The Government Sector: 2008 by The Mcgraw-Hill Companies, Inc. All Rights Reserved

Chapter 7
The Government Sector
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 7-1
Objectives
• Government spending
• The graphing of the C + I + G line
• Types of taxes
• The average and marginal tax rates
• Sources of government revenue
• Principles of taxation
• The economic role of government
Introduction: The Growing
Economic Role of Government
• Most of the growth over the past seven decades
was due to the Depression and World War II
• Since 1945 the roles of government at the
federal, state, and local levels have expanded
– The seeds of that expansion were sown during the
Roosevelt administration
• The government exerts four basic influences
– It spends more than $3.0 trillion
– It levies even more in taxes
– It redistributes hundreds of billions of dollars
– It regulates the economy
State and Local Government
Spending
• Main expenditures
– Education
– Health
– Welfare
• Spending is a little more than half the
level of federal spending
• Police protection and prisons are now
straining state and local budgets
Government Purchases versus
Transfer Payments
• The federal, state, and local governments
spends over $3.0 trillion a year
– GDP = C + I + G + Xn
– Approximately half are “transfer payments”
• The largest transfer payment is social security
• These payments end up in the “C” part GDP
– Approximately half are “government
purchases”
• The largest government purchase is defense
• These end up in the “G” part of GDP
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
7-7
Graphing the C + I + G Line
To keep the graph as
simple as possible, we are
assuming the government
spends a constant amount
of money regardless of the
level of disposable income
Graphing the C + I + G Line
How much is G?
Answer: 2000
The Average Tax Rate and the
Marginal Tax Rate
This is a hypothetical illustration
Income Marginal Total Average

Level Tax Rate Tax Taxes Tax Rate
Marginal Tax Rate

0 - $100 0 % 0 $0 0.0 %
Marginal Tax Rate

0 - $100 0 % $0 $0 0.0 %
$101 - $200 $10
Marginal Tax Rate

0 - $100 0 % $0 $0 0.0 %
$101 - $200 $10
Additional Taxes Paid ( $10)

MTR = -------------------------------- ----------
Additional Taxable Income ($100)
Marginal Tax Rate

0 - $100 0 % $0 $0 0.0 %
$101 - $200 10 % $10

MTR = -------------------------------- ----------
Marginal Tax Rate

0 - $100 0 % $0 $0 0.0 %
$101 - $200 10 % $10

MTR = -------------------------------- ----------
The Marginal Tax Rate (MTR) is the rate you pay on the last
dollars you earned
Marginal Tax Rate

0 - $100 0 % $0 $0 0.0 %
$101 - $200 10 % $10 $10
Marginal Tax Rate

0 - $100 0 % $0 $0 0.0 %
$101 - $200 10 % $10 $10
Total Taxes Paid ( $10)

ATR = -------------------------------- ----------
Entire Income ($200)
Marginal Tax Rate

0 - $100 0 % $0 $0 0.0 %
$101 - $200 10 % $10 $10 5.0 %

ATR = -------------------------------- ----------
Marginal Tax Rate

0 - $100 0 % $0 $0 0.0 %
$101 - $200 10 % $10 $10 5.0 %

ATR = -------------------------------- ----------
Marginal Tax Rate

0 - $100 0 % $0 $0 0.0 %
$101 - $200 10 % $10 $10 5.0 %

ATR = -------------------------------- ----------
The Average Tax Rate (ATR) is the overall rate you pay on
your entire income
Marginal Tax Rate

0 - $100 0 % $0 $0 0.0 %
$101 - $200 10 % $10 $10 5.0 %
$201 - $300 12 % $12 $22 7.3 %
Marginal Tax Rate

0 - $100 0 % $0 $0 0.0 %
$101 - $200 10 % $10 $10 5.0 %
$201 - $300 12 % $12 $22 7.3 %
$301 - $400 15 % $15 $37 9.3 %
Marginal Tax Rate

0 - $100 0 % $0 $0 0.0 %
$101 - $200 10 % $10 $10 5.0 %
$201 - $300 12 % $12 $22 7.3 %
$301 - $400 15 % $15 $37 9.3 %
$401 - $500 28 % $28 $65 13.0 %
Marginal Tax Rate

0 - $100 0 % $0 $0 0.0 %
$101 - $200 10 % $10 $10 5.0 %
$201 - $300 12 % $12 $22 7.3 %
$301 - $400 15 % $15 $37 9.3 %
$401 - $500 28 % $28 $65 13.0 %
$501 - $600 50 % $50 $115 19.2 %
Marginal Tax Rate

