The Role of the Government
Chapter 9: The Role of the Government
In general, the art of government consists in taking as much money as possible from one party of the citizens to give to the other.
—Voltaire, Dictionnaire Philosophique (1764)
The government has many roles in the U.S. economy. Like other businesses, the government spends and makes money, consumes goods and services, and employs people. Federal, state, and local governments raise funds directly through taxes and fees. They often borrow money from the public by selling securities, such as bonds. A bond is an investment in which people loan money to the government for a specified time and interest rate. Governments also disburse money via contracts with businesses or through social programs that benefit the public.
Finally, the federal government is a manipulator of the U.S. economy. It influences macroeconomic factors, such as inflation and unemployment, through fiscal policy and monetary policy. Fiscal policy revolves around spending and taxation. Monetary policy is concerned with the amount of money in circulation and operation of the nation's central banking system.
Governments are responsible for providing services that individuals cannot effectively provide for themselves, such as military defense, fire and police departments, roads, education, social services, and environmental protection. Some government entities also provide public utilities, such as water, sewage treatment, or electricity. To generate the revenue necessary to provide services, governments collect taxes and fees and charge for many services they provide to the public. If these revenues are not sufficient to fund desired programs, governments borrow money.
Even before the United States became an independent nation, taxes were a significant issue for Americans. The Stamp Act of 1765 was the first tax imposed specifically on the North American colonies by the British Parliament and was strongly resisted by the colonists, who maintained that only representative legislatures in each colony possessed the right to impose taxes. The view that “taxation without representation” was tyranny contributed to the opposition to British rule that led to the Revolutionary War (1775–1783). Of course, it was necessary for the newly independent colonies to establish taxes of their own. As Benjamin Franklin (1706–1790) wrote, “In this world nothing can be said to be certain, except death and taxes” (November 13, 1789), and over the next two centuries a complex taxation code was developed at the federal, state, and local levels.
The most common taxes levied by federal, state, and local governments are:
- Income taxes—charged on wages, salaries, and tips
- Payroll taxes—Social Security insurance and unemployment compensation, which are paid by employers and withdrawn from payroll checks
- Property taxes—levied on the value of property owned, usually real estate
- Capital gains taxes—charged on the profit from the sale of an asset such as stock or real estate
- Corporate taxes—levied on the profits of a corporation
- Estate taxes—charged against the assets of a deceased person
- Excise taxes—collected at the time something is sold or when a good is imported
- Wealth taxes—levied on the value of assets rather than on the income they produce
Taxes are broadly defined as being either direct or indirect. Direct taxes (such as income taxes) are paid by the entity on whom the tax is being levied. Indirect taxes are passed on from the responsible party to someone else. Examples of indirect taxes include business property taxes, gasoline taxes, and sales taxes, which are levied on businesses but passed on to consumers via increased prices.
When individuals with higher incomes pay a higher percentage of a tax, it is called a progressive tax; when those with lower incomes pay a larger percentage of their income, a tax is considered regressive. The federal income tax is an example of a progressive tax, because individuals with higher incomes are subject to higher tax rates. Sales and excise taxes are regressive, because the same tax applies to all consumers regardless of income, so less prosperous individuals pay a higher percentage of their income.
Borrowing against the Future
Like many members of the public, government entities sometimes spend more than they make. When cash revenues from taxes, fees, and other sources are not sufficient to cover spending, money must be borrowed. One method used by government to borrow money is the selling of securities, such as bonds, to the public. A bond is basically an IOU that a government body writes to a buyer. The buyer pays money up front in exchange for the IOU, which is redeemable at some point in the future (the maturity date) for the amount of the original loan plus interest. In addition, the federal government has the ability to write itself IOUs—to spend money now that it expects to make in the future.
U.S. government bodies borrow money because they are optimistic that future revenues will cover the IOUs they have written. This optimism is based in part on the power that governments have to tax their citizens and control the cost of provided government services. Even though tax increases and cuts in services can be enacted to raise money, these actions have political and economic repercussions. Politicians who wish to remain in office are reluctant to displease their constituents. Furthermore, the more citizens pay in taxes, the less money they will have to spend in the marketplace or invest in private business, thereby hurting the overall economy. As a result, governments must weigh their need to borrow against the future likely consequences of paying back the loan.
The U.S. Census Bureau performs a comprehensive Census of Government every five years; the most recent was conducted in 2007 (http://www.census.gov/govs/www/cog2007.html). In between the censuses, annual surveys are
conducted to collect certain data on government finances and employment.
The 2007 Census of Government found 89,476 local government units in operation. These units are comprised of counties, municipalities, townships, school districts, and special districts. Special district governments usually perform a single function, such as flood control or water supply. For example, Florida is divided into five water management districts, each of which is responsible for managing and protecting water resources and balancing the water needs of other government units within its jurisdiction.
The latest survey data for local government revenues were compiled between 2005 and 2006. Local governments took in just over $1.4 trillion that year. (See Figure 9.1.) Nearly three-fourths of the money came from only three sources: intergovernmental revenue (33%), property taxes (25%), and charges for services (14%). Intergovernmental revenue consists of funds transferred to local governments from the federal and state governments. State funds accounted for the vast majority of intergovernmental transfers between 2005 and 2006.
Taxes, particularly property taxes, are an important source of revenue for many local governments. Property taxes accounted for a fourth of all revenue between 2005 and 2006 and were the largest single source of self-generated money. (See Figure 9.1.) Consumption taxes were also collected on sales and gross receipts. This includes selective taxes levied against particular goods, such as motor fuels, alcoholic beverages, and tobacco products. Miscellaneous taxes include personal and corporate income taxes, motor vehicle license taxes, and a wide variety of other taxes.
