Chapter 16

Taxes, Borrowing,

and the National Debt

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In this world nothing can be said to be certain, except death and taxes.

—Benjamin Franklin (1706–1790), Complete Works, 1887–1888

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Government

• Government expenditures (a lot of money)
• On social and poverty programs
• On infrastructure
• To control pollution and big business
• To ensure equal opportunity
• On agriculture and the control of crime
• To increase aggregate demand and stabilize the economy
• Military spending
• Stimulus money to expand our economy

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Government

• Government revenue
• Taxes:
• Individual income earners, property owners, businesses, and consumers
• Government borrowing
• Issue government securities
• Government bonds and treasury bills
• An IOU, a piece of paper stating that the government has borrowed money and promises to repay it, plus interest at some future point in time
• Sold to: banks, corporations, and individuals (domestic and foreign)

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Figure 16-1: Revenue from federal taxes as a share of total federal tax revenue, 2016

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Federal Taxes

• The personal income tax
• 47% of total federal tax revenue
• Placed on most forms of individual income
• A different tax rate is applied to different increments of income (tax brackets)

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Federal Taxes

• Capital gains
• Net income received when an asset is bought at a particular price and sold at a higher price
• Payroll taxes—for social insurance
• 2nd largest federal tax category (34%)
• Based on earnings from work
• Usually deducted directly from the paycheck or paid by your employer
• To fund various social insurance programs

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Federal Taxes

• Corporate income tax
• Tax on corporate profits
• Excise taxes
• Taxes applied to the purchase of specific goods or services
• About 3% of federal tax revenue
• Estate and gift taxes
• Taxes on estate and gifts
• Only on estates over $5 million

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State Taxes

• State taxes
• Sales and excise taxes
• Personal income taxes
• Corporate (net) income taxes
• Licenses
• Property taxes

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State Taxes

Local Taxes

• Local taxes
• Property taxes—levied by local governments
• Bring in by far the highest percent local tax revenue
• Levied directly on owners of buildings and land
• Depend on the value of this property
• Much of the property tax—passed from owner to renter (higher rents)
• Used to fund local public schools

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LO1

Local Taxes

16-11

Government Taxes

• Effects of taxes on the macroeconomy
• Increased government expenditure
• A rise in aggregate demand
• Increase in taxes
• Decreased consumer spending
• A decline in aggregate demand
• Combined effect
• A small net increase in aggregate demand
• Small expansion in the economy

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Figure 16-3: Increased government spending on public parks, financed by increased taxes vs. government borrowing

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Panel A shows the increase in AD that occurs as a result of the increased government spending on parks. A relatively large increase in GDP results. Panel B shows the impact of the increased government spending on parks, assuming that this spending is financed by increased government taxes. AD increases as a result of the increased government spending, but it shifts back as a result of the increased taxes, which result in lower after- tax income for consumers, thereby reducing some of their consumption spending. The net increase in AD is very small, resulting in just a very small increase in GDP.

Government Taxes

• Progressive tax
• Takes a greater percentage of income from high-income people than from low-income people
• Federal personal income tax
• Proportional tax
• Takes the same percentage of income from people of all income levels
• State personal income tax

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Federal Personal Tax Rates, 2010*

* For a married couple filing a joint return

LO1

Federal Personal Tax Rates, 2010*

A married couple filing a joint return with taxable income of $80,000 will pay $12,362 in income tax (an average tax rate of 15 percent).

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Government Taxes

• Regressive tax
• Takes a greater percentage of income from low-income people than from high-income people
• Sales tax
• Property taxes, excise taxes
• Social Security tax

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Table 16-1: Effects of the sales tax on two hypothetical high- and low-income families in one year

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Table 16-2: Effects of the social security tax on two hypothetical high- and low-income people in one year

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Government Taxes

• Effects of taxes on microeconomy of individual markets
• Excise tax
• New equilibrium
• Lower quantity
• Higher price
• Influences consumer behavior
• Encourages reduced consumption
• Burden of tax depends on demand and supply elasticities
• Good source of government tax revenue

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Figure 16-4: Effects of an excise tax on a hypothetical market for gasoline

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A $3 per gallon excise tax will shift back the supply curve for gasoline. At the new equilibrium E’, the price is $6 per gallon and the quantity of gasoline is 75 gallons. The excise tax of $3 per gallon is paid by the suppliers of gasoline to the government. Because consumers pay more and suppliers keep less, both groups bear part of the burden of the excise tax.

