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Two Views of the Proper Role of Government in the Economy


Photo: The Bettmann Archive

Paul Samuelson and Milton Friedman are two of America's most distinguished economists. In recognition of their achieve­ments, Samuelson was awarded the Nobel Prize in Economics in 1970 and Friedman in 1976. Both spent most of their professional lives on the faculty of major universities (Samuelson at the Massachusetts Institute of Tech­nology, and Friedman at the University of Chicago). Given their similarities, one would think that the two would also hold similar views on economic issues. Nothing could be further from the truth. And some of their sharpest differences center on the question of what ought to be the proper role of government in the economy.

Classical economists in the tradition of Adam Smith had long recognized the need for government to provide goods and services that would not or could not be provided by the private sector (like national defense). But they urged that this participation be kept to a minimum.

But Samuelson argued that too many of the problems the classical economists wanted to leave to the marketplace were not subject to its influence. These externalities, affecting things like public health, education, and environmental pollution were not subject to the laws of supply and demand.. Consequently, it was up to government to establish goals for the economy and use its powers to achieve them.

Photo: courtesy Harcourt Brace

Jovanovich, Inc.

Milton Friedman sees things differently. Like the classical economists of old, he regards supply and demand as the most powerful and potentially benefi­cial economic forces. The best that government can do to help the economy, in Friedman's view, is to keep its hands off business and allow the market to "do its thing." The minimum wage laws are a case in point. Whereas Samuelson endorses minimum wage laws as a means of helping workers at the bottom of the income ladder, Friedman would argue that by adding to unemployment, they harm the very people they were designed to help. That is, he explains, by increasing labor costs, minimum wage laws make it too expensive for many firms to hire low-wage workers. As a result, those who might otherwise be employed are laid off.

On the one hand, Samuelson endorses the concept of government-sponsored programs such as public housing and food stamps as a means of reducing poverty. Friedman, on the other hand, would prefer to give the poor additional income and allow them to use the funds to solve their problems without government interference. To apply this concept, Friedman suggested the "negative income tax." The graduated income tax takes an increasing amount in taxes as one's income rises. The negative income tax would apply a sliding scale of payments to those whose income from work fell below a stated minimum.




State And Local Finances

The cost of governing has also increased dramatically for the states and localities. Taxes are also the principal source of income to state and local governments. Of these,sales taxesaccounted for about half of all tax revenue collected by the states. You pay sales taxes — a few cents at a time — on most of your purchases. Most states and communities collect 4-7 percent of the price of the goods you buy as sales taxes. These pennies add up to millions of dollars for state and local govern­ment operations.Income taxes are the second most impor­tant source of revenue to the state governments. Individuals in most states are required to pay a percentage of their income to the state in taxes. Among local governments, the property tax provides the most revenue. Property taxes are usually based on the value of real estate, land and buildings.

Another important source of revenue is the money passed along to the states by the federal government, and to the localities by the federal government and the states. As indicated by chart 10-4, these accounted for 18 cents of every state and local budget dollar. Federal aid to the states has usually been in the form ofgrants-in-aid— money given by the federal government to a state or local government. Grants-in-aid usually have two conditions attached to them: that they be used for a particular purpose, and that the state or local government share part of the cost. Over the years, the federal government has used grants-in-aid to involve state governments in programs it deemed worthwhile. Mass transit, highways and social welfare programs have benefited from grants-in-aid.

In recent years, the federal government has also made block grants to the states and localities.Block grants are sums of money with "no strings attached." The state or local govern­ment is free to spend it as it sees fit, without the need to provide matching funds.

The use of block grants in place of grants-in-aid has gener­ated some political controversy. Supporters of block grants like them because they enable the states and local governments to spend funds as they see fit. Too often, they argue, bureaucrats in Washington, with little knowledge of local needs, set guide­lines that lead to wasteful spending.

Opponents, on the other hand, argue that some states would never provide for the needs of their poor, unemployed or minorities unless the federal government provided funds especially for that purpose.

Most of the money spent by states and communities goes штещ education. The next largest share goes to help people in need of things like welfare, housing, health and hospitals.

Taxes, Taxes, Taxes....

"But in this world nothing can be said to be certain, except death and taxes." — Benjamin Franklin, 1789.

Few economic topics excite controversy more easily than taxes. While most would agree that neither government nor modern society could survive without them, taxes are more likely to be criti­cized than praised. But as Benjamin Franklin noted long ago they are a certainty, and for that reason we ought to know something about them.

Why Do Governments Collect Taxes? Although the principal purpose of taxes is to pay for the cost of government, it is doit the only function taxes serve.

