Chapter 16

Chapter 16: Financing Government
Section 1

Copyright © Pearson Education, Inc. Slide 2Chapter 16, Section 1
Objectives
1. Explain how the Constitution gives
Congress the power to tax and places
limits on that power.
2. Identify the most significant federal taxes
collected today.
3. Describe nontax sources of revenue.

Key Terms
• fiscal policy: the methods used by the
government to raise and spend money
• progressive tax: a tax whose rate
increases with one’s income
• payroll tax: taxes withheld from employee
paychecks
• regressive tax: taxes levied at a fixed
rate without regard to the taxpayer’s ability
to pay them

Key Terms, cont.
• excise tax: a tax on the manufacture, sale,
or consumption of goods and services
• estate tax: a tax on the assets of someone
who dies
• gift tax: a tax on gifts from one living person
to another
• customs duty: taxes on goods brought to
the U.S. from abroad
• interest: a charge for borrowed money,
usually a percentage of the money borrowed

Introduction
• How is the Federal Government financed?
– The Federal Government is financed largely by direct
and indirect taxes.
– The major taxes are the individual income tax,
corporation income tax, payroll taxes, excise taxes,
estate and gift taxes, and customs duties.
– The government also raises a smaller amount of
nontax revenue through interest, fees, and sales.

The Power to Tax
• The first power granted to Congress by the
Constitution is the power to tax.
• Congress taxes to raise revenue to operate the
federal government.
• Congress also uses the taxation power to
require or deny licenses for certain activities in
order to serve the public interest.

The Power to Tax, cont.
• Though taxes are
used to fund the
programs that the
public expects, many
complain about the
burden placed on
taxpayers.
– How does this cartoon
illustrate this view?

Direct vs. Indirect Taxes
• Checkpoint: How does a direct tax differ from an
indirect tax?
– A direct tax is levied upon a specific individual.
Examples include taxes on personal property or
income.
– An indirect tax can be shifted to another person for
payment. For example, a tax levied on a liquor
producer is passed along to the consumers who buy
the liquor in the form of higher prices.

Limitations on Taxation
• Checkpoint: How does the Constitution limit the
power to tax?
– Congress can levy taxes only for public purposes.
– Congress cannot tax U.S. exports.
– Direct taxes on individuals must be distributed evenly
among the States.
– All indirect taxes must be set at the same rate in all
parts of the country.
– The federal government cannot tax the government
functions of State or local governments, such as
providing public education.

Limitations on Taxation, cont.
• There are exceptions to these limitations:
– The federal government can tax businesses
operated by State and local governments if
they are not considered to represent normal
government functions.
– The 16th
Amendment, ratified in 1913, allows
Congress to levy a direct individual income
tax.

Income Tax
• Income tax on
individuals and
corporations is the
largest source of
federal revenue.
• Income taxes are
progressive—higher
earnings are taxed at
a higher rate.

Individual Income Tax
• Individual income tax is
levied on each person’s
earnings for the previous
year, minus certain
exemptions and
deductions.
• Tax returns for the
previous year must be
filed by April 15th
. The IRS
receives more than 120
million returns each year.

Individual Income Tax, cont.
• Individual income taxes provide the bulk of
federal revenue.
• Most people have income taxes withheld from
their paychecks. Others pay estimated taxes.

Corporation Income Tax
• Each corporation must pay income tax.
• There are many deductions allowed. For
example, churches and nonprofit or charitable
organizations pay no corporate income tax.

Payroll Taxes
• The federal government collects payroll taxes to
finance Social Security, Medicare, and the
unemployment compensation program.
• These are regressive taxes, paid at a fixed rate
regardless of income.

Excise Taxes
• Excise taxes are often figured into the retail price
of goods and services.
• Excise taxes on tobacco, alcohol, and gambling
are called sin taxes, while those on luxury goods
are called luxury taxes.

Gift and Estate Taxes
• Gift taxes are levied on gifts from one person to
another, while estate taxes are levied on the
assets of someone who dies.
• Most estates are not subject to the tax. Gifts up
to $12,000 in one year are tax-free.