The revenue included in “charges for services” comes from many local sources, including hospitals, sewage treatment facilities, solid waste management, parks and recreation areas, airports, and educational facilities (e.g., the sale of school lunches). (See Figure 9.1.)
Other revenue sources for local governments are public utilities, miscellaneous general revenue, and insurance trusts. (See Figure 9.1.) Public utilities primarily supply electricity, water, natural gas, and public transportation (such as buses and trains). Miscellaneous general revenue comes from a variety of sources, including interest payments and the sale of public property. Insurance trusts are monies collected from the paychecks of local government employees to pay for worker programs, such as retirement benefits.
PROPERTY TAXES. A property tax is tax levied on the value of land, buildings, businesses, or personal property, including business equipment and automobiles. The U.S. Department of the Treasury explains that property taxes in the United States date back to the Massachusetts Bay Colony in 1646 and that the separate states began imposing property taxes soon after declaring independence from Britain. A property tax is an example of an ad valorem tax. Ad valorem is a Latin phrase meaning “according to the value.”
Property taxes are generally levied annually and calculated by multiplying the property value by an assessment ratio to obtain a taxable value. Assessment ratios can vary from less than 0.1 (less than 10%) to more than 1.0 (greater than 100%). The calculated taxable value is multiplied by a tax rate typically expressed in tax dollars per hundred or thousand dollars of value. For example, a home valued at $150,000 in an area with an assessment ratio of 0.5 (50%) would have a taxable value of $75,000. Assuming a tax rate of $3 per $1,000 of value, the property tax would be three times $75, or $225. Tax rates based on $1,000 of value are also known as millage rates.
Government entities at the local and sometimes state level determine the tax rate and the assessment ratio for their area. If permitted by their constituents, governments may choose to increase these values to raise additional revenue. Because real estate generally increases in value over time, property taxes can increase each year even if the tax rate and the assessment ratio remain constant.
Local governments spent nearly $1.4 trillion on annual expenses between 2005 and 2006. (See Figure 9.2.) Education was the largest single component, accounting for $525 billion and encompassing about 37% of the total. Spending on public health, welfare, and hospitals; utilities; environmental and housing concerns; and public safety (e.g., police and fire) each accounted for roughly 10% of the total.
According to the Census Bureau (May 16, 2008, http://ftp2.census.gov/govs/estimate/06slsstab1a.xls), salaries and wages for local government employees amounted to $518.1 billion, or 37% of the total expenditures between 2005 and 2006.
The Census Bureau (March 5, 2007, http://ftp2.census.gov/govs/apes/06locus.txt) estimates that in March 2006 local governments employed the equivalent of 11.9 million full-time employees. The payroll for that month was nearly $43.9 billion. Education positions were the single largest component, accounting for 6.9 million employees and $24.3 billion in payroll (more than half of employee numbers and payroll). The second largest component consisted of police, fire, and corrections officers. Nearly 1.4 million of them were employed by local governments and accounted for $6.3 billion of monthly payroll.
According to the Census Bureau, state governments had revenues of nearly $1.8 trillion between 2005 and 2006. (See Figure 9.3.) Intergovernmental revenue (funds from the federal government) accounted for almost one-fourth (24%) of the total. Insurance trusts were the largest source of self-generated revenue for states, accounting for 21% of the total. Other major sources of revenue included sales taxes (19%) and individual income taxes (14%). Charges for services, miscellaneous general revenue, and miscellaneous taxes (such as property taxes) each accounted for 9% or less of the total.
In February 2008 the Census Bureau released detailed data on state tax collections for 2007. Each of the fifty states is ranked in Table 9.1 by total tax collected. In general, the largest and most populous states collected the most taxes. Four states—California, New York, Texas, and Florida—accounted for 38% of all taxes collected in 2007.
STATE SALES TAXES. Sales taxes are a major source of revenue for state governments. (See Figure 9.3.) The Federation of Tax Administrators (FTA) is a nonprofit organization that provides research services for the tax administrators of all fifty states. According to the FTA, in “State Sales Tax Rates” (January 1, 2008, http://www.taxadmin.org/fta/rate/sales.html), forty-five states and the District of Columbia assessed sales taxes. As of January 2008, the five states without a sales tax were Alaska, Delaware, Montana, New Hampshire, and Oregon. The state sales tax rates ranged from a low of 2.9% in Colorado to 7% and greater in California, Mississippi, New Jersey, Rhode Island, and Tennessee. Nearly all states exempted prescription drugs and food from sales taxes.
STATE INCOME TAXES. In “State Individual Income Taxes” (January 1, 2008, http://www.taxadmin.org/fta/rate/ind_inc.html), the FTA provides information on state income tax rates. As of January 2008, forty-three states and the District of Columbia imposed income taxes. The states that did not tax income were Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. Two additional states, Tennessee and New Hampshire, taxed only personal income derived from dividends and interest.
According to the FTA, several states imposed a single rate for all income levels, including Colorado (4.6%), Illinois (3%), Indiana (3.4%), Massachusetts (5.3%), Michigan (4.4%), Pennsylvania (3.1%), and Rhode Island (25% of federal tax liability). Many states have devised tax codes based on multiple income brackets. Overall, tax rates varied from a low of 0.4% in Iowa to a high of 9.5% in Vermont.
The Census Bureau reports that state governments had expenditures of nearly $1.6 trillion between 2005 and 2006. (See Figure 9.4.) About $428 billion (28%) of this total was in the form of transfers to other governments, such as local governments within the state. The remainder was devoted to spending priorities at the state level. Public welfare and social services composed the single largest expense at $407 billion, accounting for 26% of all money expended. Education and libraries accounted for the second largest category of expenditures at $202 billion, or 13% of the total. State spending on education is primarily for higher education, such as colleges and universities. Payments from insurance trusts amounted to 11% of state spending. All other expenditures each accounted for 6% or less of state spending.
