chapter 12 the fiscal policy approach to stabilization

Chapter 12

The Fiscal Policy Approach to Stabilization

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13-2

Introduction

In the early 2000s the Japanese government sought to cut taxes and increase spending. By early 2004 it launched plans for increasing taxes then in 2005 contemplated cutting them again.

In this chapter, you will learn about policy time lags, which contributed to the Japanese government’s on-again, off-again tax policies.


Did You Know That...

• Since the early 2000s, total government spending has increased at a rate of about 8% per year?

• This is the largest annual rate of growth since the 1940s and 1950s?

• There are consequences of higher government spending for equilibrium real GDP and the price level?


Discretionary Fiscal Policy

• Discretionary Fiscal Policy

The discretionary changes in government expenditures and/or taxes in order to achieve certain national economic goals is the realm of fiscal policy.

High employment (low unemployment)

Price stability

Economic growth

Improvement of international payments balance


Discretionary Fiscal Policy (cont'd)

• Fiscal Policy

The discretionary changing of government expenditures or taxes to achieve national economic goals, such as high employment with price stability



• An increase in government spending will stimulate economic activity

• Changes in government spending Military spending Education spending Budgets for government agencies


Figure 13-1 Expansionary and Contractionary Fiscal Policy: Changes in Government Spending, Panel (a)

If there is a recessionary gap in panel (a), fiscal policy can presumably increase aggregate demand


Figure 13-1 Expansionary and Contractionary Fiscal Policy: Changes in Government Spending, Panel (b)

If there is an inflationary gap, fiscal policy can presumably decrease aggregate demand



• Questions

Would the increase in government spending equal the size of the gap?

What impact would expansionary fiscal policy have on the price level?


Figure 13-2 Contractionary and Expansionary Fiscal Policy: Changes in Taxes, Panel (a)

• In panel (a), the economy is initially at E1, where real GDP exceeds long-run equilibrium• Contractionary fiscal policy can

move aggregate demand to AD2 via a tax increase

• A new equilibrium is at E2 at a lower price level• Real GDP is now consistent

with LRAS


Figure 13-2 Contractionary and Expansionary Fiscal Policy: Changes in Taxes, Panel (b)

• In panel (b) with a recessionary gap (in this case $500 billion) taxes are cut

• AD1 moves to AD2

• The economy moves from E1 to E2, and real GDP is now at $12 trillion per year

• We are at the long-run equilibrium level



• Change in taxes

A rise in taxes causes a reduction in aggregate demand because it can reduce consumption spending, investment expenditures, and net exports.



• Question

What would be the long-run impact of a tax cut on real GDP if the economy is at full-employment equilibrium?


Possible Offsets to Fiscal Policy

• Fiscal policy does not operate in a vacuum and important questions must be answered. How are expenditures financed and

by whom?

If taxes are increased what does government do with the taxes?

What will happen if individuals worry about increases in future taxes?


Possible Offsets to Fiscal Policy (cont'd)

• Crowding-Out Effect

The tendency of expansionary fiscal policy to cause a decrease in planned investment or planned consumption in the private sector; this decrease normally results from the rise of interest rates.


Figure 13-3 The Crowding-Out Effect, Step by Step


Figure 13-4 The Crowding-Out Effect

Expansionary policy causing deficit spending initially shifts from AD1 to AD2

Due to crowding out, AD shifts inward to AD3

Equilibrium GDPbelow full-employment GDP—recessionary gap



• Planning for the future: the Ricardian equivalence theorem

Ricardian Equivalence TheoremThe proposition that an increase in the

government budget deficit has no effect on aggregate demand



• Planning for the future: The Ricardian equivalence theorem

The reason for the offsetPeople anticipate that a larger deficit today will

mean higher taxes in the future and adjust their spending accordingly.



• Direct Expenditure Offsets

Actions on the part of the private sector in spending income that offset government fiscal policy actions

Any increase in government spending in an area that competes with the private sector will have some direct expenditure offset.


International Policy Example: Britain Pays Up but Receives Little Economic Payoff

• The United Kingdom makes the third highest net contribution to the EU budget, even though EU expenditures contribute so little to total planned spending in that nation.

• How do taxes that British residents pay to fund their government’s contribution to the EU budget affect aggregate demand in the United Kingdom?



• The supply-side effects of changes in taxes

Expansionary fiscal policy could involve reducing marginal tax rates. Advocates argue this increases productivity

since individuals will work harder and longer, save more, and invest more.

The increased productivity will lead to more economic growth.



• Supply-Side Economics

The suggestion that creating incentives for individuals and firms to increase productivity will cause the aggregate supply curve to shift outward



• Question

Would a tax increase cause you to work more or less?


