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CHAPTER 16

GOVERNMENT TAXATION AND EXPENDITURE


I. CHAPTER OVERVIEW

Government has, in most industrial countries, grown tremendously over the course of this century. In
response to two world wars, a deep and severe depression, a cold war, and a myriad of other social and
economic concerns, governments have taken on the burdens of providing for an increasingly complex
society. Government spending has increased. Taxation, income-support programs, and regulatory
intervention have increased.
This growth in the size and scope of government has not come without controversy. Those opposed
to big government in the United States believe that “Uncle Sam” has overstepped his bounds and needs to
be reigned in. It must be admitted before we even begin our discussion that “government failure” is as
much of a possibility as “market failure;” that is, government programs can fail to distribute resources in
an efficient or equitable manner. However, in order to make this assessment, we need to develop some
analytical tools.
It is our goal in the chapter to, first, learn about the types of roles that a government could play in a
mixed economy. Second, we will turn our attention to the roles actually assumed by government at all
levels in the U.S. economy. We will consider the major expenditure patterns of government at all levels
that help to define a system of fiscal federalism that distributes responsibilities across local, state, and
federal authorities. Finally we will address issues of taxation and develop some alternative strategies that
might be used to collect revenues that must be used to finance all this spending.

II. LEARNING OBJECTIVES

After you have read Chapter 16 in your text and completed the exercises in this Study Guide chapter, you
should be able to:
1. Describe the path that fiscal federalism has followed in the United States this century.
2. List, explain, and provide examples of the four major functions that government must consider:
(a) improving economic efficiency, (b) reducing economic inequality, (c) stabilizing the economy
through macroeconomic policies, and (d) conducting international economic policy.
3. Discuss the construction of an efficient system of fiscal federalism and the blurring of
responsibilities that necessarily occurs along the boundaries of the different levels of government. List
the most important types of expenditures made at each level.
4. Describe the conflicting principles of taxation—the benefit approach and the ability-to-pay
approach—and the compromise between the two that has been accomplished in the United States.
Relate these principles to the notions of horizontal and vertical equity.
5. Categorize alternative tax schemes as progressive, proportional or regressive and as involving
direct or indirect taxation.
6. Understand the principles around which the federal, state, and local tax system are organized.
7. Discuss efficiency as an issue in the design of a tax system
8. Define the term tax incidence and explain why and how a tax might not be “paid” by the
economic agent identified in the tax code.

III. REVIEW OF KEY CONCEPTS

Match the following terms from column A with their definitions in column B.
A B
__ Economic regulation 1. Tax that takes a larger fraction of income in taxes from poor families than
from rich families.
__ Social regulation 2. States that the government should levy the heaviest taxes on those inputs
and outputs that are most price-inelastic in supply or demand.
__ Laissez-faire 3. Concerns the tax treatment of people with different levels of income.
__ Income 4. The view that government should interfere as little as possible in economic
redistribution activity and leave decisions to the marketplace.
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__ Public-choice 5. Collects taxes at each stage of the production process.


theory
__ Fiscal federalism 6. Taxes designed to help the environment as well as to raise revenues.
__ Entitlement 7. Implies a division of fiscal responsibilities among the different levels of
programs government.
__ Benefit principle 8. Government policies designed to protect public health and safety.
__ Ability-to-pay 9. Government policies designed to enforce price controls, establish conditions
principle of exit and entry, and set safety standards for markets.
__ Horizontal equity 10. Equal to total taxes divided by total income.
__ Vertical equity 11. States that those who are essentially equal should be taxed equally.
Progressive taxes 12. Claimed that the disincentive effects of high marginal tax rates were
responsible for many of the nation’s ills—low savings, recession, etc.
__ Regressive taxes 13. Government policies designed to devote more resources to providing
services for poor people.
__ Direct taxes 14. The branch of economics that studies the way that governments make
decisions.
__ Indirect taxes 15. The way that the burden of a tax is ultimately borne and its total effects on
the behavior of economic agents.
__ Effective tax rate 16. Holds that different individuals should be taxed in proportion to the benefit
that they receive from government programs.
__ Marginal tax rate 17. Taxes that are levied on goods and services, and thus only “indirectly” on
individuals.
__ Value-added tax 18. Programs that provide benefits or payments to any person who meets
eligibility requirements set down by law.
__ Ramsey tax rule 19. States that the amount of taxes people pay should relate to their income or
wealth.
__ Supply-side 20. Tax that takes a larger fraction of income from rich families than from poor
economics families.
__ Green taxes 21. The extra tax that is paid per dollar of extra income.
__ Tax incidence 22. Taxes that are levied directly upon individuals or firms.

