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Special Topic 1
Government Spending and Taxation
OUTLINE
I. Government Expenditures
A. Government spending includes both purchases of goods and services and income
transfers.
1. About three-fifths of government spending takes place at the federal level. Four
categories income transfers (including Social Security), health care, national
defense, and interest on the debt account for 85 percent of federal spending.
2. At the state and local level, the largest categories of spending are education and
public welfare.
B. Government Spending Per Person
1. During the first 125 years of U.S. history, federal expenditures per person were
C. How has the Composition of Federal Spending Changed?
1. During the last five decades, the composition of federal spending has shifted away
from national defense and toward spending on income transfers and health care.
II. Taxes and the Finance of Government
A. Types of Taxes
1. The federal government derives approximately half of its revenue from the
personal income tax and another third from the payroll tax.
2. State and local revenues are derived primarily from sales taxes, income taxes, user
charges, and grants from the federal government.
B. Taxes and the Cost of Government
1. A tax dollar extracted from an individual or a business ends up costing the private
economy much more than just one dollar. This is the case for two main reasons.
a. The collection of taxes is costly.
counterproductive activities)..
C. How Has the Structure of the Personal Income Tax Changed?
1. Even though marginal tax rates have been reduced substantially during the last four
decades, upper-income Americans pay a much larger share of the federal income
tax today than was previously the case.
D. Income Levels and Overall Tax Payments
1. The U.S. income tax system is highly progressive the percentage of income taken
from high earners is greater than for those with less income.
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III. How Does the Size of Government Affect Economic Growth?
A. The size of the U.S. government is smaller than that of Japan and major Western
European countries, but larger than for a number of high-growth Asian economies.
B. When governments focus on the core activities of providing (1) a legal and
IV. Expenditures, Taxes, Debt Finance, and Democracy
A. More than half of American families derive benefits from various transfer programs,
while the share of the population paying federal income tax has declined substantially
during the past decade.
B. Moreover, large budget deficits have pushed the debt to GDP ratio to levels not seen
since the aftermath of World War II.
OBJECTIVES
In this special topic, we take a closer look at government in the United States. We focus on the
taxing and spending activities of government. The feature documents the major categories of
government spending and sources of tax revenue. We show that the size of the federal government
grew dramatically in the 20th century and early 21st century. Over the past 50 years, federal
government spending has moved away from national defense and toward spending on income
transfers and health care. With regards to government revenue, the U.S. tax system is highly
progressive and the tax burden has increased over time.
Lastly, we show the size of the U.S. government is smaller than that of Japan and major
Western European countries, but larger than for a number of high-growth Asian economies. When
governments focus on productive activities they promote economic growth. However, when
governments expand into activities for which they are ill-suited, they deter growth. The empirical
evidence indicates that the governments of most, if not all, industrial countries are larger than the
growth-maximizing size.
IMPORTANT POINTS AND TEACHING SUGGESTIONS
1. Exhibit 1 demonstrates that real federal spending per person (measured in 2012 dollars) was
generally less than $50 prior to the Civil War and it ranged from $125 to $200 throughout the
1870 1916 period. However, beginning with the spending build-up for World War I in 1917,
real federal spending per person soared, reaching $11,051 in 2012. The 2012 figure is almost
80 times that of 1916.
2. To provide some information regarding changes in the composition of government spending,
review with students Exhibit 2. This exhibit shows that federal government spending, over the
past four decades, has shifted away from defense and toward income transfers and health care.
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3. Exhibit 3 shows that almost half of federal revenues are derived from the personal income tax.
The payroll tax and corporate income tax are also major sources of federal revenue. The major
revenue sources of state and local governments are sales and excise taxes, personal income
taxes, user charges, and grants from the federal government.
4. Students are often surprised at how large a share of the personal income tax burden is borne by
those with high incomes. Exhibit 4 shows that about one-third of all federal personal income tax
payments are paid by those with the highest 1 percent of income. It also shows that though
HINTS FOR ANSWERING CRITICAL ANALYSIS QUESTIONS
2. The shift away from national defense and toward income transfers and health care is unlikely
to improve the operation of the economy. National defense is a public good, while income
transfers and health care are not. Public goods will not be provided at an efficient level by the
private sector and so the public provision of such goods will improve economic efficiency.
The shift away from public goods will likely decrease economic efficiency.