Every function superadded to those already exercised by the government, causes its influence over hopes and fears to be more widely diffused, and converts, more and more, the active and ambitious part of the public into hangers-on of the government, or of some party which aims at becoming the government. If the roads, the railways, the banks, the insurance offices, the great joint-stock companies, the universities, and the public charities, were all of them branches of government; if, in addition, the municipal corporations and local boards, with all that now devolves on them, became departments of the central administration; if the employés of all these different enterprises were appointed and paid by the government, and looked to the government for every rise in life; not all the freedom of the press and popular constitution of the legislature would make this or any other country free otherwise than in name.{666}
Chapter 19
GOVERNMENT FINANCE
The willingness of government to levy taxes fell distinctly short of its propensity to spend.
Arthur F. Burns{667}
Like individuals, businesses, and other organizations, governments must have resources in order to continue to exist. In centuries past, some governments would take these resources directly in the form of a share of the crops, livestock or other tangible assets of the population but, in modern industrial and commercial societies, governments take a share of the national output in the form of money. However, these financial transactions have repercussions on the economy that go far beyond money changing hands.
Consumers can change what they buy when some of the goods they use are heavily taxed and other goods are not. Businesses can change what they produce when some kinds of output are taxed and others are subsidized. Investors can decide to put their money into tax-free municipal bonds, or into some foreign country with lower tax rates, when taxes on the earnings from their investments rise—and they can reverse these decisions when tax rates fall. In short, people change their behavior in response to government financial operations. These operations include taxation, the sale of government bonds and innumerable ways of spending money currently, or promising to spend future money, such as by guaranteeing bank deposits or establishing pension systems to cover some or all of the population when they retire.
The government of the United States spent nearly $3.5 trillion in 2013.{668} One of the ways of dealing with the many complications of government financial operations is to break them down into the ways that governments raise money and the ways that they spend money—and then examine each separately, in terms of the repercussions of these operations on the economy as a whole. In fact, the repercussions extend beyond national boundaries to other countries around the world.
Acquiring wealth has long been one of the main preoccupations of governments, whether in the days of the Roman Empire, in the ancient Chinese dynasties or in modern Europe or America. Today, tax revenues and bond sales are usually the largest sources of money for the national government. The choice between financing government activities with current tax revenues or with revenues from the sale of bonds—in other words, going into debt—has further repercussions on the economy at large. As in many other areas of economics, the facts are relatively straightforward, but the words used to describe the facts can lead to needless complications and misunderstandings. Some of the words used in discussing the financial operations of the government—“balanced budget,” “deficit,” “surplus,” “national debt”—need to be plainly defined in order to avoid misunderstandings or even hysteria.
If all current government spending is paid for with money received in taxes, then the budget is said to be balanced. If current tax receipts exceed current spending, there is said to be a budget surplus. If tax revenues do not cover all of the government’s spending, some of which is covered by revenues from the sale of bonds, then the government is said to be operating at a deficit, since bonds are a debt for the government to repay in the future. The accumulation of deficits over time adds up to the government’s debt, which is called “the national debt.” If this term really meant what it said, the national debt would include all the debts in the nation, including those of consumers and businesses. But, in practice, the term “national debt” means simply the debt owed by the national government.
Just as the government’s revenues come in from many sources, so government spending goes out to pay for many different things. Some spending is for things to be used during the current year—the pay of civilian and military personnel, the cost of electricity, paper, and other supplies required by the vast array of government institutions. Other spending is for things to be used both currently and in the future, such as highways, bridges, and hydroelectric dams.
Although government spending is often all lumped together in media and political discussions, the particular kind of spending is often related to the particular way money is raised to pay for it. For example, taxes may be considered an appropriate way for current taxpayers to pay for spending on current benefits provided by government, but issuing government bonds may be considered more appropriate to have future generations help pay for things being created for their future use or benefit, such as the highways, bridges and dams already mentioned. In the case of city governments, subways and public libraries are built to serve both the current generation and future generations, so the costs of building them are appropriately shared between current and future generations by paying for their construction with both current tax revenues and money raised by selling bonds that will be redeemed with money from future taxpayers.
GOVERNMENT REVENUES
Government revenues come not only from taxes and the sale of bonds, but also from the prices charged for various goods and services that governments provide, as well as from the sale of assets that the government owns, such as land, old office furniture, or surplus military equipment. Charges for various goods and services provided by local, state or national governments in the United States range from municipal transit fares and fees for using municipal golf courses to charges for entering national parks or for cutting timber on federal land.
The prices charged for goods and services sold by the government are seldom what they would be if the same goods or services were sold by businesses in a free market—and therefore government sales seldom have the same effect on the allocation of scarce resources which have alternative uses. In short, these transactions are not simply transfers of money but, more fundamentally, transfers of tangible resources in ways that affect the efficiency with which the economy operates.
