Chapter 10 Government Spending, Taxation, and Deficits

Transcription

1 Chapter 10 Government Spending, Taxation, and Deficits After reading Chapter 10, GOVERNMENT SPENDING, TAXATION, AND DEFICITS, you should be able to: Explain why there is no Market Test in the public sector. Differentiate between Exhaustive Expenditures and Transfer Payments. Explain the two principles of taxation, the Benefit Principle and the Ability-to-Pay Principle and discuss their pros and cons. Define the terms Proportional Tax, Progressive Tax and Regressive Tax. Explain Marginal Tax Rates and why they affect people s behavior. Define what is meant by a federal budget Deficit and Surplus, and tell how they relate to the National Debt. Tell why it is difficult to reduce the federal government s budget deficit. Explain the importance of the Median Voter in a majority rule situation and discuss the problems that arise from this role. Define Rational Ignorance and Special Interest Groups and tell how they interact in a democracy. Outline I. No Market Test for Government Spending A) A Market Test ensures that private goods and services yield benefits equal to or greater than costs. Private spending decisions use a simple rule: carry out an activity as long as the marginal benefits exceed the marginal costs. B) The analogous rule the government should try to follow is that a government action should be undertaken only if the benefits from the action exceed the costs of the action. C) Government expenditures are either exhaustive expenditures or transfer payments. Exhaustive Expenditures are government purchases that divert resources from the private sector, making them no longer available for private use. Transfer Payments transfer income from one individual or organization to another. II. Taxation A) There are two principles of fairness and efficiency in taxation. 1. The Benefit Principle: those who benefit from a government program should pay for the program. a. Advantages of the benefit principle are that those who do not benefit from a program do not pay for it. Benefit-based taxes are more likely to insure that the gain from the program equals or exceeds its costs. b. A disadvantage of the benefit principle is that it is often difficult to determine who benefits from a specific government program.

2 Chapter 10 Government Spending, Taxation, and Deficits The Ability-to-Pay Principle: those who are better able to pay should bear the greater burden of taxation, whether or not they benefit. a. An advantage of the ability-to-pay principle is that it is not necessary to try to determine who benefits from any specific government project. b. Some disadvantages of the ability-to-pay principle are the difficulty in defining abilityto-pay, the adoption of programs whose total costs exceed total benefits, and the reduction of work incentives. B) Types of taxes: 1. Proportional Taxes: Taxpayers earning different incomes pay the same percentage of their income as taxes. 2. Progressive Taxes: Higher income taxpayers pay a higher percentage of their income as taxes. 3. Regressive Taxes: Higher income taxpayers pay a lower percentage of their income as taxes. C) The Marginal Tax Rate is the ratio of the increase in taxes to the increase in income. High marginal tax rates may reduce the incentive to work. III. Deficits and the National Debt A) The federal government runs a Deficit if expenditures exceed tax collections and other revenues. It has a Surplus if taxes and other revenues are greater than expenditures. B) The National Debt is the total amount of federal government issued debt. 1. National debt is Internal if it is owed to citizens of the country. Payments on internal national debt merely transfer income from one citizen to another without changing the nation s total income. 2. National debt is External if it is owed to a foreign resident. Payments on externally owned debt reduce the nation s total income. C) There are two main reasons it has proven difficult to reduce the government s deficit: 1. About 75 percent of government expenditures are for things on which spending cannot be reduced, such as interest on the national debt or products for which the government has signed contracts to buy. 2. People who are affected by proposed spending cuts lobby to prevent the spending reductions, while people affected by tax hikes lobby to eliminate the proposed tax increases. IV. Majority Rule: the Power of the Median Voter A) When government actions are undertaken in accordance with Majority Rule, the median voter controls the extent of the actions. The Median Voter is the voter whose preferences are such that fifty percent of voters desire more of a project and fifty percent desire less. B) Problems with the role played by the median voter are that: 1. the decisions reached may not respond to what some individuals wants, 2. majority voting may not take account of the intensity of different people s preferences, and 3. the resulting allocation of resources may not be efficient. C) Logrolling permits the approval of projects by vote trading coalitions that would be opposed by a majority if considered in isolation. D) Rational Ignorance is the decision to acquire additional information because the marginal costs exceed the marginal benefits.

