Chapter 10

Introduction to
Government Finance

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Federal, State, and Local Revenue
$3 trillion annually
 Sources:
 Taxes:
 Payroll
 Income (Corporate and Personal)
 Property
 Sales and Excise
 Estate
 Tariffs
 Fees
 Tuition
 Licenses

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 Purpose and Consequences of
Government Finance

 Political Equilibrium

 Market Equilibrium and Its Efficiency

 The Distribution of Income

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 Taxes
Taxes are compulsory payments to
government

4
 Tax Basics
Tax Base
 The item or activity that is to be taxed
 A general tax is one that taxes all of the components of the
economic base, with no exclusions, exemptions, or
deductions from the tax base.

 A selective tax is one that taxes only certain portions of the

tax base, or it might allow exemptions and deductions from
the general tax base. An excise tax is a selective tax on the
manufacture or sale of a particular good or service.

Tax Rate Structure

 The relationship between the amount that is
to be paid in tax and the tax base for a given
accounting period
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 Tax Basics (Continued)

∆ Total Taxes Paid

MTR =
∆Value of the Tax Base
Average Tax Rate
The total amount of tax divided by the total amount
of the tax base
Total Taxes Paid
ATR =
Value of the Tax Base
Tax bracket
The range of the tax base in which the marginal rate
is constant 6
Descriptors of the Tax Rate Structure
 A Progressive Tax has a structure where the
marginal tax rate is increasing and greater than
the average tax rate.
 A Proportional Tax has a structure where the
marginal tax rate is constant and equal to the
average tax rate. (Sometimes called a Flat Tax)
 A Regressive Tax has a structure where the
marginal tax rate is decreasing and less than the
average tax rate.

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Figure 10.1 A Proportional Tax Rate Structure

Tax Rate (Percent)

ATR = MTR
t

0
Tax Base (Dollars per Year)
8
 Figure 10.2 A Progressive Tax Rate Structure

MTR
35
Tax Rate (Percent)

ATR
25

15

0 4,000 29,000 70,000

Tax Base (Dollars of Taxable Income per Year)
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 Figure 10.3 An Example of a Regressive Tax Structure

15.30
Tax Rate (Percent)

12.35

0 ATR

2.9
MTR
$76,200 $100,000
Annual Labor Earnings per Worker
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 Average Tax Rates in the US
Average Tax Rates

Tax Brackets Marginal Tax Beginning End of

(Taxable Income) Rates (MTR) of Bracket Bracket

0-$4,000 0 0 0

$4000-$29,000 15 0 11
$29,000-$70,000 25 13 20

Above $70,000 35 20 34*

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Average Tax Rates Throughout the World

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How Should the Burden of Government
Be Financed?
Benefit Principle
 Those who benefit the most from a
particular program should pay the most
for that program (Lindahl Tax principle at
work).
Ability-to-Pay Principle
 Those who have the greatest ability to
pay should be required to pay the most.

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Criteria for Evaluating Methods of Government Finance
Equity
 The distribution of the government finance burden
should coincide with commonly held notions of fairness
and ability-to-pay.
Efficiency
 The system of government finance should raise
revenues with the least loss in efficiency in the private
sector.
Administrative ease
 A government finance system should be relatively easy
to administer consistently, without excessive costs to
collect, enforce, and comply with taxes and tax laws.

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Horizontal and Vertical Equity
 Horizontal equity is achieved when individuals of the
same economic capacity (measured, for example, by
income) pay the same amount of taxes per year (or
over their lifetimes).

 Vertical equity is accomplished when individuals of

differing economic ability pay annual tax bills that differ
according to some collectively chosen notion of
fairness.

 Both concepts are subjective.

 “Economic capacity” is difficult to measure and
administer.
 “Ability to pay” requires value judgments on the
proper income distribution.
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Tax Compliance, Avoidance and Evasion

 Tax Evasion is the term for illegal ways to

avoid paying taxes. It is typically the result of
not declaring income or overstating
otherwise legal deductions.

 Tax Avoidance is the term for legal ways to

avoid paying taxes, typically the result of
avoiding activities that are taxed, delaying
the time at which taxes are owed, or taking
an action designed to lower a tax burden.

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 Figure 10.4 Reducing Tax Evasion
A B

Cost and Benefit

Cost and Benefit

MC MC

E
E
E2 1

MB = MTR MB1 = MTR1

MB2
0 D* 0 D* D*
2 1
Unreported Income per Year (Dollars) Unreported Income per Year (Dollars)

C
MC2 MC
1
Cost and Benefit

E1

MB = MTR

D* D*
0
2 1
Unreported Income per Year (Dollars)
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Alternatives to Taxation

 Debt Finance is the means of financing

expenditures by issuing bonds.

 Inflationary Finance is the means of

financing expenditures through the
printing of money.

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 Figure 10.5 Inflationary Finance

T
C
G2 I
Guns per Year

G1 A

0 B2 B1 T'
Butter per Year 19
 More alternatives to Taxation
Donations
 Money (but more usually time) is voluntarily given to
government. Military service or work in the Peace Corps
can be considered a donation when the compensation is
less than the market value of the time.
User Charges
 Users of a government service can expect to pay for that
service. Examples include tuition, fees paid to enter state
parks, greens fees at publicly owned golf courses.
Earmarked Taxes
 Taxes can be implemented to fund specific public goods.
Examples include gasoline taxes and tolls designed to
fund road and bridge repair.

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 Figure 10.6 User Charges and Efficiency

MSC

Z*
C* + S*
Charges

S*
C*
Z MSB = MPB + MEB
MPB

0 Q*
Trash Pickups per Year 21
User Charges and the Transportation
Infrastructure

 Economists argue that voters demand

better roads and airports in part
because the price to use them (usually
zero) is less than the true marginal cost
(which should include congestion
costs.)

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User Charges and Efficiency
 Roads and Bridges wear out when too much
weight is concentrated on too few axles.

 Tolls motivate the wrong behavior in that they

tax per axle rather than on pounds per axle.

 Estimates suggest that taxing pounds per axle

and using the revenue to create stronger
roads would pay for itself more than eight-
fold.

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 Figure 10.7 User Charges for a Congestible
Government-Supplied Service
User Charges (Cents per Mile)

D1 = MSB1 D2 = MSB2 MSC

E*
20
E1 N* E2
0 80 100 120 150
Vehicles per Mile per Hour
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Government Enterprise
 Local Utilities

 Lotteries

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State Lotteries
 38 states run or participate in lotteries.

 State Lotteries account for more than 3% of state

revenues.

 People of varying incomes spend approximately the

same amount on lotteries, which suggests that the
lottery system is a regressive means of creating
government revenue.

 Lotteries pay out a smaller portion of revenue to

winners than other forms of gaming (horse racing,
casinos, etc.).

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