Lesson Four

The Public and Private Material World

Introduction
The one constant in our economic system has been change.
This long-term evolution has taken place as we have reacted
to various problems that have occurred in our system. A viable
private and public sector—called a dual system—has been a
direct result of these changes.

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 LEARNING OBJECTIVES
Please note the listed objectives. As you will see, the course materials
are all objective driven. This provides you with a constant way to direct
and monitor your progress throughout the course. Each objective is color-
coded and corresponds to that particular section in the text.

OBJECTIVE ONE 1 OBJECTIVE TWO 2 OBJECTIVE THREE 3

Provide an overview of the Explain the concept of Describe both the Functional
Public Sector in contrast Externalities and the Distribution of Income
to the Private Sector in the concept of Public Goods vs. as well as the Personal
U.S. economy. Private Goods. Distribution of Income in the
U.S. economy and the uses
of that Income.

OBJECTIVE FOUR 4 OBJECTIVE FIVE 5 INTERACTIVE EXERCISE

Identify the three Forms Identify the major Economic Use the Major Economic
of Business Ownership Functions of Government Models to demonstrate
and the advantages and along with the types of an understanding of the
disadvantages of each form. Government Spending chain reactions resulting
and forms of Government from human choices and
Taxation. how they move through
an economy. Demonstrate
an understanding of the
Tradeoffs that result.

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 In Lesson Two, many of the major economic, political and social changes were
described in some detail from an historical perspective. Some of America’s
most challenging economic problems, such as the monopoly and oligopoly
power of the late 1800s, the labor unrest of the early 1900s, the Great Depres-
sion in the 1930s and the growing environmental problems in more recent
years, gave rise to the conclusion that a pure market economy had difficulty
solving certain problems. Historically, we have turned to government to help
provide solutions to these problems.

Over the years, as government has assumed a larger role, it has become more
accurate to describe our overall system as a mixed economy or dual system
rather than a pure free-market system. Certainly there has been controversy
about the growth and role of government, and many normative judgments
have been made about this evolution.

SOCIAL BALANCE
One of the ways to begin analyzing the growth of government is with the con-
cept of social balance, which is simply the allocation of resources between
public and private sectors. By allocation, we mean spending by the private
and public sectors. If we look at our current GDP (total spending in the econ-
omy), roughly one-third of the total is spent by government and two-thirds by
the private sector. That is our current allocation of resources—the social bal-
ance. If we decide that we want more public goods, that balance will change
and more taxes must be imposed or debt incurred to reflect that change. The
public sector is dependent on the private sector for adequate tax revenue or
the government must borrow funds.

PUBLIC AND PRIVATE SECTORS

The Public Sector of our economy consists of all branches of government,
including city, county, state and federal levels. The largest expenditures are
made by state and local government. During the past few years, we allocated
about $1.7 trillion annually to state and local governments and $1.1 trillion annu-
ally to the federal government. See U.S. Department of Commerce, Bureau of
Economic Analysis (www.bea.gov/national) for the latest information.

The Private Sector of an economy is the resource allocation (spending) by

all consumers and businesses. The private sector is largely a market-oriented
system of allocation based on consumer demand met by producer supply.

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 PUBLIC AND PRIVATE GOODS
Public Goods are typically unrestricted in availability (accessible to all) in con-
trast to Private Goods, which are produced by businesses and are restricted
in availability. Private goods are offered only to individuals who pay for such a
good or service. We conclude that private goods are subject to an exclusion
principle while public goods are inclusive in principle. If you do not have the
money for a private good, you are excluded from obtaining that good, but pub-
lic goods are available without direct cost to the consumer.

Another distinguishing feature of public spending is that public costs do not

increase with increasing use. Public goods do not usually have a marginal
cost. An example is the cost of national defense. National defense is avail-
able to all (inclusive) and has no additional cost (marginal cost) by including
more people.

