978-1259723223 Chapter 20

Chapter 20 – Public Finance: Expenditures and Taxes

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Chapter 20 – Public Finance: Expenditures and Taxes

McConnell Brue Flynn 21e

DISCUSSION QUESTIONS

1. Use a circular flow diagram to show how the allocation of resources and the distribution of

income are affected by each of the following government actions. LO1

a. The construction of a new high school.

b. A 2-percentage-point reduction of the corporate income tax.

c. An expansion of preschool programs for disadvantaged children.

d. The levying of an excise tax on polluters.

Answer:

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There will be some reallocation of resources from private enterprise to government and

some decrease in unemployment, unless the economy is already at full employment. In

this case, there will some upward pressure on prices since, to the extent the program is a

transfer payment, there will be no increase in production.

d. The levying of an excise tax on polluters.

This will be an increase in net taxes paid by business (11). Since business will regard this

as an increase in costs, it will decrease its demand for resources (2), leading to a

decreased flow of income to the resource markets (1). With less money income,

households will decrease their consumption demand for goods and services from

businesses (4) and business receipts (3) will be less. Also, the decrease in household

income will lead to a decrease in net household taxes paid to government (12).

The distribution of income will be slightly away from profits and therefore toward the

other three categories. To the extent that total tax revenues increase (11) – (12), there will

be a slight increase in allocation of resources to government away from private

enterprise. There will also likely be a reallocation of resources towards pollution control

equipment. The increased costs to business, having caused decrease in supply, will tend

to increase unemployment and prices.

2. What do economists mean when they say government purchases are “exhaustive” expenditures

whereas government transfer payments are “non–exhaustive” expenditures? Cite an example of a

government purchase and a government transfer payment. LO1

3. What are the main categories of government spending? What are the main categories of

government revenue? LO2

4. What is the most important source of revenue and the major type of expenditure at the federal

level? LO3

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5. For state and local governments, what are the three most important sources of revenue and

types of expenditure? LO4

6. How do the top two categories of federal employment differ from the top two categories of

local and state employment? LO5

Answer: Half of federal government jobs are in national defense or the postal service.

7. Distinguish between the benefits-received and the ability-to-pay principles of taxation. Which

philosophy is more evident in our present tax structure? Justify your answer. To which principle

of taxation do you subscribe? Why? LO6

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8. What is meant by a progressive tax? A regressive tax? A proportional tax? Comment on the

progressivity or regressivity of each of the following taxes, indicating in each case where you

think the tax incidence lies: (a) the federal personal income tax; (b) a 4 percent state general sales

tax; (c) a federal excise tax on automobile tires; (d) a municipal property tax on real estate; (e) the

federal corporate income tax; (f) the portion of the payroll tax levied on employers. LO6

9. What is the tax incidence of an excise tax when demand is highly inelastic? Highly elastic?

What effect does the elasticity of supply have on the incidence of an excise tax? What is the

efficiency loss of a tax, and how does it relate to elasticity of demand and supply? LO7

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Answer: The incidence of an excise tax is likely to be primarily on consumers when

demand is highly inelastic and primarily on producers when demand is elastic. The more

elastic the supply, the greater the incidence of an excise tax on consumers and the less on

producers.

The efficiency loss of a sales or excise tax is the net benefit society sacrifices because

consumption and production of the taxed product are reduced below the level of

allocative efficiency which would occur without the tax. Other things equal, the greater

the elasticities of demand and supply, the greater the efficiency loss of a particular tax.

10. Given the inelasticity of cigarette demand, discuss an excise tax on cigarettes in terms of

efficiency loss and tax incidence. LO7

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11. ADVANCED ANALYSIS Suppose the equation for the demand curve for some product X is

P = 8 – .6Q and the supply curve is P = 2 + .4Q. What are the equilibrium price and quantity?

Now suppose an excise tax is imposed on X such that the new supply equation is P = 4 + .4Q.

How much tax revenue will this excise tax yield the government? Graph the curves, and label the

area of the graph that represents the tax collection “TC” and the area that represents the efficiency

loss of the tax “EL.” Briefly explain why area EL is the efficiency loss of the tax but TC is not.

LO7

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Since the government collects $2 per unit sold, government revenue equals $8 (=$2×4).

The area EL represents the loss to society that results from the reduction in consumption

and production of good X. The loss occurs because the fifth and sixth units are no longer

produced. The area TC represents a shifting from buyers and sellers in the market to

government and, by extension, the beneficiaries of public goods provided with the taxes

collected. There is no loss of output to society in area TC.

12. Is it possible for a country with a regressive tax system to have a tax-spending system that

transfers resources from the rich to the poor? LO8

13. LAST WORD Does a progressive tax system by itself guarantee that resources will be

redistributed from the rich to the poor? Explain. Is the tax system in the United States

progressive, regressive, or proportional? Does the tax-spending system in the United States

redistribute resources from higher income earners to lower income earners?

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Answer: No, a progressive tax system by itself does not guarantee that resources will be

distributed from the rich to the poor. It is quite possible that the tax revenue is returned to

the rich in terms of the goods, services, and transfers provided by the government.

However, it does appear that the tax-spending system in the United States is progressive.

That is, not only is the tax system progressive in the United States (there is a higher

average tax rate on individuals with higher incomes), but the tax revenue collected is

disproportionately spent (relative to taxes paid) on the lower quintiles of the income

distribution.

REVIEW QUESTIONS

1. The city of Joslyn has three sources of revenue: borrowing, proprietary income from running

the local electric power utility, and taxes. If it received $10 million from running the electric

power utility and borrowed $40 million, how much did it collect in taxes if total revenue was

$14? LO2

a. $140 million.

b. $110 million.

c. $100 million.

d. Nothing.