The Census Bureau (March 5, 2007, http://ftp2.census.gov/govs/apes/06stus.txt) estimates that in March 2006 state governments employed the equivalent of 4.3 million full-time employees. The payroll for that month was nearly $16.8 billion. Education positions were the single largest component, accounting for 1.7 million employees and $6.9 billion in payroll. The second largest contingent consisted of corrections officers. Nearly half a million of them were employed by state governments in March 2006, accounting for $1.7 billion of monthly payroll.
For accounting purposes, the federal government operates on a fiscal year (FY) that begins in October and runs through the end of September. Thus, FY 2009 covers the period of October 1, 2008, through September 30, 2009. Each year by the first Monday in February the U.S. president must present a proposed budget to the U.S. House of Representatives. This is the amount of money that the president estimates will be required to operate the federal government during the next fiscal year.
It can take several months for the House to debate, negotiate, and approve a final budget. The budget must also be approved by the U.S. Senate. This entire process can take many months, and sometimes longer than a year. This means that the federal government can be well into (or beyond) a fiscal year before knowing the exact amount of its budget for that year.
Detailed data on the finances of the federal government are maintained by the Office of Management and Budget (OMB), an executive office of the U.S. president. The OMB assists the president in preparing the federal budget and supervises budget administration. Information on the FY 2009 budget is available at http://www.whitehouse.gov/omb/budget/fy2009/. Budget documents include historical tables that provide annual data on federal government receipts, outlays, debt, and employment dating back to 1940 or earlier. The FY 2009 budget includes
|TABLE 9.1 States ranked by total state taxes, 2007|
|SOURCE: “States Ranked by Total State Taxes: 2007,” in Federal, State, and Local Governments: 2005 State Government Tax Collections, U.S. Department of Commerce, U.S. Census Bureau, February 29, 2008, http://www.census.gov/govs/statetax/07staxrank.html (accessed May 24, 2008)|
|[Amount in thousands]|
final values for years through 2007 and estimates for 2008 through 2013.
The federal government had revenues (receipts) of $2.5 trillion in 2007. (See Figure 9.5.) Individual income taxes were the largest single component, amounting to $1.2 trillion, or 47% of the total. The second largest source
of revenue was social insurance and retirement receipts, at $873 billion, or 34% of the total. Corporation income taxes accounted for another 13%, followed by other revenue at 4% and excise taxes at 3%.
TAXES ON INCOME. The federal income tax was authorized in 1913 with ratification of the Sixteenth Amendment to the U.S. Constitution: “The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration.” In the United States tax rates are approved by Congress and signed into law by the president; the Internal Revenue Service (IRS), a bureau of the Department of the Treasury, enforces the tax codes and collects tax payments, which are due each year on April 15.
The percentage of an individual's income that he or she pays in federal tax is based on his or her income level, which determines the individual's tax bracket. Tax brackets change as Congress modifies the tax codes, but individuals with higher incomes are always taxed at a higher rate than individuals with lower incomes. Through a variety of tax credits and deductions, individuals can lower the amount of income on which taxes are calculated, thereby lowering the amount of tax they pay.
The federal tax on corporate income has been in effect since 1909. Because corporations are owned, and individuals derive income from them, the potential exists for “double taxation,” that is, the same income taxed twice, once as corporate income and, when the profits have been distributed to shareholders, again as individual income. To reduce the effects of double taxation, various credits and deductions have been enacted throughout the years to allow income to pass through a corporation without being taxed until it reaches the individual. Credits and depreciation schedules reduce the amount of revenue subject to tax.
SOCIAL INSURANCE AND RETIREMENT RECEIPTS. Social insurance and retirement receipts are collected to fund specific programs for people who are retired, disabled, unemployed, or poor. The primary programs are Social Security and Medicare. Social Security provides funds to most workers who retire or become disabled. It
also pays money to the survivors of workers who die. Medicare is a health insurance program for poor people.
As of 2008, the federal government collected money to pay for these two programs as follows:
- Social Security—a tax of 12.4% on earned annual income up to $102,000. In other words, people who earn more than the annual limit pay the tax on $102,000, no matter how much they earn.
- Medicare—a tax of 2.9% on earned annual income. No income limit.
These taxes are known as payroll taxes, because they are assessed based on the amounts that businesses pay their workers. Half of the tax (6.2% for Social Security plus 1.45% for Medicare) is paid by wage earners and is deducted from their paychecks; the other half is paid directly by employers. Self-employed people pay the entire tax bill but can deduct half of it as a business expense when they file income taxes.
Unemployment insurance is a joint federal-state program almost entirely funded by employers. Employers that meet certain criteria (regarding number of employees and amount of payroll) pay both state and federal unemployment taxes.
EXCISE TAXES AND OTHER RECEIPTS. Sales and excise taxes are considered taxes on consumption. Even though there is no federal sales tax, the federal government does levy excise taxes on items such as airplane tickets, gasoline, alcoholic beverages, firearms, and cigarettes. Excise taxes on certain commodities are often hypothecated, meaning they are used to pay for a related government service. For example, fuel taxes are typically used to pay for road and bridge construction or public transportation, or a cigarette excise may go to cover government-supported health-care programs. Excise taxes can be intended to generate revenue or to discourage use of the taxed product (as in high cigarette taxes that raise the per-pack cost in an attempt to discourage smoking).