Customs Duties
• Customs duties, also called tariffs or import
duties, are charged on many goods imported
into the United States.
• They were once the main source of federal
income, but are now minor.

Nontax Revenues
• Checkpoint: What are three examples of federal
nontax revenues?
– The government receives interest on money
borrowed from the Federal Reserve System and other
loans.
– The government also charges fees for issuing
passports, copyrights, patents, and trademarks.
– The sale or lease of public lands also generates
government income.

Review
• Now that you have learned about how the
Federal Government is financed, go back
and answer the Chapter Essential
Question.
– How should the federal budget reflect
Americans’ priorities?

Section 2

Objectives
1. Describe federal borrowing.
2. Explain how the Federal Government’s
actions can affect the economy.
3. Analyze the causes and effects of the
public debt.

Key Terms
• deficit: the shortfall created when income
is lower than expenses
• surplus: the excess created when income
is higher than expenses
• demand-side economics: the view that
increased government spending will
create higher employment, boost the
economy, and raise tax revenues

Key Terms, cont.
• supply-side economics: the view that
lower taxes, not greater government
spending, will boost the economy
• public debt: the total amount of money
owed by the federal government

Introduction
• What effect does borrowing have on the
federal budget and the nation’s economy?
– Borrowing can be used to provide an
economic stimulus for the nation and to pay
off budget deficits in times of crisis or
overspending.
– However, such borrowing leads to future
deficits and higher interest payments on the
increasing public debt.

The Power to Borrow
• The Constitution gives Congress the power to
borrow money. For 150 years Congress used
this power to:
– Pay for crises such as wars
– Pay for large-scale projects such as the
construction of the Panama Canal
• For most of the past 80 years, the
government has borrowed money to pay for
yearly budget deficits because it spends
more than it raises from taxpayers.

Deficits and Surpluses
• The government did
not have a budget
surplus from 1969 to
1998.
• The government
creates the budget
based on estimates.
– What factors
mentioned on the
chart likely affected
the budget for that
year?

The Depression
• At the height of the Great Depression, one fourth
of the nation’s labor force was unemployed and
18 million were dependent on public relief
programs.
• State governments, private charities, and banks
were all overwhelmed.
• The traditional approach was to keep
government involvement in the economy limited
and let the free market solve the problem.

Keynesian Economics
• In contrast, President
Roosevelt’s New Deal
used the ideas of John
Maynard Keynes to
stimulate the economy.
• Keynes said that
government should spend
heavily on public
programs during times of
high unemployment.

Supply-Side Economics
• Under President Reagan, the theory of supply-side
economics took hold.
• This theory says that lowering taxes increases the
supply of money in private hands and boosts the
economy without higher government spending.
• In 2008, supply-side supporter George W. Bush
approved both an economic stimulus plan and a
$700 billion bailout of home lending institutions, both
Keynesian measures for dealing with a financial
crisis.

Borrowing Money
• Checkpoint: How does the federal government
borrow money?
– Congress must authorize all federal borrowing. The
Treasury Department then borrows money by selling
securities to investors.
– Securities are notes in which the government promises to
repay a certain sum, plus interest, on a certain date.
– Short term securities are usually Treasury notes, also
called T-bills.
– Long term securities are typically government bonds.

Borrowing Money, cont.
• Investors in U.S.
securities include both
American and foreign
individuals, banks,
investment companies,
and other financial
institutions.
– To which group of
investors does the
government owe the
most?

The Public Debt
• The U.S. government can borrow money
while offering lower rates of interest than
those charged to private investors.
– This is because U.S. securities are seen as safe
investments and their interest is not taxed.
• Still, borrowing so much money has produced
a huge public debt for the federal
government.
– This debt includes all the borrowed money not yet
repaid plus the interest owed.

• The public debt has exploded over the past 30 years,
passing $1 trillion for the first time in 1981.
• About 1 in every 10 dollars spent by the U.S.
government now goes to paying interest on the public
debt.
The Public Debt

• There is no constitutional limit on the public
debt.
• Congress has put limits on the debt but simply
raised them when needed.
• The amount of the
debt is hard to
imagine and will
affect future
generations of
taxpayers.
The Public Debt, cont.

