What we will not talk about here are budget deficits because states and local communities are generally required to balance their budgets, but government budget deficits are a BIG issue with the federal government, so now we'll look at the books of the federal government. 

Federal Government:  Outlays and Revenues

The federal government's finances have been the BIG story since the early 1980s - at least at the national news level - and if you really want to see the data you might go to the source - the Federal Budget or the excel version of the Historical Tables. It is a big story because we are talking about BIG money, but as you can see below, it was not always that way.  What is very clear is the significance of major wars that were paid for largely by the federal government and show up as peaks in late 1910s (WWI), the early 1940s (WWII), a little blip in the late 1960s (Vietnam), and the Reagan defense build up in the early 1980s.  The effects of the Cold War that dominated international relations from the end of WWII until the late 1980s can be seen in the slow decline of the fed's share after WWII.  Rather than return to the prewar share as it did after WWI, the federal government continued to spend heavily on defense, which kept it's share of revenue above 60 percent.

Looking at the spending data, which you can find at the Office of Management and Budget web site where you will see Historical tables, we see that in 2004 the federal government spent $2.3 trillion and collected about $1.8 trillion.  The growth in government revenues and outlays during the 20th century is evident in left-side diagram.  Clearly something happened in the late 1910s and early 1940s that increased outlays, while something happened in the early 1980s and 2000s that reduced tax revenues sharply.  What happened were the two world wars (1918+ and 1940+) and the Reagan and Bush tax cuts and accompanying recessions (early 1980s and 2000s), issues we examine in detail in the macro course. 

What appears to be the case here is a meteoric growth in federal government spending and taxes in recent years, but as you should remember from the earlier data analysis unit, things are not often what they appear to be.  What we know is prices rose and the economy expanded greatly during the 20th century, and we ought to take that into account when we look at the government's finances.  We do that by creating new variables measuring outlays, revenues, and deficits divided by GDP, the measure we have of the size of the economy.  By creating this variable we can see if government spending, taxes, or borrowing (deficit) are growing faster or slower than the overall economy and, as is evident in the right-side graph, the story looks completely different.  You will notice WWII is very evident with the spike in government outlays that approached 50 percent of national output.  Also evident in the graph is the growth of the government that began in the Great Depression of the 1930s as the federal government, under president Roosevelt's New Deal, began to take a more active role in the economy.  Before WW I federal outlays averaged less than 5 percent of GNP, in the 1930s they averaged 8-9 percent, and in the years directly following WW II they averaged 12 percent.  After a spike of government outlays during the Korean war, the US government's share of the economy continued to rise so that by the early 1980s its share of the economy was approaching 25 percent - a reflection of the combined effects of active government involvement in the economy and the Cold War.  We can also see the Reagan tax cuts and the defense buildup in the early 1980s as the two lines begin to diverge; the convergence in the 1990s attributed to the collapse of the Berlin Wall that brought an end to the Cold War and reductions in military spending, the emergence of the rapid economic growth in the "New Economy," and the Clinton tax increases; and the lines begin to diverge again after Bush's election - the result of a sluggish economy after 9/11, the Bush tax cuts, and the War on Terrorism. 

Now let's look more closely at the sources of revenues and the pattern of spending. 

Federal Revenues

The growth in the federal government has been accompanied by significant changes in the sources of those revenues.  As we saw earlier, in the pre Great Depression 1930s the federal government relied heavily on tariffs and excise taxes.  In 1934, during the Great Depression and before the modern Social Security system had begun, excise taxes (think sales taxes) accounted for the largest share of government revenue (47%), followed by the "other "category that includes gift taxes, customs duties, and Federal Reserve profits (27%).  By 1939, after the Social Security legislation had been enacted, the share of revenue from Social Insurance Taxes (think unemployment and retirement) had risen from 0 to nearly 30 percent of revenue, offsetting the declines in tariff and excise tax revenues.  The most dramatic changes, however, occurred during the 1940s.  Since passage of the Sixteenth Amendment to the US Constitution in 1913 authorizing the collection of a federal income tax, the personal income tax was largely a tax on only the nation's wealthy and not a source of substantial revenues, but this changed during the war when the tax rates were raised and the base broadened.  Between 1939 and 1945, revenues from personal and corporate income taxes increased 1500 percent and the share of revenue collected by corporate and personal income nearly doubled from 34 to 76 percent.  Following WWII, personal income taxes remained at the higher level and continued to account for between 40 and 50 percent of total revenue, while corporate income taxes continued to decline in terms of general importance with the exception of the reversal in the early 1950s to help finance the Korean War.  Offsetting the decline in corporate income taxes has been an increase in social insurance taxes - what you can think of as the FICA contribution on your pay stub - that now bring in almost as much as income taxes. You can see this on your pay stub where the two taxes separated and you .  These taxes, which accounted for less than one of every ten dollars raised by the federal government in the late 1940s, accounted for nearly one of every three dollars raised in the early 2000s - about the same share as the personal income tax.  Finally, excise taxes that accounted for about one-third of federal revenue before WW II, accounted for about one-twentieth at the end of the 1990s. 

As we move forward, it is important to keep in mind that all of these receipts from the various sources all go into a general fund that is used to pay the government's bills.  This will be important when we see where Social Security shows up in the budget and when we sort through all of the claims and counterclaims about the Social Security deficits and impending bankruptcy. It is also important to keep in mind who pays these taxes because there is a dramatic difference between who pays social insurance taxes and who pays income taxes, and as these shares change there will be a potentially dramatic redistribution of the tax burden - something we will examine later in this unit.  We will also talk about two Bush tax cuts of 2001 and 2003.  We'll look briefly at the nature of those cuts and then look into the issue of who pays the federal taxes - a hotly contested issue during the discussions leading up to the tax cut legislation.

Federal Outlays

The dramatic changes in the revenue sources of the federal government have been matched by changes spending patterns.  Defense's share of total federal outlays, which during WW II accounted for nearly 90 percent of federal outlays, dropped sharply after the war, only to rise again to account for almost 70 percent of outlays during the Korean War in the early 1950s.  The decline following the Korean War was much slower than after WW II, a reflection of the effect of the Cold War on defense spending, but it did continue to decline with only three reversals - the Vietnam war in the late 1960s, the Reagan defense buildup in the early 1980s, and the Bush buildup in the early 2000s.  Also evident are two steep declines - after the Vietnam war in the 1970s and after the collapse of the communist governments in the 1990s. Despite the decline in the relative importance of defense, the US entered the 21st century spending an enormous amount on defense.  Defense spending in 2004 was estimated to be $450 billion - far more than the spending of any other country and more than 50 percent higher than defense spending in 2000 before Bush's buildup.  Based on data available at the Center for Defense Information, we find that the US spent $399 billion in fiscal year 2004, more than six times the $65 billion spent by Russia, which ranks second in defense spending, eight times the $46 billion spent by China, and more than the combined spending of the top twenty spenders on defense.  

Increasing rather dramatically in importance in the federal budget have been outlays on human resources.  In fact the curves for defense and human resources are almost the mirror images of each other - with defense spending "squeezing" out human resources during WW II and Korea, and then rising in importance with only a slight slowdown in the 1980s when defense spending increased under Reagan and the spending on interest increased as a result of the rising budget deficits.  With large deficits the government's debt - what it owed - increased and with the increased debt came larger interest payments.  Within the function of human resources, Social Security accounted for the largest share in 2003 - about one third of the total, but the spending on health and Medicare, which came into existence in 1966, were rising rapidly and together they are projected to account for 50 percent of human resource spending by 2009.  Spending on physical resources (energy, transportation, and natural resources and the environment), meanwhile, remained under 20 percent of the total, with physical resources declining in importance after 1980. 

The changing composition of federal outlays has also meant that the government has less "control" over its spending.  The distinction is increasingly being made between discretionary spending, what the government can control, and nondiscretionary, what existing laws mandate and cannot be controlled without a rewriting of the laws.  Nondiscretionary spending, which accounted for roughly one-third of all spending in the early 1960s, accounted for two-thirds in the early 2000s, so that at the turn of the 21st century the US government's spending was largely on autopilot.  Within discretionary outlays, meanwhile, you can see the changing fortunes of the military-industrial complex.  After a buildup for the Vietnam War in the late 1960s, defense's share of outlays dropped sharply as the government expanded domestic programs, a pattern Ronald Reagan reversed with his military buildup in the 1980s.  After "The Wall" came down at the end of the 1980s and the Cold War was declared over, another shift away from defense occurred under Clinton, only to be reversed under Bush after 2000.

