Copyright 2011 by Pearson Education, Inc. Chapter 6 Funding the Public Sector All rights reserved. Introduction In recent years, various U.S. politicians and pundits have called for boosts in tax rates for higher-income individuals and tax cuts for middle- and lower-income individuals How much should income tax rates vary across households based on their incomes? Are tax rates currently low for higher-income households relative to those faced by lower-income households? To evaluate these questions, you must understand more about the structure of tax systems 6-2 Learning Objectives Distinguish between average tax rates and marginal tax rates Explain the structure of the U.S. income tax system Understand the key factors influencing the relationship between tax rates and the tax revenues governments collect 6-3
Learning Objectives Explain how the taxes governments levy on purchases of goods and services affect market prices and equilibrium quantities Understand how the Social Security system works and explain the nature of the problems it poses for today s students 6-4 Chapter Outline Paying for the Public Sector Systems of Taxation The Most Important Federal Taxes Tax Rates and Tax Revenues Taxation from the Point of View of Producers and Consumers Financing Social Security 6-5 Did You Know That... Since 1986, Congress has added 3 million words in 14,000 amendments to U.S. tax laws? To obtain all the funds required to finance their operations, governments collect taxes from many different sources (property tax, sales tax, income tax, etc), hence the numerous words written into a variety of statutes 6-6
Paying for the Public Sector Three sources of government funding 1. Fees, or user charges 2. Taxes 3. Borrowing 6-7 Paying for the Public Sector Government Budget Constraint The limit on government spending and transfer payments Imposed by the fact that every dollar spent must be provided for by taxes 6-8 Policy Example: California Makes Payments with IOUs Instead of Cash In 2009, the state of California began issuing its own IOUs, known as registered warrants, when its indebtedness exceeded its capacity to make payments California s registered warrants are borrowings against future tax receipts, issued in a state of emergency to enable the state of California to satisfy its government budget constraint 6-9
Systems of Taxation Tax Base The value of goods, services, wealth, or incomes subject to taxation Tax Rate The proportion of a tax base that must be paid to a government as taxes 6-10 Policy Example: The Same Tax Rate, but Different Tax Bases for Different People City and county governments in Florida collect property taxes by applying a tax rate to assessed valuations of structures and surrounding properties Florida permits municipalities to establish a dualbracket system, which allows seasonal residents to be taxed at a higher rate than permanent residents Why do you suppose Florida chooses to value properties of permanent residents lower than those of seasonal residents? 6-11 Systems of Taxation Marginal Tax Rate The change in the tax payment divided by the change in income Marginal tax rate = Change in taxes due Change in taxable income 6-12
Systems of Taxation Tax Bracket A specified interval of income to which a specific and unique marginal tax rate is applied Average Tax Rate The total tax payment divided by total income 6-13 Systems of Taxation Proportional Taxation A tax system in which, regardless of an individual s income, the tax bill comprises exactly the same proportion 6-14 Systems of Taxation Proportional taxation Marginal tax rate = Average tax rate Income Rate Tax liability $10,000 20% $2,000 $100,000 20% $20,000 6-15
Systems of Taxation Progressive Taxation A tax system in which, as income increases, a higher percentage of the additional income is paid as taxes 6-16 Systems of Taxation Progressive taxation: income tax Marginal tax rate > Average tax rate Income Rate Tax liability $0 $10,000 5% $500 $10,001 $20,000 10% $1,000 $20,001 $30,000 30% $3,000 $4,500 6-17 Systems of Taxation Regressive Taxation A tax system in which as more dollars are earned, the percentage of tax paid on them falls 6-18
Systems of Taxation Regressive taxation: Social Security Marginal tax rate < Average tax rate Income Rate Tax liability $50,000 10% $5,000 $100,000 5% $5,000 6-19 Policy Example: Millionaire Taxes Become the New Government Fad In the mid-2000s, California established a special 1 percent income-tax surcharge on people earning more than $1 million per year Shortly thereafter, New Jersey applied a similar tax surcharge for a special millionaire income-tax bracket, but decided that millionaires were people earning more than $500,000 per year 6-20 Policy Example: Millionaire Taxes Become the New Government Fad (cont d) A few years later, New York government officials established a millionaire tax surcharge to people earning more than $300,000 per year By the late 2000s, the idea of a millionaire tax surcharge was catching on in Washington, D.C., where House representatives introduced bills to apply millionaire federal-income-tax surcharges on annual incomes above $280,000 6-21