Review
• Now that you have learned about the
effect borrowing has on the federal budget
and the nation’s economy, go back and
answer the Chapter Essential Question.

Section 3

Objectives
1. Identify the key elements of federal
spending.
2. Define controllable and uncontrollable
spending.
3. Explain how the President and Congress
work together to create the federal
budget.

Key Terms
• entitlement: benefits that must be paid
under federal law to everyone who meets
the eligibility requirements
• controllable spending: items in the
federal budget that the government can
increase or decrease spending on each
year

Key Terms, cont.
• uncontrollable spending: budget
expenses that are either fixed by federal
law or are largely out of the government’s
control from year to year
• continuing resolution: emergency
legislation passed by Congress to fund
federal agencies whose budget
appropriations have not been approved by
the required deadline

Introduction
• How is federal spending determined?
– The various federal agencies submit budget
proposals to the Office of the President, which
reviews and alters them before presenting a
complete budget to Congress.
– Congress makes further adjustments to the
budget until appropriations bills are approved
and sent to the President to be vetoed or
signed into law.

Spending Priorities
• The federal government
spends over $700 billion a
year on entitlement
programs.
• These are benefits that
must be paid under federal
law to people who meet
eligibility requirements.
• Social Security, Medicare,
Medicaid, and food stamps
are major examples.

Spending Priorities, cont.
• The Department of Defense spent more than
$636 billion on national defense in 2010.
– This figure does not include all defense-related
federal expenditures.
• Treasury Department payments on the public
debt are now the fourth-largest category of
federal spending.

Controllable Spending
• Congress and the President can decide
how much to spend on many specific
items in the federal budget.
– Such controllable spending includes national
parks, highway projects, military equipment,
educational aid, and civil service pay.
• This spending is also called discretionary
spending.

Uncontrollable Spending
• Many public programs have uncontrollable
spending limits that neither Congress nor the
President can change.
– This includes the interest due on the vast federal debt.
– Most entitlements—Social Security benefits, food stamps,
and so on—are also largely uncontrollable. Congress can
only redefine the eligibility standards or reduce the amount
of benefits.
– Nearly 80% of all federal spending now falls into the
uncontrollable category.

Overview of the Federal Budget
• Checkpoint: How is the budget both a
financial and political statement?
– Financially, the budget is a detailed estimate
of federal income and expenditures for the
upcoming year.
– Politically, the budget is also a declaration of
the President’s public policy plans, some of
which will be accepted, altered, or rejected by
Congress over a period of several months.

The President
• At least eighteen months before a fiscal year, each
federal agency prepares detailed estimates of its
spending needs for that year.
• These plans are submitted to the President’s Office of
Management and Budget (OMB).
• The OMB reviews and adjusts these budget proposals.
• The President then sends the final budget request to
Congress on the first Monday in February.

Congress
• The House and Senate Budget Committees study the
budget proposal with the help of the Congressional
Budget Office (CBO).
– The CBO is Congress’s independent version of the OMB.
• The Budget Committees each submit a Budget
Resolution that is debated and voted on in each house.
• The two Budget Resolutions are merged into one version
that Congress votes on by May 15th.

Congress, cont.
• The House and Senate Appropriations
Committees use the income and spending
guidelines in the Budget Resolution to help them
decide how to divide money among federal
agencies.
– Each Appropriations Committee creates 13 spending bills
in each house of Congress, which are then resolved in 13
separate spending bills for federal agencies.
• Congress votes on the final version of each
spending bill.

Congress, cont.
• Appropriations subcommittees hold many
public hearings to examine agency requests
and take testimony from lobbyists and others
about specific spending plans.
– Why do you think
these hearings
are open to the
public?

Approving the Budget
• The total cost of all appropriations bills cannot
be greater than the maximum limit set by the
Budget Committees.
• Each appropriations bill approved by Congress
goes to the President to be vetoed or signed into
law.
• If, as often happens, an appropriations bill is not
approved by October 1, Congress must pass a
continuing resolution to fund any affected
agencies to ensure their continued operation.

