- Study Guide (Course-wide Content)
A. Government Control of the Economy
- The economic role of government has increased sharply over the last century. The government influences and controls private economic activity by using taxes, expenditures, and direct regulation.
- A modern welfare state performs four economic functions: (a) It remedies market failures; (b) it redistributes income and resources; (c) it establishes fiscal and monetary policies to stabilize the business cycle and promote long-term economic growth; and (d) it manages international economic affairs.
- Public-choice theory analyzes how governments actually behave. Just as the invisible hand can break down, so there are government failures, in which government interventions lead to waste or redistribute income in an undesirable fashion.
- The American system of public finance is one of fiscal federalism. The federal government concentrates its spending on issues of national concern—on national public goods like defense and space exploration. States and localities generally focus on local public goods—those whose benefits are largely confined within state or city boundaries.
- Government spending and taxation today take approximately one-third of total national output. Of this total, about 55 percent is spent at the federal level, and the balance is divided between state and local governments. Only a small fraction of government outlays is devoted to traditional functions like police and the courts.
- Notions of "benefits" and "ability to pay" are two principal theories of taxation. A tax is progressive, proportional, or regressive as it takes a larger, equal, or smaller fraction of income from rich families than it does from poor families. Direct and progressive taxes on incomes are in contrast to indirect and regressive sales and excise taxes.
- More than half of federal revenues come from personal and corporate income taxes. The rest comes from taxes on payrolls or consumption goods. Local governments raise most of their revenue from property taxes, while sales taxes are most important for states.
- The individual income tax is levied on "income from whatever source derived," less certain exemptions and deductions. The marginal tax rate, denoting the fraction paid in taxes for every dollar of additional income, is the key to determining the impact of taxes on incentives to work and save.
- The fastest-growing federal tax is the payroll tax, used to finance social security. This is an "earmarked" levy, with funds going to provide public pensions and health and disability benefits. Because there are visible benefits at the end of the stream of payments, the payroll tax has elements of a benefit tax.
- Economists point to the Ramsey tax rule, which emphasizes that efficiency will be promoted when taxes are levied more heavily on those activities that are relatively price-inelastic. A new approach is green taxes, which levy fees on environmental externalities, reducing harmful activities while raising revenues that would otherwise be imposed on goods or productive inputs. But in all taxes, equity and political acceptability are severe constraints.