Question

Please describe the roles that Correcting Market Externalities, Redistribution of Resources , Substitution of Tax, Stabilization for intergovernmental grants plays in the U.S. fiscal system. INCLUDE EXAMPLES FOR EACH ROLE DESCRIBED.

Answer 1

• Correcting market Externalities: Government can play a role in reducing negative externalities by taxing goods when their production generates spillover costs. This taxation effectively increases the cost of producing such goods. The higher cost, then, better reflects the true cost of production because it includes the spillover costs of, say, pollution. So, such taxation attempts to make the producer pay for the full cost of production. The use of such a tax is called internalizing the externality. For example, let's assume the cost of producing the widgets noted earlier is two dollars per unit, but an additional 20 cents per unit had been shifted to society as a negative externality in the form of dirty air. The government could place a 20 cent tax on each widget produced to ensure that the firm pays the actual cost of production-which is now two dollars and twenty cents, including the cost of the negative externality. As a result of the higher cost of production, the firm will reduce its production of widgets thus reducing the level of pollution.
• Redistribution of Resources: Governments at all levels in the United States redistribute a significant amount of money via tax and spending policies, although the magnitude depends on the methodological assumptions made with regard to the distribution of major public goods like national defense and the budget deficit.Comparing redistribution since 2000, one can see that the amount of income redistribution from the top quintile, when measured as a percentage of the group’s market income, has increased over the past twelve years when one assumes that today’s large budget deficits are borne by today’s taxpayers, although income redistribution to the bottom quintile has fallen when using that same metric.The thorniest of these issues is the treatment of public goods like national defense. There are generally two schools of thought regarding how government spending should be treated: the “cost of services” approach and the “benefit principle” approach.

  The cost of services approach distributes government spending based on each family's share of the total cost to government from providing the government service. The cost of services approach makes no assumptions about how people benefit from public goods, it simply divides the spending equally across families based on the government’s cost of providing the service.

  For example, under the cost of services approach, national defense is distributed to each family based on the average cost of provision, where the average cost is based on each household and the number of persons. Specifically,percent of national defense is distributed evenly to each household, while percent of national defense is distributed evenly to each person.

  By contrast, the benefit principle approach distributes the spending on public goods to people based on their share of the nation’s income; in other words, high-income people are assumed to derive more benefits from national defense than low-income people. Here we distribute government spending based on each family's share of the benefit from each government program. The benefit of a spending program for a family is how much the family would (hypothetically) be willing to pay to keep that program in existence.For example, under the benefit principle approach, national defense is distributed to each family based on each family's share of the nation's income, as it is assumed that high-income families would be willing to pay more for national defense than low-income families.In addition to transfers and consumption items, governments in the United States also spend a large amount each year financing debt.

• Substitution of Tax:  The empirical evidence in the literature has shown that the fiscal policy of a U.S. state is influenced by the fiscal policies of its neighbors (Brett,Craig, and Pinske (2000), Buettner (2001, 2000),Heyndels and Vuchelen (1998), Ladd (1992), andRork (2003)). In the same way, it is natural to think that decisions regarding one instrument of fiscal policy influence the decisions regarding other available instruments within each state. Specifically, state governments do not set taxes considering one tax at a time or each different tax based only on its own effects, but rather consider a full tax package, setting all taxes simultaneously. An important question then, is how one specific tax affects the other taxes within the same state. Using instrumental variables we estimate the effect of sales taxes on personal and corporate income taxes within a state. The results show that 1 percent increase in the sales tax rate is associated with a 0.47 and a 0.3 percent decrease in the personal and corporate income tax rates respectively. The importance of these results is that they show not only that taxes are in fact interdependent within one jurisdiction, but also that state governments compensate the decline in revenues from one tax increasing the revenues from other taxes. For example, in 1997 Vermont taxed personal income with a 25 percent of the federal income tax liability and the top statutory federal tax rate was 39.6 percent. We set the tax rate equal to 9.9 percent then. There exist some alternatives proxies for the state sales to foreign citizens that we could not use. The Travel Industry Association of America, for example, calculates the impact of international visitor spending on state economies, but it is available for only a few years. The Census Bureau reports the number of visitors each state receives, but is available only for some states and also for only a few years.
• Stabilization for intergovernmental grants: It could be argued that the recent upward trend in outlays for federal grants to state and local governments is about to end because there is a general consensus that anticipated growth in federal discretionary spending, which includes outlays for federal grants to state and local governments, may be targeted for reductions as part of an effort to address the federal deficit and debt. However, Congress’s historical tendency to use federal grants to state and local governments as a means to create jobs and promote national economic growth suggests that the upward trend in federal grant outlays and federal grant numbers that has been experienced over the past several decades may continue, although at a slower pace. President Trump’s FY2020 budget request estimates that total outlays for federal grants to state and local governments will increase from $696.5 billion in FY2018 to an anticipated $749.5 billion in FY2019 and $750.7 billion in FY2020. In retrospect, with the exception of the early 1980s, federal grant funding, the number of federal grants, and the issuance of federal mandates have increased under both Democratic and Republican Congresses and Presidents. Historically, there have been notable differences between the two parties’ approaches toward federalism. Although both parties have generally opposed unfunded federal mandates, the Republican Party has done so more aggressively, as evidenced by its 1994 Contract With America, sponsorship of UMRA, and recent legislative efforts to broaden UMRA’s coverage to include, when requested by the chair or ranking Member of a committee,the prospective costs of legislation that would change conditions of federal financial assistance. The Republican Party has also advocated the devolution of certain federal grant-inaid programs to state and local governments while the Democratic Party has generally opposed devolution. The Republican Party has also been more aggressive in its support of the decentralization of grants-in-aid decisionmaking to state and local governments through the consolidation of categorical grants into block grants, for revenue sharing, and administrative relief from various grant conditions. But, overall, the historical record suggests that for most Members of both political parties, regardless of their personal ideological preferences, federalism principles are often subordinated to other policy goals, such as reducing the federal budget deficit, promoting social values or environmental protection, and guaranteeing equal treatment and opportunity for the disadvantaged. As long at this continues to be the case, and the public continues to express support for specific government programs ̶ even if they generally oppose “big” government as a whole there is little evidence to suggest that the general historical trends of increasing numbers of federal grants to state and local governments, increasing outlays for those grants, an emphasis on categorical grants, and continued enactment of federal mandates, both funded and unfunded, are likely to change.