Funding the Public Sector

Introduction

The chapter explores how governments fund their activities, focusing on taxation, borrowing, and user charges. It highlights demographic changes affecting Social Security and the increasing financial pressures on public sector funding.

6.1 Paying for the Public Sector: Systems of Taxation

Governments finance their operations through three main sources: user charges, taxes, and borrowing. The government budget constraint requires that every dollar spent must be funded by taxes or borrowing.

• Tax base: The value of goods, services, wealth, or incomes subject to taxation.

• Tax rate: The proportion of the tax base paid as taxes.

• Marginal tax rate: The change in tax payment divided by the change in income.

• Tax bracket: Income intervals to which specific marginal tax rates apply.

• Average tax rate: Total tax payment divided by total income.

Types of Taxation

• Proportional taxation: All income levels pay the same percentage. Marginal and average tax rates are equal.

• Progressive taxation: Higher incomes pay a higher percentage of additional income as taxes.

• Regressive taxation: As income increases, the percentage of tax paid falls. Example: Social Security taxes above a certain income threshold.

Example Table: Tax Systems Comparison

6.2 The Most Important Federal Taxes

Federal, state, and local governments collect various taxes:

• Federal: Individual income taxes, corporate income taxes, Social Security taxes, import and excise taxes.

• State and Local: Sales taxes, property taxes, personal and corporate income taxes.

Federal Personal Income Tax

• Accounts for 50% of federal revenue.

• Tax rates rise with income, making the system progressive.

Capital Gains and Losses

• Capital gain: Positive difference between sale and purchase price of an asset.

• Capital loss: Negative difference between sale and purchase price.

• Higher capital gains tax rates may discourage asset sales, reducing tax revenue.

Corporate Income Tax

• Accounts for 7% of federal tax revenue.

• Corporations taxed on profits (revenues minus expenses).

• Double taxation: Profits taxed at corporate level and again as dividends to shareholders.

• Retained earnings: Profits kept for investment, not distributed to shareholders.

• Tax incidence: The burden of corporate taxes is shared among consumers, stockholders, and employees.

Social Security and Unemployment Insurance Taxes

• Social Security taxes imposed on earnings up to a threshold; both employers and employees contribute.

• Unemployment insurance taxes paid by employers, with rates varying by state and employer history.

6.3 Tax Rates and Tax Revenues

State and local governments often rely more on taxes on goods and services than on income taxes. The relationship between tax rates and revenues is complex.

• Sales taxes: Assessed on prices paid for goods and services; often ad valorem (fraction of market price).

• Static tax analysis: Assumes tax base is unaffected by rate changes.

• Dynamic tax analysis: Recognizes that higher rates may shrink the tax base, potentially reducing revenues.

Maximizing Tax Revenues

• Dynamic analysis predicts that excessively high tax rates can decrease the tax base and overall revenues.

• Behavioral responses include shifting purchases, shopping online, or buying in advance to avoid higher taxes.

6.4 Taxation from the Point of View of Producers and Consumers

Taxes on goods and services affect market prices and equilibrium quantities.

• Excise tax: Levied on specific goods or services.

• Unit tax: Constant tax per unit purchased.

• Excise taxes increase production costs, shifting the supply curve upward and raising equilibrium prices while reducing quantities.

• The tax burden is shared between consumers (higher prices) and producers (lower net revenue).

Example Table: Tax Burden Distribution

Issues & Applications: Social Security Viability

To address Social Security shortfalls, options include increasing tax collections (raising contribution rates or subjecting more earnings to taxation) or reducing payouts (raising eligibility ages).

Summary Discussion of Learning Objectives

• Average vs. Marginal Tax Rates: Average tax rate is total tax divided by income; marginal tax rate applies to the last dollar earned.

• Tax System Structure: Progressive systems increase rates with income; regressive systems decrease rates; proportional systems keep rates equal.

• Tax Rates and Revenues: Static analysis assumes no change in tax base; dynamic analysis accounts for behavioral responses.

• Market Effects: Taxes shift supply curves, affecting prices and quantities; burden is shared between consumers and producers.