Final Review (Exam 3)

8/3/2019 Final Review (Exam 3)

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THE DESIGN OF THE TAX SYSTEM

y Two objectives of policymakers in designing a tax system:o Efficiencyo Equity

y How Federal Tax System evolved?o Raise Tax Revenueo Be Fairo Influence Behavior: Excise tax on spirits

y VOLUNTARY COMPLIANCE: THEINTERNALREVENUE SERVICE(IRS)o A system of cpmliance that relies on individual citizens to report their income freely

and voluntarily, calculater their tax liability correctly, and file a tax return on time

o Voluntary: the income tax system: Means that you can minimize your taxes by taking advantage of various

deductions and tax credits.

Means that you must tell the IRS what your tax liability is file a tax return Does not mean that the tax laws dont apply to you

y THE COST OF TAXES TO TAXPAYERS:o the tax payment itselfo Deadweight Losses (DWLs) of a tax

Because taxes distort incentives = DWLs The reduction of taxpayers economic well-being by the amount of revenue

raised by the government.

o AdministrativeBurdens Complying w/ tax laws creates DWLs Taxpayers lose additional time & money documenting, computing, and avoiding

taxes over and above the actual taxes they pay

It is part of the inefficiency it createso The Average Tax Rate = total taxes paid divided by total incomeo TheMarginal Tax Rate = the extra taxes paid on an additional dollar of incomeo Lump-sum tax = is the same amount for every person regardless of earnings or any

actions that the person might take.

Considered efficient taxes because they do not influence a persons decision onhow much to work

y TAXES ANDEQUITYo BENEFITS PRINCIPLE:

The idea that people should pay taxes based on the benefits they receive fromgovernment services

y A Gasoline Tax: Tax revenues from a gasoline tax are used to finance ourhighway system

y People who drive the most also pay the most toward maintaining roads


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According to this principle, it is fair for people to pay taxes based on benefitsthey receive from the government.

o ABILITY-TO-PAYPRINCIPLE: The idea that taxes should be levied on a person according to how well that

person can shoulder the burden

It leads to two corollary notions of equity According to this principle, it is fair for people to pay taxes on their capability to

handle the financial burden.

VERTICALEQUITY:y The idea that taxpayers w/ a greater ability to pay taxes should pay

larger amounts (e.g. people w/ higher incomes should pay more than

people w/ lower incomes)

Alternative Tax Systems (w/in Vertical Equity)

y Regressive Tax: tax for which high-income taxpayers pay a smallerfraction of their income than do low-income taxpayers

y Progressive Tax: a tax for which high-income taxpayers pay a largerfraction of their income than do low-income taxpayers

y Proportional Tax: a tax for which high-income taxpayers and low-income taxpayers pay the same fraction of income

HORIZONTALEQUITY: the idea that taxpayers w/ similar abilities to pay taxesshould pay the same amounts (e.g. two families w/ the same # of dependents &

the same income living in different parts of the country should pay the same

federal taxes.

y Marriage Tax: when a couple gets married they stop paying taxes asindividuals and start paying taxes as a family; if each has a similar

income, their total tax liability INcreases

y Regressive Tax vs. Progressive Tax?o Regressive tax: tariff and excise taxo Progressive taxes: federal income tax

y The FAIR TAX:o Eliminate the federal income tax & replace w/ a National Sales Taxo Abolish the Internal Revenue Serviceo TheNational Sales Tax rate initially would be 23%, w/ adjustments made to the rate in

subsequent years.

o Progressive tax to make it fair for low-income Americans U.S. lawful HHs would receive a monthly rebate, Family Consumption

Allowance (FCA), based on family size (regardless of income) at poverty level C,

according to the poverty guidelines published by the U.S. Department ofHealth

& Human Services.

Collect only on new purchases (used purchases tax-free) Business Purchases tax exempted


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o Pros:1. Easier to understand than the current convoluted income tax systems: the rich spend

$ trying to find loopholes to avoid taxes

2. Transparency in government easy to see that everyone pays the same rate onpurchases

3. No tax on Income = encourage venture K to invest in an entrepreneurs to help fuelthe American Dream jobs could be created w/ this new influx of capital

4. Increased Productivity: current progressive income tax decreases the incentive towork harder & be productive as you move up the ladder higher.

