CHAPTER 10
GOVERNMENT SPENDING, TAXATION, AND DEFICITS
After reading Chapter 10, GOVERNMENT SPENDING, TAXATION, AND DEFICITS, you should be able to:
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List two principles of taxation and discuss their pros and cons.
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.
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.
CHAPTER OUTLINE
I. GOVERNMENT SPENDING
A.
B.
C.
D.
Private spending decisions use a simple rule: Undertake an action only if the benefits from the
action—the marginal benefits—exceed the costs of the action—the marginal costs.
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.
If a private sector firm undertakes actions where the cost of the action exceeds the benefits, the
company will go bankrupt. No such market discipline exists for government actions.
Government expenditures are either exhaustive expenditures or transfer payments. EXHAUSTIVE
EXPENDITURES are government purchases that divert resources from the private sector, while
TRANSFER PAYMENTS transfer income from one individual (firm or organization) to another.
II. TAXATION
A.
Two principles of fairness in taxation have developed.
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 gain from a program do not
pay for it. Benefit-based taxes are more likely to insure that the gain from the program
exceeds its costs.
b. A disadvantage of the benefit principle is that it is often impossible to determine who
benefits from a specific government program.
2. The ABILITY-TO-PAY PRINCIPLE: those who are better able to pay for programs should
pay more regardless of how much 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.
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B.
C.
b. Some disadvantages of the ability-to-pay principle are the difficulty in defining "ability-topay," the adoption of programs whose total costs exceed total benefits, and the reduction of
work incentives.
Types of taxes:
1. PROPORTIONAL TAXES: Taxes for which high and low-income taxpayers pay the same
percentage of their income.
2. PROGRESSIVE TAXES: Taxes for which high-income taxpayers pay a higher percentage of
their income as taxes than low-income taxpayers.
3. REGRESSIVE TAXES: Taxes for which high-income taxpayers pay a lower percentage of
their income as taxes than low-income taxpayers.
The MARGINAL TAX RATE is the fraction of additional income that must be paid as extra
taxes. Marginal tax rates affect people's economic decisions. Supply-side economists suggest that
reducing marginal tax rates will greatly increase people's willingness to work, form businesses, and
take business risks.
III. THE MEDIAN VOTER
A.
B.
C.
D.
IV.
A.
B.
C.
When government actions are undertaken in accordance with majority rule, the median voter
controls the extent of the actions. The MEDIAN VOTER is that voter whose preferences are such
that fifty percent of voters desire more of a project and fifty percent desire less.
Problems with the role played by the median voter are that:
1. the decisions reached may not respond to what some individuals desire,
2. majority voting may not take account of the intensity of different people's views, and
3. the resulting allocation of resources may not be efficient.
LOGROLLING refers to vote trading among groups so that projects favored by one group gain not
only that group's votes but also the votes of another group.
RATIONAL IGNORANCE reflects the decision by a voter to remain relatively uninformed about
an issue because the marginal costs (to the voter) of gathering information about the issue exceed
the marginal benefits.
1. SPECIAL INTEREST GROUPS are groups who share a strong preference about certain
government actions.
2. Rational ignorance makes possible legislation that harms the majority of people but favors
special interest groups.
DEFICITS AND THE NATIONAL DEBT
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.
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.
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,
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while people affected by tax hikes lobby to eliminate the proposed tax increases.
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3.
For these reasons, some politicians and economists favor a constitutional amendment that
would require a balanced budget.
REVIEW QUESTIONS
True or 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.
Multiple Choice
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.
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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.
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Essay Questions
Write a short essay or otherwise answer each question.
1. Complete the following table.
Personal, Taxable
Income
$20,000
$21,000
$22,000
$23,000
Income Tax
Paid
$2,000
$2,200
$2,500
$2,900
Marginal Tax
Rate
XXX
20.0%
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
Art
Bobby
Christine
David
Ellen
Desired number of police
2
6
4
7
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7. 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?
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ANSWERS TO REVIEW QUESTIONS
True or False
True
1.
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.
False
2.
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.
False
3.
The ability-to-pay principle holds that those who have a greater ability to pay for government
programs should pay more for them.
False
4.
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.
True
5.
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.
True
6.
This is the definition of marginal tax rates. Marginal tax rates influence decisions about how
much to work or whether to start a business.
False
7.
The government runs a deficit when its taxes and other revenues are less than its spending.
False
8.
When the government runs a deficit, it borrows from the private sector. This raises the
national debt.
False
9.
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.
True
10. This is the definition of a special interest group.
Multiple Choice
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).
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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
$20,000
$21,000
$22,000
$23,000
Income Tax
Paid
$2,000
$2,200
$2,500
$2,900
Marginal Tax
Rate
XXX
20.0%
30.0%
40.0%
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.
7. The city will still hire 6 police.
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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.
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