GOVERNMENT, SPENDING, TAXATION, AND DEFICITS

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Chapter 10

• GOVERNMENT, SPENDING, TAXATION, AND DEFICITS

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1. No Market Test for Government Spending

• Rule Any economic activity will be carried out
  as long as its marginal benefits exceed its
  marginal costs (Private/Public)
• A market test ensures that private goods and
  services yield benefits equal to or greater than
  their costs.
• Government spending is carried out by 87,000
  federal, state and local governments in the U.S.

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1. No Market Test for Government Spending cont.

• Exhaustive expenditures are government purchases
  that divert resources from the private sector,
  making them no longer available for private use.
  (Ex. A local government hires a police officer or
  repairs a road).
• Transfer payments transfer income from one
  individual or organization to another. (Ex.
  Payments to families with dependent children
  transfer income taxpayers to poor families).
• The Social Security transfer program transfers
  income from currently employed workers to retired
  or disabled workers.

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2. Taxation

• Government rarely sells its goods or services.
• Except in rare cases, government programs must be
  financed through taxes.

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2.1 Principles of Taxation

• The benefit principle of taxation argues that
  those who benefit from a public expenditure
  program should pay for the program.
• Two basic advantages 1) People who do not
  benefit do not pay (non-drivers taxed to build
  roads). 2) Benefit taxes are more likely to
  ensure that benefits equal or outweigh the costs.
  
• Disadvantage difficult to determine who
  benefits, who benefits from police protection,
  national defense, etc.

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2.1 Principles of Taxation cont.

• The ability-to-pay principle of taxation states
  that those better able to pay should bear the
  greater burden of taxation, whether or not they
  benefit.
• The rich should bear a heavier responsibility for
  public schools, national defense, etc. as they
  are better able to pay than the poor.
• Negative those who work harder and earn more are
  penalized by having to pay more for government
  programs that benefit others.

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2.2 Taxes and Private Decision Making

• Experts and politicians have long debated whether
  taxes should be
• Neutralaffect private decision making as little
  as possible.
• Used to promote social goals.
• Most governments use taxes designed to affect
  private behavior.

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2.2.1. Progressive and Regressive Taxes

• With a proportional tax, taxpayers earning
  different incomes pay the same percentage of
  their income as taxes.
• With a progressive tax, higher-income taxpayers
  pay a higher percentage of their income as taxes.
  (Distributes income from rich to poor).
• With a regressive tax, high-income taxpayers pay
  a smaller percentage of their income as taxes.

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2.2.2 Marginal Tax Rates

• The marginal tax rate is the ration of the
  increase in taxes to the increase in income.
• A marginal tax rate of 50 percent means that for
  every extra dollar earned, 50 cents goes to taxes
  and the remaining 50 cents stays with the
  taxpayer as after-tax income.
• The marginal tax rate can have an effect on work
  effort.

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2.3 Government Revenues

• The federal government raises 1.6 trillion of
  its 1.9 trillion in revenues from personal
  income taxes and payroll (Social Security) taxes.
• The federal government collects the relatively
  small remainder of its revenue in the form of
  corporate profit taxes and sales taxes.
• State and local governments collect most of their
  revenues through sales taxes, which tend to be
  regressive.

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2.4 The Size of Government

• The most common measure of the size of government
  is governments share of total spending of the
  entire economy.
• In the year 2002, government in the U.S. accounts
  for more than 30 percent of all spending.
• United States spend less in the economy versus
  other affluent countries they have to collect
  enormous amounts for social security.

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3. The Federal Budget

• Special attention needs to be given to the budget
  of the federal government.
• The spending and taxation of state and local
  government are diffused and uncoordinated they
  are thus beyond the control of national
  policymakers.
• The federal government, on the other hand, are
  subject to control by the federal executive and
  legislative branches they regulate the pace of
  economic activity.

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3.1 Deficits and Debt

• The federal budget runs a deficit if federal
  expenditures exceed federal tax collections and
  other revenues.
• The national dept is the total of outstanding
  federal government IOUs (outstanding government
  bonds).
• The Burden of the Debt on Different Generations
  Example
• National debt is internal if it is owed to the
  citizens of the country. It is external if it is
  owed to citizens of other countries.

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2.2 Problems of Deficit Reduction

• Politicians, economists, and the general public
  favor deficit reduction.
• Why is it so difficult to achieve a balanced
  budget in the last quarter-century?
• 75 percent of all federal government spending is
  for relatively uncontrollable expenses.

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2.2 Problems of Deficit Reduction cont.

• To cut the size of the federal deficit, federal
  revenues must be increased, federal outlays must
  be reduced, or a combination of these two.
• Everyone favors deficit reduction, few are
  willing to pay the personal price of a lower
  deficit, particularly when it comes to giving up
  spending and tax programs that are of benefit to
  themselves.
• Where did the 4 Trillion Surplus Go? Example

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4. Majority Rule The Power of the Median Voter

• The median voter is the voter whose preferences
  are such that 50 percent of the voting population
  desires less of the public good and 50 percent
  desires more of it.
• Under majority rule, the median voter determines
  the outcome and this raises three important
  questions
• Social choices need not respond to individual
  wants.
• Majority voting rules may not reflect the
  intensity of preferences.
• Majority voting need not be efficient.

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5. Logrolling

• When public choices involve multiple decisions,
  there is no assurance that majority rule will
  prevail.
• Logrolling permits the approval of projects by
  vote-trading coalitions that would be opposed by
  a majority if considered in isolation.
• Ex. A favor interstate highway, B favors a new
  ship channel, A en B coalition, each agree to
  support the others project.
• Dairy Subsidies Rational Ignorance and
  Logrolling Example

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6. Rational Ignorance

• Rational ignorance is a decision not to acquire
  additional information because the marginal costs
  exceed the marginal benefits.
• Private choices individuals inform themselves
  about the price and qualities of cars, TVs, etc.
• Public choices individuals must gather
  information about complex and confusion public
  issues, e.g. Should a new flood control project
  be build?

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6. Rational Ignorance cont.

• Special-interest groups are minority voting
  groups with intense preferences about specific
  government policies.
• Dairy farmers and domestic steel manufacturers
  are well informed about public policies that
  affect their economic well-being.
• A central problem of public choice is that
  benefits of government policies are highly
  concentrated while the costs are highly diffused.