The “other” category in Figure 9.5 includes estate and gift taxes and customs duties and fees. Estate and gift taxes are taxes on wealth. Estate taxes are levied against a person's estate after that person dies; gift taxes are levied against the giver while the giver is alive. Estate and gift taxes only apply to amounts over specified limits. According to the IRS (May 1, 2008, http://www.irs.gov/businesses/small/article/0,,id=164871,00.html), as of 2008 only total taxable estates and lifetime gifts exceeding $1 million actually had to pay estate and gift taxes.
Customs duties are taxes charged on goods imported into the United States. The taxes vary by product and by exporting nation.
According to the OMB, the federal government spent nearly $2.8 trillion during FY 2007. (See Table 9.2.) The OMB breaks down expenditures into broad categories called superfunctions and narrower categories called functions. Overall, human resources were the largest expenditure for the federal government, accounting for 61% of spending during 2007. The largest single component of federal spending was for the Social Security program, which accounted for 20% of expenditures. Social Security was followed by Medicare and income security (both at 13%), and health (9%).
According to the Census Bureau (June 28, 2007, http://ftp2.census.gov/govs/apes/06fedfun.pdf), the federal government employed 2.7 million civilian (nonmilitary) employees as of December 2006. The civilian payroll for that month was nearly $13.9 billion. The largest contingent of workers (over 772,000 people) worked for the U.S. Postal Service. It accounted for 28% of civilian employees and 26% of the total payroll. The next largest workforce was employed in national defense and international relations (more than 698,000 employees). This workforce accounted for 19% of the total payroll.
The U.S. Department of Defense reports in Financial Summary Tables (February 2008, http://www.defenselink.mil/comptroller/defbudget/fy2009/fy2009_summary_tables _whole.pdf) that it employed nearly 1.4 million military personnel on full-time active duty at the end of FY 2007. The Department of Defense had outlays of nearly $129 billion for all military personnel (active and reserve duty) for that year.
|TABLE 9.2 Federal government outlays, fiscal year 2007|
|SOURCE: Adapted from “Table 3.1. Outlays by Superfunction and Function: 1940–2012,” in Budget of the United States Government, Fiscal Year 2008: Historical Tables, U.S. Government Printing Office, 2007, http://www.white- house.gov/omb/budget/fy2008/pdf/hist.pdf (accessed May 27, 2008)|
|[Billions of dollars]|
|Amount||Percent of net total by super function||Percent of net total by super function or function|
|Education, training, employment, and|
|Veterans benefits and services||72||3%|
|Natural resources and environment||35||1%|
|Commerce and housing credit||0.2||0.01%|
|Community and regional development||33||1%|
|General science, space and technology||25||0.90%|
|Administration of justice||45||1.60%|
|Undistributed offsetting receipts||-81|
|Total, federal outlays||2,784||100$||100$|
Federal Deficits and Surpluses
If the government spends less money than it takes in during a fiscal year, the difference is known as a budget surplus. Likewise, if spending is higher than revenues, the difference is called a budget deficit. A balanced budget occurs when spending and revenue are the same.
Figure 9.6 shows the annual surplus or deficit from 1900 to 2012 as reported in the OMB's FY 2008 budget (years 2007 to 2012 are estimated). In general, the federal government had a balanced budget for more than half of the twentieth century, excluding slight deficits that occurred around World War I (1914–1918) and World War II (1939–1945). Beginning in 1970 the United States had an annual deficit for nearly three decades. The years 1998 through 2002 had budget surpluses. In 2000 the surplus reached a record $236 billion. Budget deficits returned between 2003 and 2007 and are forecast by the OMB for 2008 through 2011. In 2004 the federal deficit reached a record high of nearly $413 billion and then began to shrink. The OMB predicts that budget deficits will continue to shrink through 2011 and that a budget surplus of $61 billion will occur in 2012.
Whenever the federal government has a budget deficit, the Department of the Treasury must borrow money to cover the difference. The total amount of money that the Treasury has borrowed over the years is known as the federal debt, or more commonly the national debt. Budget surpluses cause the debt to go down, whereas deficits increase the debt.
The national debt was low until the early 1940s, when it jogged upward in response to World War II government spending. (See Figure 9.7.) Over the next three decades the debt increased at a slow pace. During the late 1970s the national debt began a steep climb that has continued into the 2000s. The budget surpluses from 1998 through 2002 had a slight dampening effect on the growth of the debt but did not actually decrease the amount of debt. The budget deficits of the years that followed sent the debt into another rapid incline. By the end of FY 2007, the national debt stood at $9 trillion.
BORROWED MONEY AND IOUS. The national debt has two components: money that the federal government has borrowed from the public and money that the federal government has loaned itself. The public loans money to the federal government by buying federal bonds and other securities. The government borrows the money with a promise to pay it back with interest after a set term. Some of the most common federal securities sold to the public are Treasury bills, Treasury notes, Treasury bonds, and savings bonds. These vary in value, interest paid, and set terms. Public investors include individuals and businesses (both domestic and foreign) and state and local governments.
The federal government also borrows from itself. This is debt owed by one Treasury account to another. Most of the so-called internal debt involves federal trust funds. For example, if a trust fund takes in more revenue in a year than is paid out, it loans the extra money to another federal account. In exchange, the loaning trust fund receives an interest-bearing security (basically an IOU) that is redeemable in the future from the Treasury. In Federal Debt and the Commitments of Federal Trust Funds (May 6, 2003, http://www.cbo.gov/ftpdocs/39xx/doc3948/10-25-LongRangeBrief4.pdf), the Congressional Budget Office (CBO) explains this accounting procedure in simple terms. The CBO sums up the situation by stating that “what is in the trust funds is simply the government's promise to pay itself back at some time in the future.”
