1 Chapter 22 The Public Sector Key Concepts Key Concepts Summary Practice Quiz Internet Exercises Internet Exercises ©2002 South-Western College Publishing.

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Chapter 22 The Public Sector

• Key Concepts• Summary• Practice Quiz• Internet Exercises

©2002 South-Western College Publishing

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What is the purpose of this chapter?

To examine public-sector decisions of politicians, government bureaucrats, voters, and special interest groups

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What about the size of government?

Since the 1950’s, government expenditures have grown from about one-quarter to over one third of GDP

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35 40 45 50 55 60 65 70 75 80 85 90 95

Year5%10%15%20%25%30%35%40%45%50%

Total government expenditures

Federal government expenditures

00

Government Expenditures 1935 - 2000

State & Local Gov. Expenditures

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1970 Federal OutlaysOther

International affairs

Veteran's benefits

Agriculture

Transportation

Education and health

Interest on federal debt

National defense

Income security

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2000 Federal OutlaysOther

International affairs

Veteran's benefits

Agriculture

Transportation

Education and health

Interest on federal debt

National defense

Income security

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1970 State & Local Outlays Other

Civilian safety

Highways

Health & hospitals

Income security

Education

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2000 State & Local Outlays Other

Civilian safety

Highways

Health & hospitals

Public Welfare

Education

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Federal Receipts 2000Other

Excise taxes

Corporate income taxes

Social insurance taxes

Individual income taxes

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State & Local Receipts 2000Other

Corporate income taxes

Individual income taxes

Property taxes

State sales tax

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How do taxes in the U.S. compare to taxes

in other countries?U.S. citizens are among the most lightly taxed people in the industrialized world

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0035 40 45 50 55 60 65 70 75 80 85 90 95Year5%

10%15%20%25%30%35%40%45%50%

Total government taxes

Federal government taxes

Growth in Taxes in the U.S., 1935 - 2000

State & Local Gov. Taxes

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What are two types of taxes?Benefits received

Ability to pay

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What is the benefits received principle?

The concept that those who benefit from government expenditures should pay the taxes that finance their benefits

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What is the ability to pay principle?

The concept that those who have higher incomes can afford to pay a greater proportion of their income in taxes, regardless of the benefits

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Which principle dominates in the U.S.?

The ability-to-pay principle dominates the benefits-received principle

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What is aprogressive tax?

A tax that charges a higher percentage of income as income rises

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What is theaverage tax rate?

Total tax due divided by total taxable income

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What is themarginal tax rate?The change in taxes due divided by the change in taxable income

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What is aregressive tax?

A tax that charges a lower percentage of income as income rises

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What is aproportional tax?

A tax that charges the same percentage of income, regardless of the size of income

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What is a flat rate tax?Same as a proportional tax

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What ispublic choice theory?

The analysis of the government decision-making process to allocate resources

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Who isJames Buchanan?

The founder of public choice theory which applies economic analysis to politics

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What is thebenefit - cost analysis?

The comparison of the additional rewards and costs of an economic alternative

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What is the basic rule of benefit-cost

analysis?A firm will produce additional units as long as marginal benefit exceeds the marginal cost

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Why might government be

inefficient in solving society’s problems?

• Majority rule problem• Special interest effect• Rationale ignorance• Bureaucratic inefficiency• Shortsightedness effect

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What is themajority rule problem?

Voting can lead to a rejection of projects with marginal total benefits exceeding the marginal cost

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Can majority rule lead to inefficient solutions?

Yes, “one person one vote” cannot measure the intensity of voters’ preferences as well as the market

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What is the special-interest group effect?Special-interest groups can create government support for programs with costs out-weighing their benefits

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Why can special-interest voting be

inefficient?A small group within the society can benefit while the whole society pays the costs

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What isrational ignorance?

The voters choose to remain uninformed because the marginal cost of obtaining information is higher than the marginal benefit from knowing it

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What is bureaucratic inefficiency?

The bureaucracy may become more powerful than elected officials

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What is the shortsightedness

effect?Democracy has a bias toward programs offering clear benefits and hidden costs

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Key Concepts

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Key Concepts

• What has happened to the size of government?

• How do taxes in the U.S. compare to other countries?

• What is the benefits received principle?• What is the ability to pay principle?• What is a progressive tax?

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Key Concepts cont.• What is the marginal tax rate?• What is a regressive tax?• What is a proportional tax?• What is the majority rule problem?• What is the special-interest group effect?• What is rational ignorance?• What is bureaucratic inefficiency?• What is the shortsightedness effect?

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Summary

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Between 1970 and 2000, income security became the largest category of federal expenditures. During the same period, national defense declined from the largest spending category to the second largest.

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Net interest on the federal debt has grown from 9 percent of the budget in 1970 to 12.5 percent in 2000. Therefore, income security and net interest payments combined accounted for 60.5 percent of federal outlays in 2000.

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The government's share of total economic activity has generally increased since World War II ended in 1945. Most of the growth in combined government expenditures as a percentage of GDP reflects rapidly growing federal government transfer programs.

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0035 40 45 50 55 60 65 70 75 80 85 90 95Year5%

10%15%20%25%30%35%40%45%50%

Total government taxes

Federal government taxes

Growth in Taxes in the U.S., 1935 - 2000

State & Local Gov. Taxes

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State and local government tax revenues consist primarily of sales and property taxes. While states rely on income taxes for revenue, they also collect sales and excise taxes. In addition, state budgets depend greatly on charges and revenue-sharing grants from the federal government.

