Chapter 6 Powerpoint

Chapter 6
Funding the
Public Sector

Introduction
During the past few years, federal government spending
has increased at the same time that revenues collected
from taxes and other sources have declined. To cover its
expenditures, the federal government has resorted to
borrowing.
As you will learn in this chapter, however, the
government budget constraint indicates that ultimately
spending and revenues must be equalized.

Copyright ©2014 Pearson Education, Inc. All rights reserved.

6-2

Learning Objectives
• Distinguish between average tax rates and
marginal tax rates
• Explain the structure of the U.S. income tax
system
• Understand the key factors influencing the
relationship between tax rates and the tax
revenues governments collect


6-3

Learning Objectives (cont'd)
• Explain how the taxes governments levy on
purchases of goods and services affect
market prices and equilibrium quantities


6-4

Chapter Outline
•
•
•
•
•

Paying for the Public Sector
Systems of Taxation
The Most Important Federal Taxes
Tax Rates and Tax Revenues
Taxation from the Point of View of
Producers and Consumers


6-5

Did You Know That ...
• More than a dozen U.S. states have sold bonds
promising annual payments based on projected
revenues from a legal settlement with the tobacco
industry?
• To obtain the funds required to finance their
operations, state and local governments collect
taxes from many different sources such as
property tax, sales tax, income tax, and hotel
occupancy tax.
• At the federal level, there are Social Security taxes,
Medicare taxes, and income taxes.

6-6

Paying for the Public Sector
• Three sources of government funding
1. Fees for government services, or user charges
2. Taxes
3. Borrowing


6-7

Paying for the Public Sector (cont'd)
• Government Budget Constraint
– The limit on government spending and transfer
payments
– Imposed by the fact that every dollar spent
must be provided for by taxes


6-8

Example: State Tuition Rates Jump – Even at the
Last Moment

• To continue operations with limited budgets
during the recession of the late 2000s, more
than half of the states have cut spending on
higher education.
• In turn, state universities have responded
by raising tuition.
• At a number of state universities, tuition
rates have increased as late as the final
course registration date.


6-9

Systems of Taxation
• Tax Base
– The value of goods, services, wealth, or incomes
subject to taxation

• Tax Rate
– The proportion of a tax base that must be paid
to a government as taxes


6-10

Policy Example: Is It Time to Replace
Gasoline Taxes with Mileage Taxes?
• Taxes on gasoline are a major source of
funds for road construction and repair.
• Yet, with more battery-powered vehicles on
the road, the gasoline tax base has been
shrinking.
• The Congressional Budget Office has
suggested using a mileage tax base.
• Vehicle owners would be taxed based on the
number of miles driven, as recorded by a
mileage meter on the vehicle.

6-11

Systems of Taxation (cont'd)
• Marginal Tax Rate
– The change in the tax payment divided by the
change in income

change in taxes due
Marginal tax rate =
change in taxable income


6-12

• Tax Bracket
– A specified interval of income to which a specific
and unique marginal tax rate is applied

• Average Tax Rate
– The total tax payment divided by total income


6-13

• Proportional Taxation
– A tax system in which, regardless of an
individual’s income, the tax bill comprises
exactly the same proportion
– Taxpayers at all income levels pay the same
percentage of their income in taxes


6-14

Proportional taxation
Marginal tax rate = Average tax rate
Income
$10,000
$100,000

Tax Rate
20%
20%


Taxes
$2,000
$20,000

6-15

• Progressive Taxation
– A tax system in which, as income increases, a
higher percentage of the additional income is
paid as taxes


6-16

Progressive taxation
Marginal tax rate > Average tax rate
Income
$0–$10,000
$10,001–$20,000
$20,001–$30,000


Tax Rate Taxes
5%
$500
10%
$1,000
30%
$3,000

6-17

Policy Example: Calculating the Top
U.S. Marginal Tax Rate
• In the progressive tax system of the federal
government and most states, the highest
income earners pay the highest overall tax
rates.
• The highest U.S. income earners are able to
keep for their own use just over half of the
last dollar they earn.


