Chapter 22 The Public Sector

1. Chapter 22The Public Sector • Key Concepts • Summary • Practice Quiz • Internet Exercises ©2000 South-Western College Publishing

2. In this chapter, you will learn to solve these economic puzzles: Is a flat tax fair? How does the Social Security tax favor the upper-income worker? Should we replace the income tax with a national sales tax or a flat tax? How does the tax burden of the United States compare to other countries?

3. What is the purpose of this chapter? To examine public-sector decisions of politicians, government bureaucrats, voters, and special interest groups

4. What has happened to the size of Government? Since the 1950’s, government expenditures have grown from about one-quarter to over one third of GDP

5. Government Expenditures 1935 - 1998 50% 45% Total government expenditures 40% 35% 30% 25% State & Local Gov. Expenditures 20% 15% 10% Federal government expenditures 5% Year 45 50 00 55 60 65 70 75 80 85 90 95 40 35

12. How do taxes in the U.S. compare to taxes in other countries? U.S. citizens are among the most lightly taxed people in the industrialized world

14. 45 50 55 60 65 70 75 80 85 90 95 40 35 Growth in Taxes in the U.S., 1935 - 1998 50% 45% Total government taxes 40% 35% 30% 25% State & Local Gov. Taxes 20% 15% 10% Federal government taxes 5% Year 00

15. How does the Government decide which tax is appropriate? Benefits received Ability to pay

16. What is the Benefits Received Principle? The concept that those who benefit from government expenditures should pay the taxes that finance their benefits

17. What is the Ability to Pay Principle? The concept that those who have higher incomes can afford to pay a greater proportion of their income in taxes, regardless of the benefits

18. Which principle dominates in the U.S.? The ability-to-pay principle dominates the benefits-received principle

19. What is aProgressive Tax? A tax that charges a higher percentage of income as income rises

20. What is theAverage Tax Rate? Total tax due divided by total taxable income

21. What is theMarginal Tax Rate? The change in taxes due divided by the change in taxable income

22. What is aRegressive Tax? A tax that charges a lower percentage of income as income rises

23. What is aProportional Tax? A tax that charges the same percentage of income, regardless of the size of income

24. What is a Flat Rate Tax? Same as a proportional tax

25. Federal Individual Income Tax Rate Schedule for a Single Taxpayer, 1998 Taxable Income Marginal Tax Rate 0 — $23,350 15.0% $23,350 — $61,400 28.0% 31.0% $61,400 — $128,100 $128,100 — $278,450 36.0% 39.6% $278,450 + —

26. What isPublic Choice Theory? The analysis of the government decision-making process to allocate resources

27. Who is James Buchanan? The founder of public choice theory which applies economic analysis to politics

28. What is theBenefit - Cost Analysis? The comparison of the additional rewards and costs of an economic alternative

29. What is the basic Rule of Benefit-cost Analysis? A firm will produce additional units as long as marginal benefit exceeds the marginal cost

30. Why might Government be Inefficient in solving Society’s Problems? • Majority rule problem • Special interest effect • Rationale ignorance • Bureaucratic inefficiency • Shortsightedness effect

31. What is theMajority Rule Problem? Voting can lead to a rejection of projects with marginal total benefits exceeding the marginal cost

32. Can Majority Rule lead to inefficient solutions? Yes, “one person one vote” cannot measure the intensity of voters’ preferences as well as the market

33. What is the Special-Interest Group Effect? Special-interest groups can create government support for programs with costs out-weighing their benefits

34. Why can Special-Interest Voting be inefficient? A small group within the society can benefit while the whole society pays the costs

35. What isRational Ignorance? The voters choose to remain uninformed because the marginal cost of obtaining information is higher than the marginal benefit from knowing it

36. What is Bureaucratic Inefficiency? The bureaucracy may become more powerful than elected officials

37. What is the Shortsightedness Effect? Democracy has a bias toward programs offering clear benefits and hidden costs

38. Key Concepts

39. Key Concepts • What has happened to the size of Government? • How do taxes in the U.S. compare to other countries? • What is the Benefits Received Principle? • What is the Ability to Pay Principle? • What is a Progressive Tax?

40. Key Concepts cont. • What is the Marginal Tax Rate? • What is a Regressive Tax? • What is a Proportional Tax? • What is the Majority Rule Problem? • What is the Special-Interest Group Effect? • What is Rational Ignorance? • What is Bureaucratic Inefficiency? • What is the Shortsightedness Effect?

41. Summary

42. Government expenditures represented a rising share of GDP from the 1950’s to 1985 compared to private-sector spending. The major source of the growth in the public sector is transfer programs, officially tabulated in a category called income security. After 1985, government outlays decreased as a percentage of GDP.

43. Government Expenditures 1935 - 1998 50% 45% Total government expenditures 40% 35% 30% 25% State & Local Gov. Expenditures 20% 15% 10% Federal government expenditures 5% Year 45 50 00 55 60 65 70 75 80 85 90 95 40 35

44. Federal tax revenues are the primary source of revenue for all federal government units. The most important taxes at the federal level are the individual income tax and payroll taxes. Although not a tax revenue, borrowing has become the federal government’s third largest method of collecting funds.

45. 45 50 55 60 65 70 75 80 85 90 95 40 35 Growth in Taxes in the U.S., 1935 - 1998 50% 45% Total government taxes 40% 35% 30% 25% State & Local Gov. Taxes 20% 15% 10% Federal government taxes 5% Year 00

46. State and local government tax revenues consist primarily of sales and property taxes. While states rely on income taxes for revenue, they also collect sales and excise taxes. In addition, state budgets depend greatly on charges and revenue-sharing grants from the federal government.

47. Local governments collect most of their tax revenue from property taxes, but the majority of their receipts are from charges and grants from the federal and state governments.

48. The taxation burden, measured by taxes as a percentage of GDP, is lighter in the U.S. than many other advanced industrial countries. Since 1960, federal taxes have remained a fairly constant fraction of GDP. State and local taxes, however, have generally increased as a percentage of GDP since the 1950’s

50. The benefits-received principle and the ability-to-pay principle are the two basic philosophies of taxation fairness. The gasoline tax is a classic example of the benefits-received principle because users of the highways pay the gasoline tax. Progressive income taxes follow the ability-to-pay principle because there is a direct relationship between the average tax rate and income size.