IV. SUMMARY AND CHAPTER OUTLINE

This section summarizes the key concepts from the chapter.

A. Government Control of the Economy


1. Governments use primarily three tools to influence private economic activity: taxes, expenditures and
transfer payments, and regulations. Taxing and spending are often referred to as fiscal tools; the
government is operating as a consumer or is attempting to redistribute income. Regulations establish rules
which limit the ability of firms to operate in their own best interest.
2. The economic role of government has grown dramatically at all levels and across many countries over
the last half-century. Economic regulation has involved government in price setting, in monitoring and
encouraging competition, and in establishing safety standards in many industries. Examples of actions in
this area include the recent decision againt Microsoft in the software industry, and the development of the
Occupational Safety and Health Administration (OSHA), which oversees the welfare of employees at work.
Social regulation has involved government in the area of public health and safety. Examples of actions in
this area include the institution of seat belt laws in many states and the Clean Air Act, which established
clear targets for diminishing the amount of pollution in the air we breathe.
3. There are four primary functions of government in a mixed economy. First, government can take
actions to improve economic efficiency. Although the invisible hand can bring about efficient solutions to
economic problems, there are times when the market fails. A legal system is needed to enforce contracts
and to establish rules for agents operating in the economy. Some sort of antitrust policy is needed to limit
the extremes of imperfect competition and the emergence of monopoly power. Government is needed to
improve the quality of information in an economy and to negotiate efficient solutions to problems
involving externalities and public goods. In short, the government can help to move the economy toward
the efficiency represented by the competitive ideal.
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Second, government can take actions to make the distribution of income less unequal. Remember that
efficiency and equity do not necessarily go hand in hand. There is no reason to believe that an efficient
economy will provide an equitable distribution of income and resources. When society becomes concerned
about inequalities, government can step in and redistribute income and wealth, usually by means of taxing
and spending policies.
Third, government can take actions to stabilize the economy. From its earliest days, capitalist
societies have gone through expansionary times, in which the level of economic activity was high and
growing, as well as contractionary times, in which the level of economic activity was low and sinking.
Inflation and unemployment have, from time to time, caused problems in the economy and led to
instability. The role for government in this case is to develop policy initiatives that will counteract these
natural tendencies of a capitalist economy and smooth out these swings over the course of the business
cycle.
Fourth, government plays an important role in representing the country in the international economy.
In recent years this has meant that government tries to facilitate international trade by limiting tariff and
quota barriers. Wealthy nations have developed programs to aid poorer countries, particularly in times of
crisis. Also, macroeconomic policies are coordinated across governments in order to make them more
effective.

B. Government Expenditures
1. The United States has adopted a system of fiscal federalism that assigns various expenditure programs
to the levels of government whose jurisdictions most closely match the geographical boundaries of their
spillover effects. As a result, we see the federal government providing and managing programs like
national defense, space exploration, and foreign affairs. We see local governments taking care of things
like police protection, fire protection, public education, and other “local public goods.” Finally, we see
state governments administering highway, port, and welfare programs, as well as health care and criminal
justice systems. Frequently the money required to support the programs at state and local levels flows
down from the federal government, but the administration of the programs is conducted at the lowest
possible level.
It should be noted, of course, that this structure is in a constant state of flux. The boundaries between
governments and the spillover effects of programs are typically hard to define, and programs are forever
being transferred from one level of government to another.
2. Government taxation and spending at all levels account for roughly one-third of GDP, with 70 percent
of that total spent at the federal level. The largest federal spending category is national security and
international affairs, but the fastest growing category is entitlement programs which provide benefits or
payments to any person who meets certain eligibility requirements set down by law. Examples of
entitlement programs include social security, Medicare, and unemployment insurance.

