Chapter 6
Funding the
Public Sector
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Introduction
In recent years, various U.S. politicians and pundits have called
for boosts in tax rates for higher-income individuals and tax
cuts for middle- and lower-income individuals.
How much should income tax rates vary across households
based on their incomes?
Are tax rates currently low for higher-income households
relative to those faced by lower-income households?
To evaluate these questions, you must understand more about
the structure of tax systems.
6-2
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Paying for the Public Sector
• Three sources of government funding
1. Fees, or user charges
2. Taxes
3. Borrowing (bonds)
• Government Budget Constraint
– The limit on government spending and transfer
payments
– Every dollar spent must be provided for by taxes
6-3
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Systems of Taxation (cont'd)
• Average Tax Rate
– The total tax payment divided by total income
• 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
6-4
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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
6-5
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Systems of Taxation (cont'd)
Proportional taxation
Marginal tax rate = Average tax rate
Income
$10,000
$100,000
Rate
20%
20%
Tax liability
$2,000
$20,000
6-6
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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
6-7
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Systems of Taxation (cont'd)
Progressive taxation: income tax
Marginal tax rate > Average tax rate
Income
$0–$10,000
$10,001–$20,000
$20,001–$30,000
Rate
5%
10%
30%
Tax liability
$500
$1,000
$3,000
$4,500
6-8
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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
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Systems of Taxation (cont'd)
Regressive taxation: Social Security
Marginal tax rate < Average tax rate
Income
$50,000
$100,000
Rate
10%
5%
Tax liability
$5,000
$5,000
6-10
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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
6-11
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Figure 6-1 Sources of Government
Tax Receipts
Source: U.S. Department of Commerce, Bureau of Economic Analysis.
6-12
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Table 6-1 Federal Marginal Income
Tax Rates
6-13
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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
6-14
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The Most Important Federal
Taxes (cont'd)
• Who really pays the corporate income tax?
– Tax incidence is distributed among
• Consumers
• Stockholders
• Employees
6-15
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The Most Important Federal
Taxes (cont'd)
• Social Security taxes
– Social Security rates today are imposed on
earnings up to roughly $105,000.
– Contributions are 6.2% for employers and 6.2%
for employees.
6-16
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The Most Important Federal
Taxes (cont'd)
• Unemployment taxes
– Paid by employer
– 0.6% 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
6-17
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Financing Social Security
• Today’s seniors are
beneficiaries of rapidly
increasing levels of
federal spending.
• Probably half of all
federal spending will go
to the elderly by 2025.
– Medicare and Social
Security
Ida Fuller paid $24.75 in SS
taxes and got $22,888.92 until
the age of 100 in 1975
6-18
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Financing Social Security
(cont'd)
• Social Security was founded in 1935, as the
United States was recovering from the
Great Depression.
– Means of guaranteeing a minimum level of
pension benefits
– Early recipients had high rates of return on their
Social Security contributions
6-19
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Figure 6-6 Projected Social Security
Rates of Return for Future Retirees
Sources: Social Security Administration and author’s estimates.
6-20
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Financing Social Security
(cont'd)
What Will it Take to Salvage Social Security?
• There are five options to consider
1. Raise taxes
2. Reduce retirement benefit payouts
3. Reduce disability payments
4. Reform immigration policies
5. Find a way to increase the rate of return
6-21
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Myth #6: Government does what it
does, it ain’t my business
• Think again … you pay for whatever the
government does.
6-22
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