6-18

• Regressive Taxation
– A tax system in which as more dollars are
earned, the percentage of tax paid on them falls
– A smaller percentage of income is taken in taxes
as income increases


6-19

Regressive taxation: Social Security*
Marginal tax rate < Average tax rate
Income
$100,000
$200,000

Tax Rate
10%
5%

Taxes
$10,000
$10,000

* No social security tax after $100,000 in income


6-20

• Question
– What types of taxes do federal, state and local
governments collect?

• Answers
– Federal government: individual income taxes,
corporate income taxes, Social Security taxes,
import and excise taxes
– State and local governments: sales taxes,
property taxes, personal and corporate income
taxes


6-21

Figure 6-1 Sources of Government Tax
Receipts

Source: Economic Report of the President, Economic Indicators

6-22

• The federal personal income tax
– Accounts for almost 44% of all federal revenue
– All U.S. citizens, resident aliens, and most others
required to pay (includes income earned abroad)
– Rates paid rise as income increases


6-23

Table 6-1 Federal Marginal Income Tax
Rates


6-24

(cont'd)
• Arguments for the progressive tax
– Redistribution of income
– Ability to pay
– Benefits received

• Counterargument
– No strong evidence of redistribution


6-25

Policy Example: Figuring Out How Much to
Pay In Income Taxes Is Not Cheap
• The Internal Revenue Service has estimated
that U.S. taxpayers spend nearly $200
billion per year to determine how much they
owe in income taxes.
• In addition, taxpayers devote 7.6 billion
hours to this process.
• Using an opportunity cost of $16 per hour,
this amounts to a total cost of roughly $325
billion per year.


6-26

(cont'd)
• Capital Gain
– The positive difference between the purchase
price and the sale price of an asset
• You buy a share of stock for $5 and sell for $15: you
have a capital gain of $10

• Capital Loss
– The negative difference between the purchase
price and the sale price of an asset


6-27

(cont'd)
• The corporate income tax
– Accounts for 12% of federal tax revenue and 2%
of all state and local taxes collected
– Corporations are generally taxed on the
difference between total revenues and expenses


6-28

Table 6-2 Federal Corporate Income
Tax Schedule


6-29

(cont'd)
• Double taxation
– Corporation pays taxes on its profits
– Corporation declares a dividend on after-tax
profits
– Dividend income is taxed


6-30

(cont'd)
• Retained Earnings
– Earnings that a corporation saves, or retains, for
investment in other productive activities
– Earnings that are not distributed to stockholders

• Tax Incidence
– The distribution of tax burdens among various
groups in society


6-31

(cont'd)
• Who really pays the corporate income tax?
– Tax incidence is distributed among
• Consumers
• Stockholders
• Employees


6-32

(cont'd)
• Social Security taxes
– Social Security rates today are imposed on
earnings up to roughly $106,800
– Contributions are 6.2% for employers and 6.2%
for employees


6-33

(cont'd)
• Unemployment taxes
– Paid by employer
– 0.8% of first $7,000 of wages for employees
earning more than $1,500
– States may levy an additional tax up to 3%
based on record of the employer


6-34

• State and local governments
– Taxes imposed on goods and services yield more
revenues than income taxes
– A fundamental issue is how to set tax rates to
extract the largest possible payments


6-35

(cont'd)
• Sales Taxes
– Taxes assessed on the prices paid on a large set
of goods and services

• Ad Valorem Taxation
– Assessing taxes by charging a tax rate equal to
a fraction of the market price of each unit
purchased


6-36

Policy Example: States Seek to Apply
Sales Taxes to Internet Retailers’ Sales
• In an attempt to increase tax revenues,
some states have targeted Internet retailers
who are linked to other sellers, known as
affiliates, who have a physical presence
within the state.
• Whenever state governments have tried to
tax these retailers, the affiliate programs
have been eliminated.
• Thus, these states have not succeeded in
expanding their sales tax base.

6-37

(cont'd)
• Static Tax Analysis
– Based on the assumption that changes in the tax
rate leave the tax base unaffected

• Dynamic Tax Analysis
– Recognizes that higher tax rates may shrink the
tax base


6-38

What If . . . The government seeks to collect
higher taxes by increasing capital gains tax
rates?