3 104 Gregory Essentials of Economics, Sixth Edition E) Because of multiple issue voting and rational ignorance, Special Interest Groups minority voting groups with intense preferences about specific government policies are able to obtain government programs that favor them but harm a majority of the people. Review Questions True/False If the statement is correct, write true in the space provided; if it is wrong, write false. Below the question give a short statement that supports your answer. 1. In a democracy with majority rule, the preferences of the median voter play a decisive role in determining the amount of a government s project. 2. Rational ignorance refers to the fact that legislators cannot be experts on everything. 3. The ability-to-pay principle of taxation is that those who benefit from a program should have the ability to pay for the program. 4. An example of a progressive tax is a tax that requires everyone, without exception, to pay taxes equal to 15 percent of their income. 5. Under a regressive tax system, high-income taxpayers pay a smaller fraction of their income as taxes than do low-income taxpayers. 6. The fraction of additional income that must be paid as extra taxes is the marginal tax rate. 7. The government runs a deficit whenever its tax and other revenues are greater than its expenditures. 8. Government deficits allow the government to reduce the amount of the national debt. 9. Ever since the election of Ronald Reagan in 1980, politicians have found it increasingly easy to reduce the size of the deficit. 10. A special interest group is a voting group with similar intense opinions about specific government policies.

4 Chapter 10 Government Spending, Taxation, and Deficits 105 Multiple Choice Questions Circle the letter corresponding to the correct answer. 1. The marginal tax rates of a progressive tax (a) rise with income. (b) do not change with income. (c) fall with income. (d) first rise and then fall with income. (e) first fall and then rise with income. 2. The benefit principle of taxation is best illustrated by which of the following taxes? (a) A sales tax on liquor that helps fund education (b) A sales tax on gasoline that helps fund road repairs (c) Income taxes that help fund welfare payments to poor people (d) The exemption from sales taxes of certain necessities such as food (e) A sales tax on cigarettes that helps fund road repairs 3. The ability-to-pay principle is best illustrated by which of the following taxes or fees? (a) An automobile registration fee based on the weight of the car (b) An automobile registration fee based on the value of the car with the fee higher the more valuable the car (c) A toll charged to drive on beaches (d) The flat $10 tax imposed on everyone who works in Pittsburgh (e) Taxes levied on peanut growers that go to fund research into growing improved peanuts 4. Suppose when your income was $20,000 you paid $1,000 in taxes. If your income rose to $21,000 and you paid $1,500 in taxes, what was the marginal tax rate? (a) 10% (b) 15% (c) 13.6% (d) 9.1% (e) 50% 5. Poorer people generally spend a larger fraction of their income than do richer people. (That is, poorer people save a smaller fraction of their income.) So a general sales tax imposed on all purchases is a (a) marginal tax. (b) benefit tax. (c) proportional tax. (d) progressive tax. (e) regressive tax. 6. Which of the following statements about the deficit is false? (a) It has proven very hard to reduce the size of the deficit. (b) The larger the budget deficit, the greater the addition to the national debt. (c) If the government spends more than it receives in tax revenues, it is running a deficit. (d) It is illegal for the federal government to run a deficit. (e) None of the above; that is, they are all true statements.

5 106 Gregory Essentials of Economics, Sixth Edition Essay Questions Write a short essay or otherwise answer each question. 1. Complete the following table. Personal, Taxable Income Income Tax Paid Marginal Tax Rate $20,000 $2,000 XXX $21,000 $2, % $22,000 $2,500 $23,000 $2, Is the tax illustrated in Question 1 a proportional, progressive or regressive tax? Why? 3. The only fair taxes are those levied according to the benefit principle. Any expenditures funded by other types of taxes ought to be eliminated. Comment on this. For the next two questions, suppose Gregory owns $1000 of the national debt while Rush owns none of the debt. Further, assume Gregory and Rush each earn $10,000 a year from their jobs. 4. If Gregory and Rush are the country s only residents, what is the total income of the country? Suppose the government decides to tax all residents equally to pay $100 in interest on the national debt. How much must Gregory pay in taxes? Rush? After the taxes are paid and the government has paid the interest on the debt, what is Gregory s income? Rush s income? The total income of the country? 5. If Gregory is now a resident of a foreign country, what is the total income of the domestic country? If the government decides to tax all its residents equally to pay $100 in interest on the national debt, how much must Gregory pay in taxes? How much must Rush pay? After the taxes are paid and the government has paid the interest on the debt, what is Gregory s income? Rush s income? The total income of the domestic country? 6. Suppose a city of five people is considering the size of its police force. If the city is made up of the following five people, and they agree to use majority rule to determine the size of the force, how many police will be hired? Person Desired number of police Art 2 Bobby 6 Christine 4 David 7 Ellen If David became concerned about an impending crime wave and decided he wanted 18 police hired, and no one else changed their desired number of police, how many police will the city now hire? 8. Who is the median voter in Question 6? In Question 7?