Federal Government:  Deficits and the Debt

Federal deficits and debt: The official record

It's now time to look at the imbalances and indebtedness of the government - what it borrows and what it owes.  In the left-side diagram we see a graph of the budget deficit - the gap between the revenue and outlay lines.  What is clear are the deficits during the two world wars, the Reagan tax cuts in the early 1980s, the turnaround under Bill Clinton in the 1990s, and the deficits after Bush's tax cuts in the early 2000s.  These number can be misleading, however, because the size of the economy is also much larger, so we adjust the deficit data to account for the larger economy.  If we were looking at your financial situation this would be equivalent to looking at either how much you are borrowing this year or the amount you are borrowing divided by your current income because the latter measure is a better measure of the "burden" of your borrowing.  If your income doubles and your borrowing does not change, then you would see the borrowing/income variable decrease indicating the borrowing was less painful financially.  The same is true for the federal government, and you can see the imbalances in the fed's finances also look very different when adjusted for the size of the economy.  The deficits of Reagan and Bush appear much smaller than they did originally, while the deficit during WW II reveals how large they were relative to the economy.  At the peak of the wartime spending the US government was borrowing nearly 30 percent of national income, a figure that was possible because of the patriotic response to the sale of war bonds.  Also visible in the graph is the dramatic turnaround in the budget deficit in the Clinton 1990s and the Bush 2000s, but that discussion will need to wait until the macro course. What we can say here is that the deficits created today will have enormous impact on your generation because it will be today's college students who will be asked to repay the loans made to the US government to finance its deficit, which is why we have heard in recent years about a new concept - intergenerational equity that we will discuss in the final section. 

For a little bit of perspective on the US data, we can look at the OECD data summarized in the table below.  What you can see is that the US ended the 1990s with a surplus while most countries had deficits, but by 2004 the US had a deficit that was above average for the wealthy countries, although it was still substantially lower than Japan's deficit. 

The result of the deficits has been a run-up in the indebtedness of the federal government, which is usually measured with the privately held debt of the US government that you can find information on at the Department of the Treasury web site.  Once again the story is very different depending upon which perspective you take.  In the left-side diagram it appears as though the debt of the US began exploding in the 1980s, with only a brief reversal in the late 1990s when we had those Clinton surpluses. By 2004 this debt was estimated at $4.4 trillion - or about $15,000 for every person, and $60,000 for every family of four.  When adjusted for the economy's size, we see that the through 1980 the debt/GDP ratio declined sharply from its peak at about 110 percent of GDP at the end of WWII, then rose during those Reagan deficits in the 1980s, fell during the Clinton surpluses of the 1990s, and began rising again during the Bush deficits of the 2000s. 

While it is interesting to know that every American in 2004 owed about $15,000, it is the debt/GDP ratio that is more important for assessing the financial health of the government.  Someone has to lend the money to the US government to finance it's debt, but as the debt/GDP ratio begins to rise the government's creditworthiness begins to be questioned by international investors.  The problem is that we do not know when a country gets close to its limit, but we can look at the OECD data and see the US has a low debt/GDP ratio relative to the other rich countries.  What we cannot see here is the impact of Social Security on the viability of the government's financial condition, even though it was difficult to get through a week in early 2005 without some story on the impending fiscal crisis, so now we will look at Social Security and the budget. 

At this time you might be asking why is it that the discussions of budget deficits are all focused on the federal government?  It is a reasonable question - and one with a simple answer.  The federal government is the only level of government that does not have a legal budget constraint.  It turns out that state and local governments are required to balance their budgets, but this does not mean they are not guilty of pushing expenses into the future.  What's different is their technique for doing it.  State and local governments employ millions of individuals that have accepted the following deal - they take a lower salary today as compensation for generous pensions that will be paid by future tax payers.  This allows today's politicians to meet their budgets and pushes back the day of reckoning onto their successors at a time when they will be safely retired - and probably collecting one of those pensions. 

What is an appropriate tax structure?

You know from your own experiences that governments have found many things to tax.  Those of you who have worked and taken home a paycheck know there is a BIG difference between what you earn and what you actually take home in your paycheck.  The difference is the taxes you pay - Federal Withholding Tax which is your federal income tax, F.I.C.A., which is your social security contribution, and your state income tax, if your state has one. You also pay sales tax when you buy something at the store; an excise tax when you buy gasoline, booze, or cigarettes; property tax if you own a house; and increasingly a gambling tax when you play the lottery.  It is easy to see what the government is actually taxing, but what should the government be taxing? This became an important question in 2000 when George Bush, with his massive tax cut, began a move to substantially revamp the federal tax system by changing what the federal government taxes. 

There are two criteria used to evaluate taxes - efficiency and equity. With regard to efficiency, there is the issue of how many resources are devoted to the collection of the taxes.  It was fairly easy, and not too costly, to set up the system to collect taxes on international trade, or to impose excise taxes on the purchase of products like booze and butts, which is why the US government chose these as its primary sources of income in the early days of the nation.  There is also the issue of how much a particular tax distorts the behavior of individuals and firms.  In general there is support for taxes that do not distort the behavior of decision makers by altering prices, or at least a preference for those that least affect the market's incentives. To understand the efficiency issue all you need to do is compare two taxes - one that is a 1 percent tax on your income that happens to be $50,000 and the other is a lump sum tax of $500.  Both taxes raise the same revenue -$500, but the two taxes will have different effects on behavior.  Under the first of these taxes, the one on income, your taxes will change as your income changes so you may actually take the taxes into consideration as you decide on how many hours or weeks to work.  You might find yourself saying "Why should I work that extra hour since it will only increase my taxes?"  If you paid a lump sum tax of $500, meanwhile, the tax would not enter into your decision because you would pay this regardless of how many hours you worked.  Given that the lump-sum tax would not affect your decision to work, on efficiency grounds it would be preferred because the decision makers would be doing what they originally wanted to do, and in a perfectly competitive world - that ideal we have talked about - this would be as good as it gets.  

It is not, however,  always true that the government is interested in taxes that have a neutral effect on behavior.  In fact there are times government policy makers want to alter behavior. A good example would be the excise tax on cigarettes.  The federal government has restricted cigarette advertisements and begun to advertise the risks of smoking in an effort to discourage smoking that was deemed hazardous to one's health.  In addition to the negative advertising, the government has also raised the price of cigarettes with an excise tax, which should reduce smoking if there is a downward sloping demand curve.₁₈  Other excise taxes would be the taxes on booze, a far better approach to reducing alcohol consumption than prohibition, and the tax on gasoline which has been used quite successfully by European nations attempting to reduce energy usage.  What we find is this type of tax is likely to be supported if there is widespread acceptance of the government's goal.  This explains why the US has been so successful at raising taxes on cigarettes, which most people accept as harmful to health, and unsuccessful at charging higher taxes on gasoline to bring the cost more in line with what Europeans pay for gas.  Too many Americans drive and do not see the benefits of reduced driving to warrant the additional taxes that add to driving costs.  An additional possible impact of a tax on gasoline would be additional hours worked, what could be viewed as an unintended by-product of the tax. (NBER Working Paper No. 10330).  Taxes have also been identified as a primary factor explaining the growing gap in the number of hours worked between the US and other developed countries, the lower tax rates in the US acting as an incentive to work. (Prescott 2004)

With regard to the equity, or fairness criteria, there are actually two generally accepted views.  The first requires there to be a positive relationship between what a person pays in taxes and the benefits received from the services provided by the government, what is sometimes referred to as the benefits principle.  For example, Americans pay taxes to support the national parks regardless of whether or not they use the parks, and residents of land-locked Wyoming pay as much in federal taxes to support the system of buoys on the Intercoastal Waterway that extends from Virginia to Florida as does the resident of North Carolina who uses the waterway extensively.  In both of these cases there is no link between the taxes one pays and the value one receives from the tax payments.  Proponents of the benefits principle would push for higher user fees on some of the services.  Boaters when they register their boat could pay a hefty tax to pay for the maintenance of the buoy system while visitors to the National Park System could pay higher entry fees. Two other examples are the excise tax on gasoline and Social Security.  The more you drive, the more you pay in gas excise taxes; and the more you contribute to social security, the more you receive in benefits.  The problem with this criteria, one we will discuss in a later unit, is that many goods and services provided by the government cannot be priced this way - the classic example being defense.  Everyone benefits from defense, but everyone has an incentive to underpay their share for defense and the government has no way of ascertaining the magnitude of the benefit accruing to each individual, so it is "forced" to set tax collections independent of any benefit.

