Transcript Choice, Change, Challenge, and Opportunity

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
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
debtt= 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.
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.
Interest rate
Saving Supply
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.