Study Notes: Government Spending, Taxes, and Fiscal Policy

Chapter 23: Government Spending, Taxes, and Fiscal Policy

1. The Government Sector

• Overview of Government Sector: Key aspects include:

  • Government Spending

  • Government Revenue

  • Hidden Government Spending: Tax Expenditures

  • Government Deficits and Debt

2. Fiscal Policy

• Definition of Fiscal Policy: Government's use of spending and tax policies to stabilize the economy.

• Characteristics of Fiscal Policy:

  • Countercyclical nature: Aims to counteract business cycle effects.

  • Expansionary Fiscal Policy: When the economy is weak, government increases spending and lowers taxes to boost aggregate demand.

  • Contractionary Fiscal Policy: When the economy is overheating, government decreases spending and raises taxes to weaken aggregate demand.

3. Government Deficits and Debt

A. Overview of the Federal Budget

• Annual Proposed Budget: Released by the President, vast in size and scope, representing a battle over priorities.

• Purpose: To understand how government prioritizes spending through the allocation of resources.

B. Government Spending

1. Total Government Spending Overview

   • Breakdown of total government spending in 2020:

     • Local: 16% ($1.7 trillion)

     • State: 19% ($2 trillion)

     • Federal: 65% ($6.9 trillion)

   • Historical Expansion of Federal Spending (as % of GDP):

     • 1929: 3%

     • 1941: 17%

     • 2022: 25%

2. Composition of Federal Spending

   • Major Categories:

     • Social Insurance Programs and Military spending account for about three-quarters of federal spending.

     • Definition of Social Insurance: Government-provided insurance against adverse outcomes (e.g., unemployment, illness).

   • Interest on Debt: Consumes 5% of the budget, leaving approximately 20% for non-military programs:

     • Includes education, energy, transportation, and international affairs.

3. Mandatory vs. Discretionary Spending

   • Mandatory Spending: Set by law, includes programs like Social Security and Medicare, which cannot be easily cut.

   • Discretionary Spending: Categories decided by Congress annually, comprising about 30% of total federal spending.

     • Roughly half of discretionary spending is allocated to military programs.

4. Comparison with Other Countries

• Total government spending is lower in the United States compared to other developed nations, which often provide:

  • Publicly funded health care

  • Low-cost or free higher education

  • Paid parental leave

  • Greater support for low-income families

5. Government Revenue

A. Sources of Federal Tax Revenue

• Primary Sources:

  • Individual Income Taxes contribute 51% of revenue.

  • Payroll Taxes contribute 32%.

B. Details on Payroll and Income Taxes

• Payroll Taxes: Levied on earned income, funds Medicare and Social Security.

  • Includes:

  • Medicare: 2.9% from workers,

  • Social Security: 6.2% with contribution caps.

• Income Taxes: Progressive system, levied on all income sources (both earned and unearned).

  • Key Distinction: Income vs. Wealth—income is money received in a year; wealth refers to assets.

C. Corporate Taxes

• Corporate taxes represent 9% of federal taxes but are ultimately borne by people:

  • Shareholders lose: $0.75 for every dollar of corporate tax.

  • Workers lose: about $0.25.

6. State and Local Government Revenues

• Types of Taxes:

  • Sales Tax: Based on purchase price.

  • Excise Tax: Levy on specific products.

  • Property Tax: Based on property value, often regressive.

7. Hidden Government Spending

A. Tax Expenditures

• Definition: Deductions or credits that lower tax obligations to encourage specific activities.

  • Example: American Opportunity Tax Credit provides a $2,500 deduction for tuition tied to engaging education.

  • Political cost: Usually included in tax code, less scrutinized than budget spending.

B. Government Regulation

• Regulation can also disguise spending by mandating employers cover costs (e.g., parental leave).

8. Key Takeaways: The Government Sector

• Predominantly increased government roles in social insurance and education over time.

• Major spending categories: Military, social insurance (federal), education (state/local), with hidden spending through tax expenditures and regulation.

9. Fiscal Policy As a Countercyclical Force

• Important Features of Fiscal Policy:

  • Expansionary: Increases spending to boost GDP during economic weakness.

  • Contractionary: Decreases spending to lower GDP during economic overheating.

• Impact of Government Spending:

  • Direct Impact: Purchases increase aggregate expenditure.

  • Indirect Impact: Transfer payments stimulate consumption when recipients spend.

10. Government Deficits and Debt

A. Definitions

• Budget Deficit: When annual expenditures exceed revenues, contributing to total debt.

• Budget Surplus: Occurs when revenues exceed expenditures, allowing for debt repayment.

• Gross Government Debt: Total cumulative indebtedness.

• Net Government Debt: Debt owed to individuals/entities outside government.

B. Considerations Regarding Government Debt

1. Reasons Not to Worry:

   • Most debt is owed domestically.

   • Future generations can assist in repayment.

   • Government has unique options for managing debt (e.g., taxing, printing money).

2. Reasons to Worry:

   • Higher debt can hinder economic growth.

   • Limits future fiscal leeway for policymakers.

   • Risk of lending crises due to confidence loss among lenders.

3. Concerns Regarding Social Security:

   • Although it is funded through payroll tax contributions, its future is uncertain as financial resources face depletion by 2033.

   • If funds run out, recipients might receive only 70% of expected benefits.

C. Conclusion

• Real implications of government deficits and debt on economic stability, growth prospects, and future fiscal policies.

• Robust solutions are necessary to maintain stability and ensure support for essential government obligations.