6 Chapter 10 Government Spending, Taxation, and Deficits 107 Answers to Review Questions True/False 1. True. The median voter is the voter whose preferences are such that 50 percent of voters want less of the project being voted upon and 50 percent of voters want more of the project. 2. False. Rational ignorance refers to the decision by a voter not to collect more information about an issue or person up for election because the benefit from the added information is exceeded by the cost of gathering it. 3. False. The ability-to-pay principle holds that those who have a greater ability to pay for government programs should pay more for them. 4. False. This tax is not progressive because high income taxpayers pay the same proportion of the income (15 percent) as low income taxpayers. Hence, this is a proportional tax. 5. True. This is the definition of a regressive tax. It is important to realize that the names regressive and progressive imply nothing about the relative desirability of the two sorts of taxes. They are merely labels. 6. True. This is the definition of marginal tax rates. Marginal tax rates influence decisions about how much to work or whether to start a business. 7. False. The government runs a deficit when its taxes and other revenues are less than its spending. 8. False. When the government runs a deficit, it borrows from the private sector. This raises the national debt. 9. False. Because the deficit seems so difficult to reduce, some economists and politicians advocate a constitutional amendment that would require the government to balance its budget. 10. True. This is the definition of a special interest group. Multiple Choice Questions 1. (a) The increase in marginal tax rates means that people pay a larger fraction of their income as taxes when their incomes increase. 2. (b) In this case, those individuals who use the road repairs (drivers) pay for the repairs (through the gas tax). 3. (b) Wealthier people generally own more valuable cars, so under this scheme the wealthy pay larger fees than do the poor. 4. (e) The marginal tax rate equals the change in taxes, $500 ($1,500 minus $1000) divided by the change in income, $1,000 ($21,000 minus $20,000).

7 108 Gregory Essentials of Economics, Sixth Edition 5. (e) Since poor people spend more of their income, they would pay a larger fraction of their income as sales taxes. 6. (d) While some politicians and economists recommended passing a balanced budget amendment to the constitution, which might make deficits illegal, this is presently not the case. Indeed, for most of the past 25 or so years, the federal government has run a deficit. Essay Questions 1. Personal, Taxable Income Income Tax Paid Marginal Tax Rate $20,000 $2,000 XXX $21,000 $2, % $22,000 $2, % $23,000 $2, % The marginal tax rate equals the change in taxes divided by the change in income; for example, ($2,200 $2,000) / ($21,000 $20,000) = 20%. 2. The tax is a progressive tax. This is evident because the fraction of income paid as taxes rose with income (because the marginal tax rates rose with income). 3. This normative statement would make impossible many programs generally agreed to be desirable. For instance, it is often impossible to tell who benefits to what degree from public goods, such as defense. Without this information, it is impossible to implement a benefit principle method of finance. Another example is income maintenance programs (such as food stamps and welfare) that are designed to benefit poor people by giving them income. It would defeat the purpose of the programs if the beneficiaries were required to pay for the benefits. 4. The total income is $20,000, the sum of Gregory s plus Rush s incomes. Gregory must pay $50 in taxes. Rush must also pay $50 in taxes. Gregory s income equals $10,050. (The $10,000 of earned income less the $50 in taxes plus the $100 in interest paid on the debt.) Rush s income equals $9,950. (The $10,000 of earned income less the $50 in taxes.) The total income of the country equals $20,000. Paying interest on internally owned national debt does not change the country s total income. 5. The total income is $10,000. Gregory pays no taxes because Gregory is not a resident of the country. Rush pays $100 in taxes. Gregory s income is $10,100. (The $10,000 in earned income plus the interest paid on the debt.) Rush s income is $9,900. (The $10,000 in earned income less the $100 in taxes.) The country s total income is now $9,900. Paying interest on externally owned national debt lowers the country s total income. 6. The city will hire 6 police, because Bobby, David and Ellen will all vote for this amount. It will not hire more than 6, because Bobby will not vote for a larger number.

