Chapter 17 (Chapter 36)
The Federal Budget:
Taxes and Spending
MODERN PRINCIPLES OF ECONOMICS
Third Edition
Outline




Tax Revenues
Spending
Is Government Spending Wasted?
The National Debt, Interest on the National
Debt, and Deficits
 Will the U.S. Government Go Bankrupt?
 Revenues and Spending Undercount the
Role of Government in the Economy
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Introduction
“There are 10^11 stars in the galaxy.
That used to be a huge number. But it's
only a hundred billion. It's less than the
national deficit! We used to call them
astronomical numbers. Now we should
call them economical numbers.”
― Richard P. Feynman, Nobel Prize
winner in physics
http://www.usdebtclock.org/
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Introduction
 Since the mid-1950s, the federal government
has spent about 20% of GDP and has raised
about 18% of GDP.
 That equals $3.5 trillion in spending in 2013.
 This chapter answer the questions:
• Where does the money come from?
• Where does the money go?
• For how long can the U.S. government keep
spending more than it raises in taxes?
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Tax Revenues
 As of 2013, the federal government was taking
in about $2.8 trillion a year.
 That works out to nearly $9,000 for every man,
woman, and child in the U.S.
 Three sources account for more than 90% of
the revenue:
• Individual income tax.
• Social Security and Medicare taxes.
• Corporate income tax.
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Tax Revenues
U.S. Federal Tax Receipts (2013)
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Definition
Marginal tax rate:
the tax rate paid on an additional dollar
of income.
Average tax rate:
the total tax payment divided by total
income.
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Income Tax
 Individual income tax is the single largest
source of revenue for the federal government.
 The marginal tax rate is the tax rate paid on an
additional dollar of income.
• For incomes less than $18,150, the marginal
tax rate is 10%.
• For income earned greater than $457,600,
the marginal tax rate is 39.8%.
 In 1960, the lowest marginal tax rate was 20%
and the highest rate was 91%.
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Income Tax
 It is the marginal rate that determines things like
the incentive to work additional hours.
 The average tax rate is your total tax payment
divided by your total income.
 If income = $50,000, you pay:
• 10% on the first $18,150, or $1,815.
• 15% on the next $31,850 ($50,000 −
$18,150), or $4,778.
 Average tax rate: $6,593/$50,000×100 = 13.2%.
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Income Tax
U.S. Marginal and Average Tax Rates
(Married, Filing Jointly, 2014)
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Self-Check
If the tax rate is 10% on income up to $30,000
and 15% on income up to 60,000, what is the
average tax rate for someone earning $55,000?
a. 12%.
b. 12.27%.
c. 12.5%.
Answer: b: (10% x 30,000) + (15% x 25,000) =
6,750/55,000 x 100 = 12.27%.
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Income Tax
 Some income is exempt from taxation.
 Each person generally gets one tax exemption
for him- or herself, one for a spouse, and one for
each child or dependent.
 In 2014, for example, each exemption let you
have $3,950 of income tax free.
 The tax system also allows deductions for
expenses like home mortgage interest,
donations to charity, state and local taxes, and
very high medical expenses.
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Income Tax
 Income received from interest, dividends, and
capital gains is also taxed.
Dividends - stockholders’ share of the profits.
Marginal Tax Rate = 15% for most people.
Marginal Tax Rate = 5% for low income people.
Capital Gains - the difference between the
price an asset was purchased at and its selling
price.
Marginal Tax Rate = 15%.
Capital losses can offset income from capital gains.
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Taxes on interest, dividends, and capital gains
• Political debate about how investment
income should be taxed.
 Democrats—favor higher tax rates.
• Why?: Rich people (who invest more than the
poor) should bear a higher share of the
burden.
 Republicans—favor lower tax rates.
• Why?: Lower taxes provide incentive to invest
and create economic growth.
• The Capital Gains Tax: an appropriate tax on
lazy fatcats? Or stifling the engine of growth?