Sometimes taxes are levied to protect selected industries. For a number of years a tariff (a tax on imports) helped to protect American steel manufacturers by making imported steel more costly than it would have been otherwise.

Taxes have also been used to discourage activities the govern­ment believes to be harmful. For example, taxes on cigarettes and liquor, so called "sin taxes," have been levied both to raise money and to discourage people from smoking and drinking.

Taxes have been used to encourage certain activities. In the 1980’s, for example, the government wanted to encourage busi­ness to modernize plants and increase productivity. It did so, in part, by offering to reduce the taxes of firms that purchased new machinery and equipment.

The federal government can use its ability to tax to regulate the level of economic activity. The size of the economy is directly related to consumer and business spending. By increasing or decreasing taxes, government can directly affect the amount of money available to be spent.

Evaluating Taxes. Most people would agree that some taxation is necessary, but the question of which taxes, and in what amounts, can lead to considerable disagreement. In comparing the merits of one tax to another, it is convenient to focus on following questions:

· Who ought to pay the taxes?

· What types of taxes are being considered?

· Who will actually pay the taxes?


Types Of Taxes: Progressive, Proportional And Regressive

Most taxes can be classified as progressive, proportional or regressive. Aprogressive tax takes a larger percentage of a higher income and a smaller percentage of a lower income. The federal income tax is the best known example of a progres­sive tax.

A proportional tax takes the same percentage of all incomes, regardless of size. So, for example, a proportional income tax of 10 percent would cost a person with a $10,000 income $1,000 in taxes, and a person with a $100,000 income $10,000 in taxes.

A regressive tax is one that takes a higher percentage of a low income and a lower percentage of a high income. Although they are not based on a person's income,sales taxes have a regressive effect because they take a larger share of earnings from a low-income taxpayer than from a high-income taxpayer. For example, a low-income family and a high-income family buy $500 refrigerators with a sales tax of eight percent. They would both pay a $40 sales tax. But the $40 represents a higher percentage of the low-income family's total income than that of the high-income family.

Which tax is the fairest? Few would argue that a regressive tax is fair. Those who favor the ability-to-pay principle would support a progressive tax, and possibly the proportional tax. There are some, however, who argue that the proportional tax is not fair.

The proportional tax seems to be fair because everyone pays the same rate. Miss Rich, with her income of $100,000 pays 10 times as much as Mr. Poor who has an income of $10,000. Mr. Poor, however, can barely get by on $10,000; he needs every penny he earns. Miss Rich, on the other hand, can pay a tax of $10,000 and still have $90,000 left over — a very substantial sum! She can pay for all of her basic needs, enjoy many luxuries, and still have money left to save or invest. Although her tax was 10 times as large as Mr. Poor's, she did not suffer as much in paying it.

In analyzing the impact of taxes on individuals, economists often concentrate ondiscretionary income— the amount that a person has left after buying necessities (food, clothing, shelter, medical care, transportation, etc.). Let's assume that Mr. Poor has $1,000 left after having met all his needs. By levying a tax of $1,000, the government has taken 100 percent of Poor's discretionary income. What about Miss Rich? Let's say that she needs $50,000 to meet all of her needs (as she defines "needs"), and that she has $50,000 left as a discretionary income. The government takes $10,000 of this, or only 20 percent. She still has $40,000 left for luxuries, savings and investments. If we look at the discre­tionary incomes of Mr. Poor and Miss Rich, we find that the proportional tax is actually a regressive tax!


The economic role of government (local, state, and federal) has grown dramatically in recent years. Federal participation in the economy has outpaced the other two, so that now federal spending is about twice that of the state and local govern­ments combined.

There are two principal reasons for the growth of government. One is the enormous expense involved in meeting the nations past, present and future defense needs. The second is the public demand for more and better services.

The principal items of expense to the federal government can be classified as direct payments to individuals, national defense and interest on the national debt. The single largest item of expense to the states and localities is education.

Taxes provide the principal source of income to all levels of government. Income taxes are the principal source of federal tax income. State and local governments rely on sales, income and property taxes as their principal sources of revenue.

In evaluating taxes it is customary to focus on the following questions:

· Who ought to pay taxes?

· What types of taxes should be levied?

· Who will actually pay the tax?

When government receipts equal expenditures, the budget is balanced. When receipts exceed expenditures, the difference represents a surplus; and when they are less than expenditures, the difference is a deficit. Federal deficits have pushed the total national debt to record levels. Whether these deficits will prove to be helpful or harmful to the nation's economic health has been a matter of sharp controversy.

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