Externalities
In a market economy there are important differences between public and private goods. Private goods are considered “rival and excludable” – one person consuming a good means that another cannot, and those who do not pay for the good/service are excluded from consuming them. In contrast, public goods are non-rival and non-excludable; multiple people can enjoy them simultaneously and non-payers are not excluded. This creates what is called the free-rider problem, an externality that means that non-payers cannot be excluded from enjoying the good or service.
Externalities can be positive or negative, and they are often used as an example of where government interference in the economy can do good. In all cases, externalities are positive or negative effects that are not captured by the normal price mechanism of a market economy. Companies that pollute, for instance, do not pay anything extra for the damage they do to the environment. Likewise, those who work in their yard and beautify their neighborhoods may increase property values for others with no direct compensation back to them.
To deal with externalities, governments can use their powers of taxation and subsidy. Taxation can be used to impose costs on negative actions (negative externalities) with an eye towards reducing the occurrence and/or using the proceeds of the tax to remediate the damage done. Likewise, a subsidy can encourage positive externalities to continue and expand. In practice, however, there are considerable inefficiencies to taxation and subsidies and they rarely produce the desired effects in a cost-effective manner.
Externalities are not the only reason that governments impose taxes on their citizens. Taxes fund government operations that range from the provision of collective services (military and police services, courts, roads, etc.) to a variety of transfer payments that are aimed at stabilizing economic activity (unemployment insurance and earned income credits) and reducing poverty. (For more on the government use of taxes and spending, check out What The National Debt Means To You.)
Taxes
When considering taxes, it is important to understand the difference between marginal and average tax rates. Marginal rates refer to the tax rate in effect on the last dollar earned, while the average tax rate is the product of total taxes paid divided by total taxable income.
There are three major types of taxes in the U.S. tax system. Progressive taxes result in higher average rates as income increases; personal income tax is a common example. Regressive taxes result in lower average tax rates as income falls; sales tax is commonly used as an example. Proportional taxes maintain a constant rate irrespective of income. (To learn how taxes started in the US, see The History Of Taxes In The U.S.)
Implications of Taxation and Government Spending
Broadly speaking, fiscal policy is the use of taxation and government spending for the purposes of macroeconomic goals. Fiscal policy can be expansionary, that is aimed at growing the economy and increasing employment, or contractionary (aimed at slowing the growth of the economy). Expansionary fiscal policy features increased government spending and/or decreases in the tax rates, while contractionary policy is the opposite (lower government spending and/or higher tax rates).
Government economic actions are not without consequences, however.
When governments increase their spending, crowding out can occur – government spending reduces available funds and increases the cost of capital, leading many businesses to abandon expansion projects. Likewise, when a government spends in excess of receipts (a deficit) and must borrow funds to finance that deficit, crowding out can occur.
Likewise, taxation causes problems of its own. Taxes shift the equilibrium for goods and services away from its optimal level, therefore reducing consumer and producer surpluses. This reduction is called the deadweight loss and it basically represents the net benefit that is being sacrificed by society because of the presence of the tax. (For more on government spending, read Do Tax Cuts Stimulate The Economy?)
Tariffs are levies charged by a government on imported goods. Tariffs are not as significant to economies now as in years past; prior to the implementation of personal income taxes, tariffs were a major source of U.S. government revenue. There are principally two kinds of tariffs. Revenue tariffs are taxes levied on goods that are not produced domestically, while protective tariffs are levied on goods that are produced domestically.