• When people learn about upcoming
increases in the capital gains tax rate, they
can attempt to sell their assets immediately.
• Alternatively, asset sales can be postponed
if the tax rate is expected to fall.
• Indeed, there is considerable evidence of an
inverse relationship between capital gains
tax rates and realized capital gains.


6-39

(cont'd)
• If the disincentive effects of higher tax rates are
small, static analysis may give a fairly accurate
estimate of the change in tax revenues resulting
from a tax rate change
• As tax rates escalate, members of the public have
a greater incentive to remove their activities from
the tax base; a dynamic analysis would be
necessary to determine the overall effect on
government revenues


6-40

Figure 6-2 States with the Highest and
Lowest Sales Tax Rates


6-41

(cont'd)
• Maximizing tax revenues
– Dynamic tax analysis predicts ever-higher tax
rates bring about declines in the tax base
– At sufficiently high rates the government’s tax
revenues begin to fall off


6-42

Figure 6-3 Maximizing the Government’s
Sales Tax Revenues


6-43

Producers and Consumers
• Excise Tax
– A tax levied on purchases of a particular good or
service

• Unit Tax
– A constant tax assessed on each unit of a good
that consumers purchase


6-44

Producers and Consumers (cont'd)
• Excise taxes on gasoline become added
costs of production
• This shifts the supply curve up by the
amount of the unit tax
• Consequently, the equilibrium price of
gasoline rises and the equilibrium quantity
declines


6-45

Figure 6-4 The Effects of Excise Taxes on the Market
Supply and Equilibrium Price and Quantity of Gasoline


6-46

Producers and Consumers (cont'd)
• Who Pays the Tax?
– In our example, the price that each consumer
pays is $0.30 per gallon higher
– Therefore, consumers pay three-fourths of the
excise tax and producers absorb the remainder


6-47

You Are There: How to Keep Social Security in
Business
• Nancy Altman is co-director of Social Security
Works, a group dedicated to preserving the Social
Security programs that provide benefits to the
elderly and disabled.
• Altman proposes two ways of preserving both
programs:
– 1) Combine both programs, so that tax dollars originally
intended to provide benefits for the elderly would be
diverted to disability benefits
– 2) Increase the Social Security tax rate


6-48

Issues & Applications: What Determines the U.S.
Long-Run Average Tax Rate?
• Figure 6-5 on the next slide displays the average
U.S. federal tax rate for each year since 1934.
• Since the early 1950s, this overall average tax rate
has ranged between 15 and 21 percent.
• The greater instability of the average individual
income tax rate reflects both changes in marginal
tax rates and variations in the amount of income
subject to taxation.
• The current ratio of federal spending to national
income of about 24 percent is well above the
overall tax rate of 15 percent.

6-49

Figure 6-5 The Overall Average Federal Tax Rate
and Its Components and Federal Spending as a
Percentage of National Income


6-50

Summary Discussion of Learning
Objectives
• Average tax rates versus marginal tax rates
– Average tax rate is the ratio of total tax
payments to total income
– Marginal tax rate is the change in tax payments,
induced by a change in total taxable income:
applies to the last dollar earned


6-51

Objectives (cont'd)
• The U.S. income tax system taxes personal and
business income
– A tax system is progressive when marginal tax rate
increases as income rises
– Contrasts with regressive system, in which higher-income
earners pay lower marginal tax rates
– Under proportional taxation, the marginal and average
rate are equal


6-52

Objectives (cont'd)
• The relationship between tax rates and tax
revenues
– Static tax analysis assumes that the tax base
does not respond significantly to an increase in
the tax rate
– Dynamic tax analysis reveals how an increase in
the tax rate causes the tax base to decline


6-53

Objectives (cont'd)
• How taxes on purchases of goods and
services affect market prices and quantities
– A tax collected from the seller of a good will shift
the supply curve up
– To the extent that the price rises, consumers
pay a portion of the tax and sellers pay the
remainder


6-54

Chapter 6 Powerpoint

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