Ch. 17 TB – The Federal Budget – Taxes and Spending Notes

Ida May Fuller and Social Security

Ida May Fuller received the first Social Security check in 1940 (#00-000-001).
She paid $24.75$ in Social Security taxes and received $22.54$ in her first check.
By the time she died in 1975 at age 100, she had received $22,888.92$ in benefits.
The federal government has generally spent about 20% of GDP and raised about 18% of GDP since the mid-1950s.
In 2023, federal spending was more than $6 trillion.

Federal Tax Revenues

The federal government takes in about $4.7 trillion, or approximately $14,000 for every man, woman, and child in the United States.
The individual income tax, Social Security and Medicare taxes, and the corporate income tax account for more than 90% of the revenue.

Individual Income Tax

The marginal tax rate is the tax rate paid on an additional dollar of income.
Marginal tax rates increase in uneven steps until the top marginal tax rate of 37% is reached on any income earned greater than $693,750.
Marginal tax rates today are lower and flatter than they have been in the past.
In 1960, the lowest marginal tax rate was 20% and the highest rate was 91%.
In 1913, when the income tax began, the top marginal rate was just 7% and that rate didn’t take effect until annual income was over $10 million.
The average tax rate is the total tax payment divided by total income.
For example, if your income is $50,000, then your total income tax under the current system can be calculated as follows. You pay 10% on the first $22,000, or $2,200, then you pay 12% on the next $28,000, or $3,360, for a total tax of $5,560. Your average tax rate is then $\frac{5560}{50000} = 11.12 \%$ .
The standard deduction for a married couple in 2023 is $27,700, which means that someone with an income of $100,000 is taxed as if they had an income of $72,300 and a person with an income of $27,700 is considered to have zero taxable income.
Most people take the standard deduction, but there are also deductions for certain types of “special” spending such as mortgage interest, state and local taxes, and charity, and if these items add up to more than your standard deduction you can take the itemized deductions instead.

Taxes on Capital Gains and Interest and Dividends

The income tax is a tax on your labor income and also on any income you receive from your investments, namely your interest income, your dividends, and your capital gains.
You may receive interest income, for instance, on your savings accounts, and this income usually is taxed as if it were labor income.
You receive a capital gain, for instance, if you buy stock at $110 a share and later resell it at $210 a share. Your capital gain is the extra $100 you made from the rise in the value of the stock.
You pay a tax on those profits and currently the standard capital gains tax rises from 0% for those with low incomes to 15% for most taxpayers to 20% for those whose income puts them in the highest income tax bracket.
Capital gains taxes are paid only when the assets are sold and not while the assets are simply being held.
For instance, capital gains allow for “loss offsets.” If you gain $100 selling one stock and lose $100 selling another, usually the two sums cancel each other out in the calculation of your tax liability.

Alternative Minimum Tax (AMT)

Alternative minimum tax: a separate income tax code, begun in 1969 to prevent the rich from not paying income taxes; not indexed to inflation and thus now an extra tax burden on many upper middle class families
The AMT was started in 1969 after a televised congressional hearing revealed that 155 households with income over $200,000 (about $1.2 million in today’s dollars) had paid no income tax.
The AMT requires taxpayers to make two computations.
First, they must compute what they owe under the standard tax code; then, they must compute what they owe under the AMT, which is typically based on a flat rate of either 26% or 28%, with no deductions allowed. The taxpayer must then pay whichever number is higher.

Social Security and Medicare Taxes

Almost all workers in the United States pay the Federal Insurance Contributions Act tax, better known as the FICA tax, the acronym that you see on your payroll check.
The FICA tax is 6.2% of your wages on the first $160,200 of income. In addition, your employer also pays a 6.2% tax on the same earnings so the total FICA tax is 12.4%.
The FICA taxes fund Social Security payments.
Medicare is partly financed out of general revenues and partly financed out of special payroll taxes.
For most workers, 1.45% is withheld from their paychecks in the form of a Medicare premium and the employer pays another 1.45%.
Self-employed individuals pay the full 2.9% themselves.

The Corporate Income Tax

In 2017, after a contentious debate, the corporate tax rate in the United States was reduced from 35% to 21%.
A cut in the corporate tax rate increases the incentive to invest in the corporate sector. As more capital enters the corporate sector, the return to capital and to the capitalists in that sector falls. Thus, some of the gains from a corporate tax must flow elsewhere.
A cut in the corporate tax rate, therefore, will increase the return to capital overall but that too is not the end of the story. A higher return to capital will increase the incentive to invest.
As investment increases, the return to capital in all sectors will decline. Thus, some of the gains from a corporate tax must flow elsewhere. Where? In order to be productive, capital needs workers.
A useful rule to remember is that elasticity = escape. The more elastic factors can escape a tax, which will thus be borne by the less elastic factors.
Capital tends to be highly elastic—it moves between sectors and countries with relative ease.
A majority of the corporate tax is borne by capital but a substantial 30% to 50% of the corporate tax is born by workers and consumers.