C. Economic Aspects of Taxation


1. Tax policy is informed by two opposing points of view—the benefits approach and the ability-to-pay
approach. The underlying question here is, who should pay, and who should pay the largest amount, for
collective goods? Following the benefits approach, we would tax people in proportion to the benefit they
receive from government programs. This may work well for things like state parks; those who use the
parks might pay a larger share of their upkeep. However, for various entitlement programs, this criterion
falls a bit short. For example, if welfare recipients could afford to pay for the welfare program, they would
not need to take advantage of it.
Following the ability-to-pay approach, we would tax people in proportion to their income or wealth.
The higher the income or wealth, the higher the taxes. Some individuals would be paying for programs
and services that they would never need to take advantage of; the notion of fairness involves redistribution
of resources within the system.
2. Further issues of fairness are reflected in the notions of horizontal and vertical equity. Horizontal
equity implies that people who are viewed as equal should he taxed equally. Vertical equity relates to the
tax treatment of people with different levels of income. The bottom line here is that equity is very difficult
to define in absolute terms.
A tax system must carefully balance these alternative notions in order to result in a fair distribution of
resources.
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3. Taxes are progressive if they take larger proportions of higher incomes and regressive if they take
smaller portions of higher incomes. Income taxes tend to be progressive by design; sales and excise taxes
tend to be regressive by conduct. A tax is not, however, progressive simply because it collects more
money from a rich individual than from a poor one. To establish whether a tax is regressive or
progressive, you must (1) find the amount of tax typically paid at various income levels within the
population and (2) express this tax paid as a percentage of income. If these percentage figures rise as
income rises—that is, if the percentage of income paid in tax rises as income rises—then the tax is
progressive. If the percentage figures go down as you move to higher income levels, on the other hand,
then the tax is regressive. If the percentage figure is pretty much the same at all income levels, then the tax
is neither progressive nor regressive; rather, it is proportional.
Taxes can further be classified as direct (levied directly upon individuals or firms) or indirect (levied
on goods and services, and hence only indirectly on individuals or firms who consume those goods and
services). An example of a direct tax is the personal income tax; an example of an indirect tax is a gasoline
tax.
4. The federal government raises most of its revenue from individual and corporate income taxes. Other
federal taxes include sales and excise taxes, payroll taxes, and corporate profits taxes. Sales and excise
taxes are levied as a percentage of sales or per unit of an item purchased; these are controversial because
they appear to be regressive. Because poorer people tend to spend larger portions of their income on
consumption goods, they tend to pay a larger portion of their income as sales taxes. Payroll taxes are
collected to pay for social insurance programs. Corporations must pay corporate profits taxes; these are
controversial in the sense that they provide disincentives for corporate investment.
5. Local governments employ property taxes most heavily. In fact, approximately 30 percent of the total
revenues of state and local government are raised through property taxes. (Henry George would he pleased
to hear this!) States rely on sales taxes and, in some cases, income taxes.
6. Given this overview of taxes in the United States, it is worth wondering whether or not this group of
policies provides an efficient use of resources. Taxes certainly have incentive effects and hence alter the
behavior of market agents. For example, higher income tax rates effectively lower wage rates for workers.
We know that decreases in wages are accompanied by both substitution effects, which encourage workers to
supply fewer hours, and income effects, which may encourage workers to supply more hours. In either
case, individual behavior may be modified in response to changes in tax policy. Exemptions in the tax
rate exist for home mortgage interest, giving people an incentive to invest in housing markets. Knowing
that tax rates are scheduled to change encourages people to alter the timing of their receipts. All of these
factors are important to consider when investigating the efficiency of taxation.
In addition to these incentive effects, we must also ask which goods and services can be taxed most
efficiently. The Ramsey tax rule states that the government should levy the heaviest taxes on those inputs
and outputs that are most price-inelastic in supply or demand. This will result in the smallest change in
quantity exchanged across the market and will generate the greatest amount of revenue for the government.
However, remember that the types of goods that tend to have the most inelastic demands are necessities;
increasing taxes on food, fuel, water, etc. might be worrisome on the grounds of equity.
7. Questions of incidence ask who pays specific taxes in the form of decreased purchasing power. They
are related to questions about the degree to which various taxes create disincentives for people to work
harder and/or save more. The benefit or transfer portrait of expenditure programs tends to offset regressive
treatment of low-income taxpayers.

V. HELPFUL HINTS

1. A more complete analysis of government fiscal policies (taxing and spending), along with models of
their effects on the economy, can be found in a course on macroeconomics. Take one!
2. Even the most extreme advocates of laissez-faire would agree that the government has a role to play in
establishing and maintaining a legal system in an economy. Without some set of rules and regulations and
without some ultimate arbitrator of disagreements, contracts would be very difficult to enforce, and
uncertainty would increase dramatically. Take Russia as an example. The dismantling of the socialist
structure has led to the introduction, for the first time in 80 years, of private property. Without a strong
legal system, problems arise as agents attempt to understand both ownership and responsibility to
contractual obligations. This has been a huge hurdle for the Russians; until the legal system is accepted as
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part of the system endless disputes will occur, and foreign investors will be less willing to enter into
contracts with Russian businesses.
3. The term business cycles was used in this chapter. This term refers to the natural expansions and
contractions that occur in the level of economic activity over time. Consider Figure 16-l. The trend line
shows a stable and steady growth path for the macroeconomy. It indicates that the level of economic
activity tends to increase steadily over time. However, in reality, the growth path of the macroeconomy is
not so stable and smooth. In fact, the level of economic activity follows the business cycle: periodic
peaks and troughs that occur naturally. In its role as provider of stability the government takes actions
which serve to dampen these business cycles and move the economy closer to the trend line.