PRIVATE SECTOR—INCOME
Private sector income is measured in two forms: personal distribution of income
and functional distribution of income. Personal distribution of income is the
allocation of total income per household, while the functional distribution of
income is payments for production factors.

In the personal distribution of income, an individual can do one of two things

with after-tax income—spend it or save it. Americans spend about 88 percent
of their income for personal consumption and 12 percent for government
taxes, and they save about 0 percent (in recent years) or may even have a neg-
ative savings in some months (meaning they borrow for some current expendi-
ture). Americans have a lower savings rate than workers in other industrialized
nations. See Figure 4.1.

12%
88%
0%

$1210 Billion $8746

$ 8746 Billion
Billio

Figure 4.1

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 GLOBAL SAVINGS RATES
Note the household savings rate in Japan, Germany and the United States
since 1970. Each nation has dramatically decreased its savings rate. Saving
is necessary for capital investment but many industrialized nations have bor-
rowed from developing nations, like China, for their investments. This debt
is a claim by developing nations on borrowers’ future income, employment
and output.

Individuals spend 59 percent of their income for services (such as medical,

education, child care, etc). Services comprise about 75 percent of our total
national output. The next largest share of personal spending (29  percent)
is for nondurable goods (goods lasting less than 3 years, such as food
and clothing). The smallest expenditure, at 12 percent, is for durable
goods (lasting more than 3 years), such as furniture and automobiles. See
Figure 4.2.

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 Personal Expenditures by Economic Sector

59% 12%

Figure 4.2

PRIVATE SECTOR—FUNCTIONAL DISTRIBUTION OF INCOME

The functional distribution of income is based on the factors of production and
the income that comes to each. The factors of production are land, labor, capital
and entrepreneurship. Each factor is paid according to its contribution to pro-
duction. Laborers receive income for wages and salaries, entrepreneurs for prof-
it, landowners for rent and capital providers for interest. Labor receives about
71 percent of national income, entrepreneurship about 23 percent, landowners
about 5 percent, with the remaining 1 percent going to capital. See Figure 4.3.

Income from Factors of Production

Figur e 4.3 Figure 4.3

5% Land
23% Entrepreneurship
1% Capital
71% Labor

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 PERSONAL DISTRIBUTION OF HOUSEHOLD INCOME
The income of U.S. households is computed by the U.S. Census Bureau and
is available in many different categories. The median (point where 50  percent
made more and 50 percent made less) household income for 2007 was
$50,233. The top 1.9 percent of households made more than $250,000, and
the bottom 10 percent made less than $11,050. The lowest 20 percent of
households made less than $19,178, and the top 20 percent made more than
$90,000. Poverty, estimated at about $17,000 for a household, included about
12.7 percent of all households.

HOUSEHOLD INCOME GROWTH

Notice in the Real Median Household Income graph that the median house-
hold income increases between 1969 and 1996 have been modest. Median
incomes during this period increased slightly, but there were also changes in
the size and composition of the median household.

Real Median Household Income: 1967 to 2006

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 PERSONAL DISTRIBUTION OF INCOME BY PERCENTILE GROUP
The personal distribution of household income describes the way income is
divided into groups among households in this country. This is normally ana-
lyzed by dividing all U.S. households in 5 equal groupings of 20 percent each.
If income were evenly distributed, each 20 percent segment would receive
exactly 20 percent of income. Figure 4.4 shows that this is not the case.
According to recent data, the top 20 percent received more than 50 percent of
the total income and the bottom 20 percent received only 3.4 percent of the
total income.

You will see further discussion of this important question in the PowerPoint
presentation for this lesson.

