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expansion phase. If aggregate demand were to decrease, the aggregate demand curve would shift to the left (AD3). This would result in a lower equilibrium real GDP (Q3)—in other words, an economic contraction. Shifts in aggregate supply affect real GDP in a similar way, as you can see in Figure 12.10. An increase in aggregate supply shifts the aggregate supply curve to the right (AS2). As aggregate supply increases, the price level goes down (P2) and equilibrium real GDP rises (Q2), marking an expansion phase. If aggregate supply were to decrease, the aggregate supply curve would shift to the left (AS3). The result would be a higher price level (P3) and lower equilibrium real GDP (Q3)—in other words, stagflation. FIGURES 12.9 AND 12.10 CHANGES IN AGGREGATE DEMAND AND SUPPLY FIGURE 12.9 CHANGE IN AGGREGATE FIGURE 12.10 CHANGE IN AGGREGATE DEMAND SUPPLY AS AS3 AS1 AS2 AD2 AD1 AD3 P2 P1 P3 P3 P1 P2 AD Q3 Q1 Q2 Real GDP Q3 Q1 Q2 Real GDP ANALYZE GRAPHS 1. As aggregate demand decreases, what happens to price level and real GDP? 2. As aggregate supply decreases, what happens to price level and real GDP? AP P LI CATION Analyzing Cause and Effect B. Assuming aggregate demand remains the same, why does the price level go up when aggregate supply decreases? Economic Indicators and Measurements 361 Why Do Business Cycles Occur? KEY CONCEPT S You have seen that shifts in aggregate demand and aggregate supply indicate changes in the business cycle. But what causes these shifts? Four factors are especially important: (1) decisions made by businesses, (2) changes in interest rates, (3) the expectations of consumers, and (4) external shocks to the economy. These factors involve the “ripple effect,” the cause-and-effect interactions that ripple through the economy. FACTOR 1 Business Decisions When businesses decide to decrease or increase production, their decisions can have far-reaching effects. If enough businesses make similar decisions, it can lead to a change in the business cycle. Demand slump Consider the ripple effect of a decision by businesses in the recording industry. In response to a slump in demand, the producers decide to reduce production of compact discs. First,
they reduce the number of hours worked at their compact disc manufacturing facilities. Some workers get laid off, others work shorter hours. In a related move, the recording businesses cut back on their investment in new CD manufacturing equipment. That decision will lead to a decrease in the demand for machinery, which puts producers of the machinery in the same situation that the recording businesses were in. The machinery businesses will also cut back on production and lay off workers. The recording industry businesses also decide to reduce the number of new recordings they commission, thereby reducing the income of musicians, recording engineers, record promoters, and other associated workers. All of the workers that are now unemployed or working less must cut back on their purchases. The single decision by the recording industry businesses had numerous consequences. By itself, it might not be enough to change the business cycle for the entire country. But if enough businesses make similar decisions, a contraction in the business cycle might result. New technology Alternatively, business decisions can also increase aggregate supply and fuel an expansion. For example, suppose computer chip manufacturers adopt a new technology that greatly reduces production costs. Those manufacturers become more productive—the supply of their products increases and the cost of their products goes down. Businesses that make products that use computer chips can make their products more cheaply. Other businesses may now be able to make new products with the more readily available computer chips. All of these businesses hire more workers to handle the increased production. The aggregate supply increases, and the economy experiences an expansion. Find an update on factors affecting the business cycle at ClassZone.com 362 Chapter 12 FACT OR 2 Changes in Interest Rates Another event that has a ripple effect in the economy and causes shifts in aggregate demand and supply is a change in interest rates. Rising interest rates, for example, make it more costly for consumers to borrow money to make purchases—from televisions to cars to houses. This decreased purchasing power lowers the level of aggregate demand and promotes a contraction in the economy. When interest rates fall, the opposite happens. Aggregate demand rises, promoting an expansion. Consider what may happen to businesses when interest rates rise. With the higher cost of borrowing money, businesses may cut back on their investment in capital goods. As you saw earlier, such a cutback would lead to less business activity for the producers of capital goods. As the aggregate supply decreases, a contraction in the economy is likely. But falling interest rates would lead to an increase in aggregate supply and an economic expansion. Higher or lower interest rates also affect the housing market. When interest
rates are low, people are inclined to purchase housing rather than rent, so housing sales and all related economic activities increase, contributing to an economic expansion. When interest rates rise, the high cost of loans limits mortgage eligibility, so more people rent. Housing sales slow down, contributing to an economic contraction. FACT OR 3 Consumer Expectations Every month, 5,000 households are surveyed to find out how people are feeling about the economy, and the results are published in the Consumer Confidence Survey report. Why? The way consumers are feeling about prices, business activity, and job prospects influences their economic choices, and their choices can bring about changes in aggregate demand. For example, when consumers are confident about the future and believe that they are economically secure, they tend to consume more, driving up aggregate demand and encouraging an economic expansion. FACT OR 4 External Issues A nation’s economy can also be strongly influenced by issues and events beyond its control or outside of its borders. Examples include such natural disasters as Hurricanes Katrina and Rita, which struck the Gulf Coast in the summer of 2005. The hurricanes damaged oil refineries, oil wells, and offshore oil platforms. The effects of Katrina and Rita, combined with conflicts in other oil-producing countries, led to higher oil prices and slowed down the growth of the U.S. economy. The oil embargo of 1973 is another example. The Organization of the Petroleum Exporting Countries (OPEC) reduced the amount of oil supplied to Western nations that had supported Israel in the Yom Kippur and October wars. The price of oil rose by 400 percent. The higher prices raised production costs and resulted in an economic contraction in the United States. AP P LI CATION Analyzing Cause and Effect C. Describe the ripple effect of a natural disaster like Hurricane Katrina on the economy. External Issues Natural disasters can affect the economy. Hurricane Katrina washed this oil-drilling platform into this bridge.. Economic Indicators and Measurements 363 Predicting Business Cycles KEY CONCEPT S QUICK REFERENCE Leading indicators are measures of economic performance that usually change before real GDP changes. Coincident indicators are measures of economic performance that usually change at the same time as real GDP changes. Lagging indicators are measures of economic performance that usually change after real GDP changes. Economists try to predict changes in the business cycle to help businesses and the government make informed economic choices. They base their predictions on sets of economic indicators. • Leading indicators are measures of economic performance that usually change six to nine months before real
GDP changes. Examples include new building permits, orders for capital goods and consumer goods, consumer expectations, average manufacturing workweek, stock prices, and the money supply. Economists look for trends in these indicators that last several months before they predict a change. • Coincident indicators are measures of economic performance that usually change at the same time as real GDP changes. These indicators include such items as employment, sales volume, and personal income. • Lagging indicators are measures of economic performance that usually change after real GDP changes. Such indicators are useful for confirming the end of an expansion or contraction in the business cycle. They include length of unemployment and the ratio of consumer credit to personal income. F I G U R E 12.11 U. S. L E A D I N G ECO ATO INDEX OF LEI FIRST QUARTER GDP SECOND QUARTER GDP THIRD QUARTER GDP FOURTH QUARTER GDP RECESSION (MAR.-NOV. 2001 12.0 11.5 11.0 10.5 10.0 9.5 9.0 8. 1998 1999 2000 2001 2002 2003 2004 Sources: The Conference Board; U.S. Bureau of Economic Analysis; National Bureau of Economic Research Year and quarter ANALYZE GRAPHS 1. Find a period of at least four quarters in which the index of leading economic indicators accurately predicted a change in real gross domestic product. 2. Do changes in the real gross domestic product always echo changes in the index of leading economic indicators? What does this say about predicting changes in the nation’s economy? APPLICATION Using a Decision-Making Process D. If you were the manager of an electronics store, how might you use the news that leading indicators suggest a contraction in the economy in six months? 364 Chapter 12 The Great Depression Millions of Americans were thrown into poverty during the 1930s. These people received soup from a charity kitchen. Business Cycles in U.S. History KEY C ONCEPT S The agency that tracks economic indicators and business cycles in the United States is the National Bureau of Economic Research (NBER). It measures contractions from peak to trough and expansions from trough to peak. NBER identified about 20 extended contractions, or recessions, in the American economy in the 20th century. The worst of these by far was the Great Depression. The Great Depression “Back in those dark depression days,” President Ronald Reagan once recalled, “I saw my father on a Christmas Eve open what he
thought was a Christmas greeting from his boss. Instead, it was the blue slip telling him he no longer had a job. The memory of him sitting there holding that slip of paper and then saying in a half whisper, ‘That’s quite a Christmas present’ –it will stay with me as long as I live.” Millions of people who lived through the Great Depression were haunted by such memories. For more than a decade, beginning with the stock market crash in 1929, the United States and much of the world suffered a terrible economic contraction. Not until the United States entered World War II in 1941 did the American economy begin a full recovery. Between the years 1929 and 1933, when the depression was at its worst, U.S. real GDP declined by about a third. Sales in some big businesses, including General Motors Corporation, declined by as much as 50 percent. In the resulting cutbacks, millions of workers lost their jobs. The unemployment rate skyrocketed from 1929 to 1933, leaving one in four American workers jobless. Businesses failed at a higher than usual rate, and banks failed at a tremendously high rate. The number of bank closings, either temporary or permanent, soared from 659 in 1929 to 4,000 in 1933. The New Deal President Herbert Hoover, who had been elected in 1928, was not able to bring about a recovery. Franklin D. Roosevelt, accepting the nomination to run for president against Hoover in 1932, promised Americans “a new deal,” and the programs he enacted after winning the election came to be known by that name. Roosevelt’s New Deal programs focused on federal spending to help the economy revive. Through a number of government agencies created just for this purpose, the American economy came under closer government regulation and many Americans were put back to work—employed by the federal government itself. Spending by the federal government rose from about 3 percent of GDP in the 1920s to about 10 percent in the mid-1930s. In this cartoon, Franklin D. Roosevelt is surrounded by children representing programs created as part of the New Deal. Economic Indicators and Measurements 365 Economists debate whether the New Deal programs led to sustained economic growth. But when the United States entered World War II in 1941, spending on the war effort also helped the economy to recover. Unemployment plunged to 1.2 percent by 1944. Business Cycles Since the Great Depression According to NBER, there have been about a dozen economic contractions and expansions in the U.S. economy
since the Great Depression. The recessions have been less severe and have occurred less often than those before the 1930s. However, the contraction of the mid-1970s was an especially difficult time, triggered in part by the Oil Embargo of 1973. The unemployment rate rose from an average of 5.4 percent in the first half of the decade to an average of 7.4 percent from 1975 to 1979. At the same time, prices also rose, creating stagflation. FIGURE 12.12 U. S. BUSINESS CYCLES ) RECESSION PERIODS REAL GDP (IN 2000 DOLLARS) 12 10 8 6 4 2 1925 1935 1945 1955 1975 1985 1995 2005 1965 Year Sources: U.S. Bureau of Economic Analysis; National Bureau of Economic Research ANALYZE GRAPHS 1. According to the graph, how many recessions occurred from 1929 to 2005? 2. About how long was the longest business cycle shown on this graph? The 1990s, in contrast, saw strong economic expansion, fueled in part by the explosive growth of information technology. The economy experienced a brief recession in the early 2000s, which was extended slightly by the terrorist attacks on September 11, 2001. Through 2005, the U.S. economy continued to expand, although not at the heated pace of the 1990s. APPLICATION Making Inferences and Drawing Conclusions E. One industry that flourished during the Great Depression was the movie industry. Comedies were especially popular, and stories often portrayed the lives of the wealthy. Why do you think the movie industry fared so well? 366 Chapter 12 S E C T I O N 2 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs. MACROECONOMIC EQUILIBRIUM a. contraction expansion b. aggregate demand aggregate supply c. leading indicators lagging indicators 2. Between which two points of the business cycle is a contraction measured? 3. What is the difference between demand and aggregate demand? 4. Name four factors that can trigger changes in the business cycle. 5. Name three coincident indicators of the Great Depression. 6. Using Your Notes Write a brief stages statement of your expectations for the economy from the point of view of the consumer. Use your completed cluster diagram and make references to what you have learned about the business cycle. Business Cycle Use the Graphic Organizer at Interactive Review @ ClassZone.com. Comparing and Contrasting Economic Information What were the similarities and differences between the
Great Depression and the recession in the 1970s? 8. Solving Economic Problems Did President Roosevelt’s New Deal focus on generating aggregate demand, or was its main focus on increasing aggregate supply? Explain. 9. Analyzing Cause and Effect Are the components that are considered leading economic indicators causes or effects of changes in the business cycle? 10. Challenge In the 1990s many people speculated that the economy had been transformed by new technologies. Paul A. Volcker, former chairman of the U.S. Federal Reserve Bank, described it this way: “The speed of communication, the speed of information transfer, the cheapness of communication, the ease of moving things around the world are a difference in kind as well as degree.” Do you think that business cycles are inevitable? Can they ever be eliminated entirely? Explain your answer P1 AS1 AD1 Real GDP Q1 Interpreting Graphs The graph shows an economy at its macroeconomic equilibrium, where the aggregate demand curve (AD1) intersects the aggregate supply curve (AS1). P1 indicates the equilibrium price level, and Q1 shows the equilibrium level of real GDP. Draw Aggregate Demand and Aggregate Supply Curves Read the following scenarios. Copy the graph onto your own paper, then graph the changes that would occur in the Scenario 1 in blue. Graph the changes that would occur in the Scenario 2 in red. Scenario 1: In a booming economy, interest rates begin to rise. Manufacturers and other producers, wary of borrowing money at higher rates, begin to cut back on production. Scenario 2: Consumer confidence is high. Most people are optimistic about their job prospects and security, and they are willing to spend money on luxuries. Challenge As a consumer, how might your confidence be affected in Scenario 1? Use to complete this activity. @ ClassZone.com 367 S E C T I O N 3 Stimulating Economic Growth TA K I N G N O T E S In Section 3, you will real GDP per capita, p. 369 • explain how economists labor input, p. 371 measure growth • analyze the causes of economic growth • discuss how productivity and economic growth are related capital deepening, p. 371 productivity, p. 372 multifactor productivity, p. 372 As you read Section 3, complete a summary chart like the one below to record what you learn about economic growth. Use the Graphic Organizer at Interactive Review @ ClassZone.com What Is Economic Growth? What Is Economic Growth? KEY CONCEPT
S In Section 2 you learned about the business cycle, the pattern of expansion and contraction in a nation’s economy. In this section you will learn more about economic growth, as measured by changes in real gross domestic product (GDP). Gauging Economic Growth Before Adam Smith (whom you learned about in Chapter 1, Section 4), many people believed that population growth and higher taxation were the secrets to economic growth. The theory held that more people paying more taxes was the best way to fill a nation’s treasury. Another view, called mercantilism, argued that increased national wealth came through exporting more goods than a country imports. In this way, the country would gain gold or silver currency from other countries. Adam Smith, however, saw that the real “wealth of nations” lay in their productive capacities. Taxes could be so high that they limit the amount of funds available for business investment and consumer spending, thereby reducing economic growth. In Smith’s view, foreign trade allows a country to focus its resources on what it does best. The more efficiently a nation uses its resources, the more productive it will be and the larger its economy will grow. Smith’s views proved to be accurate, and they serve as the basis for modern economics. The best measure of economic growth is not simply the amount of money a nation has or how much its population increases, but rather the increase in its real GDP. The rate at which real GDP changes is a good indicator of how well a country’s resources are being utilized. 368 Chapter 12 FIGURE 12.13 U. S. REAL GDP PER CAPITA 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 ) 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Source: U.S. Bureau of Labor Statistics ANALYZE GRAPHS 1. About how much was real GDP per capita in 1990? 2. About how many years did it take for real GDP per capita to double from its level in 1960? Population and Economic Growth Population growth influences economic growth. A country’s real GDP might be growing, but if its population is growing at an even faster rate, the increase in real GDP might simply reflect more workers contributing to the economy. Think of a potluck dinner. If each person brings one dish, the amount of food per person will be the same whether you invite 10 people or 100. To get a clearer picture of economic growth,
economists use a measure called real GDP per capita, which is real GDP divided by total population. Real GDP per capita reflects each person’s share of real GDP. In terms of the potluck dinner, if each person brings more than one dish to the next potluck, the amount of food per person will have increased. Real GDP per capita is the usual measure of a nation’s standard of living. Nations with higher real GDP per capita tend to have populations that are better educated and healthier. However, real GDP per capita does not mean that each person gets that amount of money. Some people will get more, others less. It also does not measure quality of life. For example, people might have to work longer hours to achieve higher rates of economic growth, leaving them with less leisure time. AP P LI CATION Explaining an Economic Concept A. Why does a nation’s real GDP have to increase at a faster rate than its population for significant economic growth to take place? Find an update on U.S. real GDP per capita at ClassZone.com QUICK REFERENCE Real GDP per capita is real GDP divided by total population. Economic Indicators and Measurements Economic Indicators and Measurements 369 What Determines Economic Growth? KEY CONCEPT S What drives economic growth? Why are some nations growing at a faster pace than others? Four key factors influence the rate of economic growth—natural resources, human resources, capital, and technology and innovation. FACTOR 1 Natural Resources One factor in economic growth is access to natural resources, especially arable land, water, forests, oil, and mineral resources. However, some countries, such as Japan, have very limited natural resources, yet their economies have grown rapidly. Others, such as India, which has the fourth-largest reserve of coal in the world and arable land covering more than half its territory, have developed more slowly Do Natural Resources Guarantee Wealth? Not necessarily. In fact, countries with abundant natural resources generally do not perform as well economically as countries with fewer natural resources—a phenomenon economists refer to as “the resource curse.” In Nigeria, for example, although oil is plentiful, personal income is low. GDP per capita is about $1,400 (in U.S. dollars). Poverty is widespread, with an estimated 60 percent of Nigeria’s population below the poverty line—and Nigeria has the largest population of any African country. At the other end of the spectrum is Japan. Although the country has
few natural resources, the strength of Japan’s economy is second only to that of the United States. GDP per capita is about $30,000 (in U.S. dollars). What Nigeria lacks, but Japan has, are the basic structures of a free market economy—private ownership, the profit motive, an effective government, and economic competition. These economic institutions are more important than natural resources for generating economic growth. Japan, with few natural resources, achieved economic success by developing alternative sources of wealth—industry and foreign trade. FIGURE 12.14 OIL PRODUCTION AND CONSUMPTION ) Nigeria Japan production consumption Source: U.S. Central Intelligence Agency, 2003 data CONNECTING ACROSS THE GLOBE 1. Synthesizing Economic Information What role do natural resources play in a country’s economic strength? Explain your answer. 2. Drawing Conclusions Figure 12.14 illustrates oil production and consumption in Nigeria and Japan. What would happen to each country’s economy if it produced less oil? What if each produced more? 370 FACT OR 2 Human Resources Another key factor in economic growth is the labor force. Economists measure this partly through labor input—the size of the labor force multiplied by the length of the workweek. The steady declines in the length of the workweek in most countries since the early 1900s have been more than made up for by the growth in the population, so labor input has grown. Perhaps even more important than the raw numbers, however, is the level of human capital—the skills and knowledge—that the labor force brings to its tasks. Some economists believe that human capital is the single most important component in economic growth. QUICK REFERENCE Labor input is the size of the labor force multiplied by the length of the workweek. FACT OR 3 Capital You learned in Chapter 1 that natural resources, labor, and capital come together through the creativity of an entrepreneur to produce goods and services. Capital is critical to this process and to economic growth. More and better capital goods increase output: the more machines a factory has and the better designed they are, the more goods the factory can churn out. Multiply this by the number of factories across a nation and the increased output equals higher GDP. The economy also grows when more capital is available per worker. An increase in the capital to labor ratio is called capital deepening. In other words, workers are provided with more and better equipment to work with. The Industrial Revolution is a prime example of capital
deepening. Sewing machines, for example, allowed clothing manufacturers to make more clothing per worker than if the workers had been sewing by hand. QUICK REFERENCE Capital deepening is an increase in the ratio of capital to labor. FACT OR 4 Technology and Innovation Technology and innovation are also important factors in economic growth. These factors promote the efficient use of other resources, which in turn leads to increased output. Some of the key technological developments that have contributed to economic growth include steam power, electricity, and the automobile. Innovations can also increase economic growth. Something as simple as adjusting an order form can contribute to economic growth by reducing the amount of time needed to complete a task. Other innovations might improve customer service or reduce the amount of material needed to create a product. Information technology has had a strong impact on economic growth. Technological advances in producing the information technology itself have led to a dramatic decline in prices. With lower prices for technology, firms are engaging in capital deepening without having to spend more money. AP P LI CATION Writing About Economics B. Using the four factors, explain how developing countries like Nigeria might improve their economic growth. Technology and Innovation Technological advancements have increased economic growth. Economic Indicators and Measurements 371 QUICK REFERENCE Productivity is the ratio of the amount of output produced to the amount of input. Productivity and Economic Growth KEY CONCEPT S Productivity refers to the amount of output produced from a set amount of inputs. When the same amount of inputs produces more output, productivity has increased. In Chapter 9, you learned about labor productivity—the amount of goods or services produced by a worker in an hour. But the broader sense of productivity includes the productivity of both labor and capital. For example, imagine that you begin building bookshelves. The inputs would include your labor plus capital, in the form of the workshop, hammers, glue, and other supplies. At first, it may take you a week to complete one bookshelf. In the process, you may waste materials as you make mistakes, and you may find that some of your tools are not ideal for the task. But after you have built several bookshelves and acquired the right tools for the job, your productivity increases. Using the same amount of input, you might now be able to produce two bookshelves per week. This section concerns the productivity of a country’s entire economy. As a country becomes more productive, its economy is likely to grow. How Is Productivity Measured? QUICK RE
FERENCE Multifactor productivity is the ratio between the amount of output produced by an industry or business sector and the amount of inputs used. To measure the productivity of a single business, you would compare the inputs to the outputs. Using the bookshelf example, you would compare the amount of capital and number of hours worked to the number of bookshelves produced. But how can we measure the productivity of a nation’s economy, which is made up of millions of different people and businesses? Economists use a measurement called multifactor productivity, the ratio between an industry’s economic output and its labor and capital inputs. By collecting multifactor productivity data on a country’s major industries and business sectors, economists can estimate the productivity of the entire economy. What Contributes to Productivity? Several factors contribute to changes in productivity. Quality of Labor A better educated, healthier workforce tends to be more productive. Using the bookshelf example, if you were to take classes in woodworking, your enhanced knowledge would enable you to produce more and better shelves. In general, the more educated the workforce, the more productive it is. As for health, people are usually more productive when they feel well than when they feel sluggish or ill. Technological Innovation Historically, as during the Industrial Revolution, new machines and technologies helped countries produce more output from the same amount of inputs. In recent times, the desktop computer and computer technology generally have generated productivity gains. Energy Costs Gas, electricity, and other fuels power the technologies that increase productivity. When energy costs rise, those tools become more expensive to use and productivity declines. By the same token, when energy costs fall, using advanced tools becomes less expensive and productivity rises. 372 Chapter 12 Financial Markets The easier it is for funds to flow to where they are needed, the more productive the economy becomes. Banks, stock markets, and similar institutions allow a country’s funds to be put to their best use. When such institutions do not exist or when they do not function efficiently, productivity is reduced. FIGURE 12.15 U. S. PR IVATE BUSI NESS MULTIFAC TOR PRODUC TIVIT Y 100 90 80 70 60 50 40 30 20 10 ( 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 Source: U.S. Bureau of Labor Statistics Year ANALYZE GRAPHS 1. What happened to productivity in the three years after the 1973 oil embargo? Why? 2. Compare this graph with Figure 12.13 on
page 369, which shows real per capita GDP. How closely is economic growth related to productivity? How Are Productivity and Growth Related? Economic growth is a measure of change in production. It does not consider how much effort or how many resources it took to produce that quantity of production. Productivity, on the other hand, is a measure of efficiency. It reflects the amount of effort and resources it took to produce a certain quantity. A country could experience economic growth—as measured by real GDP— without increasing its productivity. Such growth would be tied to an increase in the quantity of natural resources, labor, capital, or technology. If the productivity of a country increases, its real GDP can grow without increasing the quantity of inputs. As shown in Figure 12.15, productivity in the United States grew at a steady pace from 1950 to 2000. Among other things, a better educated labor force and advances in information technology contributed to the increase. The dips in the graph represent productivity setbacks, such as tighter financial markets during recessions. AP P LI CATION Drawing Conclusions C. Some countries have limited natural resources but high economic growth. Does this prove that worldwide economic growth is unlimited by natural resources? Why or why not? Economic Indicators and Measurements 373 ECO N O M I C S PAC ES E T T E R Thomas Robert Malthus: The Population Problem In the late 1700s, many European thinkers and writers predicted a future of peace and harmony in which poverty and hunger would be eliminated. Discussing humanity’s future with his father led Thomas Robert Malthus to question whether the prevailing view was perhaps too rosy. Malthus saw a problem that others had overlooked, namely, that the world’s population seemed likely to outgrow the available supply of food. He published his ideas in 1798 in “An Essay on the Principle of Population as It Affects the Future Improvement of Society.” A Natural Limit to Economic Growth? Malthus’s essay argued that human population would increase geometrically—that is, it would double— every 25 years. Malthus also estimated that food production would only increase arithmetically—that is, by the same amount each time—over that time period. Figure 12.16 uses hypothetical numbers to illustrate the problem. As time went on, agriculture would produce less food per person, and millions would be thrown into poverty and starvation. “An Essay on the Principle of Population” caused a tremendous backlash.