0 - $100 0 % $0 $0 0.0 %
$101 - $200 10 % $10 $10 5.0 %
$201 - $300 12 % $12 $22 7.3 %
$301 - $400 15 % $15 $37 9.3 %
$401 - $500 28 % $28 $65 13.0 %
$501 - $600 50 % $50 $115 19.2 %
> $600 80 %
Types of Taxes
• Direct tax
– A tax with your name on it
• Indirect tax
– A tax on things
Types of Taxes
• Progressive taxes
– Places a greater burden on those best able to pay
and little or no burden on the poor
• Proportional taxes
– Places an equal burden on the rich, the middle class,
and the poor
• Regressive taxes
– Places a heavier burden on the poor than on the rich
Nominally Progressive,
Proportional, and Regressive
Taxes
Sources of Federal Revenue
• Personal Income Tax
– The personal income tax is the largest source
of federal revenue
– Accounts for 44 percent of all federal tax
revenue
– Low income people pay little or no federal
income tax
• This means in general the middle class and the
rich pay nearly all federal taxes
Federal Personal Income Tax:The Top Marginal Tax Rate, 1954-2006
Top Marginal Tax Rates
• The Personal Income tax

• Individual personal income taxes account for
44 percent of all federal tax revenue
• In general, the middle class and the rich pay
nearly all federal income taxes
• The federal personal income tax is considered
progressive because the burden falls mainly on
the upper middle class and the rich
• The Social Security and Medicare taxes are the

Payroll Tax
• What you pay is matched by your employer
• The social security tax by law is set at 6.2%
with a wage based limitation of $94,200
• The inflation rate of the previous year raises the wage base
• The Medicare tax of 1.45% applies to all wages
and salaries. There is no wage based limitation.
Income such as rental income, interest,
dividends, and profit is exempt
• You pay 6.2% in payroll tax on wages up to
$94,200 and 1.45% on all wages and salaries
– This means the rich whose income is primarily from
rental income, interest, dividends, and profits pay
no payroll taxes on money from these sources
• The Payroll Tax is the fastest growing source of
federal revenue
– Today, 3/4th of all taxpayers pay more in social
security taxes than in federal income tax
• Think about it . . . only a tiny fraction of the
income of the rich goes to payroll taxes
The Incidence of the Social Security Tax at Various
Income Levels
Level of Earned Income Taxes Paid Average Tax Rate

$ 10,000 $ 620.00 6.2%
94,200 5,840.40 6.2%
100,000 5,840.40 5.84%
1,000,000 5,840.40 0.58%
Note: The current social security tax by law is set at

6.2% with a wage based limitation of $94,200
The Corporate Income Tax
• The corporate income tax is a tax on a
corporation’s profits
– The maximum rate is 35%, however loopholes allow
most corporations to pay significantly lower rates
than the maximum rate
– Corporate income taxes are just 3% of all federal
tax revenue
• All corporations earning profits of at least
$335,000 are to pay an average tax rate of 35%
– But loopholes in the tax law allow many
corporations to pay much lower taxes
Excise Taxes
• An excise tax is a sales tax aimed at
specific goods and services
• Accounts for about 4 percent of federal
revenue
• Most excise taxes are levied by the
federal government
– State and local governments often levy taxes
on the same items
Excise Taxes
• Excise taxes tend to reduce consumption

of certain products of which the federal
government takes a dim view
• Excise taxes are usually regressive
The Estate Tax
• The estate tax is a tax on the estates of
people when they die
– It is a graduated tax that rises to 55%
• It is levied only on estates valued at $1,000,000 or
more
– More than 90% of estate taxes are paid by
people with incomes above $200,000 a year
at the time of death
Top Marginal Income Tax Rates in 9
Leading Wealthy Nations, 2003
Sources of State and Local Tax
Revenue
• Personal income tax
– Accounts for about half of all state revenue
• Sales Tax
– Is a source of almost half of all taxes collected by the
states
– Is a highly regressive tax
• Property taxes
– Provides 80 percent of all local tax revenue
– Can influence business decisions about where to
locate
The State and Local Fiscal
Dilemma
• Since World War II, state and local governments have
been expected to provide an increasing number of
services
– Most notable are health, welfare, education, police protection
and prisons
• In 2003 states increased tuition at public colleges, cut
Medicaid eligibility and benefits, and laid off state
employees
– In addition localities spent billions of dollars on new security
measures without receiving any federal assistance
• Unfunded mandates
– The Federal government often places obligations on states
without providing the money to pay for them
The State and Local Fiscal
Dilemma
• Neighboring states and local
governments are in direct competition
with one another for tax dollars
– If one government’s tax rates rise too far
above the levels of its neighbors, it citizens
will vote with their feet
Government Tax Rates as a Percentage of GDP, 1929 and 2005
Economic Report of the President, 2003
Tax Rates are about

