Government Finance

1
Government Finance
2
Methods of Financing Government Activity

• Debt finance
• Inflation
• User charges
• Donations
• Revenues from public enterprise
• Taxation

3
Debt Financing

• Government borrowing to finance projects
• appropriate for financing capital projects
• bridges
• buildings
• dams
• ships
• airplanes

4

• Consumers give up current consumption for promise
  by government to return principle with interest
• Taxation or project revenues used to make
  payments
• Spreads taxation out over lifetime of benefits

5
Inflation

• Government purchases resources by creating money
• money creation increases price level
• increased price level reduces purchasing power of
  consumers
• less consumption
• resources shifted from private sector to public
  sector

6
User Charges

• Based on a benefits-received principle of
  taxation
• taxation according to benefits received
• depends on exclusion
• can not be used where exclusion not possible
• road tolls
• park admission fees
• gas excise tax

7
Donations

• Voluntary contributions
• monetary
• contributions to public universities
• donations to aid victims of disasters
• in-kind
• donation of land by firm to park
• labor services
• volunteer firefighters
• hospital volunteers
• park volunteers
• Peace Corps

8
Revenues from State-Owned Enterprises

• Revenues for public production of private goods
• major source of government financing in socialist
  economies
• minor source of financing in capitalist economies
• electric power charges
• transportation services

9
Taxation

• Major source of funding in capitalist economies
• along with taxation-supported debt financing
• Based on ability-to-pay principle
• payment related to individuals ability to pay
  rather than the benefits received

10
Principles of Taxation

• Tax base
• what tax associated with
• income
• consumption
• wealth
• general versus selective
• general taxes based on all components of base
• retail sales tax
• selective tax based on component of base
• excise tax on gas

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• Tax structure
• relationship between tax and base
• relationship between tax paid and measure of
  ability to pay
• income usual measure of ability to pay
• average tax rate (ATR) ratio of tax paid and
  value of tax base or income
• marginal tax rate (MTR) change in tax paid over
  change in base or income

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• Tax burden and ability to pay
• tax can be structured to place different burdens
  on different levels of income
• a PROGRESSIVE TAX increases burden as income
  rises
• ATR with respect to income rises as income rises
• a PROPORTIONAL TAX leaves burden the same
• ATR stays the same as income rises
• a REGRESSIVE TAX reduces burden as income rises
• ATR falls as income rises

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Evaluation of Taxation

• Taxes evaluated on basis of three social goals
• minimization of the efficiency costs of taxes
• maximization of fairness
• minimization of administrative costs
• Taxes should also be transparent
• should be clear who bears the burden

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• Taxes virtually always cause inefficient behavior
• behavior in response to tax rather than
  benefits/costs of relevant economic activity
• lump-sum tax is only efficient tax
• not based on economic activity
• cannot be avoided
• head tax
• Exception tax may improve efficiency if there is
  market failure
• whole point of corrective taxes

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• These goals not always compatible
• making a tax more equitable usually makes it more
  inefficient
• Taxation often used to influence behavior on
  merit/demerit grounds
• sin taxes
• taxes on alcohol and tobacco
• deductibility of mortgage interest
• encourages home ownership
• accelerated deductibility of certain investment
  expenditures
• oil exploration

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Impact of Taxes on Efficiency

• Taxes result in EXCESS BURDEN
• efficiency loss to society in addition to direct
  burden of tax to taxpayers
• tax revenue is a loss to taxpayers, but the
  resources are still there
• transfer from private to public sector
• excess burden is a loss due to distortionary
  effect of tax

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Excess Burden of Unit Excise Tax

• tax of fixed amount on each unit of a good
• unrelated to the price of the good
• gasoline tax
• causes market supply to be less than MSC
• equilibrium price higher and quantity lower than
  optimal

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Unit Excise Tax
STMSCT

SMSC
Tax Revenue
PG
T
Peff
Excess Burden
PN
DMSB
0
Qeff
QT
Q
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• Excess burden ½T?Q
• Note that ?Q depends on T
• Excess burden ½T2Qeff/Peff .
• EsEd/(Es - Ed)
• Excess burden increases quadratically with tax
• double tax, welfare falls fourfold

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• Excess burden is greater the more elastic is
  demand
• if perfectly inelastic, no welfare loss
• Excess burden is greater the more elastic is
  supply
• if perfectly inelastic, no welfare loss

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Ad Valorem Taxes

• Tax on percentage of price
• sales tax
• payroll tax
• T tPG
• Excess burden ½t2(PeffQeff) .
• EsEd/(Es - Ed)

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• Welfare loss increases with square of tax rate
• Excess burden greater the more elastic is demand
• Excess burden greater the more elastic is supply

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Impact of Taxes on Distribution of Income

• Must first determine who bears the burden of a
  tax
• difference between paying a tax and bearing a tax
• all taxes are borne by persons
• businesses are not persons
• business are legal entities representing
  collections of owners, workers, customers
• businesses pay the tax but shift the burden
• borne by owners as lower returns to investment
• borne by workers as lower wages
• borne by customers as higher prices

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Tax Incidence

• Incidence is the distribution of burden
• Before we tell the effect of a tax on the
  distribution of income, we have to know its
  incidence

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• Seller bears burden to extent that supply is
  inelastic
• Buyer bears tax to extent that demand is
  inelastic
• Incidence identical whether tax paid by seller or
  by buyer

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Incidence of Unit Excise Tax on Sellers
STMSCT

