Chapter 16- Public Finances: Expenditures and Taxes

Government and the Circular Flow

Flows in Circular Model Flow

• Flows (1) & (2): Businesses pay for resources (wages, rent, interest, profit) provided by households.

• Flows (3) & (4): Households spend money on goods/services produced by businesses.

Government in the Economy

• Flows (5) & (6): Government buys products (paper, computers, military equipment) from businesses.

• Flows (7) & (8): Government hires workers (teachers, police, military, etc.).

Government Revenue & Spending

• Flows (9) & (10): Government provides goods/services to households and businesses.

• Flows (11) & (12): Money flows to the government through:

  • Taxes (income, payroll, sales taxes).

  • Borrowing (loans, bonds).

  • Proprietary income (government-run businesses like state lotteries).

Net Taxes & “Taxes in Reverse”

• Net taxes = Taxes minus transfer payments & subsidies.

• Transfer payments: Money given to individuals (welfare, Social Security).

• Subsidies to businesses: Government support (low-interest loans, tax breaks).

Government Finance

Government Purchases & Transfers

• Government Purchases

  • exhaustive

  • products purchased require the use of resources

  • products purchases are part of the domestic output

  • EX: purchase of a missile requires physicists and engineer labor, as well as raw materials & other inputs

• Transfer Payments

  • nonexhaustive

  • do not require the use of resources

  • do not create output

  • EX: social security benefits, welfare payments, veterans’ benefits, unemployment compensation

Government Revenues

• the funds used to pay for govt purchases and transfers come from three sources: taxes, proprietary income, and funds

  • borrowed by selling bonds to the public

Govt Borrowing & Deficit Spending

• the ability to borrow allows a govt to spend more money than it collects in tax revenues & proprietary income

  • given time period

• useful during economic downturn because a govt can use borrowed funds to maintain high-spending levels on G, S, & transfer payments (even if tax revenues & proprietary income are falling)

• deficit spending: govt spending that is financed by borrowing

Federal Finance

• focus on the picture… figure 16.3

Federal Expenditures

• four areas of major federal spending

  • pensions & income security (35%)

    • includes Social Security ($683 billion), unemployment benefits, and aid for the disabled, retired, and families without a breadwinner

  • national defense (19%)

    • high costs for military readiness and defense programs

  • health programs (22%)

    • covers medicare (for retirees) and medicaid (for low-income individuals)

  • interest on public debt (5%)

    • payments on borrowed money the government owes

Federal Tax Revenues

• largest revenue sources: income tax, payroll taxes, the corporate income tax

Personal Income Tax

• personal income tax: tax on the individuals earnings

• federal personal income tax is a progressive tax

• progressive tax: a tax system where higher-income people pay a higher percentage of their income

• marginal tax rate: tax rate applied to the last dollar of income earned

• average tax rate: total taxes paid/total income

Payroll Taxes

• payroll taxes: taxes taken from workers’ paychecks to fund programs like Medicine, Social Security, Dental Insurance

• employees and employers pay these taxes equally

Corporate Income Tax

• corporate income tax: a tax on a company’s profit

• difference between its total revenue and its total expenses

• for almost all corporations, tax rate is 35%

Excise Taxes

• sales & excise taxes: taxes on G/S

• sales tax is general

  • calculated as a percentage of the price paid for a product

  • primary revenue source of most state govt

• excise tax is on specific items like gasoline or alcohol

  • levied on a per-unit basis

    • EX: $2/per pack of cig

  • federal govt collects excise taxes of various rates

State & Local Finance

• different mixes of revenues & expenditures than the federal govt has

State Finances

• figure 16.4

• Main Sources of State Tax Revenue

  • Sales & Excise Taxes (47%) – Largest source of revenue

  • Personal Income Taxes (35%) – Lower rates than federal income tax; 7 states don’t have one

  • Corporate Income Taxes & License Fees – Smaller revenue portion

  • State Lotteries (43 states) – Helps cover budget gaps

  • Federal Grants (22%) – Funds from the federal government

  • Miscellaneous Sources – Includes state-owned utilities and liquor stores

• State Spending Priorities

  • Education (36%) – Largest spending category

  • Public Welfare (28%) – Includes assistance programs

  • Health & Hospitals (7%)

  • Highways (7%)

  • Public Safety (4%)