A second principle is the ability-to-pay principle.  The concept is straightforward.  Rather than setting taxes according to the benefits received, the government sets taxes according to an individual's financial position and it is generally accepted that for fairness, taxes should increase with the ability to pay. This is referred to as vertical equity.  It is also accepted that individuals with similar ability-to-pay should pay similar amounts of taxes - what is referred to as horizontal equity. Of course, it is the details that cause the problem.  For example, consider the concept of horizontal equity.  When you read the income tax code you can see the difficulty of achieving horizontal equity. Should homeowners with mortgages pay the same taxes as those who live in apartments?  Should those who are married with children pay the same as those who are single?  Should those who have substantial business expenses pay the same as those who have limited expenses?  You will never find agreement on these issues, and these are only a few of the more obvious problems.  One of the more important of these questions is: how do we measure ability-to-pay? What do we tax? There are three potential candidates for the tax base - income, consumption, and wealth - and not surprisingly, there are arguments supporting each of these tax bases.₁₉  Those in favor of a tax on consumption, which is currently done in the US with sales and excise taxes, argue that consumption spending most closely approximates the standard of living and those who benefit more from the system should pay more.  If you are able to afford fancy electronics, then you should pay more for the costs of government than someone who is unable to make these purchases.  A second argument for the consumption tax is it easier to collect once the flow of resources across national borders becomes quite extensive.  This is one of the reasons why the consumption tax, called a VAT tax (value added tax), is a favorite source of revenue in Europe where mobility of resources and goods is quite high.  As we will see a little later, one of the drawbacks of this tax base is that the tax burden falls more heavily on those at the lower end of the income spectrum. 

Income is a second candidate, which is currently the base for the federal and state income taxes and the FICA taxes. The rationale for income as the tax base is that income is the best measure of the potential standard of living.  If you earn more you could buy more and therefore you could benefit more from the system, and therefore you should be taxed based on this figure.  A major problems with using income as the tax base is the definition of income.  Should it be your wage and salary income, your income from your previous investments, or your income from the sale of your assets?  Unfortunately there is no consensus on this issue which was at the center of the debate on the Bush tax cuts in the early 2000s. 

The final candidate for a tax base would be wealth: how much a person is worth.  The rationale for this type of tax is that a person with wealth of $1 million is in a better position to pay taxes than a person with wealth of $1 thousand. One tax that is directly related to wealth is the inheritance tax, what in recent years has been renamed the death tax.  At the time of an individual's death, a certain percentage of the deceased's estate (read value of assets) is taxed.  The income tax on dividends and interest can also be viewed as indirect taxes on wealth since the amount of interest earned would be related to the amount of what is being saved while the dividend income would be related to the value of stocks that were owned by the individual.  The argument against this tax is that it will discourage saving and the accumulation of wealth.  For example, if your estate is taxed away at your death then there will be less incentive for you to work hard and save during your lifetime and you will be tempted either not to work as hard or to spend more on consumption - maybe some fancy cars or extravagant homes.  

So what are we to tax?  Can we sort through all of this "mess" and decide upon what it is we want to tax and how much we will tax it?  Unfortunately we are not close to a consensus, and we are not likely to move toward one in the near future.  Taxes remain a hot political issue and part of the problem is it is pretty easy to come up with very different interpretations of reality.  For example, supporters of Ronald Reagan's tax cut point to the fact that it reduced every taxpayer's taxes by the same rate - a policy that would seen to pass most people's fairness test, but opponents of the plan point out that the dollar value of the tax cut overwhelmingly went to those at the high end of the income distribution - the country's wealthiest individuals and families.  You will not emerge from this course with the magic formula for an optimal tax, but you will be exposed to information you need to better understand the numbers and tax programs proposed by the presidential candidates.  To achieve this goal we will do two things.  First, we will look at the relationship between taxes and income because it is relationship that is often mentioned in the press, it is often very poorly understood, and it is important in any discussion of fairness in taxation.  We'll follow this with an examination of the Bush tax cuts and a look forward.

Taxes and Income

Regardless of what one decides to tax, it is useful to examine the relationship between the taxes paid by an individual and the individual's income.  To understand the possible relationships let's look at the table below where there are three candidates for the income tax. In each case the principle of fairness appears to be preserved since there is a positive relationship between the taxes paid and the income earned.  In each case a person earning $100,000 pays more in taxes than a person earning $30,000. 

Alternative Income - Tax Relationships	Alternative Tax and Ability-to-Pay Relationships
Taxable Income Income Tax #1 Tax rate #1 Income Tax #2 Tax rate #2 Income Tax #3 Tax rate #3 $30,000 $3,000 10% $3,000 10% $3,000 10% $60,000 $6,000 10% $4,800 8% $7,200 12% $100,000 $10,000 10% $6,000 6% $14,000 14%

A very different story emerges, however, when we look at the tax rates - the share of one's income paid in taxes.  There are three possibilities highlighted by the three taxes.  The tax rate could increase as income increases so individuals with higher incomes are paying a higher share of their income in taxes.  This would be called a progressive tax and is represented by the green line and green columns in the table.  A second possibility would be a tax rate that remains the same for all income levels - what we would call a proportional tax.  This is represented by the horizontal black line in the diagram and the black numbers in the table.  The final possibility would be a regressive tax where the rate of taxation decreases as income increases.   

Given these three possibilities, let's now look at some of the major taxes in the US and see how they should be classified.  We'll start with the federal income tax.  If you look up on the IRS web page you will find the tax forms including the 1040 form and the tax tables that will allow you to calculate your federal income tax. To see the nature of the relationship between tax rates and ability-to-pay we can use the tables to determine what a single individual would pay in taxes with taxable income of $30,000, $60,000, and $100,000.  The results appear in the table below when you look at the rates for single individuals and married couples in 2002.  As you can see the tax rate increases as income increases, although the increase is far less than it was in the 1970s before the Reagan tax cuts.  The federal income tax is an example, at least in theory, of a progressive tax.  We'll look later at the data to see if this works in practice. 

Federal Income Tax (2002)

Three other popular taxes are property taxes, consumption (sales) taxes, and payroll taxes.  On the surface they all sound as though they would be proportional since the taxes are specified as a certain percentage of property values, consumption, and income - a rate of $4.50 per $1,000 of home value, 6 percent of the value of sales, and 13 percent of your income.  As we will see here, however, all is not as it seems since it turns out they are all regressive taxes.  Let's begin with the sales tax such as you have in RI, a tax on all sales at a rate of 7 percent.  The apparent discrepancy with the sales tax can be traced to the fact that consumption spending rises slower than income - as income grows individuals begin to save and saving's share of income rises with income. In the example below, consumption (sales) falls from 95 percent of a $30,000 income to 80 percent of a $100,000 income.  Given that a sales tax is proportional to consumption (7%), the effective income tax rate falls from 6.6 percent of a $30,000 income to 5.6 percent for a $100,000 income.  To avoid the regressive nature of consumption taxes, some governments exempt spending on necessities such as food and clothing which represent a larger share of spending for low income individuals.  

To get an idea of how regressive they are we can look at the Consumer Expenditure Survey published by the Bureau of Labor Statistics where you will find expenditure and income data.  In the report they divide up the consumer units into five groups ordered by income, and it is only in the top two income groups that there is any savings.  In the top income group where the average income is $116,666, the average expenditures are $77,125  which means that about a third of the income escapes taxation.  A similar situation arises when you look at housing.  As you move from the fourth to fifth income group, the share of your income devoted to shelter for those owning a house falls about 10 percent.   