The Most Important Federal Taxes Question What types of taxes do federal, state and local governments collect? Answers Federal government: individual income taxes, corporate income taxes, Social Security taxes, import and excise taxes State and local governments: sales taxes, property taxes, personal and corporate income taxes 6-22 Figure 6-1 Sources of Government Tax Receipts 6-23 The Most Important Federal Taxes The federal personal income tax Accounts for about 43.6% of all federal revenue All U.S. citizens, resident aliens, and most others required to pay (includes income earned abroad) Rates paid rise as income increases 6-24
Table 6-1 Federal Marginal Income Tax Rates 6-25 The Most Important Federal Taxes Arguments for the progressive tax Redistribution of income Ability to pay Benefits received Counterargument No strong evidence of redistribution 6-26 International Example: Defying One Agency, Illegal Immigrants Pay Taxes to Another Most estimates suggest that between 10 million and 15 million illegal immigrants reside in the United States, or 1 out of every 20 U.S. workers The Department of Homeland Security tries to keep illegal immigrants out Meanwhile, the Internal Revenue Service is making it easy for illegal immigrants to pay federal income taxes by obtaining a special taxpayer identification number that begins with a 9 6-27
The Most Important Federal Taxes Capital Gain The positive difference between the purchase price and the sale price of an asset You buy a share of stock for $5 and sell for $15: you have a capital gain of $10 Capital Loss The negative difference between the purchase price and the sale price of an asset 6-28 The Most Important Federal Taxes The corporate income tax Accounts for 12% of federal tax revenue and 2% of all state and local taxes collected Corporations are generally taxed on the difference between total revenues and expenses 6-29 Table 6-2 Federal Corporate Income Tax Schedule 6-30
The Most Important Federal Taxes Double taxation Corporation pays taxes on its profits Corporation declares a dividend on after-tax profits Dividend income is taxed 6-31 The Most Important Federal Taxes Retained Earnings Earnings that a corporation saves, or retains, for investment in other productive activities Earnings that are not distributed to stockholders Tax Incidence The distribution of tax burdens among various groups in society 6-32 The Most Important Federal Taxes Who really pays the corporate income tax? Tax incidence is distributed among Consumers Stockholders Employees 6-33
The Most Important Federal Taxes Social Security taxes Social Security rates today are imposed on earnings up to roughly $105,000 Contributions are 6.2% for employers and 6.2% for employees 6-34 The Most Important Federal Taxes Unemployment taxes Paid by employer 0.6% of first $7,000 of wages for employees earning more than $1,500 States may levy an additional tax up to 3% based on record of the employer 6-35 Tax Rates and Tax Revenues State and local governments Taxes imposed on goods and services yield more revenues than income taxes A fundamental issue is how to set tax rates to extract the largest possible payments 6-36
Tax Rates and Tax Revenues Sales Taxes Taxes assessed on the prices paid on a large set of goods and services Ad Valorem Taxation Assessing taxes by charging a tax rate equal to a fraction of the market price of each unit purchased 6-37 Tax Rates and Tax Revenues Static Tax Analysis Based on the assumption that changes in the tax rate leave the tax base unaffected Dynamic Tax Analysis Recognizes that higher tax rates may shrink the tax base 6-38 Tax Rates and Tax Revenues If the disincentive effects of higher tax rates are small, static analysis may give a fairly accurate estimate of the change in tax revenues resulting from a tax rate change As tax rates escalate, members of the public have a greater incentive to remove their activities from the tax base; a dynamic analysis would be necessary to determine the overall effect on government revenues 6-39
Figure 6-2 States with the Highest and Lowest Sales Tax Rates 6-40 E-Commerce Example: North Carolina Confronts the Logic of Dynamic Tax Analysis During the economic downturn of the late 2000s, steep reductions in incomes and consumer spending caused the income and sales tax bases of U.S. state governments to plummet The state of North Carolina attempted to boost its sales tax by implementing a law that requires Amazon, an Internet retailer, to collect sales taxes on all sales in that state Amazon responded by ending all sales through its affiliate program with residents in North Carolina, which caused the tax-base expansion that North Carolina had sought to achieve to disappear 6-41 Tax Rates and Tax Revenues Maximizing tax revenues Dynamic tax analysis predicts ever-higher tax rates bring about declines in the tax base At sufficiently high rates the government s tax revenues begin to fall off 6-42
Figure 6-3 Maximizing the Government s Sales Tax Revenues 6-43 International Policy Example: How Iceland Slashed a Tax Rate and Boosted Tax Revenues During the 1990s and 2000s, the Icelandic government gradually cuts in its corporate income tax rate from an initial rate of 45 percent to the current rate of 18 percent In the process, the government s inflation-adjusted revenues from corporate income taxation more than doubled 6-44 Taxation from the Point of View of Producers and Consumers Excise Tax A tax levied on purchases of a particular good or service Unit Tax A constant tax assessed on each unit of a good that consumers purchase 6-45