Figure 16-1

4. It is sometimes difficult to understand why sales taxes are regressive. Since everyone in a particular
state pays the same tax percentage on purchases, it can sometimes appear as though sales taxes are
proportional. However, remember that to establish whether a tax is regressive or progressive, you must
find the amount of tax typically paid at various income levels within the population and express this tax
paid as a percentage of income. The regressive aspect of sales taxes occurs because at low income levels,
the actual amount of tax paid as a percentage of income is higher than it is at high income levels.
5. Two questions dominate any discussion of taxation: “Who should pay?” and “How do we know if
the person who should pay is, in fact, actually paying?”. These questions are very difficult to answer; as
someone once said, “Don’t tax you, don’t tax me, tax the man behind that tree.” Simply put, few people
actually like to pay taxes.
Suppose, for example, that the benefits to be derived from some public project will accrue entirely to
an identifiable group of people from within the population. It might then be reasonable to assert that the
tax revenues required to finance that project should be collected from the people who benefit; e.g., taxes for
the construction of roads might be collected solely from the people who use the roads. However, life is
rarely this simple.
In most cases of public finance, policymakers must wrestle with the question of fairness and equity:
How can society define a fair and equitable basis for distributing the burden of taxation? The debate on
these issues is a never-ending one. One side argues that the rich should carry most or all of the burden
simply because they are rich and can afford it, while the poor cannot. The opposition insists that “making
money” is at least one of the incentives for personal initiative and effort. According to this argument,
accepting a “soak-the-rich” philosophy may create a tax system that undermines incentive and encourages
the most talented and inventive members of the population to move someplace where the tax laws are less
severe. There are no magic policies that will satisfy everyone at the same time.
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Figure 16-2

6. The burden of taxation was explored and illustrated in Chapter 4; it bears repeating here. Remember
we found that the more inelastic side of the market will pay the larger portion of any new tax. Consider
Figure 16-2. Panel (a) shows the division of the tax when the supply curve is more inelastic than the
demand curve, while panel (b) shows the division of the tax when the demand curve is more inelastic than
the supply curve.

VI. MULTIPLE CHOICE QUESTIONS

These questions are organized by topic from the chapter outline. Choose the best answer from the options
available.

A. Government and Control of the Economy


1. Which of the following is a tool that the government can use to manage the economy?
a. Taxes.
b. Direct expenditures.
c. Transfer payments.
d. Regulation.
e. All the above.
2. Which of the following statements is an accurate description of the history of government spending in
the United States?
a. The cost of government at all levels climbed from nearly 10 percent of GDP in 1913 to around 15
percent in the early 1990s.
b. The cost of government at all levels climbed from 25 percent of GDP in 1913 to 35 percent in the
early l990s.
c. The cost of government at all levels climbed from approximately 10 percent of GDP in 1913 to
nearly 35 percent in the early 1990s.
d. The cost of the federal government in the United States has remained relatively constant, at around
10 percent of GDP since 1913.
e. None of the above.
3. Taxation in the United States:
a. has grown during the twentieth century at a rate that far exceeds the rate of growth of government
spending.
b. has grown at a rate that, until 1981, roughly matched the rate of growth of government spending.
c. has fallen in size in terms of fraction of GDP since 1939, but has climbed in absolute terms.
d. rose dramatically in the 1980s in an effort to balance the federal budget.
e. none of the above.
4. Regulatory activity in the United States:
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a. is composed of only economic regulations, which involve price controls, entry and exit standards,
and safety standards.
b. is composed of only social regulations, which involve public health and safety.
c. includes both economic and social regulations.
d. was eliminated in the 1930s in response to the depression.
e. was increased in the 1980s, as policymakers ignored the costs and benefits of policies and
assumed that any regulation is better than no regulation.
5. Regulation grew in the United States as it became clear that a laissez-faire policy was vulnerable to:
a. pockets of poverty that are exploited by the more fortunate.
b. the business cycle, which buffets the economic lives of nearly every citizen.
c. inefficient and unfair discrimination on the basis of sex, race, and other factors.
d. the flagrant abuse of the environment.
e. all the above.
6. Government can play a number of roles in a mixed economy. These potential roles include:
a. prescribing a legal framework that defines “the rules of the game.”
b. reallocating resources to accomplish greater efficiency in the face of, say, monopoly or pollution.
c. effecting macrostabilization by prudent exercise of fiscal, monetary, and other policies.
d. reallocating resources to accomplish greater equity.
e. all the above.
7. According to Samuelson and Nordhaus what is the function of government?
a. Improving economic efficiency.
b. Reducing economic inequality.
c. Stabilizing the economy through macroeconomic policies.
d. Conducting international economic policy.
e. All of the above.

