Chapter 6
Funding the
Public Sector
Introduction
During the past few years, federal government spending
has increased at the same time that revenues collected...
Learning Objectives
• Distinguish between average tax rates and
marginal tax rates
• Explain the structure of the U.S. inc...
Learning Objectives (cont'd)
• Explain how the taxes governments levy on
purchases of goods and services affect
market pri...
Chapter Outline
•
•
•
•
•

Paying for the Public Sector
Systems of Taxation
The Most Important Federal Taxes
Tax Rates and...
Did You Know That ...
• More than a dozen U.S. states have sold bonds
promising annual payments based on projected
revenue...
Paying for the Public Sector
• Three sources of government funding
1. Fees for government services, or user charges
2. Tax...
Paying for the Public Sector (cont'd)
• Government Budget Constraint
– The limit on government spending and transfer
payme...
Example: State Tuition Rates Jump – Even at the
Last Moment

• To continue operations with limited budgets
during the rece...
Systems of Taxation
• Tax Base
– The value of goods, services, wealth, or incomes
subject to taxation

• Tax Rate
– The pr...
Policy Example: Is It Time to Replace
Gasoline Taxes with Mileage Taxes?
• Taxes on gasoline are a major source of
funds f...
Systems of Taxation (cont'd)
• Marginal Tax Rate
– The change in the tax payment divided by the
change in income

change i...
Systems of Taxation (cont'd)
• Tax Bracket
– A specified interval of income to which a specific
and unique marginal tax ra...
Systems of Taxation (cont'd)
• Proportional Taxation
– A tax system in which, regardless of an
individual’s income, the ta...
Systems of Taxation (cont'd)
Proportional taxation
Marginal tax rate = Average tax rate
Income
$10,000
$100,000

Tax Rate
...
Systems of Taxation (cont'd)
• Progressive Taxation
– A tax system in which, as income increases, a
higher percentage of t...
Systems of Taxation (cont'd)
Progressive taxation
Marginal tax rate > Average tax rate
Income
$0–$10,000
$10,001–$20,000
$...
Policy Example: Calculating the Top
U.S. Marginal Tax Rate
• In the progressive tax system of the federal
government and m...
Systems of Taxation (cont'd)
• Regressive Taxation
– A tax system in which as more dollars are
earned, the percentage of t...
Systems of Taxation (cont'd)
Regressive taxation: Social Security*
Marginal tax rate < Average tax rate
Income
$100,000
$2...
The Most Important Federal Taxes
• Question
– What types of taxes do federal, state and local
governments collect?

• Answ...
Figure 6-1 Sources of Government Tax
Receipts

Source: Economic Report of the President, Economic Indicators
Copyright ©20...
The Most Important Federal Taxes
• The federal personal income tax
– Accounts for almost 44% of all federal revenue
– All ...
Table 6-1 Federal Marginal Income Tax
Rates

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

6-24
The Most Important Federal Taxes
(cont'd)
• Arguments for the progressive tax
– Redistribution of income
– Ability to pay
...
Policy Example: Figuring Out How Much to
Pay In Income Taxes Is Not Cheap
• The Internal Revenue Service has estimated
tha...
The Most Important Federal Taxes
(cont'd)
• Capital Gain
– The positive difference between the purchase
price and the sale...
The Most Important Federal Taxes
(cont'd)
• The corporate income tax
– Accounts for 12% of federal tax revenue and 2%
of a...
Table 6-2 Federal Corporate Income
Tax Schedule

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

6-29
The Most Important Federal Taxes
(cont'd)
• Double taxation
– Corporation pays taxes on its profits
– Corporation declares...
The Most Important Federal Taxes
(cont'd)
• Retained Earnings
– Earnings that a corporation saves, or retains, for
investm...
The Most Important Federal Taxes
(cont'd)
• Who really pays the corporate income tax?
– Tax incidence is distributed among...
The Most Important Federal Taxes
(cont'd)
• Social Security taxes
– Social Security rates today are imposed on
earnings up...
The Most Important Federal Taxes
(cont'd)
• Unemployment taxes
– Paid by employer
– 0.8% of first $7,000 of wages for empl...
Tax Rates and Tax Revenues
• State and local governments
– Taxes imposed on goods and services yield more
revenues than in...
Tax Rates and Tax Revenues
(cont'd)
• Sales Taxes
– Taxes assessed on the prices paid on a large set
of goods and services...
Policy Example: States Seek to Apply
Sales Taxes to Internet Retailers’ Sales
• In an attempt to increase tax revenues,
so...
Tax Rates and Tax Revenues
(cont'd)
• Static Tax Analysis
– Based on the assumption that changes in the tax
rate leave the...
What If . . . The government seeks to collect
higher taxes by increasing capital gains tax
rates?