Figure 13-5 Laffer Curve

Tax rates andtax revenuesrise together

Tax revenues are at a maximum

Tax rates and tax revenues fall together


Policy Example: A Laffer Curve in the Mid-2000s?

• In 2003 Congress reduced the top tax rate on corporate dividends and the tax rate on capital gains along with cutting personal income tax rates slightly.

• Many critics predicted that the federal government’s tax revenues would plummet after these rates were cut.


Policy Example: A Laffer Curve in the Mid-2000s? (cont'd)

• By the middle of 2006, after three years of higher real GDP growth, total federal income tax receipts from corporations and individuals had increased by nearly 40%.

• Why do you suppose it is difficult to determine exactly which factors are most responsible for the increase?


Discretionary Fiscal Policy in Practice: Coping with Time Lags

• Question

Is fiscal policy as precise as it appears?


Discretionary Fiscal Policy in Practice: Coping with Time Lags (cont'd)

• Time lags

Recognition Time LagThe time required to gather information about

the current state of the economy



• Time lags

Action Time Lag

The time required between recognizing an economic problem and putting policy into effect

Particularly long for fiscal policy which requires congressional approval



• Time lags

Effect Time LagThe time it takes for a fiscal policy to affect

the economy



• Fiscal policy time lags are long and a policy designed to correct a recession may not produce results until the economy is experiencing inflation.

• Fiscal policy time lags are variable in length (1–3 years), and the timing of the desired effect cannot be predicted.



• Because fiscal policy time lags tend to be variable, policymakers have a difficult time fine-tuning the economy.


Automatic Stabilizers

• Automatic or Built-In Stabilizers

Changes in government spending and taxation that occur automatically without deliberate action of CongressThe tax system

Unemployment compensation

Welfare spending


Figure 13-6 Automatic Stabilizers

The automatic changes tend to drive the economy back toward its full-employment output level


What Do We Really Know About Fiscal Policy?

• Fiscal policy during normal times

Congress ends up doing too little too late to help in a minor recession.

Fiscal policy that generates repeated tax changes (as has happened) creates uncertainty.


What Do We Really Know About Fiscal Policy? (cont'd)

• Fiscal policy during abnormal times

Fiscal policy can be effective The Great Depression—fiscal policy may be

able to stimulate aggregate demand.

Wartime—during World War II real GDP increased dramatically.


What Do We Really Know About Fiscal Policy? (cont'd)

• The “soothing” effect of Keynesian fiscal policy

Should we encounter a severe downturn, fiscal policy is available.

Knowing this may reassure consumers and investors.

Stable expectations encourage a smoothing of investment spending.


Issues and Applications: The Roller Coaster of Japanese Tax Policy

• Between 2000 and 2002, the average rate of growth in total expenditures on goods and services in Japan was 0%.

• In an effort to boost aggregate demand amid a slumping economy the Japanese government cut taxes to spur growth.

• By the end of 2004 the Japanese government found it was spending nearly twice as much as it was receiving in tax revenues, financing the rest by borrowing.


Figure 13-7 Government Spending and Tax Revenues in Japan


Issues and Applications: The Roller Coaster of Japanese Tax Policy (cont'd)

• Recognition lag The period between 2003 when aggregate

demand began to pick up and 2004 when the government recognized it is called a recognition lag.

• Action lag In 2004 the government began a plan

to phase in tax increases between 2005 and 2007.



• The roller coaster ride continues

In 2005, the Japanese government gradually phased in the first scheduled tax increase.

Spending fell and new information showed total expenditures had increased at a rate of less than 1% in 2005.



• The roller coaster ride continues

Tax increases slated for 2006 and 2007 threatened to reduce aggregate demand even further.

During 2006 the Japanese government began rethinking its policy options once more and the cycle began anew.


Introduction

In adopting the euro, European nations agreed to abide by the Stability and Growth Pact.

The pact called for limitations on government spending over tax collections to be no more than 3% of GDP—yet many European governments have since changed their tune.


Did You Know That...

• Throughout the rest of this decade, the U.S. federal government expects to run annual budget deficits?

• The relationship between budget deficits and macroeconomic performance is somewhat elusive?


Public Deficits and Debts: Flows versus Stocks

• Government Budget Deficit

Exists if the government spends more than it receives in taxes during a given period of time

Is financed by the selling of government securities (bonds)


Public Deficits and Debts: Flows versus Stocks (cont'd)

• The federal deficit is a flow variable, one defined for a specific period of time, usually one year.



• If spending equals receipts, the budget is balanced.

• If receipts exceed spending, the government is running a budget surplus.