B. Government Expenditures
8. The largest single money item in the U.S. federal government budget is currently:
a. energy, science, and environment.
b. national defense and international affairs.
c. interest on the public debt.
d. general government (including justice) .
e. social security.
9. Any highway that is built by the government and made available toll-free to the public represents an
example of:
a. private consumption.
b. a transfer expenditure.
c. a welfare expenditure.
d. monetary policy.
e. none of the above.
10. A government might reasonably introduce a widespread program of transfer payments in order to:
a. create a surplus in its budget.
b. effect some change in the social decision on the question of for whom goods are to be produced.
c. provide more collective consumption.
d. move the economy’s production-possibility curve outward and to the right.
e. reduce inflation.
11. Entitlement programs include:
a. social security.
b. national defense.
c. international monetary activity.
d. the space program.
e. all the above.
12. In the late 1980s and early 1990s, the American public began to worry about the increasing size of the
federal budget deficit. The feeling was that:
a. legislators are maximizing the government’s profits by running increasingly larger budget deficits.
b. without the discipline of competition, government has no incentive to spend money efficiently.
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c. government budget deficits lead to an efficient allocation of society’s resources.


d. government budget deficits lead to an equitable allocation of society’s resources.
f. none of the above.
13. What is fiscal federalism?
a. A system in which the federal government plays the major role.
b. A system in which congress controls the purse strings.
c. A system where there is a division of fiscal responsibilities among the different levels of
government.
d. A system in which the President plays the prominent role.
e. None of the above.

C. Economic Aspects of Taxation


14. Suppose the town of Somewhere, USA, decides to build a new ice skating rink. The town
government decides to finance the building of this rink by raising every one’s income taxes by 1 percent.
This tax scheme is based on the:
a. benefit principle of taxation.
b. indirect principle of taxation.
c. ability-to-pay principle of taxation.
d. value-added principle of taxation.
e. Ramsey tax rule.
15. If the town government from question 12 had decided instead to finance the building of this rink by
levying a tax on electricity, the scheme would be based on the:
a. benefit principle of taxation.
b. direct principle of taxation.
c. ability-to-pay principle of taxation.
d. value-added principle of taxation.
e. Ramsey tax rule.
16. The corporation income (profits) tax is defined as a tax levied on:
a. only the dividends paid to stockholders.
b. the value added to production by each corporation.
c. the corporation’s total net sales.
d. additions to corporate retained earnings.
e. dividends paid plus undistributed profits.
17. One type of income not subject to taxation at all under U.S. income tax law is:
a. income in the form of dividends from stock owned.
b. income in the form of interest on corporation bonds owned.
c. firm-provided medical insurance.
d. real income adjusted for the most recent year’s inflation.
e. income in the form of capital gains.
18. An argument made in favor of the corporation income tax is that:
a. it taxes only earnings above the normal return on invested capital.
b. without it, some fraction of corporation income may not be currently taxed at all.
c. on balance, it is a regressive tax.
d. it taxes the income received by bondholders.
e. it means double taxation (at least in part) of corporation earnings.
19. Which alternative in question 16 would be correct had it referred to an argument against the
corporation income tax?
a. only the dividends paid to stockholders.
b. the value added to production by each corporation.
c. the corporation’s total net sales.
d. additions to corporate retained earnings.
e. dividends paid plus undistributed profits.
20. The tax yielding the largest annual revenue for the federal government (disregarding social security
withholdings from wages and salaries) is the:
a. personal income tax.
b. corporation income tax.
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c. value-added tax.
d. excise tax on liquor and tobacco.
e. property tax.
21. Suppose that the tax on an income of $20,000 is equal to $4000. Assume, as well, that the tax would
rise to $4800 if this income were to rise to $22,000. The marginal rate of tax implicit in these figures is:
a. 20 percent.
b. about (but not more than) 21 percent.
c. more than 21 percent, but just under 22 percent.
d. 40 percent.
e. none of the above.
22. A general sales tax, without any exempted commodities, is considered to be a:
a. progressive tax because it applies to luxuries as well as necessities.
b. regressive tax because wealthy people spend a smaller percentage of their total incomes on taxed
commodities, and hence the proportion of tax payments to income is greater for poor people.
c. progressive tax because wealthy people spend more than poor people.
d. regressive tax because more money is collected from a poor person than from a rich one.
e. proportional tax because everybody pays the same tax percentage on each purchase.
23. A proportional tax is correctly defined as one in which (taking the taxpaying population overall, or in
terms of the typical taxpayer):
a. the ratio of tax collected to income received is the same at all income levels.
b. about the same amount of tax is collected per taxpayer, regardless of taxpayer incomes.
c. the percentage of income taken in tax falls as income climbs.
d. the amount of money taken in tax rises as income falls.
e. the preceding descriptions do not apply (because none of them is correct).
24. Which alternative in question 21 would be correct had that question referred to the correct definition of
a progressive tax?
a. 20 percent.
b. about (but not more than) 21 percent.
c. more than 21 percent, but just under 22 percent.
d. 40 percent.
e. none of the above.
25. Which alternative in question 21 would be correct had that question referred to the correct definition of
a regressive tax?
a. 20 percent.
b. about (but not more than) 21 percent.
c. more than 21 percent, but just under 22 percent.
d. 40 percent.
e. none of the above.
26. The incidence of a tax is:
a. its tendency to fluctuate in total amount collected as the economy moves from boom to recession
and back.
b. its relative importance in the budget of the government involved.
c. extent to which payment can be avoided through one or more “loopholes.”
d. its burden, in the sense of identifying the people whose real incomes are actually reduced by that
tax.
e. the effect to which its imposition is likely to induce those who must pay it to work less, in an
effort to avoid part of such payment.
27. How does an increase in income taxes affect economic behavior?
a. The number of hours worked will increase.
b. The number of hours worked will decrease.
c. The impact on hours worked is indeterminate.
d. It depends on what the money is used for.
e. The number of hours worked will remain the same.

