ECONOMICS AND PEOPLE

1. ECONOMICS AND PEOPLE Antony Davies, Ph.D. Duquesne University Part 3 UNIT 8 Click here for instructions.

2. INSTRUCTIONS • Navigation through the course will occur by clicking on the following action buttons located in the lower right corner of each screen: The HOME button will be placed in the center of each slide and will bring you to the Table of Contents for further navigation. The NEXT and BACK buttons will move you through the course content. The EXIT button will be placed at the end of each unit and will exit the unit and return you to the course menu.

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5. PART3:ECONOMICS AND SOCIETYUNIT 8:TAXES, DEFICITS, AND INFLATION

6. UNIT 8: TAXES, DEFICITS, AND INFLATION This unit is divided into several sections. Start with the micro-lecture.Then proceed onto each section. You can click on a link below to navigate to the section where you had recently left off. Micro-Lecture Section 1: Introduction Section 2: Taxation Section 3: Borrowing Section 4: Monetization & Defaults Unit Summary & Assignment

7. MICRO-LECTURE View the Lecture (00:50) Read the Text of the Lecture

8. Section 1 INTRODUCTION

9. TAXES, DEFICITS, AND INFLATION Governments impose taxes as a means of raising money. When, in a given year, a government raises more money in taxes than it spends, we say that the government has earned a budget surplus for that year.When, in a given year, a government spends more money than it raises in taxes, we say that the government has incurred a budget deficit for that year. Each annual surplus or deficit is accumulated to form what is known as the national savings(if the past surpluses are larger than the past deficits) or the national debt (if the past deficits are larger than the past surpluses).

10. TAXES, DEFICITS, AND INFLATION For example, suppose a government has no debt and no savings in 2001. In 2002, the government collects $1.1 billion in tax revenue and spends $1.0 billion. In 2003, the government collects $1.5 billion in tax revenue and spends $1.8 billion. In 2004, the government collects $1.4 billion in tax revenue and spends $1.6 billion. The government’s budget numbers look like this:

11. TAXES, DEFICITS, AND INFLATION Governments spend money on many things including infrastructure (roads, bridges, power grids), the military, and social programs (education, aid for the poor, health care). There are four ways a government can acquire money to pay for its spending: Taxation Borrowing Monetization Default Taxation and borrowing are ways in which the government raises money. Monetization and default are ways in which the government eliminates debt.

12. Section 2 TAXATION

13. Governments typically impose taxes on many things. Taxes on money that people receive are called income taxes. Taxes on labor are called wage taxes. Taxes on products that are sold are called sales taxes orexcise taxes. Taxes on products that are produced are called value added taxesor VAT. Taxes on things that people own are called property taxes. Taxes on imported or exported goods are called tariffs.

14. The progressivityor regressivityof a tax refers to how the tax changes as people’s incomes change. Progressive tax ratesare greater for people with higher incomes. Regressive tax ratesare greater for people with lower incomes. Flat tax rates are the same for all people, regardless of income.

15. Progressive tax ratesare greater for people with higher incomes. Regressive tax ratesare greater for people with lower incomes. Flat tax ratesare the same for all people, regardless of income. For example, if the government taxes poor people 10% of their incomes, but taxes rich people 50% of their incomes, we say that the government’s tax rates are progressive. If the government taxes poor people 10% of their incomes but taxes rich people 5% of their incomes, we say that the government’s tax rates are regressive. If the government taxes all people 10% of their incomes, we say that the government’s tax rate is flat.

16. As you saw in the previous units, governments specify the statutory burdenof taxes, but cannot control who ultimately pays the tax (the economic burden). You also saw that, when it taxes, the government slows economic activity. This suggests that there is an optimal level of taxation. If taxes are too high, the economy cannot grow and so people suffer from an inability to produce and consume. If taxes are too low, the government cannot raise enough money to pay for services it provides and so, again, people suffer. Economist measure the total tax burden imposed by a government as the amount of tax revenue the government collects expressed as a percentage of total economic activity (GDP).

17. Among all countries, Sweden’s government taxes its economy the most and Kuwait’s government taxes its economy the least. The more of the economy the government taxes, the more services the government can provide. But, the more of the economy the government taxes, the less economic activity occurs. Source: 2009 Index of Economic Freedom, Heritage Foundation.

