Ch. 14: Fiscal Policy

• Federal budget process and recent history of outlays, tax revenues, deficits, and debts • Supply-Side Economics • Controversies on effects of deficits on investment, saving, and economic growth • Redistribution of benefits and costs across generations • Fiscal policy as a stabilization tool

The Federal Budget and Fiscal Policy



Federal budget

• annual statement of the federal government’s outlays and tax revenues.

• Two purposes o finance the activities of the federal government o achieve macroeconomic objectives 

Fiscal policy

• the use of the federal budget to achieve macroeconomic objectives • Employment Act of 1946

it is the continuing policy and responsibility of the Federal Government to use all practicable means . . . to coordinate and utilize all its plans, functions, and resources . . . to promote maximum employment, production, and purchasing power.

Timeline for 2007 Budget

Fiscal Policy

 The Council of Economic Advisers • monitors the economy • keeps the President and the public well informed about the current state of the economy • forecasts of where it is heading.

• source of data that informs the budget-making process.

 Congressional Budget Office • Forecasts effects of legislative changes on budget and economy

Source of Revenues Revenues

Composition of Outlays

Federal Deficits and Public Debt

 Budget t = revenue t • if Budget t > 0  –outlays t budget surplus • if Budget t < 0  budget deficit  Debt t = Debt t-1 - budget t-1 • Budget deficits increase debt • Budget surpluses decrease debt

Revenues and Outlays

The U.S. Government Budget in Global Perspective

State and Local Budgets

 In 2005, when federal government outlays were about $2,500 billion, state and local outlays were almost $1,700 billion.  Most state expenditures were on public schools, colleges, and universities ($550 billion); local police and fire services; and roads.

 Greatest source of state revenue: income & sales taxes  Greatest source of local tax revenue: property & sales taxes  Many states (including Ohio) have a balanced budget amendment.

Supply-Side Economics

 Fiscal policy aimed at increasing LAS • Income taxes affect LAS by affecting labor supply.

• Higher income taxes reduce labor supply & reduce LAS • “Supply-siders” argue for low marginal tax rates.

 Graph the effect of an increase in income tax rate on • before-tax real wage rate, after-tax real wage rate.

• Tax-wedge • Equilibrium employment • LAS

Effect of an increase in income tax rate

Tax Wedge Comparisons

Federal Income Tax Marginal Rates: 2007

Top Marginal Tax Rates

Source: http://www.taxpolicycenter.org/taxfacts/displayafact.cfm?Docid=213

Historical average tax rates in U.S. by Income Quintile: Income Tax Only

Includes individual income tax only

Share of Federal Income Taxes Paid by Quintile

.: Source: http://www.cbo.gov/doc.cfm?index=6133&type=0 Includes individual income tax only

The Supply-Side: The Laffer Curve.

Tax Revenue Tax Rates

Laffer Curve and Capital Gains Tax

Source: http://time-blog.com/curious_capitalist/2008/01/do_capital_gains_tax_cuts_incr.html

The Supply-Side: Investment and Saving

 GDP =

C

+

I

+

G

+ (

X

–

M

)  GDP =

C

+

S + T



I

+

G

+ (

X

–

M

) =

S + T



I = S + (T – G)

+ (

M

–

X

) Private saving

PS

=

S +

(

M

–

X

) Government Saving GS=T-G 

I = PS

+ GS

The Supply-Side: Investment and Saving

The Supply-Side: Investment and Saving

 Fiscal policy influences investment and saving in two ways: • Taxes affect the incentive to save and change the supply of loanable funds.

• Government saving is a component of total saving and the supply of loanable funds.

The Supply-Side: Investment and Saving

 A tax on capital income decreases the supply of loanable funds  a tax wedge is driven between the interest rate and the after-tax interest rate  Investment and saving decrease.

The Supply-Side: Investment and Saving

 Ricardo-Barro Equivalence • In above diagram, it is assumed that government budget does not shift PSLF curve.

• Ricardo-Barro: o Larger deficits cause households to increase savings in order to cover future tax increases.

o Net effect of larger deficit on SLF curve is zero because PSLF curve shifts right.

o No effect on investment or interest rates o All increases in deficits are offset by increased saving (decreased consumption).

Generational Effects of Fiscal Policy

•

Generational accounting

is an accounting system that compares the present value of lifetime tax burden with the benefits of each generation.

• Is the budget deficit a burden on future generations?

• Is the deficit in the Social Security fund a burden?

• Does it matter who owns the bonds that the government sells to finance its deficit?

Generational Effects of Fiscal Policy

 Generational Accounting and Present Value • Taxes are paid by people with jobs. Social security benefits are paid to people after they retire. • To compare the value of an amount of money at one date (working years) with that at a later date (retirement years), we use the concept of present value.

Generational Effects of Fiscal Policy

 The Social Security Time Bomb • Using generational accounting and present values, economists have found that the federal government is facing a Social Security time bomb!

• In 2008, the first of the baby boomers will start collecting Social Security pensions and in 2011, they will become eligible for Medicare benefits. • By 2030, all the baby boomers will have retired and, compared to 2006, the population supported by Social Security will have doubled.

Generational Effects of Fiscal Policy

 Under the existing Social Security laws, the federal government has an obligation to pay pensions and Medicare benefits on an already declared scale.

 Gokhale and Smetters estimated that the fiscal imbalance in Social Security / Medicare was $45 trillion in 2003 —4 times the value of total production in 2003 ($11 trillion).

Generational Effects of Fiscal Policy



Generational imbalance

• division of the fiscal imbalance between the current and future generations, assuming that the current generation will enjoy the existing levels of taxes and benefits.

• The bars show the scale of the fiscal imbalance.

Generational Effects of Fiscal Policy

 International Debt • In June 2006, the United States had a net debt to the rest of the world of $5.2 trillion. • Of that debt, $2.2 trillion was U.S. government debt. • Total U.S. government debt is $4.1 trillion.

• More than half of the outstanding government debt is held by foreigners.

Stabilizing the Business Cycle



Discretionary fiscal policy

• action that is initiated by an act of Congress.



Automatic fiscal policy

(Auto stabilizers) • fiscal policy triggered by the state of the economy.

Stabilizing the Business Cycle

 Discretionary Fiscal Stabilization • An increase in government expenditure or a tax cut increases aggregate demand.

• The “multiplier process” increases aggregate demand further.

Stabilizing the Business Cycle

• A decrease in government expenditure or a tax increase decreases aggregate demand.

• The multiplier process decreases aggregate demand further.

Stabilizing the Business Cycle

 Limitations of Discretionary Fiscal Policy • Recognition lag o time it takes to figure out that fiscal policy action is needed.

o Law-making lag – time it takes Congress to pass the laws needed to change taxes or spending.

o Impact lag – time it takes from passing a tax or spending change to its effect on real GDP being felt.

Stabilizing the Business Cycle

 Automatic Stabilizers • mechanisms that stabilize real GDP without explicit action by the government.

• Taxes that rise and fall with GDP taxes and needs tested spending are automatic stabilizers.

• When real GDP decreases in a recession • wages and profits fall, so taxes fall • Needs-tested spending rises • Budget deficit grows (surplus shrinks)

The Budget and the Business Cycle



Cyclical and Structural Balances

• The

structural surplus or deficit

• the surplus or deficit that would occur if the economy were at full employment and real GDP were equal to potential GDP.

• The

cyclical surplus or deficit

• the actual surplus or deficit minus the structural surplus or deficit; • the surplus or deficit that occurs purely because real GDP does not equal potential GDP.

Stabilizing the Business Cycle