5. Increase the tax base: drug dealers, illegal immigrants pay tax.o Cons:

1. Jobs in the IRS would be lost and tax accountants need to be retrained2. High sales tax to stay revenue neutral: To bring the same government revenue as the

current system.

i. The large Sales tax would discourage people from buying things3. Create as underground economy of people trying to evade taxes

i. Intermediate goods (a part of production) would not be taxed.ii. Firms try to claim something as an intermediate good when really it is the

y FEDERAL TAX BRACKETS: the rate you pay on the "last $" you earn;o Average TAX RATES

y Real interest rate (r) =Nominal Interest Rate (i) Inflation Rateo Interest rate corrected for the effects on inflation: the difference between ion a loan

and the inflation rate

o Annual percentage rises in a lenders purchasingpowerfrom making a loano Example:

Buy a CD: Deposit $1000 at %10: receives $1100y Zero inflation CD: $10 buy 110 CDs 10% rise in purchasing powery 6% Inflation CD: $10.60 Buy 104 CDs 4% rise in purchasing powery 10% Inflation CD: $11 Buy 100 CDs No change in purchasing

power

y Nominal interest rate (i) = Inflation Rate + Real Interest Rateo The interest as usually reported w/out a correction for the effects of inflationo Annual percent rises in a lenders dollars from making a loan

y Inflation rate: measures the percent change in

Plevel from one period to the next

o (Price Index in year 2 Price Index in year 1)/Price Index in year 1y Reduced interest due to taxy After-taxNominal InterestRatey After-taxReal Interest Ratey Tax exemptions: spouse, dependentsy Deductions: apply only to specific expenses; e.g. mortgage interest


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THE LAFFER CURVE: TAX REVENUE & TAX RATE

Total Tax Revenue = Tax Base x Tax Rate

THE FEDERAL BUDGET

y Govt Budget: AUTOMATIC STABILIZERS over business cycleo BUDGET SURPLUS: Tax Rev > Spendingo BUDGET DEFICIT: Tax Rev < Spending

y Govt SPENDING = G + Transfer Payments + interests on debty NET TAXES (T) = TAX REV -Transfer Payments - interests on debty 4 MAIN SOURCES OF TAX REVENUES

o PERSONAL(INDIVIDUAL) INCOME TAXES: Paid by individuals on their income The marginal tax rate Higher-income families pay a larger % of their income in taxes

o SOCIAL SECURITYINSURANCE(PAYROLL) TAXES: the Federal Insurance Contribution Act(FICA) tax (AKA U.S. payroll (or employment) tax)

Established in 1935 to provide payment to retired workers Began as pay-as-you-go system Tax on the wages, paid by both workers and employers to finance:

y The Social Security program (AKA the federal Old-age, Survivors, &Disability Insurance (OASDI) program, earmarked

y Medicareo CORPORATEINCOME TAXES: paid by companies on their profit

Double Taxation: a situation in which two or more taxes must be paid for thesame asset or financial transaction.

y Dividendo EXCISE TAXES: specific goods; gasoline, cigarettes, alcoholic beverages

y 3 CATEGORIES OF EXPENDITURES:o TRANSFERPAYMENTS: payments that are not made in exchange for a currently

produced good or service

E.g. Social Security benefit to a person who is elderly; an unemploymentinsurance benefit to a recently laid off worker

o PURCHASES OF GOODS AND SERVICES By local, state, and federal governments It includes salaries of government employees, expenditures on public works,

etc.

o DEBT INTERESTPOVERTYANDINCOMEINEQUALITY


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y Poverty: the bottom part of income distribution, below same basicy Poverty line: developed by Mollie Orchansky, The social Security administration in 1964

o TypicalHousehold: 30% of household income spent on foodo TheDepartment of Agriculture: list of basic nutritional plan for families of different sizes

and consumption

o Adjust over time for inflationINEQUALITY: benefits are not distributed equally among societys members; the entire range of income

distribution, top to bottom.

