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to objectively consider the viewpoints of all involved parties in their decisions Why would unions and management agree to mediation? mediation process of resolving a dispute by bringing in a neutral third party arbitration or binding arbitration agreement by two parties to place a dispute before a third party for a binding settlement fact-finding agreement between union and management to have a neutral third party collect facts about a dispute and present nonbinding recommendations injunction court order issued to prevent a company or union from taking action during a labor dispute seizure temporary government takeover of a company to keep it running during a labor-management dispute Mediation One way to resolve differences is through mediation, the process of bringing in a neutral third person or persons to help settle a dispute. The mediator’s primary goal is to find a solution that both parties will accept. A mediator must be unbiased so that neither party benefits at the expense of the other. If the mediator has the confidence and trust of both parties, he or she will be able to learn what concessions each side is willing to make. In the end, the mediator recommends a compromise to both sides. Neither side has to accept a mediator’s decision, although it often helps break the deadlock. Arbitration Another popular way to resolve differences is through arbitration, a process in which both sides agree to place their differences before a third party whose decision will be accepted as final. Because both sides must agree to any final decision the arbitrator makes, this type of negotiation is also called binding arbitration. 212 UNIT 3 Economic Institutions and Issues www.CartoonStock.com Fact-Finding A third way to resolve a dispute is through fact-finding, an agreement between union and management to have a neutral third party collect facts about a dispute and present nonbinding recommendations. This process can be especially useful in situations where each side has deliberately distorted the issues to win public support, or when one side simply does not believe the claims made by the other side. Neither labor nor management has to accept the recommendations of the fact-finding committee. Injunction and Seizure A fourth way to settle labor-management disputes is through injunction or seizure. During a dispute, one of the parties may request an injunction—a court order not to act. If issued against a union, the injunction may direct the union not to strike. If issued against a company, it may direct the company not to lock out its workers. In 1995, after professional baseball players ended their strike and went back to work, the owners promptly called a lockout. The players
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then got an injunction against the owners, and the 1995 baseball season began—but without a labor agreement. Under extreme circumstances, the government may resort to seizure—a temporary takeover of operations—while the government negotiates with the union. This occurred in 1946 when the government seized the bituminous coal industry. While operating the mines, government officials worked out a settlement with the miners’ union. Presidential Intervention The president of the United States may enter a labor-management dispute by publicly appealing to both parties to resolve their differences. While rarely used, this can be effective if the appeal has broad public support. The president also can fire federal workers. In 1981 President Ronald Reagan fired striking air traffic controllers because they were federal employees who had gone on strike despite having taken an oath not to do so. The president also has emergency powers that can be used to end some strikes. When pilots from American Airlines went on strike in 1997 during a peak travel weekend, President Clinton used a 1926 federal law, the Railway Labor Relations Act, to order an end to the strike less than 30 minutes after it began. Reading Check Summarizing In what ways can labor and management resolve disputes? Intervention In 1981 President Reagan replaced striking air traffic controllers. Why did the president think this step was necessary? SECTION 2 Review Vocabulary 1. Explain the significance of wage rate, unskilled labor, semiskilled labor, skilled labor, professional labor, market theory of wage determination, equilibrium wage rate, theory of negotiated wages, seniority, signaling theory, collective bargaining, grievance procedure, mediation, arbitration, binding arbitration, fact-finding, injunction, and seizure. Main Ideas 2. Describing Use a graphic organizer like the one below to describe the four approaches to wage determination. Characteristics Method Skill level Market theory Negotiated theory Signaling theory 3. Discussing How do mediation, arbitration, and fact- finding differ from other ways to resolve labor disputes? Critical Thinking 4. The BIG Idea How does the market theory of wage determination reflect the forces of supply and demand? 5. Sequencing Information If you represented a company during a collective bargaining session, and if negotiations were deadlocked, what course of action would you recommend? Why? 6. Interpreting If you were a semiskilled worker, what could you do to move into a higher category of noncompeting labor? 7. Analyzing Visuals Look at Figure 8.5 on page 209. The graphs show wage determination based on demand and supply. What might the demand and supply curves look like for
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the company? Explain. Source: harley-davidson.com 214 UNIT 3 Economic Institutions and Issues Simone Romeo/Alamy SECTION 3 Employment Trends and Issues GUIDE TO READING Section Preview In this section, you will learn that important employment issues include union decline, unequal pay, and the minimum wage. Academic Vocabulary • trend (p. 216) • equivalent (p. 219) Reading Strategy Content Vocabulary • giveback (p. 217) • two-tier wage system (p. 217) • glass ceiling (p. 219) • set-aside contract • minimum wage (p. 219) • current dollars (p. 219) • constant dollars (p. 221) • real dollars (p. 221) • base year (p. 221) (p. 219) Explaining As you read the section, complete a graphic organizer similar to the one below to explain why women face an income gap. Lower pay for women —The Oregonian ISSUES IN THE NEWS Foreign Exchange at Minimum Wage Four decades ago... Congress created a student exchange program intended to burnish America’s worldwide reputation. The idea was simple: College students would visit for a few months, take a job, and return to their native lands imbued with affection for the red, white and blue. Today, that initiative [is] a source of cheap labor for hotels, ski resorts and restaurants. Mt. Bachelor hired 30 exchange students from Peru for the winter, paying them $7.50 an hour. Timberline Lodge, at Mount Hood, employed 20 students from Chile and also paid them the Oregon minimum wage. The tourism industry says it needs the cheap work force to keep prices down. In [such a] tight labor market,... the lures of a free ski pass and minimum wage are no longer enough for local ski bums, who can find longer-term jobs for better wages in town. ■ Important issues abound in today’s labor market. While some workers are faced with layoffs when factories close, other industries have problems filling all their available jobs. This is especially true for those positions that pay only federal or state minimum wages, such as some of the resort jobs in the news story. Difficulties in finding enough qualified workers to fill temporary jobs at the minimum wage is just one issue facing the national economy. Workers have seen a decline of unions, which limits their ability to influence wages, while women have to deal with differences in pay in the labor market.
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Tim Fuller CHAPTER 8 Employment, Labor, and Wages 215 Skills Handbook See page R36 to learn about determining Cause and Effect. Decline of Union Influence MAIN Idea Labor unions have been losing their influence and power ever since the 1940s. Economics & You You learned earlier about the rise of unions. Read on to learn about the decline of unions today. A significant trend in today’s economy is the decline in union membership and influence. As Figure 8.6 shows, 35.5 percent of nonfarm workers were union members in 1945. This number has dropped since then to about 12.5 percent by 2006. Reasons for Decline Several reasons account for this decline. The first is that many employers have made a determined effort to keep unions out of their businesses. Some companies hire consultants to map out legal strat egies to fight unions. Others try to head off the formation of a union by making workers part of the management team, adding employees to the board of directors, or setting up profit-sharing plans to reward employees. A second reason for union decline is that new additions to the labor force—especially women and teenagers—traditionally have had little loyalty to organized labor. In addition, more Americans are working in part-time jobs to help make ends meet. People who work a second job have less time to join or even support a union. Perhaps the most important reason is that unions are the victims of their own success. When union wages are higher than those of nonunion workers, union-made products become more expensive than those of foreign and nonunion producers. Renegotiating Union Wages Because unions have generally kept their wages above those of nonunion workers, union wages have been under pressure to come down. In fact, in recent years, there have been almost as many news reports of Figure 8.6 Union Membership U NION M EMBERSHIP 40% 35 30 25 20 15 10 1930 1935 1940 1945 1950 1955 1960 1965 1970 Year 1975 1980 1985 1990 1995 2000 2005 2010 Source: Bureau of Labor Statistics, 2005 Union membership grew rapidly after 1933 and peaked at 35.5 percent in 1945. Economic Analysis How would you describe the trend of union membership during the last decade? Figure 8.7 Gender and Income Over the years, the income earned by females has been only a fraction of that earned by males. Economic Analysis When did median female income first reach 70 percent of male median income? M EDIAN F EMALE I NCOME AS A P ERCENTAGE OF M EDIAN M
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ALE I NCOME 100 90 80 70 60 50 40 30 20 10 0 1955 1960 1965 1970 1975 1980 Year 1985 1990 1995 2000 2005 2010 Source: Bureau of Labor Statistics, 2006 unions fighting to maintain wage levels as there were reports of union wages rising. One way employers have been able to reduce union wages is by asking for givebacks from union workers. A giveback is a wage, fringe benefit, or work rule given up when a labor contract is renegotiated. Some companies were able to get rid of labor contracts by claiming bank ruptcy. If a company can show that wages and fringe benefits contributed significantly to its problems, federal bankruptcy courts usually allow management to terminate union contracts and establish lower wage scales. Another way to reduce union salary scales is with a two-tier wage system—a system that keeps high wages for current workers, but has a lower wage for newly hired workers. This practice is becoming widespread and often has union approval. Reading Check Identifying Why do successful unions create problems for themselves? Lower Pay for Women MAIN Idea Men are generally paid more than women because of differences in skills, the types of jobs they choose, and discrimination. Economics & You Are you or anyone in your family concerned about a job for which men are paid more than women? Read to find out about laws that will help correct the situation. giveback wage, fringe benefit, or work rule given up when renegotiating a contract two-tier wage system wage scale paying newer workers a lower wage than others already on the job Overall, women face a substantial gap between their income and the income received by men. As Figure 8.7 shows, female income has been only a fraction of male income over a 50-year period. Human Capital Differences About one-third of the male-female income gap is due to differences in the skills and experience that women bring to the labor market. For example, women tend to drop out of the labor force to raise families more often than men. Working women also CHAPTER 8 Employment, Labor, and Wages 217 tend to have lower levels of education than their male counterparts. If these two factors— experience and education— were the same for men and women, about onethird of the wage gap would disappear. Gender and Occupation Slightly less than one-third of the wage gap is due to the uneven distribution of men and women among various occupations. For example, more men work in higher-paying construction and engineering trades than women. Likewise, more women work in lower-paying household service and office occupations than men
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. The distribution of men and women in various occupations as reported by the Bureau of Labor Statistics is shown in Figure 8.8. As long as construction and engineer ing wages are higher than personal care and office worker wages, on average, men will earn more than women. Discrimination Finally, slightly more than one-third of the gap cannot be explained by specific reasons. Economists attribute this portion of differences in income to discrimination that women face in the labor market. In fact, women and minorities often encounter difficulties in getting raises and promotions Figure 8.8 Gender and Occupation D ISTRIBUTION OF W OMEN AND M EN BY O CCUPATION Construction and extraction trades Installation, maintenance, and repair Architecture and engineering Transportation and material moving Protective services (fire and police) Farming, fishing, and forestry Computer and mathematical Building and grounds cleaning, maintenance Sales and related Legal occupations Food preparation and serving related Community and social services Health care practitioner and technical Education, training, and library Office and administrative support Personal care and service Health care support occupations 60% 40% 80% Females 100% 20% 0% 20% 40% 60% 80% 100% Males Source: Bureau of Labor Statistics, 2006 One of the reasons for the difference in pay between men and women is their uneven distribution among occupations. Economic Analysis In which occupations do women make up between 60 and 80 percent of the workforce? glass ceiling seemingly invisible barrier hindering advancement of women and minorities in a male-dominated organization set-aside contract guaranteed contract or portion of a contract reserved for a targeted group, usually a minority minimum wage lowest legal wage that can be paid to most workers (also see page 58) current dollars dollar amounts or prices that are not adjusted for inflation that are like reaching a glass ceiling— an invisible barrier that obstructs their advance ment up the corporate ladder. Legal Remedies Two federal laws are designed to fight wage and salary discrimination. The first is the Equal Pay Act of 1963, which prohibits wage and salary discrimination for jobs that require equivalent skills and responsibilities. This act applies only to men and women who work at the same job in the same business establishment. The second law is the Civil Rights Act of 1964. Title VII of this act prohibits discrimination in all areas of employment on the basis of gender, race, color, religion, and national origin. The law applies to employers with 15 or more workers. The Civil Rights Act also set up the Equal Employment Opportunity Commission (EEOC). The EEOC investigates charges of discrimination, issues guidelines and regulations, conducts hearings,
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and collects statistics. The government can sue companies that show patterns of discrimination. Market Remedies Another way to overcome unfair hiring practices is by reserving some market activity for minority groups. One example is the government set-aside contract, a guaranteed contract reserved for a targeted group. The federal government, for example, requires that a certain percentage of defense contracts be reserved exclusively for minority-owned businesses. Some state governments do the same for state contracts. Many set-aside programs include a “grad uation” clause that “promotes” minority-owned businesses out of the program once they reach a certain size or have received set-aside contracts for a certain number of years. Such limits are set because the program is intended to give these firms an initial boost, not a permanent subsidy. Reading Check Synthesizing What are similarities between the Equal Pay Act and set-aside contracts? The Minimum Wage MAIN Idea The minimum wage has lost purchasing power over time because it was fixed at $5.15 while prices were rising. Economics and You Have you or any of your friends ever had a job that paid exactly $5.15 an hour? Read on to learn why this wage does not buy as much as it did in the past. The minimum wage—the lowest wage that can be paid by law to most workers— was intended to prevent the exploitation of workers and to provide some degree of equity and security to those who lacked the skills need ed to earn a decent income. First set at $.25 per hour in 1939, the minimum wage increased to $5.15 by 1997. Debate Over the Minimum Wage The minimum wage has always been controversial. Supporters of the minimum wage argue that the objectives of equity and secur ity are consistent with U.S. economic goals. Besides, the wage is not very high in the first place. Opponents object to it on the grounds of economic freedom, another economic goal. This group also believes that the wage discriminates against young people and is one of the reasons that many teenagers cannot find jobs. Some parts of the country have instituted their own equivalent of a minimum wage. For example, the “living wage” of Los Angeles is substantially higher than the federal minimum wage. Any company doing business with the city is required to pay its workers at least that amount. Current Dollars Panel A in Figure 8.9 on the following page illustrates the minimum wage in current dollars, or dollars not adjusted for inflation, from 1939 to 2006
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. In this view the minimum wage appears to have increased dramatically over time. However, the figure does not account for inflation, which erodes the purchasing power of the minimum wage. CHAPTER 8 Employment, Labor, and Wages 219 Figure 8.9 The Minimum Wage The minimum wage is expressed in current dollars in Panel A, adjusted for inflation in Panel B, and as a percentage of the average wage for workers in manufacturing in Panel C. The minimum wage has been fixed at $5.15 since 1997. Economic Analysis How does the minimum wage compare to average manufacturing wages? A T HE M INIMUM W AGE IN C URRENT D OLLARS See StudentWorks™ Plus or glencoe.com. $6.00 5.00 4.00 3.00 2.00 1.00 1940 1945 1950 1955 1960 1965 1970 1975 Year 1980 1985 1990 1995 2000 2005 2010 B T HE M INIMUM W AGE A DJUSTED FOR I NFLATION 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0 1940 1945 1950 1955 1960 1965 1970 1975 Year 1980 1985 1990 1995 2000 2005 2010 C T HE M INIMUM W AGE AS A P ERCENTAGE OF THE A VERAGE M ANUFACTURING W AGE 60% 50 40 30 20 10 1940 1945 1950 1955 1960 1965 1970 1975 Year 1980 1985 1990 1995 2000 2005 2010 Sources: Statistical Abstract of the United States; Economic Report of the President, various issues 220 UNIT 3 Economic Institutions and Issues real dollars or constant dollars dollar amounts or prices that have been adjusted for inflation base year year serving as point of comparison for other years in a price index or other statistical measure Inflation To compensate for inflation, economists like to use real or constant dollars—dollars that are adjusted in a way that removes the distortion of inflation. This involves the use of a base year—a year that serves as a comparison for all other years. Although the computations are complex, the results are not. Panel B, using constant base-year prices, shows that the minimum wage had relatively more purchasing power in 1968 than in any other year. As long as the base year serves as a common denominator for comparison purposes, the results would be the same regardless of the base year used. Panel B also shows that the purchasing power of the minimum wage goes up whenever the wage increases faster than inflation. This was the case in 1997, when the wage was increased
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to $5.15. However, the minimum wage remained the same through 2006 while prices went up during the same time period. This means that the wage actually purchased a little less each year. As long as the minimum wage remains unchanged and inflation continues, the purchasing power of the wage will continue to decline. Manufacturing Wages Panel C shows the minimum wage as a percentage of the average manufact uring wage. In 1968, for example, the minimum wage was $1.60 and the average manufacturing wage $3.01, or 53.2 percent of the manufacturing wage for that year. The ratio peaked in 1968 and then slowly declined. As long as the minimum wage stays fixed and manufacturing wages go up, this ratio will continue to decline. The minimum wage will certainly be raised again. What is not certain is when this will happen. When the minimum wage becomes unacceptably low to voters and their elected officials, Congress will increase it. Some people even want to link the minimum wage to inflation, so that the wage will automatically rise when prices rise. Reading Check Summarizing What is the difference between current dollars and real dollars? SECTION 3 Review Vocabulary 1. Explain the significance of giveback, two-tier wage system, glass ceiling, set-aside contract, minimum wage, current dollars, real or constant dollars, and base year. Main Ideas 2. Listing List three ways firms renegotiate union contracts by using a graphic organizer like the one below. Renegotiating Union Contracts Givebacks 3. Identifying What are the reasons for the income gap between men and women? 4. Explaining Why is it necessary to consider inflation when examining the minimum wage? Critical Thinking 5. The BIG Idea Have labor unions outlived their usefulness? Why or why not? 6. Synthesizing Information A number of arguments exist both in favor of and against having a minimum wage. With which side do you agree? Why? Explain your answer in a brief paragraph. 7. Analyzing Visuals Look at Figure 8.9 on page 220. When was the purchasing power of the minimum wage highest? When was it lowest? Applying Economics 8. Minimum Wage Search the employment ads in your local or regional newspaper and list at least five jobs for which you qualify. Include the advertised salary for each job. Explain why each wage is higher, lower, or the same as the current federal minimum wage. CHAPTER 8 Employment, Labor, and Wages 221 NEWSCLIP For more than a century, unions have fought hard for benefits many
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workers today take for granted—an 8-hour workday, paid vacations, and health care insurance. Unions, however, have now declined in both membership and influence. Twilight of the UAW For more than two decades, the United Auto Workers (UAW) has grudgingly allowed Detroit carmakers to slash jobs as they have struggled to keep pace with the onslaught from foreign rivals. That’s what UAW President Ron Gettelfinger agreed to when he signed off on General Motors Corp.’s buyout of more than 40,000 jobs at the No. 1 carmaker and its former parts unit, bankrupt Delphi Corp. Where the union has always drawn the line is on bedrock issues: wages and benefits for workers and retirees. This time, though, that line won’t hold. GM’s buyouts are the beginning, not the end, of the concessions the union will have to make over the next few years.... What’s going on is nothing less than the slow death of what was once the country’s most powerful industrial union. Despite years of relentless global pressure, the UAW has been able to maintain some of the best blue-collar posts in the U.S. But like lumbering GM itself, the union failed to realize what it would take to compete in a world UAW M EMBERSHIP economy. In the 1980s and 1990s, it fought concessions that would have helped U.S. carmakers fend off imports.... Like GM and Ford, it’s paying the price today.... The UAW’s setbacks highlight a broader challenge faced by blue-collar America. Just as union bargaining muscle helped make the middle class, so too does its weakening signal the stiffer barriers less-skilled workers face in today’s globalized economy.... There’s another buzzsaw coming: cars from China. Every big automaker is expanding production in the Chinese market, and analysts expect most to start exporting vehicles to the U.S. in a few years. —Reprinted from BusinessWeek 600,000 Examining the Newsclip 1980 2006 Year 1. Summarizing On what two issues did the UAW refuse to negotiate in the past? 2. Determining Cause and Effect How has globalization led to the decline of the UAW? 1.5 million ),600 1,400 1,200 1,000 800 600 400 200 0 Source
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terms of membership and workers represented by unions. Section 2 (pages 207–213) 30. Explain why a college degree can lead to higher wages. 31. Identify the purpose of collective bargaining. 32. List the approaches to resolving a deadlock between a union and a company’s management. Section 3 (pages 215–221) 33. Explain why men and women are said to have “human capital” differences. 34. Describe two corrective measures being taken to close the income gap between men and women workers. 35. Identify the original intent of the minimum wage. Critical Thinking 36. The BIG Idea Unions generally argue that the best interests of workers can be served when employees are members of a union. Do you agree or disagree with this statement? Defend your answer. Economics: Principles and Practices Web site at glencoe.com and click on Chapter 8—Self-Check Quizzes to prepare for the chapter test. Self-Check Quiz Visit the 37. Contrasting Identify the differences between mediation and arbitration. Which method do you think is more effective? Write a paragraph explaining your answer. 38. Analyzing Information Some people believe that in today’s economy, the market theory of wage determination is more useful than the theory of negotiated wages. Explain why you agree or disagree. 39. Analyzing Visuals Look at Figure 8.2 on page 202. How does your state’s position on this issue affect you? Why do you think your state supports or opposes right-to-work laws? 40. Inferring Why are workers in the food service industry least likely to be unionized? Applying Economic Concepts 43. Civilian Labor Force As you go to and from school, take note of the various occupations around you. List at least 10 occupations, and then classify them according to the four major categories of labor. Which category is represented most? Is a category not represented at all? Why do you think that might be? 44. Minimum Wage Poll at least 10 people of various ages, asking for their opinions on the following statement: There should be no minimum wage. Compile the responses and present your findings to the class. Analyzing Visuals 41. Critical Thinking Explain how a supporter of raising the minimum wage would use the information from the graph below. M INIMUM W AGE Interpreting Cartoons 45. Critical Thinking Look at the cartoon below. What goal of the labor union movement does the cartoonist illustrate? What labor action are the bean
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,310 White-Collar Workers Feel the Pinch Previously reserved for low-wage jobs such as those in textile manufacturing, offshoring today impacts white-collar workers. Some studies estimate that offshoring cost U.S. workers 400,000 jobs in 2004 and predict that it will cost more than 3 million jobs by 2015. Others foresee as many as 4 million jobs lost in the services sector alone. The ranks of high-profile American companies moving parts of their operations to India include Charles Schwab, AOL, American Express, GE, and Microsoft. And the list continues to grow. More than half of Fortune 500 companies have shipped jobs overseas, including Oracle, Dell, Delta Air Lines, J.P. Morgan Chase, British Airways, and Hewlett-Packard. Lower prices for goods and services purchased in the United States Around the clock and around the world productivity for U.S. companies, resulting in more profits Loss of jobs for U.S. workers Bengaluru (Bangalore), India, with a highly educated workforce and a total population of more than 6 million, is a magnet for U.S. companies looking to offshore jobs. Effects of Offshoring Work to India What Does It Mean For You? The good news is that cheaper labor for goods and services means lower prices for you and other consumers. You also benefit from services that are available to you any time of day. For example, if you have a medical emergency that requires x-rays, the digital images can be interpreted by an Indian radiologist overnight, with results reported back to your doctor by the next morning. The bad news is that many Americans may lose their jobs. Offshoring can even change your likelihood of future success. A college degree—even an M.D. or Ph.D.—may not be enough to compete with India’s growing employment pool of cheap, educated labor. Analyzing the Issue 1. Identifying How can using workers in India increase an American company’s productivity? 2. Determining Cause and Effect What are the main reasons why American jobs are sent overseas? 3. Applying Check your local newspaper or Internet news sources for recent reports about companies in your community or state that have sent jobs overseas. On a separate piece of paper, summarize the issues discussed in these articles and describe how they affect you and your community. (t) CARO/Peter Arnold, Inc., (b) Sherwin Crasto/Reuters/Corbis CHAPTER 9 Sources of Government Revenue Why It
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Matters You have just received your first paycheck and are looking forward to being paid $8 per hour for the 20 hours you worked. You look at your check and... “What? This check isn’t for $160! Where’s the rest of my money?” Make a list of the deductions that might be subtracted from your earnings. Read Chapter 9 to learn more about how governments raise revenue. The BIG Idea All levels of government use tax revenue to provide essential goods and services. When we receive paychecks for our work, a portion of our earnings goes to the government for taxes. 228 UNIT 3 Tim Fuller Economics: Principles and Practices Web site at glencoe.com and click Economics: Principles and Practices Web site at glencoe.com and click on Chapter 9—Chapter Overviews to preview chapter information. on Chapter 4—Chapter Overviews to preview chapter information. Chapter Overview Visit the Chapter Overview Visit the SECTION 1 The Economics of Taxation GUIDE TO READING Section Preview In this section, you will learn that taxes are the most important way of raising revenue for the government. Academic Vocabulary • validity (p. 230) • evolved (p. 234) Reading Strategy Content Vocabulary • sin tax (p. 230) • incidence of a tax (p. 231) • tax loophole (p. 232) • individual income tax (p. 232) • sales tax (p. 233) • tax return (p. 233) • benefit principle of taxation (p. 234) • ability-to-pay principle of taxation (p. 234) • proportional tax (p. 235) • average tax rate (p. 235) • Medicare (p. 235) • progressive tax (p. 235) • marginal tax rate (p. 235) • regressive tax (p. 236) Defining As you read the section, complete a graphic organizer similar to the one below by listing the criteria for taxes to be effective. Then define each of the criteria in your own words. Effective Taxes PEOPLE IN THE NEWS Teenage Tax Preparers —Atlanta Journal-Constitution Since the tax season got under way... [Oakwood High School’s business management students] have prepared 44 returns for community members, fellow students and faculty members, so far netting more than $50,000 in refunds for their clients. The only high school-based Volunteer Income Tax Assistance program in [Georgia], Oakwood provide[s] free tax services for lower-
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income residents, nonspeakers of English and the disabled. The student volunteers are saving taxpayers money. “Since we’re targeting the low-income, many are not in a position to pay $200 or $300,” [said Gloria Carithers, a senior tax specialist in the IRS Atlanta office]. “That could make the difference in paying a bill or buying something for the family.” ■ An enormous amount of money is required to run all levels of government— and the need seems to be growing every year. Taxes are the primary way to do this, and taxes affect the things we do in more ways than you think. Governments levy a variety of taxes, from sales taxes on items we purchase in stores to the income tax we have to pay on our wages. One way in which we try to minimize taxes is by finding all the exemptions and deductions we are allowed to claim when we file our income tax returns. That is what the students in the news story were doing: helping their clients get the largest refund possible. Comstock Images/Alamy CHAPTER 9 Sources of Government Revenue 229 sin tax relatively high tax designed to raise revenue and discourage consumption of a socially undesirable product Economic Impact of Taxes MAIN Idea Taxes affect the decisions we MAIN Idea make in a variety of ways. Economics & You Have you ever not bought something because you could not afford the tax on it? Read on to find out how taxes affect our behavior. Taxes and other governmental revenues influence the economy by affecting resource allocation, consumer behavior, and the nation’s productivity and growth. In addition, the burden of a tax does not always fall on the party being taxed. Resource Allocation The factors of production are affected whenever a tax is levied. A tax placed on a good or service at the factory raises the cost of production and the price of the product. People react to the higher price in a predictable manner—they buy less. When sales fall, some firms cut back on production, which means that some resources— land, capital, and labor—will have to go to other industries to be employed. Behavior Adjustment Taxes are sometimes used to encourage or discourage certain types of activities. For example, homeowners can use interest payments on mortgages as tax deductions—a practice that encourages home ownership. Interest payments on other consumer debt, such as credit cards, are not deductible—a practice that makes credit card use less attractive. A so-called sin tax—a relatively high tax designed to raise revenue while reducing consumption of a
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socially undesirable product such as liquor or tobacco—is another example of how a tax can change behavior. For the tax to be effective, however, it has to be reasonably uniform from one city or state to the next so that consumers do not have alternative sales outlets that allow them to avoid the tax. Productivity and Growth Taxes can affect productivity and economic growth by changing the incentives to save, invest, and work. For example, some people think that taxes are already quite high. Why, they argue, should they work to earn additional income if they have to pay much of it out in taxes? While these arguments have validity, it is difficult to tell if we have reached the point where taxes are too high. For example, even the wealthiest individuals pay less than half of their taxable income to state and local governments in the form of income taxes. Are these taxes so high that people do not have the incentive to earn Home Ownership People who purchase homes can deduct the interest on their mortgages. How do deductions affect the total amount of taxes people owe? Corbis Figure 9.1 Shifting the Incidence of a Tax A tax on the producer increases the cost of production and causes a change in supply. Less of the tax can be shifted back to the taxpayer if demand is elastic, as in panel A. More of the tax can be shifted to the taxpayer if demand is inelastic, as in Panel B. Economic Analysis If a tax is placed on medicine, who is likely to bear the greater burden—the producer or the consumer? A E LASTIC D EMAND B I NELASTIC D EMAND See StudentWorks™ Plus or glencoe.com. S + tax S $1 tax on producer D incidence of a tax final burden of a tax Skills Handbook See page R39 to learn about Formulating Questions. Buyer pays 60 cents more because of elastic demand. e c i r P $15.60 $15.00 S + tax S $1 tax on producer D Buyer pays 90 cents more because of inelastic demand. e c i r P $15.90 $15.00 0 6 5 Quantity 0 5.8 6 Quantity an additional $10 million because they can only keep half of it? Would they work any harder if income taxes took only 30 percent of their income? While we do not have exact answers to these questions, we do know that there must be some level of taxes at which productivity and growth would suffer. Incidence of a Tax Finally, there is the matter
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of who actually pays the tax. This is known as the incidence of a tax—or the final burden of the tax. Suppose a city wants to tax a local electric utility to raise revenue. If the utility is able to raise its rates, consumers will likely bear the burden of the tax in the form of higher utility bills. However, if the company’s rates are regulated, and if the company’s profits are not large enough to absorb the tax increase, then shareholders may get smaller dividends—placing the tax burden on the owners. The company also might delay a pay raise—shifting the burden to its workers. Supply and demand analysis can help us analyze the incidence of a tax. To illustrate, Figure 9.1 shows an elastic demand curve in Panel A and an inelastic demand curve in Panel B. Both panels have identical supply curves labeled S. Now, suppose that the government levies a $1 tax on the producer, thereby shifting the supply curve up by the amount of the tax. In Panel A, the product’s market price increases by 60 cents, which means that the producer must have absorbed the other 40 cents of the tax. In Panel B, however, the same tax on the producer results in a 90cent increase in price, which means that the producer absorbed only 10 cents of the tax. The figure clearly shows that it is much easier for a producer to shift the incidence of a tax to the consumer if the consumer’s demand curve is relatively inelastic. Reading Check Summarizing How do taxes affect businesses and consumers? CHAPTER 9 Sources of Government Revenue 231 Student Web Activity Visit the Economics: Principles and Practices Web site at glencoe.com and click on Chapter 9—Student Web Activities for an activity on the individual income tax. tax loophole exception or oversight in the tax law allowing a taxpayer to avoid paying certain taxes individual income tax federal tax levied on the wages, salaries, and other income of individuals Criteria for Effective Taxes MAIN Idea To be effective, taxes must be equitable, easy to understand, and efficient. Economics & You Do you look forward to preparing your personal income tax returns? Read on to learn why you may be apprehensive about tax time. Some taxes will always be needed, so we want to make them as fair and as effective as possible. To do so, taxes must meet three criteria: equity, simplicity, and efficiency. Equity The first criterion is equity, or fairness, which means that taxes should be impartial and just.