People could not accept that the rosy future they had imagined might not come to pass. Malthus and his essay were widely attacked and criticized—but no one could ignore his argument. Malthus’s estimates turned out to be flawed. Human population increased at a slower pace than he predicted. World population was about 1 billion in 1800, but it took until 1930 to reach 2 billion. Agricultural productivity rose dramatically with the introduction of mechanized farming and advances in fertilization and pest control. Although world population accelerated around 1950, reaching about 6.5 billion by 2005, agricultural production kept pace with the growing population. Elapsed Years 100 50 25 75 0 Thomas Robert Malthus Malthus predicted a population explosion that would result in poverty and famine. F I G U R E 12.16 MALTHUS’ S POPULATION PROBLEM Bushels of Wheat (in millions) Population (in millions) Bushels per Person 10 20 30 40 50 10 20 40 80 160 1.00 1.00 0.75 0.50 0.31 APPLICATION Applying Economic Concepts D. How is Malthus’s population problem an example of the problem of scarcity? FAST FACTS Thomas Robert Malthus Career: British economist Born: February 17, 1766 Died: December 23, 1834 Major Accomplishment: Calling attention to the issue of population growth Major Work: Essay on the Principle of Population (1798, revised 1803) Famous Quotation: “Population, when unchecked, increases in geometrical ratio. Subsistence increases only in an arithmetical ratio.” Influenced: David Ricardo Charles Darwin Find an update on Thomas Robert Malthus at ClassZone.com 374 Chapter 12 S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. Explain the differences between the terms in each of these pairs. a. economic growth real GDP per capita b. capital deepening labor input 2. Name the key measurement of economic growth. 3. What four factors drive economic growth? 4. How are productivity and growth related? 5. Briefly explain the problem Malthus identified. What Is Economic Growth? 6. Using Your Notes Write a persuasive paragraph arguing one side or the other of economic growth possibilities. Refer to your completed summary chart. Use the Graphic Organizer at Interactive Review @ ClassZone.com. Solving Economic Problems In 2000, the world’s population was about 6 billion,
and about 800 million of those people did not have enough to eat. By 2050, the world’s population is expected to grow to about 9 billion. What steps should we take now to avoid having more than 1 billion people without enough to eat by 2050? Employ the ideas you learned about in this section in formulating your solution. 8. Explaining an Economic Concept Why is real GDP per capita a useful measure? Why couldn’t real GDP or GDP per capita be used for the same purpose? 9. Analyzing Cause and Effect Globalization opens international boundaries to companies, creating markets that stretch around the world. What role might global competition play in the development of innovations? 10. Challenge Going to school is your job. Your product is increasing your knowledge, and your grades are the main measure of this. Increasing your productivity would result in better grades—and more free time. Adapt the factors that contribute to economic productivity to explain how you might increase your productivity as a student. A busy factory is one route to economic growth. Stimulating Economic Growth Government policies affect economic growth. Some policies have immediate effects that last for a short time. Other policies take longer to show results but have lasting impact. Create a Healthy Economy Reflecting on what you learned in this section, consider the following possible government actions. • open a protected wilderness area for coal mining • increase funding for scholarships for low-income students • provide tax breaks for companies purchasing new equipment • strengthen laws protecting the rights of inventors Explain how each potential action might lead to economic growth. Challenge Estimate the costs and the benefits of each action. Which actions would have the most lasting positive effect on the economy? 375 Case Study Find an update on this Case Study at ClassZone.com Poland: Economic Freedom and Economic Growth Background Communists ruled Poland and controlled its economy from 1948 to 1989. After holding its first free elections in 1990, Poland made rapid progress toward full democracy and a free market economy. Economic reforms included ending government price controls, privatizing industries formerly controlled by the government, and entering the international marketplace. As Poland moved away from government control of the economy, it experienced a surge in economic growth—outdistancing many other former Communist countries in eastern and central Europe. In 2004, Poland became a member of the European Union, further increasing its economic potential. What’s the issue? How successful is Poland’s economy? Read these documents to learn about the challenges and rewards of the country’s economic transition. A. Online News Article Wroclaw
, a city in southwest Poland, offers one example of the country’s success through embracing global capitalism. This article describes that phenomenon. Wroclaw, Poland: Europe’s Next Appliance Capital? Appliance Manufacturers Pour into Southwest Poland Money and companies are pouring in—not just the prestige nameplates like Bombardier, Siemens, Whirlpool, Toyota, and Volvo, but also the network of suppliers that inevitably follows them. At first, most of the new jobs were of the semi-skilled variety. Now they have been followed by design and engineering work that aims to tap into the largest concentration of university students in Eastern Europe. “Everyone is coming, and they are coming very fast,” reports Josu Ugarte... who heads the appliance manufacturing operations here of Mondragon, the giant Spanish industrial cooperative. He predicts, confidently, that the region around Wroclaw will soon surpass Northern Italy as Europe’s appliance capital.... The secret isn’t just lower wages. It’s also the attitude of workers who take pride and are willing to do what is necessary to succeed, even if it means outsourcing parts production or working on weekends or altering vacation schedules.... Source: “Europe’s Capitalism Curtain” WashingtonPost.com July 23, 2004 Many manufacturers have opened factories in Wroclaw, Poland. This Volvo factory produces buses. Thinking Economically How has Poland’s human capital contributed to the country’s economic growth? 376 Chapter 12 Source: The Economist B. Political Cartoon Poland’s farmers were sceptical about the benefits of European Union membership. This cartoon reflects their change of heart as agricultural exports increased and they received new subsidies from the European Union. Thinking Economically Does the cartoon emphasize the free market benefits of the European Union or other benefits? C. Magazine Article Joining the European Union brought tremendous growth to Poland’s economy. This article explains some of the elements that led to the success. Reaping the European Union Harvest How the new central European members learnt to stop worrying and love the European Union After grumbling furiously about dangers to their sovereignty and their social values when they joined the European Union in May, Poles are discovering themselves now to be among the Union’s most loyal citizens. Some three-quarters say they are happy with EU membership—and no wonder. In its first eight months of membership Poland got some is the euro, the currency of the European Union] ($
3.4 billion) from the EU 2.5 billion [ budget, or roughly twice what it paid in, according to the newspaper Rzeczpospolita. Rural incomes have risen by one-third for small farmers and two-thirds for big ones, reversing eight years of stagnation and decline, thanks to munificent EU subsidies and an influx of foreign buyers offering high prices for Polish meat and fruit. Poland’s total exports rose by more than 30% in the first nine months of 2004, helped by the abolition of customs formalities. EU rules have opened the skies to budget airlines, boosting tourist numbers by 20% last year. Higher-than-expected tax revenues have meant lower-than-expected budget deficits.... Source: The Economist, January 8, 2005 Thinking Economically According to the document, how has membership in the EU helped Poland’s economic growth? THINKING ECONOMICALLY Synthesizing 1. Which economic measurements and indicators are evident in documents A and C? Explain what they convey about the strengths and weaknesses of Poland’s economy. 2. What factors have driven Poland’s economic growth? 3. Compare documents A and C, written about six months apart. What continued economic trends and new economic strengths do they describe? Economic Indicators and Measurements 377 Review this chapter using interactive activities at ClassZone.com • Online Summary • Quizzes • Vocabulary Flip Cards • Graphic Organizers • Review and Study Notes Complete the following activity either on your own paper or online at ClassZone.com Choose the key concept that best completes the sentence. Not all key concepts will be used. aggregate demand aggregate supply business cycle capital deepening coincident indicators depression disposable personal income (DPI) economic growth gross domestic product (GDP) gross national product (GNP) lagging indicators leading indicators macroeconomic equilibrium national income (NI) national income accounting net national product (NNP) nominal GDP nonmarket activities per capita real GDP personal income (PI) real GDP recession stagflation underground economy 1, the market value of all goods and services produced in a nation, is one of the key measurements used in 2. 3 is especially useful because it gives the market value of all goods and services corrected for price level changes. Another very useful measurement is 4, which shows the actual amount of money people have to spend. The economy goes through regular changes called the 5. Economists watch 6, such as building permits issued and stock prices, to predict changes in the economy.
Low points in the economy are usually self-correcting, but in times of a 7, such as the one that happened in the 1930s, government intervention may be needed. Several factors influence 8, including an increase in capital. 9, an increase in the ratio between capital and labor, increases productivity, helping the economy grow. Economists use 10, real GDP divided by whole population, to distinguish an increase in population from a higher level of economic output. 378 Chapter 12 CHAPTER 12 Assessment Gross Domestic Product and Other Indicators (pp. 350–357) 1. What is the purpose of national income accounting? 2. In what way is GDP a baseline for other economic indicators? Business Cycles (pp. 358–367) 3. What do leading indicators say about the economy? 4. Explain how a business decision might have a ripple effect that would tilt the economy on a new phase of the business cycle. Stimulating Economic Growth (pp. 368–377) 5. Explain how a country with few natural resources can still have economic growth. 6. What are the four key factors that influence economic growth? A P P LY The table below shows the size of the underground economies of selected countries. F I G U R E 12.17 U N D E RG RO U N D ECO N OM I ES I N SEL EC T ED COU N T R I ES Country GDP Per Capita (in U.S. dollars) Egypt Thailand Russia Chile Singapore Italy Switzerland United States 3,900 8,300 11,100 11,300 28,100 29,200 32,300 41,800 Underground Economy as Percent of GDP 69 70 44 19 14 27 9 10 Sources: International Monetary Fund, U.S. Central Intelligence Agency, 1998-2005 data 7. Is there a relationship between GDP per capita and the size of a country’s underground economy? 8. If a country incorporated its underground economy into the main economy, what would happen to its GDP per capita? Why. Creating Graphs Copy the blank graph onto your own paper. Then use the data in the table to create a line graph showing the percent change in U.S. real gross domestic product from 1999 through 2003. Use to complete this activity. @ ClassZone.com F I G U R E 12.18 P E RC ROM P R EC E D I N G PE R I O D Year 1999 2000 2001 2002 2003 Quarter 1 Quarter 2 Quarter 3 Quarter 4 3.4 1.0 –0.5 2
.7 1.7 3.4 6.4 1.2 2.2 3.7 4.8 –0.5 –1.4 2.4 7.2 7.3 2.1 1.6 0.2 3.6 Source: U.S. Bureau of Economic Analysis.0 6.0 4.0 2.0 0 –2.0 1999 2000 2001 2002 2003 Year and quarter 10. Analyzing and Interpreting Data Which year had the highest growth? The lowest? 11. Analyzing Cause and Effect The government enacted tax cuts and issued child tax credit refunds in 2003. What component of GDP would likely have increased because of these? 12. Distinguishing Fact from Opinion Does the graph support or counter the idea that the September 11, 2001 terrorist attacks caused a recession? 13. Challenge How could GDP grow by 5 percent a year but leave the economy no better off—or even worse off? Give two different explanations. Surveying Consumer Confidence The Consumer Confidence Survey is one poll used to determine consumer expectations. Another is the ABC/Washington Post Consumer Comfort Index, which makes 1,000 phone calls to adults each month and asks the following questions: • National Economy: “Would you describe the state of the nation’s economy these days as excellent, good, not so good, or poor?” • Personal Finances: “Would you describe the state of your own personal finances these days as excellent, good, not so good, or poor?” • Buying Climate: “Considering the cost of things today and your own personal finances, would you say now is an excellent time, a good time, a not so good time, or a poor time to buy the things you want and need?” To understand the consumer comfort index better, take a survey of your class. Step 1. Break into five small groups and discuss each of the questions. The point is to share your thoughts, not to debate who is right or wrong. Step 2. Return to your desk and write down your answers to each of the questions anonymously. Step 3. Collect the anonymous answers from the whole class. Have one person tabulate the answers to each question on the board. Step 4. Now calculate the consumer confidence of your class. For each question, add up the number of positive responses (either “excellent” or “good”). Then subtract the number of negative responses (either “not so good” or �
�poor”). Divide by the total number of students and multiply by 100. Add the result from all three questions together, and then divide by three. That will yield an overall comfort level. A level of 100 would mean everyone is satisfied with everything. A level of 100 would mean that everyone felt negatively about everything. Step 5. Discuss the result. Does it seem to accurately reflect the mood of the class? What would happen to the nation’s GDP if all consumers felt as you do? Economic Indicators and Measurements 379 Economic Challenges The national economy faces many challenges. Economics can help us understand and cope with these challenges. 380 CHAPTER 13 SECTION 1 Unemployment in Today’s Economy SECTION 2 Poverty and Income Distribution SECTION 3 Causes and Consequences of Inflation CASE STUDY The Effects of Inflation in the 1970s Facing Economic Challenges Business cycle is the series of growing and shrinking periods of economic activity, measured by increases or decreases in real gross domestic product. C H A P T E R 13 Unemployment has a variety of causes. Some level of unemployment is expected, even when an economy is healthy AT T E R S As the nation’s economy goes through business cycles, it will face the twin problems of unemployment and inflation. You may find yourself unemployed at some point during your working years, if only for a short period. For some people, persistent unemployment leads to poverty. During periods of inflation, you may have a job but your wages may buy less. More at ClassZone.com Go to ECONOMICS UPDATE for chapter updates and further information on inflation in the 1970s. (See Case Study, pp. 404–405.) Go to SMART GRAPHER to complete graphing activities in this chapter. Go to INTERACTIVE REVIEW for concept review and activities. How did inflation in the 1970s affect people and businesses? See the Case Study on pages 404–405. Facing Economic Challenges 381 S E C T I O N 1 Unemployment in Today’s Economy TA K I N G N O T E S In Section 1, you will • explain how economists measure unemployment • identify the different types of unemployment • discuss the impact that unemployment has on the economy and on individuals unemployment rate, p. 382 underemployed, p. 383 full employment, p. 383 frictional unemployment, p. 384 seasonal unemployment, p. 384 structural unemployment, p. 384 cyclical unemployment, p. 384 As you read Section 1, complete a cluster diagram
like the one below to record and organize what you learn about unemployment. Use the Graphic Organizer at Interactive Review @ ClassZone.com Unemployment Measuring Unemployment Measuring Unemployment KEY CONCEPT S In November 2005, General Motors Corporation announced that it would close or scale back about a dozen plants and lay off about 30,000 workers. The impact of a decision like that on the towns where the factories are located can be extensive. Because the unemployed cannot buy as many goods and services as they did when they had a paycheck, other area businesses might decrease output, and they might even lay off some of their own workers. If businesses across the country decide to stop hiring or to cut back, the decreased production might reduce gross domestic product (GDP), the leading measure of a country’s economic health. Economists use unemployment figures to judge the performance of the economy. The measure they use most is the unemployment rate, the percentage of the labor force that is jobless and actively looking for work. Unemployment Job fairs allow people looking for work to meet with many potential employers. The Unemployment Rate The civilian labor force, as you learned in Chapter 9, is made up of people over the age of 16 who are employed or actively looking and available for work. It does not include people in the military or those in schools, prisons, or other institutions. To determine the unemployment rate, the U.S. Bureau of Labor Statistics (BLS) surveys the labor QUICK REFERENCE The unemployment rate is the percentage of the labor force that is jobless and looking for work. 382 Chapter 13 FIGURE 13.1 U. S. UNEMPLOYMENT R ATE 10 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Source: U.S. Bureau of Labor Statistics Year ANALYZE GRAPHS 1. From 1950 to 2005, when was the unemployment rate the highest? 2. From 1950 to 2005, when was the unemployment rate the lowest? force in 60,000 households each month. Workers over the age of 16 who are not working but are able to work and who have looked for work sometime during the previous four weeks are considered unemployed. The BLS then divides the number of unemployed persons by the total number of workers in the civilian labor force to arrive at the unemployment rate. While very useful, the unemployment rate does not account for discouraged workers who have stopped looking for work. Nor does it count the underemployed, those who work part-time when they want full-time employment
or those who work at a job below their skill level. These include recently laid-off workers who may be in a temporary, lower-paying job. Full Employment Despite its name, full employment does not mean a zero unemployment rate. Instead, it means a level of unemployment in which none of the unemployment is caused by decreased economic activity. Even in a healthy economy there is always some level of unemployment. Sometimes people become unemployed when they relocate or when they leave one job to try to find another job that suits them better. Sometimes the available jobs do not match up with the skills of the available workers. In other words, some amount of unemployment is inevitable. Economists generally agree that an unemployment rate of four to six percent indicates full employment in the United States. In other countries, with different labor markets and economic policies, full employment may occur at higher or lower rates of unemployment. AP P LI CATION Explaining an Economic Concept A. Explain why the unemployment rate is based on a country’s civilian labor force, not its entire population. Find an update on the U.S. unemployment rate at ClassZone.com QUICK REFERENCE The underemployed are part-time workers who want to work full-time or people working below their skill level. Full employment means no unemployment caused by decreased economic activity. Facing Economic Challenges 383 Types of Unemployment QUICK REFERENCE Frictional unemployment is temporary unemployment of people changing jobs. Seasonal unemployment is unemployment linked to seasonal work. Structural unemployment is when jobs exist but do not match the skills of available workers. Cyclical unemployment is unemployment caused by a part of the business cycle with decreased economic activity. KEY CONCEPT S Economists pay attention not only to the unemployment statistics, but also to the reasons for unemployment. Economists recognize four types of unemployment: • Frictional unemployment, temporary unemployment experienced by people changing jobs • Seasonal unemployment, unemployment linked to seasonal work • Structural unemployment, a situation where jobs exist but workers looking for work do not have the necessary skills for these jobs • Cyclical unemployment, unemployment caused by a part of the business cycle with decreased economic activity TYPE 1 Frictional Unemployment Frictional unemployment refers to the temporary unemployment of workers moving from one job to another. The frictionally unemployed might include a parent who has spent time at home raising children and decides to move back into the work force; a magazine designer who leaves his job to seek work as a designer at a book publisher; or a recent college graduate who is looking for her first full
-time job. Frictional unemployment is a reflection of workers’ freedom to find the work best suited for them at the highest possible wage. Economists consider frictional unemployment normal and not a threat to economic stability. TYPE 2 Seasonal Unemployment Demand for some jobs changes dramatically from season to season, resulting in seasonal unemployment. Demand for construction workers, for example, typically falls in the winter months when construction activities are more difficult. Tourism peaks at certain times of the year, and different regions have different tourist seasons. Migrant farm workers, who move from one area to another following the growing schedules of the crops, are hard hit by seasonal unemployment. The winter months are especially slow, resulting in economic hardship for many migrant families. TYPE 3 Structural Unemployment Structural unemployment results when the available jobs do not match up well with the skills and experience of the available workers. A dynamic economy will often create structural unemployment as businesses become more efficient and require fewer workers to create the same amount of output. There are a number of possible triggers for structural unemployment. New technology can replace human workers or require workers to retrain. New industries requiring specialized education can leave less well-educated workers Seasonal Unemployment Demand for lifeguards is high during the warmer months. 384 Chapter 13 Offshore Outsourcing: Scourge or Boon? Many American workers fear losing their jobs to offshore outsourcing—the contracting of work to suppliers in other countries. But the likelihood of offshore outsourcing varies widely from one occupation to the next. According to a report issued by the McKinsey Global Institute in 2005, about 11 percent of all service jobs in the United States have the potential to be outsourced to another country. Jobs in information technology, engineering, and accounting are much more likely to be outsourced than jobs in health care, retail sales, and other fields that require direct personal interaction. The offshore outsourcing trend has created some structural unemployment, as laid-off workers seek new jobs. But ultimately, it should make the U.S. economy more efficient. The firms that save money by outsourcing will be more competitive. As these businesses grow, they will hire more U.S. workers. Office worker in India For some U.S. workers, outsourcing may offer unique opportunities. India has been so successful in securing business outsourced by other countries that it has a shortage of qualified labor. Because many jobs outsourced to India require workers to be fluent in English or European languages, one study predicts that 120,000 Europeans, Americans, and Australians will be working in India by 2010. CONNECT
ING ACROSS THE GLOBE 1. Synthesizing Economic Information Explain how outsourcing might change the American economy. 2. Evaluating What career do you want to pursue? Explain whether it has the potential to be outsourced. out of work. A change in consumer demand—from compact discs to computer music files, for example—can shift the type of workers needed. Offshore outsourcing, when jobs once held by Americans are staffed overseas, is another cause of structural unemployment. TYP E 4 Cyclical Unemployment Cyclical unemployment results when the economy hits a low point in the business cycle and employers decide to lay off workers. Workers who lose their jobs during a recession can have trouble finding new jobs because the economy as a whole is scaling back, and the demand for labor declines. When the economy picks up again, many workers are again able to find jobs. The duration of unemployment in these four types ranges widely, but the average duration of unemployment is relatively short. More than a third of the unemployed are out of work for five weeks or less. AP P LI CATION Making Inferences B. If you owned a clothing factory, how would a high rate of unemployment affect your business? Facing Economic Challenges 385 The Impact of Unemployment KEY CONCEPT S Although some unemployment is unavoidable, excessive or persistent unemployment hurts the economy in several ways. It reduces efficiency; it hurts the least economically secure; and it damages workers’ self-confidence. Efficiency Unemployment is inefficient. It wastes human resources, one of the key factors of economic growth. Inequality Unemployment does not follow equal opportunity rules. In an economic slowdown, those with the least experience lose their jobs first—usually minorities and the young (see the graphs below). Also, with fewer jobs available, people on the lower rungs of the employment ladder have less opportunity to advance. Discouraged Workers People who are unemployed—or underemployed—for long periods of time may begin to lose faith in their abilities to get a job that suits their skills. Potentially productive workers may give up their search for work. If they are underemployed, they may not be motivated to do their best work. F I G U R E 13. 2 U N E M P LOY M E N T R AT ES BY AG E F I G U R E 13. 3 U N E M P LOY M E N T R AT ES BY R AC E 16 to 19 years 20 to 24 years 20 18 16 14 12 10 8 6 4
2 0 25 to 34 years 35 to 44 years 45 to 54 years 55 to 64 years 65 and older 20 18 16 14 12 10 8 6 4 2 0 Black Hispanic White Asian Source: U.S. Bureau of Labor Statistics, 2005 data Source: U.S. Bureau of Labor Statistics, 2005 data ANALYZE GRAPHS 1. Which group, either age or race, has the highest rate of unemployment? 2. What happens to the unemployment rate as people get older? 3. If the majority of people aged 65 and older are retired, why is the unemployment rate for that group so low? APPLICATION Writing About Economics C. In 1889, Jane Addams founded the Hull House Association in Chicago to help newly arrived immigrants adjust to the challenges of city life. In 1910, she wrote that “of all the aspects of social misery nothing is so heartbreaking as unemployment.” Write a paragraph explaining the impact of unemployment on immigrants. 386 Chapter 13 S E C T I O N 1 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs. a. frictional unemployment structural unemployment b. seasonal unemployment cyclical unemployment 2. Explain how the unemployment rate is calculated. 3. Why are economists interested in the unemployment rate? 4. Name a job that might be affected by structural unemployment. Explain why it might be affected. 5. What is full employment? 6. Using Your Notes Write a brief summary of this section, covering measuring unemployment, types of unemployment, and the impact of unemployment. Refer to your completed cluster diagram. Measuring Unemployment Unemployment Use the Graphic Organizer at Interactive Review @ ClassZone.com. Solving Economic Problems Unemployment insurance provides money to workers who have lost their jobs through no fault of their own. In most states, the insurance is funded entirely by employers. What else might business and government do to help unemployed workers? 8. Analyzing Cause and Effect In June 2005, claims for unemployment insurance in Illinois from construction workers made up about 14 percent of all claims. In December 2005, they made up about 21 percent. Why might more construction workers file for unemployment benefits in December than in June? What type of unemployment best explains the difference? 9. Applying Economic Concepts Give specific examples from the Great Depression of the 1930s of ways in which the widespread unemployment (1) affected efficiency, (2) was distributed unequally, and (3) eroded self-esteem. 10. Challenge Think about the type of career you hope to have
when you are finished with your education. Do you think it is more likely or less likely than others to be affected by each of the various types of unemployment? Explain each of your answers. Identifying Types of Unemployment Read the following descriptions of unemployment scenarios. Categorize Economic Information Decide which of the four types of unemployment each scenario describes. • Because of reduced demand, an appliance company temporarily closes one of its factories and lays off workers. • In September, a part-time student at the University of Central Florida in Orlando loses his job at a theme park. • A newspaper journalist leaves her job to make a switch into television journalism. She has been looking for a new job for several months. • A local travel agency has to close down because of the widespread availability of direct online booking options. Challenge Young people are two to three times more likely than older people to be unemployed. Why is this? Facing Economic Challenges 387 S E C T I O N 2 Poverty and Income Distribution TA K I N G N O T E S In Section 2, you will poverty, p. 388 • explain how economists poverty threshold, p. 388 measure poverty • discuss the causes of poverty • describe how economists measure income inequality • identify what antipoverty programs are available poverty rate, p. 389 income distribution, p. 390 income inequality, p. 390 Lorenz curve, p. 391 welfare, p. 392 workfare, p. 393 As you read Section 2, complete a summary chart like the one below to pull together the most important ideas about poverty and income distribution. Use the Graphic Organizer at Interactive Review @ ClassZone.com What Is Poverty? What Is Poverty? KEY CONCEPT S QUICK REFERENCE Poverty is the condition where a person’s income and resources do not allow him or her to achieve a minimum standard of living. Poverty threshold is the minimum income needed to pay for the basic expenses of living. Persistent unemployment sometimes leads to poverty, a situation in which a person lacks the income and resources to achieve a minimum standard of living. This minimum standard varies from country to country because different countries have different ways of life. Someone who herds sheep and lives in a hut would probably be considered poor in the United States. But such a person might be thought to have a comfortable life in some other countries. Because of such disparities, there is no universal standard for what constitutes poverty. The U.S. government has established its own standard for poverty based on income levels. This poverty threshold is the official minimum