VII. PROBLEM SOLVING

The following problems are designed to help you apply the concepts that you learned in this chapter.
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A. Government Control of the Economy


1. a. Since World War I, the size of government, measured in terms of expenditures, taxation, and/or
regulation, has (remained remarkably stable / fallen slightly since World War II after growing
rapidly between wars / grown dramatically). Compared with spending amounting to slightly more
than 10 percent of GDP prior to World War I, the sum of budgets across all levels of government in
the United States had, by the 1980s (fallen back to 10 percent of GDP after peaking during the
Carter administration at 21 percent / grown steadily to nearly 25 percent of GDP / stabilized at
approximately 35 percent of GDP).
Over the same period of time, tax revenues collected by all levels of government have (kept pace
with / grown at a slightly slower pace than / grown at a slightly faster pace than) expenditures,
with enormous shortfalls coming during (the Great Depression / World War II / the Reagan
years). Nonetheless, tax revenues are still perhaps (5 / 50 / 500) percent larger now than their were at
the turn of the century.
b. The ability of the U.S. government to regulate some of the activities of some of its citizens is
justified by reference to the U.S. Constitution. In the spaces below, list at least four industries which
have faced significant regulation over the past half-century.
(1)
(2)
(3)
(4)
2. It is interesting to note that the size of the government in a nation’s economy seems to depend upon
the size of that economy; measured as a proportion of GDP, poor, less developing countries show a
tendency to tax and spend (less than / more than / about the same as) advanced countries. Using Figure
16-2 from your text, reproduced here as Figure 16-3, circle the country in each of the following pairs whose
government spends more as a fraction of GDP:
a. United States / Philippines
b. United States / United Kingdom
e. United States / France
d. United States / Japan
e. United States / Sweden
f. South Korea / Sierra Leone
g. Iran / Japan
Notice that the United States, despite all the political furor about the size of the American government,
ranks far from the top among developed countries in this ordering. In absolute terms, the size of the
American government is enormous, of course; but relative to GDP, its size is considerable more modest.

Figure 16-3
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3. a. Government can serve four distinct functions in a mixed economy. List them in the spaces
provided:
(1)
(2)
(3)
(4)
b. Each of the following activities falls into at least one of the four categories that you just
identified; indicate which in the spaces provided.
(1) Cutting taxes to reduce unemployment:

(2) Specifying that the manufacturer is liable for any harm caused by his or her product:

(3) Placing a tax on a steel producer’s pollution:

(4) Legislating that it is illegal to discriminate on the basis of sex:

(5) Enacting an income policy that penalizes larger than specified wage increases:

(6) Enacting a program of aid to families with dependent children:

(7) Enacting day-care help to allow women to work outside the home:

(8) Writing laws that allow triple damages to be awarded in cases of gross and wanton
negligence:

B. Government Expenditures
4. For the fiscal year 2001, the budget for the U.S. federal government is projected to be approximately
($.5 / $1.0 / $1.8 / $2.0) trillion. This total exceeds the 1980 level of expenditure by over $575
billion. The largest single item within this total for 2001 is (interest on the public debt / national
defense, veterans, and international affairs / education, labor, and development / social
security) . The expenditure for this item amounts to approximately ($426 / $437 / $337) billion.
(National defense / Energy / Space and technology / Entitlement) programs have grown more
quickly than any other programs in the federal budget. Spending on these items increased from (10 /
28 / 40) percent of the budget in 1960 to (22 / 47 / 58) percent of the budget in 1994.

