Public Finance and Public Choice

In this world, nothing can be said to be certain except death and taxes.

-Benjamin Franklin

Slide 1 of 25

Government spending comes from several levels

Federal State Local

$ = $100 billion

$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$

$$$$$$$$$$$$$$$$$$$$

$$$$$$$$$$$$$$

$3.5 trillion $2.0 trillion $1.3 trillion

How much did our government spend in 2012?

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U.S. Government spending is an enormous force

Combined, U.S. government

spending (at all levels) totaled more than $6 trillion in 2012.

To put that figure in perspective, that is more

than every dollar earned by every resident in China

So where does it all come from?

Slide 3 of 25

Tax revenue

For the Federal government, it primarily comes from taxes and

from borrowing.

Federal taxes will generate a little more than $2 trillion this year.

The rest of the money will be borrowed through the sale of

bonds.

Slide 4 of 25

We’ve borrowed a lot!

Here, we see the U.S. Federal Government’s spending (in red) and

revenue (in blue).

Any time the blue line is higher than the red line, that

means our government is running a surplus…i.e. saving

money.

Clearly that has not been happening lately. Total U.S. government debt exceeded

$15 trillion in 2012.

Slide 5 of 25

Funding government programs

Let’s turn our attention to taxes….

who pays them?

Slide 6 of 25

Government programs are funded (in part) through taxes and fees

How does a government determine who pays the taxes and fees?

Determining who pays gets at the idea of tax burden, a concept we’ll explore on

the next few slides.

Who should carry the burden?

Slide 7 of 25

What is tax burden?

Tax Burden - Taxes collected in an area divided by Total Income in that area.

High taxes in a low income area results in

a high tax burden.

Low taxes in a high income area results in

a low tax burden.

Slide 8 of 25

How is the State and Local tax burden in Virginia?

Virginia Ranks 41st

In Maine, 13% of income is paid to state and local

taxes!In Alaska, state and

local tax burdens are very low.

Residents receive tax rebates from oil

revenues!

People routinely complain about how high the state

and local taxes are in Virginia.

Those complaints are not justified!

What do you think:

Are State and Local taxes high or low in Virginia?

In other words, is our burden heavy or light?

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So how should burdens be distributed?

There are two schools of thought:

People should pay based on the benefits

they receive

People should pay based on their

incomes

Benefits-received principal

Ability-to-pay principal

Examples include income

and payroll taxes.

Examples include gas

taxes and tolls.

Slide 10 of 25

The benefits received principle

• These taxes are referred to as “user taxes”– Like a toll road, only people that use the service pay.

• These taxes are good for some applications– Gas Tax– Pollution Tax– Congestion Tax

• They are not good for other applications– National defense– Police and fire protection

How can you value the benefit of national defense or public safety?

Gas taxes are used to pay for road construction. Shouldn’t those that drive be those that pay?

Slide 11 of 25

The ability to pay principal

• Proponents believe tax burdens should be disproportionately heavy on higher income households and business

• This principal can be problematic

– There is not a good way to measure ability to pay

– Should households pay equal percentages of income?

This idea refers to tax regressivity and progressivity (See next slide).

Why? Because each additional dollar of income yields less marginal utility.

Slide 12 of 25

Progressive, proportional, and regressive taxes

All taxes are classified into one of these three categories based on the relationship between tax rates and taxpayers’ income.

Slide 13 of 25

Let’s evaluate three taxes to see if they are Progressive, proportional, or regressive

Household A

Income = $30,000/yr

Household B

Income = $100,000/yr

Assume a government wants to provide a

public good.

Household A

Pays $5,000 or 18%

Household B

Pays $5,000 or 5%

This tax is regressive!

The government proposes three taxes

to pay for it.

Tax Proposal #1: Each house pays

$5,000/yr

Slide 14 of 25

Let’s evaluate three taxes to see if they are Progressive, proportional, or regressive

Household A

Income = $30,000/yr

Household B

Income = $100,000/yr

Tax Proposal #2: Each house pays 5% of first $20,000 and

7% of all income above $20,000

Household A

Pays $1,700 or 5.7%

Household B

Pays $6,600 or 6.6%

This tax is progressive!

