Chapter 4

1. Chapter 4 The U.S. Economy: Private and Public Sectors

2. Overview In this chapter we will look at some facts about the US economy. We will do this by looking at the sectors that we call the public and private sectors. The private sector is usually broken down into households and businesses. The public sector could be broken down into local, state and national governments. The four major players of the economic game from a macroeconomic perspective are households, businesses, governments and the rest of the world.

3. Income Received Analogy: Each of you will earn a certain number of points this term by working and giving correct answers to questions. The amount I pay out in points = the amount you get in points. From our simple circular flow we saw firms pay out expenses and households bring home income and the two are equal. The income of households is the result of households having resources being put to use. The resources, and what they get paid, are: Land - rent, labor - wages, capital - interest, entrepreneurial ability - profit. Profit = $ value of output minus amount paid to other inputs.

4. Functional Distribution of Income Profit is the residual amount left from output that goes to the entrepreneur and since it is a residual we always have $ amount of output = $ amount paid to inputs. In the US economy labor is paid either wage or salary (we expand on the general use of the word wage). Later we will talk about legal forms of business and as such we expand on general use of word profit and in US economy talk about corporate profit and proprietors’ income as profit. In 2005 the functional distribution of income was: Wage & sal. rent interest corp profit propri. inc. 71% 1% 5% 14% 9%

5. Functional Distribution of Income Note in our “capitalist” economy owners of capital are only paid 5% of total income. This is the fact. What would be interesting to investigate (and maybe you will do the investigation) is how many people have a capital resource and compare it to the number of folks that have labor as a resource. My hunch is there are relatively few capital owners and while 5% looks small, the absolute dollar amount to these folks is quite substantial.

6. Personal Distribution of Income In economics we say all resources are ultimately owned by people and people wake up in what they call their home (at least most days of the year – maybe you travel some and wake up in a hotel). There are about 113,000,000 households in the US economy. If you divide the number by 5 you get 22,600,000 (right?). We could talk about income quintiles in the following way. Put all households in an Excel Spread sheet with the first household listed being the one with the least income from its resources in a given year. The next listed would have the next highest income from resources, and so on. The income of the first quintile would be the income of the first 22,600,000 households in our spreadsheet. The income of the second quintile would be the income of the next 22,600,000 houses, and so on.

7. Personal Distribution of Income From a recent year in the US the personal distribution of income across quintiles, in % terms, was: Lowest Second Middle Fourth Highest 3.4% 8.7% 14.7% 23.2% 50.1% Is income distributed equally across households in the US? NO The highest 20% of households has 50.1% of the income in the year shown.

8. Households as Spenders What do households do with the income earned in a year? A good rule of thumb here is to have the household think about the government as being a partner in their life and the government wants a cut of the income – let’s call this cut personal taxes. In a very general sense we say that after households pay taxes they can either have personal saving or have personal consumption expenditures.

9. Households as Spenders Personal saving is a residual in that it is the amount of income left after taxes and consumption occur. Personal consumption expenditure is for services, nondurable and durable goods households desire. Note, as a % of household income, in a recent year; Personal Consumption Personal Saving Personal Taxes 88% 0% 12%

10. Personal Saving Note that personal saving in a recent year was 0%. Some households had saving and some didn’t. On the whole the balance is zero. Have you ever heard a guy with a thick accent say, “what is dis and what is dat?” We have a word – dissave – and it means that a household has expenditure in a year greater than its income after taxes. In other words, saving is negative! How can “dat” be? The household would have to borrow or use saving it had accumulated from previous years. When households save it can take many forms – bank accounts, insurance policies and buying stocks and bonds are just a few of the ways.

11. Types of Business Organization Here we study the three basic legal forms of business and we explore advantages and disadvantages of each.

12. Business Types The three basic forms of business organizations are 1) Sole proprietorships, 2) partnerships, and 3) corporations. Of all the businesses in the U.S., about 20% are corporations. The amazing thing about corporations, though, is that they generate about 84% of all business revenue. Why do you suppose this works out this way? Let’s explore advantages and disadvantages of each form to see if there are clues as to why corporations are so successful in terms of capturing sales.

13. Proprietorship A proprietorship is a company with a sole owner. A nice thing about this form is all the profits go to the one owner as income and is only taxed as personal income, but the owner faces unlimited liability. This means the owner is personally responsible for all debts of the company. If the company has problems, not only can company assets be taken to settle the problem, personal assets of the owner may be at risk as well.

14. Partnership A partnership is a company with more than one owner, but no stock in the company has been sold. A nice thing about this form is that the owners may have skills that complement each other and thus specialization can mean higher profits that are only taxed once as personal income. Unlimited liability is still an issue for all the partners and a really bad thing would develop if one of the partners was a jerk.

15. Corporation A corporation is a legal entity in and of itself. In a partnership or proprietorship the business and the owner are basically the same thing from a legal perspective. The corporation is a separate entity from the owners, called stockholders. A nice thing about being a stockholder is you share in the profits and your liability for problems of the corporation are limited to the value of the stock invested. A downside to being a corporate stockholder is the issue of double taxation. The revenues are taxed at the corporate profit level and are taxed again if given as dividends to the stockholders.

16. push button Advise I want to start a business and I need your advice as to the form I should take. I want to make a pizza fork. It is really cool. You push the button on the stem and out of the side of the fork a razor blade sharp edge comes out so that you can slice the pizza into bit-sized pieces with ease! I think the fork will be a big seller because when you bring your pizza out to the TV room to watch the big game you won’t have to have a knife and fork. That way the knife won’t fall off your plate and get pizza sauce on your clothes and carpet. I know many people hate this when this happens. What do you think?

