The Government Budget

To prepare us for different parts of the course, it’s helpful to do an overview of the government budget. This material will focus on the U.S. federal government budget, but many concepts are applicable to other countries as well as state and local budgets. II. Types of taxes a. There are three types of taxes: progressive, flat, and regressive. These differ based on the tax rate, or the percent of income that’s paid in taxes. b. Progressive taxes have a higher tax rate on people with higher incomes. i. Tax rates here are always marginal tax rates. If you make more money and you move into a higher tax bracket, you don’t pay a higher tax rate on all the income you earned—you pay that higher rate on just part of the income that you earned, the part that’s over certain thresholds..]]

iii. Imagine the government has seven buckets, one for each tax bracket, and labeled 10%, 12%, etc. The first bucket holds $9,950. The second bucket holds $30,575 ($40,525-$9,950), etc. The last bucket holds an infinite amount of cash. iv. Imagine each person puts their taxable income (income minus deductions) into the first bucket until it’s full, then the second, the third, and so on. Each person is then taxed 10% on whatever money is in the first bucket, 12% on whatever money is in the second bucket, and so on and all those values are added together. That’s the tax bill. v. Why is it done this way? Incentives! It would be a terrible incentive structure if being in a higher tax bracket resulted in all your income was taxed at a higher rate. In that case, a raise could mean less money after taxes. vi. Incentives also explain why high-income people tend to itemize deductions—the savings from a lower taxable income are much larger when the income is taken from a higher tax bracket. “Tax avoidance” is legal ways people avoid paying taxes; during the 1950s, when the top tax rate was over 90%, tax avoidance was very common. Few people actually paid that 90% tax rate. c. Flat taxes have a constant tax rate—everyone pays the same portion of income. i. Flat taxes are simpler than progressive taxes and don’t come with the asymmetric incentives about deductions, but they obviously shift some tax burden away from the richest to other groups. d. Regressive taxes have a lower tax rate on people with higher incomes. i. There’s a fair amount of taxes that are regressive. The sales tax is one of them, since low-income households spend the vast majority of their income while high-income households spend a smaller portion of their income. 1. Suppose the sales tax is 6 percent. If a poor household spends all of their income, they will pay 6 percent of their income towards sales tax. If a rich household spends half their income, they will spend 3 percent of their income on taxes. 2. This gets complicated by the fact that not all spending is subject to sales tax. A lot of food, for example, is exempt. ii. Fines, while not technically taxes, are regressive. A $300 parking ticket is a much smaller share of a high income compared to a low income. One can link fines to income, as Finland does, and avoid this problem. III. Tax revenue a. The U.S. Federal government gets its revenue from three main sources: income tax, payroll taxes, and corporate taxes. Let’s look at each of these in detail. b. Income tax—a tax on income, including capital gains and interest, paid directly by the individual. As mentioned, this is a progressive tax. i. Despite popular rhetoric to the contrary, the U.S. has a progressive tax system, even after deductions. For example, the vast majority of income tax collected by the IRS comes from high income households.

ii. Think about this chart whenever someone says “the rich should pay their fair share.” What does “fair” mean? And share of what? Of their total income or of the total income tax revenue? c. Payroll taxes taxes—a tax on income, paid directly and indirectly by the individual. These taxes fund Social Security programs as well as Medicare (which is also partly funded out of general funds). i. Why do I say they are paid “directly and indirectly” by the individual? ii. You pay it directly because some of it comes out of your paycheck explicitly (you can see it on your W-2). iii. Your employer pays the rest—that’s the indirect part. If your employer didn’t have to pay that tax, you would get more income. How much more depends on the relative sensitivities to price (what economists call “elasticity,” something covered in detail in introductory microeconomics). d. Corporate taxes—a tax companies pay on profits. i. This is a flat tax—21%—but was progressive (ranging from 15% to 39%) before the Tax Cuts and Jobs Act of 2017. ii. Don’t companies sometimes pay zero taxes? Yes and no. No, because there are the FICA taxes we discussed (while employees shoulder some of that, they don’t shoulder all of it), and state and local taxes, plus there are many firms who do pay loads of corporate taxes (don’t extrapolate from the most attention-grabbing headlines!). But companies can avoid some taxes, because (a) some revenue is held offshore and thus not taxed and (b) the government allows for deductions, much like personal income taxes. iii. For example, Amazon famously paid zero federal corporate taxes in 2017 and 2018. How is this possible? Because of the tax code. It allows Amazon to deduct investment and employee stock compensation from its taxable profits. The code does this to more strongly incentivize firms to invest their profits and spread ownership power to company employees. That Amazon pays no taxes is the intended and natural result of the tax code. If you still don’t like this result, recognize it’s not due to any sneaky trick Amazon is doing—they are just following the incentives of the tax code. Don’t hate the player; hate the game.

I. Outlays (spending) a. There are two major types of government spending: mandatory and discretionary. b. Mandatory is spending the government has to spend due to statutory criteria and do not have set limits. These are called entitlements— government benefits with guaranteed access assuming you meet the criteria. i. Social Security, Medicare, welfare, food stamps are all examples of entitlements. c. Discretionary spending is the spending the government decides on with explicit numbers attached. When Congress decides on a budget, this is what they’re deciding on. It includes defense and nondefense spending and there are roughly equal shares of each. i. Nondefense spending includes funding for NASA, the National Institutes of Health, veterans’ health care, transportation, etc. d. Both mandatory and discretionary spending include transfers—money the government spends on others but doesn’t get anything in return. Medicare, farm subsidies, unemployment insurance are all transfers. Buying fighter jet, building a road, and doing medical research at NIH are not transfers. II. Of debt and deficits a. The government spends more than it takes in from taxes. This is called a deficit (when spending for a year exceed revenue for a year). III. The government borrows money to make up the difference (these are government bonds) and this borrowed money makes up the total debt. How much the government owes in total.

c. Note how often the government runs a deficit. The government hasn’t run a surplus since the late 1990s. Why is that? i. This is an application of our public choice section. The reality is that people who benefit from this spending vote and the future generations who have to pay the costs are too young to vote or aren’t even born yet. And the clock is ticking. d. None of this, by the way, includes unfunded liabilities: especially future Social Security and Medicare payments (but also pensions and debt). Remember, these are entitlements and, by law, the government must pay them, even if it has to borrow yet more money. e. One final note to leave on: total debt as a percent of GDP. Note that when the number’s falling, it’s largely due to GDP increasing, not the debt being paid off. Also, this data only goes back to 1966.

V. The Laffer Curve a. Isn’t paying off the debt just a matter of higher income taxes? b. It’s not so simple because the higher the income tax rate, the larger the incentive to avoid paying those taxes in the form of deductions, exemptions, and simply not working. This is especially true of very high earners who have the savings available to not work. i. For example, when the top tax rate was 90 percent (in the 1950s and 60s) and 70 percent (in the 1960s and 70s), no one actually paid those tax rates. c. The Laffer Curve illustrates this trade-off.

i. If the income tax rate is 0 percent, then the government obviously collects no revenue. If the income tax rate is 100 Tax Revenue 0% Tax Rate 100% percent, there’s no incentive to work and the government still collects no revenue.1 ii. Crucially, we don’t know the exact shape of the curve. I drew the maximizing revenue point at 50 percent tax rate mark, but maybe the maximum point is lower than that mark or higher than that mark. iii. We also don’t know how “flat” the curve is, though it’s worth noting that income tax revenue as a percent of GDP is pretty constant, suggesting that the Laffer Curve itself is pretty flat.