Government Taxes

• Effects of taxes on microeconomy of individual markets
• Property tax
• New equilibrium
• Lower quantity
• Higher rent
• Burden of the tax—both
• A portion of property taxes is passed along to renters

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Figure 16-5: Effects of the property tax on a hypothetical market for rental housing

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The $100 per month property tax on rental housing will shift back the supply curve, resulting in a new equilibrium at E’. At the new equilibrium, the rental price of housing has increased from $200 to $250, but the landlord must pay $100 to the government in property tax. Because the tenant pays more and the landlord keeps less, both groups will bear part of the burden of the property tax. Note that the equilibrium quantity has decreased.

Table 16-3: Total tax revenue as a share of GDP in Western industrialized countries, 2012^a

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Government Borrowing

• Government borrowing
• Government issues securities (bonds)
• Anyone can purchase a government security
• Government spending financed by borrowing
• Expands the economy more than government spending financed through increased taxes. Why?
• Because the government is not taxing you and reducing your spending

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Government Borrowing

• Effects of government borrowing on the macroeconomy
• Increased spending through borrowing
• Aggregate demand curve shifts forward
• Effects of government borrowing on income distribution
• Bond owners: middle- or upper-income people
• Repaid from more borrowing or taxes
• If repaid from taxes—more income inequality

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Effect of government borrowing on interest rates

• Demand curve for loanable funds
• All who wish to borrow money
• Business firms, individuals, government
• Downward sloping
• More willing and able to borrow money at low interest rates than at high interest rates
• Supply curve for loanable funds
• All who wish to lend money:
• Upward sloping
• More willing to lend at higher interest rates

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• Effects of government borrowing on interest rates
• More borrowing
• Issuing government securities
• Increased demand for loanable funds
• Higher interest rate

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Effect of government borrowing on interest rates

Figure 16-8: Effects of government borrowing on a hypothetical market for loanable funds

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The demand for loanable funds curve D represents the demand for borrowed funds by consumers, businesses, and government. If the government wishes to increase its spending on goods and services and chooses to finance these expenditures by borrowing, the demand for loanable funds will increase to D’. This increase in demand will cause an increase in the interest rate from 10 percent to 12 percent and an increase in the amount of money borrowed and lent to Q’.

Government Borrowing

• Effect of government borrowing on government budget
• Budget deficit
• Federal government spending minus federal government tax revenue in any one year
• Budget surplus
• Federal government tax revenue minus federal government spending in any one year

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March 2015

The National Debt

• National debt
• The total amount of money owed by the federal government
• Accumulation of all funds borrowed by the federal government, up to the present, which have not been repaid
• No limits
• Government can borrow indefinitely
• Roll over: borrow new money to pay old debts

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The National Debt

LO5

The National Debt

• The size of the national debt *
• Needs to be adjusted for inflation
• Important to use an appropriate benchmark
• Gross domestic product
• Imagine if you had a debt of $100,000
• Size of the national debt relative to GDP
• 53% in 1940
• 122% in 1946
• World War II

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The National Debt

• Impact of the national debt
• Positive consequences
• Enables the government to expand the economy as needed
• Expenditures that can specifically benefit our society
• In the present: Social Security and poverty reduction
• Invest in future generations: health and education

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The National Debt

• Impact of the national debt
• Negative effects
• Inequitable income redistribution
• Rising interest rates
• Interest payments made to foreign people
• Real transfer of income out of the United States
• Crowding-out effect
• Burden on future generations
• Public investment as an offset

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Crowding-Out Effect

Real interest rate (percent)

Business Investment (billions of dollars)

ID₁

ID₂

a

b

c

Increase in

investment

demand

Crowding-out

effect

LO4

13-37

Generational Accounting

• A method of analysis that computes a net tax rate that accounts for the taxes that each generation will pay compared to the services and transfers they will receive
• If government runs a deficit in one generation to finance a project where the benefits accrue to a later generation that is paying the interest on that debt then the net tax rate does not change.
• If not, the debt can affect future generations

Proposals to Require a Balanced Budget

• Balanced budget
• All government expenditures must be financed by tax revenue
• Any government spending increase must be matched by an increase in tax revenue
• Problems with the balanced budget requirement:
• Extremely difficult—too many unknowns
• Cannot fix a recession—it requires lower taxes and/or increased government spending

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Conservative versus Liberal

Liberals

• Comfortable with government taxes and spending
• Taxes do not heavily burden poor and middle class
• Like to use tax credits to support
• Spending on education
• Care of elderly people
• Traditionally—less concerned about budget deficits
• Very high budget deficits—frightening to many people

Conservatives

• Reduction in government taxes
• Private-sector spending
• Worry about the effect of various taxes on incentives
• High levels of gov. spending financed by borrowing
• Increases in interest rates
• Crowd out private spending
• Favor a balanced budget
• Government spending and budget deficits
• Expenditures for national defense
• Large current and predicted budget deficits

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