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Licensed to:
Chapter 2 35
The Economy: Myth and Reality

Taxes in America
Taxes finance this array of goods and services, and sometimes it seems that the tax collec-
tor is everywhere. We have income and payroll taxes withheld from our paychecks, sales
taxes added to our purchases, property taxes levied on our homes; we pay gasoline taxes,
liquor taxes, and telephone taxes.
Americans have always felt that taxes are both too many and too high. In the 1980s and
1990s, antitax sentiment became a dominant feature of the U.S. political scene. The old slo-
gan “no taxation without representation” gave way to the new slogan “no new taxes.” Yet,
by international standards, Americans are among the most lightly taxed people in the
world. Figure 13 compares the fraction of income paid in taxes in the United States with
those paid by residents of other wealthy nations. The tax share in the United States fell no-
tably during the early years of George W. Bush™s presidency, but has since crept up a bit.

The Tax Burden in Selected Countries, 2006

Percentage of GDP
Tax Revenues as a

40 37.4 35.7
30.1 28.2
30 27.4


SOURCE: www.stats.oeced.org











The Government as Redistributor
In a market economy, people earn incomes according to what they have to sell. Unfortu-
nately, many people have nothing to sell but unskilled labor, which commands a paltry
price. Others lack even that. Such people fare poorly in unfettered markets. In extreme
cases, they are homeless, hungry, and ill. Robin Hood transferred money from the rich to
the poor. Some think the government should do the same; others disagree.
If poverty amid riches offends your moral sensibilities”a personal judgment that each
of us must make for ourselves”two basic remedial approaches are possible. The socialist
idea is to force the distribution of income to be more equal by overriding the decisions of
the market. “From each according to his ability, to each according to his needs” was
Marx™s ideal. In practice, things were not quite so noble under socialism, but there was lit-
tle doubt that incomes in the old Soviet Union were more equally distributed than those
Transfer payments are
in the United States. sums of money that certain
The liberal idea is to let free markets determine the distribution of before-tax incomes, but individuals receive as
then to use the tax system and transfer payments to reduce inequality”just as Robin Hood outright grants from the
did. This is the rationale for, among other things, progressive taxation and antipoverty government rather than
as payments for services
programs. Americans who support redistribution line up solidly behind the liberal ap-
proach. But which ways are the best, and how much is enough? No simple answers have
emerged from many decades of debate on these highly contentious questions. Lately, as A tax is progressive if the
wage disparities have widened, the inequality issue has gained prominence on the national ratio of taxes to income
political agenda. It figured prominently in the 2008 presidential campaign, for example. rises as income rises.

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Part 1
36 Getting Acquainted with Economics

Ideology notwithstanding, all nations at all times blend public and private ownership of
property in some proportions. All rely on markets for some purposes, but all also assign
some role to government. Hence, people speak of the ubiquity of mixed economies. But
A mixed economy is one
with some public influence mixing is not homogenization; different countries can and do blend the state and market
over the workings of free sectors in different ways. Even today, the Russian economy is a far cry from the Italian
markets. There may also
economy, which is vastly different from that of Hong Kong.
be some public ownership
Shortly after most of you were born, a stunning historical event occurred: Communism
mixed in with private
collapsed all over Europe. For years, the formerly socialist economies suffered through a
painful transition from a system in which private property, free enterprise, and markets
played subsidiary roles to one in which they are central. These nations have changed the
mix, if you will”and dramatically so. To understand why this transformation is at once
so difficult and so important, we need to explore the main theme of this book: What does
the market do well, and what does it do poorly? This task begins in the next chapter.

1. The U.S. economy is the biggest national economy on 5. Governments at the federal, state, and local levels em-
earth, both because Americans are rich by world stan- ploy one-sixth of the American workforce (including the
dards and because we are a populous nation. Relative to armed forces). These governments finance their expen-
most other advanced countries, our economy is also ex- ditures by taxes, which account for about 28 percent of
ceptionally “privatized” and closed. GDP. This percentage is one of the lowest in the indus-
trialized world.
2. The U.S. economy has grown dramatically over the
years. But this growth has been interrupted by periodic 6. In addition to raising taxes and making expenditures,
recessions, during which unemployment rises. the government in a market economy serves as referee
and enforcer of the rules, regulates business in a variety
3. The United States has a big, diverse workforce whose
of ways, and redistributes income through taxes and
composition by age and sex has been changing substan-
transfer payments. For all these reasons, we say that we
tially. Relatively few workers these days work in facto-
have a mixed economy, which blends private and pub-
ries or on farms; most work in service industries.
lic elements.
4. Employees take home most of the nation™s income. Most
of the rest goes, in the forms of interest and profits, to
those who provide the capital.

Factors of production, or Inputs 22 Open economy 24 Transfer payments 35
Outputs 22 Closed economy 24 Progressive tax 35
Gross domestic product (GDP) 23 Recession 24 Mixed economy 36

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Chapter 2 37
The Economy: Myth and Reality

1. Which are the two biggest national economies on earth? 4. Roughly speaking, what fraction of U.S. labor works in
Why are they so much bigger than the others? factories? In service businesses? In government?
2. What is meant by a “factor of production?” Have you 5. Most American businesses are small, but most of the
ever sold any on a market? output is produced by large businesses. That sounds
paradoxical. How can it be true?
3. Why do you think per-capita income in Connecticut is
nearly double that in West Virginia? 6. What is the role of government in a mixed economy?

Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
The Fundamental Economic Problem:
Scarcity and Choice
Our necessities are few but our wants are endless.

U nderstanding what the market system does well and what it does badly is this
book™s central task. But to address this complex issue, we must first answer a sim-
pler one: What do economists expect the market to accomplish?
The most common answer is that the market resolves what is often called the fun-
damental economic problem: how best to manage the resources of society, doing as
well as possible with them, despite their scarcity. All decisions are constrained by the
scarcity of available resources. A dreamer may envision a world free of want, in
which everyone, even in Africa and Central America, drives a BMW and eats caviar,
but the earth lacks the resources needed to make that dream come true. Because
resources are scarce, all economic decisions involve trade-offs. Should you use that $5
bill to buy pizza or a new writing pad for econ class? Should General Motors invest
more money in improving assembly lines or in research? A well-functioning market
system facilitates and guides such decisions, assigning each hour of labor and each
kilowatt-hour of electricity to the task where, it is hoped, the input will best serve
the public.
This chapter shows how economists analyze choices like these. The same basic
principles, founded on the concept of opportunity cost, apply to the decisions made by
business firms, governments, and society as a whole. Many of the most basic ideas of
economics, such as efficiency, division of labor, comparative advantage, exchange, and the role
of markets appear here for the first time.

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Part 1
40 Getting Acquainted with Economics

For roughly 15 years, from the
early 1980s until the late 1990s, the
top economic issue of the day was
how to reduce the federal budget
deficit. Presidents Ronald Reagan,
George H. W. Bush, and Bill
Clinton all battled with Congress over tax
and spending priorities. Which programs
should be cut? What taxes should be raised?
Then, thanks to a combination of strong
economic growth and deficit-reducing poli-
cies, the budget deficit melted away like
springtime snow and actually turned into a

SOURCE: © Photodisc Green/Getty Images
budget surplus for a few fiscal years (1998
through 2001). For a while, the need to make
agonizing choices seemed to disappear”or
so it seemed. But it was an illusion. Even
during that brief era of budget surpluses,
hard choices still had to be made. The U.S.
government could not afford everything.
Then, as the stock market collapsed, the
economy slowed, and President George W.
Bush pushed a series of tax cuts through Congress, the budget surpluses quickly turned


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