y Criticism:o About 12% of income spent of foodo Not adjusted for society become richer (real gains) only for inflationo Diversity, poor in rural or in city, high (NY,CA) vs. low cost state (WV,MS)o Cash line only;o I

gnoreIn-kind

Benefits: not monetary form but form of goods and services: food stamp

and Medicaid assistance

o Omitted from measures of inequality and poverty, biasing them upwardy Why?Wages paidy Is inequality bad?

o The Life Cycle: the regular pattern of income variation over ones life Young: Poor vs. Middle age: Richer

o How much EconomicMobility is there? People move among income classes The temporarily poor and the persistently poor

y Borrow and save to offset life-cycle income changesy A better measure of inequality in living standards: not on current

income, but on Permanent Income (a persons normal income)

Due to a choicey Poor families more likely to experience:

o Homelessness, drug dependence, health problems, teen pregnancy, illiteracy,unemployment

y Most people believe government should provide a safety net.ThreeMacroeconomic Goals

1. Economic Growth2. Stable Prices

3. Full Employmenty Economic Stimulus Act 2008y The American Recovery and Reinvestment Act of 2009y Community Reinvestment Act (CRA): origin in 1977


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POLICIES TO REDUCE POVERTY

1. Set prices: cheap food, affordable housing2. Minimum-Wage Laws: laws that force a set level at which wages cannot fall below

a. Causes unemployment3. Direct subsidy on income Subsidize Businesses: tax credits

y EARNEDINCOME TAX CREDIT (EITC OREIC): a refundable tax credit offset the burden ofU.S. payroll taxes

o Negative Income Tax,Welfareo In-Kind Transfers: food stamps, Medicaid

y Government programs that supplement the incomes of the needyo Temporary Assistance for Needy Families (TANF)o Supplemental Security Income (SSI)

WHAT IS MONETARY POLICY?

y ProperMonetary policies: if An Inflationary gap? If A Recessionary gap?o Inflationary gap: Amount by which Real GDP exceed potential GDP

ProperMonetary Policy: tighter monetary policyy Decreases monetary base decrease money supplyy Increases federal funds rate

Contractionary Fiscal Policyy Decrease in Government Spending or/and an Increase in Taxesy AD decreasesy The multiplied effect shifts AD0 to AD1

o Recessionary Gap: Amount by which potential G

DPexceeds

Real G

DP

ProperMonetary Policy: buy bonds from the public to increase money supply;looser monetary policy.

y Increase Federal Funds Rate increase money supplyy Decrease Federal Funds Rate

Expansionary Fiscal Policyy The Feds Target Federal Funds Rate: the short-term interest rate that banks charge one

another for loans; the interest rate at which banks make overnight loans to one another.

o Direct control ofMonetary Base (aka. High Powered Money, outside money) Highly liquid money that consists of coins, paper money, and commercial banks

reserves with the central bank. M1 & M2: commonly used measures of money stock

y M1 Demand deposits, travelers checks, other checkable deposits,currency

y M2 Savings deposits, small time deposits, money market mutualfunds, a few minor categories + M1

o Indirect control ofMoney supply


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Money Supply: the quantity of money available in the economyy LOOSERMONETARYPOLICY

o Increases monetary base increases money supply reduces federal funds ratey TIGHTERMONETARYPOLICY

o Decreases monetary base Decreases money supply increases federal funds rateWHAT IS FISCAL POLICY?

y FiscalPolicy: the setting of the level of government expenditure and taxation by governmentpolicymakers;use of the federal budget.

y EXPANSIONARY FISCALPOLICYo An increase in Government spending and/or decrease in taxeso Aggregate Dement Increases

y CONTRACTIONARY FISCALPOLICYo A decrease in government spending and/or increase in taxeso Aggregate Demand decreases

y Discretionary Fiscal Policyo A fiscal action that is initiated by an act of congresso The government is taking actions to change spending or taxes