18. Among all countries, Sweden’s government taxes its economy the most and Kuwait’s government taxes its economy the least. The more of the economy the government taxes, the more services the government can provide. But, the more of the economy the government taxes, the less economic activity occurs. This is not to imply that Sweden experiences less economic activity than Kuwait. There are many other factors that influence economic activity in addition to taxation (e.g., workers’ educations and training, availability of resources). What is true is that, whatever a country’s level of economic activity, increasing taxation slows that activity in exchange for an increased ability for the government to provide services.

19. Section 3 BORROWING

20. When a government borrows, it does so by selling government bonds. A bond is a legal contract that states that the government promises to pay a specific sum of money to the person who owns the bond at a specific date in the future. A simple bond is a contract that looks like this: The government of the United States of America promises to pay the bearer of this bond $1,000 on January 1, 2015.

21. The government of the United States of America promises to pay the bearer of this bond $1,000 on January 1, 2015. Notice that there is no interest rate specified on the bond. The government will attempt to sell this bond for as much money as it can get. Suppose the government succeeds in selling the bond for $850. The $850 is called the priceof the bond. The government gets $850 today (suppose today is January 1, 2010) in exchange for paying back $1,000 on January 1, 2015.

22. The government of the United States of America promises to pay the bearer of this bond $1,000 on January 1, 2015. We can calculate the interest rate on the bond as follows:

23. The government of the United States of America promises to pay the bearer of this bond $1,000 on January 1, 2015. In this example, the face value is $1,000, the price is $850, and the life is 5 years, so the interest rate on the bond is:

24. The government of the United States of America promises to pay the bearer of this bond $1,000 on January 1, 2015. A mathematically easier (though less exact) formula for the interest rate is:

25. The government of the United States of America promises to pay the bearer of this bond $1,000 on January 1, 2015. Notice that, the price of the bond and the interest rate move in opposite directions. If the government finds that no one wants to buy the bond at $850, the government will have to ask a lower price. But, the lower price means that the interest rate on the bond has risen. For example, if the government sells the bond for $700 instead of $850, then the interest rate becomes 7.4% instead of 3.3%.

26. The price of the bond and the interest rate move in opposite directions. This result has important implications for government borrowing. The more debt a government incurs, the greater becomes the chance that the government will default on the debt. The greater the chance that the government will default on the debt, the less incentive people will have to purchase government bonds. The less incentive people have to purchase government bonds, the lower will be the price at which the government will be able to sell its bonds. The lower the price at which the government will be able to sell its bonds, the higher the interest rate the government pays on the borrowed money. The higher the interest rate the government pays on the debt, the greater becomes the chance that the government will default on the debt.

27. The price of the bond and the interest rate move in opposite directions. This result also has important implications for private borrowing. Because the amount of loanable money is finite, the more a government borrows, the less money is available for people and companies to borrow. This phenomenon is called crowding out.

28. As with tax revenue, countries’ debts are measured in relation to the sizes of the countries’ economies. Among all countries, Zimbabwe’s national debt is the greatest (at more than three times the size of its economy), and Equatorial Guinea’s is the lowest (at 1% of the size of its economy). Source: CIA World Factbook.

29. As with tax revenue, countries’ debts are measured in relation to the sizes of the countries’ economies. Among all countries, Zimbabwe’s national debt is the greatest (at more than three times the size of its economy), and Equatorial Guinea’s is the lowest (at 1% of the size of its economy). Zimbabwe’s debt is large relative to its GDP, in part, because its GDP is so low. The government’s land reform program has badly damaged the farming sector causing Zimbabwe to go from a country that produced enough food to feed itself plus to export to other countries to a country that must rely on food aid from other governments to feed its people. The land reform program, which eliminated land property rights for many, debt monetization, which created hyperinflation, and price controls, which created chronic shortages of products acted together to reduce Zimbabwe’s economy to $0.3 billion with 95% unemployment. Equatorial Guinea’s economy, at $23 billion, is 70 times the size of Zimbabwe’s economy. The small size of Zimbabwe’s economy contributes to the high debt-to-GDP ratio.

30. Section 4 MONETIZATION & DEFAULT

31. MONETIZATION Monetization is the printing of money to pay government debt. A classic error that people make is to equate money with wealth. Wealth is assets that a person owns. An asset is something that is valuable and, according to accounting rules, money is an asset. In economics, however, money itself is neither an asset nor is it valuable. Money represents the opportunity to obtain assets (or products) and is only as valuable as the assets (or products) it can obtain. *Economists use the term product to refer to something that was produced in the current year, and the term asset to refer to a product that was produced in a previous year.

