The Importance of Government

Economic Functions

• Provide a legal system that makes transactions fast and easy

• Promote and maintain competition in the market

• Ensure economywide stability• Redistribute resources

Provide public goods

• Characteristics of public goods– indivisible– additional users do not

add to cost– not mutually exclusive

in use– hard to collect based

on use

• Free rider problem

Merit and Demerit Goods

• Government is to promote the production and consumption of merit goods– goods thought to benefit to society

• Government is to discourage the production and distribution of demerit goods– goods thought to harm society

Correct for Externalities

• Negative Externality– A transaction

negatively impacts a third person

• Market Failure – equilibrium quantity is

too high and equilibrium price is too low

Correcting Negative Externalities

• Shift supply curve to the left– tax– number of firms in the

industry

• Shift demand curve to the left– population– income– tastes and preferences

Demand

Supply

Correct Externalities

• Positive Externality– a transaction benefits a

third party

• Market Failure– Equilibrium quantity is

too low and equilibrium price is too high

Correcting Positive Externalities

• Shift supply curve to right– subsidies– number of firms in the

industry

• Shift demand curve to right– population– tastes and preferences– income

Demand

Supply

Government Failure

• Government spends more correcting

externality than the amount of the damage

caused by the externality

Income Redistribution

Tax d o lla rs sen t toth ose w ith lower in com es

S oc ia l In su ran ce P rog ram sP u b lic A ss is tan ce P rog ram s

Tax d o lla rs takenfrom th ose earn in g h ig h er

leve ls o f in com e

G overn m en t

Why is Government so Large?

• Government Spending as a percentage of

GDP

– 1930 - 10%

– 1950 - 13%

– 1970 - 21%

– 1994 - 19%

• Increased military spending

• Population growth

• Rising expectations

• Inflation

Changing Attitudes

• In the beginning - “best that governs least”• 1930s - Public demanded government

action and help• 1960s - Johnson’s “War on Poverty”• 1990s - Government seen as too large,

inefficient, and corrupt. Many want the states and local governments to take over

The Federal Budget

– The Office of Management and budget prepares budget 15 months ahead of implementation

– President presents as recommendation to Congress in January before implementation

– Congress makes any changes they feel necessary by passing appropriation and revenue bills; submit to president for signature

– May change because: unexpected may occur and tax revenues may fall due to recession

Federal Revenues

1.20% 1.60%2.10%

4.30%

43.70%

11.20%

35.90%

Indivdual Income tax

Corporate Income Tax

Social Insurance

Excise Tax

Estate and Gift Taxes

Custom Duties

Other

Federal Expenditures

0.90%1.10% 1.10%

1.20%1.40%

0.30%

0.80%18%

14.50%

7.50%

10.20%21.80%

15.20%

2.50%

3.90%

2.50%

0.90%

National defenseInternational AffairsIncome SecurityHealthMedicareSocial SecurityVeteran's BenefitsEducation and TrainingCommerce and Housing CreditTransportationNatural ResourcesEnergySlice 13AgricultureNet InterestGeneral ScienceGeneral GovernmentAdministration of Justice

State and Local Revenues

1.70%

5.10%

14.90%

12.90%

16.50% 20.40%

11.80%

15.70%

Fees and Miscellaneous

Federal Government

Income Taxes

Property Taxes

Social Insurance

Utilities,Liquor Stores

Other Taxes

Sales Taxes

State and Local Spending

1.60%

2.40%

5.40%

2.90%

4.80%6.20%

5.60%

5.60%

7.90%

15%13.80%

25.80%

Education

Welfare

Highways

Utilities, Liquor Stores

Insurance Funds

Health and Hospitals

Other

Housing and Urban Renewal

Natural Resources

Interest on Debt

Crininal Justice

Government administration

Financing Government

• Three sources of government funds

– taxation

– borrowing

– printing money

Why Taxes?

• Pay the cost of government• Redistribute income and wealth• Promote certain industries• Influence consumer and business spending

patterns• Discourage certain behavior

Principles of Taxation

• Horizontal Equity– Equal income is taxed equally no matter how it

is earned

• Vertical Equity– Unequal income is taxed unequally

• Ability to pay - those with higher incomes should pay more in taxes

• Benefits received - those who receive the greatest amount of benefit should pay more in taxes

Taxation Systems

ProportionalTaxationSystemFlat 20%

ProgressiveTaxationSystem10% , 20% ,30%

RegressiveTaxationSystem30% , 20% ,10%

Person A$10,000 $2000 $1000 $3000Person B$20,000 $4000 $3000 $5000Person C$30,000 $6000 $6000 $6000

Taxes in the United States

ProgressiveTaxes

ProportionalTaxes

RegressiveTaxes

Personal IncomeTax

Social SecurityTaxes

Excise Taxes

Estate Taxes Property Taxes Sales Taxes

Corporate IncomeTaxes

Custom Duties

Gift Taxes

Federal Personal Income Tax Rates

Tax Rate Single MarriedFiling jointly

15% 0-22,750 0-38,000

28% 22,751-55,100 38,001-91,850

31% 55,101-115,000

91,850-140,000

36% 115,001-250,000

140,001-250,000

39.6% - 250,000+

Tax Incidence

• Inelastic Demand– Tax can be shifted to

the consumer• S2 - After tax supply curve

• Qtax- A-amount received by producer

• A-B - tax paid by producer• B-C -tax paid by consumer• A-C -total amount of tax

0

Price

Quantity

D1

S1

Pe

Qe

S2

Ptax

Qtax

A

B

C

Tax Incidence

• Inelastic Demand– Tax may be shifted

back to suppliers– A- amount that goes to

producers– A-B - amount of tax

absorbed by producers– B-C - higher price paid

by consumer– A-C- amount of tax0

Price

Quantity

D1

S1

Pe

Qe

S2

Ptax

Qtax

A

B

C