Consumption and Sales Tax

The "math" for the payroll tax is looks very much like what we saw with the sales tax.  In the US, the 2004 FICA payroll tax rate to be paid by you and your employer was 6.2 percent of your income for Social Security and 1.45 percent for Medicare.  So far we have a proportional tax rate, but this changes when we add one additional feature of the payroll tax - the income cap.  Each year a maximum income cap is specified - it was $89,700 - and no Social Security payroll tax is paid on any earnings above that level, although the tax for Medicare has no cap.  As a result of the cap, the payroll tax is also a regressive tax.  In 2004 the cap was an income of $87,900 so the payroll tax of 15.3 percent was paid only on the first $87,900 earned income, with all income above that level taxed at a rate of 2.9 percent.  If you look at the second column you see a concept that may be now to you, but one that is very important when evaluating taxes.  The marginal tax rate is the rate paid on the last dollar of earnings.  In the case of someone earning $30,000 each dollar is taxed at the same rate - 15.3 percent  - while for the person earning above $89,700 the marginal tax rate is only 2.9 percent since this is the rate paid on all income earned above $89,700.  If this person earned $200,001 then the tax on the additional dollar would be 2.9 cents, whereas a person earning $30,001 would see their tax rise by 15.3 cents.   Using the formulas we can compute the payroll taxes paid and then dividing these figures by income produces the final column that indicates the regressivity of the tax. 

Payroll Tax

A property tax would also be regressive since housing expenses represent a larger share of income for those at the bottom end of the income distribution and therefore the tax would represent a higher proportion of their income and the "math" would look almost identical to the consumption tax. These are not, however, the only regressive taxes.  Two additional taxes that merit note are the "sin taxes" on alcohol and cigarettes and the state lotteries, two taxes that state governments turned to in an effort to solve their budget problems in the years after the stock market crash and recession of 2000.  For a nice review of the issues you might want to check out Taxing Habits by Phineas Baxandall in the Boston Federal Reserve's publication, Regional Review.  With regard to alcohol and tobacco taxes, these taxes were originally paid to the federal government, but since the early 20th century when the feds turned to income and payroll taxes these excise taxes have become an increasingly important source of revenue at the state level.  According to Baxandall, "In 2002, new tobacco levies were implemented in 21 states, amounting to the largest average per-pack increase ever imposed in one year."  And while these taxes seem to be popular with voters, Baxandall notes that "one downside of balancing budgets on sin is that the money raised is paid disproportionately by the poor. The tax on a $4 bottle of wine is the same as that on a $40 bottle, so those who buy top-shelf liquor (or premium cigarettes) pay a smaller portion of the price in taxes. Poor people don’t drink more than the affluent, but the alcohol taxes they pay are a far larger portion of their incomes.  For cigarettes, the problem is exacerbated by the fact that the poor do smoke more than the better off. According to Harvard Law School Professor Kip Viscusi, over 30 percent of people earning less than $10,000 a year were smokers in 1990, compared to less than 20 percent of those earning over $50,000 annually."  What we see here is a greater percentage of lower income people will pay the tax on cigarettes, and those that pay will pay a higher percentage of their income in cigarette taxes than those at the top end of the top end of the income distribution.  

Lotteries are another growing source of revenue.  Baxandall notes the "the first state lottery in the nation was established in New Hampshire in 1964. Faced with a huge budget deficit, Governor John King was determined not to raise taxes and instead launched a limited 'sweepstakes' linked to horse racing. Today’s state lotteries offer incomparably greater convenience, speed, and variety. Unlike taxes on smoking or drinking, government gambling arrangements are not designed to reduce vice that provides the funding. State governments actively advertise and promote their lotteries—to the tune of $400 million per year. And revenues from lotteries have increased five-fold between 1980 and 2000, exceeding the sum of cigarette and alcohol tax revenues."  And again, these are regressive taxes.  According to Baxandall, "State-organized gambling acts as 'an astonishingly regressive tax' that draws disproportionately from those with lower incomes, according to the 1999 National Gambling Impact Study Commission. State lotteries are the most regressive of these activities, and a disproportionate number of lottery outlets are located in poor neighborhoods. Lottery players with incomes below $10,000 spend almost $600 a year on tickets, more than any other income group. High school dropouts spend four times as much as college graduates; blacks spend five times as much as whites. Since those who gamble are overwhelmingly likely to lose money, some characterize gambling as a tax on bad math, or—more sympathetically —as a tax on those with limited prospects. In either case, the money comes mostly from those who are least able to pay."  Maybe the best way to summarize this would be a bumper sticker that I saw years ago that went something like the following: "Lotteries- taxes for the mathematically challenged." 

For those looking for an example of a proportional tax you should check out flat tax concept where everyone would pay a certain share of their income in taxes.  This sounds very similar to what Steve Forbes, a Republican candidate for president in 1996 and 2000, was pushing, but is not quite what he was pushing if you look at the fine print.  The reason Forbes' proposal was not a true proportional tax is that not all income would be taxed and the income that escapes taxation is not equally distributed across the income spectrum.  This is why you have to be very careful sorting rhetoric from reality when you are talking about taxes or evaluating tax policies.  The pros do such a good job of presenting one side of every issue that it is extremely difficult to find a balanced treatment of the data. To give you an idea of how one can easily lie with tax numbers, let's look at the issue of taxation of dividends.  George Bush pushed for elimination of any income tax on dividend income based on the fact that the taxing of dividends reduced the incentive to save (invest).₁₉

Now let's look at what this would mean to the distribution of the tax burden.  Below are the IRS's tax data that shows the number of tax returns showing dividend income and the amount of dividend income reported.  Look at the table and think about what you would say about the elimination of the tax on dividends if you were a Bush supporter and what you would point out if you did not support Bush.  If I were a Bush supporter I would focus on the number of returns and push the fact that about 50 percent of those who will benefit from the tax cut earn less than $50,000 because in this group there are nearly 15 million returns out of a total of 31 million.  Sounds good, but if you look at the amount you see a very different story, one where 38 percent of the tax benefits will go to those earning above $200,000 because this is the share of dividend income earned by this group.  Many talking points here that will leave the electorate overloaded with data with little useful information to make a carefully considered choice.  Now we'll use our new skills at looking at IRS data and look at the Bush tax cuts.

2002 IRS Data on Dividend Earnings
(millions of returns, billions of $s)

The Bush tax cuts and reform 

George Bush ran for president in 2000 promising the American people a massive tax cut, and he delivered on that promise - twice.  Before we look at the specifics of the tax cut, we will look at some historical information that provides an important historical perspective on the tax cuts.  We begin in the mid 1970s as the wealthy countries of the world were suffering through stagflation that could be traced to the OPEC embargo in 1973.  At the time high marginal tax rates were common in most of the world's wealthy countries. The highest tax rate on income, the rate charged the wealthiest individuals, was 70% in the US, which placed it lower than that in many countries including the UK and Sweden where the rates were 83 and 87 percent.  It should be no surprise that the conservative, anti-tax movements led by Ronald Reagan in the US and Margaret Thatcher in the UK in the late 1970s successfully tapped into the anxieties of the nations' peoples, just as Howard Jarvis had tapped into the concerns of California's voters in 1978 when he led the local tax revolt known as Proposition 13 to roll back property taxes.  While rolling back property taxes would work locally since it was a large source of local taxes, if you were going to take a tax revolt nationally it would need to be targeted at the income tax that generated the largest share of federal taxes.  

Highest Marginal Tax Rates

Source:Office of Tax Policy Research

The geographic extent of the movement toward lower marginal tax rates on the world's wealthy individuals that began in the early 1980s can be seen in the table above.  The largest cuts were in Sweden and the UK, where the rates were cut over 50 percent, while the smallest declines were in Germany.  What is not clear in the table, is the timing of changes in the US rate, which are important to understand the Bush policy.  In the left-hand chart below the two substantial rate cuts orchestrated by President Reagan in 1982 and 1987 that brought the rate down from 70 to 28 percent are readily apparent.  Somewhat less obvious is the small tax increase passed by President Bush in 1991 that raised the top rate to 31 percent, despite the election promise of "Read my lips, no new taxes," and was viewed by many as an important factor leading to Bush's defeat in the 1992 presidential election. This was followed in 1993 with President Clinton's hike of the top rate to 39.6 percent.  As you can see in the right-side diagram, the exploding budget deficits of the 1980s and early 1990s, which prompted the tax increases, began to decline rapidly in the mid 1990s so that by 1998 the federal government was running budget surpluses that were projected to run into the $ trillions.  The stage was set for the Bush tax cuts that were now made possible by the improved fiscal situation. 