Personal distribution of Income by Percentile Group

Figure 4.4
Lowest 20%
3.4%

Second 20% 8.7%

Middle 20% 14.7%

Fourth 20% 23.2%

Highest 20% 50.1%

So u rce: U .S. C en su s B u reau , C en su s 2000 Su m m ary (w w w.cen su s.go v /2000)

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 WHAT DETERMINES YOUR INCOME?
Many factors determine an individual’s income including education, age, skills,
inheritance and location. However, the most important factors are education,
experience and training. According to the U.S. Census Bureau, workers in
2006 with a high school education made $28,290 median income, while work-
ers with a bachelor’s or master’s degree made $47,240 and $56,707, respec-
tively. Professional degrees result in even higher incomes. Individuals with a
professional degree, such as an MD (medical doctor), JD (lawyer), DDS (den-
tist) or DVM (animal doctor), made a median income of $121,340.

COMPARISON OF U.S. HOUSEHOLD INCOMES 1990 TO PRESENT

The U.S. household median income is higher than in most nations if the
comparison is made using parity pricing relationships (purchasing power
parity or PPP). Parity comparison attempts to make purchases in each nation
comparable by using an adjusted long-term exchange rate.

According to the Organization for Economic Cooperation and Development

(OECD), only Switzerland’s median income of $55,901 exceeds the U.S.
median income of $50,233. And in Switzerland, if adjustments are made for
comparable U.S. taxes and health insurance costs, the net median drops to
$39,306. The United Kingdom’s comparable median income is $34,000 and
Singapore’s is $30,000. Canada median income is $44,000, New Zealand’s is
$41,000 and Australia’s is $38,000.

However, the median incomes of the majority of nations in the world are less
than $10,000 per year. In fact, the majority of the world’s population lives on
less than $2 per day.

FORMS OF BUSINESS OWNERSHIP

Economists categorize output according to the three organizational forms of
business. One may start a business enterprise in one of these three forms: sole
proprietorship (alone), partnership (with one or more parties) or as a corpora-
tion (separate legal unit).

Corporations produce about 84 percent of the business output but only account
for 20 percent of the total number of firms. Sole proprietors are 70 percent of
the units but produce only 5 percent of the output. Partnerships account for
10 percent of business units and produce 10 percent of business output.

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 Figure 4.5

ADVANTAGES AND DISADVANTAGES OF OWNERSHIP FORMS

The ease of forming and operating a sole proprietorship or partnership is the
main reason owners frequently choose this form of enterprise. These simple
forms of ownership are easily understood and controlled by an owner. But,
there is also a potential problem. The extent of personal liability is unlimited,
meaning that the personal assets of the owners (sole or partners) may be tak-
en if bankruptcy occurs. Therefore, sole proprietorships and partnerships are
organized flexibly but have unlimited liability. Corporations have limited liability
but lose control to stockholders. A corporation is considered to be an artificial
legal entity and therefore assets of the corporation can be taken in bankruptcy
but not the personal assets of the owners (stockholders).

THE ORGANIZATIONAL ENVIRONMENT: COMPETITION

Business organizations are engaged in varied competitive structures within the
private economic sector. Some firms operate in highly competitive markets
with many buyers and many sellers, such as the purely competitive model,
while other firms operate in markets with little or no competition, such as the
monopoly model. Pure competition is present when the market consists of a
very large number of producers and consumers with easy entry, such as in
agriculture. Monopoly is present when there is no competition and barriers

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 exist to prevent competition. A monopoly is a one-firm industry. Competitive
markets generally have greater efficiency in resource allocation and, as a result,
have higher output and lower prices for consumers.

THE PUBLIC SECTOR

We have previously defined and described some elements of the public sector,
but now we turn our attention to specific functions of government. Although
most functions of government have come to be accepted, there is still an argu-
ment about the proper role for government and the overall social balance ques-
tion: “How much of our economy should be private and how much public?”

THE ECONOMIC FUNCTIONS OF GOVERNMENT

PROVIDES A LEGAL FRAMEWORK:
The public sector provides a system of laws for businesses and individuals
that is critical for both individual rights and commerce. A legal system must be
fair and ensure compliance with laws through enforcement. Businesses must
be able to expect stability and compliance with contracts, while individuals
must be free to choose their role in the system.