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Income Tax
 The alternative minimum tax (AMT), started in
1969, was meant to ensure that it would not be
possible for anyone to avoid all income tax.
• People were making over $100,000 and not paying
taxes!
 Big Problem: AMT not indexed to inflation
 Taxpayers make two computations and pay
whichever is higher.
• What they owe under the standard tax code.
• What they owe under the AMT, a flat rate with
no deductions.
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Definition
Alternative minimum tax (AMT):
A separate income tax code that began in
1969 to prevent the rich from not paying
income taxes. It was not indexed to inflation
and is now an extra tax burden on many
upper middle class families.
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Social Security and Medicare Taxes
 Almost all workers in the United States pay the Federal
Insurance Contributions Act (FICA) tax.
 The FICA tax funds Social Security payments.
 The FICA tax is 6.2% of your wages on the first
$117,000 of income.
 Employers pay a 6.2% tax on the same earnings.
 Research shows that much of the burden of the FICA
tax falls on workers, not on employers.
 In reality, economic research shows that the employer’s
payment is mostly taken out of the worker’s prospective
wage; in other words, if your employer didn’t have to
pay the FICA tax, your wages would be higher.
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Social Security and Medicare Taxes
 Medicare is partly financed out of general
revenues and partly financed out of special
payroll taxes.
 Employers pay 1.45% and workers pay another
1.45%.
 Again, workers pay much of the employer's
premium in the form of lower wages just like in
the case of AMT.
 Self-employed individuals pay the full 2.9%
themselves (same with FICA).
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Self-Check
Medicare and Federal Insurance Contributions
Act (FICA) taxes are paid by:
a. Workers.
b. Workers and employers.
c. Workers and self-employed individuals.
Answer: b – they are paid by workers and
employers.
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Corporate Income Tax
 The corporate income tax rate in the U.S. is
35%, one of the highest rates in the world.
 Some profitable corporations manage to define
their income and expenses in such a way that
they don’t pay any corporate income tax at all.
 The corporate income tax is paid initially by
shareholders and bondholders, who earn a
lower rate of return on their investments.
 More generally, the rate of return will fall on all
forms of capital.
 GE’s special legislation – no income tax
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Definition
A flat tax:
has a constant tax rate.
A progressive tax:
has higher tax rates on people with
higher incomes.
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Definition
A regressive tax:
has higher tax rates on people with
lower incomes.
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Distribution of Federal Taxes
 Households with incomes in the bottom 20%
pay less than 5% of their total income in federal
taxes.
 Those with incomes in the top 20% pay an
effective tax rate of around 25%.
 The U.S. tax system is progressive.
• People with higher income pay a higher percentage
of their income in tax than people with lower income.
 Other non-income taxes can be regressive
(e.g. taxes on food)
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Distribution of Federal Taxes
 What are the political chances for a flat tax?
 Eliminating the mortgage deduction would result
in lower house prices and other side effects…
• Costs would fall mainly on the middle class, i.e. the
majority of the voters
 … What do you think?
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Distribution of Federal Taxes
Who Pays Federal Taxes?
Source: Congressional Budget Office, 2013.
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Self-Check
A progressive tax means that people with higher
incomes:
a. Pay a higher tax rate.
b. Pay a lower tax rate.
c. Pay a lower rate, but higher dollar amount.
Answer: a – pay a higher tax rate.
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State and Local Taxes
 In addition to federal taxes, most people pay
state and local taxes.
 States raise more of their revenues, about 20%
on average, from sales taxes.
 Since everyone pays sales taxes regardless of
income, state and local taxation as a whole is
less progressive than income taxation.
 It depends on the state.
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Spending
 Almost two-thirds of the U.S. federal budget is
spent on just four programs:
• Social Security
• Defense
• Medicare
• Medicaid
 Interest on the national debt and various
unemployment insurance programs and welfare
programs are also large.
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Spending
U.S. Federal Spending (2013)
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Social Security
 Social Security is the single largest government
program in the world, in dollars paid.
 In 2013, $807.8 billion was paid to over 61
million beneficiaries.