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Problems arise when we ask, what is fair? You might believe that everyone should pay the same amount. Your friend may think that wealthier people should pay more than those earning less. There is no overriding guide to make taxes completely equitable. However, it does make sense to avoid tax loopholes— exceptions or oversights in the tax law that allow some people and businesses to avoid paying taxes. Loopholes are fairness issues, and most people oppose them based on equity. As a result, taxes generally are viewed as being fairer if they have fewer exceptions, deductions, and exemptions. Simplicity A second criterion is simplicity. Tax laws should be written so that both taxpayers and tax collectors can understand them. People seem more willing to tolerate taxes when they understand them. The individual income tax—the federal tax on people’s earnings—is a prime example of a complex tax. The entire federal code is thousands of pages long, and even the simplified instructions from the Internal CAREERS Certified Public Accountant The Work * Prepare, analyze, and verify financial reports that inform the general public and business firms * Provide clients with sound advice on tax advan- tages and disadvantages, and repare their income tax statements * Establish an accounting system and manage cash resources Qualifications * Strong mathematical skills and ability to analyze and interpret numbers and facts * Ability to communicate results of analyses to clients and managers, both verbally and in writing * Bachelor’s degree in accounting, with many positions requiring an additional 30 hours beyond the usual 4-year bachelor’s degree * Successful completion of Uniform CPA Examination 232 UNIT 3 Economic Institutions and Issues JLP/Jose L. Pelaez/Corbis Earnings * Median annual earnings: $50,770 Job Growth Outlook * Faster than average Source: Occupational Outlook Handbook, 2006–2007 Edition Highway Taxes In many states, you have to pay a toll to use certain roads. What does this photo imply about the efficiency of tolls? sales tax general state or city tax levied on a product at the time of sale tax return annual report by a taxpayer filed with the local, state, or federal gov ernment detailing income earned and taxes owed Revenue Service (IRS) are lengthy and difficult to understand. As a result, many people dislike the individual income tax code. A sales tax—a general tax levied on most consumer purchases—is much simpler. The sales tax is paid at the time of purchase, and the amount of the tax is computed and collected by the merchant. Some
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goods such as food and medicine may be exempt, but if a product is taxed, then everyone who buys the product pays the tax. Efficiency A third criterion for an effective tax is efficiency. A tax should be relatively easy to administer and reasonably successful at generating revenue. The individual income tax satisfies this requirement fairly well. An employer usually withholds a portion of an employee’s pay and sends it to the IRS. At the end of the year, the employer notifies each employee of the amount of tax withheld so that the employee can settle any under- or overpayment with the IRS. Because of computerized payroll records, this withholding system is relatively easy. After the close of the tax year on December 31 and before April 15 of the next year, employees file a tax return—an annual report to the IRS summarizing total income, deductions, and taxes withheld. Any difference between the amount already paid and the amount actually owed is settled at that time. Most differences are due to deductions and expenses that lower the amount of taxes owed, as well as additional income not subject to tax withholding. State and local governments usually require tax returns to be filed at the same time. Other taxes, especially those collected in toll booths on state highways, are considerably less efficient. The state has to invest millions of dollars in heavily reinforced booths that span the highway. The cost to commuters, besides the toll, is the wear and tear on their automobiles as they brake for toll booths along the road. Efficiency also means that a tax should raise enough revenue to be worthwhile while not harming the economy. One example is the federal luxury tax on small private aircraft in the early 1990s. The IRS collected only $53,000 in revenues during the first year of this tax because few planes were sold. This turned out to be less than the unemployment benefits paid to workers who lost jobs in that industry, so Congress quickly repealed that luxury tax. Reading Check Stating Why is equity important? Chris Minerva /Index Stock Imagery CHAPTER 9 Sources of Government Revenue 233 benefit principle of taxation belief that taxes should be paid according to benefits received regardless of income ability-to-pay principle of taxation belief that taxes should be paid according to level of income, regardless of benefits received Two Principles of Taxation MAIN Idea Taxes can be levied on the basis of benefits received or the ability to pay. Economics & You Do you think the taxes you pay are fair? Read on to see if you prefer one principle of taxation over another. Taxes in the United States are based on two principles
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that have evolved over the years. These principles are the benefit principle and the ability-to-pay principle. Benefit Principle Gasoline and tire taxes are used to pay for the upkeep of roads. What are the limitations of gasoline taxes? Benefit Principle The benefit principle of taxation states that those who benefit from government goods and services should pay in proportion to the amount of benefits they receive. Gasoline taxes are a good example of this principle. Because the gas tax is built into the price of gasoline, people who drive more than others pay more gas taxes—and therefore pay for more of the upkeep of our nation’s highways. Taxes on truck tires operate on the same principle. Since heavy vehicles like trucks are likely to put the most wear and tear on roads, a tire tax links the cost of highway upkeep to the user. Despite its attractive features, the benefit principle has two limitations. The first is that those who receive government services may be the ones who can least afford to pay for them. Recipients of welfare payments or people who live in subsidized housing, for example, usually have the lowest incomes. Even if they could pay something, they would not be able to pay in proportion to the benefits they receive. The second limitation is that benefits are often hard to measure. After all, the people who buy the gas are not the only ones who benefit from the roads built with gas taxes. Owners of property, hotels, and restaurants along the way are also likely to benefit from the roads that the gas tax helps provide. Ability-to-Pay Principle The belief that people should be taxed according to their ability to pay, regardless of the benefits they receive, is called the ability-to-pay principle of taxation. An example is the individual income tax, which requires people with higher incomes to pay more than those who earn less. This principle is based on two factors. First, we cannot always measure the benefits derived from government spending. Second, it assumes that people with higher incomes suffer less discomfort paying taxes than people with lower incomes. For example, a family of four with an annual taxable income of $20,000 needs every cent to pay for necessities. At a tax rate of about 13 percent, this family pays $2,623—a huge amount for them. A family of four with taxable income of $100,000 can afford to pay a higher average tax rate with much less discomfort. Reading Check Explaining Which principle of taxation do you prefer, and why? Royalty Free/Corbis Figure 9.2 Three Types
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of Taxes Progressive, proportional, and regressive are the three main types of taxes. Economic Analysis Under which type of tax do individuals with lower incomes pay a smaller percentage than do those with higher incomes? Type of tax Income of $10,000 Income of $100,000 Summary Proportional (City income tax) $97.50 or 0.975% of income $975.00 or 0.975% of income As income goes up, the percentage of income paid in taxes stays the same. Progressive (Federal income tax) $1,000 paid in taxes, or 10% of total income $25,000 paid in taxes, or 25% of total income As income goes up, the percentage of income paid in taxes goes up. Regressive (State sales tax) $5,000 in food and clothing purchases, taxed at 4% for a total tax of $200 or 2% of income $20,000 in food and clothing purchases, taxed at 4% for a total tax of $800 or 0.8% of income As income goes up, the percentage of income paid in taxes goes down. Three Types of Taxes MAIN Idea All taxes can be broken down into three categories—proportional, progressive, and regressive. Economics & You You just learned about two principles of taxation. Find out how the principles apply to different types of taxes. Three general types of taxes exist in the United States today—proportional, progressive, and regressive. As Figure 9.2 shows, each type of tax is classified according to the way in which the tax burden changes as income changes. To calculate the tax burden, we divide the amount that someone pays in taxes by their taxable income. If a person pays $100 in taxes on a $10,000 income, then the tax burden is 0.01, or 1 percent. Proportional Tax A proportional tax imposes the same percentage rate of taxation on everyone, regardless of income. If the income tax rate is 20 percent, an individual with $10,000 in taxable income pays $2,000 in taxes. A person with $100,000 in taxable income pays $20,000. If the percentage tax rate is constant, the average tax rate—total tax paid divided by the total taxable income—also is constant, regardless of income. If a person’s income goes up, the percentage of total income paid in taxes does not change. Few proportional taxes are used in the United States. One example is the 15 percent tax rate
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on corporate dividends. Regardless of overall income and how much someone receives in corporate dividends, individuals only pay 15 percent of that amount in personal income taxes. Another example is the tax that funds Medicare—a federal health-care program available to all senior citizens, regardless of income. The Medicare tax is 1.45 percent of income, with no limit on the amount of income taxed. As a result, everyone who receives a paycheck pays exactly the same rate, regardless of the size of the paycheck. Progressive Tax A progressive tax is a tax that imposes a higher percentage rate of taxation on higher incomes than on lower ones. This tax uses a progressively higher marginal tax rate, the tax rate that applies to the next dollar of taxable income. proportional tax tax in which the percentage of income paid in tax is the same regardless of the level of income average tax rate total taxes paid divided by the total taxable income Medicare federal health-care program for senior citizens progressive tax tax in which the percentage of income paid in tax rises as the level of income rises marginal tax rate tax rate that applies to the next dollar of taxable income CHAPTER 9 Sources of Government Revenue 235 regressive tax tax in which the percentage of income paid in tax goes down as income rises For example, suppose the law required everyone to pay a rate of 10 percent on all taxable income up to $7,500, and then a rate of 15 percent on all income after that. If someone had taxable income of $5,000, this person would have to pay 10 percent on the 5,001st dollar earned. In this case, the marginal tax rate on the 5,001st dollar would be 10 percent. However, if the same person had taxable income of $7,500, then the marginal tax rate would be 15 percent on the 7,501st dollar earned. In either case, the marginal tax is always the tax that is paid on the very next dollar of taxable income. The individual income tax code used in the United States today is structured just this way. It currently starts at 10 percent and then jumps to 15 percent, 25 percent, 28 percent, 33 percent, and 35 percent, depending on the amount of taxable income. One important outcome of this structure is that progressively higher marginal brackets also cause the average tax rate to go up as taxable income goes up. Regressive Tax A regressive tax is a tax that imposes a higher percentage rate of taxation on low incomes than on high incomes. For example, a person in a state with a 4 percent sales tax and an annual
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income of $10,000 may spend $5,000 on food and clothing and pay sales taxes of $200 (or.04 times $5,000). A person with an annual income of $100,000 may spend $20,000 on food and clothing and pay state sales taxes of $800 (or.04 times $20,000). On a percentage basis, the person with the lower income pays 2 percent (or $200 divided by $10,000) of income in sales taxes, while the person with the higher income pays 0.8 percent (or $800 divided by $100,000). As a result, the 4 percent sales tax is regressive because the individual with the higher income pays a smaller percentage of income in sales taxes than does the individual with the lower income. Reading Check Synthesizing Which of the types of taxes should be used for income taxes? Why? SECTION 1 Review Vocabulary 1. Explain the significance of sin tax, incidence of a tax, Critical Thinking 5. The BIG Idea Compare and contrast the characteristics tax loophole, individual income tax, sales tax, tax return, benefit principle of taxation, ability-to-pay principle of taxation, proportional tax, average tax rate, Medicare, progressive tax, marginal tax rate, and regressive tax. Main Ideas 2. Describing Use a graphic organizer like the one below to describe the economic impact of taxes. Impact of Taxes 3. Identifying What are the criteria for effective taxes? 4. Summarizing What are the main points of the two principles of taxation? 236 UNIT 3 Economic Institutions and Issues of proportional, progressive, and regressive taxes. 6. Evaluating Using the criteria described in this chapter, how would you evaluate the effectiveness of the personal income tax? 7. Analyzing Visuals School districts often are supported by property taxes. These taxes are based on a percentage of the value of a house or other real estate. Look at Figure 9.2 on page 235. In which category of taxes does the property tax fall? Applying Economics 8. Equity Which of the two principles of taxation—the benefit principle or the ability-to-pay principle—do you think is more equitable? Explain your answer. Be sure to include in your answer how the two principles differ from one another. ENTREPRENEUR Profiles in Economics Monica Garcia Pleiman (1964– ) • president and CEO of OMS, a technology consulting firm • publisher of Hispanic lifestyles magazine Latino SUAVE • cofounder of the Lat
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ina Chamber of Commerce Small Start Denver-based businesswoman Monica Garcia Pleiman knew early what she wanted to do with her life. As the daughter of a small business owner, she learned that “hard work and entrepreneurial skills” could bring financial success. She also took her high school’s only computer class—and loved it. In 1987 Pleiman earned a degree in Information Science, a 95 percent male program. After working for both large corporations and small companies, she formed the consulting firm Optimum Management Systems (OMS). Small Business Pleiman uses several successful strategies. Her practice of sharing the credit and allowing employees to grow in their jobs has resulted in a loyal OMS workforce—unusual in today’s highly competitive, ever-changing technology sector. She tries to maintain a small-business environment while providing large-company benefits. She also focuses on serving small and minority businesses. Finally, she has taken advantage of assistance by the federal government’s Small Business Administration, including attending the Minority Business Executive Program sponsored by the SBA. These strategies have paid off. OMS grew 910 percent from its start in 1998 to 2003. Revenues over $7 million per year make it one of the country’s most successful minority-owned businesses. This success allowed Pleiman to branch out and publish a new bilingual lifestyle magazine, Latino SUAVE. Examining the Profile 1. Summarizing What strategies helped Pleiman become a successful entrepreneur? 2. For Further Research What types of assistance does the Small Business Administration offer to entrepreneurs? Pleiman descends from a long line of hard workers. Her Spanish ancestors settled Colorado 200 years ago. With six brothers, “I learned how to compete against men, to prove I could make it as a woman and as a minority.” Dave Neligh CHAPTER 9 Sources of Government Revenue 237 SECTION 2 Federal, State, and Local Revenue Systems GUIDE TO READING Section Preview Academic Vocabulary In this section, you will learn that federal, state, and local governments rely on different revenue sources. • implemented (p. 242) • considerably (p. 243) Content Vocabulary • Internal Revenue Service (IRS) (p. 238) • payroll withholding system (p. 239) • indexing (p. 239) • FICA (p. 239) • payroll tax (p. 239) • corporate income tax (p. 240) • excise tax (p. 240) • estate tax (p. 241) •
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gift tax (p. 241) • customs duty (p. 241) • user fee (p. 241) • intergovernmental revenue (p. 242) • property tax (p. 244) • tax assessor (p. 244) • natural monopoly (p. 244) Reading Strategy Describing As you read the section, complete a graphic organizer like the one below to identify and describe the revenue sources for federal, state, and local governments. Revenue sources Federal Local State —The Columbus Dispatch ISSUES IN THE NEWS Taxing Tycoons Come to Newport, Rhode Island, and see what America was like before the income tax. The Elms is a Gilded Age mansion graced by a Louis XV ballroom and tapestries from Imperial Russia. Its owner made his tax-free fortune off the coal mines of Pennsylvania and West Virginia. [B]ut by the dawn of the 20th century, American farmers, miners, and factory workers started thinking that the Vanderbilts and their ilk should contribute more to the country. And so on October 3, 1913, President Wilson signed the bill that created an income tax. It touched only the wealthiest 4 percent of Americans. ■ Internal Revenue Service (IRS) branch of the U.S. Treasury Department that collects taxes The first federal income tax was enacted by the Union government in 1861 to help finance the Civil War. It was repealed in 1872. A later income tax was found unconstitutional in 1893, but it had the potential to be a major source of revenue. It was not until the ratification of the Sixteenth Amendment in 1913 that Congress could enact the current individual income tax. Since then, the top marginal tax rate has varied widely, from 1 percent for incomes over $3,000 in 1913 to 94 percent for the highest incomes during World War II. The Internal Revenue Service (IRS) is the branch of the U.S. Treasury Department in charge of collecting taxes today. 238 UNIT 3 Economic Institutions and Issues James Lemass/Index Stock Imagery Federal Government Revenue Sources MAIN Idea Individual income taxes, FICA, and borrowing constitute the main sources of government revenue. Economics & You Have you ever wondered what “FICA” on your pay stub means? Read on to find out about one of the main federal revenue sources. The federal government gets its revenue from a number of sources. Taxes are the primary source of revenue, but borrowing also plays a big part. As shown in Figure 9.3, the four largest sources of
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government revenue are individual income taxes, Social Security taxes, borrowing, and corporate income taxes. Individual Income Taxes The main source of federal government revenue is the individual income tax. In most cases, the tax is collected with a payroll withholding system, a system that requires an employer to automatically deduct income taxes from a worker’s paycheck and send them directly to the IRS. Because inflation can push a worker into a higher tax bracket, the tax code is also indexed. Indexing is an upward revision of the tax brackets to keep workers from paying more in taxes just because of inflation. Workers might otherwise move into a higher tax bracket when they receive a pay raise that makes up for inflation. FICA Taxes The second most important federal revenue source is FICA. FICA is the Federal Insurance Contributions Act tax, which is levied on employers and employees equally to pay for Social Security and Medicare. These two taxes are sometimes called payroll taxes because they are deducted from paychecks. In 2007 the Social Security component of FICA was 6.2 percent of wages and salaries up to $97,500. Above that amount, Social Security taxes are not collected, regardless of income. This means that a person with Figure 9.3 Federal Government Revenue Sources payroll withholding system system that automatically deducts income taxes from paychecks on a regular basis indexing adjustment of the tax brackets to offset the impact of inflation FICA Federal Insurance Contributions Act; tax levied on employers and employees to support Social Security and Medicare payroll tax tax on wages and salaries deducted from paychecks to finance Social Security and Medicare 2007 2001 34.9% Social security taxes 31.9% 7.6% Corporate income taxes 9.4% 3.3% 1.0% 1.4% 0% 1.9% Excise taxes Customs duties Estate and gift taxes Borrowing Miscellaneous 2.7% 1.0% 0.9% 12.8% 1.7% 49.9% Individual income taxes 39.6% Source: Economic Report of the President, 2006 In 2001 the federal government saved 1.7¢ of every dollar it spent. By 2007, the government was borrowing 12.8¢ for every dollar spent. The federal government now borrows more from investors than it collects from corporations in taxes. Economic Analysis What is the percentage of total revenue for the first four items? &The Global Economy YOU High Taxes—Are You Sure? You examine your paycheck and are dismayed to see how much money has been taken out for taxes. Before you get too outraged, however
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, do the math. What percentage of the total amount has been withheld for taxes? Ten percent? Twenty percent? This is a far cry less than would be withheld in many other countries. One measure of a country’s tax burden is the ratio of its tax revenues to gross domestic product (GDP). Despite the criticism over high taxes in the United States, our federal government’s revenues as a percentage of GDP are much lower than people realize. Sweden is usually ranked first as the country with the world’s highest taxes, whereas the United States boasts one of the lowest tax revenue-to-GDP ratios in the industrial world. TOTAL TAX REVENUE AS A PERCENTAGE OF GDP 50% 40 30 20 10 0 Sweden d Finlan France Spain Canada nited dom U g Kin ustralia nited States U A Japan Source: Organization for Economic Co-operation and Development (OECD) corporate income tax tax on corporate profits excise tax general revenue tax levied on the manufacture or sale of selected items taxable income of $97,500 pays the same Social Security tax—$6,045—as does someone who earns $1,000,000,000. In 1965 Congress added Medicare to the Social Security program. The Medicare component of FICA is taxed at a flat rate of 1.45 percent. Unlike Social Security, there is no cap on the amount of income taxed, which makes it a proportional tax. Borrowing Borrowing by the federal government is the third-largest source of federal revenue. Because tax revenues fluctuate, the government never knows exactly how much it will need to borrow. Therefore, it continues with its spending as allocated in the budget. If it does not collect enough money in taxes and user fees, it simply borrows the rest by selling bonds to investors. Figure 9.3 shows that the federal government has become dependent on this source of funds, with the amount of money borrowed exceeding the total amount of taxes collected from corporations. The increased 240 UNIT 3 Economic Institutions and Issues borrowing has been mainly due to the increased levels of government spending since 2001 that have outpaced federal revenue collection. Corporate Income Taxes The fourth-largest source of federal revenue is the corporate income tax—the tax a corporation pays on its profits. The corporation is taxed separately from individuals because the corporation is recognized as a separate legal entity. Several marginal tax brackets, which are slightly progressive, apply to corporations. The first is at 15 percent on all income under $50,
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000. The marginal brackets then rise slightly after that, and eventually a 35 percent marginal tax applies to all profits in excess of $18.3 million. Excise Taxes The excise tax—a tax on the manufacture or sale of selected items such as gasoline and liquor—is the fifth-largest source of federal government revenue. Some early excise taxes were on carriages, snuff, and liquor. Today federal excise taxes are levied on telephone services, tires, legal betting, and coal. Because low-income families spend larger portions of their incomes on these goods than do high-income families, excise taxes tend to be regressive. Estate and Gift Taxes The estate tax is the tax on the transfer of property when a person dies. Estate taxes can range from 18 to 50 percent of the value of the estate, although estates worth less than $2,000,000 are exempt. The exemption will be raised to $3,500,000 by 2009, but because these amounts are so high, fewer than 2 percent of all estates pay any tax at all. The gift tax is a tax on the transfer of money or wealth and is paid by the person who makes the gift. The gift tax is used to make sure that wealthy people do not try to avoid taxes by giving away their estates before they die. Figure 9.3 shows that estate and gift taxes account for only a small fraction of total federal government revenues. Customs Duties A customs duty is a charge levied on goods brought into the United States from other countries. The Constitution gives Congress the authority to levy customs duties. Congress then can decide which foreign imports will be taxed and at what rate. Many types of goods are covered, ranging from automobiles to silver ore. The duties are relatively low and produce little federal revenue today. Before the enactment of the income tax amendment, however, they were the largest income source for the federal government. Miscellaneous Fees Finally, only a fraction of federal revenue is collected through various miscellaneous fees. One example of a miscellaneous fee is a user fee—a charge levied for the use of a good or service. User fees were widely promoted by President Ronald Reagan, who wanted to find revenue sources that did not involve taxes. User fees include entrance charges at national parks, as well as the fees ranchers pay when their animals graze on federal land. These fees are essentially taxes based on the benefit principle, because only the individuals who use the services pay them. People also seem more comfortable with them since they are not called “taxes.”