The Bush tax cuts actually came in two rounds - one in 2001 that was the result of his promises during the presidential campaign, and the other in 2003.  

The first of these was initially promoted as policy modeled after those of Ronald Reagan and was designed to produce a savings of approximately $1.35 trillion over ten years - money that was projected to be accumulating in those anticipated government surpluses.  It included a number of tax cuts and modifications, with the two biggest pieces of the legislation being the roll back in marginal tax rates and the elimination of the estate tax that had been renamed as the death tax. The specifics of the program are described on the Whitehouse web site as follows:`

President Bush’s Agenda for tax relief released in February 2001, and signed into law as the Economic Growth and Tax Relief Act of 2001 [text of the of the Economic Growth and Tax Relief Act of 2001] in June of 2001, reflects this basic trust in the American people and confidence in the American ideal by increasing tax fairness and enhancing the performance of the economy. It includes:

• Replacing the current tax rates of 15, 28, 31, 36, and 39.6 percent with a simplified rate structure of 10, 15, 25, and 33 percent (see Appendix for rate schedule);
• Doubling the child tax credit to $1,000 per child and applying the credit to the Alternative Minimum Tax (AMT);
• Reducing the marriage penalty by reinstating the 10 percent deduction for two-earner couples;
• Eliminating the death tax;
• Expanding the charitable deduction to non-itemizers; and
• Making the Research and Experimentation (R&D) tax credit permanent.

The marginal tax cuts of the 1980s helped generate the venture capital that is now fueling the growth of the Internet and other technologies. New technologies are boosting productivity and economic growth by helping companies achieve new efficiencies. In this environment, entrepreneurship has become the path to prosperity for many minorities, women, and young people. Yet, today's high marginal tax rates tend to penalize continued innovation and business formation and expansion.

High marginal tax rates inhibit entrepreneurial activity because they act as a success tax, claiming a larger share of income from flourishing enterprises, while the government shares little of the risk of loss. For most entrepreneurs, income taxes reduce their companies' cash flow — the money businesses need to expand, buy more equipment, and hire more workers.

What we can be fairly certain of is that these supply-side tax cut will result in a substantial federal budget deficit, just as they did with Regan's tax cuts..  We need to also be careful when linking marginal tax rates with economic growth given that when the rates were raised in the 1990s the economy took off on a period of such rapid growth that it was dubbed the "New Economy" as it brought back memories to the "good old days" - the 1960s decade of rapid growth when marginal tax rates peaked at 70 percent.  There is no good negative link between the rate of economic growth and the highest marginal tax rates. 

The second round of tax cuts in 2003 - $550 billion that included two controversial items - the elimination of the tax on dividends and the increased write off for business outlays - the feature that gave BIG tax breaks to businesses buying gas-guzzling vehicles. What he got was a $350B Jobs & Growth Tax Relief Reconciliation Act of 2003.  The result has been a substantial cut in federal government revenues when viewed as a share of GDP.  According to a study released in 2003, the tax/GDP ratio will reach below 17 percent for the first time since the late 1950s, and it is likely to fall even further when the full effect of the tax cut kicks in.  

The Bush tax cuts, like the Reagan tax cut it was modeled after, was fiercely debated with both opponents and proponents bringing "facts" to buttress their case. There were those who said that the tax cut would be enjoyed by tens of millions of taxpayers and others who showed the tax cut would go overwhelmingly to a small number of wealthy individuals.  So who is right?  To better understand the situation let's look at the data to see who is paying taxes in the US. 

Who is paying the federal income tax and who will benefit from the Bush tax cuts

Its now time to look at the IRS data and see who pays the federal income tax since there is so much misinformation out there in the popular press.  Unfortunately we can not look at tax data to see what impact the Bush tax cuts have had because it takes years for detailed tax data to be published, but we can look at some of the older information to get an idea of why there are so many seemingly contradictory statements concerning the tax cuts.  the goal here is to try to understand how we can simultaneously hear that a tax cut will be shared by the majority of taxpayers and that the tax cut overwhelmingly favors the very wealthiest in the country.  It is hard to see how these could both be true - but they are - and we'll try to see how they can both be true, which should help you better understand the inevitable discussions of future tax policy proposals. 

We begin with a look at the IRS data that are published at their Tax Stats site where you can find the Statistics of Income Bulletins.  The data presented in this section are based on the following IRS publications that are available at that site.  The primary data source for the graphs, tables, and data presented below is  Individual Income Tax Returns, 2000.  In the year 2000, 129 million income tax returns were filed with a reported adjusted gross income (AGI) of nearly $6.4 trillion.  Because of the importance of the relationship between taxes paid and income, we will look more closely at the IRS data and divide up the taxpayers into groups according to their income.  Below is a table summarizing the IRS data where the $ amounts are in millions and the # returns are in thousands.  For example, there were nearly 25.6 million returns filed in which the AGI was between $20,000 and $50,000.  In the table below, you can see the progressive nature of the federal income since the tax rate (Tax/AGI) increases as income increases.  For those earning more than $1 million the average tax rate is 28 percent, while the rate for someone in the $50-$100,000 range will pay a tax rate of 12 percent.

2000 IRS Tax Return Data 

Based on these data we can get a handle on who is paying the taxes and who is earning the money with just a little effort.  We see that the 240,000 tax returns with over $1 million in AGI, represented .2 percent of the tax returns, nearly 13% of the AGI, and approximately 23 percent of the total income tax paid.  If we look at all of the returns with AGI above $200,000, they represent 2.2 percent of the returns and they account for about 25 percent of AGI and nearly 50 percent of taxes paid. 

2000 IRS Tax Return Data 

To be able to understand more about the impact of the Bush tax cuts on various income groups we need to look a little more closely at the sources of income.  For example, if the president eliminates taxes on dividends or reduces capital gains taxes, then we need to know who receives income from dividends or capital gains. To get a handle on this we can look at the table below where two sources of income have been highlighted - dividends and capital gains.  In the year 2000, there were 49.4 million tax returns filed where the adjusted gross income (AGI) was between $1 and $20,000 and the total reported income on these returns was $485 billion.  Of those 49.4 million returns, 39.6 million reported salary and wage income, 6.8 million reported dividend income, and 2.7 million reported a capital gain.  As it stands, this table is not too useful, but we can make a few "adjustments" that will help us gain insight into the who pays taxes question. 

2000 IRS Tax Return Data 

To make some more sense of the data the table below was created so we could see the shares of returns and income accounted for by salary & wages, dividends, and capital gains.  For example, of those tax returns filed by individuals with incomes between $50,000 and $10,000, 90 percent of them reported wage & salary income, and that income accounted for 79 percent of the total reported AGI.  Dividends and capital gains, meanwhile, were reported on 41 and 19 percent of the returns and the income from these sources represented 2 and 3 percent of AGI.  Based on this it is safe to say that the overwhelming majority of reported income in this income bracket comes from wages and salaries.  The situation looks very different, however, when we look at the upper end of the income distribution - those reporting more than $10 million in income.  In this group 85.6 percent of the returns reported wage & salary income, but this represented only 25 percent of the reported income.  Capital gains, on the other hand, appeared on 87 percent of the returns and the income from these gains represented 58 percent of reported earnings.  What this means is that if the country moves to a tax system that relies more heavily on the taxation of labor income will fall more heavily on lower income individuals.

2000 IRS Tax Return Data 

A second table based on the original data allows us to gain a somewhat different perspective on the situation.  In this second table are looking at the shares of total reported income and the number of returns accounted for by each income bracket.  Again using the $50,000-$100,000 income bracket we see that the returns in this income bracket represented 20 percent of the returns filed that year and 28 percent of the total reported AGI.  Looking at capital gains, the situation looks a bit different with this income bracket accounting for 31 percent of the returns with capital gains, but only 7 percent of the reported capital gains.  For those in the $10 million+ income bracket we see that the returns in this income bracket represented .01 percent of the returns filed that year and 4.7 percent of the total reported AGI.  Looking at capital gains, the situation looks a bit different with this income bracket accounting for .06 percent of the returns with capital gains, but 27.8 percent of the reported capital gains.  