Slide 15 of 25

Let’s evaluate three taxes to see if they are Progressive, proportional, or regressive

Household A

Income = $30,000/yr

Household B

Income = $100,000/yr

Tax Proposal #3: Each house pays

10% of total income.

Household A

Pays $3,000 or 10%

Household B

Pays $10,000 or 10%

This tax is proportional!

Slide 16 of 25

Example of a Progressive tax: Federal income tax

Do you ever wonder why the schedule

for federal income tax is so confusing?

Household A

Income = $34,625/yr

Income tax=$4,439

Tax rate =12.8%

Household B

Income = $126,761/yr

Income Tax = $24,897

Tax rate =19.6%

Federal Income tax

is Progressive!

The schedule ensures that

this tax remains

progressive!

Slide 17 of 25

Example of a regressive tax: Virginia’s sales tax

Household A

Income = $34,625/yr

Retail Expenditures = $25,420

Sales tax costs = $1,271

Tax rate =3.7%

Household B

Income = $126,761/yr

Retail Expenditures = $60,250

Sales tax costs = $3,013

Tax rate =2.4%

Virginia’s sales tax rate is 5%.

At first glance, this looks proportional.

Sales tax is regressive!

Slide 18 of 25

Many taxes are regressive

• Payroll taxes - regressive– These taxes are only applied to a fixed

amount of income• Social Security and Medicaid taxes are levied

only on first $87,000 of income

• Property taxes - regressive– Taxes are higher as a percent of income

• In some cases rates are increased in poorer areas to make up for declining revenues making those taxes more regressive

Slide 19 of 25

Evaluate any new tax!

Unfortunately, the sales tax seems to be the tax of choice for financing

many new government projects.

During the course of your life, your state and local government will ask you to vote

on many projects.

I encourage you to evaluate the funding source carefully.

As a regressive tax, sales tax places more burden on low income households.

For example, it might seem unfair to use sales tax to finance a basketball arena that may only be attended by

high income households.

Slide 20 of 25

Keep in mind that determining who pays a tax can be tough

D

S

In this market, equilibrium price will be $700 and quantity will

be 16 units.

However, if a $200 per unit tax is levied, supply

will shift to the left.

Price will rise, and quantity will fall

Note how price has only increased by $100.Some ($100) of the tax

is being paid by the consumer

The rest, is being paid by the producer.

$200 tax

This idea of determining who pays is referred to as the “Incidence of tax”

Slide 21 of 25

Keep in mind that determining who pays a tax can be tough.

D

S

Notice though – with a far more elastic

demand curve, the incidence of taxation

falls more on the producer.

Here the purple box (share of taxes paid by

the producer) is far bigger than the red box (share of taxes paid by

the consumer)

$200 tax

This should make sense. With elastic demand, consumers

are willing to go without given a higher price.

Therefore, the tax falls on the producer.

Slide 22 of 25

Keep in mind that determining who pays a tax can be tough.

D

S

The opposite is true with an inelastic

demand.

Here the purple box (share of taxes paid by

the producer) is far SMALLER than the red

box (share of taxes paid by the consumer)

$200 tax

Again, this should make sense. With inelastic demand,

consumers have to have this good. A tax will largely be “passed on” to the consumer.

Slide 23 of 25

In Summary

Some of the money that a government spends is used to correct for market

failure.

Some of that money comes from taxes (and fees) with the rest coming from

borrowing.

However the burdens of those taxes are not carried equally by all.

As a voter, you should consider these burdens carefully when analyzing a newly

proposed tax change!

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Credits

Slide 4: http://en.wikipedia.org/wiki/File:Capitol_Building_Full_View.jpgSlide 6: http://www.flickr.com/photos/safari_vacation/7220861734/Slide 7: http://commons.wikimedia.org/wiki/File:StateLibQld_2_102489_Sugar_cane_worker_carrying_a_bundle_of_cut_cane_at_Nambour,_Queensland,_1938.jpgSlide 10: http://www.flickr.com/photos/donkeyhotey/6263542143/Slide 11: http://commons.wikimedia.org/wiki/File:Shuto_expressway_oi_toll_booth.jpgSlide 19: http://www.flickr.com/photos/68751915@N05/6757828303/Slide 20: http://commons.wikimedia.org/wiki/File:London_Olympics_2012_Basketball_Arena.jpg

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