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Reading Check Explaining Why are corporations taxed separately from individuals? estate tax tax on the transfer of property when a person dies gift tax tax paid by the donor on transfer of money or wealth customs duty tax on imported products user fee fee paid for the use of a good or service User Fees Visitors to national parks such as Kenai Fjords National Park in Alaska have to pay an entrance fee. How are user fees assessed intergovernmen tal revenue funds that one level of government receives from another level of government Skills Handbook See page R50 to learn about Using Bar and Circle Graphs. State Government Revenue Sources government to help fund the state’s expenditures for welfare, education, highways, health, and hospitals. MAIN Idea States rely on funds from the federal government in addition to income taxes and sales taxes. Economics & You Do you ever wonder why you pay a tax on items you purchase in a store? Read on to learn about sales taxes. State governments collect their revenues from several sources. Figure 9.4 shows the relative proportions of these sources, the largest of which are examined below. Intergovernmental Revenues The largest source of state revenue consists of intergovernmental revenue—funds collected by one level of government that are distributed to another level of government for expenditures. States receive the majority of these funds from the federal Sales Taxes Most states also have implemented sales taxes to add to their revenue. A sales tax is a general tax levied on consumer purchases of nearly all products. The tax is a percentage of the purchase price, which is added to the final price the consumer pays. Merchants collect the tax at the time of sale. The taxes are then turned over to the proper state government agency on a monthly or other periodic basis. Most states allow merchants to keep a small portion of what they collect to compensate for their time and bookkeeping costs. The sales tax is the second largest source of revenue for states, although five states—Alaska, Delaware, Montana, New Hampshire, and Oregon— do not have a general sales tax. Figure 9.4 State and Local Government Revenue Sources See StudentWorks™ Plus or glencoe.com. State governments Local governments State and local governments have their own sources of revenue. While many have an individual income tax, this is not a major source of funding. Economic Analysis What are the two largest sources of state and local revenues? 26.6% 20.1% 13.4% Intergovernmental revenue 34.9% Sales taxes Individual income tax 5.4% 1.5% 12.
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2% Employee retirement and insurance 0.8% 4.7% 4.4% 2.2% 2.1% 1.8% 0.9% 0.8% Borrowing Higher education fees Interest earnings Corporate income tax Hospital fees Utility revenue Property taxes 10.8% Other 4.5% 0.6% 2.4% 0.2% 3.7% 7.6% 24.0% 14.4% Taxes Most people have to pay taxes to all levels of government. What does the cartoon imply about the impact of taxes on people Individual Income Taxes All but seven states—Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming—rely on the individual income tax for revenue. The tax brackets in each state vary considerably, and taxes can be progressive in some states and proportional in others. Other Revenues States rely on a variety of other revenue sources, including interest earnings on surplus funds; tuition and fees collected from state-owned colleges, universities, and technical schools; corporate income taxes; and hospital fees. While the percentages for revenue sources in Figure 9.4 are representative of most states, wide variations among states exist. For example, Alaska is the only state without either a general sales tax or an income tax, so it has to rely on other taxes and fees for its operating revenue. Reading Check Contrasting How do states without individual income taxes find sources of revenue? Local Government Revenue Sources MAIN Idea Local governments rely mostly on intergovernmental revenue and property taxes. Economics & You Do you hope to own a house some day? Read on to learn how this will add another tax to those you are already paying. Like state governments, local governments have a variety of revenue sources, as shown in Figure 9.4. These sources include taxes and funds from state and federal governments. The main categories are discussed below. Intergovernmental Revenues Local governments receive the largest part of their revenues—slightly more than one-third—in the form of intergovernmental transfers from state governments. These funds are generally intended for education and public welfare. A much smaller amount comes directly from the federal government, mostly for urban renewal. Harley Schwadron/www.CartoonStock.com CHAPTER 9 Sources of Government Revenue 243 Figure 9.5 State and Local Taxes as a Percentage of State Income State income is the sum of all income earned by all people in the state. State and local governments receive a percentage of that income as tax revenue from a number of sources. The
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five states without sales taxes—Alaska, Delaware, Montana, New Hampshire, and Oregon—rely on other taxes to provide state revenues. Economic Analysis Which states have the highest level of taxes? The lowest level? 6.4 11.5 10.0 9.6 9.5 10.3 9.5 10.1 10.0 10.9 9.5 10.2 9.9 U.S. Average 10.1 Source: Tax Foundation, 2006 9.4 8.8 10.9 10.7 10.0 11.4 9.8 10.9 9.4 9.4 9.3 10.5 10.4 7.4 11.1 13.0 10.1 10.3 11.0 10.5 10.3 8.3 12.0 9.7 9.7 10.0 9.8 11.4 10.5 10.4 8.0 10.3 12.2 10.0 8.7 9.8 9.9 9.2 property tax tax on tangible and intangible possessions such as real estate, buildings, furniture, stocks, bonds, and bank accounts tax assessor person who examines and assesses property values for tax purposes natural monopoly market structure in which average costs of production are lowest when a single firm exists (also see page 176) Property Taxes Utility Revenues The second-largest source of revenue for local governments is the property tax—a tax on tangible and intangible possessions. Such possessions usually include real estate, buildings, furniture, farm animals, stocks, bonds, and bank accounts. Most states also assess a property tax on automobiles. The property tax that raises the most revenue is the tax on real estate. Taxes on other personal property, with the exception of automobiles, are seldom collected because of the problem of valuation. For example, how would the tax assessor—the person who assigns value to property for tax purposes—know the reasonable value of everyone’s wedding silver, furniture, clothing, or other tangible property? Instead, most communities find it more efficient to hire one or more individuals to assess the value of a few big-ticket items such as buildings and motor vehicles. The third-largest source of local revenue is the income from public utilities that supply water, electricity, sewerage, and even telecommunications. Because of economies of scale, many of of these companies are natural monopolies. A community needs only one set of electrical power lines or underground water pipes, for example, so one company usually supplies all of
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the services. When people pay their utility bills, the payments are counted as a source of revenue for local governments. Sales Taxes Many cities have their own sales taxes. Merchants collect these taxes along with the state sales taxes at the point of sale. While these taxes typically are much lower than state sales taxes, they are the fourth most important source of local government revenues. 244 UNIT 3 Economic Institutions and Issues Other Revenue Sources Figure 9.4 on page 242 shows a variety of ways in which local governments collect their remaining revenues. Some local governments receive a portion of their funds from hospital fees. Others may collect income taxes from individuals and profit taxes from corporations. Still another revenue source for local governments is the interest on invested funds. If local governments spend more than they collect in revenues, they can borrow from investors. While borrowed funds are small compared to those of the federal government, they form an important source of local government funding. Local governments look for revenues in a number of ways. Still, the revenue sources available in general are much more limited than those available to the state and federal levels of government. Reading Check Recalling Which property tax earns the most revenue for local governments? Tax Assessments Tax assessors determine the value of property for tax purposes. Why are property taxes important for local communities? SECTION 2 Review Vocabulary 1. Explain the significance of Internal Revenue Service (IRS), payroll withholding system, indexing, FICA, payroll tax, corporate income tax, excise tax, estate tax, gift tax, customs duty, user fee, intergovernmental revenue, property tax, tax assessor, and natural monopoly. Main Ideas 2. Listing Use a graphic organizer like the one below to list the federal government’s major revenue sources. Major Sources of Federal Government Revenue 3. Describing How do the major revenue sources for state and local governments differ? Critical Thinking 4. The BIG Idea Federal, state, and local governments receive revenue from various sources. Which source do you think best satisfies the tax criteria discussed in Section 1? Defend your answer in a written paragraph. 5. Drawing Conclusions Why do you think sales taxes are generally applied to food and beverages purchased in restaurants, but not to those purchased in stores? 6. Analyzing Visuals Look at Figure 9.4 on page 242. Why do you think the revenue from income taxes and property taxes differ so much between state and local governments? 7. Synthesizing How do excise taxes differ from other taxes such as sales taxes or estate taxes? Applying Economics 8
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. User Fees User fees have been compared to taxes based on the benefit principle of taxation. Define user fees in your own words. What are the pros and cons of user fees for national parks? photocritic.org/Alamy Images CHAPTER 9 Sources of Government Revenue 245 CASE STUDY Dreaded Tax Returns Buried in Paper Every spring, you can tell it’s close to the April 15 tax deadline by the anxious faces of frustrated taxpayers and exhausted accountants. The U.S. tax system is one of the most complicated in the world, with almost 17,000 pages of tax code and more than 600 forms. Record keeping, education, and compliance cost the nation $265 billion annually. In 2005 it took about 115,000 Internal Revenue Service (IRS) employees and almost $10.7 billion to collect about $1 trillion from 125 million taxpayers and 7 million businesses. P ERCENTAGE OF T AXPAYERS U SING P ROFESSIONAL H ELP 65% 60 55 50 45 40 35 ’85 ’87 ’89 ’91 ’93 ’95 Year ’97 ’99 ’01 ’03 Source: Internet Revenue Service Time is Money Because the tax code has become so complex, more and more Americans hire tax preparers to help them with their returns. On top of that, about 2.2 million taxpayers overpay—by an average of $438—because they either don’t itemize deductions or don’t include all deductions or exemptions they could claim. Although many Americans file their tax returns online, they still spend an average of 17 hours completing the forms. The complexity of the system has caused many people to long for a simpler flat-tax system. 246 UNIT 3 Economic Institutions and Issues Royalty-Free/Corbis The European Solution Several eastern European countries have adopted a flat tax, where everyone pays the same percentage above an exempt amount, regardless of income. The first was the Baltic republic of Estonia, which adopted a flat tax rate of 26 percent in 1994. Most Estonians take only 5 to 20 minutes to complete and electronically file an “e-postcard.” The country’s tax department spends one penny for every dollar of income tax collected, compared to 25 cents the IRS spends in the United States. NEWS FLASH The Longest Return General Electric’s 2006 tax return was 24,000 pages long. Had they filed a paper return, it would have been
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a stack 8 feet high; instead, they filed a 237-megabyte electronic return. Analyzing the Impact 1. Summarizing Why is the U.S. income tax system so complicated? 2. Drawing Conclusions Do you think it is easier for a small country like Estonia to implement a flat tax than it would be for the United States? Explain. SECTION 3 Current Tax Issues and Reforms GUIDE TO READING Section Preview Academic Vocabulary In this section, you will learn that one consequence of tax reform was to make the individual tax code more complex than ever. Content Vocabulary • payroll withholding statement (p. 248) • accelerated depreciation (p. 249) • investment tax credit (p. 249) • alternative minimum tax (p. 249) • capital gains (p. 250) • flat tax (p. 251) • value-added tax (VAT) (p. 252) • concept (p. 251) • controversial (p. 252) Reading Strategy Listing As you read the section, complete a graphic organizer like the one below by listing the advantages and disadvantages of the flat tax. Include a definition of flat tax in your own words. Advantages Disadvantages Flat tax Value-added tax ISSUES IN THE NEWS A Trophy Loophole —The San Francisco Chronicle One of the looniest tax loopholes imaginable... [is]... a tax break for big-game hunters who can deduct the cost of an expensive safari when they donate the stuffed trophy to a museum. By using tax-code provisions designed to encourage charitable donations, a hunter can give away a trophy specimen. This gives a fat tax break to the hunter. It’s also created a system of tax dodging and shady dealing. Little-known museums exist largely to take in the trophies and sign tax receipts. Senator Charles Grassley... wants to end such hunting deductions [but] a similar proviso is missing from a tax overhaul in the House.... ■ The individual tax code is incredibly complex. The complete code is about 17,000 pages long and contains approximately 9 million words. It has been estimated that Americans spend more than 7 billion hours every year filling out their federal tax returns for the IRS. Every year, magazines like Money ask professional tax preparers to fill out tax returns for a hypothetical family—only to find out that no two returns are the same. If experts can’t get it right, then the rest of us will obviously have a difficult time.
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Also, it is all too easy for lawmakers to insert special-interest provisions in the tax code, such as the one in the news story above. It is no wonder that the tax code has been amended about 14,000 times in the last 20 years—and Congress is still not done with changes! Randy Wells/Corbis CHAPTER 9 Sources of Government Revenue 247 payroll withholding statement document attached to a paycheck summarizing pay and deductions Personal Finance Handbook See pages R24–R27 for more information on paying taxes. Examining Your Paycheck MAIN Idea The income taxes you pay are summarized on the stub that is attached to your paycheck. Economics & You Do you have a job where your taxes are taken out before you are paid? Read on to learn how these taxes are deducted from your paycheck. Most of the federal, state, and local taxes are deducted directly from your paycheck. Employers list these deductions on the payroll withholding statement—the stub attached to a paycheck that summarizes income, tax withholdings, and other deductions, as shown in Figure 9.6. The worker to whom the check belongs makes $10 an hour and receives a check every two weeks. If the length of the workweek is 40 hours, the worker’s gross pay amounts to $800. The worker is single, has no deductions, and lives and works in Kentucky. According to withholding tables the federal government supplied for that year, biweekly workers making at least $800, but less than $820, have $104.70 withheld from their paychecks every pay period. Similar tables for the state of Kentucky specify that $40.01 is withheld for state income taxes. Because these are both estimates, and because even minor differences between the amounts withheld and the amount actually owed can grow, the worker will file state and federal tax returns between January 1 and April 15 of the following year to settle the differences. Another deduction is the half-percent city income tax that amounts to $4. Because the amount is relatively small, most cities do not require taxpayers to file separate year-end tax forms. The FICA tax amounts to 7.65 percent (6.20 percent for Social Security and 1.45 percent for Medicare) of $800, or $61.20. The FICA is deducted from the gross pay, along with $3.20 in miscellaneous deductions, which leaves a net pay of $586.89. If the worker has insurance payments or retirement contributions, or puts money into a credit union, more deductions will appear
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on the pay stub. Reading Check Summarizing How are payroll deductions calculated? Figure 9.6 Biweekly Paycheck and Withholding Statement 2,195,903 21-2 000 Number Date June 29 07 20 The withholding statement attached to your paycheck summarizes the federal and state tax deductions from your pay. Other withholdings may include city income taxes and voluntary deductions, such as health insurance payments and savings plans. Economic Analysis What percentage of this individual’s pay has been deducted from the paycheck? Pay to the order of Sara Pena ˜ $ 586.89 Five Hundred Eighty-Six Dollars and 89/100 Dollars Memo Treasurer PLEASE DETACH AND RETAIN THIS PORTION AS YOUR RECORD OF EARNINGS AND DEDUCTIONS Date Pay End Vo. No. Emp. No. Hrs. Misc. Cr. Un. Ins. Gross 6/29/07 6/23/07 1376 80 3.20 104 70 40 01 4 00 61 20 800 00 586 89 Federal State City FICA Ret. Bonds Other Net Figure 9.7 Tax Table for Single Individuals, 2006 If taxable income is over... But not over... The tax is: $0 $7,550 $30,650 $74,200 $154,800 $336,550 $7,550 $30,650 $74,200 $154,800 $336,550 no limit 10% of the amount over $0 $755 plus 15% of the amount over $7,550 $4,220 plus 25% of the amount over $30,650 $15,107.50 plus 28% of the amount over $74,200 $37,675.50 plus 33% of the amount over $154,800 $97,653.00 plus 35% of the amount over $336,550 According to the individual income tax table, a single individual with $6,000 of taxable income would pay $6,000 x.10, or $600 in taxes. Economic Analysis How much in taxes would an individual with $40,000 of taxable income pay? Source: IRS Schedule X Tax Reform MAIN Idea Numerous changes have been made to the federal income tax code since 1981. Economics and You Do you or your family pay federal income taxes? Read on to learn why keeping up with the tax code is so difficult. Tax reform has received considerable attention recently. Since 1981, there have been more changes in the tax code than at any other time in our
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nation’s history. Tax Reform in 1981 When Ronald Reagan was elected president in 1980, he believed that high taxes were the main stumbling block to economic growth. In 1981 he signed the Economic Recovery Tax Act, which included large tax reductions for individuals and businesses. Before the Recovery Act, the individual tax code had 16 marginal tax brackets ranging from 14 to 70 percent. The act lowered the marginal rates in all brackets, capping the highest marginal tax at 50 percent. In comparison, today’s tax code, shown in Figure 9.7, has six marginal brackets ranging from 10 to 35 percent. Businesses also got tax relief in the form of accelerated depreciation—earlier and larger depreciation charges—which allowed firms to reduce federal income tax payments. Another section of the act introduced the investment tax credit—a reduction in business taxes that are tied to investment in new plants and equipment. For example, a company might purchase a $50,000 machine that qualified for a 10 percent, or $5,000, tax credit. If the firm owed $12,000 in taxes, the credit reduced the tax owed to $7,000. Tax Reform: 1986, 1993 By the mid-1980s, the idea that the tax code favored the rich and powerful was gaining momentum. In 1983 more than 3,000 millionaires paid no income taxes. In 1986 Congress passed sweeping tax reform that made it difficult for the very rich to avoid taxes altogether. The alternative minimum tax—the personal income tax rate that applies whenever the amount of taxes paid falls below a designated level—was strengthened. Under this provision, people had to pay a minimum tax of 20 percent, regardless of other circumstances or loopholes in the tax code. As the United States entered the 1990s, the impact of 10 years of tax cuts was beginning to show. Government spending was growing faster than revenues, and the government had to borrow more. The resulting tax reform of 1993 was driven more by the need for the government to balance its accelerated depreciation schedule that spreads depreciation over fewer years to generate larger tax reductions investment tax credit tax credit given for purchase of equipment alternative minimum tax personal income tax rate that applies to cases in which taxes would otherwise fall below a certain level Skills Handbook See page R54 to learn about Understanding Percentages. CHAPTER 9 Sources of Government Revenue 249 Figure 9.8 Total Government Receipts per Capita, Adjusted for Inflation Although a recession in 2001 reduced revenues from 2002 to 2003, total revenue collections by all levels of government have grown dramatically over the years.
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Economic Analysis How does the graph reflect the tax reforms since 1981? T OTAL G OVERNMENT R ECEIPTS AS A P ERCENTAGE OF GDP Total government Federal government State and local government 40 35 30 25 20 15 10 5 0 1959 1962 1965 1968 1971 1974 1977 1980 1986 1989 1992 1995 1998 2001 2004 2007 1983 Year Source: Economic Report of the President, 2006 capital gains profits from the sale of an asset held for 12 months or longer budget than to overhaul the tax brackets. As a result, two top marginal tax brackets of 36 and 39.6 percent were added. Tax Reform in 1997 The next significant reform followed four years later with the Taxpayer Relief Act of 1997. The forces that created it were both economic and political. On the economic side, the government found itself with unexpectedly high tax revenues in 1997. The two new marginal tax brackets of 36 and 39.6 percent that had been added in 1993, along with the closure of some tax loopholes, meant that most people paid more taxes than before. On the political side, the Republicans had gained a firm majority in Congress and now saw a need to fulfill a commitment to their supporters. They reduced the tax on capital gains—profits from the sale of an asset held for 12 months or longer—from 28 to 20 percent. The new law also lowered inheritance taxes. 250 UNIT 3 Economic Institutions and Issues Some people thought that the tax cuts favored the wealthy, and even the government agreed. An analysis by the United States Treasury Department determined that nearly half of the benefits went to the top 20 percent of wage and income earners. The lowest 20 percent received less than 1 percent of the tax reductions. With all its changes, the 1997 federal tax law became the most complicated ever. Tax Reform in 2001 By 2001 politicians faced a new issue : the federal government was actually collecting more taxes than it was spending. These surpluses were projected to continue to the year 2010. Surpluses could have been used to repay some of the money the government borrowed in the 1980s or to fund new federal spending. The government also could cut taxes to “give the money back to the people.” In the end, President Bush backed a massive $1.35 billion, “temporary” 10-year tax cut due to expire in 2011. The main feature of the 2001 tax reform was to reduce the top four marginal tax brackets of 27, 30, 35, and 38.6 percent to 25, 28, 33, and 35 percent by 2006
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. The law also introduced a 10 percent tax bracket and eliminated the estate tax on the wealthiest 2 percent of taxpayers by 2010. Tax Reform in 2003 Slow economic growth in 2002 convinced the Bush administration and Congress to accelerate many of the 2001 tax reforms. Specifically, the top four marginal tax brackets were reduced immediately rather than in 2006. For lower income taxpayers, the top end of the 10 percent bracket was increased modestly. The child tax credit was also expanded from $600 to $1,000. Finally, the 20 percent capital gains tax bracket was reduced from 20 to 15 percent. The 2003 tax cuts put the federal government back in the same situation as in 1993. A series of tax cuts reduced taxes in upper income brackets, and government was still spending more than it collected in taxes. Permanent Tax Cuts by 2011? The tax cuts of 2001 and 2003 were “temporary” in the sense that they were due to expire in 2011. Whether that happens or not will depend on several things. One complicating factor is that the rate of economic growth in the six years following the 2001 tax cuts was slightly lower than the rate of growth in the six years following the 1993 tax increase. This makes it difficult to argue that lower taxes are needed for higher rates of growth. However, the biggest factor will be the extent to which the federal government continues to spend more than it collects in taxes. If the present trend continues, it will be difficult to preserve the tax cuts because the government will need so much additional revenue. Reading Check Inferring Why have tax reforms occurred so frequently in recent years? flat tax proportional tax on individual income after a specified threshold has been reached Alternative Tax Approaches MAIN Idea The need for new federal revenues will influence future tax reform. Economics and You You learned earlier about state sales taxes. Read on to find out how another tax is similar to the sales tax. Some people want to change the personal income tax; others want to replace it with something else. Because of this, we hear a lot about two alternatives: the flat tax and the value-added tax. The Flat Tax The concept of a flat tax—a proportional tax on individual income after a specified threshold has been reached—did not receive much attention until Republican candidate Steve Forbes and others raised the issue in the 1996 presidential elections. The primary advantage of the flat tax is the simplicity it offers to the taxpayer. A person would still have to fill out an income tax return every year but could skip many current steps, such as itemizing deductions.