CORRECTS FOR MISALLOCATION OF RESOURCES:

Government can reallocate resources when negative or positive externalities
(also called spillover benefits or costs) affect the economic system. A nega-
tive externality is present when production or consumption inflicts costs on
third parties not part of a market transaction. An example is pollution caused
by automobiles. Individuals driving automobiles gain by having transportation
and the automobile manufacturer gains by making the sale, but third parties
that are not part of this transaction are given the cost of air pollution and traffic
congestion.

Government attempts to correct or lessen negative externalities through regu-

lation, taxes and fines. Taxes imposed on those who pollute increase costs
and cause a decrease in supply. Regulation may also be imposed directly to
decrease pollution. A combination of regulation and increased taxes has been
used to decrease automobile pollution in the United States. This occurred
when catalytic converters were required on cars, causing an increase in the
costs to manufacture and use. There was a decrease in the supply schedule

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 and a decrease in the equilibrium quantity with the increased cost. An increase
in taxes causes a similar impact of decreasing supply, causing prices to rise
and quantity produced to decrease.

A positive externality exists when third parties benefit from a transac-

tion that they did not directly undertake. An example of a positive exter-
nality is education. When society spends funds on education, the student
gains skills and the educational institution gains revenue. However, society
at large is assumed to benefit through the productivity increase provided by
a college-educated person. It is also a benefit to society. Such students with
more education will be more likely to pay taxes and be less likely to be unem-
ployed. Government subsidizes education and other public goods such as
medical care, because they have a positive affect (externality) on society at
large. Government subsidies cause a shift right (increase) in the supply for a
good or service.

REDISTRIBUTES INCOME:
Government can also reallocate resources of an economy through taxation,
by making social payments or by providing services. Federal income tax
rates are higher (progressive) on higher-income individuals. By taking more
funds through personal income taxes and providing welfare funds (transfer
payments), resources are reallocated. Transfer payments are funds given for
welfare, Medicare (elderly medical care) and Social Security (retirement pay-
ments). Transfer payments are paid without goods or services given in return to
government. Government also provides services directly to some low-income
individuals for health benefits (Medicaid). These taxes and transfers change
the overall personal distribution of income.

MAINTAINS A STABLE ECONOMY:

Government (mainly the federal branch) can promote a stable economy by
increasing spending and/or decreasing taxes in recessions and decreasing
spending and/or increasing taxes during inflationary times. The government
actions of taxation and spending are part of a fiscal policy that can be used
to exert a counter-cyclical effect on our overall economy. This, as well as
the use of monetary policy, will be discussed in much more detail in later
lessons.

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 ENCOURAGES AND ENSURES COMPETITION:
Government helps ensure the existence of competition. Monopoly power can
significantly reduce the efficient use of resources within society. Since the pas-
sage of the Sherman Antitrust Act of 1890 and other, more recent regulation,
an important function of government has been facilitating competition within
the market. Recently, the U.S. Justice Department has been given broad regu-
latory authority to monitor competition in private markets.

THE SOCIAL BALANCE DEBATE

Over the past century, there has been a continuous trend of increased spend-
ing by government as a percent of national income. In 1900, the branches of
government spent about 10 percent of total national income as compared to
about 30 percent today. There are many reasons why government spending
has increased, including war and defense, population growth (more people
need services), urban areas requiring more government services, and the con-
cept of equal opportunity. Government is involved in allocating resources to
provide expected services and to assist low-income families with opportu-
nities. These services were not expected in 1900. The arguments about the
proper role of government will, undoubtedly, continue. However, if we look
at the broad issue, most economists would agree that our dual system has
worked reasonably well over many years.

TAXATION
As we have seen, government has the ability to impose taxes, which provides
the major means to pay for public goods. Although no one likes to pay taxes,
they are a fact of life. As Supreme Court Justice Oliver Wendell Holmes said,
“Taxes are the price that we pay for living in a civilized society.” Everything has
a cost—public goods are no different.

AN EFFECTIVE TAX
Several basic economic questions need to addressed in order for a tax system
to be effective:

• Is it fair and equitable to all taxpayers?

