Economics Unit 5 – Economics of Taxations

Section 9.1 – economic impact of taxes

• When a tax is placed, the good or service raises the cost of production and the price of the product
• With less products sold, resources has to be cut from a business
• Can be used to encourage/discourage certain types of activities
• Sin tax – relatively high tax designed to raise revenue and discourage consumption of a socially undesirable product
• Can affect productivity and economic growth by changing the incentives to save, invest, and work
• Incidence of a tax – final burden of a tax

Criteria for effective taxes

• Equity, taxes should be impartial and just
• Tax loopholes – exception or oversight in tax law allowing a taxpayer to avoid paying certain taxes
• Simplicity, both taxpayers and tax collectors can understand them
• Individual income tax – federal tax levied on the wages, salaries, and other income of individuals
• Sales tax – general state or city tax levied on a product at the time of sale
• Efficiency – relatively easy to administer and reasonably successful at generating revenue
• Tax return – annual report by a taxpayer filed with the local, state, or federal government detailing income earned and taxes owned

Two principles of taxation

• Benefit principle of taxation – belief that taxes should be paid according to benefits received regardless of income
• Limitations: those who receive government services may be the ones who can least afford to pay for them; benefits are often hard to measure
• Ability to pay principle of taxation – belief that taxes should be paid according to level of income, regardless of benefits received

Three types of taxes

• Proportional tax – tax in which the percentage of income is the same regardless of the level of income
• Average tax rate – total taxes paid divided by the total taxable income
• Medicare – federal health care program for senior citizens
• Progressive tax – tax in which the percentage of income paid in tax rises as the level of income rises
• Marginal tax rate – tax rate that applies to the next dollar of taxable income
• Regressive tax – tax in which the percentage of income paid in tax goes down as income rises

Section 9.2 – federal, state, and local revenue systems

• Internal revenue service – branch of the US treasury department that collects taxes

Federal government revenue sources

• Payroll withholding system – system that automatically deducts income taxes from paychecks on a regular basis
• Indexing – adjustment of the tax brackets to offset the impact of inflation
• FICA – Federal insurance contributions act; tax levied on employers and employees to support social security and Medicare
• Payroll tax – tax on wages and salaries deducted from paychecks to finance social security and Medicare
• Borrowing by the federal government is the third-largest source of federal revenue
• Corporate income tax – tax on corporate profits
• Excise tax – general revenue tax levied on the manufacture or sale of selected items
• Estate tax – tax on the transfer of property when a person dies
• Gift tax – tax paid by the donor on transfer of money or wealth
• Customs duty – tax on imported products
• User fee – fee paid for the use of a good or service

State government revenue sources

• Intergovernmental revenue – funds that one level of government receives from another level of government
• Most states have implemented sales taxes to add to their revenue

Local government revenue sources

• Property tax – tax on tangible and intangible possessions such as real estate, buildings, furniture, stocks, bonds, and bank accounts
• Tax assessor – person who examines and assesses property values for tax purposes
• Natural monopolies – market structure in which average costs of production are lowest when a single firm exists

Chapter 10.1 – the economics of government spending

• Pork – a line-item budget expenditure that circumvents normal budget procedures and benefits a small number of people or businesses

Government spending in perspective

• Public sector – the part of the economy made up of local, state, and federal governments
• Public opinion gave government a larger role in everyday economic affairs
• Massive government spending funded the united states involvement in world war ii
• Private sector – that part of the economy made up of private individuals and businesses
• Transfer payment – payment for which the government receives neither good nor services in return
• Grant in aid – transfer payment from one level of government to another that does not involve compensation

Impact of government spending

• Subsidy – government payment to encourage or protect a certain economic activity
• Distribution of income – way in which the nation’s income is divided among families, individuals, or other designated groups

Section 10.2 – federal, state, and local government expenditures

• Federal budget – annual plan outlining proposed expenditures and anticipated revenues

Federal government expenditures

• Fiscal year – 12-month financial planning period that may not coincide with the calendar year
• The president’s budget proposes a request, which is sent to the congress for approval
• The budget will be broken down to 13 categories, which will also be sent to subcommittees
• Appropriations bills – legislation authorizing spending for certain purposes
• If approved, the bill will be sent to the president for signature
• Budget deficit – a negative balance after expenditures are subtracted from revenues
• Budget surplus – a positive balance after expenditures are subtracted from revenues
• Mandatory spending – federal spending authorized by law that continues without the need for annual approvals by congress
• Discretionary spending – spending for federal programs that must receive annual authorization
• Income security consists of a wide range of programs that includes retirement benefit for both federal civilian employees and retired military
• Medicare – federal health-care program for senior citizens, regardless of income
• Medicaid – joint federal state medical insurance program for low income people
• Interest on debt makes up the sixth largest category of federal spending

State government expenditures

• Balanced budget amendment – constitutional amendment requiring government to spend no more than it collects in taxes and other revenues, excluding borrowing
• Intergovernmental expenditures – funds that one level of government transfers to another level for spending
• Public welfare in forms of cash assistance, payments for medical care
• Insurance and retirement funds for state employees

Local government

• Power to approve spending rests with mayor, the city council, county judge, or some elected representative or body
• Revenues collected from property taxes, city income taxes, and other local sources
• Local government fund institutions, police force, and community workers
• Roads and highways are another expense for local government

10.3 – deficits, surpluses, and the national debt

From deficits to debt

• Deficit spending – annual government spending in excess of taxes and other revenues
• Depends on the way expenditures are reported and the state of economy
• Changes in economy affect budget projections (strong economic growth can cause the deficit to shrink due to the high tax collections and lower unemployment claims)
• National debt – total amount borrowed from investors to finance the government’s deficit spending
• Balanced budget – annual budget in which expenditures equal revenues
• Trust fund – special account used to hold revenues designated for a specific expenditure such as social security, Medicare, or highways
• Per capita – per person basis; total divided by population
• Private debt owed to others while national debt to ourselves
• Private borrowing usually makes plans to repay the debt; when government borrows, they issue new bonds to pay off the old bonds
• Private individuals give up purchasing power because they have less money to purchase
• Federal government does not give up purchasing power, because the taxes collected from some groups are simply transferred to other groups

Impact of the national debt

• National debt can cause a transfer of purchasing power from the private sector to the public sector
• Government can reduce economic incentives if it appears to spend money in a careless manner
• Federal government uses deficit spending, it must borrow money in financial markets; raises interest rates, forcing all borrowers to pay more for the temporary use of funds
• Crowding out effect – higher than normal interest rates and diminished access to financial capital faced by private borrowers when they compete with government borrowing in financial markets
• National debt and the tax structure can impact the distribution of income

Reducing deficits and the debt

• Balanced budget and emergency deficit control act of 1985 failed for two reasons
  • Congress discovered that it could get around the law by passing spending bills that took effect two or three years later
  • Economy started to decline in 1990, triggering a suspension of budget cuts when the economy was weak
• 1990 budget enforcement act (main feature below)
• Pay as you go provision – requirement that new spending proposals or tax cuts must be offset by reductions elsewhere
  • Cutting spending was too difficult
• 1996, line item veto – power to cancel specific budget items without rejecting the entire budget
• Spending caps – limits on annual discretionary spending
• 1993 President Clinton”s omnibus budget reconciliation act attempted to trim $500 billion from deficit over 5 years
  • Spending reduction with increase tax
• Entitlement – program or benefit using established eligibility requirements to provide health, nutritional, or income supplements to individuals