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A second advantage is that a flat tax would close most tax loopholes if it did away with most deductions and exemptions. Finally, a flat tax reduces the need for tax accountants, tax preparers, and even a large portion of the IRS. As a result, Americans would no longer have to spend 7 billion hours every year preparing tax returns. However, a flat tax also has disadvantages because it would remove many of the incentives built into the current tax code. Tax Exempt? Each year taxpayers take advantage of a long list of deductions and tax credits to reduce their tax burden. In the year 2006, the Tax Foundation reported that a record 43.4 million tax returns from 91 million individuals showed no taxes due. Combined with the 15 million Americans who don’t file returns at all, about 41 percent of the U.S. population did not contribute to the federal treasury. CHAPTER 9 Sources of Government Revenue 251 Figure 9.9 The Value-Added Tax The VAT is like a national sales tax added to each stage of production. As a result, it is built into the final price of a product and is less visible to consumers. The third and fifth columns show the value added at each stage, and the fourth and sixth columns show the cumulative values. Economic Analysis Is a VAT regressive, proportional, or progressive? Why? No taxes With a 10% value-added tax Value added Cumulative value Value added with a 10% VAT Cumulative with VAT Step 1 Step 2 Step 3 Step 4 Step 5 Step 6 Loggers fell trees and sell the timber to the mills for processing. Mills cut the timber into blanks that will be used to make bats. Bat manufacturers shape and paint or varnish the bats and sell them to wholesalers. Wholesalers sell the bats to retail outlets where consumers can buy them. Retailers put the bats on the shelves and wait for consumers. Consumers buy the bats for: $1 $1 $5 $1 $2 $1 $2 $7 $8 $10 $10 $1 + $.10 = $1.10 $1 + $.10 = $1.10 $5 + $.50 = $5.50 $1 + $.10 = $1.10 $2 + $.20 = $2.20 $1.10 $2.20 $7.70 $8.80 $11.00 $11.00 value-added tax (VAT) tax on the value added at every stage of the production process
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For example, the tax code now allows homeowners to deduct interest payments on home mortgages. Other incentives include deductions for education, training, and child care. Another problem is that no one knows exactly what rate is needed to replace the revenues collected under the current tax system. Supporters of the flat tax argue that a 15 percent rate would work. Other estimates by the U.S. Treasury put the tax closer to 23 percent—which represents more of a burden on low-income earners because their taxes would increase compared to current rates. Finally, there is no clear answer as to whether a flat tax would further stimulate economic growth. After all, the extraordinary growth of the American economy in the 1990s, the longest period of peacetime prosperity in our history, took place when taxes were much higher. The Value-Added Tax Another controversial proposal is to adopt the equivalent of a national sales tax by taxing consumption rather than income. This could be done with a value-added tax (VAT)—a tax placed on the value that manufacturers add at each stage of production. The United States currently does not have a VAT, although it is widely used in Europe. To see how the VAT works, consider how the tax impacts the manufacturing and selling of wooden baseball bats. First, loggers cut the trees and sell the timber to lumber mills. The mills process the logs for sale to bat manufacturers. The manufacturers then shape the wood into baseball bats. After the bats are painted or varnished, they are sold to a wholesaler. The wholesaler sells them to retailers, who sell them to consumers. As Figure 9.9 shows, a VAT tax is levied at each stage of production. 252 UNIT 3 Economic Institutions and Issues The VAT has several advantages. First, it is hard to avoid because it is built into the price of the product being taxed. Second, the tax incidence is widely spread, which makes it harder for a single firm to shift the burden of the tax to another group. Third, the VAT is easy to collect, because firms make their VAT payments directly to the government. Consequently, even a relatively small VAT can raise a tremendous amount of revenue, especially when it is applied to a broad range of goods and services. Finally, some supporters claim that the VAT would encourage people to save more than they do now. After all, if none of your money is taxed until it is spent, you might think more carefully about purchases, decide to spend less—and save more. The main disadvantage of the VAT is that it tends to
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be virtually invisible. In the baseball bat example, consumers may be aware that bat prices went from $10 to $11, but they might attribute this to a shortage of good wood, higher wages, or some other factor. In other words, it is difficult for taxpayers to be vigilant about higher taxes if they cannot see them. Inevitability of Future Reforms The tax code is more complex now than at any time since 1981—a fact that virtually guarantees future attempts to simplify it. The recent flat tax movement provides just one such example. While simplification is desirable, unexpected events often require new expenditures—which in turn may require changes in the tax code. The unexpected cost of the war in Iraq, along with the enormous damage inflicted by hurricane Katrina in 2005, are two examples of such unexpected costs. Reform also can result from political change, which tends to be abrupt as one party leaves office and another enters. New administrations often display a sense of urgency to finally do things the “right” way, or to clean up the presumed excesses of their predecessors. Finally, it is difficult for politicians to give up the power to modify behavior, influence resource allocation, support pet projects, or grant concessions to special interest groups by changing the tax code. Reading Check Describing How does a value- added tax work? Why is it useful? SECTION 3 Review Vocabulary 1. Explain the significance of payroll withholding statement, accelerated depreciation, investment tax credit, alternative minimum tax, capital gains, flat tax, and value-added tax (VAT). Main Ideas 2. Identifying What are the major types of federal, state, and local taxes on the payroll withholding statement? 3. Listing Use a graphic organizer like the one below to list the advantages and disadvantages of the value-added tax. Critical Thinking 4. The BIG Idea What factors led to the tax reform measures passed in 1981, 1986, 1997, and 2001? 5. Summarizing What changes would you recommend if you were in charge of revising the federal tax code? Explain your answer in a written paragraph. 6. Analyzing Visuals Look at Figure 9.7 on page 249. How can you tell whether this tax is progressive, regressive, or proportional? 7. Cause and Effect Describe the factors that are likely to cause future revisions of the tax code. Value-Added Tax Applying Economics Advantages Disadvantages 8. Flat Tax Use examples to explain what might happen to donations for charitable organizations under a flat tax. CHAPTER 9 Sources of
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Government Revenue 253 NEWSCLIP A flat tax has often been debated in the United States. Today Russia and several countries in Eastern Europe utilize it as a way to keep taxes simple and avoid tax loopholes. This has spurred Western Europe to take a closer look. Europe Circles the Flat Tax The flat tax. In the eyes of many fiscal conservatives, it’s the Holy Grail of public policy: One low income tax rate paid by all but the poorest wageearners, who are exempt. No loopholes for the rich to exploit. No graduated rates that take a higher percentage of income from people who work hard to earn more. No need for a huge bureaucracy to police fiendishly complex tax laws. U.S. conservatives have been pushing the idea for decades. But it has gotten its first real road test in the former Soviet bloc, where at least eight countries, from minuscule Estonia to giant Russia, have enacted flat taxes since the mid-1990s. Most of these countries’ economies are growing at a far-healthier clip than those of their neighbors to the west. So it’s no surprise that calls for a flat tax are now being heard in Western Europe, the most heavily taxed zone on the planet.... Even without pressure from the East, many Western European governments face growing complaints about the complexity of their tax regimes.... F LAT T AXES Country Estonia Latvia Russia Serbia Slovakia Ukraine Georgia Romania Source: Hoover Institution Year 1994 1995 2001 2003 2003 2003 2004 2005 Rate 23% 25% 13% 14% 19% 13% 12% 16% 254 UNIT 3 Economic Institutions and Issues Kia Motors Slovakia, s.r.o Drawn by low taxes, Kia built a manufacturing plant in Slovakia. There’s no guarantee, of course, that flat taxes would work as well in Western Europe as they have in the countries to the east. In the former Soviet bloc, most of the countries that enacted flat taxes gained revenue as people who had worked in the shadow economy began reporting their income and paying taxes. The former tax dodgers figured that with rates so low, it was no longer worth running the risk of breaking the law. Moscow, which introduced a flat tax in 2001, saw its income tax revenues more than double in real terms from 2000 to 2004. —Reprinted from BusinessWeek Examining the Newsclip 1. Analyzing According to the article, why do fiscal conservatives promote a flat tax? 2. Determining Cause and Effect Why might
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Western European countries not see similar revenue increases? CHAPTER 9 Visual Summary Study anywhere, anytime! Download quizzes and flash cards to your PDA from glencoe.com. Types of Taxes All taxes in the United States can be broken down into three categories: proportional, progressive, and regressive. Proportional Progressive Regressive • Percentage of income paid in taxes stays the same regardless of income • Example: Medicare • Percentage of income paid in taxes goes up as income • Percentage of income paid in taxes goes down as income goes up • Example: individual income tax goes up • Example: sales tax Government Revenue Sources Federal, state, and local revenue sources differ. Much of the federal revenue is sent on to state and local governments. Federal Government • • • • • • • • Individual income taxes FICA Borrowing Corporate income taxes Excise taxes Estate and gift taxes Customs duties Miscellaneous fees State Governments Local Governments • • • • • • • Intergovernmental revenue Sales taxes Individual income taxes Tuition and fees from colleges and universities Corporate income taxes Hospital fees Other • • • • • • • Intergovernmental revenue Property taxes Public utilities Sales taxes Individual income taxes Hospital fees Other Alternative Tax Approaches Because the federal tax code has become so large and cumbersome, people have discussed the flat tax and the value-added tax as two alternatives. F LAT T AX V ALUE-A DDED T AX Pro gressiv e Flat Regressive Income Stages of bat manufacture Value-added tax Cumulative value Retailer sells bats Value-added: $2 Wholesaler sells bats Value-added: $1 Manufacture creates bats Value-added: $5 Lumber mill cuts into shape Value-added: $1 Raw lumber Value-added: $1 $.20 $11.00 $.10 $.50 $.10 $.10 $8.80 $7.70 $2.20 $1.10 CHAPTER 9 Sources of Government Revenue 255 CHAPTER 9 Assessment & Activities Review Content Vocabulary Review the Main Ideas On a separate sheet of paper, choose the letter of the term identified by each phrase below. a. ability-to-pay b. payroll tax c. estate tax d. excise tax e. FICA f. VAT g. tax return h. regressive tax i. sales tax j. capital gains 1. tax on wages and salaries withheld from paycheck 2. average tax per dollar decreases as taxable income increases Section 1 (pages 229–236) 17. Describe how taxes can be used to affect
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people’s behavior. 18. Describe the limitations of the benefit principle of taxation. 19. Explain why a sales tax is considered to be a regressive tax. 20. Explain the three criteria used to evaluate taxes. Section 2 (pages 238–245) 3. profits from an asset held 12 months or longer 21. Identify the two components of FICA. 4. tax on the manufacture or sale of certain items 22. Distinguish between excise taxes, estate and gift taxes, 5. annual report to the government detailing income earned and taxes owed 6. large source of revenue for state governments 7. national sales tax on value added at each stage of production 8. Social Security and Medicare taxes 9. tax on the transfer of property when a person dies 10. tax paid by those who can most afford to pay and customs duties. 23. List the main sources of revenue for state and local governments by using a graphic organizer like the one below. Sources of Revenue State Local Section 3 (pages 247–253) 24. Discuss the deductions that are withheld from Review Academic Vocabulary paychecks. Replace the underlined word in each sentence below with the appropriate synonym from the following list: validity, evolved, implement, considerably, concept, and controversial. 25. Describe the major tax reform bills enacted since 1981. 26. Explain why Congress enacted the alternative minimum tax. 27. Identify the advantages and disadvantages of a flat tax. 11. The tax code has developed into a complicated system. 12. The idea of a flat tax has been debated for a long time. 13. The government needs tax revenue to fulfill its goals. Critical Thinking 14. The IRS questioned the legitimacy of the deduction. 28. The BIG Idea If you were an elected official who 15. The tax code has changed substantially since its origin. 16. Abolishing tax deductions would be an unpopular move by the government. wanted to increase tax revenues, which of the following taxes would you prefer to use: individual income, sales, property, corporate income, user fees, VAT, or flat? Provide reasons for your decision. 256 UNIT 3 Economic Institutions and Issues 29. Inferring Why do you think Alaska has no sales tax or personal income tax? 30. Comparing and Contrasting What were the goals of the Economic Recovery Tax Act of 1981, the 1986 tax reform, and 2001 tax changes? 31. Synthesizing For one week, keep a list of all taxes you hear or read about in the news media or pay in
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your community. Classify your journal entries into three categories: federal, state, and local taxes. Then draw a matrix like the one below and classify each in the appropriate place. Which taxes appeared in the news most frequently? Ability-to-pay principle Benefit principle Regressive Proportional Progressive 32. Analyzing What provisions of tax measures enacted in the last 20 years benefit taxpayers with higher incomes? Applying Economic Concepts 33. User Fees In your own words, write a rationale for a user fee that you think should be enacted. 34. Taxes Some people object to state and local governments imposing sales and property taxes. What would you say to these people in defense of the two taxes? Thinking Like an Economist 35. Critical Thinking Describe how an economist might go about analyzing the consequences of shifting from the individual income tax to a consumption tax like the VAT. Economics: Principles and Practices Web site at glencoe.com and click on Chapter 9—Self-Check Quizzes to prepare for the chapter test. Self-Check Quiz Visit the Writing About Economics 36. Expository Writing Does the concept of a flat income tax meet the three criteria for effective taxes? Write a brief summary of your findings and use it to either support or oppose such a proposal. Math Practice 37. After deductions and exemptions, Mindy’s unmarried brother had taxable income of $98,000 in 2006. According to the tax table in Figure 9.7 on page 249, what will he owe in federal income taxes? What did he pay in Social Security taxes? What did he pay in Medicare taxes? Analyzing Visuals 38. Look at Figure 9.3 on page 239 and compare the reve- nue from the various sources for the years 2001 and 2007. In which categories did revenues decrease? How did the federal government make up these decreases? Interpreting Cartoons 39. Critical Thinking Look at the cartoon below. Who are the people seated in the chairs? Whom do the figures in the bottom left corner represent? What statement is the cartoonist trying to make? OLIPHANT ©2003 UNIVERSAL PRESS SYNDICATE. Reprinted withpermission. All rights reserved. OLIPHANT © 2003 UNIVERSAL PRESS SYNDICATE. Reprinted with permission. All rights reserved. CHAPTER 9 Sources of Government Revenue 257 DEBATES IN ECONOMICS Should E-Commerce Be Taxed? $ A lot of buying and selling occurs on the Internet—so much, in fact, that r
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umblings of an e-commerce sales tax have become a roar. In 2005 more than 700,000 people in the United States earned either full- or part-time income on eBay. This statistic alone ensures that a tax showdown between the IRS and e-commerce retailers is on the horizon. Can you sift through the debate to determine whether or not buying and selling online should be subject to taxation? As you read the selections, ask yourself: “Should e-commerce be taxed?” PRO SALES TAX REVENUE LOSSES Inability to collect the [e-commerce sales] tax potentially has a number of important implications. Firms have an incentive to locate production and sales activity to avoid tax collection responsibility, thereby imposing economic efficiency losses on the overall economy. The sales tax becomes more regressive as those who are least able to purchase online are more likely to pay sales taxes than those who purchase online more frequently. Further, state and local government Internet sales in 2003 $1.27 trillion Taxable internet sales in 2003 $751 billion Sales on which taxes were not collected $236.3 billion in 2003 $329.2 billion in 2008* State and local revenue loss $15.5 billion in 2003 $21.5–33.7 billion in 2008* * 2008 figures are estimated tax revenues are reduced.... [T]he Census Bureau reports a combined $1.16 trillion in... e-commerce transactions by manufacturers, whole salers, service providers, and retailers, and Forrester Research, Inc.’s expectations continue to be for strong growth in e-commerce in coming years. Thus, the revenue erosion continues to represent a significant loss to state and local government. —Dr. Donald Bruce and Dr. William F. Fox, Professors, Center for Business and Economic Research, University of Tennessee 258 UNIT 3 Economic Institutions and Issues Colin Young-Wolff/PhotoEdit CON ONLINE TAX PROPOSAL MISGUIDED The Direct Marketing Association (DMA) is cau- tioning legislators about bills introduced... that would allow states to force online sellers to collect sales taxes for all state and local taxing jurisdictions.... The failure of... these bills to address a reduction in the number of tax jurisdictions is a key flaw, and remains a critical obstacle to a workable streamlined sales tax program. There are currently approximately 7,600 different sales tax jurisdictions in this country, including states, counties and municipalities
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. 262) • private sector (p. 263) • transfer payment (p. 263) • grant-in-aid (p. 263) • subsidy (p. 264) • distribution of income (p. 264) • constituents (p. 261) • reluctant (p. 265) Reading Strategy Listing As you read the section, complete a graphic organizer similar to the one below by listing reasons for the increase in government spending since the 1940s. Reasons Rise in government spending ISSUES IN THE NEWS Grand Old Spenders —George Will, Washington Post Conservatives have won seven of 10 presidential elections, yet... per-household federal spending [is] more than $22,000 per year, the highest in inflation-adjusted terms since World War II. Federal spending... has grown twice as fast under President Bush as under President Bill Clinton, 65 percent of it unrelated to national security. In 1991, the 546 pork projects... cost $3.1 billion. In 2005, the 13,997 pork projects cost $27.3 billion, for things such as improving the National Packard Museum in Warren, Ohio (Packard, an automobile brand, died in 1958). Washington subsidizes the cost of water to encourage farmers to produce surpluses that trigger a gusher of government spending to support prices... [and]... almost $2 billion is spent each year paying farmers not to produce. ■ The amount of net spending by all levels of government—federal, state, and local— amounts to an ever-increasing portion of our GDP, the dollar measure of all final goods and services produced in a country in a year. It wasn’t always this way, but sometimes politicians have a hard time saying “no” when it comes to taking care of their constituents and the interests of their home districts. A recent political trend, as discussed in the news article above, is the increasingly popular use of pork in the federal budget. Pork is a term used by some to describe a line-item budget expenditure that circumvents normal budget-building procedures. Because most pork projects provide generous benefits to a small number of individuals or businesses, taxpayers generally would not otherwise approve the projects. pork a line-item budget expenditure that circumvents normal budget procedures and benefits a small number of people or businesses K Hart/Vikki Hart/Getty Images CHAPTER 10 Government Spending 261 public sector that part of the economy made up of local, state, and federal
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governments Government Spending in Perspective MAIN Idea The government spends its revenues on goods, services, and transfer payments. Economics & You Do you wonder how the taxes you pay are spent? Read on to learn about government expenditures. Spending by the public sector—the part of the economy consisting of federal, state, and local governments—was relatively low prior to the Great Depression. Since then, attitudes have shifted and spending has increased sharply. Spending Since the 1930s The growth in government spending since the 1930s had two main causes. First, a major change in public opinion gave government a larger role in everyday economic affairs. This change, in turn, was a response to President Franklin D. Roosevelt’s New Deal, which used large-scale government projects to fight the Great Depression. The Tennessee Valley Authority (TVA), for example, brought low-cost electricity to millions of people in the rural South during the mid-1930s. Second, massive government spending funded the United States involvement in World War II. This resulted in more people working, as factories converted to war production. Most people, some of whom faced unemployment during the 1930s, seemed to become more comfortable with the government’s larger role in the domestic economy. As shown in Figure 10.1, expenditures by all levels of government—federal, state, and local—have grown ever since. From about 23 percent of GDP in 1960, they have increased to over 31 percent today. In fact, public-sector spending has grown so large that all levels of government combined now spend more than all of the privately owned businesses in the United States. Figure 10.1 Government Spending G OVERNMENT S PENDING AS A P ERCENTAGE OF GDP 40% 35 30 25 20 15 10 1960 Total government Federal government State and local government 1965 1970 1975 1980 1985 Year 1990 1995 2000 2005 2010 Source: Economic Report of the President, 2006 Spending by all levels of government has grown considerably since 1959. Between 2000 and 2005 alone, government expenditures have consumed an additional 5.4 percent of GDP, a $674 billion increase. Economic Analysis Does the graph show any period of decreased government spending? See StudentWorks™ Plus or glencoe.com. Some people question how many goods and services government should provide and, therefore, what level of revenue collection is required to support these expenditures. Others question which services the government should provide and which services the private sector—the part of the economy made up of private individuals and privately owned businesses—should provide. Two Types
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of Spending In general, government makes two broad kinds of expenditures. The first is in the form of goods and services. The government buys many goods, such as tanks, planes, ships, and even space shuttles. It needs office buildings, land for parks, and capital goods for schools and laboratories. The government also needs to purchase supplies and pay for utilities. Finally, it must hire people to work in its agencies and staff the military. Payments for these services include the wages and salaries for these workers. State and local governments have similar expenditures. The second type of government expenditure is a transfer payment—a payment for which the government receives neither goods nor services in return. Transfer payments can be made to individuals and include Social Security, unemployment compensation, welfare, and aid for people with disabilities. With the exception of Social Security, people normally receive these payments solely because they need assistance. A transfer payment that one level of government makes to another is known as a grant-in-aid. The receiving government counts this payment as intergovernmental revenue. Interstate highway construction programs are examples of grants-in-aid. The federal government grants money to cover the major part of the cost, while the states in which the highways will be built pay the rest. The construction of new public schools also can be financed through grants-in-aid. Reading Check Contrasting What is the difference between transfer payments and government spending on goods and services? Grants-in-Aid States usually receive federal funds to pay for the majority of highway construction projects. Why do states rely on federal funds for such projects? private sector that part of the economy made up of private individuals and businesses transfer payment payment for which the government receives neither goods nor services in return grant-in-aid transfer payment from one level of government to another that does not involve compensation AP Photo/Terry Gilliam CHAPTER 10 Government Spending 263 Allocation of Resources States require students to take graduation exams because of federal legislation. How can such laws affect the economy? Impact of Government Spending MAIN Idea Government spending has a direct impact on our economy. Economics & You Have you considered attending a public college because a private one seems out of reach? Read on to find out how government spending affects your life. The enormous size of the public sector gives it the potential to affect people’s daily lives in many ways. It can affect resource allocation, the distribution of income, production in the private sector, and the tax burden on people. subsidy government payment to encourage or protect a certain economic activity (also
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see page 122) distribution of income way in which the nation’s income is divided among families, individuals, or other designated groups Affecting Resource Allocation Government spending decisions directly affect how resources are allocated. If the government spends its revenues on missile systems in rural areas, for example, rather than on social welfare programs in urban areas, the shift of resources stimulates economic activity in rural areas. Public sector spending can indirectly affect allocation of resources. In agriculture, the decision to support the prices of cotton, milk, grains, or peanuts keeps the factors of production working in those industries. 264 UNIT 3 Economic Institutions and Issues Jose Luis Pelaez, Inc./Corbis If the government withdraws the subsidies for these crops, farmers would produce less of each and resources would be released for employment in other industries. Government is so involved in the economy that even seemingly modest decisions can have an enormous impact on the things we produce. For example, because of the No Child Left Behind legislation, the government now requires schools to conduct extensive testing in reading and math. As a result, some schools have increased the amount of time they spend on these subjects and therefore have decreased the amount of time spent on other subjects. The decision to downgrade or even drop other subjects diminishes the demand and eventually the production of textbooks and educational supplies used in those areas, while increasing the demand for resources needed for reading and math. Redistributing Income Government spending also influences the distribution of income, or the way in which income is allocated among families, individuals, or other groups. Increasing or decreasing transfer payments, for example, can directly affect the incomes of needy families who receive financial support from the government. Government decisions about where to make expenditures indirectly affect many people’s incomes. The decision to buy fighter planes from one factory rather than another has an impact on the communities near both factories. The decision to spend billions on rebuilding Iraq and Afghanistan increased the incomes of those working in the national defense industries but not those who work in inner cities or other areas that lack such factories. Competing With the Private Sector When the government produces goods and services, it often competes with the private sector. In higher education, many public colleges and universities compete with more expensive private ones. The cost difference often is due to the subsidies public institutions receive from their states. In the area of health care, the government runs a system of hospitals for military veterans, which are funded with taxpayer dollars. At the same time, these facilities compete with hospitals in the private sector that offer similar
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services. Increasing the Tax Burden Finally, the growth of government spending has not gone unnoticed by the average American. The increased tax burden that is needed to support the expenditures has attracted enormous attention in recent years. Most people would like to reduce their taxes, but most people are also reluctant to give up the many benefits that government provides. In short, spending by all levels of government, which amounts to about one-third of our GDP, has a large and often controversial impact on the American economy. Finding the money to pay for these expenditures is a difficult task. Yet many people seem to want even more of these goods, services, and transfer payments. Reading Check Explaining How does government spending affect the distribution of income? Skills Handbook See page R44 to learn about Detecting Bias. SECTION 1 Review Vocabulary 1. Explain the significance of pork, public sector, private sector, transfer payment, grant-in-aid, subsidy, and distribution of income. Main Ideas 2. Identifying In which three ways might government spending impact the economy? 3. Listing Use a graphic organizer like the one below to list two kinds of government spending and provide three examples of each. Types of Government Spending Critical Thinking 4. The BIG Idea Describe two reasons for the growth of government spending since the 1930s. 5. Analyzing Visuals Look at Figure 10.1 on page 262. How does the spending by state and local governments compare to federal spending? What might explain any differences? 6. Explaining Why are people often reluctant to support a reduction in government spending? 7. Detecting Bias How does the “pork” spending described by the columnist on page 261 illustrate a conflict between political and economic goals? Applying Economics 8. Transfer Payments Do you think that transfer payments, such as unemployment compensation, are a successful or unsuccessful way to accomplish the goal of economic security? Explain your answer. CHAPTER 10 Government Spending 265 NEWSCLIP In the United States, the government sector competes with the private sector for scarce resources. This does not just mean the resources to build interstate highways or ensure food safety. In fact, there is a particularly scarce resource the government is trying to lure from the private sector—brains. The NSA: Security in Numbers The job offers arrived in plain envelopes. For decades, the mathematicians who accepted them stole off to Washington and the hush-hush National Security Agency, the nation’s top techno-spy center. Through the cold war, NSA math whizz