 Current payments are paid out of current taxes.
• There is no “lockbox”
• This is no fund of $$ with your name on it, only IOUs
• SS essentially pushed government spending forward
for the first 80 years
• Tremendous political benefits from this spending
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Social Security
 The average retiree receives $1,200 a month.
 Social Security benefits are defined by a
complex formula depending on years worked,
average earnings, marital status, the year you
retire, and at what age.
 No doubt that Congress will make “adjustments”
to pay-out formulas in the future
 Why not “means-test” SS benefits?
 SS is not a tax, but a supplemental retirement
program
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Social Security
 The program was getting very expensive, so in
1983 the full retirement age began to increase.
 The Social Security tax rate increased from 2%
in 1940 to 12.4% today.
 Social Security has become less generous:
• A single male retiring in 1975 received
$46,807 more in benefits than he paid in
taxes.
• The same male retiring in 2010 receives only
$8,286 more in benefits than he pays.
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Social Security
 Different individuals are treated differently
depending on their wealth, life expectancy,
marriage status, and other factors.
 Social Security redistributes wealth across
income classes – for medium- and high-wage
workers it is a net cost.
 Married people with nonworking spouses get
50% more than singles.
 Anyone with greater life expectancy gets a
bigger benefit.
 Net benefits are declining over time
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Defense
 The United States
spends much more
on its military than
does any other
country in the world.
 Under a broader
definition of
defense, spending
is around $750
billion annually.
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Medicare and Medicaid
 Medicare reimburses the elderly for many of
their medical expenses. (FREE HEALTHCARE!)
 In fiscal year 2013, Medicare spending
amounted to $585 billion.
 Medicaid covers the poor and the disabled.
 In 2013, Medicaid expenditures were around
$265 billion, paid for jointly by federal and state
governments.
 The Affordable Care Act of 2010 modifies the
American health insurance system.
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Welfare Spending
 Other than defense, the largest programs are
Social Security and Medicare, which transfer
wealth to the elderly, not to the poor.
 Most welfare payments fall into a few categories.
 Personal welfare payments are made to poor
households with children.
 The largest is Temporary Assistance for Needy
Families, which subsidizes a portion of rent.
 The Earned Income Tax Credit (EITC) pays poor
people based on their earnings.
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Welfare Spending
 Unemployment insurance (UI) makes payments
to people who are out of work.
 It is not restricted to the poor.
 UI is a large program that can expand rapidly
during recessions.
 Just $31.4 billion was spent on UI in 2007.
 That number increased to $155 billion in 2010
before falling to $72 billion in 2013.
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Everything Else
All other federal spending programs include:
 Farm subsidies.
 Spending on roads,
bridges, and infrastructure.
 The Disaster Relief Fund.
 The Small Business
Administration.
 The Food and Drug
Administration.
 Federal courts.
 Federal prisons.
 The FBI.




Foreign aid.
Border security.
NASA.
The National Institutes of
Health.
 The National Science
Foundation.
 Financial assistance to
students.
 The wages of all federal
employees.
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Self-Check
The largest amount of federal government
spending goes to:
a. Social security.
b. Defense.
c. Medicare.
Answer: a – the largest amount of federal
spending goes to social security (23.4%).
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Is Government Spending Wasted?
 Government spending can be ineffective due to
weak incentives and lack of information.
 When the U.S. spent over a hundred billion
dollars on reconstruction efforts in Afghanistan
and Iraq, many billions went to waste or fraud.
 The U.S. government lacked information about
local wants and needs.
 The ultimate boss – the American taxpayer –
could not easily monitor how the money was
being spent.
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Is Government Spending Wasted?
 It is difficult to cut spending on big programs
without cutting benefits.
 Most waste is due to problems of information and
incentives that are difficult to solve.
 Most of the money is being spent on the big
programs, which are well-known and well
monitored.
 If we want more spending, taxes must rise.
 If we want lower taxes, spending and benefits
must fall.