2000 IRS Tax Return Data 

Now let's use this information and look at the Bush tax cuts.  We'll begin with a tax cut on capital gains.  We can see from the second table that this cut will affect only 12 percent of the returns and affect 10 percent of the reported income - nothing too dramatic here.  If we look a little closer though, we see that the tax cut is not evenly distributed among the taxpayers.  For those earning between $20,000 and $50,000, a cut in capital gains would affect less than 9 percent of the taxpayers in the bracket and the cut would affect less than 23 percent of their income.  Not too many of these lower income people would see tax cuts and the ones that did would only see it on a small percentage of their income.  At the other end of the income distribution the situation looks very different. For those earning more than $10 million, 91 percent would benefit from a capital gains tax cut because they report capital gains income, and the cut would be substantial since 58 percent of their reported income came from capital gains.  Looked at a bit differently using the second table, 11 percent (1+3+7) will go to those earning less than $100,000, while 56% will go to those earning over $1,000,000, and a full 38% will go to those earning over $10 million. 

So what we see is that if you are going to be able to understand the charges and counter charges in the tax cut debate, you will have to pay attention and listen carefully.  What should be clear, though, is capital gains and dividend tax cuts tend to benefit those individuals who earn more of their income from these sources - those at the upper end of the income distribution, while income tax cuts will benefit those whose wages and salaries represent a large share of their income - those at the bottom end of the income distribution.₂₀ 

What's ahead?

The challenge facing government will be to solve the apparent dilemma - a faster pace of technological change and global restructuring that creates a large pool of displaced workers needing government protection at the same time the ability of the governments to raise money is being reduced.  There is also the challenge posed by the ageing of the population which will increase the size of the retired population that is drawing a government pension and decrease the size of the working-age population that is paying the taxes that fund those pensions. This is at the center of the issue of intergenerational equity that focuses attention on the transfer of assets and liabilities between generations and on the unfunded liabilities of programs such as Social Security and Medicare.  What we can be certain of is that the current laws are unsustainable, that the US will be unable to honor all of its commitments to  the baby boom generation without significant changes.  The choice is not simple, but it is inescapable: changes need to be made that either sharply reduce the benefits earned by those boomers getting ready to retire or increase the taxes paid by those still working - and that means many of you.  If these changes are not made then we face an intergenerational conflict that can be expected to be quite ugly. 

It is also true that globalization is here to stay and that the world has entered into a new era - an era where fossil fuel is no longer cheap.  The extent of the "pain" caused by the transition to a higher energy price world will depend upon how fast it happens and how well the nation's individuals and businesses respond to the higher prices.  This is one of the areas where the government can step in and facilitate the transition so that the nation can avoid a painful reliving of the 1970s where the country suffered through an awful decade.  

1. John Joseph Wallis, "American Government Finance in the Long Run: 1790 to 1990," Journal of Economic Perspectives, 14:1 2000

2. Peter Heller, "Who will pay? Coping with aging societies, climate change, and other long-term fiscal challenges," IMF Working Paper November 2003

3. And they do have a point since governments can look a lot like a Taking Hand.  In Naked Economics, a name designed to evoke an economy with limited government clothing (intervention), reference is made to a study in which the researchers looked at the process of starting a business in different countries around the world.  It was easiest in Canada where is took only two procedures and two days, while in Bolivia it took twenty procedures and in Mozambique it took about six months, and in some countries (Vietnam, Mozambique…) entrepreneur needed to give up 1-2 times an annual salary to get a new business licensed. 

For those looking for the philosophy of conservatives, it is captured in the following quotes - the first from President Hoover in 1931, and the second from a clergy member in Syracuse, NY focus on how the policies alter the incentives to work, while the third from the Treasury Secretary Mellon focuses on the "cleansing" nature of recessions that weed out the weakest.

1. This is not an issue as too whether people shall go hungry or cold in then United States. It is solely a question of the best method by which hunger and cold shall be prevented. It is a question of whether the American people...will maintain the spirit of charity and mutual self-help... as distinguished ... from appropriations out of the Federal Treasury for such purposes... If we break down this sense of responsibility and individual generosity ... in times of national difficulty and if we start appropriations of this character we have ... impaired something infinitely valuable in the life of the American people... Once this has happened... we are faced with the abyss of reliance in future upon government charity in one form or another. I am confident that our people have the resources, the initiative, the courage, the stamina and the kindliness of spirit to meet this situation in the way they have met their problems over generations. 

2. ...the care of the indigent aged and crippled children and those unemployed through no fault of their own, is a most worthy objective. It would seem to me, however, that time is granted the old should be just above subsistence level, for the reason that otherwise savings and preparation for that time is discouraged, and thrift is indirectly penalized. There is already appearing and growing stronger a wide-spread tendency to depend upon the government, which where it appears tends to replace the older American spirit of independence. This may be unavoidable, but in any case it is a sign of decadence and most alarming. It goes along with the failure of personal initiative.

3.  Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. … It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people."

4. There were three developments that can be traced back to the 1980s that brought the issue of the role of the government to the center of public debate and contributed to the ferocity of the disagreements in the early 21st century. The first was the explosion in federal red ink in the US.  The US government was spending much more each year than it was taking in in taxes - in large part the result of Reagan's massive tax cut and defense spending increases in the 1980s.  The result was a budget deficit (negative surplus) in 1992 that had grown to almost $300 billion, and a national debt that had risen to $3 trillion, numbers so staggering that there was a general consensus something had to be done to control the deficits because the US could not continue indefinitely borrowing hundreds of billions of dollars each year to pay for its expenses.  If you fast-forward past the budget surpluses of the latter Clinton presidency that marks one of the more remarkable financial turnarounds, you find the situation is little changed when we look at the deficits approaching $500 billion under the Bush administration.  These deficits, combined with the severe budgetary pressures at the state level, the same ones that "forced" those double-digit tuition rate increases at many public universities, have brought government finances under public scrutiny and prompted heated debates over how the government should spend its money.

There have also been heated debates on taxes, which is nothing new, as many of you know from your history courses.  In the earliest days of the nation - actually before there even was a nation -  the rallying cry of the American colonists in their battle for independence from Britain was "no taxation without representation." And the debate did not end when the nation actually gained its independence.  Alexander Hamilton, the first Secretary of the Treasury, after having made a "deal" in which the new government of the United States would assume the debts incurred by the states during the war, had to find the money to back the deal, and he settled on a tax on distilled liquor. The result was the Whiskey Rebellion in 1794 in which some Americans rebelled against the imposition of this federal tax on whiskey.  More recently, but still before the time of most of you reading this, there was the tax revolt led by Howard Jarvis in California that became known as Proposition 13.  In 1978 the voters of California approved Proposition 13 that, according to Steven Moore from the conservative Cato Institute, "was a political earthquake whose jolt was felt not just in Sacramento but all across the nation, including Washington, D.C. Jarvis's initiative to cut California's notoriously high property taxes by 30 percent and then cap the rate of increase in the future was the prelude to the Reagan income tax cuts in 1981.  It also incited a nationwide tax revolt at the state and local levels. Within five years of Proposition 13's passage, nearly half the states strapped a similar straitjacket on politicians' tax-raising capabilities and many of those tax limitation measures remain the law of the land today." It was an earthquake and the US is still experiencing the after shocks as you could see in the 2000 election, an election you should remember.  Taxes were once again an issue with candidate Bush promising massive tax cuts and a restructuring of taxes as center piece of his economic program.

The third reason was the "collapse of the wall" separating the communist and capitalist worlds - a wall that had divided the world since the end of WW II.  The situation was described by Winston Churchill at a speech in March of 1946 at Westminster College in Fulton, MO.  As Churchill saw it, "From Stettin in the Baltic to Trieste in the Adriatic an iron curtain has descended across the Continent…"  The line that Churchill mentions appears in the diagram below as the red line that runs from Germany in the north to Italy in the south, and much of the Cold War can be thought of as a series of hot (Vietnam, Korea) and cold (Berlin airlift, Cuban missile crisis) conflicts between these two blocks of countries.  By 1990, however, the wall had begun to crumble.  For the countries of the former Soviet Union, those to the right of the line, this meant the end of communism and the need to determine the proper mix of command and market in their emerging economies.  In those countries to the left of the line, the capitalist democracies that included the economic and military superpower United States, it was a time to reconsider the role of government in light of the fact that the "Cold War threat" of communism was now greatly diminished.  The expectation was that there should be a corresponding reduction in defense spending and it was time to look at how the United States was going to spend this "Peace Dividend."  Unfortunately this discussion of the Peace Dividend was put on hold indefinitely when the Bush administration launched the "War on Terrorism" it says could last for 40 years - about the length of time of the Cold War - and began a massive buildup in military spending to wage that war. 