8 Chapter 10 Government Spending, Taxation, and Deficits The city will still hire 6 police. 8. The median voter in Question 6 is Bobby. Fifty percent, two voters (Art and Christine), favor hiring fewer police than does Bobby, while 50 percent (David and Ellen) favor hiring more. The median voter in Question 7 is still Bobby. The change in David s desires from Question 6 to Question 7 did not affect the number of police hired. This is a problem arising from allocating resources using majority voting rules. Additional Questions 1. The table below shows the 2004 Federal Income marginal tax rates for a single person. Tax rate Single 10% $0 7,150 15% $7,151 29,050 25% $29,051 70,350 28% $70, ,750 33% $146, ,100 35% over $319,100 (a) Suppose you make $25,000. How much do you owe the government? (b) What if you make $100,000? (c) What if you make $300,000? (d) For each of the previous cases calculate your average tax rate as a percentage of your total income? What observation can you make? 2. Suppose the sales tax in your state is 5%. For every $100 you spend you pay $5 in taxes. Is the sales tax proportional, progressive or regressive? 3. Many people do not vote in presidential elections. They argue that even if they voted for the candidate they prefer, their vote would have no effect on the outcome of the election. What concept discussed in this chapter does this idea illustrate? 4. In Chapter 9 you learned about credit markets and how interest rates are determined. Suppose that besides the demand for credit by firms for investment, the government also demands credit to finance government deficits. On a credit market diagram show what happens to the interest rate and the amount of investment undertaken by private firms if the government deficit increases. 5. Suppose Senator s Bird, Fox, and Hound have to vote on three alternative budget proposals: (1) increase the size of the budget (2) maintain the budget at its current level (3) reduce the size of the budget Senator Bird prefers A to B and B to C. Senator Fox prefers B to C and C to A. Senator Hound prefers C to A and A to B. (a) Suppose the three senators vote on A versus B, which proposal passes. (b) Suppose the three senators vote on B versus C, which proposal passes. (c) Suppose the three senators vote on A versus C, which proposal passes. (d) Do you notice anything peculiar about your three answers? What?

9 110 Gregory Essentials of Economics, Sixth Edition Answers 1. (a) Taxes =.10 7, (25,000 7,150) = $3,392.5 (b) Taxes =.10 7, (29,050 7,150) +.25 (50,000 29,050) = $9, (c) Taxes =.10 7, (29,050 7,150) +.25 (70,350 29,050) +.28 (146,750 70,350) +.33 (300, ,750) = $ (d) Average tax rates = Taxes Paid / Income $3,392.50/$25,000 = 13.57% $9,237.50/$50,000 = % $86,289.50/$300,000 = 28.76% As your income increases the average tax rates rise so the tax system is progressive. Note however that average tax rates increase with income but at a decreasing rate. 2. A sales tax is regressive. Although it appears that it may be proportional since everyone pays the same percentage, what matters is what percentage of your income you pay in taxes, not the percentage of how much you spend. A person with a higher income will save a larger fraction of their income than a person with a low income. Although the higher income person may spend more and pay more in taxes, as a percent of their total income they will pay a smaller amount. 3. Rational ignorance. In this case the cost of gathering information about the various candidates plus the cost of actually going out and voting exceed the benefits, which in this case are close to zero. Since their vote doesn t matter they feel there is no gain to voting. 4. The higher government deficit will lead to an increase in the demand for credit. This will lead to a higher interest rate from i 0 to i 1. Although the total amount of credit exchanged in the market has increased from I 0 to I 1, the amount of investment undertaken by private firms has fallen from I 0 to I 2. Thus, the higher government deficits lead to a decrease in private investment. See the figure on the following page. 5. (a) Senator Bird and Hound both vote for A so A passes. (b) Senator Bird and Fox both vote for B so B passes. (c) Senator Fox and Hound both vote for C so C passes. (d) In the first vote a majority prefer A to B. In the second vote a majority prefer B to C. It would seem to follow that A would be preferred to C, however, in the third vote C is preferred to B. Therefore, the results are inconsistent.