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National Debt
Budget Cuts Visualized:
http://www.wimp.com/budgetcuts/
US Debt - Visualized in physical $100 bills (2:10)
https://www.youtube.com/watch?feature=player_embedded&v
=iTBODoBaCns
What Are the Dangers of Too Much Debt? (3:08)
https://www.youtube.com/watch?v=ID4xay5RITY&feature=yo
utu.be
Debt Limit – A Guide to US Federal Debt (3:08)
https://www.youtube.com/watch?v=Li0no7O9zmE&feature=pl
ayer_embedded
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Definition
National debt held by the
public:
All federal debt held by individuals,
corporations, and governments other
than the U.S. federal government.
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Interest on the National Debt
 A better measure of our current debt is the
national debt
• which is all federal debt held by individuals,
corporations, state or local governments, foreign
governments, and other entities other than the federal
government itself.
 As of 2014, the national debt held by the public
was nearly $13 trillion.
 GDP is about $17 trillion, so the U.S. has a debtto-GDP ratio of over 70%.
 This debt-to-GDP ratio is not excessive but the
national debt is rising very quickly.
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The National Debt
The Debt-to-GDP Ratio, 1940–2013
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Interest on the National Debt
 Every year, the government must pay interest to
the bondholders who lent it money.
 In 2014 the federal government paid about $184
billion in interest payments.
 As the U.S. economy recovers, interest rates will
increase, and interest on the debt will increase.
 Interest on the debt will also increase as the
debt-to-GDP ratio increases.
 If interest rates return to “normal,” debt service
will rise to over $1 trillion/year, perhaps higher
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Definition
Deficit:
The annual difference between federal
spending and revenues.
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Deficits
 The national debt is the total amount of money
owed by the federal government at a given point.
 It is a cumulative total of previous obligations.
 The deficit is the yearly difference between what
the government is spending and what the
government is collecting in revenues.
 When spending is greater than revenues, the
government must borrow to make up the deficit,
or difference.
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Deficits
Spending, Revenues, and Deficits of the U.S. Government as a
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Percentage of GDP, 1960–2013
Self-Check
The annual difference between federal revenues
and spending is called:
a. The national debt.
b. Government borrowing.
c. The deficit.
Answer: c – the deficit.
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The Future
Will the US Government Go Bankrupt?
The Congressional Budget Office (CBO): “under any
plausible scenario, the federal budget is on an
unsustainable path…”
Isn’t the Debt “money we owe ourselves?”
Maybe in the past, but not anymore
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The Future
 Many economists are worried about the future
debt-to-GDP ratio, largely due to demographics
and increasing health-care costs.
 The increase in the number of elderly people
means higher Social Security and Medicare
payments.
 An even bigger problem is rising health-care
costs per person.
 This will require some combination of increased
taxes, reduced spending, or higher debt.
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The Future
 Increased taxes will probably be in the form of
higher inflation, via partial monetarization of the
debt/deficits
 US dollar “Reserve Currency” status will likely be
lost
 Standard of living will drop in the US
• Greek standard of living dropped 30-40%
 The good news? Many European countries and
Japan will precede the US into “bankruptcy”
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Government Spending
Government Spending in the United States Today
Is Lower than in Most Other Developed Countries
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The Role of Government
 Government spending is one measure of how
government affects the economy, but it is not
complete or fully accurate.
 For example, the Environmental Protection
Agency has a budget of about $9 billion yet both
its costs and its benefits are much higher.
 Until 1973 the United States ran a military draft.
 Drafted soldiers are relatively cheap, but the
draft involves a significant opportunity cost.
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Takeaway
 The federal government has revenues and
spending of over $3.5 trillion.
 The majority of tax revenues comes from
individuals in the form of individual income taxes
and tax on wages.
 Around 20% of spending is on defense.
 About one-third of the federal budget goes for
Social Security and Medicare payments.
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Takeaway
 It is likely that federal expenditures will rise in
the future, mostly because of rising health-care
expenditures.
 One question is whether and how federal
revenues will rise to keep the budget sufficiently
close to balancing.
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