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 debt debt t = debt t-1 + deficit t-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.

Supply Side Effects of Fiscal Policy • 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.

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.

Interest rate Saving Supply Investment Demand

The Supply Side: Inv & Saving – Increased taxes on business profits reduce investment demand.

Saving Supply Interest rate Investment Demand

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.