Chapter 7

The Government Sector

McGraw-Hill/Irwin
Companies, All Rights Reserved

2009 The McGraw-Hill

Chapter Objectives
In this chapter well be looking at these topics:
1.
2.
3.
4.
5.
6.

Government spending.
The graphing of the C + I + G line.
Types of taxes.
The average and marginal tax rates.
Sources of government revenue.
The economic role of government.

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Introduction: The Growing Economic Role of

Government
Most of the growth over the past 7 decades was due
to the Depression and WWII.
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 4 basic influences:

1.
2.
3.
4.

It spends more than $3.0 trillion.

It levies even more in taxes.
It redistributes hundreds of billions of dollars.
It regulates the economy.

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Government Revenues and Spending,

Fiscal Year 2009 Estimate

Source: Economic Report of the President, 2008; www.budget.gov.

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Spending: Past, Present, and Future

** 2009 figures are from President George W. Bushs 2009 budget. They are projected estimates of
actual spending.
Source: Congressional Budget Office.
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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.

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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.

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Graphing the C + I + G Line

If we assume government
spending is constant across all
levels of disposable income at
$167 billion, we see how it shifts
the function up and results in a
new equilibrium at $10.8 trillion.
The slope of the function is
determined by the MPC.
The impact of spending on the
new equilibrium is determined by
a multiplier that we will learn
about later.

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Questions for Thought and Discussion

How did the Great Depression encourage the growth
of government?
Do future forecast make the governments present role
appear to be sustainable?

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The Average Tax Rate and the Marginal Tax

Rate
The Average Tax Rate (ATR) is the overall rate you
pay on your entire income.
The Marginal Tax Rate (MTR) is the rate you pay on
the last dollars you earned.

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The Average Tax Rate and the Marginal Tax

Rate: A Hypothetical Illustration
Income
Level

Marginal
Tax Rate

Total
Average
Tax
Taxes
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 %

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Types of Taxes
Direct tax
A tax with your name on it

Indirect tax
A tax on things

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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

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Nominally Progressive, Proportional, &

Regressive Taxes

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Sources of Federal Revenue

Personal Income Tax
The personal income tax is the largest source of federal
revenue.
Accounts for 44% 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.

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Federal Personal Income Tax:The Top

Marginal Tax Rate, 19932008

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Top Marginal Combined Income Tax

Rates in 11 Leading Wealthy Nations,
2006*

*Combined federal, state, and local income taxes.

Source: OECD.
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Sources of Federal Revenue

The Personal Income tax
Individual personal income taxes account for 44% 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.

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Sources of Federal Revenue (continued)

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.

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Sources of Federal Revenue

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.

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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.

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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The Corporate Income Tax

The corporate income tax is a tax on a corporations
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.

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Excise Taxes
An excise tax is a sales tax aimed at specific goods
and services.
Accounts for about 4% 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 tend to reduce consumption of certain

products of which the federal government takes a dim
view.
Excise taxes are usually regressive.

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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.

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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% of all local tax revenue.
Can influence business decisions about where to locate.

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The State and Local Fiscal Dilemma

Since WWII, 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.

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The State and Local Fiscal Dilemma

Neighboring states and local governments are in direct
competition with one another for tax dollars.
If one governments tax rates rise too far above the levels of
its neighbors, it citizens will vote with their feet.

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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.

Source: Economic Report of the President, 2008;

Survey of Current Business, March 2008,
www.bea.gov.
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Tax Receipts as a Percentage of GDP in the

U.S. and Selected Countries, 2006
Organization for Economic Cooperation and Development

Source: Organization for Economic Cooperation and Development.

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Questions for Thought and Discussion

Is the American income tax regressive or progressive?
Are payroll taxes regressive or progressive?

How do high tax rates impact the quality of life of

citizens in the industrialized world?

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Economic Role of Government

Provision of Public Goods and Services
Redistribution of Income
Stabilization
Economic Regulation

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Provision of Public Goods and Services

Some examples include:

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

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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.

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Stabilization
Two basic goals of the federal government:
1. Stable prices with little or no inflation
2. Low unemployment

An economic rate of growth high enough to keep the

unemployment rate to a minimum.

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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.

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Adam Smiths Dos and Donts

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.

Dont do anything else.

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Conclusion
Until the 1930s, the federal government more or less
followed the role prescribed by Adam Smith.
The governments economic role has expanded
tremendously these last 7 decades.
It will probably continue to grow into an even more
monolithic all-powerful colossal Big-Brother in the
coming years.

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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.
However, the surplus is spent by the government each year
to offset its deficits.
The U.S. 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).

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Will Social Security Be There for You?

(continued)
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
governments 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!

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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.

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Questions for Thought and Discussion

How does the present role of government deviate from
the role envisioned by Adam Smith?
Would it be possible or desirable to return to a government
with a more limited role?

How can government continue to provide social

security and Medicare?
Should this be a role played by government?

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