Chapter 5The U.S. Economy: Private & Public Sectors

Mixed Economy = Free Market + Socialism

Functional Distribution of US Income 2002

W ages & Salar ies

Rents

In teres t

Corporate Prof its

Propr ie tors Inc ome

Wages and Salaries 72 %

Rents 2%

Interest 8%

Corporate Profits 9%

Proprietors Income 9% owner of a business

Disposition of Household Income: How it’s spent

2008 International Monetary Fund

The five economic functions of the government # 1

Provide a Legal Framework for Capitalism:

• Enforce Laws and Contracts.

• Print Money• Establish official weights &

measures• Establish standards for

consumer goods (ex. Meat Inspection Act)

The five economic functions of the government # 2

Protect markets from monopolistic behavior and promote competition (ex Sherman Anti Trust Act)

The five economic functions of the government # 3

Redistribute Income. • Provide an Economic

Safety Net: subsidize (welfare, social security)

• Tax the rich to give to the poor

• Regulate labor (minimum wage, unions)

The five economic functions of the government # 4

Pay for the Infrastructure* that allows economic growth

* the fundamental facilities and systems serving a country, such as transportation and communication systems, power plants, and schools.

http://www.cnn.com/2009/US/03/12/corridor.h/index.html#cnnSTCVideo

US Budget for 2009

The five economic functions of the government # 5

Correct Market Failures: (Recession, Inflation)

• Stabilize the Economy: Provide market information, Correct negative externalities, Subsidize goods with positive externalities

• Fight unemployment

• Encourage price stability

• Promote economic growth 

Spending Side Effects: Spillovers (Market Failures)

• Benefits: gov'ts, firms and individuals can pay for goods & services that do not just benefit them but spillover & benefit us all

• Costs: gov'ts, firms and individuals can pay for goods & services that create a negative cost to others

Spillovers

• are EXTERNALITIES of economic activity* or processes upon those who are not directly involved in it.

• For good (Benefit) or bad (cost)

*producing, selling, buying goods/services

Spillovers are Market Failures

• Negative: pollution, Odors from a rendering plant

• Positive: the beauty of a homeowner's flower garden is a positive spillover effect upon neighbors.

two major cases of market failure #1 Spillovers (Positive or Negative Externalities)

Pollution (obviously) negative because cost to society is not 100% paid by company.

Vaccinations, you can be the one unvaccinated kid; Pharmaceutical company loses the profit from your vaccine.

two major cases of market failure # 2

2. Fails to allocate any resources whatsoever to the production of certain goods/services whose output is economically justified. (regards Public Goods)

Two basic corrective actions the government can take to correct for negative externalities

1. legislate

there is one drug bust in the U.S. every 18 seconds

Two basic corrective actions the government can take to correct for negative externalities

Tax the offending product (Excise Tax)

positive spillover benefits or positive externalities

Actually create a loss in the economy and are also considered a ‘market failure’.

The loss to the economy in the graph is represented by the rectangle created by (Ps – Pp) x (Qs- Qp)

A positive externality can be corrected.

The guy in the middle wants to sell his house. The value is enhanced by his neighbors (Rod & Mariah) property values.

He doesn’t bother spending $$ to fix it up.

three ways a positive externality can be corrected

• Subsidize the seller• Subsidize the buyer• You provide the good

Correcting Externalities

• Subsidize Consumers

• ex: cities provide funds to improve neighborhoods, lighthouses, education, and national defense.

Correcting Externalities

• Subsidize Suppliers

• Ex: gov't provides funds for hospitals & universities

http://www.cnn.com/video/#/video/world/2010/09/23/boulden.uk.wind.farm.cnn?hpt=Sbin

PRIVATE GOOD

• A private good is rival and excludable.

• An example of a private good is my car. There are a fixed number of cars; there are not enough built for everyone to own one. My car is also excludable; I do not have to allow anyone else to drive or ride in my car.

PUBLIC GOOD:

• Paid for by the government, is non- excludable and is non rival.

• The non rival part of this definition means that my consumption does not affect your consumption of a good; I do not "use it up". (Examples: Air, national defense, sunlight, fireworks)

Non-excludability

• Non-rivalness and non-excludability may cause problems for the production of such goods. Why bother producing it if I can’t make $$

Free Riders

• Those who consume more than their fair share of a public resource, or shoulder less than a fair share of the costs of its production.

Free Riders are Consumers & Producers

• Ex: factories that pollute, do not pass the ‘cost of pollution’ to consumer.

• Price of that good in the market place is too low.

Negative Externality: Pollution in ChinaIt’s why goods are cheaper to make there.

Why Free Riders are a Market Failure

Underestimates the ‘real’ demand for a good/service as so industry under-produces and revenues & jobs are lost

Free Riders

• Free riding is considered to be an economic "problem" only when or when it leads to the excessive use of a common property resource.

Firms Are Profit Orientated

• In the Free Market & Capitalistic systems private firms do not produce those goods/services because they can’t stop free riders, so why would anyone pay?

Tragedy of the Commons

is a dilemma in which multiple individuals, acting independently, and solely and rationally consulting their own self-interest, will ultimately deplete a shared limited resource even when it is clear that it is not in anyone's long-term interest for this to happen.

Spillovers Create Inefficiency

• Doesn’t matter Beneficial or negative, both cause goods to be over or under produced.

As Gt Br pays for wind farms, demand for coal decreases,price decreases, and China uses more coal and there is less incentive for China to use wind energy.