Source: Historical Atlas of the Twentieth Century

5. According to the Census Department's Preliminary Report, there were than 87,849 independent local government units in 2002.  In the fifty years since 1952 the number of county governments has remained virtually unchanged, the number of municipal and township governments have risen about 6 percent, the number of school districts has decreased by 85 percent, and the number of special district governments has increased 200 percent.  The decrease in school districts reflects the consolidation movement and the absorption of independent school governments into municipal or state governments, while the growth of special district governments reflects the growth in agencies focused on natural resources, sewerage, water supply, and housing and community development.

Governmental Units

We will focus on the finances of governments as a measure of sixze, but you also might want to look at employment. To get a sense of the relative size of these governments, we can look at some employment and payroll numbers for 2002.  Of the 20 million civilian government employees, 1 of every 8 was a federal employee, 2 of every 8 were state employees, and 5 of every 8 were local employees.  As you can see, when you are talking about government employees, you are talking primarily about local governments.  The fact that the federal government's share of the government payroll (60%) is higher than the share of employment reflects the higher average salaries of the federal employees and the greater reliance of the federal government on full-time workers.  Later we'll look at the finances that show a somewhat different picture of the relative size of the governments, but now we will look briefly at the history of government in the US to see how we got to where we are. 

2002 Government Employment and Payroll

	Total Employees	Full-time Equivalent Employment	March Payroll (Billion $s)
Federal (Civilian)	2,690,149	2,426,467	$11.6
State	5,072,130	4,222,751	$14.9
Local	13,276,830	11,379,390	$37.5
RI		32,360	$64.0

6. For those interested, you might check out the US Census site that has the Population of the 100 Largest Cities and Other Urban Places for each decade since 1790.The rural nature of the US in 1790 is evident in the table below where you have the population for the nation's largest cities in 1790.  At the top of the list were New York and Philadelphia. You will note that both Newport and Providence were in the list of top ten, but those rankings would not last long. 

1790 Population of Nation's Largest Cities

7. As a compromise with the strong state crowd, under the Virginia plan the House, with its composition determined by popular vote, was given the power to initiate tax law, while the Senate, with two appointed Senators, was given the power to amend tax legislation.  Compromises were not easy to come by, however, and the issue of slavery continued to dominate fiscal debates until the Civil War.  In a good example of the power of demographics, in the first two decades of the 19th century the population growth in the US was fastest in the Middle Atlantic and Western states that favored protective tariffs so by the 1920s the US began imposing more protective tariffs that culminated in the Tariff of 1828, sometimes known as the Tariff of Abominations by southern opponents, and launched the nullification movement.  South Carolina's John Calhoun noted the tariff had a real impact on the regional distribution of wealth and that this made it unconstitutional and thus opened the door for a state to secede from the US.  The issue "went away" in the 1840s as tariffs were lowered in the US, while in England the Corn Laws were repealed, which opened the door for expanded international trade.

8. New York City, with a population of 123,000, was twice as large as the nation's second largest city in 1820, but New York's Governor DeWitt Clinton saw a very different future, one in which NYC would become "the granary of the world, the emporium of commerce, the seat of manufactures, the focus of great moneyed operations, ...[a]nd before the revolution of a century, the whole island of Manhattan, covered with inhabitants and replenished with a dense population, will constitute one vast city.” (NYS Canals, Erie Canal: A Brief History, New York State online site.) The key was the canal, described as "Clinton's Ditch," that would speed up painfully slow and expensive transportation. For example, in 1800 it took one week to travel from NYC to Rochester, NY and six weeks to travel to Chicago, but by 1830 the canal and other transportation improvements had cut the travel time to Chicago in half and in one week you could get from NYC into eastern Ohio.  By linking NYC with the Great Lakes, NYC became the point of entry and exit for goods moving into and out from the vast interior of the US, and by 1840 the city had grown to 313,000 - three times larger than any other city - and as the nation expanded, NYC's lead over other cities continued to expand.  For those interested in some historical maps that allow you to see the expansion of the country, you might try the segeneology maps of US and U of VA maps and Outrage dynamic map. 

For those interested in a "neat" graphic on the rates of travel, you should check out the Introduction to A Nation Transformed by Information edited by Alfred Chandler and James Cortada. While the Erie Canal was the most famous state investment in transportation infrastructure of that period, it was certainly not the only one.  Lowell, an important mill city northwest of Boston in the early 19th century, was a terminus for one of the nation's earliest railway companies - the Boston and Lowell Railroad Company that began running in 1835 on a line that paralleled an earlier state investment - the Middlesex Canal that had linked Lowell with the Atlantic Coast since 1803 and provided the transportation link that established Lowell as one of the state's leading manufacturing sites.  In fact most of the major eastern cities developed canal systems that allowed them to tap into the resources in the interior.  In Pennsylvania, for example, a number of canals were constructed to link the coal fields of western PA to Philadelphia and other east coast destinations, but by the Civil War the canal links to the interior had been replaced by railroad links - almost 9,000 miles.

9. The federal government was severely limited in its ability to raise funds due to the restriction on direct taxation, so it relied heavily on tariffs that were raised substantially, beginning during the Civil War, that provided protection for northern factories.  During the war the US government issued currency (greenbacks) to finance its operation and then raised excise taxes sharply to soak up the newly printed money.  Because they were consumption taxes, the burden of the taxes fell more heavily on the lower income individuals, and this prompted a search for a tax that was less harsh on the lower income group.  The search ended with a progressive income tax proposal, modeled after the British system, that had a high minimum taxable level and exempted most wage earners. 

10. Howard P. Chudacoff, Judith E. Smith,  The Evolution of American Urban Society (5th Edition) p43

11. ibid

12.  One of the first "security services" that cities attempted to provide was fire protection, that until the mid 1800s was overwhelmingly based on volunteers.  It was also not very successful with major fires leveling large parts of many American cities during this period.  In New York City, for example, there were major fires in 1776, 1835, and again in 1845, while in San Francisco there were numerous fires that ravaged the city in the gold rush days of 1850-1851.  For those looking for an image of life's dangers in the "modern" city of the mid 19th century, including the rowdiness, fighting among the various volunteer fire departments, and use of outdated equipment, you might want to check out the movie, Gangs of New York.  In response to these problems with volunteer fire departments, by the mid 19th century we began to see paid fire departments.  The first was in Cincinnati in 1853 and by 1863 New York City had its paid fire department, but this was no guarantee that major fires were a thing of the past.  Major fires devastated Chicago in 1871 and San Francisco in 1906.  

Water was another urban necessity that eventually came under public control.  In New York City, the largest of the nation's cities, the first public well was dug in 1677, and about 100 years later a public reservoir was constructed. In Philadelphia in 1798 the government took over the supply of water to city residents, probably as part of an effort to eliminate the yellow fever outbreaks that had ravaged the city during much of the 1790s, and within fifty years many of the nation's major cities all had public water supplies.  Police forces were next - the logical response to urban unrest.  "Mob violence had characterized American cities since colonial days, but by the 1830s and 1840s ethnic, racial, political, and social conflicts - in part attributed to the number of immigrants arriving in the country - were beginning to stir upper and middle class to support the creation of stronger, more efficient police forces to preserve life and property."₁₁  The first police department in the country was in Boston, MA where "the initiation of a formal department began in 1838, when the General Court passed a bill allowing the city of Boston to appoint police officers.  The department was structured after the model developed by Sir Robert Peele for the London Police force." [Boston Police Department]  The result in the US was that by 1840, following the lead of Boston, cities were establishing salaried policemen.  

