Chapter 10 GOVERNMENT, SPENDING, TAXATION, AND DEFICITS 1. No Market Test for Government Spending Rule: Any economic activity will be carried out as long as its marginal benefits exceed its marginal costs (Private/Public) A market test ensures that private goods and services yield benefits equal to or greater than their costs. Government spending is carried out by 87,000 federal, state and local governments in the U.S. 1. No Market Test for Government Spending – cont. Exhaustive expenditures are government purchases that divert resources from the private sector, making them no longer available for private use. (Ex. A local government hires a police officer or repairs a road). Transfer payments transfer income from one individual or organization to another. (Ex. Payments to families with dependent children transfer income taxpayers to poor families). The Social Security transfer program transfers income from currently employed workers to retired or disabled workers. 2. Taxation Government rarely sells its goods or services. Except in rare cases, government programs must be financed through taxes. 2.1 Principles of Taxation The benefit principle of taxation argues that those who benefit from a public expenditure program should pay for the program. Two basic advantages: 1) People who do not benefit do not pay (non-drivers taxed to build roads). 2) Benefit taxes are more likely to ensure that benefits equal or outweigh the costs. Disadvantage: difficult to determine who benefits, who benefits from police protection, national defense, etc. 2.1 Principles of Taxation – cont. The ability-to-pay principle of taxation states that those better able to pay should bear the greater burden of taxation, whether or not they benefit. The rich should bear a heavier responsibility for public schools, national defense, etc. as they are better able to pay than the poor. Negative: those who work harder and earn more are penalized by having to pay more for government programs that benefit others. 2.2 Taxes and Private Decision Making Experts and politicians have long debated whether taxes should be: Neutral—affect private decision making as little as possible. Used to promote social goals. Most governments use taxes designed to affect private behavior. 2.2.1. Progressive and Regressive Taxes With a proportional tax, taxpayers earning different incomes pay the same percentage of their income as taxes. With a progressive tax, higher-income taxpayers pay a higher percentage of their income as taxes. (Distributes income from rich to poor). With a regressive tax, high-income taxpayers pay a smaller percentage of their income as taxes. 2.2.2 Marginal Tax Rates The marginal tax rate is the ration of the increase in taxes to the increase in income. A marginal tax rate of 50 percent means that for every extra dollar earned, 50 cents goes to taxes and the remaining 50 cents stays with the taxpayer as after-tax income. The marginal tax rate can have an effect on work effort. 2.3 Government Revenues The federal government raises $1.6 trillion of its $1.9 trillion in revenues from personal income taxes and payroll (Social Security) taxes. The federal government collects the relatively small remainder of its revenue in the form of corporate profit taxes and sales taxes. State and local governments collect most of their revenues through sales taxes, which tend to be regressive. 2.4 The Size of Government The most common measure of the size of government is government’s share of total spending of the entire economy. In the year 2002, government in the U.S. accounts for more than 30 percent of all spending. United States spend less in the economy versus other affluent countries; they have to collect enormous amounts for social security. 3. The Federal Budget Special attention needs to be given to the budget of the federal government. The spending and taxation of state and local government are diffused and uncoordinated; they are thus beyond the control of national policymakers. The federal government, on the other hand, are subject to control by the federal executive and legislative branches; they regulate the pace of economic activity. 3.1 Deficits and Debt The federal budget runs a deficit if federal expenditures exceed federal tax collections and other revenues. The national dept is the total of outstanding federal government IOUs (outstanding government bonds). The Burden of the Debt on Different Generations Example National debt is internal if it is owed to the citizens of the country. It is external if it is owed to citizens of other countries. 2.2 Problems of Deficit Reduction Politicians, economists, and the general public favor deficit reduction. Why is it so difficult to achieve a balanced budget in the last quartercentury? 75 percent of all federal government spending is for relatively uncontrollable expenses. 2.2 Problems of Deficit Reduction – cont. To cut the size of the federal deficit, federal revenues must be increased, federal outlays must be reduced, or a combination of these two. Everyone favors deficit reduction, few are willing to pay the personal price of a lower deficit, particularly when it comes to giving up spending and tax programs that are of benefit to themselves. Where did the $4 Trillion Surplus Go? Example 4. Majority Rule: The Power of the Median Voter The median voter is the voter whose preferences are such that 50 percent of the voting population desires less of the public good and 50 percent desires more of it. Under majority rule, the median voter determines the outcome and this raises three important questions: 1. 2. 3. Social choices need not respond to individual wants. Majority voting rules may not reflect the intensity of preferences. Majority voting need not be efficient. 5. Logrolling When public choices involve multiple decisions, there is no assurance that majority rule will prevail. Logrolling permits the approval of projects by votetrading coalitions that would be opposed by a majority if considered in isolation. Ex. A favor interstate highway, B favors a new ship channel, A en B coalition, each agree to support the other’s project. Dairy Subsidies: Rational Ignorance and Logrolling Example 6. Rational Ignorance Rational ignorance is a decision not to acquire additional information because the marginal costs exceed the marginal benefits. Private choices: individuals inform themselves about the price and qualities of cars, TVs, etc. Public choices: individuals must gather information about complex and confusion public issues, e.g. Should a new flood control project be build? 6. Rational Ignorance – cont. Special-interest groups are minority voting groups with intense preferences about specific government policies. Dairy farmers and domestic steel manufacturers are well informed about public policies that affect their economic well-being. A central problem of public choice is that benefits of government policies are highly concentrated while the costs are highly diffused.