Taxation from the Point of View of Producers and Consumers Excise taxes on gasoline become added costs of production This shifts the supply curve up by the amount of the unit tax Consequently, the equilibrium price of gasoline rises and the equilibrium quantity declines 6-46 Figure 6-4 The Effects of Excise Taxes on the Market Supply and Equilibrium Price and Quantity of Gasoline 6-47 Taxation from the Point of View of Producers and Consumers Who Pays the Tax? In our example, the price that each consumer pays is $0.30 per gallon higher Therefore, consumers pay three-fourths of the excise tax and producers absorb the remainder 6-48
Financing Social Security Today s seniors are beneficiaries of rapidly increasing levels of federal spending Probably half of all federal spending will go to the elderly by 2025 Medicare and Social Security 6-49 Financing Social Security Social Security was founded in 1935, as the United States was recovering from the Great Depression Means of guaranteeing a minimum level of pension benefits Early recipients had high rates of return on their Social Security contributions 6-50 Financing Social Security Social Security Contributions Mandatory taxes paid out of workers wages and salaries Rate of Return Proportional annual benefit that results from making an investment Inflation-Adjusted Return Measured in terms of real goods and services, after effects of inflation taken out 6-51
Figure 6-5 Private Rates of Return on Social Security Contributions, by Year of Retirement 6-52 Financing Social Security Social Security faces Slow growth in membership Less workers per retiree Negative rates of return Benefits exceeding taxes 6-53 Financing Social Security What Will it Take to Salvage Social Security? There are five options to consider 1. Raise taxes 2. Reduce retirement benefit payouts 3. Reduce disability payments 4. Reform immigration policies 5. Find a way to increase the rate of return 6-54
Financing Social Security (cont d) Raise taxes increase the rate or expand the base Reduce benefit payouts Increase the eligibility age Cut benefits to nonworking spouses Introduce means testing 6-55 Financing Social Security Reduce disability benefits Tighten requirements, or separate the disability benefit from the Social Security system Reform immigration policies Changes in laws could offer hope of dealing with tax burdens and workforce shrinkage 6-56 Financing Social Security Increase Social Security s rate of return Inflation-adjusted return available on stocks 7 9% since the 1930s Uncertainty of returns Political pressure 6-57
Figure 6-6 Projected Social Security Rates of Return for Future Retirees 6-58 Issues and Applications: Progressive Income Taxation in the United States Just how progressive is the current U.S. income tax system? The average tax rate for the lower half of the income distribution of taxpayers is about 3% The average tax rate paid by those in the top half of income earners paying taxes is more than 10% higher 6-59 Issues and Applications: Progressive Income Taxation in the United States The tax rate rises as incomes increase, so the U.S. income-tax system is clearly progressive in the upper range of incomes Lower income people typically pay a very small share of the total tax payments The U.S. has a progressive tax system 6-60
Figure 6-7 Average Tax Rates and Shares of U.S. Federal Income Taxes for Different Income Groups 6-61 Summary Discussion of Learning Objectives Average tax rates versus marginal tax rates Average tax rate is the ratio of total tax payments to total income Marginal tax rate is the change in tax payments, induced by a change in total taxable income: applies to the last dollar earned 6-62 Summary Discussion of Learning Objectives The U.S. income tax system taxes personal and business income A tax system is progressive when marginal tax rate increases as income rises Contrasts with regressive system, in which higher-income earners pay lower marginal tax rates Under proportional taxation, the marginal and average rate are equal 6-63
Summary Discussion of Learning Objectives The relationship between tax rates and tax revenues Static tax analysis assumes that the tax base does not respond significantly to an increase in the tax rate Dynamic tax analysis reveals how an increase in the tax rate causes the tax base to decline 6-64 Summary Discussion of Learning Objectives How taxes on purchases of goods and services affect market prices and quantities A tax collected from the seller of a good will shift the supply curve up To the extent that the price rises, consumers pay a portion of the tax and sellers pay the remainder 6-65 Summary Discussion of Learning Objectives How Social Security works and why it poses problems for today s students Social Security benefits are paid from current taxes The current schedule of benefits for retirees will be an overwhelming tax burden for future generations 6-66
Summary Discussion of Learning Objectives What will it take to salvage Social Security? 1. Raise taxes 2. Reduce retirement benefit payouts 3. Reduce disability payments 4. Reform immigration policies 5. Find a way to increase the rate of return 6-67