fiscal policy, the budget, and the national debt zfiscal policy -- the federal government changing...

Fiscal Policy, the Budget, and the National Debt

Fiscal Policy -- the Federal government changing its government position (G - T) in order to stabilize the economy.

The Federal Budget

Budget = Tax Revenues - Government Expenditure (over a given period)

Budget = Tax Revenues - (Government purchases of goods and services + Transfer Payments + Interest on the National Debt)

Budget Definitions

Budget < 0 -- Budget DeficitBudget > 0 -- Budget SurplusBudget = 0 -- Balanced Budget

Realistic Goal -- Balanced Budget when Y = YF.

The Federal Budget: 2000 (Billions of Dollars)

Tax Revenues = $2065.7Government Expenditure = $1813.9Budget = $251.8

Source: Economic Indicators, May 2001

Breakdown of Tax Revenues

Personal Income Taxes = $1017.7Corporate Profits Taxes = $244.0Indirect Business Taxes = $108.4Contributions for

Social Insurance = $695.6

Breakdown of Government ExpenditurePurchases of Goods and Services

= $489.2Transfer Payments = $782.4Grants-in-aid to State

and Local Governments = $108.4Net Interest Paid = $259.4Net Subsidies of

Gov’t Enterprises = $38.4

The Budget: In Our Notation

Recall variable definitions:

-- T = net taxes

= tax revenues

- (transfer payments

+ interest on the

national debt)

-- G = government purchases of

goods and services

The Budget and The Budget Position

Budget = T - GBudget Position (or size of deficit)

= G - T

The National Debt

The National Debt -- The total accumulated stock of debt owed by the government to its lenders.

Expanded by deficits, reduced by surpluses

National Debt -- Realistic Goal

Realistic Goal -- consider the Debt-Income Ratio =

(National Debt)/(GDP).Consumers are allowed a Debt-Income

Ratio maximum of 2.0.For the US in 2000 = ($3410.1)/($9963.1) = 0.342 Conclusion – National Debt in US not a

major concern.

The Income Tax and Automatic Stabilization

Automatic Stabilization -- due to the income tax system, tax revenues change in directions that help to stabilize the economy, without any change in the tax structure (I.e. fiscal policy)

The Income Tax as an Automatic Stabilizer

Y* (maybe > YF) Tax Revenues

helps to cool the economy

Y* (maybe < YF) Tax Revenues

helps to stimulate the economy

Note -- all this takes place without any change in the tax structure, as prescribed by fiscal policy.

The Income Tax and the Budget

Y* Tax Revenues T (T - G)A strong and growing economy

improves the budget.

Y* Tax Revenues T (T - G) A weak economy generates a lower

budget.

Strategy of Fiscal Policy

Expansionary policies seek to induce more purchasing of goods and services by increasing (G - T) -- i.e. G or T.

Contractionary policies seek to induce less purchasing of goods and services by decreasing (G - T) -- i.e. G or T.

Specific Types of Fiscal Policy

Change Government Purchases of Goods and Services (G)

-- Expansionary: G -- Contractionary: GChange Transfer Payments (TP)

-- Expansionary: TP -- Contractionary: TP

Tax Policy as Fiscal Policy

Change Marginal Tax Rate (t) -- Expansionary: t -- Contractionary: t

Change Autonomous Net Taxes (T0) – taxes that don’t depend upon income (e.g. sales taxes). -- Expansionary: T0

-- Contractionary: T0

Fiscal Policy in the AD-AS ModelExpansionary Fiscal Policy shifts the

AD curve rightward, increases Y* and P*.

Contractionary Fiscal Policy shifts the AD curve leftward, decreases Y* and P*.

Note -- like monetary policy, fiscal policy is justified only from a short-run perspective.

Obstacles to Fiscal Policy EffectivenessDifficulties in getting the proper

policy passed through Congress and the president.

A tax cut that isn’t used for spending. AD curve does not shift rightward, no change in Y*.

Worries about the Federal Budget within a sluggish economy.

The Crowding Out Effect -- An Adverse “Side Effect”

The Crowding Out Effect -- Expansionary fiscal policy creates an increased need for more borrowing by the government. This financing increases the demand for financial capital. As a result, long-term interest rates (r*) rise and Investment (I*) decreases.

The Crowding Out Effect -- Fiscal Policy Effectiveness

Crowding Out Effect -- makes fiscal policy less effective than would be otherwise.

Decrease in investment to some extent offsets rise in (G - T).

Smaller shift in AD curve than would be without the crowding out effect.

Ways to Avoid the Crowding Out Effect

Bottom line -- get the supply of financial capital to shift rightward at the same time as when expansionary fiscal policy occurs.

-- expansionary monetary policy

-- increased private saving

-- increase in foreign capital

inflows

A Benefit of Government Debt ReductionConsider the “Crowding Out Effect” in

reverse.Suppose that the government runs a

budget surplus and uses it to reduce the national debt.

Demand for financial capital shifts leftward, r* decreases and I* increases, cushions some of the contraction.

Distinctive Fiscal Policy Actions in the US

World War IIThe Kennedy-Johnson Tax Cut of

1964The Nixon Tax Increase of 1969The Reagan Economic Recovery and

Tax Act of 1981Clinton Tax Increases of 1993Bush Tax Cut of 2001-02?