income needed for the basic necessities of life in the United States. The Poverty Threshold The poverty threshold, also called the poverty line, is the amount of income the government has determined to be necessary for meeting basic expenses. People with incomes below that threshold are considered to live in poverty. The threshold, first formulated in the early 1960s, was calculated by finding the cost of nutritionally sound food and then multiplying by three, on the assumption that food costs are about a third of a person’s expenses. The threshold differs according to the size of the household and is adjusted annually to reflect changing prices. In 2005, the poverty threshold for a family of four in the United States was about $20,000. That same year, the median income for a family of four was over $65,000. 388 Chapter 13 QUICK REFERENCE The poverty rate is the percentage of people living in households that have incomes below the poverty threshold. The Poverty Rate The poverty rate is the percentage of people living in households that have incomes below the poverty threshold. Unlike the unemployment rate, the poverty rate is based on the population as a whole. Through census information, the poverty rate can be estimated for individuals, households, or specific segments of the population, such as African-American children or single-parent households. The overall poverty rate in the United States declined between 1993 and 2000 to a low of 11.3 percent. It began to rise in 2000 and by 2004 had climbed to 12.7 percent, with 37 million people living below the poverty line. (See Figure 13.4.) Poverty, like unemployment, does not hit all sectors of society equally. Children are especially at risk. Children made up more than half of the 1.3 million increase in the number of people living in poverty between 2002 and 2003. The number of families below the poverty line that are headed by a single mother also rose. Minorities and families that live in either an inner city or a rural area tend to have higher than average poverty rates. While the numbers tell the statistical story of poverty, only personal voices can convey the toll of being poor. James Baldwin, an African-American writer born in poverty, wrote that “anyone who has ever struggled with poverty knows how extremely expensive it is to be poor.” FIGURE 13.4 U. S. P OVER T Y R ATE, 1959 –20 0 4 25 20 15 10 Find an update on the U.S. poverty rate at ClassZone.com 1960 1965 1970 1975
1980 1985 1990 1995 2000 2005 Source: U.S. Census Bureau ANALYZE GRAPHS 1. From 1959 to 2004, when was the poverty rate the highest? When was it lowest? 2. What decade saw the largest drop in the rate of poverty? AP P LI CATION Drawing Conclusions A. Why is the poverty rate based on the entire population, while the unemployment rate is based on the civilian work force? Facing Economic Challenges 389 The Problem of Poverty KEY CONCEPT S Across the globe, about half of the world’s 6 billion people live in poverty. In the United States, one of the world’s wealthiest countries, almost 40 million people live below the poverty level. Even good economic times, such as the boom that the United States experienced in the 1990s, do little to move large numbers of people out of poverty. Why is an adequate income out of reach for so many people? Factors Affecting Poverty Four major factors have the strongest influence on who lives in poverty in the United States: education, discrimination, demography, and changes in the labor force. Education As you learned in Chapter 9, usually there is a direct relationship between level of education and income: the higher the level of education, the higher the income. In the United States, the poverty rate of people who did not complete high school is 12 times higher than that of people with a college education. Discrimination White males tend to have higher incomes than racial minorities and women, even when there are no differences in education or experience. Certain groups sometimes face wage discrimination or occupational segregation and may find it difficult to move beyond low-paying jobs. Government initiatives, as well as the pressures of the competitive marketplace, have helped to reduce job discrimination. Demographic Trends In the 1950s, about one-fourth of all marriages ended in divorce. Now, almost half of all marriages end in divorce. Over the same period, births to unmarried mothers jumped from about 5 percent of all births to over 30 percent. Such demographic trends lead to higher poverty rates because single-parent families are more likely to have economic problems than two-parent families. Changes in the Labor Force The shift in the labor force from mainly manufacturing to mainly service industries is one of the changes that affects the distribution of poverty. When manufacturing jobs were plentiful, even relatively low-skilled workers were able to earn a good wage. As the jobs shifted from manufacturing to service, the wages did not always follow. Workers in many service jobs, such as fast-food clerks, tend
to earn lower wages than similarly skilled workers in manufacturing. Income Distribution The United States has one of the highest median family incomes in the world, yet millions of Americans live below the poverty line. This disparity is reflected in the country’s income distribution, the way income is divided among people in a nation. All countries have some degree of income inequality, an unequal distribution of income. Unless everyone earns the same amount, there will always be a difference between the incomes of the wealthiest citizens and those of the poorest. Compared to other advanced nations, the United States has relatively high income inequality. However, less advanced countries tend to have the most extreme differences between what the rich earn and what the poor earn. QUICK REFERENCE Income distribution is the way income is divided among people. Income inequality is the unequal distribution of income. 390 Chapter 13 FIGURE 13.5 INCOME DISTRIBUTION IN THE UNITED STATES GROUP 5 GROUP 4 a GROUP 3 GROUP 2 a If income were evenly divided, a line of income equality would result. b The actual income distribution is reflected by the Lorenz curve. c Each point reflects the cumulative income of that cumulative percent of households. b 50.0 GROUP 1 26.8 c 100 80 60 40 20 12.1 3.4 0 20 40 60 80 100 Cumulative percent of households Source: U.S. Census Bureau, 2004 data ANALYZE GRAPHS 1. According to the graph, about how much of the total income in the United States is earned by the lowest 60 percent of households? 2. How would the graph change if the lower groups earned a greater percent of the nation’s total income? A Lorenz curve graphically illustrates the degree of income inequality in a nation. The Lorenz curve in Figure 13.5, for example, plots income distribution in the United States. If income were distributed equally, then 20 percent of the population would receive 20 percent of the income, 40 percent would receive 40 percent, and so on. That distribution would be represented with a diagonal line. However, income is not equally divided. The Lorenz curve in Figure 13.5 shows that the lowest 20 percent of the population (Group 1) receives only about 3.4 percent of the nation’s total income. The lowest 40 percent (Group 2)—which includes the lowest 20 percent plus the next 20 percent—receive about 12.1 percent of the nation’s total income. The more the Lorenz curve dips away from the diagonal line of equality
, the greater the level of income inequality. In the United States, the income gap between the lower 80 percent of the population and the top 20 percent grew steadily throughout the late 1900s. In 1970, the richest 20 percent of Americans earned on average 9 times more than the poorest. By 1997, they were earning 15 times more. Households are not stuck in one group. When people gain experience and education, their incomes tend to increase. When they retire or make poor economic decisions, their incomes decrease. AP P LI CATION Applying Economic Concepts B. In 2004, the richest 20 percent of households in the United States received about 50 percent of the nation’s income. Based on that proportion, if $100 was shared among five people, how much would the richest one receive? How much would each of the other four get if they shared the rest equally? QUICK REFERENCE Lorenz curve is a curve that shows the degree of income inequality in a nation. Facing Economic Challenges 391 Antipoverty Programs QUICK REFERENCE Welfare is government economic and social programs that provide assistance to the needy. Food Stamps The food stamp program helps those with low incomes to buy groceries. KEY CONCEPT S In 1964, in his first State of the Union Address, President Lyndon Johnson pledged: “This administration today, here and now, declares unconditional war on poverty in America.” Johnson’s antipoverty programs were among many that the U.S. government has tried in an effort to close the income gap. These programs are often referred to as welfare, government economic and social programs that provide assistance to the needy. Some of these programs, however, have been criticized for wasting government funds and for harming rather than helping the recipients. During the 1980s and 1990s, the government changed its approach, and it now uses tax breaks, grants, job training, and other “self-help” initiatives in addition to cash benefits. Programs for Low-Income Households The national food stamp program, which was established by the Food Stamp Act of 1964, helps ensure that no one will go hungry. Qualifying individuals and families receive electronic benefit transfers, which have replaced the paper food stamps that had been used originally. Recipients are given a card tied to an account into which the government makes monthly deposits of food benefits. The card can be used only to purchase food at grocery stores. Since 1975, the number of food stamp recipients has fluctuated from year to year from about 16 million to
about 27 million. In 2005, almost 26 million people participated in the program. The Medicaid program is another antipoverty measure for low-income households. Medicaid offers health care for the poor and is funded by both the federal and state governments. The expense to each state is often as much as 25 percent of the state budget. Medicaid is the only health care coverage for about 40 million Americans, nearly half of them children. Another antipoverty program is the earned-income tax credit. This program provides the working poor a refund of payroll taxes and other taxes deducted from their paychecks. About 21 million people received these credits in 2004. One benefit of the program is that the money refunded to the recipients generally gets spent in their own communities. This spending helps to boost the economies of poor neighborhoods. General Programs The U.S. government’s Social Security program—which pays benefits to retirees, survivors, and the disabled—is the largest government program in the world. In the year 2004 alone, it paid out $500 billion, and that amount is expected to increase as people born during the baby boom after World War II reach retirement age. It was established in 1935 by the Social Security Act. 392 Chapter 13 The Social Security program is funded through a special payroll tax. At retirement, all workers—rich and poor alike—are entitled to monthly checks to help with living expenses. Another payroll tax helps to fund Medicare, a government health insurance program for seniors. Medicare became part of the Social Security program in 1965. These benefits have been key in reducing the number of older Americans in poverty. From 1960 to 1995, the poverty rate of those aged 65 and over fell from about 35 percent to about 10 percent. The Social Security Act also established a system of unemployment insurance administered through state governments. People who lose their jobs through no fault of their own are eligible to receive income while they look for work. Each state administers its own unemployment insurance program. Most of the programs are funded by taxes paid by employers, but in a few states employees contribute too. These benefits, which usually last no more than 26 weeks, help people avoid financial problems while they seek new employment. Other Programs Other antipoverty programs supplement the largest programs. One is the Community Services Block Grant program, which provides blocks of federal money to local communities to address such issues as employment, education, and housing. Job training is another. One such program provides grants to community colleges to develop training for hightech, high-growth jobs. Another way to provide jobs for the unemployed
and at the same time boost the economy of a struggling neighborhood is through Empowerment Zones. The government tries to attract businesses to these specially designated neighborhoods by not charging them certain taxes. Businesses that operate in Empowerment Zones provide needed services and offer employment opportunities to area residents. In 1996, the federal welfare program under- Job Training Job training helps unemployed people to learn new skills. went substantial revision in a series of changes often referred to as welfare-to-work. These changes included new incentives for working, which older welfare programs often did not provide. Workfare, for example, is a program that requires welfare recipients to do some kind of work in return for their benefits. Their work provides a useful service and also helps prepare the workers for future jobs. Direct financial aid, now called Temporary Assistance for Needy Families (TANF), now has a limit of five years. QUICK REFERENCE Workfare is a program that requires welfare recipients to do some kind of work. AP P LI CATION Explaining an Economic Concept C. In terms of government spending, what is a fundamental difference between the food stamp program and the Empowerment Zone initiative? Facing Economic Challenges 393 ECO N O M I C S PAC ES E T T E R Hernando de Soto: Another Path out of Poverty Peruvian economist Hernando de Soto has attacked the problem of poverty by redefining it: “The poor... are essentially the biggest source of wealth within [a] country.” According to de Soto, the poor have numerous assets—but in most countries they lack the basic property rights they need to grow economically. “They have houses but not titles; crops, but not deeds; businesses, but not statutes of incorporation.” In short, their wealth is not protected by the rule of law. Prosperity Through Property Rights As a young man, de Soto was struck by the sharp contrast between the poverty in Peru’s shantytowns and the energetic industry of the people. These thoughts led him, in time, to establish the Institute for Liberty and Democracy (ILD), which addresses this contrast in Peru and throughout the world. De Soto estimates that 4 billion of the world’s 6 billion people are shut out of the formal economy. Antiquated and needlessly complex laws make it difficult for these people to gain legal ownership of their homes and businesses, assets that are recognized as theirs in the informal economy. De Soto estimates that
the assets of the world’s poor add up to about $10 trillion. He argues that until legal systems change to accommodate the poor, they will continue to prefer to operate in the informal economy—at the cost of lost economic opportunity for everyone. If the resources of the poor could be brought into the formal economy and developed, the wealth they would create could lift struggling nations out of poverty into prosperity. De Soto’s critics point to his non-scholarly Hernando de Soto De Soto developed innovative ideas about the origins of poverty. FAST FACTS Hernando de Soto Title: President and Chief Executive Officer of the Institute for Liberty and Democracy Born: 1941 in Arequipa, Peru Major Accomplishments: Founded Institute for Liberty and Democracy Major Publications: The Other Path (1986); The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else (2000) Reputation: “The poor man’s capitalist”—New York Times Magazine One of the “100 most influential people in the world”—Time Magazine Find an update on Hernando de Soto at ClassZone.com approach, but he says that he purposely “closed the books and opened his ears” as he traveled throughout the world listening to the voices of the poor. Former U.S. President Bill Clinton echoed the sentiments of many world leaders when he described de Soto’s ILD as “the most promising antipoverty initiative in the world.” APPLICATION Writing About Economics D. De Soto said: “Capitalism... allowed the people that came from humble origins of the world to have economic rights the way only nobility... had it before. So capitalism is essentially a tool for poor people to prosper.” Do you agree with that explanation? Write a paragraph to explain your answer. 394 Chapter 13 S E C T I O N 2 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs. a. poverty threshold poverty rate b. income distribution income inequality c. welfare workfare 2. Why is it difficult to determine a universal poverty threshold? 3. What groups are especially hard hit by poverty? 4. What four factors help explain the distribution of poverty? 5. What does the Lorenz curve show? 6. Using Your Notes Describe five different antipoverty programs and the problems each combats. Refer to your
completed summary chart. What Is Poverty? Use the Graphic Organizer at Interactive Review @ ClassZone.com. Making Inferences and Drawing Conclusions A number of antipoverty programs are targeted specifically at children: • State Children’s Health Insurance Program (SCHIP) provides health insurance to low income children who do not qualify for Medicaid and have no health insurance • National School Lunch Program provides free or reduced price lunches to eligible children • School Breakfast Program provides cash to schools for offering breakfasts to more than 8 million children nationally What are the economic benefits of antipoverty programs aimed at children? 8. Solving Economic Problems Antipoverty programs in the United States are least effective for immigrant families and for non-elderly people without children. Why might this be so? 9. Analyzing Cause and Effect How does the earned income tax credit aid both the working poor and their communities? 10. Challenge In 2005, the poverty threshold for a family of four was an annual income of just over $19,800. Based on this income, devise a monthly budget for a family of four. Assume that no taxes or payroll deductions will reduce the family’s income. Also assume that the family lives in an apartment that costs $700 per month. Provide a detailed account of your estimated allowances for food, clothing, and other expenses. Food aid from the United States and other nations assists those in extreme poverty. Understanding World Poverty Different parts of the world have different levels of poverty. FIGURE 13.6 PERCENT OF POPULATION IN POVERTY Region Percent Sub-Saharan Africa South-Central Asia World China North Africa Latin America / Caribbean Eastern Europe Source: World Bank, 2004 data 75 75 53 47 29 26 14 Analyze and Interpret Data Use the information in the table to answer these questions. 1. The table uses a poverty threshold of living on less than $2 a day. Why doesn’t North America appear? 2. China has a population of about 1.3 billion people. About how many of them, in millions, live in poverty? Challenge Do the same factors that affect poverty in the United States apply to the rest of the world? Facing Economic Challenges 395 S E C T I O N 3 Causes and Consequences of Inflation TA K I N G N O T E S In Section 3, you will inflation, p. 396 • explain how economists consumer price index (CPI), p. 396 measure inflation • identify what causes inflation • describe how inflation affects the economy producer
price index (PPI), p. 397 inflation rate, p. 397 hyperinflation, p. 398 deflation, p. 398 demand-pull inflation, p. 399 cost-push inflation, p. 399 wage-price spiral, p. 400 As you read Section 3, complete a cluster diagram like the one below to record what you learn about inflation. Use the Graphic Organizer at Interactive Review @ ClassZone.com Inflation How Is Inflation Measured? What Is Inflation and How Is It Measured? KEY CONCEPT S In 2006, militants attacked many of Nigeria’s oil installations, demanding that more of the country’s oil wealth be shared with the Nigerian people. Before the attacks, Nigeria produced about 2.5 million barrels of oil a day, and the country was the fifth largest source of oil imported by the United States. On news of the attacks, the price of oil rose by almost 20 percent. Some economists predicted that if oil stayed at those price levels, manufacturers might raise the prices of their products to compensate for higher fuel costs. They suggested that the high oil prices might ultimately lead to inflation, a sustained rise in the level of prices generally or a sustained fall in the purchasing power of money. Economists have several instruments for measuring inflation. Consumer Price Index One tool for gauging inflation is the consumer price index (CPI), a measure of changes in the prices of goods and services commonly purchased by consumers. Creating the index requires many different steps, but the following describes the basic process. The U.S. government surveys thousands of people across the country to find out what goods and services they buy on a regular basis. The government then creates a “market basket” of about 400 different QUICK REFERENCE Inflation is a sustained rise in the general price level or a fall in the purchasing power of money. Consumer price index (CPI) is a measure of changes in the prices of goods and services commonly purchased by consumers. 396 Chapter 13 goods and services purchased by a typical household. The basket is adjusted to account for how much of a household’s budget goes to purchase each type of item. For example, families tend to spend more on food than on lawn care, so the market basket is balanced to reflect this. Each month, government workers research the current prices of the items in the market basket. What consumers spend to fill the basket can then be compared to prices in the reference base, which reflects the level of prices in the three years 1982
to 1984. Those numbers are given the value of 100. See the Connect to Math sidebar for more information. Find an update about the U.S. consumer price index at ClassZone.com FIGURE 13.7 U. S. CONSUMER PRICE I NDE X 200 180 160 140 120 100 80 60 40 20 ) 1970 1975 1980 1985 1990 1995 2000 2005 Source: U.S. Bureau of Labor Statistics Year ANALYZE CHARTS 1. If you paid $500 to fill the market basket in 1984, about how much would you pay to fill the basket in 2005? 2. Prices doubled from 1971 to 1980. How long did it take them to double again after 1980? CONNECT TO MATH Suppose the original value of the market basket was $500 and the current year’s value is $550. To determine CPI, you divide the new value by the original value and multiply by 100. The current CPI, then, is 110. $550 / $500 x 100 = 110 Producer Price Index The CPI shows the level of inflation experienced by consumers, but producers also experience inflation. The tool that gauges that kind of inflation is the producer price index (PPI), a measure of changes in wholesale prices. The PPI is constructed in roughly the same way as the CPI, but it reflects the prices producers receive for their goods rather than the prices consumers pay. The difference between consumer prices and producer prices lies in all the additional fees consumers pay, such as sales taxes or shipping charges. Like the CPI, the PPI is tied to a reference base of producer prices. More than 10,000 PPIs for individual products and groups of products are available. The indices are grouped either by stage of production (finished goods, intermediate goods, and raw materials, for example) or by industry. Index changes from period to period are calculated in the same general way as the CPI. Because producers tend to encounter inflation before consumers, PPI tends to lead CPI as an indicator of inflation. Economists use CPI and PPI to calculate the inflation rate, the rate of change in prices over a set period of time. QUICK REFERENCE Producer price index (PPI) is a measure of changes in wholesale prices. Inflation rate is the rate of change in prices over a set period of time. Facing Economic Challenges 397 M AT 13. To calculate the rate of inflation, economists evaluate the prices of many different goods. This hypothetical example uses a simplified market basket consisting of prices for
milk, bread, and juice. The table shows that the prices of milk and bread increased from Year B to Year C, but the price of juice decreased. To see the general trend in prices, you must look at the total price of the market basket of milk, bread, and juice. The steps below show how to use this simplified market basket to calculate the rate of inflation for Year C. The base year is Year A. Price of a Market Basket Year A Year B Year C $2.50 $2.40 $2.60 1 gallon milk 1 loaf bread $1.00 $1.35 $1.53 1 gallon juice Price of basket CPI, base: Year A $2.00 $2.30 $2.20 $5.50 $6.05 $6.33 100 110 115 Step 1: Calculate each year’s consumer price index (CPI). Price of market basket Price of basket in base year × 100 = CPI Calculations for Year C $6.33 $5.50 × 100 = 115 Step 2: Use the CPI to calculate the rate of inflation. CPI − CPI for preceding year CPI for preceding year × 100 = Rate of Inflation 115 − 110 110 × 100 = 4.5 The rate of inflation in Year C was about 4.5 percent. Choosing a market basket To calculate the rate of inflation, economists use a complicated market basket of hundreds of goods. The market basket is intended to represent the goods that are purchased by a typical urban consumer. Types of Inflation The different types of inflation are defined according to the degree or level of the inflation rate. Rates below 1 percent are negligible, and those between 1 and 3 percent are moderate. If a moderate rate continues over a period of time, the result is creeping inflation. A rapid increase in price level is known as galloping inflation. If galloping inflation gets out of hand, the result is hyperinflation—a rapid, uncontrolled rate of inflation in excess of 50 percent per month. One of the most dramatic episodes of hyperinflation happened in Germany in 1922 and 1923. At the height of the crisis, prices rose at a rate of about 322 percent per month. Deflation, a decrease in the general price level, happens more rarely. The Great Depression of the 1930s in the United States was marked by deflation. APPLICATION Applying Economic Concepts A. If the price of milk goes up, is that inflation? Why or why not? QUICK REFERENCE Hyperin
flation is a rapid, uncontrolled rate of inflation in excess of 50 percent per month. Deflation is a decrease in the general price level. 398 Chapter 13 QUICK REFERENCE Demand-pull inflation results when total demand rises faster than the production of goods and services. Cost-push inflation results when increases in the costs of production push up prices. What Causes Inflation? KEY C ONCEPT S Economists generally distinguish between two kinds of inflation, each with a different cause. When the inflationary forces are on the demand side of the economy, the result is demand-pull inflation, a situation where total demand is rising faster than the production of goods and services. When the forces that lead to inflation originate on the supply side of the economy, the result is cost-push inflation, a situation where increases in production costs push up prices. Demand-Pull Inflation In demand-pull inflation, total demand rises faster than the production of goods and services, creating a scarcity that then drives up prices. Suppose, for example, that consumers gain confidence in the economy and decide they want to buy more durable goods—new refrigerators, stoves, second cars, and so on. It takes producers some time to recognize this rise in demand and to gear up for higher production. During this lag period, consumer demand pushes up prices on the currently available goods. Figure 13.9 illustrates how demand-pull inflation happens. As you will learn in Chapter 16, the U.S. government creates and controls money through the Federal Reserve Bank. If the government creates too much money during the lag period before an increase in production makes more goods available, there will be too much money chasing too few goods, and prices will rise. The creation of excess money is the main reason for demand-pull inflation. F I G U R E 13. 9 Demand-Pull Inflation Consumers demand more of a product Producers are slow to respond Government creates more money Consumers have more money to spend $ 1 0 $ 1 5 Prices rise $ 2 0$ 1 5 Prices rise ANALYZE CHARTS 1. In the first scenario, did the demand curve shift or the supply curve? 2. In the second scenario, which curve shifts when the supply of money increases? Facing Economic Challenges 399 Cost-Push Inflation In cost-push inflation, prices are pushed upward by rising production costs. When production costs increase, producers make less of a profit. If consumer demand is strong, producers may raise their prices in order to maintain their profits. A general trend of
