CH. 15: FISCAL POLICY

• Federal budget process and the recent history of expenditures, taxes, deficits, and debt

• Supply-side effects of fiscal policy on employment and potential GDP

• Effects of deficits on saving, investment, and economic growth

• Fiscal policy’s ability to redistribute benefits and costs across generations

• Fiscal policy and stabilization.

Elements of Fiscal Policy• Federal budget

– annual statement of the federal government’s expenditures and tax revenues.

• Fiscal policy – use of the federal budget to achieve macroeconomic

objectives

• Employment Act of 1946 – committed the government to work toward “maximum

employment, production, and purchasing power.”

• Council of Economic Advisers – monitors the economy and advises the President on

economic policy.

Balancing Acts on Capitol Hill

– In 2004, the federal government planned • taxes of 17.3 cents per dollar earned.• spending of 20 cents per dollar earned.• deficit of almost 3 cents per dollar earned.

– For most of the 1980s and 1990s, the government ran deficits.

– National debt is now about $13,000 per person.

Budget information is from www.publicagenda.org

Federal spending has grown

Spending as a % of GDP has been stable

..new records on $ value of deficits

…not a record as % of GDP

..new records on level of debtdebtt= debtt-1+ deficitt-1

..not a record as % of GDP

More history from textbook

Who holds the debt?

Top tax rate has dropped over time

U.S. is a relatively low tax country

State and Local Budgets

• In 2002, when the federal government spent $2,000 billion, state and local governments spent almost $1,900 billion, mostly on education, protective services, and roads.

• State and local budgets are not used for stabilization purposes, and occasionally are destabilizing in recessions.

• A tax on labor income creates a tax wedge

• Taxes on consumption such as sales or value-added taxes add to the tax wedge indirectly.

Supply Side Effects of Fiscal Policy

The Supply Side:Employment and Potential GDP

• Does the Tax Wedge Matter?– Potential GDP per person in France is 31

percent below that in the United States– According to research by Edward Prescott,

the entire difference is explained by the larger tax wedge in France.

U.S. taxes in international perspective

The Supply Side: The Laffer Curve

• An increase in the tax rate– decreases

employment.– encourages tax

evasion (both legal and illegal)

– could cause tax revenue to rise or fall.

The Supply Side: Investment, Saving, and Economic Growth

• The Sources of Investment Finance

GDP = C + I + G + X – M.

and

GDP = C + S + T.

• From these two equations,

I = S + T – G + M – X.

The Supply Side: Inv & Saving

I = S + M – X + T – G

= PS + GS– PS: private saving

• S: Private domestic saving• (M-X) Foreign saving (i.e. borrowing from foreign

co’s)

– GS: government saving• Taxes-Government Spending-Transfers

The Supply Side: Inv & Saving

• Sources of funds for investment:– Foreign sources

have become larger.

– The government deficit has become a drain on investment.

The Supply Side: Inv & Saving

• Fiscal policy can influence investment in two ways:• Taxes affect the incentive to save or invest• Government saving—the budget surplus or deficit—is part of total saving

The Supply Side: Inv & Saving

–An income tax drives a wedge between the before-tax and after-tax interest rate and decreases saving supply.

Saving Supply

Investment Demand

Interest rate

The Supply Side: Inv & Saving

–Increased taxes on business profits reduce investment demand.

Saving Supply

Investment Demand

Interest rate

Policies to promote Investment

• Encourage savings– Pensions– IRAs– MSAs– Capital gains / dividends tax

• Encourage Investment– Business tax rates– Investment tax credits– Accelerated depreciation

Policies to promote Investment

• Government Saving– A government budget deficit is a decrease in

total saving. – crowding-out occurs if a government budget

deficit decrease investment is called.

Crowding Out

• The Ricardo-Barro effect – an increase in private saving by an amount

equal to the government budget deficit.– occurs if households recognize that a

government budget deficit must be paid for by higher taxes in the future.

– Ricardian Equivalence: Deficit has no effect on interest rates or investment.

Stabilizing the Business Cycle

• Fiscal policy may seek to stabilize the business cycle work by changing aggregate demand.– Discretionary fiscal policy is a policy action

that is initiated by an act of Congress.– Automatic fiscal policy (auto. Stabilizers) is

a change in fiscal policy triggered by the state of the economy.

Stabilizing the Business Cycle

– Multiplier effects– Government spending multiplier

• An increase in government purchases increases aggregate income, which induces additional consumption expenditure.

– The tax multiplier is the magnification effect of a change in taxes on AD.

• An increase in taxes decreases disposable income, which decreases consumption expenditure and decreases AD and real GDP.

Stabilizing the Business Cycle

• Limitations of Discretionary Fiscal Policy– The use of discretionary fiscal policy is

hampered by three time lags:• Recognition lag• Law making lag• Impact lag

Stabilizing the Business Cycle

• Automatic Stabilizers– Mechanisms that stabilize real GDP without

explicit action by the government.– Income taxes and transfer payments – Government’s budget deficit also varies with

this cycle.• In a recession, taxes fall, transfer payments rise,

and the deficit grows• In an expansion, taxes rise, transfers fall, and

deficit shrinks.

The budget and the business cycle

The budget and the business cycle

– Structural surplus or deficit • surplus or deficit that would occur if the economy

were at full employment and real GDP were equal to potential GDP.

– Cyclical surplus or deficit • actual surplus or deficit minus the structural

surplus or deficit; • it is the surplus or deficit that occurs purely

because real GDP does not equal potential GDP.