Transcript Choice, Change, Challenge, and Opportunity

FISCAL POLICY
31
CHAPTER
Objectives
After studying this chapter, you will able to
 Describe the federal budget process and the recent
history of expenditures, taxes, deficits, and debt
 Examine the supply-side effects of fiscal policy on
employment and potential GDP
 Explain the effects of deficits on saving, investment, and
economic growth
 Explain how fiscal policy choices redistribute benefits and
costs across generations
 Explain how fiscal policy can be used to stabilize the
business cycle
Balancing Acts on Capitol Hill
In 2004, the federal government planned collect in taxes
17.3 cents of every dollar earned.
The federal government planned to spend 20 cents out of
each dollar earned.
So the government planned a deficit of almost 3 cents per
dollar earned.
For most of the 1980s and 1990s, the government ran
deficits, to the extent that the national debt is now about
$13,000 per person.
What are the effects of government deficits and debt?
The Federal Budget
The federal budget is the annual statement of the federal
government’s expenditures and tax revenues.
Fiscal policy is the use of the federal budget to achieve
macroeconomic objectives, such as full employment,
sustained long-term economic growth, and price level
stability.
The Federal Budget
The Institutions and Laws
Fiscal policy is made by
the president and
Congress.
Figure 31.1 illustrates the
timeline.
The Federal Budget
Fiscal policy operates within the framework of the
Employment Act of 1946, which committed the
government to work toward “maximum employment,
production, and purchasing power.”
The President’s Council of Economic Advisers monitors
the economy and advises the President on economic
policy.
The Federal Budget
Highlights of the 2004 Budget
The projected fiscal 2004 Federal Budget has tax
revenues of $1,955 billion, expenditures of $2,256 billion,
and a projected deficit of $301 billion.
Tax revenues come from personal income taxes, social
insurance taxes, corporate income taxes, and indirect
taxes.
Personal income taxes followed by social insurance taxes
are the two largest revenue sources.
The Federal Budget
Expenditures are classified as transfer payments,
purchases of goods and services, and debt interest.
Transfer payments are by far the largest expenditure, and
are sources of persistent growth in expenditures.
The Federal Budget
The federal government’s budget balance equals tax
revenue minus expenditure.
If tax revenues exceed expenditures, the government has
a budget surplus.
If expenditures exceed tax revenues, the government has
a budget deficit.
If tax revenues equal expenditures, the government has a
balanced budget.
The Federal Budget
The Budget in Historical Perspective
Figure 31.2 on the next slide shows the government’s tax
revenues, expenditures, and budget surplus or deficit as a
percentage of GDP for the period 1980–2004.
The government had a deficit of 5.2 percent in 1983.
The deficit declined and in 1998 to 2001, the government
had a surplus.
A deficit arose again in 2002 and 2003.
The Federal Budget
The Federal Budget
Figure 31.3 on the next slide shows the evolution of the
components of tax revenues and expenditures as a
percentage of GDP over the period 1983–2003.
Tax revenues increased and expenditures decreased.
The Federal Budget
The Federal Budget
Government debt is the total amount that the government
has borrowed—that the government owes. It is the
accumulation of all past deficits.
The Federal Budget
Figure 31.4 shows the
evolution of the debt as a
percentage of GDP since
1942.
The Federal Budget
The U.S. Government
Budget in Global
Perspective
Figure 31.5 compares
government budget deficits
around the world in 2003.
The world as a whole that
year had a government
budget deficit of about 3.1
percent of world GDP.
The Federal Budget
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.
The Supply Side:
Employment and Potential GDP
Fiscal policy has important effects on employment and
potential GDP called supply-side effects.
The Supply Side:
Employment and Potential GDP
Full Employment and
Potential GDP
Demand and supply in the
labor market determine
the full employment real
wage rate and
employment level.
Figure 31.6(a) shows full
employment in the labor
market.
The Supply Side:
Employment and Potential GDP
The production function
along with the level of
employment at full
employment determine
potential GDP.
Figure 31.6(b) shows
potential GDP when full
employment is 250 billion
labor hours a year.
The Supply Side:
Employment and Potential GDP
The Effects of the
Income Tax
A tax on labor income
influences potential GDP
by changing the supply of
labor and changing full
employment equilibrium
Figure 31.6(a) shows the
effect of the income tax on
the labor market.
The Supply Side:
Employment and Potential GDP
Figure 31.6(b) shows the
effects of the income tax
on potential GDP.
Full employment
decreases to 200 billion
labor hours a year.