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abulary In this section, you will learn that governments provide money for many services and programs. • ambiguity (p. 267) • coincide (p. 268) Reading Strategy Describing As you read the section, complete a graphic organizer similar to the one below by describing the different types of government spending. Government Spending Content Vocabulary • federal budget (p. 267) • fiscal year (p. 268) • appropriations bill (p. 268) • budget deficit (p. 269) • budget surplus (p. 269) • mandatory spending (p. 269) • discretionary spending (p. 270) • Medicare (p. 270) • Medicaid (p. 271) • balanced budget amendment (p. 271) • intergovernmental expenditures (p. 272) —Los Angeles Times ISSUES IN THE NEWS The President’s Budget Plan President Bush on Monday sent Congress a proposed $2.77 trillion budget for 2007 that would boost Defense and Homeland Security while trimming the growth of Medicare and other social service programs... [and]... leave a deficit of $354 billion next year— the fourth-largest ever in dollar terms—which would settle down to around $200 billion for the subsequent four years..... Departments that would gain the most under Bush’s budget include the Pentagon, which would see spending rise 7%, and the Department of Homeland Security, where a 6% increase would go largely to immigration enforcement, air travel security and the Federal Emergency Management Agency. ■ When it comes to the numbers presented in the federal budget—the annual plan outlining proposed revenues and expenditures for the coming year—there is often a fair amount of ambiguity. As the news article above shows, the federal budget offers only a rough estimate of the actual revenues and expenditures. For example, the economy could suddenly slow down or speed up, affecting the amount of tax revenues collected. In addition, events might occur that require unanticipated spending. This was the case after the terrorist attacks on September 11, 2001, and the subsequent wars in Afghanistan and Iraq. federal budget annual plan outlining proposed expendi tures and anticipated revenues Andy Nelson/The Christian Science Monitor/Getty Images CHAPTER 10 Government Spending 267 Federal Government Expenditures MAIN Idea The federal government establishes a budget and allocates funds accordingly. Economics and You Has your family created a budget to control income and expenses? Read on to learn how the federal government makes its budget decisions. The federal budget spans a fiscal year— a 12-month financial planning period
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that may or may not coincide with the calendar year. The government’s fiscal year starts on October 1 and expires on September 30 of the following calendar year. Establishing the Federal Budget The president’s Office of Management and Budget (OMB), part of the executive branch, is responsible for preparing the federal budget. However, the president’s budget is only a request, and Congress can approve, modify, or disapprove it. By law, the budget must be sent to both houses of Congress by the first Monday in February. Once the House of Representatives receives the president’s budget request, it breaks down the budget into 13 major expenditure categories and assigns each to a separate House subcommittee. Each of the subcommittees then prepares an appropriations bill, an act of Congress that allows federal agencies to spend money for a specific purpose. Subcommittees hold hearings, debate, and vote on each bill. An approved bill is sent to the full House Appropriations Committee. If it passes there, the bill is sent to the entire House for a vote. The Senate acts on the budget after the House has approved it. The Senate may approve the bill as sent by the House, or it may draft its own version. If differences exist between the House and the Senate versions, a joint House-Senate conference committee tries to work out a compromise bill. During this process, the House and the Senate often seek advice from the Congressional Budget Office (CBO). The CBO is a nonpartisan congressional agency that evaluates the impact of legislation and projects future revenues and expenditures that will result from the legislation. If the House and Senate both approve the compromise bill, they send it to the president for signature. Because Congress literally took apart, rewrote, and put back together the president’s budget, the final Student Web Activity Visit the Economics: Principles and Practices Web site at glencoe.com and click on Chapter 10—Student Web Activity for an activity on the federal budget. fiscal year 12-month financial planning period that may not coincide with the calendar year appropriations bill legislation authorizing spending for certain purposes Public Hearings Secretary of State Condoleezza Rice discusses the State Department’s budget with an appropriations committee. Which part of Congress holds hearings? 268 UNIT 3 Economic Institutions and Issues Ken Cedeno/Corbis Figure 10.2 The Federal Budget for Fiscal Year 2007 In its budget, the federal government projected revenues of $2,416 billion and planned on spending $2,770 billion in fiscal year 2007. The difference of
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$354 billion, or 12.8 cents of every dollar spent, would be borrowed from investors. Economic Analysis What is the largest mandatory spending item in the budget? The largest discretionary item? D EFICIT AND R EVENUE = E XPENDITURES See StudentWorks™ Plus or glencoe.com. Deficit = $354 billion Deficit 12.8% Revenues = $2,416 billion Individual income taxes 39.6% Social insurance and retirement receipts 31.9% Corporate income taxes 9.4% Excise taxes Miscellaneous receipts Customs duties and fees Estate and gift taxes 2.7% 1.7% 1.0% 0.9% Expenditures = $2,770 billion 21.2% Social security 19.0% National defense 14.2% 13.3% 10.1% 8.9% 3.2% 2.8% 2.7% 1.6% 1.2% 1.0% 0.8% Medicare Income security Health Net interest Education, training, employment, and social services Transportation Veterans benefits and services Administration of justice International affairs Community and regional development Other Sources: Department of the Treasury, Office of Management and Budget, 2006 version may not resemble the original proposal. In many cases, a bill may have changed considerably, with items added to the president’s original budget. If the budget was altered too much, the president can veto the bill and force Congress to come up with a budget closer to the original version. However, once signed by the president, the budget becomes the official document for the next fiscal year that starts on October 1. The federal budget shown in Figure 10.2 is called the fiscal year 2007 budget because 9 of the 12 calendar months fall within the year 2007. The figure shows $2,416 billion (over $2 trillion) of revenues and $2,770 billion of spending, leaving a budget deficit—an excess of expenditures over revenues—of $354 billion. If expenditures were less than revenues, the result would be a budget surplus. Social Security The individual expenditures in the federal budget can be grouped into broad categories. The largest is for payments to aged and disabled Americans through the Social Security program. Retired persons receive benefits from the Old-Age and Survivors Insurance (OASI) program. Those unable to work receive payments from disability insurance (DI) programs. Spending for Social Security is sometimes called mandatory spending, or spending authorized by law that continues budget deficit a negative balance after expenditures are subtracted from revenues
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budget surplus a positive balance after expenditures are subtracted from revenues mandatory spending federal spending authorized by law that continues without the need for annual approvals by Congress CHAPTER 10 Government Spending 269 discretionary spending spending for federal programs that must receive annual authorization Medicare federal health-care program for senior citizens, regardless of income without the need for annual approvals by Congress. This is because the total Social Security payments in any given year are dependent on the number of people eligible for Social Security and the level of benefits already approved by Congress. National Defense For much of the late 1900s, national defense comprised the largest category of spending, although it is now second to Social Security. National defense includes CAREERS Budget Analyst The Work * Research, analyze, develop, and execute annual budgets or financial plans * Seek new ways to improve a company’s efficiency and increase profits * Review financial requests, examine past and current budgets, and research developments that can affect spending Qualifications * Keen analytical skills and knowledge of mathematics, statistics, accounting, and computer science * Strong oral and written communication skills to present— and defend—budget proposals * Ability to work well under deadlines * Bachelor’s degree, with most firms and government employers requiring a master’s degree Earnings * Median annual earnings: $56,040 Job Growth Outlook * Average Source: Occupational Outlook Handbook, 2006–2007 Edition 270 UNIT 3 Economic Institutions and Issues Michael Newman/PhotoEdit military spending by the Department of Defense and defense-related atomic energy activities, such as the development of nuclear weapons and the disposal of nuclear wastes. Defense expenditures are called discretionary spending—spending that must be approved by Congress in the annual budgetary process. Unlike Social Security payments, which normally go up as the population gets older, annual defense expenditures can go up, down, or remain the same, depending on the will of the president and Congress. Income Security Income security consists of a wide range of programs that includes retirement benefits for both federal civilian employees and retired military. Other programs are designed to support people unable to fully care for themselves. Federal programs pay for child care, foster care, and adoption assistance. Those unable to support themselves receive Supplemental Security Income (SSI), subsidized housing, federal child support, Temporary Assistance for Needy Families (TANF), and food stamps. Most income security expenditures are mandatory and therefore not authorized annually. Medicare Medicare, a health-care program available to all senior citizens regardless of income, began in 1966 and is another mandatory program. It provides an insurance plan that covers major hospital costs.
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Medicare also offers optional insurance that provides additional coverage for doctor and laboratory fees, outpatient services, and some equipment costs. In recent years, Medicare expenditures have risen dramatically as the population has aged and the cost of caring for the elderly has gone up. Given the increasing cost of medicine and current population trends, increases in this category of expenditure are expected to continue. Health Health-care services for low-income people, disease prevention, and consumer safety account for a significant part of the federal budget. Medicaid, for example, is a joint federal-state medical insurance program for low-income persons. Because the payments have already been determined by Congress, this is one of the mandatory expenditure programs. Other mandatory programs include health-care services for working and retired federal employees. Some programs in this category are discretionary. The Occupational Safety and Health Administration (OSHA), which monitors occupational safety and health in the workplace, is one such program. Other discretionary programs include AIDS and breast cancer research, substance abuse treatment, and mental health services. Net Interest on Debt When the federal government spends more than it collects in taxes and other revenues, it borrows money to make up the difference. The government has to pay interest on this debt, and the interest currently makes up the sixth-largest category of federal spending. The amount of interest paid is a mandatory expenditure that varies with changes in interest rates and the size of the federal debt. The federal government is still running deficits and therefore adding to its total debt. If interest rates rise, then this will become an increasingly larger category in the federal budget. Other Expenditure Categories Other broad categories of the federal budget include education, training, employment, and social services; transportation; veterans’ benefits; administration of justice; and natural resources and the environment. They include both mandatory and discretionary spending. Reading Check Summarizing What steps are involved in establishing the federal budget? SW Production/Index Stock Imagery Medicaid People with disabilities are among those eligible for Medicaid if they cannot afford health care. Why is Medicaid a mandatory expenditure? State Government Expenditures MAIN Idea At the state level, expenditures include public welfare and higher education. Economics and You If you want to attend college, have you found money available for financial aid? Read on to learn where these funds come from. Individual states, like the federal government, also have expenditures. Like the federal government, states must approve spending before distributing funds. The Budget Process At the state level, the process of creating a budget and getting approval for spending can take many forms. For example,
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some states such as Kentucky have biannual budgets, or budgets that cover two years at a time. In most states, the process is loosely modeled after that of the federal government. Unlike the federal government, however, some states have a balanced budget amendment—a constitutional provision requiring that annual spending not exceed revenues. Medicaid joint federal-state medical insurance program for low-income people balanced budget amendment constitutional amendment requiring government to spend no more than it collects in taxes and other revenues, excluding borrowing CHAPTER 10 Government Spending 271 intergovernmental expenditures funds that one level of government transfers to another level for spending Under this provision, states often must cut spending when revenues drop. A reduction in revenues may occur if sales taxes or state income taxes fall because of a decline in the general level of economic activity. Intergovernmental Expenditures As Figure 10.3 on the opposite page shows, the largest category of state spending is intergovernmental expenditures— funds that one level of government transfers to another level for spending. These funds come from state revenue sources such as sales taxes, and they are distributed to counties, cities, and other local communities to cover a variety of educational and other municipal expenditures. employees retire, become unemployed, or are injured on the job. Contributions to these funds make this category a significant expenditure. Their main beneficiaries are teachers, legislators, highway workers, police, and other state employees. Higher Education State governments have traditionally taken responsibility for the large task of funding state colleges and universities. In most states, the tuition that students pay covers only a portion of higher education expenses. States usually budget funds to pay the remainder of the cost. On average, higher education is the fifth-largest state expenditure. Public Welfare Other Expenditures The second largest category of state expenditures is public welfare. These payments take the form of cash assistance, payments for medical care, spending to maintain welfare institutions, and other welfare expenditures. Insurance Trust and Retirement Many states have their own insurance and retirement funds for state employees. The money in these funds is invested until The expenditures in the remaining state budget categories are relatively small. As Figure 10.3 shows, states spend money on a wide range of activities including corrections; utilities such as electricity, gas, and water; hospitals; and parks and recreation. Highways and road improvements are possible exceptions because they may require larger amounts of state money. Reading Check Explaining How does a balanced budget amendment work Higher Education States usually fund part of the expenses for state colleges and universities. What are other large categories of state expenditures? 272 Figure 10.3 State and
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Local Expenditures Both state and local expenditures consist of a myriad of categories. Intergovernmental expenditures and public welfare use up almost half of state budgets, while education is the main expenditure for local governments. Economic Analysis How do expenditures for public welfare, education, and utilities compare between state and local governments? See StudentWorks™ Plus or glencoe.com. State $1,359 billion Local $1,195 billion 28.1% 19.5% 12.4% Intergovernmental expenditure Public welfare Unemployment and workers’ compensation, retirement 3.5% 2.0% Elementary and secondary education 35.5% 10.1% Higher education Highways Government administration Hospitals Corrections Interest on general debt Health Utilities Fire protection Police protection Parks and recreation 2.2% 3.6% 4.7% 4.6% 1.6% 3.8% 2.6% 10.2% 2.3% 4.8% 2.3% Housing and community development 2.6% Other 12.5% 5.3% 3.2% 2.8% 2.7% 2.3% 2.2% 1.6% 0.7% 0.3% 7.9% Source: Bureau of the Census, August 2006 Variations due to rounding CHAPTER 10 Government Spending 273 &The Global Economy YOU Footing the Bill for Public Education Nearly 50 million students are enrolled in public elementary and secondary schools in the United States. Property taxes and intergovernmental revenues are the largest funding sources for these schools. lower in the test than did those of other countries. Perhaps money can buy schools, but it cannot buy student learning. How much does your education cost in taxpayer dollars? For the 2002—2003 school year, expenditures per student averaged $8,044 in the Unites States. New Jersey had the highest expenditures with $12,568 per student. Utah was at the lowest end of the range, with expenditures at $4,838 per student. As the world becomes more economically interdependent, you will face increasing global competition for jobs after you graduate. While the United States spends on average more on education to prepare you and other students, this spending is no guarantee of success. When students all over the world participated in a math achievement test, U.S. students ranked INTERNATIONAL EDUCATION SPENDING Slovakia Hungary Czech Republic South Korea Netherlands Finland Belgium Japan Australia Canada United States 0 1,000 2,000 3,000 4,000 6,000 Annual K–12 per
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pupil spending 5,000 7,000 $8,000 Source: National Center for Education Statistics Local Government Expenditures MAIN Idea Local governments spend money mainly on education, utilities, and public safety. Economics and You Have you ever wondered who pays for textbooks or extracurricular activities at your school? Read on to find out about the responsibilities of local governments. Local governments include counties, parishes, townships, municipalities, tribal councils, school districts, and other special districts. The different categories of expenditures made by these local governments are illustrated in Figure 10.3 on the previous page. The Budget Process At the local level, power to approve spending often rests with the mayor, the city council, the county judge, or some other elected representative or body. The methods used to approve spending and the dates of the fiscal year itself are likely to vary considerably from one local government to the next. Generally, the amount of revenues collected from property taxes, city income taxes, and other local sources is relatively small and limits the spending of local agencies. Some local governments are even bound by state requirements to avoid deficit spending. Elementary and Secondary Education Local governments have primary responsibility for elementary and secondary education. Expenditures budgeted in this category include administrators’ and teachers’ salaries, wages for maintenance and cafeteria workers, textbooks, and other supplies. School districts also pay 274 UNIT 3 Economic Institutions and Issues for the construction and upkeep of all school buildings. Schools account for more than one-third of all local government spending, making it the largest item in most local budgets. Utilities Public utilities serve communities by providing services such as sewerage, electricity, natural gas, and water. For most local governments, spending on these utilities amounts to the second-largest expenditure and consumes about 10 percent of local spending. In the typical community, the majority of expenditures on utilities are for schools, libraries, civic centers, and administrative buildings. Street lighting and traffic lights account for other expenditures. Public Safety and Health Most communities maintain a full-time, paid police force. Many have fire departments with paid, full-time firefighters as well. However, some communities, especially those with smaller populations and limited budgets, maintain volunteer fire departments to keep the cost down. On the other hand, some communities, especially larger cities, own and staff their own hospitals. Spending for health and safety in general tends to be about equal for each local government. However, the spending on these categories varies greatly from one state to another. Other Expenditures Highways, roads, and
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street repairs absorb most of the remaining spending. This category includes the repair of potholes, the installation and repair of street signs, snow removal, and other streetrelated items that are not covered by state budgets. Reading Check Synthesizing Which local expenditures would you categorize as mandatory spending, and why? Skills Handbook See page R47 to learn about Making Predictions. SECTION 2 Review Vocabulary 1. Explain the significance of federal budget, fiscal year, appropriations bill, budget deficit, budget surplus, mandatory spending, discretionary spending, Medicare, Medicaid, balanced budget amendment, and intergovernmental expenditures. Main Ideas 2. Listing Use a graphic organizer like the one below to list the five largest federal government expenditures. Federal Spending 3. Discussing What is the focus of state budgets? 4. Describing How do local governments spend their funds? Critical Thinking 5. The BIG Idea Describe the difference between mandatory and discretionary spending. 6. Making Predictions People are living longer, and families have fewer members. How will the combination of these two factors affect future transfer payments such as Social Security? 7. Making Generalizations If you were to argue for reduced spending at the state and local levels, which categories would you choose? 8. Analyzing Visuals Look at Figure 10.3 on page 273. Why do state expenditures not include elementary and secondary education? Do they not pay for it? Explain. Applying Economics 9. Local Government Spending Conduct research on the budget procedures for your local city or county government. Write an essay describing how the budget is created and who has spending authority. CHAPTER 10 Government Spending 275 CASE STUDY Boeing Going Strong Wide Range of Products The United States government spends billions of dollars for defense every year; in 2005 alone, that amount exceeded $500 billion. One of the companies the government has turned to for its defense needs is aircraft manufacturer Boeing. Employees at Boeing have built helicopters and passenger planes, fighter planes and missiles, satellites and spacecraft. They have sent astronauts to the moon and brought countries together aboard the International Space Station. NEWS FLASH Fighting Terrorism In 2002, Boeing was awarded a contract by the U.S. Department of Transportation to provide explosive detection systems in 438 U.S. airports. Boeing’s Defense Link William Boeing, founder and owner, started the company in 1916 with the incorporation of the Pacific Aero Products Company. That same year, Boeing produced its first airplane, the B&W B OEING D EFENSE AND T OTAL R EVENUES ) 60 50 40 30 20 10
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0 Total revenues Defense revenues 2000 2001 2002 2003 2004 2005 Year Source: www.defensenews.com 276 UNIT 3 Economic Institutions and Issues Getty Images Seaplane. Just a year later the company began its relationship with the government through test flights for the U.S. Navy. The Navy responded by ordering 50 seaplane trainers for a total of $116,000. Almost 90 years later in 2003, the Navy purchased 210 Super Hornets for a staggering $8.6 billion. Ahead of the Pack Over time, Boeing has become the world’s leading aerospace producer and the largest manufacturer of commercial jetliners and military aircrafts combined. From its small beginnings, the company now has customers in nearly 150 countries, with 150,000 workers in 48 states and 67 countries. While Boeing sells its products to both governments and private customers, defense revenues make up more than half of total revenues—and help Boeing to be the secondlargest defense company in the United States. Analyzing the Impact 1. Summarizing Why is defense spending important to Boeing? 2. Drawing Conclusions What world events may have contributed to the increase in defense revenues from 2000 to 2005? SECTION 3 Deficits, Surpluses, and the National Debt GUIDE TO READING Section Preview Academic Vocabulary In this section, you will learn that deficit spending has helped create a national debt. • mandate (p. 282) • instituted (p. 282) Reading Strategy Discussing As you read the section, list the various attempts by government to reduce the federal deficit and the national debt, then discuss the results. Attempt Result Content Vocabulary • deficit spending (p. 278) • national debt (p. 278) • balanced budget (p. 278) • trust funds (p. 278) • per capita (p. 279) • crowding-out effect (p. 281) • “pay-as-you-go” provision (p. 282) • line-item veto (p. 282) • spending cap (p. 282) • entitlement (p. 283) —The Kentucky Post ISSUES IN THE NEWS Expensing Our Wars [T]he chairman of the Senate Budget Committee, Judd Gregg, a Republican from New Hampshire, is considering treating the cost of the wars in Iraq and Afghanistan as a regular budget item. The Bush administration has spent $440 billion so far on those wars, $120 billion of it this fiscal year, and the meter is running at the rate of $4.5 billion a month in
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Iraq and $800 million a month in Afghanistan. The wars have been funded in a series of five emergency spending measures [that] are intended to deal with sudden, unexpected and short-term emergencies like [hurricane] Katrina. The bills are passed outside the regular appropriations process and are carried off budget, [which] tends to minimize the apparent cost. ■ In the past 45 years, the federal budget has shown a surplus only five times. The first was in 1969, and the last four occurred in the years 1998 to 2001. Federal budget deficits in most years have added to the total amount of debt that the government owes. Since 2001 more than $2 trillion in debt has been added, bringing the total national debt to about $8.5 trillion. Deficits occur for a number of reasons. For one, tax reductions are politically popular. For another, most people are in favor of the government spending more money on them. Finally, expenses such as wars and natural disasters are difficult to predict. However, as we read in the news article, expenditures don’t go away simply because they are not recorded in the budget. Nicolas Cotto/Corbis CHAPTER 10 Government Spending 277 deficit spending annual government spending in excess of taxes and other revenues national debt total amount borrowed from investors to finance the government’s deficit spending balanced budget annual budget in which expenditures equal revenues trust fund special account used to hold revenues designated for a specific expenditure such as Social Security, Medicare, or highways From Deficits to Debt MAIN Idea Because of deficit spending, the national debt has increased dramatically. Economics and You Do you recall news stories about the nation’s budget deficit? Read on to learn how deficits are created. Historically, a remarkable amount of deficit spending—or spending in excess of revenues collected—has characterized the federal budget. Sometimes the government plans deficit spending. At other times, the government is forced to spend more than it collects because unexpected developments cause a drop in revenues or a rise in expenditures. Predicting the Deficit The government projected a $354 billion deficit for fiscal year 2007. Whether this is the actual amount at the end of the fiscal year, however, depends on the way expenditures are reported and the state of the economy. For example, no money was budgeted for the wars in Afghanistan and Iraq in the fiscal year 2007 budget. Instead, the president and Congress made nearly $100 billion of “supplemental requests” to cover the anticipated war costs. These war expenditures will ultimately be reflected in the
