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Chapter in a Nutshell
Public goods are not free goods. Resources are needed to produce city streets, just as they are needed to produce automobiles that drive up and down those streets. The opportunity cost of producing public goods -- measured by how much we must give up of private goods -- is always a matter of public debate. But even if we know how many public goods we want and are willing to make the sacrifice to acquire them, the question still remains: How does the government get the money it needs to provide those public goods?
In pre-modern societies, a government would often simply commandeer the resources it needed. If it needed labor to construct roads, it simply rounded up people to make the roads. The roads were built, but not necessarily in the most efficient way. In modern societies, government has shifted from commandeering resources to commandeering money. That's the essence of a tax system.
There are a number of ways to tax. Perhaps the simplest is a poll (or head) tax, say, $100, that is levied on every adult in a population. If there are 1,000 people, then the government's tax revenue is $100,000. An alternative way of taxing the population is by levying the tax on the person's income, rather than on the person. This is the income tax. An income tax structure can be regressive (the rich are taxed a lower percentage of their income than are the poor), proportional (the rich and poor are taxed the same percentage) or progressive (the rich are taxed a higher percentage). The government can also levy taxes on corporate profits, or on wealth (such as property tax or estate and gift taxes). Perhaps the most widely used tax is levied not on a person's income or wealth, but on the person's consumption (sales and excise taxes). Contributions to the Social Security system are another form of taxation, but these are earmarked to finance the benefits the Social Security system is obligated to pay.
What does the U.S. tax structure look like? At the federal level, the income tax is the most important source of revenue. Its structure is progressive, with five tax brackets. The richer you are, the higher the tax rate on your higher income. If you are married and you and your spouse together earned $300,000, you paid 15 percent on your first $41,200; 28 percent on the income over $41,200 up to $99,600; 31 percent on income over $99,600 up to $151,750; 36 percent on income over $151,750 up to $271,050; and 39.6 percent on the income over $271,050 up to $300,000. Most states have their own state income taxes, but these are not as important a contributor to state revenue as their sales taxes. The property tax is the primary source of revenue for local governments.
For all but a few years since World War II, federal government spending has exceeded the tax revenues collected. How does government make up for the deficit (one year's contribution to the public debt)? The chapter focuses on the federal government's use of debt financing. The government sells securities through its Department of the Treasury. These securities are its IOUs. People loan money to the government in return for interest payments. The securities are regarded as very safe investments because the government has never defaulted on either interest or principal. The securities come in three forms: Treasury bills, which mature in one year or less; Treasury notes, which mature in 2 to 10 years; and Treasury bonds, which mature in 30 years.
The public debt has risen enormously since 1929, particularly since the 1980s, but so has GDP. The debt/GDP ratio was lower in 1996, by about one-third, than at the end of World War II. Big spurts in the debt/GDP ratio occurred in the decades of the 1930s, the 1940s, and the 1980s. The debt/GDP ratio for the United States is similar to those in other industrialized countries.
Government debt, like government deficits, is a contentious political issue. How much longer can the government finance its deficits by selling IOUs before it goes bankrupt? Are we placing a terrible financial burden on future generations?
Economists distinguish between an internally financed debt (its securities are purchased by its own population) and an externally financed debt (its securities are purchased by foreigners). An internal debt neither adds to nor subtracts from the nation's income. If 100 percent of the U.S. government debt is held internally (by U.S. citizens) then all the interest that the government pays goes to Americans. Where does the government get the money to pay for the interest? By taxing its citizens. In a sense then, Americans tax themselves to pay themselves. What about future generations? If future generations are forced to pay for the debt, they pay it only to themselves.
An external debt is different. The people who are taxed to pay the interest on the debt are not the same people who receive the interest payments. An external debt can burden future generations.
Internally financed debt can still cause problems. If the debt is held by few people, then everybody is taxed to pay the interest that goes to the few. In this way, the debt contributes to greater income inequality. It can also create over consumption because people view their securities holdings as real wealth and save less than they perhaps should. It can also contribute to inflation and crowding out of private investment.
Deficits and debt are not inevitable. A balanced budget exists if tax revenues match government spending. The extraordinary rise in the deficits and debt in the 1980s resulted from the tax reform acts of 1981 and 1986 that overhauled our tax rates and brackets, and with them, tax revenues. The Gramm-Rudman-Hollings Act of 1985 was intended to introduce discipline to the budgetary process by setting targets for deficit reduction. This act failed to achieve its goals. A constitutional amendment that would mandate a year-by-year balanced budget was seriously considered by Congress but failed. However, during the late 1990s, what many thought was impossible actually happened. The deficit shrank to zero. As a result of rising tax revenues due to increasing national income, coupled with cuts in government spending, the budget has become balanced.
After studying this chapter, you should be able
to:
· Describe the various ways that governments have financed their activities over time.
· Discuss different systems of income taxation.
· Explain why an excise tax is a tax on consumption.
· Compare the magnitudes of federal, state, and local tax revenues.
· Describe how government spending can be financed through the sale of government securities.
· Evaluate the danger of a large public debt to our economic health.
· Recount the debate over the federal budget deficit during the 1980s and 1990s.
• The Internal Revenue Service (http://www.irs.gov/) provides information and statistics (http://www.irs.ustreas.gov/prod/tax_stats/) on federal individual income taxes, corporate income taxes, and excise taxes.
• The Bureau of the Public Debt (http://www.publicdebt.treas.gov/) provides the latest statistics on the public debt, as well as information on Treasury bonds and notes.
