Chapter 18
Taxation
and Public
Expenditure
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In this chapter you will learn to
1. Describe the main sources of government revenue in the
United States.
2. Explain why a tax can lead to allocative inefficiency.
3. Describe the main categories of government spending.
4. Explain why transfer payments for the elderly are an
increasing proportion of government spending.
5. Describe the factors that determine the scope and nature of
government’s role in the economy.
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Taxation
Tax Expenditures
Tax Expenditures: Tax revenues returned to taxpayers who
take actions that the government deems
desirable
Example: health insurance
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Figure 18.1 International Comparison
of Government Tax Revenues, 2004
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Progressivity
Average Tax Rate: % of income that individual pays in taxes
An income tax is:
- progressive if the ATR rises as income rises
- regressive if the ATR falls as income rises
- proportional if the ATR is constant as income rises
Most income-tax systems achieve their progressivity by
having marginal tax rates that rise with income
– “tax brackets”
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The U.S. Tax System
Sources of federal government revenues:
• personal income taxes
• payroll taxes
• corporate Income taxes
• excise and sales taxes
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Tax Brackets
Tax bracket: A range of taxable income for which there is a
constant marginal tax rate.
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Figure 18.2 Sources of
Government Revenues, 2005
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Income Taxes
APPLYING ECONOMIC CONCEPTS 18.1
How Federal Taxes Affect Your
Paycheck
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Evaluating the Tax System
Taxation and Equity
Equity is normative. Two principles are helpful in assessing
equity:
1. the ability-to-pay principle
2. the benefits-received principle
- vertical and horizontal equity
Problems:
- ability to pay is not the same as income.
- how to measure benefits received?
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How Progressive is the U.S. Tax
System?
A modern government relies on many kinds of taxes.
Assessing the entire tax system is complicated by two factors:
1. the progressivity of the system depends on the mix
of the different taxes (federal taxes tend to be
progressive; property taxes are slightly regressive)
2. income from different sources are taxed at different
rates
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Negative Income Tax
APPLYING ECONOMIC CONCEPTS 18.2
Poverty Traps and the Negative
Income Tax
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Taxation and Efficiency
Taxes often generate allocative inefficiency.
Two burdens of taxation:
1. direct burden is the amount paid by taxpayers
2. excess burden is the allocative inefficiency
generated by a tax
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Taxation and Efficiency
Most taxes impose both burdens:
- by taking resources from market participants, they
impose a direct burden
- by changing behaviour, they generate a
deadweight loss — the excess burden
The government’s tax policy should strive to minimize
allocative inefficiency for a given amount of tax revenues.
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Figure 18.3 Direct and Excess
Burdens of an Excise Tax
Case 1: Only a direct burden, no excess burden.
Case 2: No direct burden (no sales), some excess burden.
Case 3: Both direct and excess burdens.
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Figure 18.4 Direct and Excess
Burdens of an Income Tax
The same principle applies with an income tax...
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Figure 18.5 A Laffer Curve
Along a Laffer curve:
- increases in the tax rate beyond some level (t0) lead
to disincentive effects, and decrease tax revenues.
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Public Expenditure
Federal, state and local governments spend an amount equal
to about one-third of the nation’s annual output.
There are two broad categories of government expenditure:
1. purchases of goods and services
2. transfer payments (including payments made to other
governments)
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Figure 18.6 Spending by Governments
as a Share of National Income,
1960–2005
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Figure 18.7 Federal, State,
and Local Spending, 2005
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Purchases of Goods and Services
Because public goods are underprovided by private markets
due to the free rider problem, government spending tends to
be concentrated on providing public goods.
- national defense is 2/3 of federal government
spending
- education is about 20% of state and local
government spending
- policy and fire services are about 15% of the state
and local government spending
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Transfer Payments
The largest category of transfer payments by the federal
government is made to individuals.
Federal government transfer payments include transfers to:
– elderly persons (Social Security and Medicare)
– needy persons (welfare and Medicaid)
– other governments (grants-in-aid)
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Evaluating the Role of
Government
Public Versus Private Sector
Government activities reallocate resources between the
private and public sectors
- a different mix of goods and services from what
would otherwise exist
What is the appropriate mixture of public and private
expenditures?
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Evaluating the Role of
Government
John Kenneth Galbraith (1908-2006) lamented the
reallocation away from the public sector, especially in the
United States
- “private affluence and public squalor”
His classic 1958 book The Affluent Society discussed
his views of the appropriate role of government in the
economy.
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Scope of Government Activity
It is important to maintain an appropriate perspective about
the role of government in the economy.
One pitfall is to become overwhelmed by the government’s
role, and forget that people are mostly free to make decisions
in their own ways.
Another pitfall is to fail to recognize that a significant share of
of taxes is used to finance goods and services that add to the
welfare of individuals — such as education, health care, and
roads.
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Evolution of Policy
In a democratic society, the majority’s view on the amount of
intervention that is desirable will have a considerable
influence on the amount of intervention that actually occurs.
The economist’s job is to continue analyzing and explaining
the effects of alternative policies.
Only then will the electorate and policymakers be able to
make informed choices.
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