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amount of money the government spends, but they did not appear in the budget when it was first released. Second, changes in the economy affect budget projections. Strong economic growth could cause the deficit to shrink because of Deficits Anyone? European countries that want to become members of the European Union (EU) and adopt the euro as their currency have to take their deficits seriously. To be eligible, they must be able to control their economies—and that includes their budgets. In order to be accepted into the “euro zone,” a nation is expected to keep its budget deficit at less than 3 percent of its GDP and its public debt at less than 60 percent of its GDP. 278 UNIT 3 Economic Institutions and Issues higher tax collections and lower unemployment claims. Likewise, a downturn in the economy could result in lower tax collections and higher unemployment insurance payments. Deficits Add to the Debt Panel A of Figure 10.4 on the opposite page shows the history of the federal budget deficit since 1965. When the federal government runs a deficit, it must finance the revenue shortage by borrowing. It does this by selling U.S. Treasury notes and other securities to the public. If we add up all outstanding federal notes, bonds, and other debt obligations, we have a measure of the national debt—the total amount borrowed from investors to finance the government’s deficit spending. As Panel B in Figure 10.4 shows, the national debt grows whenever the government runs a deficit by spending more than it collects in revenues. If the federal budget runs a surplus, then some of the borrowed money is repaid and the amount of total debt goes down, as it did from 1998 to 2001. If the federal government achieves a balanced budget—an annual budget in which expenditures equal revenues—the national debt will not change. A Growing Public Debt The national debt has grown almost continuously since 1900, when the debt was $1.3 billion. By 1929 it had reached $16.9 billion, and by 1940 it was $50.7 billion. By mid-2006 the total national debt had reached about $8.5 trillion. Some of this debt is money that the government owes itself. For example, approximately $3.5 trillion of this debt is in government trust funds—special accounts used to fund specific types of expenditures such as Social Security and Medicare. When the government collects the FICA or payroll tax, it puts the revenues in these trust accounts. The money is then invested in government securities until it is paid out
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. Figure 10.4 The Federal Deficit and the National Debt Panel A shows the annual budget deficit since 1962. Panel B shows the national debt during the same time period. The government ran a surplus from 1998 to 2001 which allowed it to pay off some of the national debt. Economic Analysis Why has the deficit increased so rapidly since 2002? A A NNUAL B UDGET D EFICIT 400 200 0 –200 –400 –600 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Year B N ATIONAL D EBT $6,000 5,000 4,000 3,000 2,000 1,000 ) 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Year Sources: Congressional Budget Office, 2006; Economic Report of the President, 2006 per capita per person basis; total divided by population Because trust fund balances represent money the government owes to itself, most economists tend to disregard this portion of the debt. Instead, they view the public portion of the debt—which amounted to nearly $5 trillion in mid-2006—as the economically relevant part of the debt. Figure 10.5 on the next page presents two alternative views of the total national debt held by the public. Panel A shows the debt as a percentage of GDP. In Panel B, the national debt is computed on a per capita, or per person, basis. Public vs. Private Debt Despite the size of the public debt, several important differences between public and private debt mean that the country can never go bankrupt. One is that we owe most of the national debt to ourselves— whereas private debt is owed to others. Another difference is repayment. When private citizens borrow, they usually make plans to repay the debt by a specific date. When the government borrows, it gives little thought to repayment and simply issues new bonds to pay off the old bonds. CHAPTER 10 Government Spending 279 Figure 10.5 Two Views of the National Debt The national debt as a percent of GDP has ranged from about 34 to almost 50 percent since 1965. The amount owed per person increased most years during the same period. Economic Analysis What has happened to the size of the national debt since 2001? A AS A P ERCENTAGE OF GDP 60% 50 40 30 20 0 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Year B O N A P ER-C APITA B ASIS 18,000 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 1965 1970 1975 1980 1985 1990 1995
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2000 2005 2010 Year Source: Congressional Budget Office A third difference has to do with purchasing power. When private individuals repay debts, they give up purchasing power because they have less money to buy goods and services. The federal government does not give up purchasing power, because the taxes collected from some groups are simply transferred to other groups. The exception is the 15 to 20 percent of the public debt owned by foreigners. When payments are made to investors outside the United States, some purchasing power is temporarily diverted from the U.S. economy. Reading Check Contrasting What are the differences between public and private debt? Impact of the National Debt MAIN Idea The national debt affects the distribution of income and transfers purchasing power from the private to the public sector. Economics and You Do you hear your parents talk about interest rates? Read on to learn how the national debt affects interest rates. Even though we owe most of the national debt to ourselves, it affects the economy by transferring purchasing power, reducing economic incentives, causing a crowdingout effect, and redistributing income. 280 UNIT 3 Economic Institutions and Issues National Debt The more the government borrows today, the more future generations will have to repay. What other effects does the national debt have on the nation Transferring Purchasing Power The national debt can cause a transfer of purchasing power from the private sector to the public sector. In general, when the public debt increases, taxes increase and people have less money for themselves. Purchasing power can also be transferred from one generation to another. If the government borrows today and leaves the repayment to future taxpayers, then today’s adults will consume more and their children less. The accumulation of debt by one generation can thus reduce the economic well-being of the next. Reducing Economic Incentives Government can reduce economic incentives if it appears to spend money in a careless manner. A community, for example, may use a federal grant to purchase expensive equipment that its citizens would not want to pay for themselves. If the taxpayers that benefit from a project would not fund it themselves, other taxpayers would not want their taxes to go to such projects. Crowding Out When the federal government uses deficit spending, it must borrow money in financial markets. This borrowing can drive John Cole / Scranton Times-Tribune interest rates up, forcing all borrowers to pay more for the temporary use of funds. Because the government borrows so much, it competes with businesses and individuals such as potential home buyers for available money. This competition can cause a crowding-out
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effect—the higherthan-normal interest rates caused by heavy government borrowing. If private borrowers cannot afford the higher interest rates, they are squeezed out of the market. crowding-out effect higher-than-normal interest rates and diminished access to financial capital faced by private borrowers when they compete with government borrowing in financial markets Redistributing Income Finally, the national debt and the tax structure can impact the distribution of income. Suppose that the government taxes upper-income individuals and spends the money on the poor. This would redistribute income from the rich to the poor. The opposite would happen if the poor were taxed and the money spent on the rich. In either case, the people paying less in taxes would benefit from the tax policy. This is not a purely hypothetical situation. The individual income tax cuts made since 2001 have made income taxes less progressive, shifting some of the tax burden from higher- to lower-income groups. Reading Check Analyzing How does the transfer of purchasing power between generations affect you? CHAPTER 10 Government Spending 281 Figure 10.6 The Size of the National Debt The public ly held portion of the national debt reached $5 trillion in 2006 and continues to rise. Attempts to reduce the debt by legislation alone have failed. The only other ways to reduce it are by raising taxes or reducing federal spending. Economic Analysis Why is it difficult for legislators to increase revenues or reduce spending? WILL WE EVER SHRINK THE NATIONAL DEBT? A $1 bill is about 6 inches (15.2 cm) long. If 5 trillion of these bills were laid end to end, they would form a chain 474 million miles (764 km) long—more than enough to stretch from the surface of the earth to the surface of the sun and back—two and a half times! “pay-as-you-go” provision require ment that new spending proposals or tax cuts must be offset by reductions elsewhere line-item veto power to cancel specific budget items without rejecting the entire budget spending cap limits on annual discretionary spending Skills Handbook See page R35 to learn about Identifying the Main Idea. Reducing Deficits and the Debt MAIN Idea Congress has tried a number of measures to reduce deficits and the national debt. Economics and You Did your parents teach you how to avoid overspending? Read on to learn about attempts to limit the nation’s debt. In order to control the size of the national debt, we have to first address the federal budget deficit. Concern over deficit spending since the 1980
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s has led to a number of attempts to control it. Legislative Failures One of the first significant attempts to control the federal deficit took place when Congress tried to mandate a balanced budget. The legislation was formally called the Balanced Budget and Emergency Deficit Control Act of 1985, or Gramm-RudmanHollings (GRH) after its sponsors. Despite high hopes, GRH failed for two reasons. First, Congress discovered that it could get around the law by passing spending bills that took effect two or three years later. Second, the economy started to decline in 1990, triggering a suspension of budget cuts when the economy was weak. In 1990 Congress passed the Budget Enforcement Act (BEA). The BEA’s main feature was a “pay-as-you-go” provision— a requirement that new spending proposals or tax cuts must be offset by reductions elsewhere in the budget. If no agreement on the reductions could be reached, then automatic, across-the-board spending cuts would be instituted. Congress soon discovered that cutting spending was more difficult than it thought, so it sus pended the provision in order to increase spending. In 1996 Congress gave the president a line-item veto—the power to cancel specific budget items without rejecting the entire budget—but the Supreme Court declared it unconstitutional. This was followed by the Balanced Budget Agreement of 1997, which featured rigid spending caps—legal limits on annual discretionary spending—to assure that Congress balanced the budget by 2002. However, the caps required politically unpopular cuts in many programs such as health, science, and education, so the caps were also abandoned. 282 UNIT 3 Economic Institutions and Issues entitlement program or benefit using established eligibility requirements to provide health, nutritional, or income supplements to individuals Raising Revenues President Clinton’s Omnibus Budget Reconcil iation Act of 1993 was an attempt to trim $500 billion from the deficit over a five-year period. The act featured a combination of spending reductions and tax increases that made the individual income tax more progressive—especially for the wealthiest 1.2 percent of taxpayers. Higher tax rates, along with strong economic growth, combined to produce four consecutive years of federal budget surpluses. By 2001 Congress expected annual surpluses for another 10 years. Rather than pay down the debt, however, Congress cut tax rates while also increasing spending. Reducing Spending Another way to control the deficit is by reducing federal spending. This can be more difficult than it sounds because spending is subject to unexpected change. For
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example, the 2001 terrorist attacks led to unplanned government spending on homeland security and wars in Afghanistan and Iraq. Because this was also the first year of President Bush’s tax cuts, and because economic activity was low, the federal government had fewer tax revenues to spend. As a result, record federal budget deficits returned in 2002. In addition, spending was difficult to reduce because the federal budget had so many entitlements—broad social programs with established eligibility requirements to provide health, nutritional, or income supplements to individuals. People are entitled to draw benefits if they meet the eligibility requirements. Although most entitlements are classified as mandatory spending, Congress can revise them. Still, this is difficult to do for members of Congress because the programs are so popular. In the end, Congress has a difficult task ahead. Any action to reduce budget deficits and the national debt will depend on the willpower of Congress to make unpopular and difficult choices. Reading Check Describing What events in 2001 have added to the national debt? SECTION 3 Review Vocabulary 1. Explain the significance of deficit spending, national Critical Thinking 5. The BIG Idea Why is it so difficult to rein in the debt, balanced budget, trust fund, per capita, crowding-out effect, pay-as-you-go provision, line-item veto, spending cap, and entitlement. Main Ideas 2. Describing What is the difference between the national national debt? Use examples to explain your answer. 6. Analyzing Visuals Look at Figure 10.5 on page 280. Why do you think the national debt as a percentage of GDP has not risen at the same rate as the debt per capita? 7. Determining Cause and Effect How can the federal debt and the federal deficit? debt affect worker incentives? 3. Listing Use a graphic organizer like the one below to list five ways the national debt can affect the economy. National Debt: Possible Effects on the Economy 1. 2. 4. Identifying What were the results of government efforts to reduce deficits? 8. Drawing Conclusions Which do you think is a better way to reduce budget deficits: pay-as-you-go provisions or line-item vetoes? Explain your answer in a brief paragraph. Applying Economics 9. Deficit Spending If you were given the task of reducing entitlement programs to limit deficit spending, which ones would you select to reduce or alter? Write a short essay that includes the reasons for your choices. CHAPTER 10 Government Spending 283 Profiles in Economics ECONOMIST Alice Rivlin is an
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outspoken critic of budget deficits. She argues that spending cannot be brought under control until Congress is willing to take action. While the problems are large, Rivlin believes that “we will find ways to solve them.” Alice Rivlin (1931– ) • founding director of the Congressional Budget Office • director of the White House Office of Management and Budget • vice chair of the Federal Reserve Board Ms. Economics At a time when few women had full-time jobs, fewer went to college, and almost none pursued economics, Alice Rivlin discovered the subject and found her niche. Rivlin is well known for her insistence on solid analysis, innovative thinking, and a steadfast insistence on “fiscal sanity”—balanced federal budgets and a low national debt. These traits served her well as the founding director of the Congressional Budget Office. Rivlin likened the job to an entrepreneurship, because she had to find ways to provide Congress with nonpartisan projections on the impact of proposed legislation on the nation’s budget and debt. Balancing the Federal Checkbook Rivlin believed that Reaganomics had a negative effect on the U.S. economy. In 1992 she published Reviving the American Dream: The Economy, the States, and the Federal Government, which outlined her plan for “fiscal sanity” and the responsibilities of national and state governments. She believes that competition between states to attract corporations leads to too many tax breaks, resulting in too few tax dollars to implement needed—and often federally mandated—social programs. Instead states should engage “in an aggressive effort to improve their infrastructure and improve their education systems in order to attract business.” The book influenced then-presidential candidate Bill Clinton, for whom she became Director of the White House Office of Management and Budget. In this position she oversaw a transition from federal debt to surplus in just two years. This success led her to membership on the Federal Reserve Board. Today Rivlin looks for ways to fight budget deficits as a Senior Fellow at the Brookings Institution, an economics and policy think tank located in Washington, D.C. Examining the Profile 1. Summarizing How does Rivlin define “fiscal sanity”? 2. Determining Cause and Effect According to Rivlin, what is the best way for states to attract business? 284 UNIT 3 Economic Institutions and Issues Time Life Pictures/Getty Images CHAPTER 10 Visual Summary Study anywhere, anytime! Download quizzes and flash cards to your PDA from glencoe.com. Federal Budget
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Process Each year, the president sends a federal budget to Congress. The budget undergoes a lengthy approval process until it is signed into law. Office of Management and Budget prepares a budget President submits budget to Congress House breaks down budget and assigns to subcommittees Subcommittees prepare appropriations bills House Appropriations Committee votes on bills President vetos bill and sends back to Congress Conference committee writes compromise bill President signs bill Bill sent to president Senate drafts different version of bill Senate approves House bill Full House votes on bills and sends to Senate Major Budget Categories The major budget categories vary for federal, state, and local governments. The focus of the federal government is on nationwide programs and expenditures. States pass on much of their budget to local governments and spend the rest on state-level programs. Local governments focus their expenditures on local needs. Federal government • Social Security • National defense • Income security • Health care State governments Intergovernmental expenditure Public welfare Insurance trust and retirement Higher education • • • • • • • Local governments Elementary and secondary education Utilities Public safety and health Surpluses, Deficits, and Debt When revenues exceed expenditures, governments enjoy a budget surplus. If revenues are less than expenditures, governments are faced with a budget deficit. They then have to borrow money to meet expenditures and incur debt. Budget Surplus Budget Deficit Revenues Surplus Expenditures Deficit Borrowing Debt Expenditures Revenues CHAPTER 10 Government Spending 285 CHAPTER 10 Assessment & Activities Review Content Vocabulary Review the Main Ideas Write a sentence about each pair of terms below. The sentences should show how the terms are related. 1. public sector, private sector 2. transfer payment, grant-in-aid 3. distribution of income, deficit spending 4. federal budget, fiscal year Section 1 (pages 261–265) 17. Explain the two kinds of government spending. 18. Describe the way the government competes with the private sector. 19. Explain why politicians insert “pork” items into other legislation. 5. appropriations bill, balanced budget amendment Section 2 (pages 267–275) 6. deficit spending, national debt 7. deficit spending, crowding-out effect 8. entitlement, balanced budget 9. mandatory spending, discretionary spending 10. spending cap, budget deficit Review Academic Vocabulary Each of the sentences below contains a synonym for one of the following terms. Match the sentence to the term. a. constituents b. reluctant c. coincide d. ambiguity e. mandate f. instituted 11. States have a requirement to provide public schools
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. 12. The federal budget leaves some uncertainty about actual expenditures. 13. The state legislature was hesitant when it came to reducing spending for roads. 14. The fiscal year often does not correspond with the calendar year. 15. The representative was concerned about maintaining the support of the voters in his district. 16. Some states have passed balanced budget amendments. 286 UNIT 3 Economic Institutions and Issues 20. Identify the purpose of a balanced budget amendment. 21. Identify the categories of federal, state, and local spending by using a graphic organizer like the one below. Categories of Spending Federal State Local 22. List the three major categories of spending by local governments. Section 3 (pages 277–283) 23. Discuss the relationship of the federal deficit to the federal debt. 24. List four legislative attempts to deal with the problem of federal budget deficits. 25. Explain why entitlements are so named. Critical Thinking 26. The BIG Idea Why is it more difficult for politicians to reduce mandatory spending than discretionary spending? 27. Comparing and Contrasting What is the difference between transfer payments and government spending on goods and services? 28. Drawing Conclusions Review the discussion on attempts to reduce the deficit on pages 282 and 283. Use a chart similar to the one below to outline the main features and weaknesses of these legislative attempts. Can you find a common reason why these attempts have failed? What do you think would need to be done to avoid future failures? Legislation Features Weaknesses 29. Determining Cause and Effect How does a balanced budget amendment affect the budget process? 30. Making Inferences Do you think transfer payments are the best way to distribute tax revenue? How would the tax collection system have to change if the government levels that actually spend the money had to collect the taxes themselves? Applying Economic Concepts 31. Human Capital Which of the categories in Figure 10.3 on page 273 reflect an investment in human capital? 32. Government Spending Make a list of ways you and your family benefit from government expenditures. Provide at least one example each for the federal, state, and local government. Math Practice 33. A neighbor spent $25,000 a year for 10 years and had an annual income of $20,000 during this period. What is the neighbor’s total debt? Economics: Principles and Practices Web site at glencoe.com and click on Chapter 10—Self-Check Quizzes to prepare for the chapter test. Self-Check Quiz Visit the Analyzing Visuals 34. Classifying Information Examine
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the major types of federal expenditures in Figure 10.2 on page 269. Classify each as to whether they are entitlement or nonentitlement programs. Thinking Like an Economist 35. Critical Thinking An economist likes to think in terms of trade-offs and opportunity costs. If you wanted to make changes to a balanced state budget in any given year, what would be the opportunity cost of lowering taxes? Of increasing discretionary spending? Writing About Economics 36. Persuasive Writing Which of the two types of government spending has the most impact on the economy? Explain your answer in a two-page paper. Interpreting Cartoons 37. Critical Thinking What is the topic of the cartoon below? What point is the cartoonist making about the topic? How does he do it? Do you think the cartoon is effective Paul Combs, Editorial Cartoonist/The Tampa Tribune. CHAPTER 10 Government Spending 287 CHAPTER 11 Financial Markets Why It Matters You have just been hired as a financial planner to provide advice on how to invest wisely and effectively. Miguel, your client, is a widower raising two young children. He wants to be sure that (1) he will have enough money to send his children to college, and (2) he will be financially secure in his retirement. What advice would you give Miguel? Read Chapter 11 to learn more about how people can accomplish their financial goals. The BIG Idea Governments and institutions help participants in a market economy accomplish their financial goals. Traders on the Chicago Mercantile Exchange talk to one another with hand signals. 288 UNIT 3 Getty Images Economics: Principles and Practices Web site at glencoe.com and click on Chapter 11—Chapter Overviews to preview chapter information. Chapter Overview Visit the SECTION 1 Savings and the Financial System GUIDE TO READING Section Preview Academic Vocabulary In this section, you will learn how the components of a financial system work together to transfer savings to investors. Content Vocabulary • saving (p.289) • savings (p. 289) • certificate of deposit (p. 290) • financial asset (p. 290) • financial system (p. 290) • financial intermediary (p. 290) • nonbank financial institution (p. 292) • finance company (p. 292) • premium (p. 292) • pension (p. 292) • pension fund (p. 292) • risk (p. 293) ISSUES IN THE NEWS Follow My Money • sector (p. 291) • compensation (p. 294) Reading Strategy Desc
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ribing As you read the section, complete a graphic organizer like the one below by describing how financial intermediaries channel money. Financial intermediary Way to channel money —www.businessweek.com Jonathan Ping is not a financial guru. And he’s not a millionaire (yet). He’s simply a 27-year-old engineer living with his wife and dog in a rented house in Portland, Oregon. Within the next 18 months he hopes to scrape up $100,000 for a down payment on a home, and he wants to build a net worth of $1 million by age 45. So far he’s at $88,953. How do I know this? It’s in bold type in the top right-hand corner of his Web log, where Ping keeps a daily tally of his progress. He’s one of more than 150 bloggers, mostly 22 to 35, who have adopted an open-source approach to personal finance. In stark contrast to their parents’ generation, for whom comparing incomes can be awkward, if not downright taboo, bloggers list financial information down to the dollar in retirement, brokerage, and savings accounts. They recommend investments, decry credit-card debt, and wallow together over high taxes. ■ For an economic system to grow, it must produce capital—the equipment, tools, and machinery used in production. In order for this to happen, saving must take place. To the economist, saving means the absence of spending, while savings refers to the dollars that become available when people abstain from consumption. Our financial system continually evolves to meet the needs of both savers and investors. If you decide to save your income, as Jonathan Ping in the news story and other bloggers are doing, you should learn about some important investment considerations. You also will see that you can choose from a wide variety of options. saving absence of spending that frees resources for use in other activities or investments savings the dollars that become available for investors to use when others save Jonathan of MyMoneyBlog.com, a Personal Finance Blog CHAPTER 11 Financial Markets 289 Saving and Economic Growth MAIN Idea The financial system brings savers and borrowers together and helps the economy grow. Economics & You Do you have a personal savings account? Read on to learn how your savings are used to help the economy. When people save, they make funds available for others to use. Businesses can borrow these savings to produce new goods and services, build new plants and equipment, and create more jobs. Saving thus
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makes economic growth possible. Savers and Financial Assets People can save in a number of ways. They can open a savings account, buy a bond, or purchase a certificate of deposit— a document showing that an investor has made an interest-bearing loan to a bank. In each case, savers obtain a receipt for the funds they save. Economists call these documents financial assets—claims on the property and the income of the borrower. The documents are assets because they are property that has value. They represent claims on the borrower because they specify the amount loaned and the terms at which the loan was made. Stocks, or ownership claims on a corporation, are another type of financial asset. However, because stocks have some unique features that require additional consideration, we will discuss them separately in the last section of this chapter. Collectively, investors have a full range of financial assets from which to choose. The Circular Flow of Finance In order for people to use the savings of others, the economy must have a financial system—a network of savers, investors, and financial institutions that work together to transfer savings to investors. The financial system has three parts. The first part is made up of the funds that a saver transfers to a borrower. The second consists of the financial assets that certify conditions of the loan. The third comprises the organizations that bring the surplus funds and financial assets together. Financial intermediaries are the institutions that lend the funds that savers provide. Financial intermediaries include depository institutions such as banks and credit unions, life insurance companies, pension funds, and other institutions that channel savings to borrowers. These institutions are especially helpful to small savers, who have only limited funds available to deposit. certificate of deposit document showing that an investor has made an interest bearing loan to a financial institution financial asset a stock or other document that represents a claim on the income and property of a borrower, such as a CD, bond, Treasury bill, or mortgage financial system network of savers, investors, and financial institutions working together to transfer savings for investment uses financial intermediary institution that channels savings to investors Personal Finance Handbook See pages R6–R9 for more information on saving and investing. Saving When you open a savings account, you make money available for business investments. How does money from savers reach investors? 290 Ariel Skelley/Corbis Figure 11.1 Overview of the Financial System Financial intermediaries help channel surplus funds from savers to borrowers, who put the money to work. Savers also lend directly to governments