rising prices leads to inflation. Cost-push inflation is often the result of supply shocks—sharp increases in prices of raw materials or energy. For example, in 1973 and 1974, many members of the Organization of Petroleum Exporting Countries (OPEC) limited the amount of oil they sold to the United States and other Western countries. The resulting rapid rise in the price of oil led to cost-push inflation. Cost-Push Inﬂ ation Shortages of raw materials or energy can lead to cost-push inﬂ ation. Wages are a large part of the production costs for many goods, so rising wages can lead to cost-push inflation. A wage-price spiral is a cycle in which increased wages lead to higher production costs, which in turn result in higher prices, which then lead to demands for higher wages. You can see the wage-price spiral in motion in Figure 13.10. F I G U R E 13.10 Wage-Price Spiral Producers raise prices to pay for higher production costs $ $ QUICK REFERENCE A wage-price spiral is a cycle that begins with increased wages, which lead to higher production costs, which in turn result in higher prices, which result in demands for even higher wages. Workers demand a wage increase to pay higher prices Workers receive a wage increase The wage increase drives up the production costs ANALYZE CHARTS 1. Using the cotton industry as an example, explain how the cycle might proceed. Use the cotton workers, cotton growers, textile mills, and other intermediate industries in your explanation. 2. Do employers grant wage increases whenever employees ask for a raise? What economic principles determine wage levels? APPLICATION Categorizing Economic Information B. What type of inflation would result if bad weather hit farmers hard over a long stretch 400 Chapter 13 of time? What Is the Impact of Inflation? KEY C ONCEPT S Since the 1960s, the impact of inflation on the United States economy has been significant. Inflation has raised interest rates, limited the growth of the stock market, forced agricultural bankruptcies, and slowed production. It has also had a huge impact on politics. More than half of those who voted for Ronald Reagan in 1980 said that his promise to stop the long-running inflation of the 1970s was the decisive factor. Inflation is a major challenge to economic stability. For the economy as a whole and for individual consumers, inflation has an especially strong impact on the purchasing power of the dollar and on interest rates. E FFE CT
1 Decreasing Value of the Dollar With inflation, today’s dollar buys less than last year’s. The consumer price index, illustrated in Figure 13.7, shows that the real value of a dollar has declined steadily. The rising index represents the declining value of the dollar. Consider how this declining value affects people who are on a fixed income. Suppose, for example, that your cousin started college with a savings of $10,000 to see him through. He planned to spend $2,500 a year on carefully budgeted expenses. However, because of inflation, each of those dollars bought less each year. To pay for exactly the same things he bought in his freshman year for $2,500, by the time he was a senior he needed $2,750. Inflation had pushed prices up by 10 percent over the four-year period. Senior citizens living on a fixed retirement income—as well as anyone else with a fixed income—are especially vulnerable to the decreasing value of the dollar through inflation. YO U R EC IN FL ATION AND PU RC HA SES Buy now or wait? If condominium prices have skyrocketed, does it make more sense to buy a condo now or to continue renting until the market cools off?? ▲ Apartment $750 per month ▲ Condominium $200,000 mortgage Facing Economic Challenges 401 Conversely, inflation can help borrowers. With inflation, those who borrow at a fixed rate of interest can repay their debts with dollars that are worth less, making their repayments smaller than they would have been without inflation. Suppose someone borrows $100 at 5 percent interest, promising to pay the lender $105 after a year. If inflation rises at 5 percent, the $105 the borrower pays the lender will have the same purchasing power as the $100 of the original loan. The borrower essentially paid no real interest on the money he borrowed. EFFECT 2 Increasing Interest Rates As prices increase, interest rates also tend to increase. Lenders raise their interest rates to ensure they earn money on their loans despite inflation. Higher interest rates mean that borrowing money becomes more expensive. For example, a $10,000 loan at 10 percent interest to be repaid over the course of five years would have a monthly payment of $212.47. At 5 percent interest, the monthly payment would be only $188.71. At the end of five years, you would have paid over $1,425 more for the loan at the higher rate. When interest
rates are high, businesses are less likely to borrow to expand or to make capital improvements. Consumers are less likely to make purchases of high-priced items that they would need to finance. People carrying debt on credit cards have to make higher monthly payments as their rates rise. EFFECT 3 Decreasing Real Returns on Savings Inflation also has a significant effect on savings. People who save at a fixed interest rate get a lower rate of return on their savings. While the interest paid on savings tends to increase during inflationary times, the difference between the rate of return and the rate of inflation still leaves them at a disadvantage. For example, if someone puts $100 in a savings account that pays 5 percent interest per year, they will have $105 at the end of a year. But if the rate of inflation for the year was 10 percent, that $105 will buy only about what $95 bought when they deposited their money. Although they have more dollars, that money will buy less. Inflation, then, can discourage savings, leading more people to make purchases today rather than saving for tomorrow. Inflation is the most commonly used economic term in the popular media, far outpacing the distant second, unemployment. Inflation worries many people, especially those who remember the volatile 1970s. Much of the worry centers on a person’s individual standard of living: Will my wages keep up with rising prices? Will my savings see me through retirement? Fear of inflation has contributed to the shift away from the traditional American belief in saving over consumption. APPLICATION Writing About Economics C. According to opinion polls, most Americans feel inflation is a more serious problem than unemployment. Write a paragraph stating your view on which is more serious. Use convincing reasons and examples. Increasing Interest Rates Higher interest rates make borrowing more expensive. 402 Chapter 13 S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs. MACROECONOMIC EQUILIBRIUM a. consumer price index producer price index b. hyperinflation deflation c. demand-pull inflation cost-push inflation 2. What are the stages in a wage-price spiral? 3. Use a specific example to explain cost-push inflation. 4. Use a specific example to explain demand-pull inflation P1 AS1 AD1 5. What are three effects of inflation? 6. Using Your Notes If you were a business owner, what decisions might you make on news of a steady rise in inflation
? Refer to your completed cluster diagram and provide specific examples. How Is Inflation Measured? Inflation Use the Graphic Organizer at Interactive Review @ ClassZone.com. Analyzing Cause and Effect Why would producers tend to experience inflation before consumers? What type of inflation would the producers experience? 8. Explaining an Economic Concept How does the creation of excess money cause a demand-pull inflation? Refer to Figure 13.9 to help you answer this question. 9. Applying an Economic Concept Imagine that union leaders are meeting with the owners of a steel manufacturer to negotiate a new five-year contract for union employees. Explain how both sides of the union-management negotiation team must take the unpredictability of future inflation into account. 10. Challenge The cost of attending college has been rising faster than the inflation rate, at times twice as fast. For proof, ask your school guidance counselor for a catalog from a private college that shows prices from several years ago. Compare the old prices to the current prices shown on the college website. Calculate the percentage increase for this school. Real GDP Q1 Estimating the Effects of Inflation Suppose that a natural disaster disrupts the production of oil so dramatically that prices for oil and related products double in a short period of time. In this graph of macroeconomic equilibrium, P1 shows the price level before the natural disaster. Draw Aggregate Supply and Demand Curves On your own paper, recreate the graph of macroeconomic equilibrium. Then draw the new aggregate supply curve that would result from the natural disaster scenario, and indicate where P2 would fall. Challenge Explain what will happen to total economic output because of the change in prices. How does the new graph show this? Use ClassZone.com to complete this activity. @ Facing Economic Challenges 403 Case Study Find an update on this Case Study at ClassZone.com The Effects of Inflation in the 1970s Background Periods of high inflation can wreak havoc with a country’s economy. In the 1970s, for example, the United States experienced the biggest and most sustained period of inflation in the country’s history. By 1979, inflation had risen into the “double digits,” that is, to 10 percent per year or higher. The prices of consumer goods—everything from food and gas to cars and houses—rose dramatically. Those on fixed incomes were particularly hard-hit, because as prices rose their limited budgets bought less. What’s the issue? How did inflation affect people and businesses in the 1970
s? Study these sources to discover what it was like to live with a high rate of inflation. A. Economic Analysis In the late 1960s, the rate of inflation began rising in many countries. This article explains inflation’s effects on the U.S. economy. The Industrialized World and Inﬂ ation How inflation affected the U.S. economy For the years 1967 through 1978, the U.S. inflation rate averaged 6.1 per cent a year, compared with an average of 2 per cent for the years 1952 through 1967. Even during the 1973–74 recession, unlike most previous recessions, the inflation rate continued at a relatively high rate. In the late 1970s inflation speeded up again, reaching unprecedented levels. Inflation would not be so bad, in the opinion of some economists, if it were accompanied by substantial increases in output and employment. But economic growth in the United States slowed during the highinflation 1970s, bringing on a condition that economists describe as “stagflation.” Another measure of economic health—productivity, or output per worker—also slowed dramatically in [those] years throughout the industrialized world, and in the United States and Great Britain for a time failed to increase at all. For the United States, a country long accustomed to ever-increasing material wealth, the fall-off in economic growth and the constantly eroding value of the dollar were traumatic developments. If the trends continued, the average American could no longer anticipate a constantly rising standard of living. Source: The Search for a New Economic Order, The Ford Foundation, 1982 Thinking Economically Explain how the effects of inflation might be offset by increases in output and employment. 404 Chapter 13 B. Cartoon In this cartoon by Larry Katzman, a father offers an early lesson in economics. Newspaper Editorial Prices rose dramatically during the 1970s. This editorial reflects the anger many consumers felt about the situation. Thinking Economically Which type of inflation does the cartoon reflect? Explain your answer. Protesting Inﬂ ation Consumers grew impatient with the government’s inability to control inflation. Here we are, spending more and getting less, but the [government] economists are optimistic. What makes them so happy? The rate of inflation may have dropped 1 per cent. Just suppose the rate of inflation had gone down from 5 per cent to 4 per cent.... To me this is another increase of four cents, and a further shrinkage of my dollar. Obviously this type of economics is good
for someone. It certainly isn’t good for me, or my friends, or my relatives. Everyone is complaining, but the experts are satisfied. I have a family of meat eaters.... Long ago I discovered a marvelous cut of meat called skirt steak. It used to cost 89 cents a pound. It has inched its way up and has recently taken a leap to $1.59 and overtaken sirloin steak. Chopped meat is now where my skirt steak used to be.... Even the lowly onion is no longer cheap. A weekly trip to the supermarket, which in 1969 cost $50, now costs $70. Source: The New York Times, September 29, 1972 Thinking Economically Why might a small decrease in a large rate of inflation satisfy government economists but frustrate consumers? THINKING ECONOMICALLY Synthesizing 1. Name one example from each document that shows how inflation has a negative impact on the economy. 2. Inflation is a general rise in price levels. Are the examples of price increases in documents B and C symptoms of inflation or isolated price increases? 3. Compare the tone of documents A and C. Do economists care as much about inflation as consumers? Explain your answer. Facing Economic Challenges 405 Review this chapter using interactive activities at ClassZone.com • Online Summary • Quizzes • Vocabulary Flip Cards • Graphic Organizers • Review and Study Notes Complete the following activity either on your own paper or online at ClassZone.com Choose the key concept that best completes the sentence. Not all key concepts will be used. consumer price index (CPI) cost-push inflation cyclical unemployment deflation demand-pull inflation frictional unemployment full employment hyperinflation income distribution income inequality inflation inflation rate Lorenz curve poverty poverty rate poverty threshold producer price index (PPI) seasonal unemployment structural unemployment underemployed unemployment rate wage-price spiral welfare workfare There are different types of unemployment. 1 represents workers changing jobs to increase their working satisfaction or to accommodate a move to another region. 2 results from significant changes in the economy and in the way work is done. Even during periods of 3 about 4 to 6 percent of the work force is still unemployed. Nearly 40 million people in the United States have incomes below the 4, even though the nation has one of the highest median incomes in the world. The poorest receive assistance through 5. In recent years 6, which requires an exchange of labor for government benefits, has replaced some direct cash
payments. 7, a rise in the general level of prices, is another economic challenge. To monitor it, government economists developed the 8, which tracks what consumers pay for a market basket of items, and the 9, which tracks prices from the producers’ point of view. They monitor the 10 using these indices. 406 Chapter 13 CHAPTER 13 Assessment Unemployment in Today’s Economy (pp. 382–387) 1. What are the four main kinds of unemployment and how do they differ from one another? 2. What are three negative impacts of unemployment? Poverty and Income Distribution (pp. 388–395) 3. Which of the following persons is most likely to live in poverty: a senior citizen, a disabled adult, a college graduate, or a child? Explain your answer with specific facts and reasons. 4. Describe three antipoverty programs you feel are most useful and give reasons for your position. Causes and Consequences of Inflation (pp. 396–405) 5. Describe two causes of inflation. 6. Which consequence of inflation would be the most troublesome to you personally? Explain your answer. A P P LY The table below shows employees laid off from selected industries in 2004. It also shows how many of these jobs were replaced by outsourcing. 7. What type of unemployment is it when an industry lays off workers but outsources their jobs? Name an example from the table. 8. Which industries’ job cuts are probably due to changes in the business cycle? FIGURE 13.11 L AYOFFS AND OUT SOU RC I NG Employees Laid Off Replaced by Outsourcing Industry Mining Apparel Manufacturing Computer and Electronic Products Transportation Equipment Retail Trade 6,123 11,583 14,979 40,634 143,660 Transportation and Warehousing 59,098 Educational Services 1,429 Health Care and Social Assistance 44,212 Source: U.S. Census Bureau, 2004 data 0 4,102 6,481 6,223 5,298 2,090 0 621. Creating Graphs The population can be divided into five equal groups—or quintiles—according to income. Income mobility means moving from one quintile to another. A study done by the U.S. Treasury Department between 1979 and 1988 showed the following about taxpayers who started out in the lowest quintile: • 14.2 percent of the taxpayers in the bottom quintile in 1979 were still there in 1988 • 20.7 percent had moved to the next higher quintile • 25 percent had moved
to the middle quintile • 25.3 percent had moved to the second highest quintile • 14.4 percent of those who started in the lowest quintile had moved into the highest quintile Create a bar graph that illustrates these facts about income mobility in the United States. Use to complete this activity. @ ClassZone.com 10. Analyzing and Interpreting Data What conclusions can you draw about income mobility based on the above data? 11. Analyzing Cause and Effect Think of three possible reasons a person might be able to move from one level of income to another. 12. Explaining an Economic Concept Which antipoverty programs use market forces to achieve their goals? Explain your answer. 13. Analyzing and Interpreting Data Consider the following data: Consumer Price Index: Unemployment Rate: Gross Domestic Product: up by 6 percent up to 7 percent up by 1 percent What’s the economic problem? To correct the problem, which of these measures would you address first and why? 14. Challenge Which economic challenge— unemployment, poverty, or inflation—represents the greatest threat to social stability, in your opinion? Explain your answer with reasons and examples. The Pursuit of Happiness Do you need money to be happy? Since income alone does not tell the whole story of someone’s quality of life, some people think other measures besides income should be used to determine a household’s well-being. Many elements beyond material possessions also affect a person’s quality of life. To better understand the relationship between wealth and happiness, create a quality-of-life threshold by following the steps below. Step 1. As a whole class, discuss the differences between income and quality of life. Step 2. Break into five small groups and devise a quality-of-life threshold, a standard below which a person would be considered seriously impoverished. Step 3. Try to find a measure for each of your criteria. For example, if one standard is “lives in warm climate,” define the temperature range that qualifies as warm. Step 4. Report your criteria to the rest of the class and explain how you would measure each. Step 5. With the whole class, debate the relative merits of each quality-of-life threshold and its measurement. Challenge Write a paragraph explaining how the quality-of-life threshold you developed relates to Hernando de Soto’s ideas about property and prosperity (see page 394). Facing Economic Challenges 407 Macroeconomics U n i t 6 The Role
of Government in the Economy Government Spending Government funds pay for national parks such as the Grand Canyon National Park. Government raises the money for such services through taxation. 408 CHAPTER 14 SECTION 1 How Taxes Work SECTION 2 Federal Taxes SECTION 3 Federal Government Spending SECTION 4 State and Local Taxes and Spending CASE STUDY Should Online Sales Be Taxed? Government Revenue and Spending modified free enterprise economy is an economic system, like that of the United States, that includes some government involvement that influences the free enterprise system. C H A P T E R 14 tax is a mandatory payment to a local, state, or national government, while revenue is government income from taxes and other nontax sources AT T E R S Taxes are a part of your everyday life—from the income tax withheld from your paycheck to the sales tax you pay on the snack you bought at the sandwich shop. The revenues raised from these taxes fund programs that are familiar to you. For example, the highways you drive on, the police that protect you, and the parks that you use are all paid for by government revenues. More at ClassZone.com FIGURE 14.3 SHIFTING TAX INCIDENCE Go to ECONOMICS UPDATE for chapter updates and current news on sales taxes on Internet purchases. (See Case Study, pages 440–441.) Go to ANIMATED ECONOMICS for interactive lessons on the graphs and tables in this chapter S2 S1 D 0 1 2 3 4 5 6 Quantity (thousands) Go to INTERACTIVE REVIEW for concept review and activities. Who pays more of a tax—the consumer or the producer? See Figures 14.3 and 14.4 on page 415. Government Revenue and Spending 409 S E C T I O N 1 How Taxes Work TA K I N G N O T E S In Section 1, you will • explain why the government establishes taxes • identify the principles and structure of taxes • examine the incidence of taxes • describe how taxes affect the economy progressive tax, p. 412 regressive tax, p. 412 incidence of a tax, p. 415 tax incentive, p. 417 tax, p. 410 revenue, p. 410 tax base, p. 412 individual income tax, p. 412 corporate income tax, p. 412 sales tax, p. 412 property tax, p. 412 proportional tax, p. 412 As you read Section 1, complete a cluster diagram, using the key concepts and other helpful words and phrases. Use the Graphic Organizer at Interactive Review @ ClassZone.com Taxes
Government Revenue KEY CONCEPT S QUICK REFERENCE A tax is a mandatory payment to a government. Revenue is government income from taxes and other sources. Governments provide certain public goods that generally are not provided by the market, such as street lighting, highways, law enforcement, and the court system. Government also provides aid for people in need. Where does the money come from to pay for such goods and services? The most important source is taxes. A tax is a mandatory payment to a local, state, or national government. Revenue is government income from taxes and nontax sources. Nontax sources include borrowing and lotteries. The rights of government to tax are set down in the U.S. Constitution and in state constitutions. Principles of Taxation When Chelsea started her 20-hour-per-week job at the local library, she expected to receive $120 in her weekly paycheck. However, she was surprised to see that some money was deducted from her pay for various taxes. She wondered why she had to pay these taxes. 091988 AND DEDUCTIONS Economists use certain principles and criteria to evaluate whether or not taxes should be paid and who should pay them. These principles most often are based on the benefits taxpayers receive from taxes and their ability to pay. VACATION ANNUAL SICK OVERTIME COMP DESCRIPTIONS REGULAR 120.00 120.00 HOURS/ UNITS 20 00 CURRENT EARNINGS BEG BAL EARNED USED YTD Hazelmere Public Library END BAL SOC. SEC NUMBER 123 45 6789 DEPARTMENT AQUISITIONS PAY PERIOD WK ENDING 05/06/08 - 05/13/08 DATE DESCRIPTIONS REGULAR MEDIC 401 (K) OTHER DESCRIPTIONS CURRENT FED TAX SOC SEC MEDICARE ST TAX EMPLOYEE NAME CHELSEA SAMPSON 12.00 7.44 1.74 2.40 CHECK NUMBER 091988 CURRENT YTD TAXES AND DEDUCTIONS DESCRIPTIONS FED TAX SOC SEC MEDICARE ST TAX CURRENT 12.00 7.44 1.74 2.40 0 0 0 0 0 0 0 0 YTD 12.00 7.44 1.74 2.40 410 Chapter 14 SPLMNT ADDSCHD GROSS PAY 120.00 120.00 DEDUCTIONS 0 0 NET PAY 96.42 Benefits-Received Principle The benefits-received
principle of taxation holds that people who benefit directly from public goods should pay for them in proportion to the amount of benefits received. One example of this principle is the financing of road construction and maintenance through taxes on gasoline. However, it is difficult for governments to assess exactly how much different taxpayers benefit from services like national defense, national parks, local police and fire protection, and public education. Ability-to-Pay Principle The ability-to-pay principle of taxation holds that people should be taxed on their ability to pay, no matter the level of benefits they receive. According to this principle, people with higher incomes will pay more than people with lower incomes. The level of benefits received is not a consideration. Yet, income alone might not completely determine someone’s ability to pay taxes. Other questions also arise. For example, should everyone pay the same percentage of income, which still results in wealthier people paying more in taxes, or should those with higher incomes pay a higher percentage of their income in taxes? Criteria for Taxation Tax systems attempt to meet three criteria: equity, simplicity, and efficiency. However, the criteria are sometimes in conflict, and a given tax may not meet all of the criteria equally well. Equity The equity, or fairness, of a tax is established by how uniformly the tax is applied. Equity requires that people in similar situations pay a similar amount of taxes. For example, everyone who buys gasoline pays the same tax, or all people with the same level of income pay the same amount in taxes. In addition, some believe that equity requires that people with higher incomes pay more than people with lower incomes. Simplicity The simplicity of a tax is determined by how easy it is for the taxpayer to understand and how easy it is for the government to collect. In addition, there should be no confusion about the time the tax is due and the amount to be paid. The sales tax, which you’ll read about on the next page, meets the criterion of simplicity. A set percentage of the price of a taxed item is collected every time that item is purchased. Efficiency The efficiency of a tax can be judged by how well the tax achieves the goal of raising revenue for the government with the least cost in terms of administration. From the taxpayers’ viewpoint, tax efficiency can be judged by the amount of effort and expense it takes to pay the tax. Of all the types of taxes levied, the individual income tax—which you’ll learn more about on the next page—best meets the
criterion of efficiency. AP P LI CATION Drawing Conclusions A. Businesses and homeowners both benefit from police protection. How does this state- ment show the limitations of the benefits-received principle of taxation? Simplicity One criticism of the U. S. tax code is that it is too complicated. Find an update on taxation at ClassZone.com Government Revenue and Spending 411 Tax Bases and Structures KEY CONCEPT S Government imposes taxes on various forms of income and wealth in order to raise the revenue to provide public goods and various other services. Each type of wealth subject to taxes is called a tax base. The four most common tax bases are individual income, corporate income, sales, and property. Tax Bases Individual income tax is a tax based on an individual’s income from all sources: wages, interest, dividends, and tips. All taxes are ultimately paid from income, but using income as a tax base means that the amount of tax is directly linked to a person’s earnings. For most individuals, income is earned mainly from work in the form of wages or tips. It may also come from savings and investment in the form of interest and dividends. Corporations pay income tax too. Corporate income tax is a tax based on a corporation’s profits. Sales tax is a tax based on the value of designated goods or services at the time of sale. Generally, sales taxes are imposed on a wide range of goods and services. The tax usually is a percentage of the posted price of the good or service and is included in the final price that the buyer pays. The seller then passes the tax revenue collected from customers on to the government that has imposed the tax. Property tax is a tax based on the value of an individual’s or business’s assets, generally real estate. Homeowners and business owners pay property taxes based on the value of their buildings and the land on which the buildings stand. Property tax is generally included in the rents charged by property owners to individuals or businesses that rent the property, whether it is an apartment, an office, a factory, or a retail store. Property tax may also be imposed on other assets such as automobiles. You may have heard references to a particular government’s tax base growing or shrinking. Such statements refer to the amount of wealth that is available to be taxed. If overall personal income rises, the individual income tax base grows. If there are fewer homes or businesses in a certain locality or if their value declines, the property tax base shr
inks because there is less wealth for the government to tax. Tax Structures The way in which taxes are imposed on the different tax bases gives rise to three different tax structures. These tax structures are distinguished from one another based on the percentage of income that a particular tax takes. A proportional tax takes the same percentage of income from all taxpayers regardless of income level. A progressive tax places a higher percentage rate of taxation on high-income earners than on low-income earners. A regressive tax takes a larger percentage of income from people with low incomes than from people with high incomes. Proportional Tax A proportional tax is sometimes called a flat tax, because the rate of tax is the same for all taxpayers. For example, all taxpayers in a given country or state might be charged a flat 15 percent tax on their income, no matter how much QUICK REFERENCE A tax base is a form of wealth—such as income, property, goods, or services—that is subject to taxes. Individual income tax is based on an individual’s income from all sources. Corporate income tax is based on a corporation’s profits. Sales tax is based on the value of goods or services at the time of sale. Property tax is based on the value of an individual’s or a business’s assets. A proportional tax takes the same percentage of income from all taxpayers. A progressive tax places a higher percentage rate of taxation on highincome people. A regressive tax takes a larger percentage of income from low-income people. 412 Chapter 14 M AT 14.1 Understanding a Progressive Tax Step 1: Study the table to the right, which shows income tax brackets for a progressive tax. Each marginal tax rate is applied only to the income in that tax bracket. For example, for a taxable income of $12,000, $10,000 is taxed at 10 percent and the remaining $2,000 is taxed at 15 percent. Income Bracket $0–$10,000 $10,000–$30,000 $30,000–$50,000 Step 2: Assume you have a taxable income of $40,000. The table to the right shows how much of that income is in each tax bracket. Income in Each Bracket $10,000 $20,000 $10,000 Marginal Tax Rate 10% 15% 25% Tax Bracket 10% 15% 25% Step 3: Calculate the marginal tax for the income in each bracket. Add these figures to get the