During the pioneering era in America, the federal government of the United States sold to the public vast amounts of land that it had acquired in various ways from the indigenous population or from foreign governments such as those of France, Spain, Mexico and Russia. In centuries past, governments in Europe and elsewhere often also sold monopoly rights to engage in various economic activities, such as selling salt or importing gold. During the late twentieth century, many national governments around the world that had taken over various industrial and commercial enterprises began selling them to private investors, in order to have a more market-directed economy. Another way for governments to get money to spend is simply to print it, as many governments have done at various periods of history. However, the disastrous consequences of the resulting inflation have made this too risky politically for most governments to rely on this as a common practice. Even when the Federal Reserve System of the United States resorted to the creation of more money, as a policy for dealing with a sluggish economy in the early twenty-first century, the Federal Reserve coined a new term—“quantitative easing”—that many people would not understand as readily as they would understand a more straightforward term like “printing money.”
Tax Rates and Tax Revenues
“Death and taxes” have long been regarded as inescapable realities. But which of the various ways in which taxes can be collected is actually used, and which particular tax rate is imposed, makes a difference in the w
ay individuals, enterprises, and the national economy as a whole respond. Depending on those responses, a higher tax rate may or may not lead to higher tax revenues, or a lower tax rate to lower tax revenues.
When tax rates are raised 10 percent, it may be assumed by some that tax revenues will also rise by 10 percent. But in fact more people may move out of a heavily taxed jurisdiction, or buy less of a heavily taxed commodity, so that the revenues received can be disappointingly far below what was estimated. The revenues may, in some cases, go down after the tax rate goes up.
When the state of Maryland passed a higher tax rate on people earning a million dollars a year or more, taking effect in 2008, the number of such people living in Maryland fell from nearly 8,000 to fewer than 6,000. Although it had been projected that the additional tax revenue collected from these people in Maryland would rise by $106 million, instead these revenues fell by $257 million.{669} When Oregon raised its income tax rates in 2009 on people earning $250,000 or more, Oregon’s income tax revenues likewise fell by $50 billion.{670}
Conversely, when the federal tax rate on capital gains was lowered in the United States from 28 percent to 20 percent in 1997, it was assumed that revenues from the capital gains tax would fall below the $54 billion collected under the higher rates in 1996 and below the $209 billion that had been projected to be collected over the next four years, before the tax rate was cut. Instead, tax revenues from the capital gains tax rose after the capital gains tax rate was cut and $372 billion were collected in capital gains taxes over the next four years, nearly twice what had been projected under the old and higher tax rates.{671}
People adjusted their behavior to a more favorable outlook for investments by increasing their investments, so that the new and lower tax rate on the returns from these increased investments amounted to more total revenue for the government than that produced by the previous higher tax rate on a smaller amount of investment. Instead of keeping their money in tax-exempt municipal bonds, for example, investors could now find it more advantageous to invest in producing real goods and services with a higher rate of return, now that lower tax rates enabled them to keep more of their gains. Tax-exempt securities usually pay lower rates of return than securities whose returns are subject to taxation.
As a hypothetical example, if tax-exempt municipal bonds are paying 3 percent and taxable corporate bonds are paying 5 percent, then someone who is in an income bracket that pays 50 percent in taxes is better off getting the tax-exempt 3 percent from municipal bonds than to have 2.5 percent left after half of the 5 percent return on corporate bonds has been taxed away. But, if the top tax rate is cut to 30 percent, then it pays someone in that same income bracket to buy the corporate bonds instead, because that will leave 3.5 percent after taxes. Depending on how many people are in that income bracket and how many bonds they buy, the government can end up collecting more tax revenues after cutting the tax rates.
None of this should be surprising. Many a business has become more profitable by charging lower prices, thereby increasing sales and earning higher total profits at a lower rate of profit per sale. Taxes are the prices charged by governments, and sometimes the government too can collect more total revenue at a lower tax rate. It all depends on how high the tax rates are initially and how people react to an increase or a decrease. There are other times, of course, where a higher tax rate leads to a correspondingly higher amount of tax revenues and a lower tax rate leads to a lower amount of tax revenues.