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and businesses, who issue bonds or other financial assets for the money they borrow. Economic Analysis What do lenders receive in return for their funds? See StudentWorks™ Plus or glencoe.com. Surplus funds Households, businesses Financial Intermediaries Commercial banks Savings and loan associations Savings banks Mutual savings banks Credit unions Life insurance companies Mutual funds Pension funds Finance companies Governments, businesses Financial assets Figure 11.1 shows the circular flow that takes place when funds are transferred from savers to borrowers. Savers can provide their funds directly to the borrower. They also can do so indirectly through the many financial intermediaries in the economy, such as banks, life insurance companies, and credit unions. The documents that certify the ownership of the funds—the certificates of deposit, savings and other bank accounts, as well as bonds— are the financial assets that return to the lender. Financing Capital Formation Any sector of the economy can borrow, but governments and businesses are the largest borrowers. If a corporation borrows directly from savers—or indirectly from savers through financial intermediaries— the corporation will issue a bond or other financial asset to the lender. When the government borrows, it issues government bonds or other financial assets to the lender. Any sector of the economy can supply savings, but households and businesses are the biggest sources of funds. Savers can provide some funds directly to borrowers, as when households or businesses purchase bonds directly from government or businesses. Capital formation depends on saving and borrowing. When households borrow, they invest some of the funds in homes. When businesses borrow, they invest some of the funds in tools, equipment, and machinery. When governments borrow, they invest some of the funds in highways, hospitals, universities, and other public goods. In the end, everyone benefits from the financial system. The smooth flow of funds through the system helps ensure that savers will have an outlet for their savings. Borrowers, in turn, will have a source of financial capital that can be invested in capital goods to benefit future economic growth. Reading Check Summarizing How does the financial system bring savers and borrowers together? CHAPTER 11 Financial Markets 291 nonbank financial institution nondepository institution that channels savings to investors finance company firm that makes loans directly to con sumers and specializes in buying installment contracts from merchants who sell on credit premium price paid at regular intervals for an insurance policy pension regular payment to someone who has worked a certain number of years, reached a certain age, or has suffered an injury pension fund fund that collects and invests
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income until payments are made to eligible recipients Nonbank Financial Intermediaries MAIN Idea Organizations other than banks can transfer money from savers to borrowers. Economics & You Have you ever heard your parents discuss pensions? Read on to learn why these are called nonbank financial intermediaries. Banks, credit unions, and savings associations obtain funds when they accept regular deposits. Another important group of financial intermediaries is called nonbank financial institutions—or nondepository institutions that also channel savings to borrowers. Finance companies, life insurance companies, and pension funds are examples of nonbank financial institutions. Finance Companies A finance company is a firm that specializes in making loans directly to consumers. It also buys installment contracts from merchants who sell goods on credit. Many merchants, for example, cannot afford to wait years for their customers to pay off high-cost items purchased on an installment plan. Instead, a merchant will sell a customer’s installment contract to a finance company for a lump sum. This allows the merchant to advertise easy credit terms without actually accepting the full risks of the loan. The finance company then carries the loan full term, absorbing losses for an unpaid account or taking customers to court if they do not pay. Tough Payoff Finance companies charge much higher interest rates than banks or credit unions, which makes their loans much more expensive. Let’s assume you want a 60-month car loan for $6,000. A bank loan with an 8-percent interest rate would cost you $1,300 in interest over the life of the loan. Interest on the same loan at a finance company charging 12 percent interest would total $2,008, or at 16 percent, $2,755. A few percentage points make a big difference! 292 UNIT 3 Economic Institutions and Issues Some finance companies make loans directly to consumers. These companies generally check a consumer’s credit rating and will make a loan only if the individual qualifies. Because they make some risky loans and pay more for the funds they borrow, finance companies charge more than commercial banks for loans. Life Insurance Companies Another financial institution that does not get its funds through deposits is the life insurance company. Although its primary purpose is to provide financial protection for the people who are insured, it also collects a great deal of cash. The head of a family, for example, may purchase a life insurance policy to leave money for a spouse and children in case of his or her death. The premium is the price the insured pays for this policy, usually paid monthly, quarterly, or annually for
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the length of the protection. Because insurance companies collect cash for these premiums on a regular basis, they often lend surplus funds to others. Pension Funds The pension fund is another nondepository financial institution. A pension is a regular payment intended to provide income security to someone who has worked a certain number of years, reached a specified age, or suffered a particular kind of injury. A pension fund is a fund set up to collect income and disburse payments to those persons eligible for retirement, old-age, or disability benefits. In the case of private pension funds, employers regularly withhold a percentage of workers’ salaries to deposit in the fund. During the 30- to 40-year lag between the time the savings are deposited and the time the workers generally use them, the money is usually invested in high-quality corporate stocks and bonds. Reading Check Comparing and Contrasting How do finance companies, life insurance companies, and pension funds channel savings to borrowers? Figure 11.2 The Power of Compound Interest This table shows the balance in an account if monthly deposits of $10 were compounded monthly. The higher the interest rate and the longer money is invested, the larger the final balance will be. Economic Analysis How much interest is earned after the first 10 years at 6 percent? See StudentWorks™ Plus or glencoe.com. C OMPOUND I NTEREST Annual interest (in percent) 5 0 2 4 6 8 10 12 $600 $630 $663 $698 $735 $774 $817 10 $1,200 $1,327 $1,472 $1,639 $1,829 $2,048 $2,300 Value at end of year 20 15 $1,800 $2,097 $2,461 $2,908 $3,460 $4,145 $4,996 $2,000 $2,948 $3,668 $4,620 $5,890 $7,594 $9,893 25 $2,500 $3,888 $5,141 $6,930 $9,510 $13,268 $18,788 30 $3,600 $4,927 $6,940 $10,045 $14,904 $22,605 $34,950 Basic Investment Considerations would grow with a larger deposit! That is why many investment advisers tell people to save something every month. MAIN Idea Investors should consider several factors before investing their money. Simplicity Economics & You Have you thought
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about investing some of your savings? Read on to learn what factors to consider. You may want to participate in the financial system by investing in stocks, bonds, and other financial assets. Before you do so, you should be aware of four basic investment considerations. Consistency Most successful investors invest consistently over long periods of time. In many cases, the amount invested is not as important as investing on a regular basis. Figure 11.2 shows how a monthly deposit of $10 would grow over a 5- to 30-year period at various interest rates. Even at modest rates, the balance in the account accumulates fairly quickly. Because $10 is a small amount, imagine how the account Most analysts advise investors to stay with what they know. Thousands of investments are available, and many are quite complicated. Knowing a few fundamental principles can help you make good choices among these options. One rule that many investors follow is to ignore any investment that seems too complicated. Another often-cited rule is that an investment that seems too good to be true probably is. A few investors do get lucky, but most build wealth because they invest regularly, and they avoid the investments that seem too far out of the ordinary. The Risk-Return Relationship Another important factor is the relationship between risk and return. Risk is the degree to which the outcome is uncertain but a probable outcome can be estimated. Investors realize that some investments are riskier than others, so they normally risk situation in which the outcome is not certain, but the probabilities can be estimated Skills Handbook See page R57 to learn about Interest Rates. CHAPTER 11 Financial Markets 293 Figure 11.3 Risk and Return T HE R ELATIONSHIP B ET WEEN R ISK AND R ETURN Junk bonds Speculative stock Common stock Preferred stock Investment-grade bonds Prime commercial paper U.S. Treasury bills Increasing degrees of risk The level of risk for investments can vary considerably. U.S. Treasury bills are regarded as the safest investments, while speculative stock and junk bonds are considered among the riskiest. Economic Analysis Why do investors require higher returns for some investments? demand higher returns as compensation. This relationship between increasing risks and returns is illustrated in Figure 11.3. As an investor, you must consider the level of risk that you can tolerate. If you are comfortable with high levels of risk, then you may want to purchase risky investments that promise high returns. Otherwise consider lower-risk investments instead. Investment Objectives Finally, you need to consider your reason for investing. For example, if you
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want to cover living expenses during periods of unemployment, you might want to accumulate assets that can easily be converted into cash. If you want to save for retirement, you might want to purchase common stocks that generate dividend income and appreciate in value over time. Investors have a large number of stocks, financial assets, and other investments from which to choose. The investor’s knowledge of his or her own needs is important in making these decisions. Reading Check Identifying If you were to invest your money, what would your objectives be? SECTION 1 Review Vocabulary 1. Explain the significance of saving, savings, certificate of deposit, financial asset, financial system, financial intermediary, nonbank financial institution, finance company, premium, pension, pension fund, and risk. Main Ideas 2. Describing How does saving compare to savings? 3. Identifying Use a graphic organizer like the one below to describe the nonbank financial intermediaries. Nonbank Financial Intermediaries 4. Explaining Why is consistency important when saving? 294 UNIT 3 Economic Institutions and Issues Critical Thinking 5. The BIG Idea What is the relationship between the financial system and the economy? 6. Comparing and Contrasting How do life insurance companies and pension funds differ in the way they serve their clients? 7. Analyzing Visuals Look at Figure 11.2 on page 293. If you invested $10 a month for 20 years at an annual interest rate of 6 percent, what would be your ending balance? How much of that would be your initial investment? How much would be the interest earned? Applying Economics 8. Financial Assests Why is an I.O.U. that you write and give to a friend in payment of a debt considered an example of a financial asset? ENTREPRENEUR Profiles in Economics Sallie Krawcheck (1965– ) • chief financial officer for Citigroup Inc., the world’s largest financial institution • ranked number 6 on Forbes’s top 100 of “The World’s Most Powerful Women” for 2006 Sallie Krawcheck thinks that nothing prepared her better for Wall Street than feeling like an outcast in seventh grade. Ready to take contrarian stands today, she believes that one of the best lessons she learned then was to “zig when everyone else is zagging.” Indirect Road to Success While Sallie Krawcheck came to her current position at a fast pace, it was not on a straight path. Armed with a journalism degree,
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she became an investment banker but did not enjoy it. Instead she decided to pursue an MBA at Columbia University, only to return to investment banking when she could not find other job opportunities. Then, in a quick series of events, Krawcheck got married, had a baby, quit her job, and discovered within just two weeks of quitting that she enjoyed working too much to give it up. She decided to try her hand as a research analyst, but was rejected by every firm except the one—Sanford C. Bernstein—that would eventually help launch her fast-track career. Rising Star As a research analyst, Krawcheck evaluated the stock of financial institutions. She looks back on this time as the best possible training for her future roles. Krawcheck learned to be persistent, work hard, be willing to learn from mistakes and, perhaps most importantly, stand by her decisions: “As an analyst, I was very comfortable being uncomfortable, and as a CFO I have to be comfortable being uncomfortable. I have to be fine with delivering bad news.” Krawcheck’s reputation grew along with her success. Called “Mrs. Clean” because of her unwavering insistence on ethics and honesty, she was hired as the CEO of Smith Barney, the research and brokerage division of Citigroup which had gone through a period of ethical turmoil. Two years later, she found herself in the position of CFO at Citigroup, with an annual salary of $500,000 in 2005. Bonuses and other benefits pushed the total up to nearly $10 million. Examining the Profile 1. Identifying What skills helped Krawcheck most in being promoted and becoming a successful CFO? 2. Making Inferences What lessons do you think Krawcheck learned from her early career? Mark Peterson/Corbis CHAPTER 11 Financial Markets 295 SECTION 2 Financial Assets and Their Markets GUIDE TO READING Section Preview Academic Vocabulary In this section, you will learn about the characteristics of various investments to help with your investments. • offset (p. 298) • presumed (p. 300) Content Vocabulary • bond (p. 297) • coupon rate (p. 297) • maturity (p. 297) • par value (p. 297) • current yield (p. 297) • junk bond (p. 299) • municipal bond (p. 299) • tax-exempt (p. 300) • savings bond (p. 300) • beneficiary (p. 301) • Treasury note (p
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. 301) • Treasury bond (p. 301) • Treasury bill (p. 301) • Individual Retirement Account (IRA) (p. 302) • capital market (p. 302) • money market (p. 302) • primary market (p. 303) • secondary market (p. 303) Reading Strategy Identifying As you read the section, use a graphic organizer similar to the one below to identify and describe at least four financial assets. Financial Assets ISSUES IN THE NEWS Want More Interest? Meet Bond, Junk Bond —www.usatoday.com Let’s think about a little number: 4.59%. It’s not the percentage of Americans who understand Olympic curling rules. It’s the amount of interest you can earn annually on a 10-year Treasury note. That would be $45.90 a year on a $1,000 investment. Ah, good times. Good times. You might be wondering, “Is there any way I can get a bit more interest?” Well, yes. You could invest some of your portfolio in a junk-bond fund. Bonds are long-term, interest-bearing IOUs... [and]... bonds issued by corporations tend to pay higher interest. That’s because they can go bankrupt and default on their bonds. Bonds issued by companies with poor credit ratings pay the highest interest of all. The only problem: When you buy junk bonds at high prices, you run the risk of nastiness if the economy gets smacked. ■ When you decide to invest your money, you will have a variety of investment options. As you read in the news story, not all options are alike. Some investments carry only a small risk, but they also offer a smaller return. Other investments may offer the possibility of larger returns, but the higher risk means you may never see that money if the company defaults on its promise to pay. Many financial assets are available in the market. Before you invest in any of these, it helps to know the risks involved in each. 296 UNIT 3 Economic Institutions and Issues JosÈ Fuste Raga/zefa/Corbis Bonds as Financial Assets MAIN Idea A bond is a long-term investment, with the price determined by supply, demand, and the buyer’s assessment of repayment risk. Economics and You Have you ever received a government bond as a birthday present? Read on to learn how the value of a
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bond is determined. Governments and businesses issue bonds when they need to borrow funds for long periods. A bond is a formal long-term contract that requires repayment of borrowed money and interest on the borrowed funds at regular intervals over time. Increasingly bonds are taking on an international flavor, with companies in one country issuing bonds in another. While this may seem complex, the main components of a bond are relatively simple. Bond Components A bond has three main components: the coupon rate, or the stated interest on the debt; the maturity, or the life of the bond; and the par value, the principal or the total amount initially borrowed that must be repaid to the lender at maturity. Suppose, for example, that a corporation sells a 6 percent, 20year, $1,000 par value bond that pays interest semiannually. The coupon payment to the holder is $30 semi annually (.06 times $1,000, divided by 2). When the bond reaches maturity after 20 years, the company retires the debt by paying the holder the par value of $1,000. Bond Prices The investor views the bond as a financial asset that will pay $30 twice a year for 20 years, plus a final par value payment of David Waisglass/Laughingstock $1,000. Investors can offer $950, $1,000, $1,100, or any other amount for this future payment stream. Investors consider changes in future interest rates, the risk that the company will default, and other factors before they decide what to offer. Supply and demand among buyers and sellers will then establish the final price of the bonds. Bond Yields In order to compare bonds, investors usually compute the bond’s current yield, the annual interest divided by the purchase price. If an investor paid $950 for the bond described above, the current yield would be $60 divided by $950, or 6.32 percent. If the investor paid $1,100 for the bond, the current yield would be $60 divided by $1,100, or 5.45 percent. It may appear as if the issuer fixes the return on a bond when the bond is first issued. However, the interest received and the price paid determine the actual current yield of each bond. The result is that the bond yield, like the bond price, is determined by supply and demand bond contract to repay borrowed money and interest on the borrowed money at regular future intervals coupon rate stated interest on a corporate, municipal, or government bond maturity life of
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a bond or length of time funds are borrowed par value principal of a bond or total amount borrowed current yield bond’s annual coupon interest divided by purchase price; measure of a bond’s return Bonds Corporate and government bonds are attractive because they can be safe and may be tax-exempt. How is the actual return of a bond determined? CHAPTER 11 Financial Markets 297 Bond Ratings Because the credit-worthiness, or financial health, of corporations and governments differ, all 6 percent, 20-year, $1,000 bonds will not cost the same. There are no guarantees that the issuer will be around in 20 years to redeem the bond. Therefore, investors will pay more for bonds issued by an agency with an impeccable credit rating. However, investors will pay less for a similar bond if it is issued by a corporation with a low credit rating. Fortunately, investors have a way to check the quality of bonds. Two major corporations, Standard & Poor’s and Moody’s, publish bond ratings. They rate bonds on a number of factors, including the basic financial health of the issuer, the expected ability to make the future coupon and principal payments, and the issuer’s past credit history. Bond ratings, shown in Figure 11.4, use letters scaled from AAA, which represents the highest investment grade, to D, which generally stands for default. If a bond is in default, the issuer has not kept up with the interest or other required payments. These ratings are widely publicized, and investors can find the rating of any bond they plan to purchase. Bonds with high ratings sell at higher prices than do bonds with lower ratings. A 6 percent, 20-year, $1,000 par value bond with an AAA-grade rating may sell for $1,100 and have a current yield of 5.45 percent. Another 6 percent, 20-year, $1,000 par value bond issued by a different company may have a BBB rating, and may therefore only sell for $950 because of the higher risk. The second bond, however, has a higher current yield of 6.32 percent. This is consistent with the basic risk-return relationship, which states that investors require higher returns to offset increased levels of risk. Bonds issued by the U.S. government are considered to be the safest of all financial assets because they have almost no risk of ever being in default. Because of this, these bonds also have the lowest yields. Reading Check Describing What factors determine a bond�
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�s value? Figure 11.4 Bond Ratings Standard & Poor’s Moody’s Highest investment grade High grade Upper medium grade Medium grade Lower medium grade Speculative Vulnerable to default Subordinated to other debt rated CCC Subordinated to CC debt Bond in default AAA AA A BBB BB B CCC CC C D Aaa Aa a Baa Ba B Caa Ca C D Best quality High quality Upper medium grade Medium grade Possesses speculative elements Generally not desirable Poor, possibly in default Highly speculative, often in default Income bonds not paying income Interest and principal payments in default Sources: Standard & Poor’s; Moody’s. Both Standard & Poor’s and Moody’s publish bond ratings. Junk bonds, those with ratings of BB or Ba and lower, are generally the riskiest types of bonds. Economic Analysis How do bond ratings affect the price of bonds Certificates of Deposit CDs can vary in cost and length of maturity. What are other characteristics of Certificates of Deposit? junk bond bond that carries an exceptionally high risk of nonpayment and a low rating municipal bond bond, often tax exempt, issued by state and local governments Skills Handbook See page R58 to learn about Interpreting Cartoons. Financial Assets and Their Characteristics insurance limit. The National Credit Union Association insures most CDs issued by credit unions. MAIN Idea Investments include CDs, bonds, bills, and IRAs, all of which vary in cost, maturity, and risk. Economics and You Have you seen bank advertisements for CDs? Read to find out how these compare to other investments. The modern investor has a wide range of financial assets from which to choose. These include certificates of deposit, bonds, and Treasury notes and bills. They vary in cost, maturity, and risk. Certificates of Deposit Certificates of deposit (CDs) are one of the most common forms of investments available. Many people think of them as just another type of account with a bank, but they are really loans investors make to financial institutions. Because banks and other borrowers count on the use of these funds for a certain time period, they usually impose a penalty if people try to cash in their CDs early. CDs are attractive to small investors because they can cost as little as $500 or $1,000. Investors can also select the length of maturity, giving them an opportunity to tailor the expiration date to future expenditures such as college tuition, a vacation, or some other expense. Finally, the CDs issued
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by commercial banks, savings banks, and savings associations are included in the $100,000 FDIC King Features Syndicate, Inc. Corporate Bonds Corporate bonds are an important source of corporate funds. Some individual corporate bonds have par values as low as $1,000, but par values of $10,000 are more common. The actual prices of the bonds are usually different from the par values. Investors generally decide on the highest level of risk they are willing to accept. They then try to find a bond that has the best current yield. Junk bonds— exceptionally risky bonds with a Standard & Poor’s rating of BB or lower, or a Moody’s rating of Ba or lower—carry a high rate of return as compensation for the higher possibility of default. Investors usually purchase corporate bonds as long-term investments, but these bonds can be quickly sold if investors need cash for other purposes. The Internal Revenue Service considers the interest, or coupon, payments on corporate bonds as taxable income, a fact investors must consider when they invest in bonds. Municipal Bonds Municipal bonds, or “munis,” are bonds issued by state and local governments. States issue bonds to finance highways, state buildings, and some public works. Cities issue bonds to pay for baseball parks and football stadiums, or to fund libraries, parks, and other civic improvements. CHAPTER 11 Financial Markets 299 tax-exempt not subject to tax by federal or state governments savings bond low-denomination, non-transferable bond issued by the federal government Municipal bonds are attractive investments for several reasons. First, they are generally regarded as safe investments. Unlike companies, state and local governments do not go out of business and therefore rarely default. In addition, because governments have the power to tax, it is generally presumed that in the future they will be able to pay interest and principal for any bonds they have issued. CAREERS Stockbroker The Work * Supply the latest price quotations on stocks and keep informed about the financial activities of corporations issuing stock * Provide clients with financial counseling and advice on the purchase or sale of particular securities * May design an individual client’s financial portfolio, which could include securities, life insurance, corporate and municipal bonds, mutual funds, certificates of deposit, annuities, and other investments Qualifications * Excellent sales skills and communication skills * Ability to act quickly is helpful in building and keeping a strong customer base * College degree in business administration, economics, or finance * Must pass licensing exam Earnings * Median annual earnings: $69,200
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Job Growth Outlook * Average Source: Occupational Outlook Handbook, 2006–2007 Edition 300 UNIT 3 Economic Institutions and Issues Robert Essel NYC/Corbis More importantly, municipal bonds are generally tax-exempt, meaning that the federal government does not tax the interest paid to investors. In some cases, the states issuing the bonds also exempt the interest payments from state taxes, which makes them very attractive to investors. The tax-exempt feature also allows the government agencies to pay a lower rate of interest on the bonds, thereby lowering the government’s cost of borrowing. Government Savings Bonds The federal government generates financial assets when it sells savings bonds. Savings bonds are low-denomination, nontransferable bonds issued by the U.S. government that are also called EE savings bonds. Investors can purchase them through banks and financial intermediaries, obtain them through payroll-savings plans, or buy them directly from the U.S. Treasury over the Internet. Regardless of how they are purchased, there are two kinds of savings bonds; one is paper-based, and the other is paperless. The paper bonds are available in denominations ranging from $50 to $10,000, and they are purchased at a 50 percent discount from their redemption value. For example, you might obtain a new $50 savings bond today for $25, or a $10,000 bond for $5,000. You may then have to hold the bond for up to 30 years before you can redeem it for the full face value, depending on the purchase date and the interest rate. The government pays interest on these bonds, but it builds the interest into the redemption price rather than sending checks to millions of investors on a regular basis. Paperless bonds are purchased directly from the Treasury over the Internet. All an investor has to do is open an account, and the bonds will be issued electronically to the investor ’s account. The electronic bonds sell at face value, so you pay $50 for a $50 bond, or $10,000 for a $10,000 bond. Interest is added monthly and compounded semi annually, but to take some of the beneficiary person designated to take ownership of an asset if the owner of the asset dies Treasury note U.S. government obligation with a maturity of 2 to 10 years Treasury bond U.S. government bond with a maturity of 10 to 30 years Treasury bill short-term United States government obligation with a maturity of one year or less in denominations of $1,000 Although these financial assets have no
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collateral or backing, they are popular because they are generally regarded as the safest of all financial assets. Due to the trade-off between risk and return, however, these assets also have the lowest returns of all financial assets. Treasury Bills Federal government borrowing generates other financial assets known as Treasury bills. A Treasury bill, also called a T-bill, is a short-term obligation with a maturity of 4, 13, or 26 weeks and a minimum denomination of $1,000. T-bills do not pay interest directly but instead are sold on a discount basis, much like government savings bonds. For example, an investor may pay the auction price of $960 for a 26-week bill that matures at $1,000. The $30 difference between the amount paid and the amount received Savings Bonds The federal government issues paper-based EE Savings Bonds in low denominations. How can you purchase these bonds? uncertainty out of the investment, the U.S. Treasury guarantees that the bond will at least double in value every 20 years. Savings bonds are popular because they are easy to obtain and there is virtually no risk of default. They cannot be sold to someone else if the investor needs cash, but they can be redeemed early, with some loss of interest, if the investor must raise cash for other purposes. Most investors who purchase long-term savings bonds treat them as a form of automatic savings. Other investors buy the bonds for their heirs by designating a beneficiary, or someone who inherits the ownership of the financial asset if the purchaser dies. A grandmother, for example, may buy EE saving bonds in her name and designate a grandchild as the beneficiary. When the grandmother dies, the beneficiary automatically takes ownership of the savings bond without having to pay any inheritance taxes. Treasury Notes and Bonds When the federal government borrows funds for periods lasting longer than one year, it issues Treasury notes and bonds. Treasury notes are United States government obligations with maturities of 2 to 10 years, while Treasury bonds have maturity dates ranging from more than 10 to as many as 30 years. The only collateral that secures both is the faith and credit of the United States government. Treasury notes and bonds come in denominations of $1,000, which means that small investors can afford to buy them. The notes and bonds are issued electronically, and investors purchase them directly from the U.S. Treasury. Since the investors’ accounts are computerized, the Treasury adds the periodic interest payments directly to these accounts rather than mailing checks to the investors