2. Suppose George made $20,000 last year and that he lives in the country of Harmony. The

way Harmony levies income taxes, each citizen must pay 10% in taxes on their first

$10,000 in earnings and then 50% in taxes on anything else they might earn. So given

that George earned $20,000 last year, his marginal tax rate on the last dollar he earns will be

__________ % and his average tax rate for his entire income will be

_________________. LO3

a. 50 %; 50 %

b. 50 %; less than 50 %

c. 10 %; 50 %

d. 10 %; less than 50 %

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Answer: b. 50 percent; less than 50 percent.

George’s marginal tax rate will be 50 percent and his average tax rate will be less

than 50 percent.

To see why this is true, begin by looking at the marginal tax rate that George must

pay on the last dollar he earns. Because his income is $20,000 per year, we know that the

higher 50 percent rate will apply to the last dollar he earned because that last dollar is

above the $10,000 cutoff at which the higher 50 percent rate applies.

With respect to the average tax rate that George will pay, it has to be less than 50

percent because it will be the average of the 10 percent rate that he is required to pay on

his first $10,000 income and the 50 percent rate that he is required to pay on the rest of

his income. If you average a higher number (like 50 percent) with a lower number (like

10 percent), you will always get something in between—in this case, a number that has to

be less than 50 percent.

Another way to see why George’s average tax rate must be less than 50 percent is to

do the math and calculate his average tax rate. To begin with, since the tax rate on the

first $10,000 of income is 10 percent, George will owe $1000 in taxes on that first

$10,000 in income (because 10 percent of $10,000 is $1000). And since the tax rate on

the rest of George’s income is 50 percent, he will owe $5000 in taxes on the next $10,000

of his income. Thus, in total, George will owe $6000 in taxes on his $20,000 income.

That makes for an average tax rate of 30 percent (= $6000/$20,000 times 100 to turn the

fraction into a percent).

And 30 percent is of course less than 50 percent.

3. The nation of Upstandia uses kroner for money and its tax code is such that a person

making 100,000 kroner per year pays 40,000 kroner per year in income taxes; a person making

200,000 kroner per year pays 70,000 kroner per year in income taxes; and a person making

300,000 kroner per year pays 90,000 kroner per year in income taxes. Upstandia’s income tax

system is: LO6

a. Progressive.

b. Regressive.

c. Proportional.

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4. Identify each of the following taxes as being either progressive or regressive. LO6

a. Personal income tax

b. Sales taxes

c. Payroll taxes

d. Property taxes

5. The efficiency loss of imposing an excise tax is due to: LO7

a. Paying a higher price per unit.

b. Producing and consuming fewer units.

6. True or false. The incidence of property taxes that are levied on rented houses and

apartments is high—meaning that they are paid almost entirely by the landlords, who are billed

by the government for those taxes. LO8

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PROBLEMS

1. Suppose a tax is such that an individual with an income of $10,000 pays $2,000 of tax, a

person with an income of $20,000 pays $3,000 of tax, a person with an income of $30,000 pays

$4000 of tax. What is each person’s average tax rate? Is this tax regressive, proportional, or

progressive? LO7

Feedback: To calculate the average tax an individual pays, divide the tax payment by the

individual’s income. Remember when you are finding a rate to multiple your answer by

2. Suppose in Fiscalville there is no tax on the first $10,000 of income, but a 20 percent tax on

earnings between $10,000 and $20,000 and a 30 percent tax on income between $20,000 and

$30,000. Any income above $30,000 is taxed at 40 percent. If your income is $50,000, how much

will you pay in taxes? Determine your marginal and average tax rates. Is this a progressive tax?

LO7

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Feedback: Since the individual has an income of $50,000 we must calculate the taxes

3. For tax purposes, “gross income” is all the money a person receives in a given year from any

source. But income taxes are levied on “taxable income” rather than gross income. The difference

between the two is the result of many exemptions and deductions. To see how they work, suppose

you made $50,000 last year in wages, earned $10,000 from investments, and were given $5,000

as a gift by your grandmother. Also assume that you are a single parent with one small child

living with you. LO7

a. What is your gross income?

b. Gifts up to $14,000 per year are not counted as taxable income. Also, the “personal exemption”

allows you to reduce your taxable income by $4,050 for each member of your household. Given

these exemptions, what is your taxable income?

c. Next, assume you paid $700 in interest on your student loans last year, put $2,000 into a health

savings account (HSA), and deposited $4,000 into an individual retirement account (IRA). These

expenditures are all tax exempt, meaning that any money spent on them reduces taxable income

dollar-for-dollar. Knowing that fact, now what is your taxable income?

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d. Next, you can either take the so-called standard deduction or apply for itemized deductions

(which involve a lot of tedious paperwork). You opt for the standard deduction that allows you as

head of your household to exempt another $8,500 from your taxable income. Taking that into

account, what is your taxable income?

e. Apply the tax rates shown in Table 20.1 to your taxable income. How much federal tax will

you owe? What is the marginal tax rate that applies to your last dollar of taxable income?

f. As the parent of a dependent child, you qualify for the government’s $1,000 per-child “tax

credit.” Like all tax credits, this $1,000 credit “pays” for $1,000 of whatever amount of tax you

owe. Given this credit, how much money will you actually have to pay in taxes? Using that actual

amount, what is your average tax rate relative to your taxable income? What about your average

tax rate relative to your gross income?

Chapter 20 – Public Finance: Expenditures and Taxes