On June 19, 2008, the Department of the Treasury (http://www.treasurydirect.gov/govt/reports/pd/mspd/2008/opds062008.pdf) reported that the national debt was nearly $9.5 trillion, broken down as follows:
- Owed to the public—$5.3 trillion (56% of the total)
- Intragovernmental—$4.2 trillion (44% of the total)
According to the Department of the Treasury, in “The Debt to the Penny and Who Holds It” (July 2008, http://www.treasurydirect.gov/NP/BPDLogin?application=np), the portion of the national debt that the government owes to itself has grown substantially since the 1990s. In 1997 intragovernmental debt made up 30% of the total debt.
Over the following decade the intragovernmental debt grew to account for more than 40% of the total debt.
AS A PERCENTAGE OF THE GDP. Economists often discuss the national debt in terms of its percentage of the gross domestic product (GDP; the total market value of final goods and services produced within an economy in a given year), because a debt amount alone does not provide a complete picture of the effect of that debt on the one who owes it. According to the Central Intelligence Agency (CIA), in World Factbook (July 15, 2008, https://www.cia.gov/library/publications/the-world-factbook/rankorder/2186rank.html), in 2007 the U.S. national debt made up an estimated 60.8% of the nation's GDP in 2007.
INTERNATIONAL COMPARISON. In World Factbook, the CIA ranks nations of the world in descending order of national debt as a percentage of GDP in 2007. The United States ranked twenty-sixth on this list, behind industrialized nations including Japan (195.5%), Italy (104%), Singapore (101.2%), Greece (89.7%), Belgium (84.9%), Israel (80.6%), Norway (75.1%), Canada (68.5%), France (64%), and Germany (63.2%). By comparison, the United Kingdom had a national debt to GDP ratio of 43%, Spain was at 35.9%, China was at 18.4%, and Australia was at 15.4%.
THE BURDEN ON THE ECONOMY. The national debt represents a twofold burden on the U.S. economy. The debt owed to the public imposes a current burden. The federal government pays out interest to investors, and these interest payments are funded by current taxpayers. The debt that the federal government owes to itself is a future burden. At some point in the future the securities issued for intra-governmental debt must be redeemed for cash. The government will have to raise these funds by raising taxes, reducing spending, and/or borrowing more money from the public.
To fund itself, the federal government uses the money of its constituents. The buying of federal securities, such as bonds, represents a voluntary investment in government by the public. Federal securities are considered a safe low-risk investment because they are backed by an entity that has been in existence for more than two hundred years and has a proven track record of fiscal soundness. However, money invested in government securities is not available for private investment. In general, private investments are seen as more stimulating for the economy because they provide direct funds for growth, such as the building of new factories and the hiring of new workers. Public (government) investment may or may not have a stimulating effect on the economy, depending on how the funds are spent.
Taxes represent an involuntary investment by the public in government. The effect of taxes on the economy is a source of never-ending debate in U.S. politics. Taxing personal income decreases the spending power of the individual; people have less money to invest in private enterprise or to use to consume goods and services. Limited taxation is favored by those who believe that workers and companies with more available money to spend will participate to a greater extent in the economy. This, they say, will lead to economic growth. Others observe that cutting taxes without severely reducing government spending leads to large budget deficits and undermines the government programs that provide a social safety net to the disadvantaged.
The Bush Tax Cuts
Historically, the Republican Party has advocated smaller government and lower taxes. The Economic Growth and Tax Relief and Reconciliation Act (EGTRRA) of 2001 was initiated by the first administration of George W. Bush (1946–) and is commonly referred to as the “Bush tax cuts.” The EGTRRA instituted a series of tax rate reductions and incentive measures to be phased in over several years. Included in the law were increases in income tax credits for families with children and reductions in estate, gift, and generation-skipping transfer taxes (a special tax on property transfers from grandparents to their grandchildren), but it did not address business taxes. It also called for reductions in the tax brackets.The EGTRRA was designed to expire on January 1, 2011, unless additional measures are passed to extend its provisions.
The Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) of 2003 accelerated implementation of the EGTRRA, reduced taxes on capital gains and dividends, and increased deductions for property depreciation. Additional measures were accelerated or added through the Working Families Tax Relief Act of 2004, the American Jobs Creation Act of 2004, the Tax Increase Prevention and Reconciliation Act of 2005, the Pension Protection Act of 2006, and the Economic Stimulus Act of 2008. The latter included a one-time tax rebate for eligible Americans of up to $600 per qualifying adult and $300 per qualifying child.
TAX CUT ADVOCATES. President Bush was reelected in 2004, and he pressed Congress to make the provisions of the EGTRRA permanent as a way to stimulate the U.S. economy. Bush asserted that his policies would reduce poverty by lowering taxes for low- and lower-middle income families. In addition, he asserted that tax breaks benefit families by helping them reduce their debt.
In the press release “Treasury Releases Papers on Anniversary of President's 2003 Tax Relief” (May 28, 2008, http://www.ustreas.gov/press/releases/hp999.htm), the Department of the Treasury announces the issuing of two reports in May 2008 that highlighted “the benefits to American families and businesses from the tax relief enacted over the last seven years.” According to the first report, Topics Related to the President's Tax Relief (http://www.treasury.gov/press/releases/reports/president_taxrelief_topics_0508.pdf), the tax cuts have made the individual income tax “highly progressive.” As proof, the Treasury cites data indicating that in 2005 the top 1% of taxpayers paid 39.4%, the top 5% paid 59.7%, and the top 50% paid 96.9% of all individual income taxes. In the second report, Tax Relief in 2001 through 2011 (http://www.treasury.gov/press/releases/reports/taxrelief_20012011_052708.pdf), the Treasury gives examples of the tax increases that will affect American families if the Bush tax cuts are allowed to expire. For example, the Treasury predicts that a family of four with one income earner making $40,000 per year in 2007 dollars will experience a tax increase of $2,345 in 2011.