At this level of
employment, potential
GDP decreases to $10
trillion.
The Supply Side:
Employment and Potential GDP
The gap between the before-tax wage rate and the aftertax wage rate is like a wedge and is called the tax wedge.
Taxes on Expenditure and the Tax Wedge
Taxes on consumption such as sales taxes add to the tax
wedge.
The reason is that a tax on consumption expenditure
decreases the quantity of goods that an hour of labor can
buy and is equivalent to an income tax.
The Supply Side:
Employment and Potential GDP
Some Real World Tax
Wedges
Figure 31.7 shows the tax
wedges in the United
States, the United
Kingdom, and France.
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.
The Supply Side:
Employment and Potential GDP
Tax Revenues and the
Laffer Curve
An increase in the tax rate
decreases employment.
If the decrease in
employment is large, the
total amount collected in
taxes might decrease
when the tax rate
increases.
The Supply Side:
Employment and Potential GDP
Figure 31.8 shows the
relationship between the
tax rate and tax
revenues—called the
Laffer curve.
In the United States, an
increase in the tax rate
would bring an increase in
tax revenue.
But perhaps not so in
France.
The Supply Side:
Employment and Potential GDP
The Supply-Side Debate
“Supply-siders,” economist who believe the supply-side
effects to be large, first came to prominence during the
early 1980s and were associated with the Reagan
administration.
At that time, they were regarded as extreme and branded
“voodoo economists” by the first President Bush.
Today, the supply side is the mainstream.
The Supply Side: Investment, Saving,
and Economic Growth
The Sources of Investment Finance
A quick refresher of the national income accounting
equations is needed.
GDP = C + I + G + X – M.
And
GDP = C + S + T.
From these two equations, you can see that
I = S + T – G + M – X.
The Supply Side: Investment, Saving,
and Economic Growth
The equation
I=S+T–G+M–X
says that investment, I, is financed by:
Private domestic saving, S,
Foreign saving, M – X,
Government saving, T – G
The Supply Side: Investment, Saving,
and Economic Growth
Call saving S plus foreign saving M – X private saving, PS.
Then investment is financed by the sum of private saving
and government saving.
That is
I = PS + T – G
The Supply Side: Investment, Saving,
and Economic Growth
If taxes exceed government purchases, T > G, the
government has a budget surplus and government saving
is positive.
If taxes are less than government purchases, T < G, the
government budget is in deficit and government saving is
negative.
The Supply Side: Investment, Saving,
and Economic Growth
Figure 31.9 shows the
contributions of the
sources of investment
finance from 1973 through
2003.
Foreign sources have
become larger.
The government had a
large deficit in 2003.
The Supply Side: Investment, Saving,
and Economic Growth
Fiscal policy can
influence investment in
two ways:
 Taxes affect the
incentive to save
 Government saving—
the budget surplus or
deficit—is part of total
saving
The Supply Side: Investment, Saving,
and Economic Growth
Taxes and the Incentive to Save
A tax on interest income drives a wedge between the
after-tax interest rate earned by savers and the before-tax
interest rate paid by firms to finance investment.
The effects of a tax on interest income are more serious
than those on labor income because:
 Lower investment slows the growth rate and has a
cumulative effect on potential GDP
 Inflation makes the effective tax rate on interest income
high
The Supply Side: Investment, Saving,
and Economic Growth
Figure 31.10 shows the
effects of taxes on the
incentive to save
With no taxes, investment
is $2 trillion and the
interest rate is 3 percent a
year.
The Supply Side: Investment, Saving,
and Economic Growth
An income tax drives a
wedge between the
before-tax and after-tax
interest rate and
decreases saving supply.
Investment decreases to
$1.8 trillion and the
interest rate rises to 4
percent a year.
The Supply Side: Investment, Saving,
and Economic Growth
Government Saving
Because government saving is part of total saving, the
direct effect of a government budget deficit is a decrease
in total saving.
When total saving decreases, the real interest rate rises
and the equilibrium quantity of investment decreases.
The tendency fo a government budget deficit to decrease
investment is called a crowding-out effect.
The Supply Side: Investment, Saving,
and Economic Growth
Figure 31.11 illustrates
the crowding out effect
of an increase in the
government budget
deficit.
The Supply Side: Investment, Saving,
and Economic Growth
A government budget deficit also has an indirect effect that
offsets the direct effect.
The Ricardo-Barro effect is an increase in private saving
by an amount equal to the government budget deficit.
This effect occurs if households recognize that a
government budget deficit must be paid for by higher
taxes in the future.