32. MONETIZATION For example, suppose you are in a city and you have a suitcase filled with $1 million in money. The money has tremendous value to you because you can walk into any store and exchange the money for products – food, clothes, a car, an apartment. Now, suppose you are on a raft in the middle of the ocean. All you have with you is a suitcase filled with $1 million in money. You only have two valuable assets: the raft and the suitcase. The money has no value because, being stranded and alone in the middle of the ocean, there is no opportunity for you to use the money to obtain products. Money, unto itself, is not valuable. Any value it has comes solely from the fact that others will give you assets or products in exchange for the money.

33. This raises the question: Why would people give you assets in exchange for money if money, unto itself, has no value? The answer is: Because those people believe that other people will give them assets or products in exchange for the money. Notice this rather dangerous line of reasoning: Money has value only if people can exchange the money for assets or products. People will exchange assets or products for money only if they believe that the money has value. Given this circular reasoning, you can see that it is extremely important that a country’s people believe that the country’s money has value.

34. The average price of products in a country reflects the ratio of the amount of money in the economy to the amount of products in the economy. For example, suppose that there are a total of $100 billion in money in an economy and that, each year, producers and consumers buy and sell 50 billion items. $100 billion was used to buy 50 billion items, so the average price per item was $100 billion / 50 billion items = $2.00 per item. *The average price level is somewhat more complicated than this, because one must adjust for the number of times each dollar changed hands, but this analogy is adequate for our discussion.

35. $100 billion was used to buy 50 billion items, so the average price per item was $100 billion / 50 billion items = $2.00 per item. If the government prints an additional $20 billion, then there is now $120 billion being used to buy 50 billion items, and so the average price per item rises to $120 billion / 50 billion = $2.40 per item. Printing an additional $20 billion in money caused the average price level to rise by 20% from $2.00 to $2.40. We call this rise in the average price level inflation.

36. Remember that money has value only if people can exchange the money for assets or products. When the average price level rises from $2.00 to $2.40, each dollar buys 20% fewer products than before. Inflation has made the money less valuable.

37. Inflation makes money less valuable. When the government prints money to pay its debts, all money in the economy becomes less valuable. Suppose a person has saved $1,000 and the government prints money thereby creating 20% inflation. The money the person saved will now buy 20% fewer products than before. By printing money, the government has done the same thing as if it had taxed the person 20% of his savings and used that money to pay its debts. Monetizing debt achieves the same result as if the government taxed people who saved money and used the money to pay its debts.

38. Monetizing debt achieves the same result as if the government taxed people who saved money and used the money to pay its debts. If the government monetizes a large amount of debt thereby creating very high inflation, called hyperinflation,there is a danger that people will lose faith in the money. If this happens, people will no longer accept money in exchange for assets and products and so all the country’s money will become valueless. In turn, this will impose tremendous costs on people because people would have to resort to barter – exchanging goods directly for other goods.

39. DEFAULT A government defaults on its debt when it announces that it will not repay debt. Typically, government default on portions of their debt. For example, a government may announce that it will only pay 10 cents for every $1 dollar it owes. Default and monetization are similar. The difference lies in who ends up losing.

40. DEFAULT When the government monetizes debt, everyone who is holding money loses because the money they are holding becomes less valuable. When the government defaults on debt, those who are holding government bonds lose because the bonds become less valuable. Defaulting on debt can create significant economic problems for a country in the future. From time to time, governments naturally need to borrow money. If a government defaults on its debt, it will find it extremely difficult to borrow money in the future.

41. UNIT SUMMARY In this unit, you learned that the government can pay for spending via four mechanisms: taxation, borrowing, monetization, and default. You learned that responsible governments use taxation and borrowing judiciously, that too much taxation or too much borrowing slows the economy, and that monetization and default hurt those who have savings or those who have loaned to the government.

42. ASSIGNMENT,PART 1 Pick a country (preferably your own) to research. Referring to the amount of government spending, the major tax rate(s), deficit, and the national debt, write an 3- to 5--page paper describing the major services the government provides, how much those services costs, and what mechanism the government uses to pay for those services.

43. ASSIGNMENT,PART 2 Explain the way in which the issues you wrote about in your paper impact your ministry. Post this to the JPIC 220 Google Groups discussion page. • HOW TO POST ONTO GOOGLE GROUPS • Click on the Google Groups discussion link above. • Sign in into Google Groups so that you are able to post via the “Sign In” link on the top right of the page. • Click “Reply” to add your response.

44. ASSIGNMENT, PART 3 Keeping in mind what you have learned about the impact of taxes, borrowing, and debt, meet in groups and discuss the pros and cons of your governments’ spending, taxation, and borrowing.