Government and Taxation

Government expenditures include both transfer payments, which distribute money to citizens, and purchases of goods and services, which are part of aggregate demand in the economy.  About 57 percent of government expenditures are for purchases, and the remainder are for transfers.

About 60 percent of government receipts are from taxes imposed by the federal government, and the remainder are from taxes imposed by state and local governments. Through grants-in-aid,  money collected by one level of government may be used to pay for goods and services provided by another level of government.

Microeconomic analysis suggests that, in a market- capitalist system, government may be able to improve resource allocation by providing market-support services and by correcting for market failures, such as those that arise from externalities. 

Markets provide excessive quantities of goods or services that generate negative externalities. Government may correct negative- externality market failure by shifting the supply curve to the left through regulations or through taxes.

Positive externalities cause markets to pro vide quantities that are less than the socially efficient quantity Government may correct positive externality market failure by shifting the demand curve to the right through regulations or through subsidies to purchasers. However, it usually is easier to provide subsidies to suppliers, thereby shifting the supply curve to the right. 

Because of nonexcludability, markets en counter the free-rider problem and fail to provide efficient quantities of goods and services that are consumed collectively. Government can overcome the free-rider problem by imposing taxes to finance collective goods and services. Because of non rivalry in consumption, tax money can be pooled into a common fund to finance the provision of a collective good or service.

Tax payments have several purposes: market correction, discouraging free riding, preference revelation, income redistribution, and resource allocation. Individual income taxes are the largest source of government revenue in the United States. Through personal exemptions and tax-rate brackets, individual income taxes are progressive. Average tax rates are higher as income rises. Indexing has been installed in income taxes to prevent inflation from causing bracket creep. The Tax Reform Act of 1986 eliminated or reduced many deductions and exclusions so that tax rates could be lowered. However, the tax is still very complicated. Flat-tax proposals advocate having only one tax bracket and only one tax rate.

Two taxes are used to finance Social Security-one on the worker's pay and one on the employer's payroll. Microeconomic analysis indicates that the payroll tax reduces the demand for labor and lowers employment and wage rates. The Social Security system may reduce saving if it leads workers to reduce private saving to finance retirement.

Corporation income taxes are imposed on the accounting profits of corporations. These taxes may be shifted forward to consumers or backward to labor and other suppliers of resources. Dividends and other returns to stockholders also may be reduced by the tax. The actual burden of these taxes is uncertain. 

Sales and excise taxes also may be shifted. Price-inelastic demand tends to place more burden on purchasers of the good or service, where as price- elastic demand tends to place more of the burden on resource owners. Government collects more revenue if demand is price inelastic than if it is price elastic, other things being equal. Excess burden will arise from these taxes if reduced quantities involve units of the good or service on which benefits exceeded costs.

Motor fuels taxes may be classed as user charges when the money collected from the tax is used to finance construction and maintenance of highways. A user charge is similar to a price charged for a good or service. 

Property taxes are annual taxes on the value of property, mainly land and buildings. They tend to reduce the supply and increase the market price of housing. Property taxes are used mainly by local governments and are especially important in. financing elementary and secondary education.

Public choice theory applies economic concepts to decision making in group situations. Taxpayers, voters, elected officials, and government employees are assumed to base their actions on self-interest. Taxation is based on benefits received rather than on ability-to-pay principles. Government agencies often use benefit-cost analysis in designing programs. Fiscal federalism studies the assignment of responsibilities to different levels of government in a multilevel system of government.