two and a half times as
high as they were in
1929
Tax Receipts as a Percentage of GDP in the United States and
Selected Western European Countries, 2004
Organization for Economic Cooperation and Development
Economic Role of Government
• Provision of Public Goods and Services
• Redistribution of Income
• Stabilization
• Economic Regulation
Provision of Public Goods and
Services
• Some examples
– Defense of the country
– Maintenance of internal order
– A nationwide highway network
– Provision of a money supply
– Public education
– Running the criminal justice system
– Environmental protection
Redistribution of Income
• The government does redistribute hundreds of
billions of dollars every year
– Social security redistributes money from those
currently working to those who have retired
– Welfare for the poor
• Examples are food stamps, Medicaid, disability payments,
and unemployment benefits
– Welfare for the rich
• Examples are subsidies to corporate farmers and tax
breaks for defense contractors, oil companies, and other
large corporations
Stabilization
• Two basic goals of the federal
government
– Stable prices with little or no inflation
– Low unemployment
• An economic rate of growth high enough to keep
the unemployment rate to a minimum
Economic Regulation
• The government provides the economic rules of
the game
– This must be done within the social and political
context in which the economy operates
• The government must allow individuals and business firms
to operate with the maximum degree of freedom
• There is little agreement as to how far economic freedom
may be extended without interfering with society as a
whole or the economic rights of specific individuals or
business firms
Adam Smith’s Dos and Don’ts
• Do
– Protect society from the violence and
invasion of other countries
– Establish an exact administration of justice
– Erect and maintain certain public works and
institutions where private enterprise could
not profit from doing so
• Don’t do anything else
Conclusion
• Until the 1930s, the federal government more
or less followed the role prescribed by Adam
Smith
• The government’s economic role has expanded
tremendously these last seven decades
• It will probably continue to grow into an even
more monolithic all-powerful colossal Big-
Brother in the coming years
Will Social Security
be There for You?
• Currently, the federal government is receiving $150
million more in Social Security Taxes than it is paying
out
– This surplus is deposited in the Social Security trust (trust me)
fund
– How ever, the surplus is spent by the government each year to
off set its deficits
– The US Treasury places I.O.U.s, (government securities) in the
Social Security trust fund
• In essence, the right hand (general fund) gives the left hand
(social security trust fund) an I.O.U. and spends the money
• This fund consist consists of trillions of dollars of government
securities (I.O.U.s . . . they have been doing this for decades)
be There for You?
• The Looming Crises
– In 2011, the baby boomers (born between 1946 and
1964) will be retiring
– This means the annual social security surplus which
is being spent by the government and replaced by an
I.O.U. will disappear
– Social Security checks will then have to be paid out
of the government’s general fund
• The government will have to make good on its I.O.U.s by
selling the government securities in the social security trust
fund (borrowing the money)
• However, the trust fund I.O.U.s will run out around 2042!
be There for You?
• The Looming Crises
– The government will borrowing hundreds of billions
of dollars by selling the government securities in the
trust fund (I.O.U.s) to pay social security recipients
• Selling government securities is simply borrowing money
from the people who buy them
• These I.O.U.s will be gone by 2042
– Financing the social security system by borrowing
money will be on top of financing an already huge
and growing federal budget deficit
– This will push up interest rates and possibly
precipitate a financial collapse of unprecedented
proportions unless strong measures are taken now
to raise social security taxes and lower benefits
Social Security is the Good News
the Bad News is Medicare
• Medicare is even more seriously under
funded than Social Security
• By 2018 Medicare spending will surpass
Social Security spending
– Remember all those retiring baby boomers?
• Medicare is much more complex than
Social Security
Big government, like rock ‘n’ roll, is here to stay.
But can the politician’s song and dance match
Medicare & Social Security’s tunes?

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Chapter 7

The Government Sector

Income Marginal Total Average

Income Marginal Total Average

Income Marginal Total Average

Income Marginal Total Average

Additional Taxes Paid ( $10)

Income Marginal Total Average

Additional Taxes Paid ( $10)

Income Marginal Total Average

Additional Taxes Paid ( $10)

Income Marginal Total Average

Income Marginal Total Average

Total Taxes Paid ( $10)

Income Marginal Total Average

Total Taxes Paid ( $10)

Income Marginal Total Average

Total Taxes Paid ( $10)

Income Marginal Total Average

Total Taxes Paid ( $10)

Income Marginal Total Average

Income Marginal Total Average

Income Marginal Total Average

Income Marginal Total Average

Income Marginal Total Average

• The Personal Income tax

• The Social Security and Medicare taxes are the

Level of Earned Income Taxes Paid Average Tax Rate

Note: The current social security tax by law is set at

• Excise taxes tend to reduce consumption

Tax Rates are about

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