total tax for a taxable of income of $40,000. The total tax on $40,000 of taxable income is $6,500. More Calculations Repeat calculations for taxable incomes of $25,000 and $45,000. Income in bracket Marginal tax rate Marginal tax $10,000 $20,000 $10,000 10% 15% 25% $1,000 $3,000 $2,500 Total tax: $6,500 NEED HELP? Math Handbook, “Understanding Progressive Taxes,” page R7 their income is. An individual who earns $20,000 would pay $3,000 in taxes, and an individual who earns $50,000 would pay $7,500 in taxes. In the United States, some state and local governments have proportional taxes on individual income. For example, the state of Michigan has a flat income tax rate of 3.9 percent, while the state of Massachusetts has a 5.3 percent rate. Similarly, the city of Bowling Green, Ohio, collects a flat rate of 1.92 percent on its residents’ incomes. Progressive Tax As you saw above, even with a proportional tax, the amount of tax increases as income increases. A progressive tax is one in which the tax rate also increases as a person’s income increases. In other words, under a progressive tax structure, a high-income person not only pays more in the amount of taxes but also pays a higher percentage of income in taxes. Figure 14.1 shows how a progressive income tax works. You can see that a progressive tax is most closely linked to the ability-to-pay principle. In the United States, the federal income tax is a progressive tax, because the tax rate increases as income increases. (You’ll learn more about the federal income tax in Section 2.) Many states, including California, Kansas, New York, and South Carolina, also have progressive income taxes. Government Revenue and Spending 413 14. 2 Three Types of Tax Structures Proportional Tax A proportional tax takes the same percentage of income from all taxpayers, regardless of income level.?What is the impact of each of the tax structures? Progressive Tax A progressive tax is based on income level. It takes a larger percentage of income from high-income earners and a smaller percentage of income from lowincome earners. Regressive Tax A regressive tax hits low-income earners harder than it hits high-income earners. This is because the proportion of income that goes to taxes
falls as income rises. ANALYZE CHARTS Look again at the description of the various tax bases on page 412. Consider which kind of tax structure applies to each of these tax bases. Write a brief paragraph explaining your choices. Regressive Tax With a regressive tax, the percentage of income paid in taxes decreases as income increases. Some taxes are regressive because they are applied to sales, not income. For example, although a sales-tax rate is applied equally to all items subject to the tax, the tax as a percentage of income is regressive. This is because low-income earners tend to spend a higher proportion of income than do high-income earners. Suppose that a state charges 5 percent sales tax on certain goods sold in the state. If the Jones family earns $20,000 and spends $15,000 on taxable goods, they pay $750 in sales taxes (5 percent of $15,000), or 3.75 percent of their income. If the Smith family earns $50,000 and spends $25,000 on taxable goods, they pay $1,250 in sales tax (5 percent of $25,000), or 2.5 percent of their income. For similar reasons, property taxes on homes are also considered regressive. Lowincome homeowners usually spend a higher percentage of their income on housing than do high-income homeowners. Therefore, property taxes take a higher percentage of their income. In addition, poorer communities often charge a higher tax rate, because the property has a lower value and therefore the property tax base is smaller. Even those who do not own homes are subject to the regressive property tax, because property taxes are generally passed on to renters. Figure 14.2 above shows the impact of each type of tax structure on low-income earners and high-income earners. APPLICATION Comparing and Contrasting B. How do proportional, progressive, and regressive taxes meet the criteria of simplicity 414 Chapter 14 and equity? Who Pays the Tax? KEY C ONCEPT S The impact of a tax can also be measured by who actually pays it. The incidence of a tax is the final burden of that tax. In other words, it is the impact of the tax on a taxpayer. For example, taxes imposed on businesses may get passed on to the consumer in the form of higher prices or rents. To understand this, you need to apply the concepts of supply and demand. QUICK REFERENCE The incidence of a tax is the final burden of the tax. Effect of
Elasticity on Taxes Suppose that the government imposes a $1 tax on a product. Demand elasticity influences the incidence of this tax. If a product has elastic demand, the seller pays more of the tax, because the seller faces decreased quantity demanded if prices rise. If the product has inelastic demand, the consumer pays more of the tax in the form of higher prices. The seller recognizes that quantity demanded will go down only slightly for goods or services that have inelastic demand, because they are less pricesensitive. Figures 14.3 and 14.4 illustrate the difference in tax incidence between products with elastic and inelastic demand. FIGURES 14.3 AND 14.4 SHIFTING TAX INCIDENCE FIGURE 14.3 ELASTIC DEMAND AND TAXES FIGURE 14.4 INELASTIC DEMAND AND TAXES ) S2 S1 S2 S1 b D 1 2 3 4 5 6 Quantity (thousands) Quantity (thousands) When a $1 tax is imposed, the supply curve (S1) shifts to the left (S2) by the amount of the tax. a In Figure 14.3, the equilibrium price increases to $3.40, and the seller pays more of the tax. b In Figure 14.4, the equilibrium price rises to $3.80, and the consumer pays more of the tax. ANALYZE GRAPHS 1. In Figure 14.3, how does quantity demanded at equilibrium change? 2. Which producer’s revenues would be least affected by the $1 tax? Use interactive demand elasticity curves at ClassZone.com AP P LI CATION Applying Economic Concepts C. Who would bear the greater incidence of these taxes: a. $1 tax on movie tickets? b. $1 tax on gasoline? Give reasons for your answers. Government Revenue and Spending 415 Impact of Taxes on the Economy KEY CONCEPT S Taxes do more than provide government with the revenue that allows it to provide public goods and other programs. Taxes have an economic impact on resource allocation, productivity and growth, and the economic behavior of individuals and businesses. Government chooses what to tax and how to tax based on the amount of income it wants to raise and the other economic effects it wants to achieve. IMPACT 1 Resource Allocation A tax placed on a good or service will increase the costs of production and therefore shift the supply curve to the left. If the demand remains the same, the price of the good or service will
go up. This shift will likely result in a shift in resources. Recall what you learned about tax incidence earlier. If a supplier is not able to pass increased costs along to the consumer in the form of higher prices, the supplier may choose to shift production to another good that will be more profitable. For example, if the government imposed a 10 percent tax on luxury yachts, which have elastic demand, the producer of the yachts would not be able to raise prices enough to cover the full cost of the tax. If it were no longer profitable to sell the yachts because of the extra cost of the tax, the producer might decide to shift resources to producing small fishing boats or go into a different business. IMPACT 2 Productivity and Growth When taxes on interest and dividends are high, people tend to save less than when taxes on this source of income are low. Therefore, taxes also have an impact on the amount of money available to producers to invest in their businesses. Some economists also believe that high taxes reduce incentives to work. They suggest that people may spend more time on activities other than work if a large percentage of their income goes to taxes. Other economists suggest that the underground economy is a result of high taxes. The underground economy refers to jobs, services, and business transactions conducted by word of mouth and, for the most part, paid for in cash to avoid paying taxes. For example, Bob has a part-time landscaping business. He works on the weekends, charges lower prices than larger landscaping companies, and insists that his customers pay him in cash. Since there are no records of Bob’s business transactions, it is difficult for the government to tax his income. 416 Chapter 14 Underground Economy Bob avoids paying taxes on his landscaping business by working on a cash-only basis. QUICK REFERENCE A tax incentive is the use of taxes to influence economic behavior. IMPACT 3 Economic Behavior A tax incentive is the use of taxes to encourage or discourage certain economic behaviors. By providing tax credits or rebates, the government may encourage behavior that it believes is good for the economy and for society. For example, it may give tax rebates to businesses for opening new factories, offices, and stores in economically depressed areas. Or government may give tax credits to consumers for activities such as recycling or using energy more efficiently. The positive tax incentive with the widest impact is perhaps the home mortgage interest deduction, which is designed to encourage home ownership. (You’ll learn more about tax deductions later in
this chapter.) So-called sin taxes are often imposed on products or activities considered to be unhealthful or damaging to society, such as gambling, alcohol, and cigarettes. These taxes are generally levied on products or activities for which there is relatively inelastic demand, so that the incidence of the tax will fall on the consumer. Yet because demand for such products is relatively inelastic, the government knows that decline in quantity demanded will not cause tax revenues to decrease dramatically. (Figure 14.5 shows how the quantity demanded of cigarettes changes when states enact higher cigarette taxes.) Demand for sin-tax products becomes somewhat more elastic as tax increases get steeper. For example, cigarette sales in Washington fell by nearly 19 percent in the year after the state imposed a 60-cents-per-pack tax increase in 2002. Even so, since the tax increase was so large, cigarette tax revenues went up by more than 40 percent. FIGURE 14.5 THE EFFECT OF CIGARETTE TAXES ON QUANTITY DEMANDED ) S2 S1 D When a tax is imposed on cigarettes, the supply curve shifts to the left by the amount of the tax. On this graph, a 75-cent tax shifts the supply curve from $3.40 per pack to $4.15 per pack. The increased price results in less demand. 10 20 30 40 50 60 Cigarette packs sold (in millions) ANALYZE GRAPHS 1. How does the quantity demanded of cigarettes change when the price rises from $3.40 to $4.15 per pack? 2. How does this graph illustrate the concept of tax incentives? AP P LI CATION Analyzing Effects D. What effect does the underground economy have on government revenue? Government Revenue and Spending 417 For more information on evaluating sources, see the Skillbuilder Handbook, page R28. Using the Internet for Research The Internet is a powerful tool for researching information. The Web site of the U.S. Treasury Department, for example, provides information on government revenue and spending. RESEARCHING ON THE INTERNET Below is an example of FAQs, or “frequently asked questions.” Use the following tips to help you navigate this and similar Internet Web sites that you might use for research. FAQs are one of several formats that present information on the Web site. Menus often provide links to other areas of the Web site. This is an actual inquiry that was received by the Treasury from a student. Source: U
.S. Department of the Treasury T HINKING ECONOMICALLY Using the Internet 1. Why do you think the student used the phrase “taxation without representation”? (If you are unfamiliar with the phrase, use a search engine to research its origin.) 2. How might you navigate this page of the U. S. Department of the Treasury Web site to locate a press release on new tax legislation? 3. Access this Web site and use the FAQs to discover how the Treasury Department answers the question: Why do I have to pay taxes? 418 Chapter 14 S E C T I O N 1 Assessment ClassZone.com AC T I C E 1. Explain the difference between the terms in each of these pairs. a. tax revenue b. sales tax property tax c. progressive tax regressive tax 2. Why do governments collect taxes? 3. What are the four most used tax bases? 4. How does demand elasticity influence the incidence of a tax? Driver’s license 5. What is the purpose of a tax incentive? 6. Using Your Notes What are the major criteria for a good tax system? Refer to your completed cluster diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com Taxes Evaluating Taxes Review what you have learned about the principles and criteria used to evaluate the effectiveness of a tax, and then complete the following activities. Draw Conclusions Evaluate the effectiveness of each tax listed in the chart below by indicating with a checkmark whether it meets each principle and criterion. 7. Categorizing Economic Information Colorado has a state Tax Principles Criteria income tax of 4.63 percent on all income and a sales tax of 2.9 percent. Are these taxes proportional, progressive, or regressive? Give reasons for your answers. 8. Drawing Conclusions In 2005, Hurricane Katrina destroyed many homes and businesses along the Gulf Coast of the United States. How did this natural disaster affect the tax bases in communities in that region? 9. Analyzing Effects Where does the burden of an increase in a sin tax usually fall? Illustrate your answer with supply and demand curves. Use @ ClassZone.com to complete this activity. 10. Applying Economic Concepts Demand for insulin is highly inelastic. Would the government be likely to use a tax on insulin as a tax incentive? Why or why not? 11. Challenge Pennsylvania and Illinois each have state income taxes of about 3 percent of income. In Illinois, the first $2,000 of individual income is
exempt from taxation. Pennsylvania has no similar individual tax exemptions. Is one state’s tax more progressive than the other? Why or why not? (You’ll learn more about tax exemptions in Section 2.) Fee for driver’s license Sales tax Flat rate income tax Progressive income tax Highway tolls Property tax Corporate income tax Challenge How would you evaluate a tax to support public education that was imposed only on families with children? Government Revenue and Spending 419 S E C T I O N 2 Federal Taxes TA K I N G N O T E S In Section 2, you will withholding, p. 421 • describe the process of paying taxable income, p. 421 individual income taxes • explain taxes for Social Security, Medicare, and unemployment • identify other taxes that are collected by the federal government tax return, p. 421 FICA, p. 423 Social Security, p. 423 Medicare, p. 423 estate tax, p. 425 gift tax, p. 425 excise tax, p. 425 customs duty, p. 425 user fee, p. 425 As you read Section 2, complete a cluster diagram using the key concepts and other helpful words and phrases. Use the Graphic Organizer at Interactive Review @ ClassZone.com Federal Taxes Individual Income Tax KEY CONCEPT S The federal government takes in around $2.5 trillion in revenue each year. This money comes from several sources, including individual income tax, social insurance taxes, corporate income taxes, estate taxes, gift taxes, excise taxes, and customs taxes. The largest source of taxes for the federal government is the individual income tax. (You can see the contribution of the various taxes to total revenue in Figure 14.8 on page 425.) The government began using the income tax after the Sixteenth Amendment to the U.S. Constitution, which recognized this type of direct taxation on individuals, was ratified in 1913. Prior to that time, excise taxes and customs duties were the main sources of federal revenue. (Figure 14.8 shows that today only a very small portion of federal tax revenue comes from excise taxes and customs duties.) Social insurance taxes are the second largest source of federal tax revenue. Workers and employers share the burden of these taxes. EXAMPLE Paying Your Taxes If taxpayers had to pay their income taxes in one lump sum at the end of each year, some people would have difficulty coming up with all the money at once. Also, receiving revenue just once a year would create problems for the government. Drawing up a budget for the year would be very difficult,
and developing sound economic plans for the future would be almost 420 Chapter 14 impossible. Therefore, to make it easier for taxpayers and the government, a payroll tax—a tax that is taken from a worker’s paycheck—is collected. The payroll tax is deducted from a paycheck as withholding, or money taken from a worker’s pay before the worker receives it. To see how this works, let’s look at the example of Scott, who works part-time during the school year and full-time during the summer at the Main Street Grocery Store. For every hour Scott works, he earns $6. Because of withholding for taxes, the amount he receives in his paycheck is less than the total amount he earns. In this way, he pays his taxes as he earns income, and the government receives a steady stream of revenue. The Main Street Grocery Store forwards the money withheld from Scott’s paycheck to the Internal Revenue Service (IRS). The IRS is the government agency that collects the money for the federal government and administers the federal tax system. The federal income tax is a progressive tax based on the ability-to-pay principle of taxation. This means that people with higher incomes not only pay more in total taxes but also pay a higher percentage of their income in taxes. The amount owed is based on taxable income, the portion of income subject to taxation. Under federal income tax laws, taxpayers may take certain exemptions and deductions from their total earned income to reduce the amount of their taxable income. Exemptions are allowed for each individual adult and child, so larger families reduce their taxable income by a greater amount than do smaller families. In addition, taxpayers may take a standard deduction or itemize deductions, such as interest paid on a home mortgage, state and local taxes, charitable contributions, and a certain portion of medical expenses. Figure 14.6 below provides information on some of the itemized deductions taken by taxpayers in 2004. Each year, taxpayers must complete a tax return, a form used to report income and taxes owed to various levels of government. The federal tax return shows how much income has been earned, the exemptions being claimed, and how much tax has been paid through withholding. State and local tax returns show similar, but less detailed, information. Taxpayers who have too much tax withheld receive a refund for overpayment. Taxpayers who have not had enough withheld must then pay any additional taxes owed directly to the IRS or to state or local revenue departments. QUICK REFERENCE Withholding
is money taken from pay before the worker receives it. Taxable income is the portion of income subject to taxation. A tax return is a form used to report income and taxes owed to government. FIGURE 14.6 SELECTED ITEMIZED DEDUCTIONS ON INDIVIDUAL INCOME TAX RETURNS Deduction Number of Returns Amount Claimed (in $) Interest Paid State and Local Sales and Income Taxes Charitable Contributions Medical and Dental Expenses 37,961,584 44,685,865 40,594,576 9,458,443 Source: Internal Revenue Service, 2004 figures 346.0 billion 217.2 billion 156.2 billion 61.3 billion About 132.4 million individual income tax returns were filed in 2004. Some 46.2 million—or 35 percent—of these returns claimed itemized deductions to taxable income. Total itemized deductions equaled close to $972 billion, or just over $21,000 for each return. ANALYZE GRAPHS 1. Which was the largest deduction taken in terms of the dollar amount claimed? 2. What percentage of total deductions taken in 2004 did state and local sales and income taxes represent? Government Revenue and Spending 421 EXAMPLE Indexing Because the federal income tax is a progressive tax, the tax rate increases as taxable income increases. The level of income that causes someone to pay a higher rate of tax is the dividing point between tax brackets. The tax bracket is identified by the tax rate for that income span. For example, the tax schedule at the bottom of this page shows that in 2006 a single taxpayer with $7,550 or less in taxable income is in the 10 percent tax bracket. Someone with taxable income between $7,550 and $30,650 is in the 15 percent tax bracket, someone with taxable income between $30,650 and $74,200 would be in the 25 percent bracket, and so on. Look again at the tax schedule below. Tax Return Checking your taxable income against the various tax brackets is an important step in completing your tax return. Suppose that Scott has $7,000 in taxable income. He is in the 10 percent bracket and pays 10 percent, or $700, in taxes. If, however, he had $8,000 in taxable income, he would be in the 15 percent tax bracket. He would pay 10 percent on the first $7,550 of his earnings and 15 percent on the remaining $450. His total taxes would be $822
.50 ($755 + $67.50) or about 10.3 percent of his income. Indexing is a revision of tax brackets to prevent workers from paying more taxes due to inflation. For example, suppose Scott’s taxable income rises from $8,000 to $8,320—a 4 percent increase—due to inflation. Without indexing, $770 of his income is taxed at the 15 percent rate and he pays $870.50 in taxes, or about 10.5 percent of his income. With indexing, the beginning level of the 15 percent bracket is adjusted by 4 percent to $7, 852. So Scott continues to pay 10.3 percent of his income in taxes. Indexing, therefore, combats the effect of inflation and keeps the rate of taxation relatively constant. APPLICATION Analyzing Effects A. How much of Scott’s income of $8,320 would be taxed at 15 percent if the 10 percent tax bracket were indexed and increased to $7,780? What effect would this have on his overall tax rate? Find an update on tax schedules at ClassZone.com 422 Chapter 14 FICA: Taxes to Ease Hardships KEY C ONCEPT S FICA is the Federal Insurance Contributions Act, a payroll tax that provides coverage for the elderly, the unemployed due to disability, and surviving family members of wage earners who have died. Also known as social insurance, FICA encompasses Social Security and Medicare. Both employees and employers make payments into FICA accounts. Social Security Social Security is a federal program to aid older citizens who have retired, children who have lost a parent or both parents, and people with disabilities. The program began during the Great Depression of the 1930s as a way to help people who were in desperate need of economic assistance. The employer and employee each pay 6.2 percent of the employee’s income up to an annual maximum. In 2006, Social Security tax was applied to $94,200 of earned income. The limit generally rises each year. Medicare Introduced in 1966, Medicare is a national health insurance program for citizens over 65 and certain other groups of people. Employers and employees each pay 1.45 percent of employee income. There is no limit on the amount of income subject to the tax for Medicare. Unemployment Taxes Unemployment compensation is a program funded by federal and state taxes and administered by the states. It provides benefits for a certain period of time to employees who lose their jobs through no fault of their own. Unemployment tax applies to
the first $7,000 earned by an employee and, for the most part, is paid only by employers. QUICK REFERENCE FICA is the Federal Insurance Contributions Act. Social Security is a federal program to aid older citizens, children who have lost a parent, and the disabled. Medicare is a national health insurance program mainly for citizens over 65. FICA Accounts As the American population ages, fears are growing that there will not be enough workers to fund FICA. Source: www.CartoonStock.com AP P LI CATION Applying Economic Concepts B. How would the employee portion of total FICA taxes for an individual earning $100,000 be split between Social Security and Medicare? Show your calculations. Government Revenue and Spending 423 Corporate Income and Other Taxes KEY CONCEPT S The federal government collects more than individual income and FICA taxes. It also uses corporate income, estate, gift, and excise taxes, as well as customs duties and user fees, to finance its operations. Corporate Income Taxes As you recall from earlier in this chapter, corporate income tax is tax on corporate profits. This tax is the third largest source of tax revenue for the federal government. Between 1941 and 1968, corporate income tax was the second largest source of revenue. Since that time, however, it has been surpassed by social insurance taxes. As Figure 14.7 shows, corporate income tax receipts have increased in total dollars since the mid-1900s, but have decreased relative both to total federal tax revenues and to the overall size of the economy. Only certain types of corporations are subject to corporate income tax. These corporations are about 8 percent of all businesses that file tax returns. While the tax rate for most corporations is 35 percent of profits, most pay only about 26 percent of their profits in taxes. Like individuals, corporations can deduct certain expenses from their profits to reduce their taxable income. Some of the most important tax breaks for corporations include deductions for investment in buildings, equipment, and research, and rules that benefit multinational corporations. A common criticism of the corporate income tax is that corporate profits are subject to double taxation. Profits are taxed at the corporate level and again at the individual level, since shareholders pay taxes on the income they receive in the form of dividends or capital gains. In recent years, the tax rate on capital gains has decreased in answer to this criticism. FIGURE 14.7 CORPORATE INCOME TAX RECEIPTS, 1950–2009 Receipts (in millions of $) As Percentage of Total Federal Tax
Revenue As Percentage of GDP 1950–59 1960–69 1970–79 1980–89 1990–99 2000–09* 185,406 262,891 437,564 675,358 1,434,246 2,189,162 Source: The Budget of the United States, FY 2007 *Reflects government budget estimates for 2006–2009 27.5 21.3 15.0 9.3 10.5 10.0 4.8 3.8 2.7 1.7 1.9 1.8 ANALYZE GRAPHS 1. What overall trend is shown in the chart? 2. Which decade diverges from this overall trend? How does it differ from the overall trend? 424 Chapter 14 Other Taxes Several miscellaneous taxes provide a small part of total federal revenue, as you can see in Figure 14.8 below. The estate tax is a tax on property that is transferred to others on the death of the owner. Most estates are not subject to this tax, because the government only taxes large estates. In 2006, estates valued at less than $2 million were not subject to this tax. The gift tax is a tax on money or property given by one living person to another. As with the estate tax, there are exemptions to the gifts that are subject to the tax. For the most part, these exemptions allow family members to give money to other family members tax-free. The excise tax is a tax on the production or sale of a specific product, such as gasoline or telephone service. The sin taxes discussed earlier in this chapter are other examples of excise taxes. In general, the government places excise taxes on goods or services for which there is relatively inelastic demand in order to maintain a steady stream of revenue. The customs duty is a tax on goods imported into the United States from another country. Customs duties are basically excise taxes on imports and are also known as tariffs. (You’ll read more about tariffs in Chapter 17.) The user fee is money charged for the use of a good or service. These fees are based on the benefits-received principle of taxation. For example, the federal government charges entrance, parking, and camping fees to visitors to national parks. So the people enjoying the parks the most pay for the benefits provided by the parks. QUICK REFERENCE The estate tax is a tax on property transferred to others on the death of the owner. The gift tax is a tax on assets given by one living person to another. The excise tax is a
tax on the production or sale of a specific good or service. Customs duty is a tax on goods imported into the United States. A user fee is money charged for the use of a good or service. FIGURE 14.8 SOURCES OF FEDERAL TAX REVENUE 1% 1% 2% 3% 11% 37% Individual income taxes account for almost half of federal tax revenue. Corporate income taxes contribute about onefourth the revenue of individual income taxes 45% Individual Income Taxes Social Insurance Taxes Corporate Income Taxes Excise Taxes Miscellaneous Receipts Customs Duties Estate and Gift Taxes Source: Budget of the United States Government, estimated figures for 2007 ANALYZE GRAPHS 1. What percentage of federal tax revenue comes from individual income taxes and social insurance taxes combined? 2. If total tax revenue for 2007 is estimated to be about $2.35 trillion, about how much revenue will come from individual income taxes? APPL IC ATION Drawing Conclusions C. There are plans to eliminate the estate tax. Who will benefit most from this? Government Revenue and Spending 425 FAST FACTS Maya MacGuineas Title: President, Committee for a Responsible Federal Budget: Program Director, New American Foundation Born: February 21, 1968 Previous Positions Held: Senior Research Analyst, Brookings Institution; Policy Analyst, Concord Coalition; Researcher, PaineWebber Board Memberships: Common Cause (government watchdog group); Centrists.Org and Third Millennium (nonpartisan policy think tanks) Publications: Articles published in Atlantic Monthly, Boston Globe, New York Times, Washington Post, Los Angeles Times, Financial Times Find an update on Maya MacGuineas at ClassZone.com ECO N O M I C S PAC ES E T T E R Maya MacGuineas: Reforming the Tax System For the most part, tax reform measures of the last few years have involved tinkering with tax rates, exemptions, and deductions. Maya MacGuineas, a tax policy analyst, thinks that it’s time for far more dramatic change—a complete overhaul of the U.S. tax system, in fact. A Tax Revolution? Why does MacGuineas think that such drastic action is needed? The present tax system, she says, is complicated, inefficient, and unfair, and doesn’t raise the revenue to fund all of the government’s programs. The new tax system, she argues, ought to be based on simplicity, efficiency, equity, and responsible budgeting. To this end