The failure of tax revenues to automatically move in the same direction as tax rates is not peculiar to the United States. In Iceland, as the corporate tax rate was gradually reduced from 45 percent to 18 percent between 1991 and 2001, tax revenues tripled.{672} High-income people in Britain have relocated to avoid impending increases in tax rates, just as such people have in Maryland and Oregon. In 2009, for example, the Wall Street Journal reported: “A stream of hedge-fund managers and other financial-services professionals are quitting the U.K., following plans to raise the top personal tax rates to 51%. Lawyers estimate hedge funds managing close to $15 billion have moved to Switzerland in the past year, with more possibly to come.”{673}
Although it is common in politics and in the media to refer to government’s “raising taxes” or “cutting taxes,” this terminology blurs the crucial distinction between tax rates and tax revenues. The government can change tax rates but the reaction of the public to these changes can result in either a higher or a lower amount of tax revenues being collected, depending on circumstances and responses. Thus references to proposals for a “$500 billion tax cut” or a “$700 billion tax increase” are wholly misleading because all that the government can enact is a change in tax rates, whose actual effects on revenue can be determined only later, after the tax rate changes have gone into effect and the taxpayers respond to the changes.
The Incidence of Taxation
Knowing who is legally required to pay a given tax to the government does not automatically tell us who in fact ultimately bears the burden created by that tax—a burden which in some cases can be passed on to others, and in other cases cannot.
Who pays how much of the taxes collected by the government?
This question cannot be answered simply by looking at tax laws or even at a table of estimates based on those laws. As we have already seen, people may react to tax changes by changing their own behavior, and different people have different abilities to change their behavior, in order to avoid taxes.
While an investor can invest in tax-free bonds at a lower rate of return or in other assets that pay a higher rate of return, but are subject to taxes, a factory worker whose sole income is his paycheck has no such options, and finds whatever taxes the government takes already gone by the time he gets that paycheck. Various complex financial arrangements can spare wealthy people from having to pay taxes on all their income but, since these complex arrangements require lawyers, accountants and other professionals to make such arrangements, people of more modest incomes may not be equally able to escape their tax burden, and can even end up paying a higher percentage of their income in taxes than someone who is in a higher income bracket that is officially taxed at a higher rate.
Since income is not the only thing that is taxed, how much total tax any given individual pays depends also on how many other taxes apply and what that individual’s situation is. Obviously, taxes on homes or automobiles fall only on those who own them and, while sales taxes fall on whoever buys any of the many items subject to those taxes, different people spend different proportions of their income on consumer goods. Lower income people tend to spend a higher percentage of their income on consumer goods, while higher income people tend to invest more—sometimes most—of their income.
The net effect is that sales taxes tend to take a higher percentage of the incomes of low-income people than they take from the incomes of higher-income people. This is called a “regressive” tax, as distinguished from a “progressive” tax that subjects higher incomes to a higher percentage rate of taxation. Social Security taxes are likewise regressive, since they apply only to incomes up to some fixed level, with income above that level not being subject to Social Security taxes. Income taxes, on the other hand, exempt incomes below some fixed level. Given the different rules for different kinds of taxation, figuring out what the total incidence of taxation is for different people is not easy in principle, much less in practice.
Issues and controversies about tax rates often discuss the incidence of taxes on “the rich” or “the poor,” when in fact the taxes fall on income rather than wealth. A genuinely rich person, someone with enough wealth not to have to work at all, may have a very modest income or no income at all during a given year. Moreover, even during years of high incomes and high rates of taxation on that income, this taxation does not touch the rich individual’s accumulated wealth. Most of the people described as “rich” in discussions of tax issues are in fact not rich at all but simply people who have reached
their peak earnings years, often having worked their way up to that peak after decades of earning much more modest salaries. Progressive income taxes typically hit such people rather than the genuinely rich.
Since each individual pays a mixture of progressive and regressive taxes, as well as taxes that apply to some goods and not to others, it is by no means easy to determine who is actually paying what share of the country’s taxes.
What is even more difficult is to determine who bears the real burden of a given tax by suffering the consequences of changed outcomes. For example, American employers pay half of the taxes that support Social Security and all of the taxes that pay for unemployment compensation. However, as we have seen in Chapter 10, how high an employer is willing to bid for a worker’s services is limited by the amount that will be added to the employer’s revenue by hiring that worker. But an employee whose output adds $50,000 to a company’s sales receipts may not be worth even $45,000, if Social Security taxes, unemployment taxes, and other costs of employment add up to $10,000. In that case, the upper limit to how far an employer would bid for that person’s services would be $40,000, not $50,000.
Even though the worker does not directly pay any of that $10,000, if the pay received by that worker is $10,000 less than it would be otherwise, then the burden of these taxes has in effect fallen on the worker, no matter who sends the tax money to the government. It is much the same story when taxes are levied on businesses which then raise their prices to the consumer. Depending on the nature of the tax and the competition in the market, the consumers can end up paying anywhere from none to all of the burden of those taxes. In short, the official legal liability for the direct payment of taxes to the government does not necessarily tell who really bears the economic burden in the end.
Basic Economics Page 49