The Bottom Line on the Distribution of Federal Taxes

Households with incomes in the bottom 20% pay very little in federal tax, less than 1% of their total income.
Those with incomes in the top 20% pay an average tax rate of just under 25%.
Those in the top 1% pay approximately 30% of their income to the federal government.
The U.S. tax system is progressive—people with higher income pay a higher percentage of their income in tax to the federal government than people with lower income.
Progressive: an income tax with higher tax rates on people with higher incomes
A flat tax has a constant tax rate applied to income at all levels of earning.
Flat tax: an income tax with the same tax rate on all levels of income (compare with progressive and regressive tax)
If the tax code were radically simplified to eliminate almost all deductions, including the deductions for mortgage interest and charitable giving, then by some calculations a flat rate of around 19% would raise approximately the same revenue as today.
Almost 70% of federal taxes are paid by people in the top 20% of income earners. The top 1% alone pay about one-quarter of all federal taxes.
A regressive tax is a tax system wherein the tax rate decreases as the taxable amount increases. This means that lower-income earners pay a higher percentage of their income in taxes compared to higher-income earners.

State and Local Taxes

Overall, state and local taxes are about 11% of GDP.
Compared with the federal government, states raise more of their revenues, about 20% on average, from sales taxes.
Since sales tax rates are the same for everyone, regardless of income, state and local taxation as a whole is less progressive than income taxation.

Federal Spending

Almost two-thirds of the U.S. federal budget is spent on just four programs in a typical year: Social Security, defense, Medicare, and Medicaid.
Interest on the national debt and various unemployment insurance programs and welfare programs are also large.

Social Security

If measured in terms of dollars paid out, Social Security is the single largest government program in the world.
The Social Security programs pay more than 1 trillion dollars in benefits annually to more than 62 million beneficiaries.
Social Security is run on a pay-as-you-go basis. That means that when the government takes in your dollars, the money does not go into an account or trust with your name on it.
In recent years, the average retiree and spouse have been paid $1,550 a month so one immediate lesson is that you shouldn’t count on Social Security alone to support you in your old age.
Social Security benefits are defined by a complex formula depending on how many years a worker worked, what their average earnings were over their working life, whether or not they are married, what year they retire, and at what age.
The complexity of the formula means that Social Security is not equivalent to a simple forced savings program under which the government requires everyone to save 12.4% of their income.
Social Security is also more generous to married people than to singles.
The age at which workers can claim their full retirement benefits was 65 for many years but, because the Social Security program was getting very expensive, in 1983, the full retirement age was made to slowly increase depending on when the worker was born.
You—assuming you were born after 1960—must wait until age 67 to claim your full retirement benefits.
A worker can start claiming some benefits as early as age 62, but people who opt for early retirement get a lower monthly payment.
Benefits are indexed to the level of wages in the United States, so over time benefits rise automatically with general increases in prosperity.
Workers who retired in the early years of Social Security received full benefits even though they paid Social Security taxes for only a portion of their working life. In addition, the Social Security tax rate increased over time, rising from 2% in 1940 to today’s rate of 12.4%.
Social Security has become less generous over time for another reason—the labor force has been growing more slowly in recent decades because fewer people are working and because the growth rate in the population has declined. It’s harder to fund benefits to yesterday’s workers when there are fewer workers to tax today.
Social Security spending currently exceeds Social Security taxes—the difference is made up by interest on past excess contributions.
The Congressional Budget Office projects, however, that interest payments will cover the Social Security deficit only until 2029.
In 2029, the difference between benefits spending and Social Security taxes will have to be made up by revenues from taxes other than the Social Security tax, increases in Social Security taxes, or decreases in benefits, such as increases in the retirement age.

Defense

The official budget for the Department of Defense is about $795 billion.
The United States spends much more on its military than does any other country in the world.

Medicare and Medicaid

Medicare reimburses older people for much of their medical care spending, covering hospital stays, doctor bills, and prescription drugs.
To be eligible for Medicare, an individual should be 65 or older and have worked for at least 10 years in a job paying Medicare premiums.
In fiscal year 2023, Medicare spending amounted to $856 billion.
Social Security and Medicare, taken together, are by far the largest undertakings of the U.S. government, and both are programs that transfer wealth to older people.
Medicare does not pay all medical bills outright. Instead, beneficiaries are required to pay some percent of the charges, known as a “copayment.”
Whereas Medicare covers older people, Medicaid covers the poor and the disabled.
The federal government and state governments pay for Medicaid jointly, but the program itself is run through state governments.

Unemployment Insurance and Welfare Spending

In reality, federal welfare payments (not including Medicaid or unemployment insurance) amount to $300–$500 billion a year (depending on exactly what one counts and whether the economy is in a recession).
Most welfare payments fall into a few common categories.
First, personal welfare payments are made to poor households with children. The largest of these is called Temporary Assistance for Needy Families (TANF).
Especially important is the Earned Income Tax Credit (EITC), which is now the main form that antipoverty policy takes at the federal level. The EITC, quite simply, pays poor people cash depending on how much they earn.
Unemployment insurance (UI) makes payments to people who are out of work and is not restricted to the poor.
In 2019, for example, just $28 billion was spent on UI, but in 2020, more than $173 billion was spent on UI to deal with the economic shutdown due to the COVID-19 pandemic.