SMSC
PG
Buyers
T
Peff
Sellers
PN
DMSB
0
Qeff
QT
Q
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Incidence of Unit Excise Tax on Buyers

SMSC
PG
Buyers
T
Peff
Sellers
PN
DMSB
DTMSB-T
0
Qeff
QT
Q
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Equity

• Economics tells us what an efficient tax looks
  like
• Economics does NOT tell us what a fair tax looks
  like
• Two concepts of fairness MAY go part of the way
• horizontal equity
• vertical equity

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Horizontal and Vertical Equity

• Horizontal equity requires individuals in
  identical economic circumstances to pay the same
  tax
• Vertical equity requires individuals in better
  circumstances to pay more

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• what does it mean to be in the same
  circumstances?
• same income?
• any adjustment for marital status or number of
  dependents?
• health costs?
• what period?
• annual versus lifetime
• what about work/leisure choices?
• should productivity and effort be penalized?
• would consumption be better?
• income reflects what we contribute to society
• consumption is what we take out of society
• what does paying more mean?
• regressive taxes can result in richer people
  paying more
• is progressivity required?

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Taxation in the United States

• Multi-level political system
• one Federal government
• 50 state governments (plus territories)
• thousands of local governments
• counties
• municipalities
• school districts
• others

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Federal Taxes

• The Federal Personal Income Tax is the major tax
  at the Federal level
• Contributions for social insurance through
  payroll taxes is the next
• increased rapidly as percent of total from late
  50s to late 80s
• Corporate profits tax
• decreasing in importance since late 50s

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State and Local Taxes

• Sales tax is most important at state level
• Property taxes next
• steadily declining as percent of total for
  decades
• Personal income taxes
• steadily increasing

35

• Corporate profits taxes not an important source
  of revenue
• In addition to taxes, state and local governments
  receive grants-in-aid from the federal government
• about 21 of total state and local revenues

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Income Taxation in the U.S.

• Based on annual household income
• Certain forms of income left out
• unrealized capital gains
• imputed value of owner occupied housing
• income spent on charitable contributions
• income spent on state and local taxes
• employer-provided health insurance
• These exclusions violate horizontal and vertical
  equity

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• Income taxes are transparent
• you know who youre taxing
• Can be made as progressive as society wants
• greater progressivity means greater excess burden
• MTRs in U.S. from 15 for income up to about
  25,000 (41,000 married filing jointly) to 39
  for incomes over about 270,000 after exemptions
  and deductions

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• Exemptions are income exclusion for taxpayer and
  dependents
• extra exemptions for aged (over 65)
• extra exemptions for blind
• exemptions just under 3,000 each
• exemptions phased out for very high incomes

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• Deductions
• exclusions from income for certain expenses
• mortgage interest
• state and local income and property taxes
• unusually large medical expenses
• charitable contributions
• moving expenses
• large employee expenses
• casualty losses

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• most taxpayers take the standard deduction
• standard deduction more than most taxpayers
  totals for regular deductions
• exemptions and standard deduction a way to ensure
  that the very poor pay no tax
• in effect, a zero tax bracket
• Income taxes potentially easy to administer
• U.S. Federal Income Tax very costly because of
  all the loopholes (ways to avoid tax)

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• Enforcement cost high
• making sure that tax properly calculated
• Compliance cost high
• costly for taxpayers to determine what their
  taxes are

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Corporation Income Tax

• Tax on the profits of corporations
• corporations are firms in which the investors
  liability is limited to the amount of investment
• Essentially a flat tax of 35 on profits
• revenues minus wages, materials, interest paid,
  and depreciation
• dividend payments not deductible

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• Corporation taxes suffer from a lack of
  transparency
• very hard to tell who bears the burden
• owners of capital in the form of lower returns
• workers in the form of lower wages
• consumers in the form of higher prices
• only thing that is certain is that the firm bears
  none of it
• only people pay taxes
• It is unlikely that the tax satisfies horizontal
  and vertical equity

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Payroll Taxes in the U.S.

• Employee pays 7.65 on first 70,000 wages
  (approximately)
• ceiling indexed to inflation
• set to 65,400 in 1997
• Employer matches
• Total of 15.3

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• The tax is regressive
• non-wage income escapes taxation
• generally it is the rich who have non-wage income
• after wage rises above ceiling, payroll tax drops
  to 2.9
• Lacks transparency
• burden of the tax the same whether paid by
  employee or employer
• only depends on elasticities of labor supply and
  demand
• labor supply in U.S. is almost perfectly
  inelastic
• thus workers bear the whole burden

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U.S. Payroll Tax
SLSupply of labor DLDemand for labor DNDemand
net of employee tax D Demand net of employer
tax TBTax on employer at equilibrium TETax on
employee at equilibrium

SL
A
W1
TB
W2
B
TE
W3
C
DL
DDL-TB
DN
0
Labor
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• The demand for labor without tax is DL.
• based on labor productivity
• Employer now pays tax, shifting demand down to D
• Out of any gross wage along D employee pays tax,
  so DN is the employees wage net of tax

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Retail Sales Tax

• Major source of revenue at state level
• Different for each state
• leads to distortions that are especially bad near
  borders when sales tax rates are different
• Flat rate based on final consumer expenditures
• in practice, not general
• services usually excluded

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• Generally regressive as expenditures as
  proportion of income greater for the poor than
  the rich
• Regressivity has led some states to exempt food

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Property Taxes

• A tax on certain forms of wealth
• Real property tax a major source of revenue at
  local level
• Reduces return to capital
• Rate differentials cause locational distortions
• Overall incidence more or less proportional