Tax cuts passed by congress in 2001 If time correctly and of the correct magnitude, the policy can be used to push

the economy to potential GDP

POLICY LIMITATIONS:

y Recognition Lag: it takes time to realize when an economic change is occurring (hard to predict-must collect and analyze data), making it hard for economists to influence the outcome with

fiscal policy before the changes have already taken hold.

y Law-Making Lag: It takes time to settle on decisions and pass policies into law, further delayingthe implementation.

y Impact Lag: the time it takes for the policy to affect the overall economy. A key part of theimpact lag is the multiplier. An initial change in government spending, taxes, the money supply,

interest rates must work through the economy, triggering changes in production and income,

which induces changes in consumption, which causes more changes in production and income,

which induces further changes in consumption.

y Activist view of policy: Laissez-faire view of policy- leave economy free of intervention and policychanges.

= in summary

In practice, discretionary fiscal policy is hampered by 3 time lags:

y Recognition LagThe time it takes to figure out that fiscal policy actions are needed.


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y Law- Making Lag- The amount of time it takes Congress to pass the laws needed to change taxesor spending.

y Impact Lag- The time it takes from passing a tax or spending change to implementing the newarrangements and feeling their effects on real GDP

AS, AD AND THE BUSINESS CYCLE

y Recession: a period of declining real incomes and rising unemployment.y Depression: a severe recession.y Model of Aggregate Demand and Aggregate Supply: the model that most economists use to

explain short-run fluctuations in economic activity around its long-run trend.

y AggregateDemand (AD): a curve that shows the quantity of goods and services that households,firms, the government, and customers abroad want to buy at each price level.

y Aggregate Supply (AS): a curve that shows the quantity of goods and services that firms chooseto produce and sell at each price level.

y Natural rate of output: the production of goods and services that an economy achieves in thelong run when unemployment is at its normal rate.

y Stagflation: a period of falling output and rising prices.y BUSINESS CYCLE:

o AD Fluctuations (p.333) From changes in consumption From changes in investment Changes in government purchases Changes in net exports

o AS Fluctuations Changes in labor Changes in capital Changes in natural resources Changes in technological knowledge

o Recession:Declining real incomes and rising unemploymento Expansion: increase in the money supplyo Peak: highest point of production/highest point of inflationary gap between two troughs

of real GDP

o Trough: lowest point of production/ lowest point of recessionary gap between twopeaks of real GDP

o Stagflation: a period of falling output and rising prices.o Full employment eqm:

Natural rate ofunemployment; potential GDP achieved GDP=Output

o Above full employment, inflation gapo Below full employment, recessionary gap


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o THEBENEFITS OF RECESSIONS May increase efficiency by driving the least efficient firms out of business

and by forcing surviving firms to trim waste and manage their resources

better.

May lead to decrease in inflation Leads to a decrease in the demand for imports, which improves a

nations balance of payments.

y Short Run AS and Long Run AS Curve (p.336):o Price level and real GDP are a vertical curve in long runo Price level and real GDP are a upward sloping curve in short-run

y Long Run Phillips Curve and Short-Run Philips Curve: Unemployment rate and Inflationo P.386-400

y Okuns Lawo The relationship between changes in real GDP and corresponding changes in

unemploymento For every percentage point the real GDP grows faster than the normal rate of increase in

potential output, the unemployment rate decreases by if a percentage point

y Effects of fiscal policy and Monetary policy to alleviate business cycleGREAT DEPRESSION (1929-1930S):WHAT CAUSED THE GREAT DEPRESSION?

y Possible Reasons:1. Decrease in the MS2. Decrease in Consumption3. Decrease in investment4. Unexpected deflation5. Increase in tariff

Prior to Great Depression

y Classical Economicso Laissez-faire: Free markets, Balanced Budgeto Natural market forces:

Flexible: Prices,Wages, interest Rates No Need for Government intervention

o The Study of how the economy operates at full employment.y Says Law: The doctrine that states that supply creates its own demand

o If GDP is $9 trillion, then production is $9 t and generates $9 t incomeo Create $9 trillion demand for current goods and serviceso No Excess demand nor Excess supply for total goods and services

y Auction prices: Prices that adjust on a nearly daily basis, fresh fish, fruit, vegetables, other foodproducts


