchase price. Supply curve shifts upward.

After-tax equilibrium is higher. Consumers and producers share burden of tax equally. Equilibrium quantity declines b/c of tax levy

Elasticities of supply and demand, generalizations1. With a specific supply, more inelastice the demand for product, the larger is the portion of tax shifted to consumers.
-With elastic, small portion is shifted to consumers and most of tax is borne by producers.
-Decline in equilibrium quantity is smaller when demand is more ineslastic. (heavy taxes on liquor, cigs, telephones, auto tires- inelastic)
2. With specific demand, the more elastic the supply, the larger is the portion of tax borne by producers. When supply is elastic, consumers bear most of tax, while producers bear small amount. Supply is inelastic, reverse is true- majority falls on sellers.
-Equilibrium quantity also declines (Ex.= gold)
Efficiency of loss of a tax1. tax revenues – consumers and producers each pay half of taxes (excise tax on wine). Gov’t uses this tax revenue to provide public goods and services. Transfer of $ from consumers to gov’t involves no loss of well-being to society
2. Efficiency loss of tax= deadweight loss of tax, is society’s sacrifice of net benefit (reduces wine by 2.5 mil bottles b/c tax) b/c the tax reduces production and consumption of product below their levels of economic inefficiency, where MB=MC
Role of elasticitiesOther things equal, the greater the elasticities of supply and demand, the greater the efficiency loss of particular tax. Two taxes yielding = revenues do not impose equal costs on society
Redistributive goalsGov’t may wish to impose progressive taxes to redistribute income. Ex. 10% excise tax fed. gov’t imposed on selected luxuries. Demand is elastic, substantial efficiency losses were expected. –But, realized the effects- reduced quantity demand so much that created widespread layoffs.
Reducing negative externalitiesW/ spillover costs, excise tax on producers might actually improve allocation efficiency by reducing output and lessening neg. externalities. ($2 excise tax on alcohol, gov’t concluded that consumption of these beverages produces neg. externalities- purposefully levied these taxes to shift market supply curve) –> are sometimes called sin taxes ( gov’ts impose taxes to discourage activities perceived harmful) -cigarettes and alcohol
Probable Incidence of U.S. Taxes: personal and payrollPersonal income tax- generally on individual b/c little chance of shifting it.
Payroll taxes- Workers bear full burden of their half of SS and Medicare (although split with employers.) FICA tax levied on employers- part of employers’ half gets shifted to workers in form of lower before tax-wages. Makes it more costly to hire workers and reduces demand for labor supply.
Probable incidence of US Taxes: Corporate income taxCorporate income tax- short run, incidence falls on company’s stockholders who bear burden of tax through lower dividends or smaller amnts. of retained corporate earnings. Firm producing profit-max. output and charging profit-max. price – will yield greatest profit after fixed percentage of firm’s profit is removed by corporate income tax-can’t pass to workers or consumers. Will shift in long-term. Workers may bear significant part of corporate income tax in form of lower wage growth (reduces return on invesment, may slow accumulation of capital or prompt firms to reallocate abroad) . May slow growth of US labor productivity
Probable incidence of US Taxes: sales/ excise taxesSales tax is general excise tax levied on full range of consumer goods and services, where specific excise tax levied on particular product. Sales tax is transparent, but excise taxes are “hidden.” Both are shifted to consumers through higher equilibrium product prices.
-Sales tax, little chance for consumers to avoid price, cannot reallocate expenditures.
-excise taxes- fall on select goods. Possibility of consumers turning to substitute goods and services is greater.
Probable incidence on property taxesMost taxes are borne by property owner b/c there is no other party to whom they can be shifted (land, personal property)

Taxes on rented property can be shifted wholly or in part from owner to tenant by boosting rent.

US Tax Structure, federal systemoverall, higher income groups pay larger percentages of their income as federal taxes than do lower-income groups. Although fed. payroll and excise taxes are regressive, fed. income tax is sufficiently progressive. Mostly paid by higher income taxpayers.
US Tax Structure, state and localas a percentage of income, property taxes and sales taxes fall as income rises. Also, state income taxes generally less progressive than federal income tax.
US Tax Structure, overall tax systemhigher income people carry a substantially larger tax burden, as a percentage of their income, than do lower-class people
US Tax Structure, overall tax system related to other rich countriesUS tax system is most progressive among OECD nations and more progressive than countries like Canada, France, United Kingdom. This is b/c other nations rely much more on national sales tax (regressive)
Income tax statement cannot be relied upon by itself to substantially alter the distribution of income b/c…gov’t might choose to spend the taxes collected from rich to pay for things that are more used by rich than poor. Does not happen in US b/c of the large tax revenues collected by rich to make income transfer payments to poor