• Is it collectable? If enough taxpayers see it as unfair, it may be difficult

to collect.

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 • Does it provide sufficient funds for effective government?

• Does it avoid over-reliance on any one tax?

• Is it regressive in its effect?

CATEGORIES OF TAXATION
ABILITY TO PAY
One long-term taxation principle suggests that those who have a greater
ability to pay should pay at a higher tax rate than those who do not. Such
taxes are called progressive; individuals with higher incomes are taxed at
a higher rate. This approach to taxation has long been applied to personal
income taxes. A higher marginal rate is applied to increasing incomes and, as
of this writing, varies from 10 percent to 35 percent on the additional taxable
income.

Figure 4.6

Federal Personal Income Taxes (2006) on Taxable Income

Marginal
ag a
Tax
a Rate
ae Single
S ge Married
a ed
10%
0% $0 - $7,550
$ ,550 $0 - $15,100
$ 5, 00
15%
5% $$7,551
,55 - $30,650 $$15,101
5, 0 - $61,300
$6 ,300
25%
5% $30,65
$30,651 - $$74,200
, 00 $61,301
$6 ,30 - $123,700
$ 3, 00
28%
8% $$74,201
, 0 - $$154,800
5 ,800 $123,701
$ 3, 0 - $$188,450
88, 50
33% $$154,801
5 ,80 - $336,550 $188,451
$ 88, 5 - $33
$336,550
35% $336,551 + $336,551 +

The marginal tax rate is applied to taxable income at varied levels of listed
income. Taxable income refers to income that is left over after standard
deductions and exemptions, as qualified by the tax code, are applied.
Therefore, using the table in Figure 4.6, we can find the tax for a mar-
ried couple making a taxable income of $16,000. This couple would pay
10 percent on $15,100 ⫽ $1,510 and 15 percent on $900 ⫽ $135 for a total
tax of $1,645.

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 BENEFITS RECEIVED
The benefits received principle is very simple. This principle argues that only
those who receive the benefits of the tax should have to pay the tax. The best
example of this would be a toll road. Those who drive on toll roads pay the toll
fee. They receive the direct benefit from paying the toll. If people do not use
the road, then they do not pay the tax.

Even though the benefits received tax might seem to be a very fair type of tax
in some cases, it is difficult to apply universally. For example, if government is
providing education as a public good, which is done throughout this country,
how could government structure an ongoing tax system based on a benefits
received principle that would be fair to all people, including future genera-
tions? We assume all of society benefits from the increased education of its
citizens because of the resulting increased goods and services produced.
However, a tax only on those students who receive an education would be
burdensome and result in decreasing educational levels, thus not promot-
ing the overall public good. Given these types of difficulties, most of our tax
structure relates more to the “ability-to-pay” concept than to the “benefits
received” concept.

CLASSIFICATION OF TAXES
Progressive taxation is present when marginal (additional) tax rates increase
with additional taxable income (i.e., a rising marginal rate is found in the federal
income tax). Personal income taxes in the United States are progressive as
individuals with higher income are taxed at a higher rate.

Proportional (flat) taxation is simply a flat rate that is applied to all individu-
als, regardless of income or wealth. Property taxes are imposed as a flat tax on
assessed value (generally market value). A specific rate is applied to the value
of the property to determine the amount of the tax. All property is taxed at the
same rate. For example, assume a 1 percent tax applied to the market value of
a home valued at $100,000; the tax would be $1,000 ($100,000 ⫻ .01). Local
school districts are often funded through a flat tax on property.

Regressive taxation is present when marginal (additional) tax rates actu-

ally decrease with additional taxable income; a decreasing marginal rate is
found with a general sales tax or payroll (Social Security) tax. Sales taxes are

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 regressive because low-income individuals spend more of their income on
taxable items. For example, assume a family makes $20,000 per year and
spends $4,000 for food that is taxed at 10 percent, paying $400 in taxes in
contrast to another family making $100,000 per year and spending $6,000 on
food with a tax of $600. The lower-income family is taxed at $400 on $20,000
or 2 percent, while the higher-income family is taxed at $600 on $100,000 or
0.6 percent.

