Chapter 7

The Government Sector

Introduction: The Growing Economic Role of Government

• Most of the growth over the past seven decades was due to the Depression and World War II

• Since 1945 the roles of government at the federal, state, and local levels have expanded– The seeds of that expansion were sown during the

Roosevelt administration

• The government exerts four basic influences– It spends more than $3.0 trillion – It levies even more in taxes– It redistributes hundreds of billions of dollars– It regulates the economy

State and Local Government Spending

• Main expenditures– Education– Health– Welfare

• Spending is a little more than half the level of federal spending

• Police protection and prisons are now straining state and local budgets

Government Purchases versus Transfer Payments

• The federal, state, and local governments spends over $3.0 trillion a year– GDP = C + I + G + Xn

– Approximately half are “transfer payments”• The largest transfer payment is social security• These payments end up in the “C” part GDP

– Approximately half are “government purchases”

• The largest government purchase is defense• These end up in the “G” part of GDP

The Average Tax Rate and the Marginal Tax Rate

Income Marginal Total AverageLevel Tax Rate Tax Taxes Tax Rate

This is a hypothetical illustration

0 - $100 0 % $ 0 $ 0 0.0 %

$101 - $200 10 % $10

Additional Taxes Paid ( $10)

MTR = -------------------------------- ----------

Additional Taxable Income ($100)The Marginal Tax Rate (MTR) is the rate you pay on the last dollars you earned

The Average Tax Rate and the Marginal Tax Rate

Income Marginal Total AverageLevel Tax Rate Tax Taxes Tax Rate

This is a hypothetical illustration

0 - $100 0 % $ 0 $ 0 0.0 %

$101 - $200 10 % $10 $10 5.0 %

Total Taxes Paid ( $10)

ATR = -------------------------------- ----------

Entire Income ($200)

The Average Tax Rate (ATR) is the overall rate you pay on your entire income

Types of Taxes• Direct tax

– A tax with your name on it

• Indirect tax– A tax on things

Types of Taxes

• Progressive taxes– Places a greater burden on those best able to pay

and little or no burden on the poor

• Proportional taxes– Places an equal burden on the rich, the middle class,

and the poor

• Regressive taxes– Places a heavier burden on the poor than on the rich

Sources of Federal Revenue

• Personal Income Tax– The personal income tax is the largest source

of federal revenue– Accounts for 44 percent of all federal tax

revenue– Low income people pay little or no federal

income tax

Sources of Federal Revenue

• The Social Security and Medicare taxes are the Payroll Tax

• What you pay is matched by your employer

• The social security tax by law is set at 6.2% with a wage based limitation of $87,000

• The inflation rate of the previous year raises the wage base

• The Medicare tax of 1.45% applies to wages and salaries only. Income such as rental income, interest, dividends, and profit is exempt

Sources of Federal Revenue

• You pay 6.2% in payroll tax on wages up to $87,000 and 1.45% on all wages and salaries

• The Payroll Tax is the fastest growing source of federal revenue

The Corporate Income Tax

• The corporate income tax is a tax on a corporation’s profits– The maximum rate is 35%

• All corporations earning profits of at least $335,000 pay an average tax rate of 35%– Loopholes in the tax law allow many

corporations to pay much lower taxes

Excise Taxes

• An excise tax is a sales tax aimed at specific goods and services

• Accounts for about 4 percent of federal revenue

• Most excise taxes are levied by the federal government– State and local governments often levy taxes

on the same items

Excise Taxes

• Excise taxes tend to reduce consumption of certain products of which the federal government takes a dim view

• Excise taxes are usually regressive

The Estate Tax

• The estate tax is a tax on the estates of people when they die– It is a graduated tax that rises to 55%

• It is levied only on estates valued at $675,000 or more

– More than 90% of estate taxes are paid by people with incomes above $200,000 a year

Sources of State and Local Tax Revenue

• Personal income tax– Accounts for about half of all state revenue

• Sales Tax– Is a source of almost half of all taxes collected by the

states– Is a highly regressive tax

• Property taxes– Provides 80 percent of all local tax revenue– Can influence business decisions about where to

locate

Economic Role of Government

• Provision of Public Goods and Services

• Redistribution of Income

• Stabilization

• Economic Regulation

Provision of Public Goods and Services

• Some examples– Defense of the country– Maintenance of internal order– A nationwide highway network– Provision of a money supply– Public education– Running the criminal justice system– Environmental protection

Redistribution of Income

• The government does redistribute hundreds of billions of dollars every year– Social security redistributes money from those

currently working to those who have retired– Welfare for the poor

• Examples are food stamps, Medicaid, disability payments, and unemployment benefits

– Welfare for the rich• Examples are subsidies to corporate farmers and tax

breaks for defense contractors, oil companies, and other large corporations

Stabilization

• Two basic goals of the federal government– Stable prices with little or no inflation– Low unemployment

• An economic rate of growth high enough to keep the unemployment rate to a minimum

Economic Regulation

• The government provides the economic rules of the game– This must be done within the social and political

context in which the economy operates• The government must allow individuals and business firms

to operate with the maximum degree of freedom

• There is little agreement as to how far economic freedom may be extended without interfering with society as a whole or the economic rights of specific individuals or business firms

Adam Smith’s Dos and Don’ts

• Do– Protect society from the violence and

invasion of other countries– Establish an exact administration of justice– Erect and maintain certain public works and

institutions where private enterprise could not profit from doing so

• Don’t do anything else