• Balanced Budget

A situation in which the government’s spending is exactly equal to the total taxes and revenues it collects during a given period of time



• Government Budget Surplus An excess of government revenues over

government spending during a given period of time



• Public Debt

A stock variable

The total value of all outstanding government securities


Government Finance: Spending More than Tax Collections

• Since 1940, the U.S. federal government has operated with a budget surplus in 13 years.

• In all other years, the shortfall of tax revenues below expenditures has been financed with borrowing.


Figure 14-1 Federal Budget Deficits and Surpluses Since 1940


Figure 14-2 The Federal Budget Deficit Expressed as a Percentage of GDP


Government Finance: Spending More than Tax Collections (cont'd)

• The resurgence of federal government deficits

• Question Why has the government’s budget recently

slipped from a surplus of 2.5% of GDP into a deficit?


Policy Example: Explaining a $109 Billion Deficit Projection Turnaround

• Why was the government’s 2005 deficit projection off by $109 billion?

• Federal tax revenues turned out to be more than 15% higher in 2005.

• Economic growth caused taxable incomes, hence revenues, to be much higher than anticipated.


Evaluating the Rising Public Debt

• Gross Public Debt All federal government debt irrespective of

who owns it

• Net Public Debt Gross public debt minus all government

interagency borrowing


Evaluating the Rising Public Debt (cont'd)

• Some government bonds are held by government agencies.

In this case, the funds are owed from one branch of the federal government to another.

To arrive at the net public debt, we subtract interagency borrowings from the gross public debt.



• Tax revenues tend to be stagnant during times of slow economic growth.

• Tax revenues grow more quickly when overall growth enhances incomes.

• As long as spending exceeds revenues, the budget deficit will persist.


Table 14-1 The Federal Deficit, Our Public Debt, and the Interest We Pay on It


Figure 14-3 Net U.S. Public Debt as a Percentage of GDP


Net U.S. Public Debt as a Percentage of GDP

• During World War II, the net public debt grew dramatically.

• After the war It fell until the 1970s

Started rising in the 1980s

Declined once more in the 1990s

And recently has been increasing again



• The government must pay interest on the public debt outstanding.

• The level of these payments depends on the market interest rate.

• Interest payments as a percentage of GDP are likely to rise in the future.



• As more of the public debt is held by foreigners, the amount of interest to be paid outside the United States increases.

• Foreign residents, businesses and governments hold nearly 50% of the net public debt.

• Thus, we do not owe the debt just to ourselves.



• If the economy is already at full employment, then further provision of government goods will crowd out some private goods.

• Deficit spending may raise interest rates, which in turn will discourage capital formation in the private sector.



• Crowding-out may place a burden on future generations.

Increased present consumption may crowd out investment and reduce the growth of capital goods—which could reduce a future generation’s wealth.

Taxes may have to be increased; imposing higher taxes on future generations in order to retire the debt.



• Paying off the public debt in the future

If the debt becomes larger, each person’s share would increase.

Taxes would be levied, and may not be assessed equally.

A special tax could be levied based on a person’s ability to pay.



• Our debt to foreign residents

We do not owe all the debt to ourselves.

Future U.S. residents will be taxed to repay principal and interest.

Portions of U.S. incomes will be transferred abroad.



• If deficits lead to slower growth rates future generations will be poorer.

• Both present and future generations will be economically better off if… Government expenditures are really investments

The rate of return on such public investments exceeds the interest rate paid on the bonds


International Example: Where Are Most Treasury Securities Held Abroad?

• More than $2 trillion in U.S. Treasury securities of the $5 trillion in net outstanding debt is held outside the United States.

• Japan accounts for more than one-third of all foreign holdings of the U.S. net public debt.


Figure 14-4 The Distribution of Foreign Holdings of U.S. Treasury Securities


International Example: Where Are Most Treasury Securities Held Abroad? (cont'd)

• For critical analysis:

Why might the fact that market interest rates in Japan have hovered very close to 0% during the 2000s help explain relatively large holdings of U.S. Treasury securities by residents of that country?


Federal Budget Deficits in an Open Economy

• Question

Is there a connection between the U.S. trade deficit and the federal government budget deficit?


Federal Budget Deficits in an Open Economy (cont'd)

• We know what a budget deficit is, but a trade deficit exists when the value of imports exceeds the value of exports.

• Some say it appears that there is a relationship between trade and budget deficits; at least there is a statistical correlation between the two.


Figure 14-5 The Related U.S. Deficits



• As the government borrows funds to finance the deficit, and domestic private consumption does not decrease, then some of these funds will be borrowed from foreigners.

• The interest rate paid on bonds will need to be high enough to attract foreign investors.



• If foreigners are using the dollars they hold to buy U.S. government bonds, then they will have fewer dollars to spend on U.S. exports.

• This shows that a U.S. budget deficit can contribute to a trade deficit.