Social Security taxes are also regressive because the tax rate only
applies to a maximum amount of $102,000 (2008) with no taxes after one
reaches this maximum. Individuals making $102,000 per year would be
taxed the same amount as individuals making $1,000,000 or even higher
annual incomes. Thus, the tax rate will decline as income increases above
$102,000. From these examples, you can understand the controversy of
regressive taxation.

CALCULATING TAX RATES

The economic calculation of marginal vs. average tax rates is found by com-
paring tax amounts with income. A marginal tax rate is the change in taxes
divided by the change in income, while an average tax rate is the amount of
taxes divided by the total income.

Notice in Figure 4.7 that the average tax is the amount of the tax divided by
the amount of the income. At $10,000, the tax is 1,000, therefore 1/10 ⫽ .10.

The marginal tax is the tax on additional income. When income increased
from $10,000 to $20,000 and the tax increased from $1,000 to $4,000, the
marginal tax rate is the change in tax ($4,000 ⫺ $1,000) over the change
in income ($20,000 ⫺ $10,000); therefore, the result is $3,000 divided by
$10,000 or .30.

Marginal tax rate is the change in taxes divided by the change in income.
Marginal taxes describe the tax rate when taxable income increases or
decreases.

When taxes are progressive, marginal tax rates increase as taxable income
increases. When taxes are regressive, marginal tax rates decrease as taxable
income increases.

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 Figure 4.7
Illustration of Progressive Tax Rates
Inco m e Tax A verage
g Tax M arginal
g Tax
$$10,000
, $$1,000
, 10% 10%
$$20,000
, $$4,000
, 20% 30%
$30,000 $9,000 30% 50%

INTENT AND EFFECT

The intent of a tax is simply the purpose lawmakers had in mind when a tax law
is passed. Most taxes are intended as progressive or proportional. A tax law is
usually not intended to be regressive, which would impose a greater burden on
low-income workers. However, economists find some taxes are progressive,
some are flat and others are regressive to some income groups.

The intent and impact of a tax may be different when we look at its real-
world application. The sales tax is intended to be proportional but, as stated
earlier, higher-income groups may not have to use all their income for con-
sumption. They may save or invest the remaining portion. Lower-income
groups do not have the same discretionary choices and are therefore taxed
at a higher rate.

TAX INCIDENCE
The incidence of a tax describes who actually pays the tax. Some taxes may
be shifted away from the intended party to someone else. Corporate taxes
are directed toward the firm, but if such taxes are shifted to the price, then
the consumer pays some tax. In this case, the corporation has effectively
shifted the tenant, depending on the price sensitivity of demand and supply
for rental units.

TAX LOOPHOLES
A tax loophole is a tax reduction built into our federal tax code for indi-
viduals or corporations. “Loopholes” are intended to promote a specific
action. For example, the tax code allows homeowners to deduct interest
and taxes on their homes to encourage home ownership. Charitable contri-
butions can also be deducted to lessen tax liability to encourage donations

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 to worthy causes. Loopholes allow tax avoidance, which is legally reducing
one’s tax liability.

Tax evasion, however, is when taxes are owed but not paid. Tax laws are pur-
posefully written to make tax liability visibly apparent and compliance enforce-
able by law officials. The Internal Revenue Service (IRS) is particularly diligent
in enforcing payment of tax liabilities.

FEDERAL GOVERNANCE: INCOME AND EXPENDITURES

FEDERAL FINANCE
As you look at Figures 4.8 and 4.9, observe the broad categories that compose
federal finance for both income and expenditure. Consider a few summary
points:

The federal government gets funds from personal income taxes (45 percent);
payroll taxes, including Social Security (37 percent); and corporate income
taxes (13 percent). Other sources of funds include excise taxes and tariffs. See
Figure 4.8 below.