TAX CUT CRITICS. Critics of President Bush's tax policy point out that changes in the tax structure unfairly shift the burden from corporations and wealthy individuals to low- and middle-class wage earners, that tax cuts already instituted have erased the federal surplus built up in the late 1990s, and that further tax cuts will lead to unacceptable increases in government debt.
Lori Montgomery examines in “As Candidates Warm to Bush Tax Cuts, Economists Warn of Long-Term Effect” (Washington Post, March 28, 2008) the effects of the Bush tax cuts and the opinions of economists who oppose continuing the cuts past their expiration date. Montgomery notes that the tax cuts are projected to save U.S. taxpayers $1.6 trillion by the time they expire. However, the economist Alan Viard states the tax cuts “are neither sustainable nor beneficial” unless the federal government makes enormous cuts in government spending, a scenario unlikely to occur. The economist Jason Furman complains “if you cut taxes without cutting spending, you're just shifting taxes to the future.”
The amount of tax an individual or family pays to the government, including his or her income, payroll, excise, and other taxes, is known as his or her tax burden. In Tax Rates and Tax Burdens in the District of Columbia—A Nationwide Comparison: 2006 (November 2007, http://www.taxadmin.org/fta/rate/DC_tax_burden_2006.pdf), Natwar M. Gandhi, the chief financial officer of the District of Columbia, focuses on the tax burden in fifty-one large U.S. cities. Gandhi estimates that an American family of three with an annual income of $50,000 paid an average of 8.7% of its income in state and local taxes in 2006, including $2,153 in property taxes, $1,265 in state or local income taxes, $943 in sales taxes, and $250 in automobile taxes. At the $75,000 income level, American families paid an average of $6,649 in state and local taxes, or 8.9% of their income in 2006. The average tax burden for families with higher incomes was 8.5% for an income of $100,000 and 8.4% for an income of $150,000.
In Who Pays Taxes and Who Receives Government Spending? An Analysis of Federal, State, and Local Tax and Spending Distributions, 1991–2004 (March 2007, http://www.taxfoundation.org/files/wp1.pdf), Andrew Chamberlain and Gerald Prante of the Tax Foundation, a non-partisan tax research organization, split American taxpayers into five quintiles based on household income and estimate each quintile's tax burden as a percentage of income. The bottom quintile (i.e., the taxpaying household in the bottom 20% ofthe income range) had a tax burden rate of 4.3%. This compares to 9.6% and 14.8% for the second and third quintiles from the bottom and 22.4% for the second quintile from the top. The top quintile had a tax burden rate of 48.8%.
Chamberlain and Prante note that even though the U.S. tax system is progressive, the country's overall fiscal system is even more progressive when federal, state, and local government spending distributions are taken into account. The researchers indicate that households in the bottom quintile of income received approximately $8.21 in government spending for every dollar of taxes paid during 2004. Middle-class households received $1.30 for every tax dollar spent, and households in the top quintile received $0.41 for every tax dollar spent. Chamberlain and Prante conclude that “the current practice of judging the fairness of policy based on tax distributions alone is clearly inadequate.”
Even though Americans commonly complain about the amount of taxes they pay, the overall tax burden in the United States is generally lower than it is in other advanced economies. The Organization for Economic Cooperation and Development (OECD) compares in Tax Administration in OECD and Selected Non-OECD Countries: Comparative Information Series: 2006 (February 2007, http://www.oecd.org/dataoecd/37/56/38093382.pdf) the tax burdens of various nations as of 2003. According to the OECD, the tax burden as a percentage of the GDP in the United States was 25.6%, which compared favorably to nations such as the United Kingdom (35.6%), Canada (33.8%), Germany (35.5%), France (43.4%), and Sweden (50.6%), and was only slightly higher than Korea and Japan (both at 25.3%).
Social Security and Medicare are two of the most expensive programs operated by the federal government. (See Table 9.2.) Together, they accounted for $952 billion of spending in 2007, or 34% of total expenditures.
Signing Social Security into law on August 14, 1935, President Franklin D. Roosevelt (1882–1945; July 3, 2008, http://www.fdrlibrary.marist.edu/odssast.html) said, “We can never insure one hundred percent of the population against one hundred percent of the hazards and vicissitudes of life, but we have tried to frame a law which will give some measure of protection to the average citizen and to his family against the loss of a job and against poverty-ridden old age.”
As part of his war on poverty, President Lyndon B. Johnson (1908–1973) signed into law the Social Security Amendments of 1965, which included a new program called Medicare to provide health insurance for the elderly.
The program conditions and requirements have been changed many times over the succeeding decades. As of 2008, people born in 1929 or later qualify for retirement benefits once they have worked for ten years. Benefit amounts are based on wage history; thus, higher-paid workers will have higher retirement benefits than lower-paid workers. The Social Security Administration (SSA) indicates in “Retirement Benefits by Year of Birth” (May 5, 2008, http://www.socialsecurity.gov/retire2/agereduction.htm) the age at which full benefits can be paid:
- People born in or before 1937—age sixty-five
- People born between 1938 and 1959—sliding age scale ranging from sixty-five and two months to sixty-six and ten months
- People born in 1960 and later—age sixty-seven
People who have worked for at least ten years are eligible for permanently reduced retirement benefits starting at age sixty-two. Benefits for widows, widowers, and family members have varying age requirements and other conditions that must be met. Medicare coverage begins at age sixty-five for everyone except for certain disabled people who can qualify earlier.
Since their inception, the Social Security and Medicare programs have been a source of partisan contention and debate. Much of the debate has centered on how the programs should be funded and the role of government in social welfare. In recent years, attention has turned to concerns about how the nation can afford these programs in the future as the population ages and as the number of earners contributing to the plans decreases.