13. The income tax was initially 3 percent of income above $600, but it slowly changed to a more progressive tax - one where those earning higher incomes paid a higher tax rate. After the war the income tax was eventually eliminated and tariffs once again became the key revenue source as well as the key difference between the Republican and Democratic parties. Republicans tended to support higher tariffs as a stimulus to higher wages and industrial production, while Democrats pushed for lower tariffs because the high tariffs were seen as the source of corruption, inequity, and high prices.  Another distinction between the two parties was their view on the relative scope of the federal government, with Republicans favoring a strong central government aggressively pursuing economic development and the Democrats favoring a more limited federal government. 

14. The McKinley Tariff also included a provision that allowed the president to negotiate reciprocal trade agreements, the intent being to open up Latin American markets to the US.  The foreign markets were seen as increasingly important since in 1893 Frederick Jackson Taylor delivered his speech in which he identified the closing of the western frontier and the end of the safety valve for surplus workers as eastern migration began to exceed western migration. 

15.  Mellon's arguments sounded very familiar to those who heard the supply-side theories of Reagan and Bush - lower tax rates would provide higher incentives to work and produce and this would translate into higher incomes and higher tax levels -  and in 1921 he began to put his ideas into law when the highest marginal tax rate was lowered sharply and capital gain income got preferential treatment.  Facing a growing Democratic opposition, Mellon's 1924 tax cut was far less than he had sought  - the top rate was cut a bit, but the estate tax was raised over Mellon's opposition.  In 1926, fresh off a Republican victory in Congress and the Presidency, Mellon moved quickly to eliminate the gift tax, gradually eliminate the estate tax, and reduce income tax rates that would bring the top rate down to 20% from 40%, and followed it up in 1928 with a further reduction in the corporate profit tax rate. 

16. The Great Depression forced Mellon to revisit his tax cuts as the budget deficit soared, and in 1932 as the depression deepened he proposed a tax increases to close the deficit.  What emerged was a tax bill that included minor changes in the income taxes that raised rates and broadened the base, and major increases in excise taxes on a wide array of goods, although the Democrats made an effort to avoid necessities and choose either luxury goods or goods for which there were substitutes.  Conservative economics provided the theoretical basis for a Republican controlled government that would stand on the sidelines and not help those who found themselves out of work or money, because to help those people would not really help them, a sentiment reflected in the following statement taken from a letter written by a clergy member in the midst of the Great Depression in the 1930s. "First of all, the care of the indigent aged and crippled children and those unemployed through no fault of their own, is a most worthy objective. It would seem to me, however, that time is granted the old should be just above subsistence level, for the reason that otherwise savings and preparation for that time is discouraged, and thrift is indirectly penalized. There is already appearing and growing stronger a wide-spread tendency to depend upon the government, which where it appears tends to replace the older American spirit of independence. This may be unavoidable, but in any case it is a sign of decadence and most alarming. It goes along with the failure of personal initiative."  Clergy Letter, All Saints' Church, Syracuse, NY  As George, a student in my class in 2004 would tell you, if a person was unemployed it was because he was a slug and thus it was HIS problem, not ours.  In the early 2000s, just as in the 1920s, it was popular to view unemployment as 'self-inflicted.'  As a result, there was no real support for government protection from unemployment - no sense of responsibility for those unfortunate enough to be unemployed.

17. Of the states sampled here, the state governments of New York (33%) and New Hampshire (33%) and Flordia (27%) spend the most on intergovernmental transfers, while Connecut (19%) and Rhode Island (13%) spend the least.  Texas spends the most on education (16%), Rhode Island the most on welfare (29%), Flordia and Massachucetts spend the most on transportation (9%), Massachucetts (8%), New Hampshire (7%) spends the most on interest, and insurance expenditures were highest in Rhode Island (14%) - in part a reflection of the fact that the state has one of the nation's oldest populations with a high rate of retirement.  

2001 State Expenditure: Percent of Total Expenditure

The averages of all 50 states also hide some substantial variations in how states raise money.  Some states, for example, do not have income taxes while others have no sales taxes.  Below is a table providing a breakdown of revenue sources for eight states. Intergovernmental transfers (primarily money from the federal government) range from 36 percent of revenue in NY to 20 percent in MA.  Individual income taxes, that account for 11 percent of state revenue nationally, bring in nothing in TX and FL where there is no income tax and virtually nothing in NH, while they account for 29 percent of state funds in MA and 24 percent in NY.  Sales taxes, meanwhile, tend to be highest in those states without individual income taxes.  FL, NV, and TX, all collect more than 39 percent of their revenues from sales taxes, far above the US average of 18 percent.  New Hampshire, with its liquor stores located just inside the NH borders, generates 7 percent of its revenue from these stores. 

2001 State Revenue: Percent of Total Revenue

18. For a feel for the magnitude of the problem you may  want to look at an article by E. Matthew Quigley published by the Boston Federal Reserve Bank in the 2003(1) issue of Regional Review, in which the author looks at the state of state finances. 

19. To see the problem let's look at a simple example.  Assume your salary is $50,000 and you decide to use $40,000 for spending and $10,000 for saving that you invest in stocks that pay you a 5 percent dividend.  If the tax rate on income is 10 percent, then you will pay $5,000 of your income in taxes plus you will pay 10 percent of the dividend income of $500, or $50 in taxes on the savings.  By taxing the dividend earnings that came from your savings, the return you received dropped to 5 percent which would reduce your incentive to save and invest in stocks.  Before we move on try to determine what this should do to the price of stock in the US, an issue that has political significance in an election year.  There is also the issue of double taxation if the savings goes into stocks that pay a dividend.  The problem, as seen by the opponents of the tax on dividends, is that corporations pay a corporate tax on their profits that include dividends, and then when these dividends are paid to the stock holders the dividends are taxed as income.  As a result of this double taxation of dividends there is less of an incentive to purchase stock, which is why one of the rationales put forward by the Bush administration for the proposal to eliminate taxes on dividend income was that the elimination would increase demand for stocks which would in turn drive up stock prices that had collapsed in 2000.  Did you get to that answer?

20. At the top end of the distribution:

1. Between 1986 and 2000, the income needed to be counted among the top 1 percent of the returns filed as measured by adjusted gross income (AGI) rose from $118,818 to $313,469, a 165 percent increase.  The average AGI per return during this period rose 113 percent. 
2. Between 1986 and 2000 the average tax rate paid by those in the top 1 percent bracket fell from 33.13 percent to 27.45 percent - a drop of 17 percent. Between 1986 and 2000 the average tax rate paid by those in the top 50 percent bracket rose from 16.32 percent to 16.86 percent.
3. Between 1986 and 2000 the share of total adjusted gross income (AGI) earned by those in the top 1 percent bracket rose from 11.30 percent to 20.81 percent - an increase of 85 percent.  
4. Between 1986 and 2000 the share of total income tax paid by those in the top 1 percent bracket rose from 25.75 percent to 37.42 percent - an increase of 45 percent.  
5. Between 1977 and 2000, the number of high income returns - those returns with inflation adjusted earnings exceeding $605,272 (in 2000 dollars) rose from 46,000 to 482,000
6. Between 1992 and 2000, the income needed to be counted among the top 400 returns filed [out of 129 million], as measured by adjusted gross income (AGI) rose from $24.4 million to $86.8 million, a 256 percent increase.  
7. Between 1992 and 2000, the share of the entire adjusted gross income accounted for by the top 400 returns filed more than doubled from .52 percent to 1.09 percent.
8. In 2000 the share of net capital gain reported by the top 400 tax returns - .0003 of the total returns files - accounted for 8.13 percent of total.  
9. Between 1992 and 2000, the average tax rate paid by the top 400 taxpayers fell from 26.38 percent to 22.29 percent.  Based on the income earned, these 400 taxpayers saved almost $2.5 billion in taxes. 

At the bottom end of the distribution:

1. Between 1986 and 2000 the average tax rate paid by those in the top 1 percent bracket fell from 33.13 percent to 27.45 percent - a drop of 17 percent. Between 1986 and 2000 the average tax rate paid by those in the top 50 percent bracket rose from 16.32 percent to 16.86 percent.
2. Between 1986 and 2000 the share of total adjusted gross income (AGI) earned by those in the bottom 50 percent percent bracket fell from 16.66 percent to 12.99 percent - an decrease of 22 percent.  
3. Between 1986 and 2000 the share of total income tax paid by those in the bottom 50 percent bracket fell from 6.46 percent to 3.91 percent.