Review
• Now that you have learned about how
federal spending is determined, go back
and answer the Chapter Essential
Question.

Section 4

Objectives
1. Describe the overall goals of the Federal
Government’s actions in the economy.
2. Explain the features and purposes of
fiscal policy.
3. Explain the features and purposes of
monetary policy.

Key Terms
• gross domestic product: the total value of all
goods and services produced in a country each
year
• inflation: a general increase in prices
throughout the economy
• deflation: a general decrease in prices
throughout the economy
• recession: an absence of GDP growth and a
shrinking economy
• fiscal policy: the government’s powers to tax
and spend to influence the economy

Key Terms, cont.
• monetary policy: the government’s power to
influence the economy by regulating the
money supply and the availability of credit
• open market operations: the process of
buying or selling government securities from
the nation’s banks
• reserve requirement: the amount of money that
the Federal Reserve Board says banks must
keep on reserve
• discount rate: the rate of interest a bank must
pay when it borrows money from a Federal
Reserve bank

Introduction
• How does the Federal Government
achieve its economic goals?
– The Federal Government tries to maintain a
healthy, growing economy through a
combination of fiscal policies.
– These involve taxation, government spending
and monetary policies based on controlling
the money supply and the availability of credit.

Overall Economic Goals
• The federal government seeks to achieve full
employment, price stability, and economic
growth.
– Full employment means that everyone able and
willing to work can find a job.
– Price stability means that overall prices for goods
and service do not rise too high (inflation) or fall too
low (deflation).
– Economic growth means that the gross domestic
product (GDP) steadily increases, avoiding recession.

Overall Economic Goals, cont.
• Checkpoint: How can inflation and
deflation affect the economy?
– High inflation means that dollars buy less
than they previously did, which robs people of
purchasing power.
– Deflation hurts the economy by making it
harder to borrow money and lowering the
money earned by farmers and other
producers, who receive less for their goods.

Fiscal Policy
• Fiscal policy is the government’s attempt to influence the
economy through taxation and spending.
• In general, higher government spending increases
economy activity, while less spending dampens activity.
• Tax increases tend to slow economic growth, while tax
cuts boost growth.
• For many years, federal fiscal policy was limited. Very
little of GDP came from federal spending. Today, federal
spending accounts for about 20% of GDP.

Fiscal Policy, cont.
• During economic downturns, policy makers usually
increase federal spending, cut taxes, or both in hopes
of expanding the economy.
• In theory, tax increases or cuts in federal spending
can slow inflation.

Monetary Policy
• Monetary policy involves increasing or decreasing
the money supply and easing or tightening the
availability of credit.
• The goal is to boost or slow down the economy as
needed.
• The seven-member Federal Reserve Board, or Fed,
carries out U.S. monetary policy. Members are
appointed to 14-year terms.
• The Fed also helps stabilize the banking system by
providing emergency funding.

Monetary Policy, cont.
• Under the guidance of
current Chairman Ben
Bernanke, the Fed
has three major tools
for altering the money
supply:
– Open market
operations
– Reserve requirements
– The discount rate

Open Market Operations
• The Federal Reserve carries out open market
operations by buying or selling government
securities to and from banks.
– Buying government securities gives banks more
money to loan to individuals and businesses. This
can boost business activity.
– Selling government bonds to banks removes
money from circulation, leaving banks with less
money to loan or invest. This slows business
activity.

Reserve Requirements
• The reserve requirement is the amount of
money that the Federal Reserve requires banks
to keep in their vaults or on deposit with one of
the 12 Federal Reserve Banks.
• Money kept in reserve cannot be loaned or
spent—it is out of circulation.
• Increasing the reserve requirement lowers the
amount of money in circulation, while decreasing
the reserve requirement does the opposite.

The Discount Rate
• The discount rate is the
interest paid by banks
borrowing from the
Federal Reserve.
• Raising the discount rate
slows borrowing, which
reduces the flow of
money. Lowering it does
the opposite.
– How does this cartoon
show the complexity of
monetary policy?

Review
• Now that you have learned about how the
Federal Government achieves its
economic goals, go back and answer the
Chapter Essential Question.

Chapter 16

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