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y Custom prices: Prices that adjust slowly, industrial commodities e.g. steel rods or machine toolswage-long term contract, union workers, university professor, government workers, high school

teachers, minimum wage workers

o Sticky Prices & StickyWages Buyer and seller agree on a price for a fixed period: the seller changes price

infrequently

Prices adjust slowly and not quickly enough to avoid shortages and surplusesy Keynesian theory and policy

o Analyzes on the idea that DEMANDDETERMINEDOUTPUT in the SR, not the P, IncreaseAD

o Short-Run in Macroeconomics: The study of how the economy operates away from fullemployment; Prices do not fully adjust to changes in demand

o Sticky Prices and StickyWageso Analyzes on the idea that DEMANDDETERMINEDOUTPUT in the SR, not the price

Increase Aggregate Demandy the Golden Age: 1960s: demand-management policy

o 1960s demand-management policyo Increase or decreases Aggregate DemandKennedy Tax Cut

o Lowered marginal rates from 91% to70% at the top and from 20% to 14% at the bottomo Rates in between were cut by about 30%o Discussed in 1961; Proposed in 1962Results

o Had little effect on the economy until 1965- 1967o Long-term effect on economic growth was significant

PRO AND CONS OF BUDGET DEFICIT

CONS:

1. Decrease in National saving, Crowding out ofInvestment2. Slowing down LR growth3. Burden to future generation

PROS:

1. AS AUTOMATIC STABILIZERS:y Stimulate AD(recessions) & Dampen AD(expansions)y Govt Spending & taxes that automatically increase and decrease along w/ the business

cycle

y Government spending and taxes that automatically increase and decrease along with thebusiness cycle


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y During the expansion: Employment Increaseso Tax Revenue increases, unemployment insurance payments decrease

y During recession: EmploymentDecreaseso Tax Revenue: Decreases,Unemployment insurance payments increase

y The Federal Budget deficit is counter cyclicalo Induced Tax: Taxes that vary with real GDP; e.g. Federal income tax, Progressive

income tax

o Needs- Tested Spending : Government expenditure on programs that pay benefitsto people and businesses depending on their economic status; e.g. Unemployment

insurance,Welfare payments

2. TAX SMOOTHINGy Alternative a sharp tax hike to finance war

3. FINANCINGWAR:y Automatic Stabilizers: changes in fiscal policy that stimulate Aggregate demand in a

recession without explicit action by policy makers Smooth out fluctuations

o Welfare and transfer programsy Recession: more people apply for welfare assistance and unemployment

benefits: Increase income increase Consumption Stimulate AD

o Consumption smoothingy People drawing on savings during an economic downturny Credit cards can help consumption smoothing

o Progressive Federal income taxOPEN ECONOMY MACROECONOMICS: TRADE

y Closed vs. Open Economyo Closed

No Exports & Imports Net Exports = 0

o Balance of Trade: the value of a nations exports minus the value of its imports; also called

the trade balance.

Trade Surplus: an excess of exports over imports; net exports are positive; acountry sells more goods and services abroad than it buys.

TradeDeficit: an excess of imports over exports; net exports are negative; sellsfewer goods/services abroad than it buys.

Balanced Trade: exports equal imports; net exports = 0o Net capital

Outflow: the purchase of foreign assets by domestic residents minus thepurchase of domestic assets by foreigners


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Inflow: the purchase of domestic assets by foreigners the purchase of foreignassets by domestic assets

what happen to domestic Investment (I)?y Trade surplus exports > imports Net Exports > 0 Income >

Domestic spending Saving > Investing sending more saving abroad

Net Capital Outflow > 0 Foreign investment > Domestic

y TradeDeficit exports < imports Net Exports < 0 Income < DomesticSpending Savings < Investment Financing domestic investment by

selling assets abroad Net capital outflow < 0 Foreign Investment

Final Review (Exam 3)

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