, MacGuineas suggests that the income tax should be simplified by ending most tax deductions and exemptions. This, she says, would also make the system more equitable, since taxpayers in higher marginal tax brackets gain the greatest benefit from these measures. In part for reasons of efficiency, MacGuineas believes that the corporate income tax should be phased out. She also supports new environmental taxes, a different approach to how the estate tax is levied, and a complete restructuring of the nation’s entitlement programs. Perhaps MacGuineas’s most revolutionary measure involves FICA taxes, which she thinks should be replaced with a progressive consumption tax. Such a tax would be tied to total spending rather than income, with rates rising as spending levels rise. For example, the first $20,000 spent would be tax-free, spending between $20,000 and $50,000 would be taxed at 10 percent, spending between $50,000 and $175,000 would be taxed at 15 percent, and so on. In other words, people who spend more would face progressively higher marginal tax rates. A progressive consumption tax would not only be simpler and fairer, MacGuineas argues, it would also provide tremendous incentives to save. APPLICATION Making Inferences Tax Reform Maya MacGuineas wants to make the tax system more equitable and less complex. D. Should spending on education and housing be exempt from MacGuineas’s consumption tax? Why or why not? 426 Chapter 14 S E C T I O N 2 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs. a. taxable income b. FICA tax return Social Security c. estate tax gift tax 2. Why is indexing important to taxpayers? 3. What is the role of the IRS in relationship to federal taxes? 4. How are excise taxes and customs duties similar? How are they different? 5. How are payroll taxes and user fees different? 6. Using Your Notes What two programs are financed by FICA? Refer to your completed cluster diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com Federal Taxes. Analyzing and Interpreting Data In 2005, the 10 percent tax bracket limit was $7,300. In 2006, it increased to $7,550. By what percentage did the tax bracket limit increase? How does this example illustrate the concept of indexing? 8. Applying Economic Concepts The Social Security tax rate for employees
is 6.2 percent, and the Medicare tax rate is 1.45 percent. Are both parts of the FICA tax proportional? Give reasons for your answer. 9. Drawing Conclusions Study these two statements about tax payments for the 2005 tax year: • On average, an individual with $100,000 in taxable income paid about 29.5 percent in combined income and FICA taxes. • On average, an individual with $150,000 in taxable income also paid about 29.5 percent in combined taxes. Why were the combined tax rates the same for these two taxpayers? 10. Challenge Review the data in Figure 14.7. As a share of federal tax revenue and as a share of GDP, by what percentage have corporate income taxes declined between the 1950s and the first decade of the 21st century? Analyzing Tax Schedules The IRS provides tax schedules, or tables, to help taxpayers calculate their taxes. Calculate Taxes Suppose that you work for a tax preparation company. Use the tax schedule on page 422 to answer the questions about the taxpayers described below. a. Chris has $8,500 in taxable income. What is her tax bracket, how much tax does she pay, and what is her actual tax rate? b. Miguel earned $35,000 in taxable income this year. How much more does he pay in taxes than if he had earned $30,000? c. Meredith had $125,000 in taxable income and had $30,000 in taxes withheld. Will she receive a refund or owe money? How much? Challenge Calculate the FICA taxes and tax rates for each of the above taxpayers. 427 S E C T I O N 3 Federal Government Spending TA K I N G N O T E S In Section 3, you will • compare the two types of government expenditures • explain how the federal budget is developed • describe how government payments are made • identify the impact that federal spending has on the economy mandatory spending, p. 428 discretionary spending, p. 428 entitlements, p. 428 Medicaid, p. 429 federal budget, p. 431 fiscal year, p. 431 appropriations, p. 431 transfer payments, p. 432 grant-in-aid, p. 432 private sector, p. 432 As you read Section 3, complete a hierarchy diagram to track main ideas and details. Use the Graphic Organizer at Interactive Review @ ClassZone.com Federal Spending main idea main idea details details Federal Expenditures KEY CONCEPT S QUICK REFERENCE Mandatory spending is required
by law. Discretionary spending has to be authorized each year. Entitlements are social welfare programs with specific requirements. As you have seen, the federal government takes in a huge amount of money in taxes. The programs and services the federal government funds with this revenue are divided into two categories. These are mandatory spending, or spending that is required by current law, and discretionary spending, or spending that the government must authorize each year. For example, the law requires that the government spend money to fund the Social Security and Medicare programs. However, the federal government can decide to fund or not fund highway construction or maintenance of national parks. The federal government, then, has certain expenses that must be paid under current law, while other expenses are covered with what is left after those required expenses have been met. TYPE 1 Mandatory Spending Mandatory spending makes up well over half of all federal spending. Most of this spending is in the form of entitlements, which are social welfare programs with specific requirements. Social Security and Medicare are entitlement programs that provide payments to anyone who is eligible based on age or disability. Many Medicare About 42 million Americans are enrolled in the Medicare program. 428 Chapter 14 of these programs are not “means tested.” In other words, anyone who meets the eligibility requirements receives the benefits, regardless of income level. For some other programs, however, income level is part of the requirement. Social Security The Social Security program takes the largest amount of federal spending. It provides benefits to older retired workers, disabled workers with limited incomes, and survivors of workers who have died. Social Security is financed through a payroll tax. Therefore, workers must have worked for a certain period of time before they are eligible to receive full benefits under the program. As the population of the United States has gotten older and more people have retired, costs for Social Security have increased. To help control costs, the government has gradually raised the age of full retirement—the point at which a worker is eligible to receive maximum benefits. Full retirement age ranges from 65 to 67, depending on the person’s year of birth. Retirement benefits are not means tested. However, if retirees have additional income, benefits may be subject to withholding. For example, in 2006 retirees could earn $1,040 a month and still receive full Social Security benefits. However, retirees who earned more than this amount had their benefits reduced by $1 for every $3 over the income limit. Medicare The Medicare program was introduced in 1966 as an additional old-age benefit under Social Security
. Originally, Medicare provided hospital insurance, funded by a payroll tax, for people over 65, as well as optional medical coverage for items such as doctor bills. This part of Medicare is funded by premiums paid by those choosing the coverage and by general tax revenues. Because of increasing numbers of retirees and increasing health care costs, Medicare costs have risen dramatically since the program began. Beginning in 2006, reforms to the program required Medicare to compete with private health insurance providers. Means testing was added for all but the lowest-income group of senior citizens. In addition, some coverage was added for prescription drugs. Medicaid Established at the same time as Medicare, Medicaid is a joint federal-state medical insurance program for low-income people. The federal government funds about 63 percent of the costs of the program, and the states pay about 37 percent. In recent years, states have tightened their eligibility requirements for Medicaid in an effort to control costs. Find an update on Social Security at ClassZone.com QUICK REFERENCE Medicaid is a government medical insurance program for low-income people. Other Mandatory Spending Programs There are a variety of other mandatory spending programs that define eligibility requirements and are then funded based on an estimate of how many people meet those requirements. The Food Stamp program provides funds for about 26 million low-income people to purchase food. Veterans’ benefits include health care coverage and disability payments for service-related illness or injury. People who have served in the military are also eligible for education assistance. The federal government spends about $50 billion a year on veterans’ benefits. Payments for the federal portion of unemployment insurance are also part of mandatory spending. In addition, the federal government pays its workers some retirement benefits. Federal employees hired after 1983 are also eligible for some Social Security retirement benefits. Services for Veterans The Veterans Administration serves the needs and represents the interests of some 26 million veterans and their dependents. 429 TYPE 2 Discretionary Spending More than one-third of federal revenue is devoted to discretionary spending. The programs covered by discretionary spending fall into several different categories. These categories include • interstate highway system and transportation programs, such as Amtrak; • natural resources and the environment, including conservation programs, pollu- tion clean-up, and national parks; • education, most notably college tuition assistance; • science, space, technology, and other research programs; • justice administration, including enforcement agencies, such as the Federal Bureau of Investigation (FBI), and the federal court system. The largest discretionary expenditure category, however, is national defense, which takes
up about 50 percent of the total discretionary budget. National defense includes a large amount of the nation’s military spending, including the salaries of military personnel, weapons, and the construction and maintenance of military bases. Not all national defense spending is discretionary. Some spending on homeland security—border protection and the enforcement of some immigration laws, for example—falls in the mandatory expenditures category. In addition, certain military spending, such as additional funding requests for the wars in Iraq and Afghanistan, is outside the basic federal budget. YO U R EC DISC RETIONARY SPENDING How will you assign discretionary spending funds? Two programs are competing for $100 million in discretionary funds—an initiative to improve math and science education in high schools and a research project to test new developments in toy safety. How will you advise officials to assign the funds and why?? Safer toys Math class APPLICATION Categorizing Economic Information A. Categorize the following items as either mandatory spending or discretionary spending: AIDS prevention programs, air traffic regulation, medical coverage for lowincome people, pollution control, retirement benefits for older workers. 430 Chapter 14 The Federal Budget and Spending KEY C ONCEPT S Each year the President and Congress work together to establish the federal budget, a plan for spending federal tax money. The budget is prepared for a fiscal year, a 12-month period for which an organization plans its expenditures. The federal government’s fiscal year runs from October 1 through September 30. The President’s budget is prepared by the Office of Management and Budget (OMB) and takes into account estimated tax receipts and requests by all federal departments and agencies. Figure 14.9 shows the OMB budget estimate for fiscal year 2007. Congress Acts on the Budget The Congressional Budget Office helps the House and Senate develop guidelines for different appropriations, which are set amounts of money set aside for specific purposes. Members of Congress often make deals to gain votes for appropriations that they support. Congress votes on the final budget and sends it to the president for approval. If the budget is not approved by the beginning of the new fiscal year, Congress passes resolutions to keep the government running on a day-to-day basis. Methods of Federal Spending After budget approval, the funds are spent in several ways. One way is direct spending, by which the government buys goods and services that it needs to operate, such as military equipment and office supplies. Paying the salaries of government QUICK REFERENCE The federal budget is a plan for spending federal tax money. A
fiscal year is a 12-month period for which an organization plans its expenditures. Appropriations are specific amounts of money set aside for specific purposes. FIGURE 14.9 THE FEDERAL BUDGET a 9% 3% 21% 10% b 11% c 14% 15% Source: The Budget of the United States, FY 2007 Social Security National Defense Medicare Income Security 17% Health Net Interest Other Education a This category includes spending for veterans’ benefits, energy, the environment, transportation, and other government programs. b Net interest is the interest that the federal government pays on loans it has taken out. c Income security includes retirement for certain government employees and housing and food programs for lowincome people. ANALYZE GRAPHS 1. What is the largest category of spending in the federal budget? 2. Approximately how much of the federal budget goes to health and education? Government Revenue and Spending 431 QUICK REFERENCE Transfer payments are money distributed to individuals who do not provide anything in return. A grant-in-aid is a transfer payment from the federal government to state or local governments. The private sector is the part of the economy owned by individuals or businesses. employees is another type of direct spending. A second way the government spends the money is through transfer payments—money distributed to individuals who do not provide goods or services in return. A grant-in-aid is a transfer payment from the federal government to state or local governments. Transfer Payments These payments are generally part of the mandatory spending you learned about earlier. For example, Social Security retirement or disability benefits and health care benefits from Medicare or veterans’ programs are transfer payments from the government to individuals. The individuals do not provide specific goods or services in exchange for these government funds. Grants-in–aid These grants are transfer payments between levels of government. The federal government makes grants to states, local governments, and regions. The grants are designated for specific categories of activities such as highway construction, certain school services, or Medicaid funding. The Impact of Federal Spending Because the federal government spends trillions of dollars, it is a big factor in the economy. The federal government influences the economy in three ways: resource allocation, income redistribution, and competition with the private sector, which is that part of the economy owned by individuals or businesses. Resource Allocation The federal government makes choices concerning where to spend money and on what to spend it, and that influences how resources are allocated. For example, if money goes to urban transit, it cannot go to fix rural roads.
Similarly, money spent on weapons systems for the military cannot be spent on some other program, such as environmental protection. Income Redistribution Government spending affects the incomes of families, individuals, and businesses. Transfer payments for health care, retirement, and Food Stamp benefits, for example, provide income support for many low-income earners. How the government awards work contracts can also influence the distribution of income. For example, if the government awards a contract to build several submarines to a shipyard in the Northeast, workers there will be assured work and an income. However, workers at a California shipyard that failed to get the contract may lose their jobs. In turn, they will not have income to spend at local businesses. Competition with the Private Sector The government may produce goods or services that are also produced in the private sector. Examples include veterans’ hospitals that compete with privately owned hospitals, or federal housing that competes with homes and apartments provided by private developers and landlords. Government Contracts A government contract, such as one to build submarines, has a huge impact on local, state, and regional economies. APPLICATION Drawing Conclusions B. How are transfer payments related to income redistribution? 432 Chapter 14 S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs. a. mandatory spending entitlement b. federal budget fiscal year c. transfer payment grant-in-aid 2. What is the difference between mandatory spending and discretionary spending? 3. Why is Medicaid an example of an entitlement program? 4. What does Congress do when it decides on appropriations? 5. How does the government compete with the private sector? 6. Using Your Notes How is the federal budget established? Refer to your completed hierarchy diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com Federal Spending main idea main idea details details. Making Inferences Between 2007 and 2009, spending on Social Security is projected to remain at 21.5 percent of the federal budget, while spending on education is projected to decline from 3.4 percent to 3.1 percent of the budget. How does this show the difference between mandatory and discretionary spending? 8. Categorizing Economic Information Categorize each of these examples of federal spending as direct spending, transfer payment, or grant-in-aid: • computers for IRS • money for urban • disability benefits • flood control in Gulf Coast region • highway funds for states housing • price supports for farmers • repair of space shuttle • salaries for national
• medical care for elderly park rangers 9. Challenge Molly’s grandmother was born in 1943. If she retires in 2005, she’ll receive $750 per month in Social Security benefits. If she waits until 2009, she will receive $1,000, and if she waits until 2010, her monthly benefit increases to $1,080. Why do you think Congress structured the Social Security benefit payments program in this way? Military base entrance Studying Economic Impact Consider what you have learned about the impact of federal spending on the economy. The chart below shows information on the impact of a hypothetical military base on an area’s economy. Direct military base employment Additional related jobs Payments to private health care providers Contracts for goods and services State and local taxes 27,400 jobs, $1 billion payroll 19,500 jobs, $800 million payroll $19 million $115 million $102.8 million Analyze Data Study the chart to answer these questions: • What is the total number of jobs attributable to the military base? • How much does the base spend on health care? Challenge Write a summary of the economic impact of the military base. Government Revenue and Spending 433 S E C T I O N 4 State and Local Taxes and Spending TA K I N G N O T E S In Section 4, you will • identify the major sources of revenue for both state and local governments • examine the concept of a balanced budget • describe the major categories of state and local expenditures balanced budget, p. 436 operating budget, p. 436 capital budget, p. 436 tax assessor, p. 437 As you read Section 4, complete a chart using the key concepts and other helpful words and phrases. Use the Graphic Organizer at Interactive Review @ ClassZone.com State Government Local Government Revenue Spending Revenue Spending State Revenues KEY CONCEPT S As you recall from earlier in this chapter, all levels of government may impose taxes to raise revenue to support their activities. The federal government has the broadest tax base, while the smallest tax base is at the local level. There are thousands of local governmental units, from towns, cities, and counties to districts set up to handle a specific problem such as mosquito control or sewage treatment. State revenues come from a variety of sources, the largest of which is intergovernmental revenue, mostly grants-in-aid from the federal government. States also raise funds from state sales taxes and from state income tax, both on individuals and on corporations. (See Figure 14.11 on page 437.)
TYPE 1 Sales and Excise Taxes All states except Alaska, Delaware, New Hampshire, Montana, and Oregon levy a state sales tax. Rates range from 2.9 percent in Colorado to 7.25 percent in California. These taxes generally are applied to most goods and services sold within the state. However, many states exempt food and prescription drugs from sales tax. Some other states tax these goods, over-the-counter drugs, and certain other medical supplies at a lower rate. In addition, charitable, religious, and educational organizations are often exempt from paying sales taxes. All states also have excise taxes on cigarettes, alcohol, gasoline, and diesel fuel. Certain government organizations, volunteer fire-fighting companies, and farmers may be exempt from fuel taxes. Many states also have special sales taxes that mostly affect tourists, such as taxes on car rentals and hotel and motel room rates. Find an update on state sales taxes at ClassZone.com 434 Chapter 14 T YPE 2 Income Tax and Other Revenue Sources Income taxes account for some 16 percent of states’ total revenue. Most states levy taxes on both individual and corporate income. However, Alaska, Florida, and Texas have no individual income tax. And Nevada, South Dakota, Washington, and Wyoming levy neither individual nor corporate income taxes. Most states have progressive tax rates on individual income and flat tax rates on corporate income. Individual income tax rates range from a low of 0.36 percent for the lowest tax bracket in Iowa to 9.5 percent for the highest tax bracket in Vermont. Figure 14.10 below compares average individual income tax rates and sales tax rates for several states. FIGURE 14.10 COMPARING STATE TAXES California Colorado No Tax Florida Illinois New York Ohio No Tax Texas Key: Average Individual Income Tax Rate Sales Tax Rate Individual income tax rates for California, New York, and Ohio are averages of lowest and highest brackets. Colorado and Illinois have a flat rate income tax. Florida and Texas have no state income tax. Source: Federation of Tax Administrators ANALYZE GRAPHS 1. Which state has the highest income tax rate? Which has the highest sales tax rate? 2. Which state has the heaviest tax burden? The average state corporate tax rate is about 6.8 percent, ranging from a low of 1 percent for the lowest brackets in Alaska and Arkansas to Pennsylvania’s flat rate of 9.99 percent. Many state governments structure their corporate tax rates to attract businesses to the state. These governments have used billions of dollars in tax cuts
and incentives for businesses to promote economic development. However, states receive benefits from these tax practices in the increased economic activity that development brings. States also raise revenue from several other sources. Many of these sources, including estate taxes and user fees, are the same as those used by the federal government. (See Figure 14.8 on page 425.) Most states also levy property taxes. In addition, most states charge several fees related to business operations. These include registration fees for certain types of businesses and license fees for doctors, dentists, lawyers, and accountants. AP P LI CATION Comparing Economic Information A. How do state income tax rates compare to federal income tax rates? Government Revenue and Spending 435 QUICK REFERENCE A balanced budget requires that total government revenue is equal to total government spending. An operating budget is a plan for day-to-day expenses. A capital budget is a plan for major expenses or investments. State Budgets and Spending KEY CONCEPT S All states except Vermont are required to have a balanced budget, in which total government revenue from all sources is equal to total government spending. However, balanced-budget requirements usually apply only to certain kinds of spending. Further, nearly every state has a reserve fund or may run a surplus, both of which can be used to balance the budget in subsequent years. State Budgets States actually work with two types of budgets—an operating budget, a plan for day-to-day expenses, and a capital budget, a plan for major expenses or investments. The operating budget generally covers expenses that occur each year, such as salaries for state government employees, payments for health and welfare benefits, and funds for education systems. Capital budgets provide funds for large construction and maintenance projects on state buildings, roads, and bridges, as well as for land acquisition for state construction needs or state parks. Usually, operating budgets are subject to balanced-budget requirements. Capital budgets are not, because they are usually funded through borrowing. In fact, capital budgets often are run at a deficit, meaning that more is spent than is collected in revenues. State Expenses Education is a major expense for the states, which not only support community colleges and state university systems but also provide assistance to local school districts. For example, state assistance accounted for about 49 percent of public school funding in 2002. Public safety, too, is a significant state expense. Spending on public safety includes state police, crime labs, and prisons and other correctional facilities. States also support a court system. Public welfare expenses involve funds for st
aterun hospitals as well as cash assistance and medical care payments to the needy. States also fund programs that help citizens with problems related to housing, disability, unemployment, and job training. Other expenses include state government administration, retirement funds for state employees, natural resources, and economic development. Deficit Spending Both federal and state governments practice deﬁ cit spending—spending more than they collect in revenues—to cover their expenses. APPLICATION Categorizing B. Would a grant to a city to build a new sewage treatment plant be part of the city’s operating budget or capital budget? 436 Chapter 14 Local Revenue and Spending KEY C ONCEPT S Local government units include counties, cities, towns, villages, townships, school districts, and other special districts. They have fewer options for raising revenue than do other levels of government. Their major revenue sources are intergovernmental revenue—or transfers—from state and federal governments and property taxes. Local governments also tap other sources, many of which are similar to the state tax base. Figure 14.11 shows revenue sources for state and local governments. Property Tax Recall that you read about property tax in the first section of the chapter. This tax can be levied on real estate and on personal property such as motor vehicles, boats, expensive jewelry, or computers. Local governments rely on a tax assessor, a government official who determines the value of the property. They then enact a tax based on a percentage of the property’s value. Other Taxes Local governments also use sales taxes, sin taxes on activities such as gambling, hospitality taxes on hotels and restaurants, entertainment taxes on tickets or entrance fees, and payroll taxes. The local payroll tax is a tax on people who work in a city but live outside the city. Such a tax is often used in large metropolitan areas where workers from the suburbs benefit from city services such as police and fire protection. F I G U R E 14.11 S O U RC ES O F S TAT E A N D LO C A L G OV State Government Revenue Local Government Revenue QUICK REFERENCE A tax assessor determines the value of property. less than 1% 2% 6% 34% 25% 1% 2% 14% 21% 37% Intergovernmental revenue Property tax Sales and excise taxes Individual income tax Corporate income tax Other Source: U.S. Census Bureau, figures for 2002–2003 28% 30% ANALYZE GRAPHS 1. What are the two largest sources of revenue for both state and
local governments? 2. Which type of government gets a larger percentage of its revenue from sales and excise taxes? Government Revenue and Spending 437 Local Spending Local governments provide most of the direct services that citizens receive. To deliver these services, local governments employ almost three times the number of workers as state governments do. Some of the most important areas of local spending are described below. Public Schools Local governments have the main responsibility for elementary and secondary schools. About 46 percent of local government spending goes to education. Government funds pay for construction and maintenance of school buildings, salaries for teachers, administrators, and other personnel, as well as for items such as textbooks and computers. Reliance on the property tax has led to difficulties for many local governments, since communities with lower property values have smaller tax bases to finance education. Public Safety Local governments provide police and fire protection to secure lives and property in their communities. They are also responsible for emergency medical equipment and personnel to provide on-site treatment and transportation to medical facilities. Local governments maintain the 911 emergency telephone number system. Other expenditures in this category include animal control, consumer protection, and preparation for and response to natural disasters. Public Welfare Local governments spend less than state governments on direct payments for medical care and assistance to the needy. However, many local governments maintain public health departments, and some own and operate their own hospitals. Local health departments are concerned with immunization programs, environmental health, and maintaining birth and death records. They also are responsible for making sure that restaurants meet health standards. Public Safety Ensuring the safety of life and property in the community—by providing ﬁ re protection, for example—is the responsibility of local government. Other Responsibilities Local governments also have primary responsibility for providing most public utilities such as water, public transit, sewage systems, and trash removal. They maintain local highways, roads, and streets, including traffic control lights and signs, snow removal, and pothole repair. Finally, local governments provide many kinds of recreational and cultural facilities including parks, recreation centers, swimming pools, and libraries. APPLICATION Drawing Conclusions B. Why do local governments rely more on property taxes as a source of revenue than do 438 Chapter 14 state governments? S E C T I O N 4 Assessment ClassZone.com AC T I C E 1. Use each of the three terms below in a sentence that illustrates the meaning of the term. a. balanced budget b. capital budget c. tax assessor 2. What is the difference between an operating budget and a capital budget?
