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
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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
This is a hypothetical illustration
Income
Level
Marginal
Tax Rate
Tax
0 - $100
0 %
$0
$101 - $200
10 %
$10
Total
Taxes
$0
Additional Taxes Paid
MTR =
Average
Tax Rate
0.0 %
( $10)
-------------------------------- ----------
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
This is a hypothetical illustration
Income
Level
Marginal
Tax Rate
Tax
Total
Taxes
Average
Tax Rate
0 - $100
0 %
$0
$0
0.0 %
$101 - $200
10 %
$10
$10
5.0 %
Total Taxes Paid
ATR =
( $10)
-------------------------------- ---------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
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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