C. Economic Aspects of Taxation


5. a. The benefit approach to taxation argues that the distribution of tax levied between citizen A and
citizen B should be proportional to the benefit each receives from the expenditures of government—a
“pay for what you get” principle. Which of the following (one or both) may be considered a valid
criticism of this principle?
(1) It assumes the particular tax in question can be linked to a particular type of expenditure. If a
government’s expenditures are large and varied, this link is often difficult to determine.
(2) Even if a particular tax can somehow be linked to a particular type of spending (e.g., federal
government spending on national defense), it is difficult to decide, in quantity terms, how much
benefit rich citizen A derives from it in comparison with poor citizen B.
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b. An alternative principle is that tax payments constitute a sacrifice by citizens and that the
distribution of sacrifices should match people’s ability to pay. It isn’t altogether easy to establish
what “ability to pay” really means, but one interpretation is that (pick one):
(1) every citizen should pay an equal amount of money in taxes, thus equalizing sacrifices.
(2) taxes should be levied and collected in strict proportion to the amount of income received by
citizens.
(3) the tax system should be constructed so that the government collects its revenue from those
who have the money.
c. The ability-to-pay approach raises two distinct issues of equity. The first asserts that equals
should pay equal taxes. This approach is identified by economists as (horizontal / vertical /
reasonable) equity. As simple as that assertion appears, it buries the fundamental question of how to
determine when two people are equal. For example, are two people earning $30,000 per year equal if
one of them has incurred $8000 in medical expenses? The tax codes say no. Medical expenses above
3 percent of adjusted gross income were deductible in 1991 (unless the taxpayer took the standard
deduction).
The second equity issue involves the taxation of unequals; it is captured under the general rubric of
(horizontal / vertical / redistributive) equity. This is the more controversial issue because of the
(dis)incentive effects of income taxation. No hard-and-fast rules have been generalized to describe
vertical equity.
6. a. In order to know whether a tax is progressive or regressive, it is (essential / not strictly essential)
to know how much money it typically collects from individuals at different levels of income.
b. One existing U.S. tax is easily classified within this progressive-regressive distinction; namely
the ____ tax. This tax is (progressive / regressive).
c. A tax levied as l percent on the first $5000 of income, 2 percent on the next $5000, 3 percent on
the next $5000, and so on, would be (progressive / proportional / regressive).
d. A tax of l0 percent on all income except the first $1000—that $1000 being exempt from
tax—around be (progressive / proportional / regressive).
e. If it is true that among cigarette smokers people with a yearly income of $8000 typically buy four
packs of cigarettes per week, whereas those with an income of $16,000 typically buy six packs per
week, then an excise tax of 10 cents per pack would be a (progressive / proportional / regressive)
tax.
7. Suppose that the federal tax schedule given in Table 16-1 is being proposed for the next tax year.

TABLE 16-1
Effective
Income Tax Payment Tax Rate
$ 5,000 $ 50 ___
10,000 200 ___
15,000 750 ___
20,000 2,000 ___
25,000 3,750 ___
30,000 7,500 ___

Calculate the effective tax rate at each level of income in the third column of Table 16-1.
Using Figure 16-4, plot the relationship between income earned and the percentage of income paid in
taxes. This tax is (regressive / proportional / progressive). How can you tell?
8. a. Disregarding social security taxes, the two taxes which yield the most revenue for the federal
government, ranked in order of their revenue importance, are:
(1)
(2)
b. The most important tax at the level of state government is the ____ tax; the most important tax at
the level of local government is the ____ tax.
c. The single biggest expenditure items at the state and local government level are for ____.
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Figure 16-4

9. A value-added tax is computed on the basis of the value added to goods by various firms at various
stages of production. If a textile firm were to pay $4000 for the yarn, material, and labor required to weave
cloth which it sells for $10,000, then the value which it would add to these materials would equal ($4000 /
$6000 / $10,000 / $14,000); a value-added tax would be levied on this amount.
Suppose another firm—a garment manufacturing firm—bought all this cloth and paid the full $10,000
for it. Suppose, as well, that it paid another $2000 for all its other raw materials, such as thread, and sold
the resulting output of garments for $20,000. The value added by this firm would be ($2000 / $4000 /
$6000 / $8000 / $10,000 / $20,000).

VIII. DISCUSSION QUESTIONS

Answer the following questions, making sure that you can explain the work you did to arrive at the
answers.