3. How is an operating budget related to a balanced budget? 4. What is the largest revenue source for state governments? What is the largest source for local governments? 5. Why do local governments need tax assessors? State Government Local Government Revenue Spending Revenue Spending 6. Using Your Notes What kinds of education do state and local governments spend money on? Refer to your completed chart. Use the Graphic Organizer at Interactive Review @ ClassZone.com. Comparing and Contrasting What are the similarities and differences in the sources of revenue for state and local governments? 8. Analyzing Effects Which level of government would be most affected if the federal government decided to limit the amount of money that it spent on the Medicaid program? Give reasons for your answer. 9. Making Inferences Voters in your city must decide whether to raise revenue by increasing the rate of property tax for owners of homes and businesses or by placing a new tax on motel and hotel room rates and car rentals. Which tax are voters more likely to choose? Give reasons for your answer. 10. Challenge Between 1992 and 2002, average state funding for public schools increased from 46 percent of all state expenditures to 49 percent of all state expenditures. At the same time, local government funding of public schools decreased from 47 percent to 43 percent. Why do you think the source of school funding has changed in this way? School board meeting Using a Decision Making Process Suppose that you are on a local school board. Total budget for the school district is $25,000,000. The chart below lists the items to be funded out of this budget. Priority Spending Category Administrative salaries Classroom computers School lunch program Special education programs Teacher salaries Textbooks and other instructional materials Utilities Decide on Funding Priorities Use a decision-making process to decide how to allocate the budget. Complete the chart by ranking the items from 1 to 7, from most important to least important. Challenge Based on your priorities, allocate a percentage of the budget to each category. 439 Case Study Find an update on this Case Study at ClassZone.com Should Online Sales Be Taxed? Background In 1992 the Supreme Court upheld a law making Internet retailers exempt from collecting most sales taxes. The ruling was based on the fact that, at the time, the various state and local rules for tax collection varied widely. The differing rules would have placed a heavy burden on Internet retailers charged with having to collect taxes on what they sold. Today, however, tax collection is becoming simpler and more streamlined. In addition, Internet purchases have become commonplace
, with shoppers buying everything from computers to airplane tickets. Many online shoppers fail to realize that they are required to pay sales tax for Internet purchases at their home state’s rate. To date, most states have tried to collect Internet sales tax on a voluntary basis. Needless to say, results have been poor. Given this and other considerations, Internet sales tax once again is a subject for debate. What’s the issue? Should there be sales tax on Internet purchases? Study these sources to discover arguments for and against taxing purchases online. A. Online News Story This news story on whether to impose the “iPod tax”—a tax on digital products—illustrates the differences of opinion on online sales tax. Entertainment Lovers May Soon Pay Tax on Downloads Wisconsin governor and legislators disagree over “iPod” tax. Wisconsin Gov. Jim Doyle now wants his state to start collecting taxes on digital music, videos and software. Key Republicans in the GOP-dominated legislature say they will block the proposal, but administration officials say they’re just trying to make things fair. “It’s an issue of tax equity,” said Jessica Iverson, a spokeswoman for the Wisconsin Department of Revenue. “If you go into a Main Street business and purchase a CD, you are paying tax....” Economists are split... as to whether adding these kinds of taxes is a good idea. Some say that taxes on digital goods will hamper the growth of a potentially vibrant new marketplace, while others say that having taxes only on offline versions of the same goods distorts the operation of free markets. Source: News.com, March 10, 2005 Thinking Economically What do you think economists mean when they say that taxing only offline versions of the same goods “distorts the operation of free markets”? 440 Chapter 14 B. Graph This graph shows the growth of online purchases during the 2000s. F I G U R E 14.12 U. S. O N L I N E P U RC H A SES ) 90 80 70 60 50 40 30 20 10 0 87.8 70.7 56.5 44.8 34.4 27.6 2000 2001 2002 2003 2004 2005 Source: U.S. Census Bureau Thinking Economically How might state and local governments use the information in the graph to support their demand to levy sales taxes on online purchases? C. Newspaper Editorial Some states are becoming proactive in their efforts to promote Internet sales tax
. This newspaper editorial describes one multistate project to facilitate the collection of the tax. Internet Sales Tax Eighteen states agree to establish uniform sales tax rules. Last week, 18 state tax collectors met in Chicago to announce an interstate agreement establishing uniform sales tax rules. Starting in October, the group will offer free software that will allow any business to easily collect the required taxes online. The states’ demonstration project will drive home the point that online sales-tax collection can be done nationwide. Many retailers already collect the taxes. Now Congress should step up and pass a law overturning the court’s exemption in states that have streamlined their tax systems. That would allow hard-pressed states to take in roughly $20 billion a year in annual sales tax revenue that is rightfully theirs, and perhaps much more, depending on the growth in online shopping. It would also help level the playing field between local and online retailers. Source: “Internet Sales Tax,” New York Times, July 5, 2005 Thinking Economically What impact has Internet shopping had on state and local revenues? Explain your answer. THINKING ECONOMICALLY Synthesizing 1. Summarize the arguments for and against an Internet sales tax as presented in the documents. 2. Who is most likely to benefit from Internet sales tax revenue? Explain your answer, using information from the documents. 3. How has government responded to e-commerce—the selling of goods and services online? Use information from the documents in your answer. Government Revenue and Spending 441 Review this chapter using interactive activities at ClassZone.com • Online Summary • Quizzes • Vocabulary Flip Cards • Graphic Organizers • Review and Study Notes Complete the following activity either on your own paper or online at ClassZone.com Choose the key concept that best completes the sentence. Not all key concepts will be used. ability-to-pay principle of taxation balanced budget benefit principle of taxation capital budget discretionary spending entitlement incidence of tax indexing mandatory spending progressive tax proportional tax regressive tax revenue tax tax base tax incentive tax return taxable income transfer payment withholding 1 is a mandatory payment to a government. 2 is government income. The 3 holds that people should be taxed on their ability to pay, no matter the level of benefits they receive. A 4 is the income, property, goods or services subject to taxes. A 5 takes the same percentage of income from all taxpayers. A 6 places a higher rate of taxation on high-income people, and a 7 takes a larger percentage of income from low
-income people. The 8 is the final burden of tax. 9 is money taken from a worker’s pay before the worker receives it. 10 is a revision of tax brackets to prevent workers from paying more taxes due to inflation. Social Security is an example of an 11, a social welfare program with specific requirements. Such programs make up most of federal 12, which is spending that is required by law. States are required to have a 13, in which government revenue and spending are equal. 442 Chapter 14 CHAPTER 14 Assessment How Taxes Work (pp. 410–419) 1. What is the relationship between tax and revenue? 2. Identify three ways that taxes affect the economy. Federal Taxes (pp. 420–427) 3. What is the largest source of federal revenue? 4. Which tax pays for Social Security and Medicare? Federal Government Spending (pp. 428–433) 5. What are three programs that make up most mandatory spending? 6. How does federal spending affect the economy? State and Local Taxes and Spending (pp. 434–441) 7. What are the two types of state budgets? 8. What tax base are tax assessors concerned with? A P P LY Look at the chart below showing average combined city and state tax rates for families with different incomes in several cities. FIGURE 14.13 STATE AND LOC AL TA XES FOR A FAMILY OF FOUR City Atlanta Chicago Houston Total taxes paid as a percent of income $25,000 $50,000 $75,000 $100,000 $150,000 8.1 10.3 11.4 11.5 11.7 9.3 9.5 10.0 9.7 9.3 6.2 6.0 6.3 5.9 5.5 Jacksonville 4.3 4.6 5.0 4.8 4.6 Los Angeles 8.6 8.7 10.3 11.2 12.3 New York 5.6 10.8 12.7 13.4 14.1 Philadelphia 11.0 13.2 13.0 12.6 12.2 Source: Statistical Abstract of the United States, 2002 figures 9. Which city has the lowest tax rate for the lowest- income families? Which has the lowest tax rate for the highest-income families? 10. Which combined city and state tax structures are progressive and which are regressive 11. Creating Graphs The state legislature proposes Develop a Federal Budget new 10 percent excise taxes on the following goods and services
: gasoline, ice cream, local telephone service, and sports cars. For each good or service create supply and demand curves showing the supply curve before the tax and how the supply curve shifts after the tax. Under each graph, write a caption explaining who will pay more of the tax— the consumer or the producer—and why. Use complete this activity. @ ClassZone.com to 12. Analyzing Data Shandra earns $30,000 per year from her job as a radiology technician. She takes a personal exemption of $3,200 and the standard deduction of $5,000 to reduce her taxable income. a. If she pays 10 percent tax on the first $7,300 of taxable income and 15 percent on the rest, how much does she pay in income tax? b. Shandra’s FICA tax rate is 7.65 percent. What are her FICA taxes? c. How much total tax does Shandra pay? What is her effective tax rate as a percentage of her taxable income and of her total income? 13. Making Inferences When Rajiv goes shopping for a new MP3 player, he notices that he pays 7.35 percent sales tax on the purchase. He knows that the state sales tax rate is 4.22 percent. What accounts for the difference? 14. Comparing and Contrasting All states have excise taxes on cigarettes and gasoline. What are the similarities and differences in the reasons why states tax these two items? 15. Challenge In 2003, Congress reduced the tax rate paid by individual investors on dividends and capital gains to 15 percent. Previously the rate for dividends had been as high as 38.6 percent, and capital gains had been taxed at 20 percent. Which of these changes addressed the charge that corporate income is subject to double taxation? Give reasons for your answer. Step 1 Choose a partner. Imagine that you are members of Congress who must determine the discretionary spending portion of the federal budget. The table below shows the categories of spending. You have a total of $960 billion to spend. Determine your spending priorities by deciding what percent of the budget to allocate to each category. FEDER AL DISC RE T IONA RY SPENDING C ATEGORIES Administration of justice Health (non-Medicaid) Agriculture International affairs Community & regional development Education Energy National defense Natural resources & environment Science, space & technology General government Transportation Step 2 Form a group with two or three other pairs of students so that there are now a total of four groups in the
class. Compare your budgets, noting areas of agreement and disagreement. Negotiate to develop a single budget proposal for your group. Step 3 Present your group’s budget proposal to the class. Include a list of reasons to support your budget choices. Step 4 As a class, decide on a final recommendation that resolves any differences among the four budget proposals. Step 5 Present your final budget to your teacher, who is acting as the President. Make necessary changes to the budget to resolve any differences between the Congress and the President. Government Revenue and Spending 443 Government Federal government actions in the areas of taxing and spending are designed to enhance the nation’s economic stability. 444 CHAPTER 15 SECTION 1 What Is Fiscal Policy? SECTION 2 Demand-Side and Supply-Side Policies SECTION 3 Deficits and the National Debt CASE STUDY Is the Federal Deficit Too Large? Using Fiscal Policy The business cycle is the series of growing and shrinking periods of economic activity. C H A P T E R 15 Fiscal policy uses taxes and government spending in an effort to smooth out the peaks and troughs of the business cycle AT T E R S In history classes, you’ve probably read about instances of rampant inflation when people needed bags and bags of cash to pay for their groceries. Or you might have read about periods of economic depression when millions of workers lost their jobs. By using a combination of spending and taxation, the federal government tries to reduce the impact of such economic extremes. More at ClassZone.com Go to ECONOMICS UPDATE for chapter updates and current news on the federal deficit. (See Case Study, pp. 468–469.) Go to ANIMATED ECONOMICS for interactive lessons on the graphs and tables in this chapter. Go to INTERACTIVE REVIEW for concept review and activities. Source: www.CartoonStock.com How big a problem is the federal deficit? See the Case Study on pages 468–469. Using Fiscal Policy 445 S E C T I O N 1 What Is Fiscal Policy TA K I N G N O T E S In Section 1, you will fiscal, p. 446 • examine the tools used in fiscal policy, p. 446 fiscal policy • determine how fiscal policy affects the economy • identify the problems and limitations of fiscal policy expansionary fiscal policy, p. 446 contractionary fiscal policy, p. 446 discretionary fiscal policy, p. 446 automatic stabilizers, p. 447 rational expectations theory, p. 452 Council of Economic
Advisers, p. 452 As you read Section 1, complete a cluster diagram that organizes the main ideas about fiscal policy. Use the Graphic Organizer at Interactive Review @ ClassZone.com Fiscal Policy Fiscal Policy Tools KEY CONCEPT S QUICK REFERENCE Fiscal refers to government revenue, spending, and debt. Fiscal policy uses taxes and government spending to affect the economy. Expansionary fiscal policy is a plan to increase aggregate demand and stimulate the economy. Contractionary fiscal policy is a plan to reduce aggregate demand and slow the economy. Discretionary fiscal policy refers to actions selected by the government to stabilize the economy. 446 Chapter 15 In Chapter 14, you learned that the government puts the tax dollars it collects to a variety of uses. The term fiscal refers to anything related to government revenue, spending, and debt. Fiscal policy is the federal government’s use of taxes and government spending to affect the economy. Fiscal policy has one of two goals: to increase aggregate demand or to fight inflation. To stabilize or strengthen the economy, the government may use one of two basic policies. When the economy slows, the government may use expansionary fiscal policy, a plan to increase aggregate demand and stimulate a weak economy. When the economy is in an inflationary period, the government may use a contractionary fiscal policy, a plan to reduce aggregate demand and slow the economy in a period of too-rapid expansion. The federal government has two basic fiscal tools to influence the economy: taxation and government spending. Discretionary Fiscal Policy As you learned in Chapter 14, discretionary spending is spending that the government must authorize each year. In other words, the government must make a choice about this type of spending. Similarly, discretionary fiscal policy involves actions taken by the government by choice to correct economic instability. This type of policy involves an active government response, through choices about taxes or government spending, to help stabilize the economy. Congress must enact legislation for these policies to be implemented. This type of fiscal policy is discussed in more depth later in this section and in Section 2. Automatic Stabilizers Unlike discretionary fiscal policy, automatic stabilizers are features of fiscal policy that work automatically to steady the economy. Both of these approaches use taxes and government spending to influence the economy. Discretionary fiscal policy involves government choices about whether an expansionary or contractionary policy is needed and how the chosen policy should be put into action. Automatic stabilizers, such as public transfer payments and progressive income taxes, may work in an expansionary or contractionary manner
, but they work automatically rather than through active policy choices. QUICK REFERENCE Policy features called automatic stabilizers work automatically to steady the economy. Public Transfer Payments As you recall from Chapter 14, public transfer payments include programs such as unemployment compensation, food stamps, and other entitlements. These payments automatically set up a flow of money into the economy. Therefore, this form of government spending helps stabilize the economy automatically. For example, during a recession more people are unemployed and qualify to receive unemployment compensation and other government benefits, such as food stamps or welfare payments. When people receive these benefits, they gain a certain amount of income to spend, and the effects of the recession are less severe than they would be without the transfer payments. When the economy improves, fewer people qualify for food stamps, unemployment compensation, and other entitlements, and government spending automatically decreases. This automatic decrease keeps the economy from growing too fast. By helping to control aggregate demand, this automatic stabilizer keeps prices from rising too quickly and leading to inflation. Progressive Income Taxes The individual income tax is progressive. As income increases, so do the tax rate and the amount of taxes paid. The progressive nature of the income tax allows it to act as an automatic stabilizer to the economy without additional government action. For example, during prosperous times, individual incomes rise, and some individuals move into higher tax brackets. These taxpayers pay more in taxes and do not have all of their increased income to spend or save. By preventing some of the increased income from entering the economy, this automatically higher taxation keeps the economy from growing too quickly and helps keep inflation in check. On the other hand, during a recession, individuals earn less income and may move into lower tax brackets. Therefore, lower incomes result in lower taxes, which automatically reduce the impact of the recession. AP P LI CATION Applying Economic Concepts A. Programs such as unemployment insurance ensure that people experiencing economic hardship have a basic level of income. How does this help to stabilize the economy? Automatic Stabilizers Unemployed workers wait to register for unemployment compensation, a program designed to stabilize the economy by providing temporary replacement wages. Find an update on automatic stabilizers at ClassZone.com Using Fiscal Policy 447 The Purpose of Fiscal Policy KEY CONCEPT S Fiscal policy can be used for expansionary or contractionary purposes. The choice of policy depends on whether the economy is weak or strong. Expansionary fiscal policy is designed to stimulate a weak economy to grow. Contractionary fiscal policy is used to slow the economy down in order
to control inflation. POLICY 1 Expansionary Fiscal Policy Government may use expansionary policy to increase the level of aggregate demand so that growth occurs in the economy. As you recall from Chapter 13, increased aggregate demand causes prices to rise, providing incentives for businesses to expand and causing GDP to increase. Expansionary fiscal policy also reduces the rate of unemployment, as there are more jobs available when businesses are expanding. Expansionary fiscal policy may involve increased government spending, decreased taxes, or both. For example, suppose the economy is in recession and, in response, the government decides to increase spending for highways. The government spends the money by contracting with private firms in many cities to build new roads. This spending creates additional jobs as the contractors hire more and more construction workers to complete the projects. If employment increases, more people will have income to spend, and aggregate demand increases for all goods and services in the economy. The government may also choose to cut taxes to stimulate the economy. By lowering individual and corporate income tax rates, the government allows individuals and businesses to have more income left after taxes. Individuals may spend their increased income and thereby increase demand for numerous goods and services. Increased income may allow them to increase their savings, which makes more money available to businesses to invest. Lower taxes also leave businesses with more money to invest in new equipment or plants, or in additional workers to produce more goods and services to meet increased demand. Whether the government increases spending, decreases taxes, or uses some combination of the two, the result is somewhat similar. As Figure 15.1 on the opposite page shows, expansionary fiscal policy leads to an increase in aggregate demand (the curve shifts to the right) and, therefore, economic growth. Expansion Increased construction of new housing is an indication that the economy is expanding. 448 Chapter 15 P OL ICY 2 Contractionary Fiscal Policy The federal government may use contractionary policy to decrease the level of aggregate demand so that inflation is reduced. When the economy is growing too rapidly, aggregate demand may increase faster than aggregate supply, leading to demandpull inflation. This type of inflation, which you read about in Chapter 13, is characterized by a steadily rising price level and a decrease in the purchasing power of people’s incomes. When the government faces such an economy, it may employ contractionary fiscal policy and use spending and taxes in ways opposite to expansionary fiscal policy. In other words, it may choose to decrease government spending or increase taxes in order to control inflation. FIGURES 15.1 AND 15.
2 EFFECTS OF FISCAL POLICY FIGURE 15.1 EFFECTS OF EXPANSIONARY FISCAL POLICY FIGURE 15.2 EFFECTS OF CONTRACTIONARY FISCAL POLICY P2 P1 AS AS P1 P3 AD2 AD1 b AD1 Y1 Y2 Real GDP AD3 Y3 Y1 Real GDP a As Figure 15.1 shows, expansionary fiscal policy causes aggregate demand (AD1) to shift to the right to AD2, or increase. b As Figure 15.2 shows, contractionary fiscal policy causes aggregate demand (AD1) to shift to the left to AD3, or decrease. ANALYZE GRAPHS 1. In Figure 15.1, what happens to real GDP as a result of expansionary fiscal policy? 2. In Figure 15.2, what happens to the price level as a result of contractionary fiscal policy? Use interactive aggregate demand and aggregate supply curves at ClassZone.com For example, if the economy is growing too rapidly, the government may cut its spending on a variety of programs such as highway construction, education, and health care. By cutting spending, the government takes money out of the economy. This decreased government spending results in less income for individuals or businesses that are directly affected by the cuts in government programs. So these individuals have less money to spend on goods and services, and aggregate demand decreases. Businesses may cut production in response to decreased aggregate demand. As aggregate demand decreases, the rise in the price level is stopped, and inflation is brought under control. Using Fiscal Policy 449 Rather than cut spending, the government may choose to increase taxes. This leads to a decrease in consumer spending and, therefore, a slowdown in the rate of inflation. In other words, when individuals and businesses have to pay higher taxes, they have less income left over to spend or invest. As a result, aggregate demand will decrease. As aggregate demand decreases, businesses may cut back production and lay off workers. This will cause a further decrease in aggregate demand, because workers will have less to spend on goods and services. And as aggregate demand falls, so will the price level. Whether the government decreases spending or increases taxes or uses some combination of the two, the impact of contractionary fiscal policy on aggregate demand and inflation is somewhat similar. Turn back to Figure 15.2 on page 449. Notice that contractionary fiscal policy results in the aggregate demand curve shifting to the left. This indicates that
aggregate demand is decreasing. This decline in aggregate demand, in turn, helps control inflation. (The major fiscal policy tools, and their impact on the economy, are reviewed in Figure 15.3.) 15. 3 Effects of Fiscal Policy on the Economy?Fiscal Policy Tools Expansionary Effects Contractionary Effects • Economic activity • Automatic stabilizers • Economic activity increases as businesses increase production, hire more workers, and increase investment • More workers have more income to spend on goods and services • Aggregate demand increases, resulting in economic growth • Raising or cutting taxes; offering tax breaks and incentives to businesses • Increasing or decreasing government spending decreases as businesses cut production and lay off workers • Workers have less income to spend on goods and services • Aggregate demand decreases, bring inflation under control ANALYZE CHARTS The government can use a combination of taxing and spending policies to stimulate a sluggish economy or to slow down an overheated economy. At what point in the business cycle do you think the economy is today? What type of fiscal policy do you think the government should apply at this time? APPLICATION Analyzing Cause and Effect B. What effect does expansionary fiscal policy have on consumer spending? Explain 450 Chapter 15 your answer. Limitations of Fiscal Policy KEY C ONCEPT S The purpose of fiscal policy is to reduce economic slowdowns, which result in unemployment, and to curb inflation. The success of fiscal policy, however, is limited by a number of issues, including policy lags and timing. LI MI TATION 1 Policy Lags Fiscal policy lags behind the economic conditions it is designed to address. This situation is often related to identifying the problem and getting Congress to move on the issue. Months of debate may precede policy change. The lag also may be related to how quickly the change in policy takes effect. For example, the time for tax changes to take effect is shorter than that for government spending. In particular, it may take a long time for public spending programs to get started and money to begin flowing into the economy. Therefore, tax changes may be more effective than policy changes in dealing with short-term recessions. LI MI TATION 2 Timing Issues The goal of fiscal policy is to provide a stable economic environment. This means that it should coordinate with the business cycle. Fiscal policy is described as countercyclical because the goal is to smooth out the peaks and troughs of the business cycle. If the timing of the policy is good, fluctuations in the business cycle will be less severe, as Figure 15.