Fewer Contributors, More Beneficiaries
Figure 9.8 shows the percentage of the U.S. population aged sixty-five and older from 2000 to 2008 and projected through 2050. A huge increase in the aged population is expected to take place during the late 2010s and 2020s because of the baby boom that followed World War II. However, as these workers retire, there will be fewer workers contributing to the plan, because succeeding generations have been smaller due to declin-
ing birth rates. At the same time, life expectancies have been increasing, meaning that elderly people are living longer past retirement age and collecting benefits for more years.
The U.S. Government Accountability Office (GAO) estimates in Federal Debt: Answers to Frequently Asked Questions—An Update (August 2004, http://www.gao.gov/new.items/d04485sp.pdf) the number of workers contributing to Social Security per beneficiary. In 1960 there were approximately five workers per beneficiary. (See Figure 9.9.) By 2000 this number had dropped to 3.3 workers. The GAO estimates that by 2060 there will be about two workers contributing for each beneficiary. This is expected to put unprecedented stresses on the Social Security system.
Funding Social Security
In The 2008 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds (March 25, 2008, http://www.ssaonline.us/OACT/TR/TR08/tr08.pdf), an annual report on the status of the Social Security trust funds—Old-Age and Survivors Insurance (OASI) and Disability Insurance (DI), the Social Security Board of Trustees notes that approximately 163 million people had earnings covered by Social Security during 2007. Together, the OASI and DI trust funds had revenues of $785 billion, of which nearly 84% came from payroll taxes. The remaining 16% was from interest earnings and taxes assessed on benefits. Approximately $585 billion was paid in benefits to forty-eight million people as follows:
- Thirty-four million retirees and their dependents
- Nine million survivors of deceased workers
- Six million disabled workers and their dependents
The trustees project that tax revenues will be less than program costs beginning in 2017. (See Table 9.3.) At that point the trust funds will be used to pay the shortfall so that payments to beneficiaries can continue at expected levels. The trust funds will be exhausted in 2041, and over the following four decades the program's
|TABLE 9.3 Key dates for the Social Security and Medicare trust funds, April 2008|
|SOURCE: “Key Dates for the Trust Funds,” in A Summary of the 2007 Annual Social Security and Medicare Trust Fund Reports, Social Security Administration, April 22, 2008, http://www.ssa.gov/OACT/TRSUM/index.html (accessed May 28, 2008)|
|Key dates for the trust funds|
|First year outgo exceeds income excluding interest||2018||2005||2017||2008|
|First year outgo exceeds income including interest||2028||2012||2027||2010|
|Year trust funds are exhausted||2042||2025||2041||2019|
|OASI = Old Age Survivors Insurance.|
|DI = Disability Insurance.|
|OASDI = Old Age, Survivors, and Disability Insurance.|
|HI = Health Insurance.|
annual income will fund approximately 75% of the benefits currently available to beneficiaries. Accessing the trust funds will put pressure on the federal budget, as the federal government has often borrowed money from the trust funds to pay for other programs but will no longer be able to do so.
In total, the trustees estimate that the Social Security program will be short by $4.3 trillion over a seventy-five-year period.
FIXING THE PROBLEM. How best to prepare for future shortfalls in Social Security is a fiercely debated issue within the federal government. During early 2005 President Bush campaigned for significant reform of the Social Security program, including allowing younger workers to opt out of the Social Security plan and establish their own retirement savings accounts. This came to be known as the privatization of Social Security.
Democrats in Congress did not accept that a radical reform of the program was necessary to recover the shortfall, as the actual deficit over a seventy-five-year period, according to the Social Security Board of Trustees, in the 2008 Annual Report, was expected to be about 2%. In other words, the payroll tax for Social Security would need to be increased by 2% to make up the difference. Democrats have suggested that such a sum could also be recouped by, for example, removing the cap on income subject to FICA taxes (those mandated by the Federal Insurance Contribution Act), but President Bush has adamantly dismissed any alternatives that could be construed as a tax increase.
In addition, the president's plan to privatize Social Security has been opposed by influential seniors groups, including the AARP (formerly the American Association of Retired Persons), a special interest group for people over age fifty. In “Frequently Asked Questions about Strengthening Social Security” (2008, http://www.aarp.org/money/social_security/frequently_asked_questions_about_social _security.html), the AARP advocates increasing the income limit subject to Social Security withholding. As of 2008, the limit was $102,000; it has been raised many times over the years. The AARP also encourages the federal government to invest trust fund assets differently so as to reap higher rates of return.
The Social Security Board of Trustees notes in the 2008 Annual Report that Hospital Insurance (HI), the largest Medicare trust fund, took in $224 billion during 2007. The vast majority of this money was from payroll taxes. The remainder came from interest earnings, taxes on benefits, beneficiary premiums, and other sources. The HI trust fund pays hospital benefits (known as Part A under Medicare) to all beneficiaries.
The trustees note that the Medicare HI trust fund faces a shortfall much sooner than the OASI and DI funds. Benefits to be paid out will exceed income (including interest) as early as 2010. The HI trust fund is expected to be exhausted by 2019. Immediately after exhaustion, tax revenues will be sufficient to pay only 78% of HI costs. That number will drop to 30% by 2082. The HI trust fund faces extreme funding problems in future decades because technological advances are expected to dramatically increase health-care costs in the United States.
The Medicare Supplementary Medical Insurance (SMI) trust fund had revenues of $238 billion during 2007. SMI covers the costs of physician services (Part B) and prescription drugs (Part D). Coverage under Parts B and D is optional and requires payment of monthly premiums. These are subtracted from the beneficiaries' Social Security checks. Part D coverage is relatively new, having been added to the Medicare program in late 2003. In 2005 the SMI trust fund was financed largely by revenues from the general fund and supplemented with beneficiary premiums and interest earnings. Because SMI is not dependent on payroll taxes, it is not expected to experience the same kind of shortfalls facing the OASI, DI, and HI trust funds. It is, however, projected to put increasing pressure on the general fund because of rising health-care costs.