1. List three industries or countries in which markets are reemerging as the primary determinant of
resource allocation. Why are markets replacing governments as the primary allocators of the world’s
resources?
2. The Food and Drug Administration has recently established new guidelines for product labels. The
purpose of this policy is to standardize the labeling across products so that consumers can more easily
make comparisons. What sort of market failure is this policy designed to attack?
3. Explain what is meant by the term fiscal federalism. List the three levels of government spending
that this term implies in the United States and describe some of the functions that occur at each level.
4. Why do governments have little incentive to spend money efficiently? Given the large federal budget
deficits that resulted from the Reagan and Bush era, would you encourage policies that impose some
constraints on federal spending?
5. List the pros and cons of the benefits principle and the pros and cons of the ability-to-pay principle of
taxation. Which approach do you find most appealing?
6. State the Ramsey tax rule. Think of four goods that might be subject to taxation if this rule is
imposed. Why might you worry about equity when considering the Ramsey tax rule?
7. How do taxpayers respond to an increase in income tax?

IX. ANSWERS TO STUDY GUIDE QUESTIONS

III. Reviews of Key Concepts


9 Economic regulation
8 Social regulation
4 Laissez-faire
13 Income redistribution
14 Public-choice theory
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7 Fiscal federalism
18 Entitlement programs
16 Benefit principle
19 Ability-to-pay principle
11 Horizontal equity
3 Vertical equity
20 Progressive taxes
1 Regressive taxes
22 Direct taxes
17 Indirect taxes
10 Effective tax rate
21 Marginal tax rate
5 Value-added tax
2 Ramsey tax rule
12 Supply-side economics
6 Green taxes
15 Tax incidence

VI. Multiple Choice Questions


1. E 2. C 3. B 4. C 5. E 6. E
7. E 8. E 9. E 10. B 11. A 12. B
13. C 14. C 15. E 16. E 17. C 18. B
19. E 20. A 21. D 22. B 23. A 24. C
25. D 26. C 27. C

VII. Problem Solving


l. a. grown dramatically, stabilized at approximately 35 percent of GDP, grown at a slightly slower
pace than, all three, 500
b. Airlines, trucking, utilities of all sorts, banking, cable television, to name a few
2. less than
a. United States
b. United Kingdom
c. France
d. Japan
e. Sweden
f. South Korea
g. Japan
3. a. (1) Redistribute income
(2) Work toward macroeconomic stability
(3) Allocate resources efficiency and provide a legal framework
(4) Allocate resources equitably
b. (1) Macro stabilization
(2) Legal framework
(3) Promote efficiency
(4) Legal, efficiency, and equity issues
(5) Macro stabilization
(6) Promote equity
(7) Promote equity and efficiency
(8) Legal framework
4. $1.8; social security; $426; Entitlement; 28; 58.
5. a. both (1) and (2)
b. (3)
c. horizontal, vertical
6. a. essential
b. Federal income, progressive
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c. progressive
d. progressive
e. regressive
7. a. The effective tax rate is the total tax divided be total income. Entries for the column are .01, .02,
.05, .10, .15, .25.
b. Plot the data from part a.
c. progressive. The effective tax rate increases as income increases.
8. a. (1) personal income tax
(2) corporate income tax
b. sales, property
c. local public goods, particularly education
9. $6000, $8000

VIII. Discussion Questions


1. Russia, China, (East) Germany. The market seems to be winning the day because governments have
not been very successful at allocating resources across these economies.
2. This policy is designed to help correct asymmetric information between buyers and sellers.
3. Fiscal federalism refers to the practice of dividing government responsibilities among federal, state,
and local authorities. The federal government handles national defense and international policies. The
state government handles many transfer policies and welfare benefits. Local governments collect property
taxes and take great responsibility for public education for grades K-12.
4. Governments have little incentive to spend money efficiently because there is no profit motive
involved in decisions. Elected officials must worry about reelection, but they do not have to worry about
competitive pressures that exist to provide private industry with incentives to be efficient. Policies that
constrain federal spending might be good if they provided legislators with constraints; however, these
policies might he counterproductive during a recession, when the government’s ability to run deficits helps
to smooth out business-cycle effects.
5. The benefits principle forces those who use services to pay for them; however, it ignores the fact that,
in many cases, those who use services do so because they have limited income. The ability-to-pay
principle taxes people based on their ability to pays, so that people with higher income or wealth
contribute more to the tax system. However, it ignores the fact that many of the people who are able to
pay do not take advantage of government services.
6. The Ramsey tax rule states that the most efficient taxes are placed on goods whose demand is most
inelastic. Goods like electricity, medications, food, and gasoline might fit this definition. Equity issues
come into play here, since these goods are necessities. We might want to make sure that we hold prices on
these goods as low as possible.
7. The impact of a change in tax rates on hours worked is unclear because the income and substitution
effects of wages changes work in opposite directions.
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