17. Role of government In any economy there is a role for the government to play. We explore those ideas here.

18. Some economic functions of Govt • providing a legal system, • promoting competition, • 3) providing public goods, • 4) ensuring economy-wide, or what is know as macroeconomic, stability.

19. Providing a legal system Property rights are the rights of an owner to use and to exchange his or her property. In the legal system, these rights are defined and protected. If the government didn’t define the legal system would we have the type of world we have today? Could private industry provide the legal system?

20. Promoting Competition It is argued that monopolies do not lead to the most efficient outcome in our economy. To get the most output for our given resources and have the lowest prices, it is felt the government must promote competition. In the US the antitrust laws are a device used to promote competition.

21. Providing public goods Private good - a good that can only be consumed by one individual at a time - their use is exclusive to the people who purchase or rent them. Public good - a good that can be consumed jointly by many individuals simultaneously. Categorize the following goods: a pbj sandwich, light from a lighthouse.

22. Free rider problem One characteristic of a public good is the exclusion principle - it is difficult to exclude people from enjoying the benefits of the good. So, how do you get people to pay for the benefits they receive? Some will try to take a free ride! Example: PBS - If you don’t pay, who will? Maybe there is a role for government to provide public goods because the private sector could not stop the free rider problem and thus make enough money to provide the good or service – but the good or service is really needed.

23. Ensuring Macro Stability In 1946 our Federal Government passed the Employment Act, establishing three goals for economic performance: Full employment, price stability and economic growth. If these goals are not achieved, the perception is we do not have stability. This topic is a major theme for a course in macroeconomics - ECO 202 at Wayne State.

24. Political functions of government 1) merit and demerit goods 2) income redistribution

25. Merit and demerit goods Merit good - political process deems socially desirable. Demerit good - political process deems socially undesirable. The government usually taxes one type and subsidizes the other. (Do you know which one is which?) Classify - cigarettes Big league sports stadiums

26. Income redistribution A type of redistribution occurs with the use of transfer payments - payments made to individuals for which in return no goods or services are concurrently rendered. Another type of redistribution occurs with transfers in kind - food stamps is an example.

27. Federal Receipts and spending Types of Federal Government Spending and % of total: Pensions and Income security 35% National Defense 20% Health 21% Interest on Public Debt 7% All other 17% Tax revenues by % of total: Personal income tax 43% Payroll taxes 37% Corporate income tax 13% Excise tax 3% All other 4%

28. Taxation Simple income tax examples - example 1 income marginal tax rate 0 to $1 .1 1.01 to 2.00 .2 2.01 to 3.00 .3 over 3 .4 person 1 income $1 - Tax = $1(.1) = .1 average tax rate = tax/income = .1/1 = .1 person 2 income $2 - Tax = $1(.1) + $1(.2) = .3 average tax rate = .3/2 = .15 Note, as people get more income 1) the marginal rate rises, 2) the average rate rises and 3) the marginal rate > average rate. This is a progressive tax example.

29. taxation Simple income tax examples - example 2 income marginal tax rate 0 to $1 .15 1.01 to 2.00 .15 2.01 to 3.00 .15 over 3 .15 person 1 income $1 - Tax = $1(.15) = .15 average tax rate = tax/income = .15/1 = .15 person 2 income $2 - Tax = $1(.15) + $1(.15) = .3 average tax rate = .3/2 = .15 Note, as people get more income 1) the marginal rate stays the same, 2) the average rate stays the same and 3) the marginal rate = average rate. This is a proportional or flat tax example.

30. taxation Simple income tax examples - example 3 income marginal tax rate 0 to $1 .4 1.01 to 2.00 .3 2.01 to 3.00 .2 over 3 .1 person 1 income $1 - Tax = $1(.4) = .4 average tax rate = tax/income = .4/1 = .4 person 2 income $2 - Tax = $1(.4) + $1(.3) = .7 average tax rate = .7/2 = .35 Note, as people get more income 1) the marginal rate falls, 2) the average rate falls and 3) the marginal rate < average rate. This is a regressive tax example.

31. Real world examples The Social Security tax is flat up to $68,400 and regressive after that. In 1998 for every $ made up to 68,400 you paid 6.2%, after that you pay 0%. The Federal income tax is progressive – see book for marginal rates. College Financial aid is progressive? The more income your family has the less you get in aid - or the more of the tuition you have to pay! Plus dollar for dollar increases in income mean the larger the % of the tuition you pay.

32. Capital gain Asset selling price - buying price = something. If something > 0 we say there is a capital gain. If something < 0 we say there is a capital loss. If something = 0 we say there is a zero capital gain or loss. Currently capital gains are taxed.

33. Taxes indexed for inflation In periods of inflation, wages often go up (as well as the prices for goods and services). But because of the inflation we can not buy more things. If we are thrown into a higher tax bracket because of the higher wage we actually get penalized in a progressive tax system (the penalty is a decline in purchasing power). In the US, the government increases the income values in the tax tables by the rate of inflation to beat this bracket creep.

34. Double taxation If you own a corporation - a stockholder - your company’s earnings may be taxed twice. Example: revenue - cost = profit the profit is taxed ATP = Association of Tennis Professionals :) = profit - tax = retained by company + paid to stock owner. The payment to the stockholder is taxed again as personal income.