  • Other (18%) – Covers various expenses

• State budgets vary, with different tax policies and spending priorities

Local Finances

• figure 16.5

• local levels of govt include counties, municipalities, townships, and school districts as well as cities and towns

• property taxes: tax on land/buildings owned

  • local govts obtain ab 71% of their tax revenues from property taxes

• Revenue Sources:

  • 71% from property taxes

  • 17% from sales/excise taxes

  • Additional funding from federal/state grants and utility income

• Spending:

  • 44% on education

  • Other major areas: welfare/health (12%), public safety (11%), housing/parks/sewerage (11%), and highways (6%)

• Local governments rely on external funding since taxes cover less than half of their expenses

Local, State, and Federal Employment

• figure 16.6

• Total Workforce:

  • 19.4 million workers (13% of the U.S. labor force)

• State & Local Government Jobs:

  • Over 50% in education

  • 9% in hospitals/health care

  • 10% in police and corrections

  • Less than 10% in public welfare and judicial roles

  • “Other” includes parks, fire fighting, transit, and libraries

• Federal Government Jobs:

  • 50%+ in national defense and postal service

  • 12% in hospitals/health care

  • 4–7% in natural resources, police, and financial administration

  • “Other” includes justice, air transportation, and social insurance

Apportioning the Tax Burden

• taxes are a major source of funding for the G & S provided by the govt

• taxes also fund wages & salaries paid to govt workers

• taxes fund public and quasi-public goods

• taxes are controversial

• economists study the total cost of taxes on society —> they analyze the size and distribution of the tax burden across income levels

Benefits Received versus Ability to Pay

• two basic philosophies coexist on how the economy’s tax burden should be apportioned

Benefits-Received Principle

• Benefits-received Principle: people should pay taxes based on the benefits they receive from government services

• Example: Gasoline taxes fund highway construction since drivers benefit from roads.

• Challenges:

  • Hard to measure benefits for public goods like defense, education, and police

  • Some services, like welfare and unemployment benefits, cannot logically follow this principle

Ability-to-Pay Principle

• Ability-to-Pay Principle: People should pay taxes based on their income and wealth, with higher earners paying more

• Justification: A dollar taken from a poor person has a greater impact than a dollar taken from a rich person

• Challenges:

  • No exact way to measure how much more the wealthy should pay

  • Tax rates depend on politics and government needs

Progressive, Proportional, and Regressive Taxes

• Progressive Tax: The tax rate increases as income increases (higher earners pay a larger percentage).

  • personal income tax

• Regressive Tax: The tax rate decreases as income increases (higher earners pay a smaller percentage).

  • sales tax

  • payroll tax

• Proportional Tax: The tax rate stays the same for all income levels (also called a flat tax).

  • corporate tax

Tax Incidence & Efficiency Loss

• Tax Incidence: The extent to which a tax affects a specific person or group.

• Issue: Some taxes may be passed on to others, meaning the person or group directly taxed may not bear the full burden

• Example: A wine excise tax may be paid by producers, but some of the tax could be shifted to consumers, depending on the elasticity of supply and demand

Elasticity & Tax Incidence

division of burden

• Price Increase: The tax raises the price consumers pay (e.g., from $8 to $9).

• Lower Producer Revenue: Producers receive less money per unit (e.g., $7 after tax, down from $8).

• Shared Burden: Both consumers and producers share the burden of the tax equally, with consumers paying higher prices and producers getting less revenue.

• Decrease in Quantity: The quantity of goods sold decreases because the higher price reduces demand.

elasticities

• Inelastic Demand: If demand is inelastic (consumers don’t reduce their purchase much when prices rise), consumers bear most of the tax burden

  • common for products like cigarettes, liquor, or tires, where demand is less responsive to price changes

• Inelastic Supply: If supply is inelastic (producers can’t easily adjust production), producers bear most of the tax burden

  • ex:, gold has an inelastic supply, so the tax burden falls on producers

• Elastic Demand: If demand is elastic (consumers reduce purchases significantly when prices rise), producers bear more of the tax burden

• Elastic Supply: If supply is elastic (producers can easily adjust production), consumers bear more of the tax burden

• Quantity Effect: The quantity sold declines less when demand or supply is more inelastic, meaning taxes have a smaller impact on sales