• When people learn abo...
Tax Rates and Tax Revenues
(cont'd)
• If the disincentive effects of higher tax rates are
small, static analysis may give ...
Figure 6-2 States with the Highest and
Lowest Sales Tax Rates

Copyright ©2014 Pearson Education, Inc. All rights reserved...
Tax Rates and Tax Revenues
(cont'd)
• Maximizing tax revenues
– Dynamic tax analysis predicts ever-higher tax
rates bring ...
Figure 6-3 Maximizing the Government’s
Sales Tax Revenues

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

6...
Taxation from the Point of View of
Producers and Consumers
• Excise Tax
– A tax levied on purchases of a particular good o...
Taxation from the Point of View of
Producers and Consumers (cont'd)
• Excise taxes on gasoline become added
costs of produ...
Figure 6-4 The Effects of Excise Taxes on the Market
Supply and Equilibrium Price and Quantity of Gasoline

Copyright ©201...
Taxation from the Point of View of
Producers and Consumers (cont'd)
• Who Pays the Tax?
– In our example, the price that e...
You Are There: How to Keep Social Security in
Business
• Nancy Altman is co-director of Social Security
Works, a group ded...
Issues & Applications: What Determines the U.S.
Long-Run Average Tax Rate?
• Figure 6-5 on the next slide displays the ave...
Figure 6-5 The Overall Average Federal Tax Rate
and Its Components and Federal Spending as a
Percentage of National Income...
Summary Discussion of Learning
Objectives
• Average tax rates versus marginal tax rates
– Average tax rate is the ratio of...
Summary Discussion of Learning
Objectives (cont'd)
• The U.S. income tax system taxes personal and
business income
– A tax...
Summary Discussion of Learning
Objectives (cont'd)
• The relationship between tax rates and tax
revenues
– Static tax anal...
Summary Discussion of Learning
Objectives (cont'd)
• How taxes on purchases of goods and
services affect market prices and...
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Chapter 6 Powerpoint

  1. 1. Chapter 6 Funding the Public Sector
  2. 2. 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
  3. 3. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-3
  4. 4. Learning Objectives (cont'd) • Explain how the taxes governments levy on purchases of goods and services affect market prices and equilibrium quantities Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-4
  5. 5. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-5
  6. 6. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-6
  7. 7. Paying for the Public Sector • Three sources of government funding 1. Fees for government services, or user charges 2. Taxes 3. Borrowing Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-7
  8. 8. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-8
  9. 9. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-9
  10. 10. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-10
  11. 11. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-11
  12. 12. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-12
  13. 13. Systems of Taxation (cont'd) • 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-13
  14. 14. Systems of Taxation (cont'd) • 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-14
  15. 15. Systems of Taxation (cont'd) Proportional taxation Marginal tax rate = Average tax rate Income $10,000 $100,000 Tax Rate 20% 20% Copyright ©2014 Pearson Education, Inc. All rights reserved. Taxes $2,000 $20,000 6-15
  16. 16. Systems of Taxation (cont'd) • Progressive Taxation – A tax system in which, as income increases, a higher percentage of the additional income is paid as taxes Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-16
  17. 17. Systems of Taxation (cont'd) Progressive taxation Marginal tax rate > Average tax rate Income $0–$10,000 $10,001–$20,000 $20,001–$30,000 Copyright ©2014 Pearson Education, Inc. All rights reserved. Tax Rate Taxes 5% $500 10% $1,000 30% $3,000 6-17
  18. 18. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-18
  19. 19. Systems of Taxation (cont'd) • 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-19
  20. 20. Systems of Taxation (cont'd) 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-20
  21. 21. The Most Important Federal Taxes • 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-21
  22. 22. Figure 6-1 Sources of Government Tax Receipts Source: Economic Report of the President, Economic Indicators Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-22
  23. 23. The Most Important Federal Taxes • 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-23
  24. 24. Table 6-1 Federal Marginal Income Tax Rates Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-24
  25. 25. The Most Important Federal Taxes (cont'd) • Arguments for the progressive tax – Redistribution of income – Ability to pay – Benefits received • Counterargument – No strong evidence of redistribution Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-25
  26. 26. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-26
  27. 27. The Most Important Federal Taxes (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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-27
  28. 28. The Most Important Federal Taxes (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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-28
  29. 29. Table 6-2 Federal Corporate Income Tax Schedule Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-29
  30. 30. The Most Important Federal Taxes (cont'd) • Double taxation – Corporation pays taxes on its profits – Corporation declares a dividend on after-tax profits – Dividend income is taxed Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-30
  31. 31. The Most Important Federal Taxes (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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-31
  32. 32. The Most Important Federal Taxes (cont'd) • Who really pays the corporate income tax? – Tax incidence is distributed among • Consumers • Stockholders • Employees Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-32
  33. 33. The Most Important Federal Taxes (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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-33
  34. 34. The Most Important Federal Taxes (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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-34
  35. 35. Tax Rates and Tax Revenues • 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-35
  36. 36. Tax Rates and Tax Revenues (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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-36
  37. 37. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-37
  38. 38. Tax Rates and Tax Revenues (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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-38
  39. 39. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-39
  40. 40. Tax Rates and Tax Revenues (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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-40
  41. 41. Figure 6-2 States with the Highest and Lowest Sales Tax Rates Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-41
  42. 42. Tax Rates and Tax Revenues (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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-42
  43. 43. Figure 6-3 Maximizing the Government’s Sales Tax Revenues Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-43
  44. 44. Taxation from the Point of View of 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-44
  45. 45. Taxation from the Point of View of 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-45
  46. 46. Figure 6-4 The Effects of Excise Taxes on the Market Supply and Equilibrium Price and Quantity of Gasoline Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-46
  47. 47. Taxation from the Point of View of 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-47
  48. 48. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-48
  49. 49. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-49
  50. 50. Figure 6-5 The Overall Average Federal Tax Rate and Its Components and Federal Spending as a Percentage of National Income Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-50
  51. 51. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-51
  52. 52. Summary Discussion of Learning 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-52
  53. 53. Summary Discussion of Learning 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-53
  54. 54. Summary Discussion of Learning 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 6-54
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