4 illustrates. If the timing is bad, however, it could make matters worse. For example, if the economy is already moving out of a recession when an expansionary fiscal policy takes effect, the result could be inflation. FIGURE 15.4 FISCAL POLICY AND THE BUSINESS CYCLE B F Line B shows how the economy fluctuates during the normal business cycle if fiscal policy actions are not used. Line F shows economic fluctuations if fiscal policy actions are effective. n nsio ansio n p x E P e ak Co n tr a c t i o n Troug h Time ANALYZE GRAPHS 1. What kind of fiscal policy might be used to address rapid movement toward a trough? 2. How does this diagram illustrate that fiscal policy is countercyclical? Using Fiscal Policy 451 LIMITAT ION 3 Rational Expectations Theory QUICK REFERENCE The rational expectations theory states that people anticipate that changes in fiscal policy will affect the economy in a particular way and that, as a result, people will take steps to protect their interests. A second phenomenon affecting timing is explained by the rational expectations theory, which states that individuals and business firms expect that changes in fiscal policy will have particular outcomes, and they take actions to protect their interests against those outcomes. These actions may limit the effectiveness of fiscal policy. For example, expansionary fiscal policy attempts to stimulate aggregate demand to increase employment. An increase in aggregate demand might also pull up the price level, causing inflation. In anticipation of rising inflation, people spend more to keep their buying power from decreasing. However, this increased spending causes more inflation and defeats the aims of the expansionary policy. QUICK REFERENCE The Council of Economic Advisers is a group of economic advisors to the president. LIMITAT ION 4 Political Issues Fiscal policy decisions are not always based on economic considerations. Sometimes, political considerations, most notably enhancing the chances of reelection, may influence the kind of fiscal policy that a government follows. The Council of Economic Advisers is a three-member group that advises the President on fiscal policy and other economic issues. Because of political pressures, however, the President may not always follow their advice. Even if the President does accept the council’s guidance, members of Congress—again because of political considerations—may not agree with proposed policies. This is an important issue, since the House of Representatives is where all tax bills originate. Fiscal Policy and Politics Decisions on economic policy often are influenced by politics. LIMITAT I
ON 5 Regional Issues Another limitation of the effectiveness of fiscal policy is related to geography. Not every state or region of the country may be experiencing the same economic issues. For example, the Gulf Coast region may be recovering from the economic effects of hurricane damage. At the same time, the West Coast may be experiencing a high tech boom that is causing inflation. The Gulf Coast might benefit from expansionary policies, while contractionary policies might be best for the West Coast. In such circumstances, broad fiscal-policy solutions may not be appropriate. APPLICATION Making Inferences C. How do policy lags and timing issues work together to limit the effectiveness of fiscal policy? 452 Chapter 15 S E C T I O N 1 Assessment ClassZone.com AC T I C E 1. Use each of the three terms below in a sentence that illustrates the meaning of the term. a. expansionary fiscal b. discretionary fiscal c. rational expectations policy policy theory 2. What are the two basic goals of fiscal policy? 3. How do expansionary fiscal policy and contractionary fiscal policy use the same fiscal policy tools in different ways? 4. What is the difference between discretionary fiscal policy and automatic stabilizers? 5. What is the role of the Council of Economic Advisers? 6. Using Your Notes What are the limitations of fiscal policy? Refer to your completed cluster diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com Fiscal Policy 7. Making Inferences Between 2001 and 2004, Congress passed a series of tax cuts and increased government spending. Do these actions reflect expansionary or contractionary fiscal policy? Explain your answer. 8. Applying Economic Concepts Agricultural price supports provide farmers with government subsidies when market prices of certain crops are low. What kind of fiscal policy is at work in this situation and how does it work? 9. Drawing Conclusions Federal government officials want to prevent a slowing economy from going into recession. They debate whether to increase spending on new public transit systems or decrease individual and corporate income tax rates. a. How would an understanding of policy lags help them decide which government action would be most effective? b. What other issues might affect their decision? 10. Challenge Make a copy of Figure 15.4 on page 451 and label the part of line F that might represent expansionary fiscal policy and the part that might represent contractionary fiscal policy. Analyzing Economic Conditions Consider what you’ve learned about economic instability and fiscal policy. Then complete the following activities. Propose Fiscal Policies For each situation listed in the chart
, identify the problem and decide whether the fiscal policy should be expansionary or contractionary. Economic Situation Problem/Fiscal Policy Needed Business investment spending declines for six straight months Consumer Price Index rises for four straight months Unemployment rate increases from 4% to 6.5% over six months Consumer confidence falls for five straight months Challenge Choose one situation and give examples of how fiscal policy might be applied to it. Using Fiscal Policy 453 S E C T I O N 2 Demand-Side and Supply-Side Policies TA K I N G N O T E S In Section 2, you will Keynesian economics, p. 454 demand-side fiscal policy, p. 454 spending multiplier effect, p. 455 supply-side fiscal policy, p. 458 Laffer Curve, p. 459 • describe how demand-side fiscal policy can be used to stimulate the economy • describe how supply-side fiscal policy can be used to stimulate the economy • identify the role that fiscal policy has in changing the economy As you read Section 2, complete a chart to show the major features of demand-side and supplyside policies. Use the Graphic Organizer at Interactive Review @ ClassZone.com Demand-side policies Supply-side policies Role of government Role of government Demand-Side Economics KEY CONCEPT S Economists have not always supported the idea of discretionary fiscal policy. Historically, most think that the national government should have a limited role in the economy. When the country experienced financial panics and depressions, the government did little to help the economy get back on track. The Great Depression of the 1930s changed many people’s minds about the role of the government. High unemployment and low production persisted for several years. Many economists concluded that the old ways were ineffective in this situation. One economist, John Maynard Keynes, proposed a new way to address the problem. The theories that Keynes put forward are called Keynesian economics, the idea that in times of recession aggregate demand needs to be stimulated by government action. Keynes believed that such an approach would lower unemployment. Keynesian economics forms the basis of demand-side fiscal policy, fiscal policy to stimulate aggregate demand. Demand-Side Policies The Civilian Conservation Corps (CCC), an employment program for young men, was one government action aimed at stimulating the economy during the Great Depression. QUICK REFERENCE Keynesian economics states that aggregate demand needs to be stimulated by government action. Demand-side fiscal policy is a plan to stimulate aggregate demand. 454 Chapter 15 Keynesian Theory Keynes argued that changes
in aggregate demand influence the business cycle, and he expressed this idea in an equation. His equation states that the GDP equals the total market value of all consumer goods (C), investment goods (I), government goods (G), and net exports (F). The equation looks like this: GDP = C + I + G + F. Keynes believed that net exports played only a small role in the economy and that government and consumer expenditures were fairly stable. He reasoned that it was investment that caused the economy to fluctuate and that investment creates a greater than one-for-one change in national income. That is, one dollar spent in investment has a spending multiplier effect, meaning that a change in spending is multiplied into a larger change in GDP. (See Figure 15.5.) QUICK REFERENCE The spending multiplier effect states that a small change in spending causes a much larger change in GDP. M AT 15. 5 Spending Multiplier Effect If Zain receives a $100 raise and spends $60 of it to buy products from Joan, Joan’s income increases too. Similarly, if Joan uses $36 of her increased income to buy products from Ravi, Ravi’s income increases. Ravi then buys from Sarah, and so on. Each increase in income contributes to the GDP, so the total effect of Zain’s spending is multiplied. To quantify how spending increases GDP, economists use the spending multiplier. Step 1: Determine the percentage of the money that is spent on domestic goods and services each time the money is reused. In the example, this is 60 percent. Step 2: Use this equation, where A is the percentage, to calculate the spending multiplier. Sample Calculations NEED HELP? Math Handbook, “Calculating and Using Percents,” page R4 1 1 − A = Spending multiplier 1 1 − 60% = 1 1 − 0.60 = 2.5 Step 3: Use the spending multiplier to calculate the total increase in GDP. Initial investment × Spending multiplier = Total increase in GDP $100 × 2.5 = $250 If businesses invest less, the spending multiplier effect means that the decrease in overall spending is greater than the initial decrease in business investment. Because this effect touches the entire economy, the government may need to step in to offset changes in investment. This idea became the basis of demand-side fiscal economics, which favors the use of fiscal policy to stimulate aggregate demand. AP P LI CATION Making Inferences A. How did Keynes�
�s equation help him conclude that if investment declined, government needed to increase spending or cut taxes to stimulate aggregate demand? Using Fiscal Policy 455 ECO N O M I C S PAC ES E T T E R John Maynard Keynes: Architect of Demand-Side Policy Many Americans are accustomed to the idea that the government plays an active role in the market economy. However, when John Maynard Keynes proposed his ideas in the 1930s, they were considered revolutionary. He questioned the principles of economics that had been accepted since the time of Adam Smith. How did Keynes’s work change the way that people viewed the role of government in the economy? Using Government Action to Stimulate Demand The economic situation of the 1920s led John Maynard Keynes to question the classical economic theories of supply and demand. Classical economists believed that a free market would eventually correct any imbalances. However, as aggregate demand fell, businesses invested and produced less, which led to layoffs. As a result, consumers had even less money to spend, and businesses cut back production even further. As early as 1929, Keynes proposed that the British government spend money on public works projects to help ease unemployment. However, he had no theoretical backing for his proposal until he read an article in 1931 about the spending multiplier. This concept proved to be the key to his new economic theory, which he published in The General Theory of Employment, Interest, and Money (1936). This ground-breaking book marked the beginning of the field of macroeconomics. Keynes’s first revolutionary idea was to define aggregate demand as the sum of investment, consumer spending, government spending and net exports. He further stated that only government intervention could break the business cycle patterns that caused so much economic suffering. Even more revolutionary, however, was his argument that it was better for the government to spend money to help stabilize the economy than to have a balanced budget. A Continuing Influence Keynes’s ideas continue to influence the way some governments deal with economic depressions. APPLICATION Contrasting Economic Information B. What made Keynes’s ideas different from those of classical economists? FAST FACTS John Maynard Keynes Career: British academic and government economist Born: June 5, 1883, in Cambridge, England Died: April 21, 1946 Major Accomplishment: Introduced the idea of using government action to stimulate aggregate demand Books: A Treatise on Money (1930); The General Theory of Employment, Interest, and Money (1936) Famous Quotation: The difficulty lies, not in
the new ideas, but in escaping from the old ones. Jobs: Lecturer in economics, Cambridge University; editor of the Economics Journal; positions with the British Treasury office during World Wars I and II Learn more about John Maynard Keynes at ClassZone.com 456 Chapter 15 Wartime Spending Massive government spending on wartime industries brought the United States out of economic depression. Government and Demand-Side Policies KEY C ONCEPT S Discretionary fiscal policy involves choices about how to use government spending and taxation to increase aggregate demand or control inflation. Demand-side policies advocate use of these fiscal policy tools to control aggregate demand and stabilize the economy. The Role of Government Keynes proposed an active role for government in the economy. He argued that the federal government ought to step into the economy using expansionary fiscal policy to promote full employment. The Great Depression had shown that the economy could reach equilibrium with less than full employment and that business was unable to break out of this cycle because of insufficient aggregate demand. Therefore, Keynes advocated increased government spending and decreased taxation to end recessions. Increased government spending helps create jobs and increases income, and decreased taxation encourages consumers to spend more, which prompts businesses to invest more. Such actions help increase aggregate demand. On the other hand, Keynes thought that when inflation was high the government should use contractionary fiscal policy to keep prices from rising. The government would take an active role through decreasing government spending or increasing taxes. Both of these actions help decrease aggregate demand and control inflation. Demand-Side Policies—Analysis In some circumstances, an increase in government spending may lead to economic recovery. For example, government spending on public works programs and on production related to World War II brought the United States out of the Great Depression. However, it is not easy to limit such spending to times of recession, because federal programs seem to take on a life of their own and are difficult to terminate. Politicians are often reluctant to discontinue programs that are popular. Excessive aggregate demand due to government or consumer spending can lead to inflation. Contractionary fiscal policy requires decreases in government spending or increases in taxation. Just as it is difficult to decrease government spending, it is difficult to enact the tax increases. Politicians must often choose between doing what is best for the economy and doing what is most likely to ensure their reelection. Furthermore, when the economy experiences stagflation—slow economic growth with high unemployment and inflation—as it did in the 1970s, demand-side policies seem to be ineffective. AP P LI CATION Drawing Conclusions C
. Why are demand-side policies more effective against recession than against inflation? Using Fiscal Policy 457 Supply-Side Economics KEY CONCEPT S QUICK REFERENCE Supply-side fiscal policy provides incentives to producers to increase aggregate supply. Some economists believe that the best way to influence the economy is through the supply side rather than through the demand side. Supply-side fiscal policy is designed to provide incentives to producers to increase aggregate supply. In other words, demand-side economics uses fiscal policy to encourage consumers to spend more, while supply-side economics focuses on cutting the cost of production to encourage producers to supply more. Figure 15.6 compares supply-side economics to demand-side economics. The Role of Government As you have learned, the role of the government in the economy falls into three categories: taxation, spending, and regulation. For the most part, supply-side economists favor less government involvement in these three areas. Supply-side economists favor cutting the tax rates on individual and corporate income because they believe that high tax rates slow economic growth by discouraging working, saving, and investing. Lower tax rates, on the other hand, encourage individuals and businesses to work, save, and invest more. Specifically, reducing the highest tax brackets provides more available income to the people most likely to invest in new business activities. Spending cuts are another way that supply-side economics seeks to stimulate aggregate supply. Cuts in spending are related to tax cuts. If the government spends less, it needs to take in less in revenue and, therefore, is able to lower taxes. Finally, decreased government regulation can also stimulate business production. Government regulations add to the costs of production and make it harder for businesses to grow. Deregulation, however, cuts costs and leads to increases in aggregate supply. F I G U R E 15. 6 Supply-Side and Demand-Side Economics Supply-Side Economics Demand-Side Economics • Focuses on stimulating production • Focuses on stimulating consumption (supply) to increase business output • Lower taxes + decreased government spending + deregulation = greater incentives for business investment • Businesses expand and create jobs; people work, save, and invest more • Greater investment and productivity cause businesses to increase output (demand) to increase business output • Increased government spending results in more money in people’s hands • People spend more • Increased demand causes business to increase output ANALYZE CHARTS 1. What is similar about supply-side and demand-side tax policies? 2. Which system favors less government involvement in the
economy? 458 Chapter 15 QUICK REFERENCE The Laffer Curve is a graph that illustrates the economist Arthur Laffer’s theory of how tax cuts affect tax revenues. The Laffer Curve Supply-side economists refer to the Laffer Curve, a graph developed by economist Arthur Laffer, to illustrate how tax cuts affect tax revenues and economic growth. As Figure 15.7 shows, Laffer theorized that tax revenues increase as tax rates increase up to a certain point. After that point, higher tax rates actually lead to decreased tax revenues. The reasoning behind the curve is that higher taxes discourage people from working, saving, and investing. So, at a tax rate of 100 percent, the government would theoretically collect no tax revenues, because people would have no incentive to earn income if it all went to the government for taxes. In other words, the higher the tax rate, the likelier it is that people will take some type of action to avoid paying more taxes. When people find alternatives to incomeproducing activity, total taxable income declines, tax revenues decrease, aggregate supply falls, and economic growth slows. Conversely, as tax rates fall, people are more inclined to undertake income-producing activity because less of their income will go to taxes. Further, they are more likely to save and invest this extra income, which will lead to increasing aggregate supply and greater economic growth. FIGURE 15.7 THE LAFFER CURVE a c e u n e v e R T2 T1 b 0 R2 R0 Tax rate 100 R1 a There is a tax rate between 0 and 100 percent (point R0) at which maximum revenue is collected. b Tax rates higher than R0, such as R1, will not bring in more revenue (T1), because higher taxes discourage productive activity and shrink the tax base. c When tax rates are higher than R0, lowering the tax rate (R2) will lead to higher tax revenue (T2). Lower tax rates tend to encourage productive activity and increase the tax base. ANALYZE GRAPHS 1. There is no tax revenue at two points on the graph—when the tax rate is 0 percent and when it is 100 percent. Why is this so? 2. How does this graph support the ideas of supply-side economists? Supply-Side Policies—Analysis When the principles of the Laffer Curve were applied in the United States in the 1980s, the results were much as Laffer had predicted. Legislation passed in that decade reduced federal income tax
rates substantially. For example, the top bracket went from 70 percent to around 30 percent. At the same time, federal government receipts from income taxes over the whole decade were about 13 percent higher than Using Fiscal Policy 459 they had been in the 1970s. Inflation and unemployment rates both fell during the decade. Further, the economy grew steadily in the 1980s, with real GDP increasing by about 3 percent each year. Even so, some of Laffer’s predictions did not hold true. The supply-side approach suggests that with lower tax rates, people will work more. However, while some people did choose to work more, others chose to work less, since they could earn the same amount of after-tax income by working fewer hours. In addition, supply-side theory states that lower tax rates encourage people to save and invest. In fact, the savings rate declined during the 1980s. Some economists have suggested that the success of supply-side policies depends on where the economy is located on the Laffer Curve. Look again at Figure 15.7 on page 459. Find the tax rate R0 on the horizontal axis and trace the broken line from that point to where the line intersects the curve. Tax revenue is maximized at this point. If the economy is not at this point on the curve, then tax rate cuts will decrease tax revenue rather than increase it. Supply-side theory offers no measures for establishing where on the curve an economy might be. Other economists have argued that it is difficult to isolate the effects of supply-side incentives from demand-side results to determine what caused unemployment and inflation rates to fall and the economy to grow during the 1980s. They suggest that tax cuts and increased government spending on defense drove up aggregate demand, resulting in economic growth. This increased spending was fueled by deficits, which you’ll learn more about in Section 3. YO U R EC DE MAND -SIDE POLIC IES VS. SU PPLY-SIDE POLIC IES Which candidate will you choose? In an upcoming congressional election, one candidate favors tax cuts and increased government spending. The other favors more substantial tax cuts, decreased government spending, and less government regulation of the economy. For which candidate will you cast your vote? Why?? ▲ Supply-side supporter ▲Demand-side supporters APPLICATION Analyzing Causes D. What fiscal policy techniques do supply-side economists advocate to reduce unemployment and fight inflation at the same time? 460 Chapter 15 S E
C T I O N 2 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs. a. Keynesian economics b. supply-side fiscal policy demand-side fiscal policy Laffer Curve 2. How did the Great Depression influence Keynesian economics? 3. How is the spending multiplier effect related to demand-side economics? 4. How are supply-side and demand-side economics different? 5. Which fiscal policy tool does the Laffer Curve address? 6. Using Your Notes How does the role of government differ in demand-side and supply-side economics? Refer to your completed flow chart. Use the Graphic Organizer at Interactive Review @ ClassZone.com Demand-side policies Supply-side policies Role of government Role of government. Creating Graphs Create a graph showing aggregate demand and aggregate supply in the economy. Then add new curves to show the expected shifts based on expansionary demand-side policies and supply-side policies. What happens to price level and GDP as a result of each type of policy? Use activity. @ ClassZone.com to complete this 8. Applying Economic Concepts Suppose that the federal government decides to increase its spending on highway construction by $5 billion to keep the economy from falling into a recession. Explain the real impact on GDP of this spending. 9. Analyzing Effects Tom, Cia, and Julie were all in the 50 percent tax bracket. When a tax cut program reduced their tax bracket to 28 percent, they all made changes in their lives. Tom decided to work fewer hours so he could begin training to run in a marathon. Cia bought the new sports car she’d been wanting. Julie chose to work more hours so she could save extra money for her daughter’s college education. Explain the effects of the tax cut for each individual. Use supply-side or demand-side economics reasoning in your answer. 10. Challenge Why is it difficult for demand-side economics to solve the problems of high unemployment and high inflation when they occur at the same time? Space research center Categorizing Economic Information Consider what you’ve learned about demand-side or supply-side fiscal policy. Then complete the following activities. Identify Policies Complete the chart by indicating whether each action reflects a demand-side or a supply-side policy. Government Action Demand-Side or Supply-Side Cut capital gains tax rates to encourage investment Expand government spending on space exploration Increase federal grants for education Reduce safety rules that businesses must follow Challenge Why
is it difficult to tell if a cut in individual income tax rates is the result of a demand-side or a supply-side policy? Using Fiscal Policy 461 S E C T I O N 3 Deficits and the National Debt TA K I N G N O T E S In Section 3, you will • examine the difference between the deficit and the debt • explain why national deficits occur • describe how deficits are financed • identify the impact of the national debt on the economy budget surplus, p. 462 budget deficit, p. 462 deficit spending, p. 462 national debt, p. 462 Treasury bills, p. 464 Treasury notes, p. 464 Treasury bonds, p. 464 trust funds, p. 465 crowding-out effect, p. 466 As you read Section 3, complete a comparison chart to show the similarities and differences between federal deficits and the national debt. Use the Graphic Organizer at Interactive Review @ ClassZone.com Federal Deficits National Debt The Federal Deficit and Debt KEY CONCEPT S Governments have frequently made efforts to balance their budgets so that spending equals the revenues collected. In reality, however, all levels of government often struggle to achieve a balanced budget. As you recall, Congress and state legislatures make budget decisions with both economic and political considerations in mind. Federal government spending falls into one of three categories: a balanced budget; a budget surplus, when the government takes in more than it spends; or a budget deficit, when government spends more than it takes in. In recent years, the federal government has rarely achieved a budget surplus. Since 1970, a surplus was recorded only between 1998 and 2001. Figure 15.8 on the opposite page shows the pattern of budget deficits and surpluses since 1980. It is important to note that a budget surplus or budget deficit refers to only one year. Deficit spending occurs when a government spends more than it collects in revenue for a specific budget year. Annual deficits contribute to the national debt, which is the total amount of money that the government owes. In effect, the national debt is equal to the sum of annual budget deficits minus any budget surpluses or other payments against the debt. Controlling the Deficit This cartoon suggests one way to deal with a budget deficit. Source: www.CartoonStock.com QUICK REFERENCE A budget surplus occurs when the government takes in more than it spends. A budget deficit occurs when government spends more than it takes in. Deficit spending is a government practice of
spending more than it takes in for a specific budget year. The national debt is the money that the government owes. 462 Chapter 15 Causes of the Deficit There are four main causes of deficit spending: national emergencies, a desire for more public goods, stabilization of the economy, and the role of government in society. Many times a budget deficit may be the result of more than one of these causes. National Emergencies Generally speaking, national emergencies are wars in which the United States is involved. Deficit spending has been used in wartime from the Revolutionary War to the war in Iraq that began in 2003. The terrorist attacks of September 11, 2001, and catastrophic weather events are other examples of national emergencies. All may require massive spending beyond the normal outlay of funds. Need for Public Goods and Services Public goods and services benefit many different people and groups. The interstate highway system, dams, flood-control projects, and airports are examples of public goods. Building such infrastructure is expensive and lasts many years. The public expects the government to provide these goods to facilitate commerce, agriculture, and transportation. Stabilization of the Economy As you learned earlier in this chapter, fiscal policy can include government spending to stimulate the economy. The classic example of this occurred during the Great Depression. The government spent money on a variety of public works projects to build roads, bridges, schools, and parks, putting millions of unemployed people to work. This government spending led to budget deficits. Role of Government in Society As you have seen, people have also come to depend on government programs such as Social Security, Medicare, Medicaid, and unemployment insurance to provide help for those in need. These programs are expensive, and because they are entitlement programs, they require funding each year. FIGURE 15.8 BUDGET DEFICITS AND SURPLUSES This line represents a balanced budget— where revenues equal expenditures. Points above the line are surpluses and points below the line are deficits. b Deficits increased during these periods due to tax cuts, increased defense and entitlement spending, and recessions. 1980 1985 1990 1995 2000 2005 Year Sources: Congressional Budget Office; Office of Management and Budget ANALYZE GRAPHS 1. When did the largest deficit occur and about how much was it? The largest surplus? 2. How would the trends shown on this graph affect the national debt? Using Fiscal Policy 463 QUICK REFERENCE Treasury bills mature in less than one year. Treasury notes mature between two and ten years. Treasury bonds mature in 30 years.
Raising Money for Deficit Spending When the federal government does not receive enough revenue from taxes to finance its spending, it can borrow money to expand the economy. In effect, the government pays for its present needs by borrowing money that it will have to repay at some future date. It does this by issuing government bonds, through the Department of the Treasury. Perhaps the best known type of bond issued by the government is the savings bond. Savings bonds mature in 20 years and are available in both small and large denominations—from $25 up to $10,000. The Department of the Treasury issues three other types of bonds. Treasury bills (T bills) are short-term bonds that mature in less than one year. Treasury notes are bonds that mature between two and ten years. And finally, Treasury bonds are issued for 30 years. Interest is paid on all these bonds, with higher interest rates sometimes being paid on instruments with longer maturity dates. Individuals, state and local governments, insurance companies, pension funds, financial institutions, the Federal Reserve banks, and foreign investors hold these bonds. Figure 15.9 shows the percentage of federal debt held by different types of investors. A trend in recent years has been an increase in the percentage of the federal debt owned by foreign investors. Most foreign investors in U.S. Treasury bonds are the central banks of other countries. Japan and China hold the largest amount of foreign investors’ share of the debt. FIGURE 15.9 CREDITORS OF THE FEDERAL GOVERNMENT 2.8% 3.4% 4.5% 5.5% 6.7% 7.0% 9.5% 16% a Pension funds are run by corporations and state and local governments. b Depository institutions include banks, savings institutions, and credit unions. 44.6% Foreign investors Federal Reserve banks State & local governments Pension funds Other investors a Mutual funds Savings bonds Insurance companies Depository institutions b Source: U. S. Treasury Bulletin, December 2005 ANALYZE GRAPHS 1. What percentage of the federal debt is owed to U.S. investors? What percentage is owed to foreign investors? 2. How do savings bonds compare to other government bonds as a form of government borrowing? APPLICATION Drawing Conclusions A. Why do all levels of government often struggle to achieve balanced budgets or 464 Chapter 15 budget surpluses? The National Debt KEY C ONCEPT S As you have seen, the national debt consists of the total accumulation of government deficits and surpluses over

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