How the government allocates resources to public goods

• Public Policy: bills to spend money or to tax

circular flow chart

Difference between government purchases and transfer payments

• Government Purchases: Government buys goods and services.

• Transfer Payments: government gives money to individuals to increase their income (Social Security) Government Purchases & Transfer Payments

as a percent of GDP

Government Spending

• government purchases and transfer payments and interest

• Biggest item: _____

Some of the causes of the growth of public spending

A) War and Defense:

B) Population Growth:

C) Urbanization and the Demand for Public Goods:

D) Environmental Quality:

E) Egalitarianism: (to try & make the world a better place)

4 major sources of Federal revenue

1. Personal Income Tax:

2. Payroll Tax:

3. Corporate Tax:

4. Excise Tax:a tax levied on certain goods (gas, cigarettes). Typically tax is added to price.

graduated or progressive tax system

• higher tax rates for people with higher incomes. Direct Relationship.

• “Ability to pay”: the more you earn, the higher your tax rate will be.

taxable income between tax bracket

0 and 8,025 10%

8,025 and 32,550 15%

32,550 and 78,850 25%

78,850 and 164,550 28%

164,550 and 357,700 33%

357,700 and above 35%

Taxable Income = Income – (Deductions + Exemptions)

• Deductions: property taxes, interest on mortgage, charity contribution, kids

Deductions aka Tax ‘Loopholes’

• The US IRS tax system allows for legal deductions that lower taxable income

• US Tax System not as Progressive as it looks!

$19,900,000 summer houseProperty taxes $40,424 Interest on Mortgage: 950,000

progressive tax system Rationale

• Has to do with creating income equity not because wealthier people drain government recourses more, (because clearly they don’t!)

Cops arrest meth lab

Tax Rates

Average Tax Rate:

ATR = Average Taxes Paid             Total Income  

Example: Income $60,000

ATR = 10,541.75 = 17.57%

60,000

taxable income between tax bracket

0 and 8,025 10%

8,025 and 32,550 15%

32,550 and 78,850 25%

78,850 and 164,550 28%

164,550 and 357,700 33%

357,700 and above 35%

Marginal Tax Rates

• Marginal Tax Rate: the rate of tax applied to the last dollar added to your taxable income

• Income is $60,000

MTR = 25%

taxable income between tax bracket

0 and 8,025 10%

8,025 and 32,550 15%

32,550 and 78,850 25%

78,850 and 164,550 28%

164,550 and 357,700 33%

357,700 and above 35%

Regressive Tax

• A tax that takes a larger percentage from low-income people than from high-income people.

• Social security (because there is a cap)

• Sin Taxes & Lotteries

Proportional Tax

• Same % for all income levels

• Ex. Sales Tax• Ends up being

Regressive because lower income people spend a larger percent of their income than rich people on sales tax.

Social Security Tax (FICA) is Regressive

• For wage levels above the limit, the absolute dollar amount of tax owed remains constant: You make $100,000 you pay same AMOUNT as Lady Gaga.

• Federal Insurance Contributions Act

Adam Smith, Wealth of Nations

“The necessaries of life occasion the great expense of the poor. They find it difficult to get food, and the greater part of their little revenue is spent in getting it. The luxuries and vanities of life occasion the principal expense of the rich, and a magnificent house embellishes and sets off to the best advantage all the other luxuries and vanities which they possess.” 1776

http://www.youtube.com/watch?v=_YXB0uGSKFU

Proportional Tax or Flat Rate

• Fixed Tax Rate: everyone pays the same %.

• Sales Tax is an example of this. Which is regressive because poorer people are left with less

Disproportionate Tax

• Tax that is NOT proportionate to income or consumption.

• Could tax rich more than poor (luxury tax) or poor more than rich (sin tax).

Lump Sum Tax:

• a fixed amount no matter what the circumstance of the taxed entity or income level of the taxpayer.

• Poll Tax• Tolls on highway• Considered

Regressive, unequal

Federal Government Revenues

#1 Individual Income taxes

#2 Payroll Taxes

#3 Corporate Income Taxes

four sources of revenue for the state governments

• Sales taxes, excise taxes

• State Income tax• Corporate Income

Taxes & Licensing Fees

Excise Taxes

• taxes paid when purchases are made on a specific good, such as gasoline.

• Excise taxes are often included in the price of the product.

• Examples: gas, cigarettes, alcohol

Benefit Received Principle

• the individuals who receive the benefit of a good or service should pay the tax necessary to supply that good or service: gas taxes are finance highway construction and repairs.

http://www.tobaccofreekids.org/research/factsheets/pdf/0097.pdf

Transfer Payment

• Funds given to State Governments from the Federal Government

• Book does not show this as major revenue source for states

four major expenditures for the state governments:

• Education• Public

welfare• Health &

Hospitals

The two major sources of revenue for the local governments

1. PROPERTY TAXES

Mayor Donald Zeigler

The major expenditures for the local governments

Lotteries!

the Federal government’s reduction in transfers and grants led to an increase in state lotteries to create the missing revenue.

By Agethe massive postwar Boomer generation 50- 64

Lottery Revenue Pays for Gov't Programs

the real winners are supposed to be education, environmental protection, and other projects earmarked to receive lottery proceeds.

How has the Federal government’s reduction in transfers and grants led to an increase in state lotteries?

• Lotteries bring in revenues to States and increasing lotteries helps states survive the Federal government giving states less.