• Visit the House (http://www.house.gov/) and the Senate (http://www.senate.gov/). What initiatives do you see Congress promoting to reduce the federal deficit?
• Try your hand at balancing the federal budget (http://garnet.berkeley.edu:3333/budget/budget.html). Did you finish with a surplus or a deficit?
[Return to Start]Kristen Hersh plans to run in 2000 for the presidency of the United States. Kristen, a successful businesswoman, worked as a campaign strategist for Steve Forbes's failed run for president in 1996. During the 1996 campaign, Kristen observed that Forbes's primary message, to simplify the federal tax structure, was well received, and his primary initiative, the flat tax, was popular with some voters. As a result, Kristen intends to establish a political platform around tax reform.
Kristen has hired Economic Consultants to explain to her the economic issues surrounding the tax reform debate. Prepare a report for Kristen that addresses the following issues:
• Internal Revenue Service (IRS)
(http://www.irs.gov/)
The IRS provides news and information about federal taxes.
• EconDebate Online: Tax Reform
(http://www.swlearning.com/economics/policy_debates/tax_reform.html)
EconDebate Online provides links to and commentary on primary and secondary resources addressing the tax
reform debate.
• Americans for Tax Reform (ATR)
(http://www.atr.org/)
The ATR works with hundreds of organizations active at the federal, state, and local levels on issues
that pertain to taxes.
• Citizens for Tax Justice
(http://www.ctj.org/)
Citizens for Tax Justice is a research and advocacy organization addressing taxation at the federal, state,
and local levels.
• Citizens for an Alternative Tax System (CATS)
(http://www.cats.org/)
CATS is a national grassroots public interest group established to abolish the federal income tax system
and replace it with a national retail sales tax.
• Joint Economic Committee Tax Reform Page
(http://www.senate.gov/~jec/txrefrm.html)
The U.S. Senate's Joint Economic Committee maintains a page addressing issues of tax reform.
• 1040.com
(http://www.1040.com/)
1040.com provides tax information and resources.
Added Perspective: More on the Net
• Visit a few organizations that advocate tax reform, such as Americans for Tax Reform (http://www.atr.org/) and Citizens for Tax Justice (http://www.ctj.org/). Do these organizations believe U.S. citizens are taxed too heavily? Too lightly? Why?
• Tax World (http://omer.actg.uic.edu/) provides links and information about local, federal, and international taxes.
[Return to Start]Test your understanding of the chapter's concepts with the interactive quiz. The quiz contains twenty multiple-choice questions, like those found on a typical exam. Questions include detailed feedback for each answer, so that you may know instantly why you have answered correctly or incorrectly. In addition, you may email yourself and/or your instructor the results of the quiz, with a listing of correct and incorrect answers. Finally, check your results versus other students around the world -- previous scores to quizzes are displayed online.
How to Take the Quiz
Start the quiz, type
in your name (required), your email address (optional), and the email address of your instructor (optional).
Answer the questions (as many or as few as you like, but you need to answer at least one question). Then
hit the submit button and see your results. At the results page, click on the link in the "description"
column to see feedback on your answers. Scroll down the page to see quiz results from students around
the world.
How the Interest Rate on Government Securities is Determined
As you read this chapter, the federal government's marketable securities - its IOUs, or new debt obligations - are offered in the form of its Department of the Treasury's bills (T-bills), notes (T-notes) and bonds (T-bonds). These IOUs are distinguished from each other by their length of maturity. T-bills are issued with 3-, 6-, or 12-month maturities. T-notes maturities range from 2 to 10 years, while T-bonds mature in more than 10 years.
Government sells these IOUs, hoping to pay as low an interest rate as possible. Makes sense, doesn't it? If you sold your own IOUs, that is, borrowed money, wouldn't you want to pay as little as possible? Buyers of government IOUs, on the other hand, hope to collect as high an interest rate as possible. That makes sense too. After all, if you accept the government's IOU, that is, loan it money, wouldn't you want to get as much as possible?
Well, what interest rate does the government pay, and how is that rate determined? Here's where the auction comes into play. The government's T-bills, T-notes, and T-bonds are sold at auctions conducted by the Federal Reserve Banks. Let's consider the weekly auctions of 3- and 6-month T-bills.
Buyers of these T-bills are people like you and large financial institutions, including dealers who specialize in government securities. To accommodate the different types of buyers, the government permits two kinds of bids - or offers to purchase - called competitive and noncompetitive tenders.
Consider first the competitive tenders. Some bidders, principally the professional dealers in government securities, will buy T-bills only if the T-bills yield an interest rate at least as attractive as a rate they can obtain elsewhere in the securities market. They submit their competitive bids stating how many T-bills they want to buy and the interest rate they wish to receive. These are closed and secret bids. The government, seeking to pay the lowest possible rate, will first accept bids from those willing to buy the T-bills at the lowest interest rate submitted, then the next lowest, and so on until the government has sold the amount of T-bills it wants to issue that week. Competitive bidders who tendered a bid at a comparatively too-high rate will end up with no T-bills. That's the nature of competition.
What about the noncompetitive tenders? People, who want to buy T-bills without the hassle of bidding, can submit noncompetitive bids, indicating how many they want to buy and that are willing to accept the average rate determined by the competitive bidders. These noncompetitive bids typically account for no more than 5 percent of the total dollar value of T-bill sales, but they make up a large majority of the buyers. They are the nonprofessionals buyers, much like you.
Adapted from the Public Information Center, Federal Reserve Bank of Chicago.
Updated 2/04/99
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