2006 Federal Government Sources of Funds

37%
13%

Figure 4.8

The federal government uses funds for income security and pensions
(35 percent); health (21 percent); national defense (20 percent); and interest on
national debt (7 percent). See Figure 4.9.

Fiscal federalism is when the federal government shares revenue with

state, local and other governmental units for poverty, health and highway
programs.

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 2006 Federal Government Use of Funds

Figure 4.9

35%
21%
20%
7%
17%

Government has two ways to spend money—transfers and purchases. A trans-

fer payment, as discussed earlier, is government spending for which nothing
is directly received in return. Examples include welfare payments or subsidies
paid to farmers. However, government also purchases goods and services just
as a consumer or a company would. Transfer payments are currently about half
of the total federal government’s spending and growing rapidly as a percent of
total spending.

TAX AND LOCAL FINANCE:

Texas gets 59 percent of operating funds from tax collections (mostly sales
taxes), 25 percent from federal aid (revenue sharing by federal govern-
ment), and 6 percent from interest income. Texas uses funds for education
(44  percent), human services (18 percent) and transportation (11 percent),
with the remainder going toward operating expenses. A relatively new source
of funds for states is a lottery, which is a game of chance run by the state to
raise revenue.

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 Texas receives much of its tax funds from sales taxes, which are regressive.
Most states in the United States receive significant funding from revenue
sharing from the federal government and from state income taxes. Texas is
one of the few remaining states that does not have an income tax.

SUMMARY
Both the private and public sectors are essential to the American economic
system. Each sector provides a critical economic function for the other. The
efficiency of the private sector promotes growth, while the public sector seeks
to promote stability, equity and competition.

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 Real-World Economics
THE ROLE OF GOVERNMENT?
Since the early 1980s, Democrats and Republicans have debated ideas about the
proper role for government. During the recent presidential campaigns, the issue has
grown more evident.

What is the proper role for government? How do tax cuts really affect our econ-
omy? Are lower taxes always better for economic growth? How have these changes
affected our society?

Consider these two opposing views, and consider how this issue has come to be a
part of our pop culture after watching the Daily Show link. What do you think?

Please access links through online E-text.

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 Lesson
Key Terms Four

Ability to Pay: A principle of taxation that entity can get someone else to pay the tax,
suggests that those who have more should we conclude that the incidence has been
pay more tax. shifted.

Benefits Received: A category of taxation Intent of a Tax: What lawmakers intend

where only those who pay the tax receive a tax to be when it is passed into law. All
the benefits of the tax. A good example is a taxes are intended to be progressive or
toll road. proportional.

Corporation: A form of business Negative Externality: When private

ownership characterized by a legal entity production shifts part of the cost to a
owning the enterprise. third party. With pollution, there is a
misallocation of resources because the
Dual System: A mixed economy with a costs of private production are shifted to
viable role for public and private sectors in society in general.
the allocation of resources.
Nondurable Goods: Goods with an
Durable Goods: Goods with an expected expected useful life of less than three years.
useful life of more than three years.
Partnership: Similar to a sole proprietor-
Effect of a Tax: The true, real-world ship but with multiple owners.
impact of a tax.
Personal Distribution of Income: Total
Functional Distribution of Income: income divided by total households or
Dividing total income into resource or factor spending units.
categories (i.e., wages, rents, profits, etc.).
Private Sector: All consumers and private
Government Purchase: Public sector firms organized with a profit motive.
purchases of goods and services.
Progressive Tax: A type of tax where the
Incidence of a Tax: The individual or rate of taxation (marginally) increases as
entity that a tax is directed toward. If that does taxable income.

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 Lesson
Key Terms Four

Proportional or Flat Tax: A type of tax

that does not change as taxable income
increases.

Public Sector: All segments of

government—federal, state and local.

Regressive Tax: When a tax has a greater

impact on lower-income groups than on
upper-income groups.