• Inelastic demand = more tax burden on consumers

• Inelastic supply = more tax burden on producers

efficiency loss of a tax

tax revenues

• When a tax is imposed, both consumers and producers share the burden

• The government collects the tax revenue to fund public goods and services, like schools or roads

• If both consumers and producers pay an equal share of the tax, society's overall well-being doesn’t decrease because the tax is simply a transfer of money from them to the government

• There is no loss of value to society because the funds are being used for services that benefit everyone, even though consumers and producers are paying more

efficiency loss

• when a tax is applied, it affects the balance between what people are willing to pay for a good (demand) and what it costs to make it (supply)

• ideally, the amount produced and consumed is where these two factors align

• the tax shifts things, causing fewer units to be produced and consumed than before

• the lost production represents a sacrifice of potential benefit because the value people placed on those units (demand) was greater than the cost to make them (supply)

• this imbalance, or lost benefit, is the deadweight loss, which shows how the tax reduces the total efficiency of the economy

role of elasticities

• taxes usually lead to efficiency loss, but the degree depends on how sensitive supply and demand are to price changes (elasticity)

• when demand or supply is more elastic, the efficiency loss (deadweight loss) is bigger, as people or producers are more responsive to price changes

• taxes that bring in the same amount of revenue can have different social costs, depending on their impact on market efficiency

• to minimize the cost of raising tax revenue, governments should design taxes that cause the least disruption to market efficiency

qualifications

• other goals may be more important than minimizing efficiency loss, like redistributing income or reducing negative externalities

• redistributive goals: governments may impose progressive taxes to redistribute wealth, even if it leads to efficiency loss

• negative externalities: excise taxes (like on alcohol or cigarettes) are sometimes used to reduce harmful behaviors by increasing the price, lowering consumption, and addressing issues like public health or environmental harm

• taxes on products like alcohol or cigarettes are called sin taxes, as they aim to discourage harmful behavior

• in some cases, taxes might be levied on luxury goods to redistribute wealth, despite efficiency losses, as seen with luxury taxes in the past

Probable Incidence of U.S. Taxes

Personal Income Tax

• personal income tax mostly falls directly on individuals since they cannot shift the burden to others

• inheritance taxes also typically fall on those inheriting wealth, as there is little opportunity to pass the tax burden elsewhere

Payroll Taxes

• workers pay their half of payroll taxes directly with no way to shift the burden

• employers' half of payroll taxes is partly shifted to workers through lower wages

• hiring costs increase due to payroll taxes, reducing labor demand and pushing wages down

• employers essentially collect part of the tax from workers by adjusting wages

Corporate Income Tax

• short run corporate income tax burden falls on stockholders through lower dividends or retained earnings

• firms don’t change prices or wages immediately since the profit-maximizing output remains the same

• long run workers may bear some of the tax through slower wage growth

• corporate tax reduces investment leading to slower productivity growth and lower labor demand

• some firms may relocate to countries with lower corporate tax rates, affecting domestic jobs and wages

Sales and Excise Taxes

• sales tax applies to a wide range of goods and services, making it harder for consumers to avoid

• excise tax applies to specific goods, allowing consumers to switch to substitutes if demand is elastic

• sales tax is fully shifted to consumers since all goods are taxed, leaving no untaxed alternatives

• excise tax shifting depends on elasticity

  • elastic demand (e.g., theater tickets) → sellers bear more of the tax since consumers can switch

  • inelastic demand (e.g., gasoline, cigarettes) → most of the tax is passed to consumers

• us relies less on sales and excise taxes compared to other countries

Property Taxes

• property taxes on owned land and homes usually stay with the owner since there's no one to shift them to

• land sale does not shift taxes because buyers factor future taxes into the price they’re willing to pay

• rented property taxes are often passed to tenants through higher rent

• business property taxes are treated as a cost and typically passed to consumers through higher prices

The US Tax Structure

• federal taxes are progressive overall—higher-income groups pay a larger percentage of their income in taxes

  • federal income tax is highly progressive

  • payroll and excise taxes are regressive but don’t outweigh income tax progressivity

• state and local taxes tend to be regressive

  • sales and property taxes take a larger share of income from lower earners

  • state income taxes are less progressive than federal

• overall U.S. tax system is progressive, but redistribution happens more through government spending than taxation alone