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Local governments collect most of their tax revenue from property taxes, but the majority of their receipts are from charges and grants from the federal and state governments.

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The largest outlays for state and local governments have been for education. Between 1970 and 1997, transfer payments for public welfare’s share of the budget rose.

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The taxation burden, measured by taxes as a percentage of GDP, is lighter in the U.S. than many other advanced industrial countries. Since 1960, federal taxes have remained a fairly constant fraction of GDP. State and local taxes, however, have generally increased as a percentage of GDP since the 1950’s

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The benefits-received principle and the ability-to-pay principle are the two basic philosophies of taxation fairness.

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The gasoline tax is a classic example of the benefits-received principle because users of the highways pay the gasoline tax.

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Progressive income taxes follow the ability-to-pay principle because there is a direct relationship between the average tax rate and income size.

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Sales, excise, and flat-rate taxes are examples of a regressive tax because each results in a greater burden on the poor than the rich.

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Public choice theory reveals the government decision making process. For example, government failure can occur for any of the following reasons:

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(1) Majority voting may not follow benefit-cost analysis, (2) special interest groups can obtain large benefits and spread their costs over many taxpayers, (3) rational voter ignorance means a sizeable portion of the voters will decide not to make informed judgements, (4) bureaucratic behavior may not lead to cost effectiveness, an (5) politicians suffer from a short time horizon, leading to a bias toward hiding the costs of programs.

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Chapter 22 Quiz

©2002 South-Western College Publishing

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1. From the 1950’s to the late-1990’s, total government expenditures as a percentage of GDP in the United States a. fell by half.b. nearly doubled.c. nearly tripled.d. increased about 40%.

D.

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35 40 45 50 55 60 65 70 75 80 85 90 95

Year5%10%15%20%25%30%35%40%45%50%

Total government expenditures

Federal government expenditures

00

Government Expenditures 1935 - 2000

State & Local Gov. Expenditures

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2. Which of the following accounted for the second largest percentage of total federal government expenditures as of 2000?a. Income security.b. National defense.c. Interest on the national debt.d. Education and health.

B

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2000Federal OutlaysOther

International affairs

Veteran's benefits

Agriculture

Transportation

Education and health

Interest on federal debt

National defense

Income security

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3. Which of the following contributed the second largest percentage of total state and local government revenues in 1998 (excluding “Other Categories”)?a. Corporate income taxes.b. Sales and excise taxes.c. Individual income taxes.d. Property taxes.

D

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State & Local Receipts 2000Other

Corporate income taxes

Individual income taxes

Property taxes

State sales tax

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4. Which of the following countries devotes about the same percentage of its GDP to taxes as the United States? a. Sweden.b. Italy.c. United Kingdom.d. Japan.

D.

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5. “The poor should not pay income taxes.” This statement reflects which of the following principles for a tax? a. Fairness of contribution.b. Benefits received.c. Inexpensive to collect.d. Ability to pay.

D. Since the poor lack the ability to pay, the tax system should be designed so they pay less taxes than people with higher incomes.

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6. Some cities finance their airports with a departure tax: Every person leaving the city by plane is charged a small fixes dollar amount that is used to help pay for building and running the airport. The departure tax follows the a. benefits-received principle.b. ability-to-pay principle.c. flat-rate taxation principle.d. public-choice principle.

A. Those persons who are gaining the most from the airport are the ones who are paying the most for it.

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7. Which of the following statements is true? a. The most important source of revenue to

the federal government is personal income taxes.

b. The most important source of revenue to state governments is sales and property taxes.

c. The most important source of revenue to local governments is local property taxes. .

d. The taxation burden, measured by taxes as a percentage of GDP, is lighter in the U.S. than in most other advanced industrial countries.

e. All of the above are true.

E

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8. Which of the following statements is true?a. A sales tax on food is a regressive

tax.b. The largest source of federal

government tax revenue is individual income taxes.

c. The largest source of state and local government tax revenue is sales and excise taxes.

d. All the above are true statements.

D.

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9. A tax that is structured so that people with higher incomes pay a larger percentage of their income for the tax than do people with smaller incomes is called a (an) a. income tax.b. regressive tax.c. property tax.d. progressive tax.

D. Answer a is not specific; b is the opposite principle, and c is based on property not income.

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10. Generally, most economists feel that a ______type of income tax is a fairer way to raise government revenue than a sales tax.a. Regressive.b. Proportional.c. Flat-rate.d. Progressive.

D. A progressive tax is argued to be fair because people with higher incomes pay more tax.

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11. The federal personal income tax is an example of a (an) a. excise tax.b. proportional tax.c. progressive tax.d. regressive tax.

C. Since the marginal tax rate increases with income, the federal personal income tax is a progressive tax.

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12. A 5 percent sales tax on food is an example of a a. flat tax.b. progressive tax.c. proportional tax.d. regressive tax.

D. A sales tax on food is a regressive tax because people with higher incomes do not spend proportionately more on food.

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13. Margaret pays a local income tax of 2 percent, regardless of the size of her income. This tax isa. proportional.b. regressive.c. progressive.d. a mix of (a) and (b).

A. Less tax is paid by a regressive tax and more tax is paid by a progressive tax as people’s incomes rise.

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14. Which of the following statements relating to public choice is true? a. A low voter turnout may result when

voters perceive that the marginal cost of voting exceeds its marginal benefit.

b. If the marginal cost of voting exceeds its marginal benefit, the vote is unimportant.

c. Special-interest groups always cause the will of a majority to be imposed on a minority.

d. All of the above.

A. This is the rational ignorance public choice theory.

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END