Taxation and Public Expenditure

Chapter 18
Taxation
and Public
Expenditure
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

In this chapter you will learn to
1. Describe the main sources of government revenue in the

United States.
2. Explain why a tax can lead to allocative inefficiency.
3. Describe the main categories of government spending.
4. Explain why transfer payments for the elderly are an

increasing proportion of government spending.
5. Describe the factors that determine the scope and nature of

government’s role in the economy.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-2

Taxation
Tax Expenditures
Tax Expenditures: Tax revenues returned to taxpayers who

take actions that the government deems
desirable
Example: health insurance

Figure 18.1 International Comparison
of Government Tax Revenues, 2004

Progressivity
Average Tax Rate: % of income that individual pays in taxes
An income tax is:

- progressive if the ATR rises as income rises
- regressive if the ATR falls as income rises
- proportional if the ATR is constant as income rises
Most income-tax systems achieve their progressivity by

having marginal tax rates that rise with income
– “tax brackets”

The U.S. Tax System
Sources of federal government revenues:

• personal income taxes
• payroll taxes
• corporate Income taxes
• excise and sales taxes

Tax Brackets
Tax bracket: A range of taxable income for which there is a

constant marginal tax rate.

Figure 18.2 Sources of
Government Revenues, 2005

Income Taxes
APPLYING ECONOMIC CONCEPTS 18.1

How Federal Taxes Affect Your
Paycheck

Evaluating the Tax System
Taxation and Equity

Equity is normative. Two principles are helpful in assessing
equity:
1. the ability-to-pay principle
2. the benefits-received principle
- vertical and horizontal equity
Problems:
- ability to pay is not the same as income.
- how to measure benefits received?
How Progressive is the U.S. Tax
System?
A modern government relies on many kinds of taxes.

Assessing the entire tax system is complicated by two factors:
1. the progressivity of the system depends on the mix

of the different taxes (federal taxes tend to be
progressive; property taxes are slightly regressive)
2. income from different sources are taxed at different

rates

Negative Income Tax
APPLYING ECONOMIC CONCEPTS 18.2

Poverty Traps and the Negative
Income Tax

Taxation and Efficiency
Taxes often generate allocative inefficiency.
Two burdens of taxation:

1. direct burden is the amount paid by taxpayers
2. excess burden is the allocative inefficiency
generated by a tax

Taxation and Efficiency
Most taxes impose both burdens:

- by taking resources from market participants, they
impose a direct burden
- by changing behaviour, they generate a
deadweight loss — the excess burden
The government’s tax policy should strive to minimize
allocative inefficiency for a given amount of tax revenues.

Figure 18.3 Direct and Excess
Burdens of an Excise Tax
Case 1: Only a direct burden, no excess burden.
Case 2: No direct burden (no sales), some excess burden.
Case 3: Both direct and excess burdens.

Figure 18.4 Direct and Excess
Burdens of an Income Tax
The same principle applies with an income tax...

Figure 18.5 A Laffer Curve
Along a Laffer curve:

- increases in the tax rate beyond some level (t0) lead
to disincentive effects, and decrease tax revenues.
Public Expenditure
Federal, state and local governments spend an amount equal

to about one-third of the nation’s annual output.
There are two broad categories of government expenditure:
1. purchases of goods and services

2. transfer payments (including payments made to other
governments)

Figure 18.6 Spending by Governments
as a Share of National Income,
1960–2005

Figure 18.7 Federal, State,
and Local Spending, 2005

Purchases of Goods and Services
Because public goods are underprovided by private markets

due to the free rider problem, government spending tends to
be concentrated on providing public goods.
- national defense is 2/3 of federal government
spending
- education is about 20% of state and local
government spending
- policy and fire services are about 15% of the state
and local government spending

Transfer Payments
The largest category of transfer payments by the federal

government is made to individuals.
Federal government transfer payments include transfers to:
– elderly persons (Social Security and Medicare)

– needy persons (welfare and Medicaid)
– other governments (grants-in-aid)

Evaluating the Role of
Government
Public Versus Private Sector

Government activities reallocate resources between the
private and public sectors
- a different mix of goods and services from what
would otherwise exist
What is the appropriate mixture of public and private

expenditures?

Evaluating the Role of
Government
John Kenneth Galbraith (1908-2006) lamented the

reallocation away from the public sector, especially in the
United States
- “private affluence and public squalor”
His classic 1958 book The Affluent Society discussed

his views of the appropriate role of government in the
economy.

Scope of Government Activity
It is important to maintain an appropriate perspective about

the role of government in the economy.
One pitfall is to become overwhelmed by the government’s

role, and forget that people are mostly free to make decisions
in their own ways.
Another pitfall is to fail to recognize that a significant share of

of taxes is used to finance goods and services that add to the
welfare of individuals — such as education, health care, and
roads.
Evolution of Policy
In a democratic society, the majority’s view on the amount of

intervention that is desirable will have a considerable influence
on the amount of intervention that actually occurs.
The economist’s job is to continue analyzing and explaining

the effects of alternative policies.
Only then will the electorate and policymakers be able to

make informed choices.

Taxation and Public Expenditure

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Chapter 18

Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

1. Describe the main sources of government revenue in the

2. Explain why a tax can lead to allocative inefficiency.

3. Describe the main categories of government spending.

4. Explain why transfer payments for the elderly are an

5. Describe the factors that determine the scope and nature of

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-2

Tax Expenditures: Tax revenues returned to taxpayers who

Example: health insurance

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-3

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-4

Average Tax Rate: % of income that individual pays in taxes

An income tax is:

Most income-tax systems achieve their progressivity by

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-5

Sources of federal government revenues:

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-6

Tax bracket: A range of taxable income for which there is a

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-7

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-8

APPLYING ECONOMIC CONCEPTS 18.1

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-9

Taxation and Equity

A modern government relies on many kinds of taxes.

1. the progressivity of the system depends on the mix

2. income from different sources are taxed at different

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-11

APPLYING ECONOMIC CONCEPTS 18.2

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-12

Taxes often generate allocative inefficiency.

Two burdens of taxation:

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-13

Most taxes impose both burdens:

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-14

Case 1: Only a direct burden, no excess burden.

Case 2: No direct burden (no sales), some excess burden.

Case 3: Both direct and excess burdens.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-16

Along a Laffer curve:

Federal, state and local governments spend an amount equal

There are two broad categories of government expenditure:

1. purchases of goods and services

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-18

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-19

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-20

Because public goods are underprovided by private markets

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-21

The largest category of transfer payments by the federal

– elderly persons (Social Security and Medicare)

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-22

Public Versus Private Sector

What is the appropriate mixture of public and private

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-23

John Kenneth Galbraith (1908-2006) lamented the

His classic 1958 book The Affluent Society discussed

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 18-24

It is important to maintain an appropriate perspective about

One pitfall is to become overwhelmed by the government’s

Another pitfall is to fail to recognize that a significant share of

In a democratic society, the majority’s view on the amount of

The economist’s job is to continue analyzing and explaining

Only then will the electorate and policymakers be able to