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. Comstock Images/SuperStock Figure 11.5 Financial Assets and Their Markets Assets in the money or capital market differ in the length of maturity. The ability to sell the asset to someone other than the original issuer determines whether that asset is part of the primary or the secondary market. Economic Analysis Why do some financial assets, such as CDs, appear in more than one market? Money market (less than 1 year) Capital market (more than 1 year) Primary market Money market mutual funds Small CDs Secondary market Jumbo CDs Treasury bills Government savings bonds IRAs Money market mutual funds Small CDs Corporate bonds International bonds Jumbo CDs Municipal bonds Treasury bonds Treasury notes Individual Retirement Account (IRA) retirement account in the form of a long-term time deposit, with annual contributions not taxed until withdrawn during retirement capital market market in which financial capital is loaned and/or borrowed for more than one year money market market in which financial capital is loaned and/or borrowed for one year or less is the investor ’s return. The investor receives $30 on a $960 investment, for a semiannual return of $30 divided by $960, or 3.1 percent. Individual Retirement Accounts Many employees invest money in Individual Retirement Accounts (IRAs), long-term, tax-sheltered time deposits that can be set up as part of an individual retirement plan. For example, a worker may decide to deposit $4,000 annually in such an account. If the worker’s spouse does not work outside the home, the spouse also can deposit $4,000 per year in a separate account. The worker deducts these deposits from the taxable income, thereby sheltering up to $8,000 from the individual income tax. Taxes on the interest and the principal will eventually have to be paid. However, the tax-deferment feature gives the worker an incentive to save today, postponing the taxes until the worker is retired and in a lower tax bracket. IRAs cannot be transferred, and penalties exist if they are liquidated early. In addition, the government sets annual contribution limits. Reading Check Analyzing What features of a government bond appeal most to you? Markets for Financial Assets MAIN Idea Financial assets are grouped into different markets depending on their maturity and liquidity. Economics and You Would you be willing to invest your money for a 20-year term? Read to learn in which market you would be involved. Investors often refer to markets according to the characteristics of the financial assets traded in them. These markets overlap to
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a considerable degree. Capital Markets Investors speak of the capital market when they mean a market in which money is loaned for more than one year. Longterm CDs and corporate and government bonds that take more than a year to mature belong in this category. Capital market assets are shown in the right-hand column of Figure 11.5. Money Markets Investors refer to the money market when they mean a market in which money is loaned for periods of less than one year. 302 UNIT 3 Economic Institutions and Issues primary market market in which only the original issuer can sell or repurchase a financial asset secondary market market in which financial assets can be sold to someone other than the original issuer The financial assets that belong to the money market are shown in the left-hand column of Figure 11.5. Note that a person who owns a CD with a maturity of one year or less is involved in the money market. If the CD has a maturity of more than one year, the person is involved in the capital market as a supplier of funds. Many investors purchase money market mutual funds. These funds are created when stockbrokers or other financial managers pool the deposits of their customers to purchase stocks or bonds. Money market mutual funds usually pay slightly higher interest rates than banks. Primary Markets Another way to view financial markets is to focus on the liquidity of a newly created financial asset. One market for financial assets is the primary market, a market where only the original issuer can sell or repurchase a financial asset. Government savings bonds and IRAs are in this market because neither of them can be transferred. Small CDs are also in the primary market because investors tend to cash them in early if they need cash, rather than trying to sell them to someone else. Secondary Markets If a financial asset can be sold to someone other than the original issuer, it then becomes part of the secondary market, where existing financial assets can be resold to new owners. The major difference between the primary and secondary markets is the liquidity the secondary market provides to investors. If a strong secondary market exists for a financial asset, investors know that the asset can be liquidated fairly quickly and without penalty, other than the fees for handling the transaction. Reading Check Contrasting How are capital and money markets different? How do primary and secondary markets differ? SECTION 2 Review Vocabulary 1. Explain the significance of bond, coupon rate, maturity, par value, current yield, junk bond, municipal bond, tax-exempt, savings bond, beneficiary, Treasury note, Treasury bond, Treasury bill, Individual
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Retirement Account, capital market, money market, primary market, and secondary market. Main Ideas 2. Explaining What is the relationship between a bond rating and the price of the bond? 3. Identifying Use a graphic organizer like the one below to identify the characteristics of financial assets. Financial Asset Characteristics Certificate of deposit 4. Stating What are markets for financial assets? Critical Thinking 5. The BIG Idea Why would an investor want to choose a certificate of deposit over a corporate bond? 6. Comparing and Contrasting What do corporate bonds, municipal bonds, and government savings bonds have in common? How do they differ? 7. Drawing Conclusions Why would someone be willing to invest in “junk” bonds? 8. Analyzing Visuals Look at Figure 11.5 on page 302. If you wanted to invest your money for retirement, in which market would you most likely invest? In which market would you invest to save for a vacation? Explain your answer using specific examples of financial assets. Applying Economics 9. Risk-Return Relationship If you had money to invest, which financial asset or assets, if any, would you choose? Explain your answer in a brief paragraph. CHAPTER 11 Financial Markets 303 CASE STUDY The NYSE Starting Small... On a warm May afternoon in 1792, 24 New York City stockbrokers and merchants met beneath a buttonwood tree to sign an agreement. This deal— the Buttonwood Agreement—marked the creation of the New York Stock Exchange (NYSE).... and Growing Big Today the 37,000-square-foot floor of the New York Stock Exchange is where the action is. Although some shares are traded electronically, traders on the floor of the exchange match buyers and sellers of listed stocks in a daily high-stakes dance. Companies pay an initial fee of up to $250,000 just to be listed on the NYSE, and yearly listing fees can reach $500,000. The NYSE, also called the “Big Board,” serves as auctioneer for about 2,600 U.S. and foreign companies. It also works to earn a profit for its own shareholders. After nearly 214 years as a notfor-profit exchange, the NYSE went public on March 8, 2006, selling shares in itself. It also Market Capitalization* of Listed Companies (in trillions) NYSE 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1990 NYSE $13.3 $12.6 $11.4 $9
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.0 $11.0 $11.5 $11.4 $10.3 $8.9 $6.8 $5.7 $2.7 NYSE % of all Euronext 33% 34% 36% 39% 41% 37% 32% 39% 40% 34% 33% 28% $2.70 $2.40 $2.10 $1.60 $1.80 $2.30 $2.40 $1.80 $1.30 $1.10 $0.90 $0.50 * Number of common shares multiplied by current price of those shares Source: 2006 NYSE Group, Inc. 304 UNIT 2 Macroeconomics: Institutions Mark Lennihan/AP Images merged with Archipelago Holdings Inc. and the Pacific Exchange to become the NYSE Group, the largest stock exchange ever. Competition From Abroad After corporate accounting scandals such as Enron were made public in the early 2000s, Congress and the Securities and Exchange Commission instituted the Sarbanes-Oxley Act in 2002. SarbOx created reams of new rules and regulations aimed at eliminating corporate corruption. The fallout from SarbOx has led many investors, companies, and even the NYSE Group itself to look to overseas exchanges, where regulations are less strict. In May 2006, the NYSE announced its $10 billion intention to merge with Euronext, which runs the Amsterdam, Brussels, Paris, and Lisbon exchanges. By merging with Euronext, the NYSE can bypass the red tape created by SarbOx and tap into new markets. Analyzing the Impact 1. Summarizing Why did the NYSE decide to expand into overseas markets? 2. Analyzing Visuals Look at the market capitalization table. What has happened to NYSE’s share of market capitalization since the enactment of SarbOx? SECTION 3 Investing in Equities and Options GUIDE TO READING Section Preview In this section, you will learn more about the equities, or stocks, that are traded in markets. Content Vocabulary • equities (p. 306) • stockbroker (p. 306) • Efficient Market Hypothesis (EMH) (p. 307) • portfolio diversification (p. 307) • mutual fund (p. 307) • net asset value (NAV) (p. 307) • 401(k) plan (p. 307) • stock exchange (p. 308) • securities exchange (
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p. 308) • over-the-counter market (OTC) (p. 309) • Dow Jones Industrial Average (DJIA) (p. 310) • Standard & Poor’s 500 (S&P 500) (p. 310) • bull market (p. 310) • bear market (p. 310) • spot market (p. 311) • futures contract (p. 311) • option (p. 311) • call option (p. 311) • put option (p. 311) Academic Vocabulary • prospects (p. 306) • implication (p. 307) Reading Strategy Describing As you read the section, use a graphic organizer similar to the one below to describe the different stock markets. Stock Market Characteristics NYSE —www.cme.com COMPANIES IN THE NEWS Snowfall Futures The Chicago Mercantile Exchange (CME), the world’s largest and most diverse financial exchange, announced today that it will begin listing and trading snowfall futures and options. Snowfall futures will be based on a CME Snowfall Index and will be offered initially on two U.S. cities—Boston and New York. These contracts will trade on a monthly basis from October through April. “CME weather futures provide the safety and soundness investors are seeking to manage their weather-related risk,” said CME’s Rick Redding. “From municipal snow removal budgets to holiday retail sales, snowfall, or lack thereof, can have a major impact on local and regional economies.” ■ While government bonds rank among the safest financial assets, equities and futures, such as the snowfall futures in the news story, are at the opposite end of the risk spectrum. They offer the lure of large returns—or a complete loss. Purchasing stock used to be complicated and required professional help. With computers and the Internet, though, today anyone can easily invest in stocks, mutual funds or, as you read in the news story, the snowfall depth futures for New York. Stinger/Getty Images CHAPTER 11 Financial Markets 305 equities stocks that represent ownership shares in corporations stockbroker person who buys or sells securities for investors Skills Handbook See page R59 to learn about Reading the Stock Market Report. Stocks and Efficient Markets MAIN Idea Investors can purchase stock through stockbrokers on exchanges, through mutual funds, or through 401(k) plans. Economics and You Does anyone in your family save for retirement through
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a 401(k)? Read on to learn how this is a way to invest in the stock market. Equities, or shares of common stocks that represent ownership of corporations, form another type of financial asset that is available to investors. Share Values investor may want There are different ways to buy equities. An to use a stockbroker—a person who buys or sells equities for clients. The investor can also open an Internet account with a discount brokerage firm. This allows the investor to buy, sell, and monitor his or her stock portfolio from a personal computer. The value of a single share of stock depends on several things. Both the number of outstanding shares to be traded and a company’s profitability influence the price. Expectations are especially important, because demand for a company’s stock increases when the prospects for its growth improve. Common to almost all stocks is that their value goes up and down daily, sometimes gaining or losing a few cents a share and at other times gaining or losing much more. This is due to a change in either the supply or the demand for a share of stock. Figure 11.6 shows a typical listing of several stocks. During the last 12 months, Exxon stock sold for as much as $65.96 and as little as $53.08 a share. Its annual dividend (DIV) is $1.28, paid in four equal installments. The yield (Yld%) is the dividend divided by the closing price. The PE, or price-earnings ratio, is a stock’s closing price divided by annual earnings of each share of common stock outstanding. Finally, Exxon closed at $60.18, which is $1.78 lower than the day before, as indicated by the Net Change (NET CHG) column. Stock Market Efficiency Most large equity markets are reasonably competitive, especially if they have a large number of buyers and sellers. When these condistions exist, stocks can be easily bought and sold, so any news that affects the supply or demand for stocks can affect stock prices on a daily basis. Figure 11.6 A New York Stock Exchange Listing 52 weeks Hi Lo Stock (SYM) 42.01 29.98 Estee Lauder (EL) 65.96 53.08 ExxonMobil (XOM) 120.01 76.81 Fedex Corp (FDX) 11.48 6.75 Ford Motor (F) DIV 0.40 1.28 0.32 0.40 Yld% PE 100S LAST NET
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CHG 1.00 2.10 0.30 5.60 34.02 10.25 20.11 691 25,966 41.16 60.18 3,175 109.92 N/A 19,606 6.91 0.26 –1.78 –5.51 –0.11 A typical New York Stock Exchange newspaper listing might include the highest and lowest prices for a 52-week period, the annual dividend payment, yield, price-earnings ratio, number of shares traded in 100s, closing price, and price change from the previous day. Other listings on the Internet show even more information. Economic Analysis Which of the stocks had the largest variation in a year? There is no sure way to invest in stocks in order to always make a profit. Stock prices can vary considerably from one company to the next, and the price of any stock can change dramatically from one day to the next. Because of this variability, investors are always looking at stocks to find the best ones to buy or sell and those to avoid. All of this attention makes the market more competitive. Diversification Many investors put their money into a variety of stocks. Why is it a good idea to diversify? Many stock market experts subscribe to a theory called the Efficient Market Hypothesis (EMH)—the argument that stocks are usually priced correctly and that bargains are hard to find because stocks are followed closely by so many investors. The theory states that each stock is constantly analyzed by many different professional analysts in a large number of stock investment companies. If the analysts observe anything that might affect the fortunes of the companies they watch, they buy or sell the stocks immediately. This in turn causes stock prices to adjust almost immediately to new market information. The main implication for the investor is that if all stocks are priced correctly, it does not matter which ones you purchase. You might be lucky and pick a stock about to go up, or you might get unlucky and pick a stock about to go down. Because of this, portfolio diversification—the practice of holding a large number of different stocks so that increases in some stocks can offset declines in others—is a popular strategy. Mutual Funds Because of the advantages of diversification, many investors buy shares in a mutual fund. A mutual fund is a company that sells stock in itself to individual investors. It then invests the money it receives in stocks and sometimes bonds issued www.CartoonStock.com “This next song’s about spreading risk in a volatile market by
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diversification.” by other corporations. Mutual fund stockholders receive dividends earned from the mutual fund’s investments. Stockholders can also sell their mutual fund shares for a profit, just like other stocks. The market value of a mutual fund share is called the net asset value (NAV)— the net value of the mutual fund divided by the number of shares issued by the mutual fund. Mutual funds allow people to invest in the market without risking all they have in one or a few companies. The large size of the typical mutual fund makes it possible to hire a staff of experts to monitor market conditions and to analyze many different stocks and bonds before deciding which ones to buy or sell. 401(k) Plans Portfolio diversification and the need for retirement planning have also increased the popularity of the 401(k) plan—a taxdeferred investment and savings plan that acts as a personal pension fund for employees. To contribute to the plan, employees of a company authorize regular payroll deductions. The money from all employees Efficient Market Hypothesis (EMH) argument that stocks are always priced about right because they are closely watched portfolio diversification strategy of holding different investments to protect against risk mutual fund company that sells stock in itself and uses the proceeds to buy stocks and bonds issued by other companies net asset value (NAV) the market value of a mutual fund share found by dividing the net value of the fund by the number of shares issued 401(k) plan taxdeferred investment and savings plan that acts as a personal pension fund for employees CHAPTER 11 Financial Markets 307 stock exchange or securities exchange physical place where buyers and sellers meet to exchange securities is then pooled and invested in mutual funds or other investments approved by the company. Contributing to a plan lowers your taxable income because you don’t have to pay income taxes on the money you contribute until you withdraw it. An added benefit of a 401(k) plan is that most employers typically match a portion of an employee’s contributions. For example, if your employer matches your contribution at 50 cents on the dollar, you have an immediate 50 percent return on the investment—even before the funds are invested. Figure 11.7 illustrates that an annual contribution of $2,000 with an employer match of 25 percent can provide a substantial retirement fund in 30 years. The 401(k) is popular because it provides a simple, consistent, and relatively safe way for employees to save—and you can take the 401(k) with you if you change jobs. Reading
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Check Explaining What determines the value of a stock? Stock Markets and Their Performance MAIN Idea Several different stock markets exist, and each is organized in a different way. Economics and You Have you ever heard the closing bell of the New York Stock Exchange on the news? Read on to learn about different stock markets. Stocks, like almost everything else, are traded in markets. Investors follow these markets daily because the performance of the market is likely to affect their stocks. Stock Exchanges Historically, investors would gather at an organized stock or securities exchange, a place where buyers and sellers meet to trade stocks. An organized exchange gets its name from the way it conducts business. Members pay a fee to join, and trades can only take place on the floor of the exchange. The oldest, largest, and most prestigious of the organized stock exchanges in the United States is the New York Figure 11.7 How Much Money Will You Have at Retirement? I NVESTMENTS R ETURNS D ATA B ASED ON: 401(k) Traditional IRA Basic savings $225,000 200,000 175,000 150,000 125,000 100,000 Source: Quicken.com • $2,000 in income invested each year for 30 years • 8% return on investment • Company matching 25% of employee contributions • 28% income tax; 20% capital gains tax (paid yearly for basic savings) See StudentWorks™ Plus or glencoe.com. Returns from retirement investment plans vary. Economic Analysis How much more would a traditional IRA earn than a basic savings plan? &The Global Economy YOU Sell, надувательство, Verkaufen N ATIONAL AND I NTERNATIONAL I NVESTMENTS After you have saved some money, you may decide to become part-owner of a company by purchasing its stock. Your investment options are not limited to those companies listed on the NYSE, however. The United States is home to an additional nine stock exchanges. You can also buy stocks in international companies. At last count, nearly 100 world stock exchanges spanned the globe. In 2005 investors spent more on international and global markets than on U.S. stocks. Where does this global trading take place? Among others, investors can buy and sell on the Bolsa de Comercio de Buenos Aires in Argentina, the Moscow Stock Exchange, or the Tokyo Stock Exchange180 160 140 120 100 80 60 40 20 0 –20 Source: Lipper U.S.
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stock funds International/global stock funds 2000 2001 2002 2003 2004 2005 Year Stock Exchange (NYSE), located on Wall Street in New York City. The NYSE lists stocks from about 2,700 companies. The firms have to pay a membership fee. They also must meet profitability and size requirements, which virtually guarantees that they are among the largest and most profitable publicly held companies. Another national exchange is the American Stock Exchange (AMEX), which also is located in New York City. It features companies that are smaller and more speculative than those listed on the NYSE. Many regional exchanges are located in other cities such as Chicago, Philadelphia, and Memphis. They list corporations that are either too small or too new to be listed on the NYSE or the AMEX. Organized stock exchanges are found in major cities all over the world, including in developing countries such as Ghana, Pakistan, and China. Developments in computer technology and electronic trading have linked the biggest markets. This means that today you can trade in most major stocks around the clock, somewhere in the world. Over-the-Counter Markets Despite the importance of the organized exchanges, the majority of stocks in the United States are not traded on these exchanges. Instead, they are traded in an over-the-counter market (OTC)—an electronic marketplace for securities that are not traded on an organized exchange such as the NYSE. The most important OTC market is the National Association of Securities Dealers Automated Quotation (NASDAQ), the world’s largest electronic stock market. Rather than being limited to a single trading location, NASDAQ trading is executed with a sophisticated telecommunications and computer network that connects investors in more than 80 countries. The total number of stocks listed on NASDAQ exceeds the combined total of the NYSE and AMEX. The organized exchanges and the OTC markets may differ, but this means little to individual investors. An investor who opens an Internet account with a brokerage firm may buy and sell stocks in both markets. When the investor places an order to buy shares, the broker forwards the order Student Web Activity Visit the Economics: Principles and Practices Web site at glencoe.com and click on Chapter 11—Student Web Activity for an activity on the stock market. over-the-counter market (OTC) electronic marketplace for securities not listed on organized exchanges such as the NYSE CHAPTER 11 Financial Markets 309 Performance of Stocks Investors use several indicators to help with their investments. What does the DJIA measure? Dow Jones Industrial Average (DJIA) measure
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of stock market performance based on 30 representative stocks Standard & Poor’s 500 (S&P 500) measure of stock market performance based on 500 stocks traded on the NYSE, AMEX, and OTC market bull market period during which stock market prices move up for several months or years in a row bear market period during which stock market prices move down for several months or years in a row to the exchange where the stock is traded— whether it is on the NYSE, AMEX, or NASDAQ—and the purchase is made there. Measures of Performance Because they are concerned about the performance of their stocks, most investors consult one of two popular indicators. When these indicators go up, stocks in general also go up. When they go down, stocks in general go down. The first of these indicators is the Dow Jones Industrial Average (DJIA), the most popular and widely publicized measure of stock market performance. The DJIA began in 1884, when the Dow Jones Corporation published the average closing price of 11 active stocks. Coverage expanded to 30 stocks in 1928. Since then, some stocks have been added and others deleted, but the sample remains at 30. Because of these changes, the DJIA is no longer a mathematical average of stock prices. Also, the evolution of the DJIA has obscured the meaning of a “point” change in the index. At one time, a one-point change in the DJIA meant that an average share of stock changed by $1. Since this is no longer true, it is better to focus on the percentage change of the index rather than the number of points. Investors also use another popular benchmark of stock perfor mance, the Standard & Poor’s 500 (S&P 500). It uses the price changes of 500 representative stocks as an indicator of overall market performance. Because the sum of 500 stock prices would be very large, it is reduced to an index number. Unlike the Dow Jones, which focuses primarily on the NYSE, the Standard & Poor’s 500 reports on stocks listed on the NYSE, AMEX, and OTC markets. The NASDAQ also computes several measures of market performance for investors. The most popular is the NASDAQ composite. In addition, there are more than 20 sub-indices that focus on everything from the size of the firms traded on the NASDAQ to the performance of individual industries. Bull vs. Bear Markets Investors often use colorful terms to describe which way the market is moving. For example, a bull
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market is a “strong” market with the prices moving up for several months or years in a row. One of the strongest bull markets in history began in 1995, when the DJIA broke 4,000—and then reached 12,000 five years later. A bear market is a “mean” or “nasty” market, with the prices of equities falling sharply for several months or years in a row. The most spectacular bear market since the 1930s was in 2001–2003, when the DJIA lost more than one-third of its value. These two terms take their names from the characteristics people associate with the animals for which they are named. Reading Check Contrasting What is the difference between an over-the-counter market and the NYSE? 310 UNIT 3 Economic Institutions and Issues FOXTROT © 2001 Bill Amend. Reprinted with permission of UNIVERSAL PRESS SYNDICATE. All rights reserved. Trading in the Future MAIN Idea Financial assets can be bought and sold in the future as well as the present. Economics and You Have you ever bought something that later went on sale? Read on to learn how an investor can protect against future price changes. Most buying and selling takes place in the present, or in a spot market. In this market, a transaction is made immediately at the prevailing price. The spot price of gold in London, for example, is the price as it exists in that city at that moment. Sometimes the exchange takes place later, rather than right away. This occurs with a futures contract—an agreement to buy or sell at a specific future date at a predetermined price. For example, you may agree to buy gold at $580 an ounce in six months, hoping that the actual price will be higher when the date arrives. A futures contract can be written on almost anything, including the size of the S&P 500 or the level of future interest rates. In most cases, the profit or loss on the contract is settled with a cash payment rather than the buyer taking delivery. An option is a special type of futures contract that gives the buyer the right to cancel the contract. For example, you may pay $5 today for a call option—the right to buy something at a specific future price. If the call option gives you the right to purchase 100 shares of stock at $70 a share, and if the price drops to $30, you tear up the option and buy the stock elsewhere for $30. If the price rises to $
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100, you execute the option, buy the stock for $70, and resell it for $100—or take a cash settlement. You could also buy a put option—the right to sell something at a specific future price. The put option, like the call option, gives the buyer the right to tear up the contract if the actual future price is not advantageous to the buyer. Reading Check Explaining Why might a contract that takes place in the future be an advantage to the buyer or seller? spot market market in which a transaction is made immediately at the prevailing price futures contract an agreement to buy or sell at a specific date in the future at a predetermined price option futures contract giving a buyer the right to cancel the contract call option futures contract giving a buyer the right to cancel a contract to buy something put option futures contract giving a buyer the right to cancel a contract to sell something SECTION 3 Review Vocabulary 1. Explain the significance of equities, stockbroker, Efficient Market Hypothesis, portfolio diversification, mutual fund, net asset value, 401(k) plan, stock or securities exchange, over-the-counter market, Dow Jones Industrial Average, Standard & Poor’s 500, bull market, bear market, spot market, futures contract, option, call option, and put option. Main Ideas 2. Describing What are the stock performance measures? 3. Evaluating Use a graphic organizer like the one below to evaluate the risks and rewards of investments. 4. Defining What is a futures contract? Critical Thinking 5. The BIG Idea What options are available to individuals who wish to invest in stocks? 6. Analyzing Would you ever invest in a futures contract? Why or why not? 7. Determining Cause and Effect If the price of a share of stock goes up, what does this suggest about the quantity demanded and quantity supplied for that stock? 8. Analyzing Visuals Look at Figure 11.6 on page 306. If you wanted to buy stock that paid large dividends, which stock would you choose? Investment Major Advantage Risk Level Applying Economics Stocks 9. Market Efficiency What does the Efficient Market Hypothesis mean to you as a potential investor as you investigate your future stock portfolio? CHAPTER 11 Financial Markets 311 NEWSCLIP Wall Street in New York City has long been synonymous with wealth and corporate power. This is no longer true. Home to the New York Stock Exchange, Wall Street is losing some of its prestige to Paternoster Square in London, site
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