Transcript Fiscal Policy - Farmer School of Business

Ch. 13: 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
• 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.
(Normal) Timeline for Budget Process
February to March
President submits budget request to Congress.
May-August:
House and Senate revise/amend proposals
September
House-Senate conference committees resolve differences and agree on final
versions of spending bills. President signs or vetoes final bills.
October 1
Beginning of fiscal year (10/1/2012 is beginning of 2013 fiscal year).
Congress passes continuing resolutions to maintain funding for any agencies
affected by appropriations bills that have not been passed and signed by the
beginning of the fiscal year.
Fiscal Policy
 The Council of Economic Advisors
• Chaired by Alan Krueger
• keeps the President and public informed about the
current state of the economy
• evaluates economic proposals
• Provides data to inform the budget-making process.
 Congressional Budget Office
• Forecasts effects of legislative changes on budget and
economy
Federal Deficits and Public Debt
 Budgett = revenuet –outlayst
• if Budgett > 0  budget surplus
• if Budgett < 0  budget deficit
• (outlays include interest on debt)
 Debtt = Debtt-1 - budgett-1
• Budget deficits increase debt
• Budget surpluses decrease debt
Revenues
The Federal Budget
Outlays
Baseline budget assume current tax and spending laws remain unchanged.
The National Debt
State and Local Budgets
• The total government sector includes state and local
governments as well as the federal government.
• In 2008, when federal government outlays were about
$3,200 billion, state and local outlays were a further
$2,000 billion.
• Most of state expenditures were on public schools,
colleges, and universities ($550 billion); local police
and fire services; and roads.
• Most states have “balanced budget amendments”.
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
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before-tax real wage rate, after-tax real wage rate.
Tax-wedge (difference between before and after tax wage)
Equilibrium employment
LAS
Effect of an increase in income tax rate
Tax Wedge Comparisons
Federal Income Tax Marginal Rates
2011 Federal Income Tax Marginal Rates
Share of income paid in taxes
Source: http://www.cbo.gov/publications/collections/tax/2010/graphics.cfm
Source: http://www.cbo.gov/publications/collections/tax/2010/graphics.cfm
Source: http://www.cbo.gov/publications/collections/tax/2010/graphics.cfm
Average Federal Tax Rate by Income Quintile, 1979-2007
(note: all federal taxes included)
The Supply-Side: The Laffer Curve.
Tax Revenue
Tax Rates
The Laffer Curve
 As tax rates rise, taxable income may fall because
• People reduce work hours
• Tax avoidance increases
o Legal tax avoidance
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Charities
Tax free bonds
Pension saving
Capital gains versus income
o Illegal tax avoidance
– Under-report income
– Inflate deductions
Laffer Curve and Capital Gains Tax
Laffer curve and corporate income tax rate – tax havens video
Source: http://time-blog.com/curious_capitalist/2008/01/do_capital_gains_tax_cuts_incr.html
According to the Laffer curve, if tax rates rise,
tax revenue
a) Will rise
b) May rise or fall
c) Will fall
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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
 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).
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.
• Size of multiplier is
controversial.
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 needstested 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
 Actual Budget = Cyclical Budget + Structural Budget
• 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 surplus or deficit that occurs purely because real
GDP does not equal potential GDP.
• Cyclical budget < 0 if GDP< potential GDP
Source: http://www.cbo.gov/ftpdocs/120xx/doc12039/01-26_FY2011Outlook.pdf
Effects of economy on budget
Source: http://www.cbo.gov/ftpdocs/120xx/doc12039/01-26_FY2011Outlook.pdf
Effects of economy on budget
Source: http://www.cbo.gov/ftpdocs/120xx/doc12039/01-26_FY2011Outlook.pdf
Cyclical and Structural Budget