Social Balance: The conscious decision

made by a society in the way that
resources are allocated between public and
private sectors.

Sole Proprietor: A form of business

ownership characterized by a single owner.

Tax Loopholes: Items built into the

federal tax code that allows a reduction
in personal and corporate tax liability for
certain activities, such as home ownership,
charity, etc.

Transfer Payments: Spending on the

part of government for which nothing is
received in return.

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 Applied Exercises
Exercise One:
Calculate the average and marginal tax rates for the following table. Is this tax
progressive? How do you know? What generalizations can you offer concern-
ing the relationship between marginal and average tax rates?

Income Tax Average Tax Rate Marginal Tax Rate

$0 0 __________________
________________
100 10 __________________
________________
200 30 __________________
________________
300 60 __________________
________________
\ 400 100 __________________
________________
500 150 __________________

Exercise Two:
Given the following Federal Tax Table, find the taxes for an individual in contrast
to a couple making a taxable income of $100,000. What is the average tax rate
for each?

Marginal Tax Rate Single Married

10% $0 - $7,550 $0 - $15,100

15% $7,551 - $30,650 $15,101 - $61,300
25% $30,551 - $74,200 $61,301 - $123,700
28% $74,201 - $154,800 $123,701 - $188,450
33% $154,801 - $336,550 $188,451 - $336,550
35% $336,551 + $336,550 +

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 Applied Exercises
Exercise Three:
Given the table of current dollar and real dollar GDP values from the Bureau of
Economic Analysis, find the following:

A: How much has GDP grown adjusted for inflation between 2000Q1 and
2009Q1?

B: When was a recession present?

C: How much inflation has occurred between 2000q1 and 2009q1?

Year/Quarter Current $ GDP Real $ GDP

2000Q1 $9,629 $9,696
2000Q2 9,823 9,848
2000Q3 9,862 9,837
2000Q4 9,954 9,906
2001Q1 10,022 9,876
2001Q2 10,129 9,906

2008Q1 14,151 11,946

2008Q2 14,295 11,727
2008Q3 14,413 11,712
2008Q4 14,200 11,522
2009Q1 14,090 11,354

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 Applied Exercises: Answers
Exercise One:

Income Tax Average Tax Rate Marginal Tax Rate

$0 0
.1
100 10 .1
.2
200 30 .15
.3
300 60 .2
.4
400 100 .25
.5
500 150 .3

Yes, it is progressive. Marginal rates rise faster than the average rates.

Exercise Two:

A: Single individual making $100,000: $755 on first $7,550, 15 percent

on $7,551 to $30,650, 25 percent on 30,651 to $74,200, 28 percent on
$74,201 to $100,000. ($755 ⫹ $3,435 ⫹ $10,887 ⫹ $7,224) ⫽ $22,301.
The average tax rate is $22,301/$100,000 ⫽ an average tax rate of
22 percent.

For a couple making $100,000: $1,510 on first $15,100 and 15 percent on

the next $46,200 and 25 percent on the final $61,300. ($1,510 ⫹ $6,930 ⫹
$9,675) ⫽ $18,115 or an average tax rate of 18 percent.

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 Applied Exercises: Answers
Exercise Three:

A: How much has GDP grown adjusted for inflation between 2000Q1 and
2009Q1?

2001Q1 ⫽ $9,697 and 2009Q1 ⫽ $11,354, therefore the difference is the

real growth ($11,354 ⫺ $9,697) ⫽ $1,658 or $1,653/$9,697 ⫽ 17 percent.

B: When was a recession present?

A decrease in real GDP occurred in 2000Q3 and 2001Q1 and again

in 2008Q2, Q3 and Q4, officially creating a recession with 3 quarterly
declines in real GDP.

C: How much inflation has occurred between 2000q1 and 2009q1?

Assuming constant dollars from 2000q1, then 2009Q1 14,090/11,354 ⫽

1.24 or approximately 24 percent total inflation of the nominal GDP over
the real GDP.

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