Growing U.S. Government Deficits: Implications for U.S. Economic Performance

• Which government deficit is the true deficit?

The government may report distorted measures of its own budget.Government has not adopted a

business-like approach to tracking its expenditures and receipts.

Official government “measures” yield lowest possible deficits and highest reported surpluses.


Growing U.S. Government Deficits: Implications for U.S. Economic Performance (cont'd)

• An operating budget includes current outlays for on-going expenses, such as salaries and interest payments.

• A capital budget, includes expenditures on investment items, such as machines, buildings, roads, and dams.



• Capital budgeting theory

For years, many economists have recommended Congress create a capital budget and remove investment outlays from the operating budget.

Opponents point out this would allow the government to grow even faster than at present.



• Even without a distinction drawn between the capital and operating budgets, there is a discrepancy about the true government deficit measure.



• Pick a deficit, any deficit: deficit estimates are produced both by The Office of Management and Budget

The Congressional Budget Office

• They have different names “Baseline deficit”

“Policy deficit”

“On-budget deficit”



• There is also some disagreement as to whether the Social Security surplus should be used to reduce current deficit numbers.

• So keep in mind that any one specific deficit measure you hear is based on a definition and a set of assumptions with which others may disagree.



• Question How do higher deficits affect the economy in the

short run?

• Answers If the economy is below full-employment, the

deficit can close the recessionary gap.

If the economy is already at full-employment, the deficit can create an inflationary gap.



• In the long run, higher government budget deficits have no effect on equilibrium real GDP.

• Ultimately, spending in excess of receipts redistributes a larger share of real GDP to government-provided goods and services.



• Thus, if the government operates with higher deficits over an extended period

The ultimate result is a shrinkage in the share of privately produced goods and services

By continually spending more than it collects, the government takes up a larger portion of economic activity.



• How could the government reduce all its red ink?

Increasing taxes for everyone

Taxing only the rich

Reducing expenditures

Whittling away at entitlements


Policy Example: How Rich Taxpayers Avoid Part of a Tax-Rate Increase

• Many have proposed raising taxes on the highest-income earners.

• Just like everyone else high-income individuals respond to incentives.

• The richest tax payers could use deferred compensation plans.

• These individuals would shift income earned in current years to future years.


Policy Example: How Rich Taxpayers Avoid Part of a Tax-Rate Increase (cont'd)

• Government estimates show increasing the top bracket from 35% to 39.6% would reduce total taxable income by at least 4%.

• Projections show the increase would give the highest income taxpayers a greater incentive to incorporate and pay lower corporate-profit tax rates.


Policy Example: How Rich Taxpayers Avoid Part of a Tax-Rate Increase (cont'd)

• Thus, raising the income tax rate by 4.6 percentage points would result in less than a 4.6% increase in government tax collections.



• In considering how expenditures might be reduced, it is important to look at entitlements.

• These are federal government payments that are legislated obligations and cannot be reduced or eliminated.



• Entitlements Guaranteed benefits under a government

program such as Social Security, Medicare, or Medicaid

• Noncontrollable Expenditures Government spending that changes

automatically without action by Congress


Figure 14-6 Components of Federal Expenditures as Percentages of Total Federal Spending



• Entitlements are the largest component of the U.S. federal budget.

• To make a significant cut in expenditures, entitlement programs would have to be revised.



• Question

What are the political costs of reducing entitlement payments for Social Security, Medicare, and Medicaid?


Issues and Applications: Budget Deficit Rules Made to Be Broken?

• Under the Stability and Growth Pact each EU member nation agreed on net public debt and annual budget deficit percentages.

• Net public debt as a percentage of GDP should be no higher than 60%, with the annual budget deficit no higher than 3% of GDP.


Issues and Applications: Budget Deficit Rules Made to Be Broken? (cont'd)

• All EU nations satisfied the 60% constraint on net public debt as a proportion of GDP.

• Several EU countries failed to satisfy the 3% limitation on the ratio of the budget deficit to GDP.


Issues and Applications: Budget Deficit Rules Made to Be Broken? (cont'd)

• During the 2000s, many nations were experiencing deficits in excess of 3% of GDP as economies slowed, entitlements grew, and tax revenues were stagnant.

• Several governments that violated the 3% limit did so hoping expansionary fiscal policies would boost aggregate demand and prevent recessions.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 12-99

Key Terms and Concepts

• automatic stabilizers

• budget surpluses

• consumption

• crowding out effect

• disposable income

• fiscal policy

• Investment

• Keynesian economics

• marginal propensity to consume (MPC)

• marginal propensity to save (MPS)

• multiplier effect

• saving

chapter 12 the fiscal policy approach to stabilization

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