FIXING THE PROBLEM. The pending shortfalls in the Medicare HI trust fund have received far less national attention than the problems facing the OASI and DI trust funds. In his 2003 State of the Union address (http://www.whitehouse.gov/news/releases/2003/01/20030128-19.html), President Bush spoke about the need for health care reform, particularly in Medicare. The president called Medicare “the binding commitment of a caring society.” However, concrete reform measures have not been forthcoming. Medicare reform is likely to require politically unpopular actions, such as raising taxes and/or reducing benefits.
The federal government plays a role in the national economy as a tax collector, spender, and employer. Federal policy makers also engage in purposeful manipulation of the U.S. economy at the macroeconomic level— for example, by influencing supply and demand factors. This was not always the case. Before the 1930s the government mostly maintained a hands-off approach to macroeconomic affairs—a tradition dating back to the founding of the nation. The ravages of the Great Depression brought a level of desperation (e.g., the unemployment rate was as high as 25%) that encouraged leaders to attempt to influence macroeconomic factors. Even though these efforts were largely futile at soothing deep economic depression, they accustomed a generation of Americans to the idea of government interference in economic affairs.
When immense federal spending during World War II helped end the Great Depression, policy makers believed they had discovered a new solution, a government solution, for economic downturns. Government efforts to manage macroeconomic factors became a routine matter over the following decades. These manipulations are commonly divided into two categories, known as fiscal policy and monetary policy.
The word fiscal is derived from the Latin term fiscalis, meaning “treasury.” It is believed that a fiscalis was originally a woven basket in which money was kept. In modern English, the word fiscal has become synonymous with the word financial. The federal government's fiscal policy is concerned with the collection and spending of public money so as to influence macroeconomic affairs. Examples of fiscal policy include:
- Increasing government spending to spur businesses to produce more and hire more, lowering the unemployment rate
- Increasing taxes to pull money out of the hands of consumers; this can lower excessive demand that is driving high inflation rates
- Decreasing taxes to put more money in the hands of consumers to increase demand and consequently increase supply (production)
These examples illustrate optimistic outcomes. In reality, the actions of fiscal policy can have complicated (and unforeseen) effects on the U.S. economy. The situation described in the first example can backfire if production does not grow fast enough to satisfy consumer demand. The result will be rising prices and high inflation rates. Likewise, tax increases and decreases can have unexpected and undesirable consequences. The relationships between the major macroeconomic factors—unemployment, inflation, and supply and demand—are complex and difficult to keep in balance.
Fiscal policy is strongly associated with the economist John Maynard Keynes (1883–1946) and is a corner-stone of Keynesian economics.
Monetary policy is concerned with influencing the supply of money and credit and the demand for them to achieve specific economic goals. The actions of monetary policy are not as direct and obvious as the tax and spend activities associated with fiscal policy. Monetary changes are achieved indirectly through the nation's banking system. The following are some results of monetary policy changes:
- An increase in the amount of money that banks can loan to the public. This leads to greater borrowing, which puts more money into the hands of consumers, increasing the demand for goods and services.
- A decrease in the amount of money that banks can loan to the public. This leads to less borrowing, which slows the growth of the money supply and dampens demand, which can reduce high inflation rates.
- Lower interest rates on loans. This encourages borrowing, which increases the money supply and consumer demand.
- Higher interest rates on loans. This discourages people from borrowing more money, which slows the growth of the money supply and can reduce high inflation rates.
Just as in fiscal policy, it is difficult to achieve the exact results desired. An oversupply of money and credit will aggravate price inflation if production cannot meet increased consumer demand. Likewise, an undersupply can lower consumer demand too much and stifle economic growth. The challenge for the federal government is deciding when, and by how much, money supply and credit availability should be changed to maintain a healthy economy. These decisions and manipulations are made by the Federal Reserve, the nation's central bank.
THE FEDERAL RESERVE SYSTEM. In 1913 Congress passed the Federal Reserve Act to form the nation's central bank. The Federal Reserve System was granted power to manipulate the money supply—the total amount of coins and paper currency in circulation, along with all holdings at banks, credit unions, and other financial institutions.
The Federal Reserve includes a seven-member board of governors headquartered in Washington, D.C., and twelve Reserve Banks located in major cities around the country: Boston, New York City, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco.
In The Federal Reserve System: Purposes and Functions (June 2005, http://www.federalreserve.gov/pf/pdf/pf_complete.pdf), the Federal Reserve explains that it uses three techniques to indirectly achieve “maximum employment, stable prices, and moderate long-term interest rates”:
- Open market operations—the Federal Reserve buys and sells government securities on the financial markets. The resulting money transfers ultimately lower or raise the amount of money that banks have available to loan to the public and the associated interest rates.
- Discount rate adjustments—the Federal Reserve raises or lowers the discount rate. This is the rate that it charges banks for short-term loans. In response, the banks adjust the federal funds rate, the rate they charge each other for loans. Then the banks adjust the prime rate, the interest rate they charge their best customers (typically large corporations). In the end, these adjustments affect the interest rates paid by the general public on mortgages, car loans, credit cards, and so on.
- Reserve requirement adjustments—the Federal Reserve raises or lowers the reserve requirement, the amount of readily available money that banks must have to operate. Each bank's reserve requirement is based on a percentage of the total amount of money that customers have deposited at that bank. Money above the reserve requirement can be loaned out by the banks. Changes in the reserve requirement influence bank decisions about loans to the public.