Generational Effects of Fiscal Policy
Is a budget deficit a burden on future generations?
What is the full burden of existing government programs
such as Social Security?
To answer questions like these, we use a tool called
generational accounting.
This accounting system was developed by Alan Auerbach
and Laurence Kotlikoff.
Recent generational accounts have been constructed by
Jagadeesh Gokhale and Kent Smetters.
Generational Effects of Fiscal Policy
Generational Accounting and Present Value
Generational accounting calculates the present value of
taxes and benefits and allocates those present values to
different generations.
The Social Security Time Bomb
As the baby boom generation retires and begins to collect
is Social Security and Medicare benefits, the payout by the
federal government on these items will be much larger
than it is today.
At the same time, the taxes paid by the baby boomers will
be lower than they are today.
Generational Effects of Fiscal Policy
To assess the federal government’s obligations, we use
the concept of fiscal imbalance, which is the present
value of the government’s commitments to pay benefits
minus the present value of its tax revenues.
In 2003, fiscal imbalance in the United States is estimated
to be $45 trillion.
Generational Effects of Fiscal Policy
Generational Imbalance
Generational imbalance is the division of fiscal
imbalance between the current and future generations.
It is estimated that under existing laws, the current
generation will pay 43 percent of its own benefits.
Future generations will pick up 57 percent of the tab!
Generational Effects of Fiscal Policy
Figure 31.12 shows an
estimate of the sources of
fiscal imbalance and its
division between the
current and future
generations.
Generational Effects of Fiscal Policy
International Debt
Much of the public debt is held not by the public but by
foreigners.
This debt represents a potential drain on Americans.
The scale of this debt in 2003 was about $4 trillion.
Foreigners own more than 50 percent of U.S. government
debt.
Stabilizing the Business Cycle
Fiscal policy action that seek to stabilize the business
cycle work by changing aggregate demand.
These policy actions can be:
 Discretionary
 Automatic
Discretionary fiscal policy is a policy action that is
initiated by an act of Congress.
Automatic fiscal policy is a change in fiscal policy
triggered by the state of the economy.
Stabilizing the Business Cycle
The Government Purchases Multiplier
The government purchases multiplier is the
magnification effect of a change in government purchases
of goods and services on aggregate demand.
A multiplier exists because government purchases are a
component of aggregate expenditure; an increase in
government purchases increases aggregate income,
which induces additional consumption expenditure.
Stabilizing the Business Cycle
The Tax Multiplier
The tax multiplier is the magnification effect a change in
taxes on aggregate demand.
An increase in taxes decreases disposable income, which
decreases consumption expenditure and decreases
aggregate expenditure and real GDP.
Stabilizing the Business Cycle
The Balanced Budget Multiplier
The balanced budget multiplier is the magnification
effect a simultaneous change in government purchases
and taxes on aggregate demand.
A $1 increase in government purchases increases
aggregate demand initially by $1 but a $1 increase in
taxes decreases consumption expenditure by less than $1
initially, so a $1 increase in both purchases and taxes
increases aggregate demand.
Stabilizing the Business Cycle
Discretionary Fiscal
Stabilization
In Figure 31.13, an
increase in government
purchases increases
aggregate demand.
A multiplier effect
increases aggregate
demand further.
Real GDP increases and
the price level rises.
Stabilizing the Business Cycle
Discretionary Fiscal
Stabilization
In Figure 31.14, a
decrease in government
purchases decreases
aggregate demand.
A multiplier effect
decreases aggregate
demand further.
Real GDP decreases and
the price level falls.
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
Automatic stabilizers are mechanisms that stabilize real
GDP without explicit action by the government.
Income taxes and transfer payments are automatic
stabilizers.
Because income taxes and transfer payments change with
the business cycle, the 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.
Stabilizing the Cycle
Figure 31.15 shows the
budget deficit over the
business cycle for 1981–
2001.
Recessions are
highlighted.
Stabilizing the Business Cycle
The structural surplus or deficit is 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 is the actual surplus or
deficit minus the structural surplus or deficit; that is, it is
the surplus or deficit that occurs purely because real GDP
does not equal potential GDP.
Stabilizing the Business Cycle
Figure 31.16 illustrates the
distinction between a
structural and cyclical
surplus and deficit.
In part (a), as real GDP
fluctuates around potential
GDP, a cyclical deficit or
surplus arises.
Stabilizing the Business Cycle
In part (b), as potential
GDP grows, a structural
deficit becomes a
structural surplus.
THE END