Everything Else

All the other spending programs of the federal government, which include:
- Farm subsidies
- Spending on roads, bridges, and infrastructure
- The Disaster Relief Fund
- The Small Business Administration
- The Food and Drug Administration
- All federal courts
- Federal prisons
- The FBI
- Foreign aid
- Border security
- NASA
- The National Institutes of Health
- The National Science Foundation
- Financial assistance to students
- The wages of all federal employees
When polled, 41% of Americans said that foreign aid is one of the two largest sources of federal expenditure. In reality, foreign aid is about 1% of the overall federal budget; the exact number depends on how that term is defined since sometimes “foreign aid” and “military assistance” are difficult to distinguish.

Is Government Spending Wasted?

There are good reasons for thinking that governments might not spend money as carefully as you or I, namely weak incentives and lack of information on how to spend the money effectively.
Economist Joel Waldfogel, estimated that billions of dollars are wasted every Christmas because most gifts cost the giver more than they are valued by the recipient.
A lot of government spending falls into this category—some people spending other people’s money on yet other people.
In Afghanistan and Iraq, for example, the United States spent more than a hundred billion dollars on reconstruction efforts, but audits revealed many billions of dollars in waste, fraud, and abuse.
Government spending can be wasteful, but if a politician claims that they will pay for new spending programs or tax cuts by cutting “waste”—beware!
Consider Social Security, the largest government spending program. Social Security transfers cash—it’s like the perfect Christmas gift recommended by economists—and because the program is well-known, it’s well monitored.
Overall, it’s difficult to cut spending on big programs without cutting benefits.
If we want more spending on those programs, ultimately taxes must rise or we must cut spending somewhere else.

The National Debt, Interest on the National Debt, and Deficits

The debt-to-GDP ratio measures a country's national debt in relation to its gross domestic product (GDP). As of 2023, the national debt of the U.S. is approximately $31 trillion, with a debt-to-GDP ratio of about 100%.
The national debt held by the public as of 2023 is about $25 trillion.
Thus, the United States has a debt-to-GDP ratio of approximately 100%.
Today’s debt-to-GDP ratio is high by past standards, especially outside of a world war. More worrying is that in 2007 the debt to GDP ratio was only 35% so the national debt is rising very quickly.
The highest debt-to-GDP ratio in U.S. history occurred in 1946 at 108%.
The government borrowed heavily to finance emergency expenditures for World War II, but following the war the debt-to-GDP ratio slowly declined until the 1980s. In the 1980s, a combination of tax cuts and increases in defense spending increased the debt-to-GDP ratio.
The ratio then fell as the economy expanded and the federal government briefly ran a series of budget surpluses under President Bill Clinton in the 1990s. More recently, the debt-to-GDP ratio increased slightly due to further tax cuts and defense spending under former President George W. Bush.
The debt-to-GDP ratio increased sharply due to the Great Recession of 2007– 2008 and its aftermath and much higher spending associated with the COVID-19 pandemic and shutdown.
The U.S. debt in 2023 was about $25 trillion and the average interest rate on the debt was a little more than 2.5%, so the federal government paid approximately $625 billion in interest payments to bondholders.
Interest payments of $625 billion is a lot, and the Federal government collects $4.7 trillion in taxes, so as a share of revenues, interest payments are 13.3%.
The debt is the total amount of money owed by the federal government at a point in time. It is a cumulative total of previous obligations. The deficit is the difference—in any given year—between federal government spending and revenues.

Should We Have a Balanced Budget Amendment?

The Nobel Prize–winning economist James Buchanan argued that deficits are a natural consequence of political incentives because future taxpayers don’t have a current vote.6
The main argument against a balanced budget amendment is that it would make it more difficult to aggressively respond to a recession with greater spending.
The United States has not passed a balanced budget amendment at the federal level (most states, however, have balanced budget rules), but other countries have adopted versions of a balanced budget law.
Sweden has one of the most interesting fiscal rules. Since 2000, Sweden’s central government has been required to budget for a 1% surplus over the business cycle.

Will the U.S. Government Go Bankrupt?

The Great Recession and the COVID-19 pandemic pushed the debt-to-GDP ratio to a higher level than anyone was expecting.
What is really worrying about our current debt levels are not disasters or recessions but demographics and increasing health-care costs. The U.S. population is getting older.
As a fraction of GDP, for example, Social Security payments will have to increase by about 41% if benefits are to be maintained at promised levels.
Because of Medicare, Medicaid, and health insurance subsidies, health-care costs will consume a larger and larger share of the federal budget.
In recent decades, health-care costs per person have been rising more than twice as fast as GDP per capita.
If taxes and spending in the United States do increase, this would make the United States more like other developed countries.
We have already cut some projected Social Security spending by increasing the age of retirement.

Revenues and Spending Undercount the Role of Government in the Economy

Government spending is one measure of how government affects the economy, but it is not a complete or fully accurate measure.
Governments take many other actions that commandeer resources from the private sector but do not show up as full budgetary expenditures.