Transcript fiscal policy

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O’Sullivan, Sheffrin, Perez
Macroeconomics: Principles, Applications, and Tools
Fiscal Policy
The conventional wisdom
among both politicians and
economic policymakers for
years was that active use by
the government of changes in
spending and taxes could play
only a limited role in fighting
recessions.
PREPARED BY
FERNANDO QUIJANO, YVONN QUIJANO,
AND XIAO XUAN XU
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Fiscal Policy
APPLYING THE CONCEPTS
1
Why are the United States and many other countries
facing dramatically increasing costs for their government
programs?
Increasing Life Expectancy and Aging Populations
Spur Costs of Entitlement Programs
2
How are tax rates and tax revenues related?
The Confucius Curve?
3
Did the 2001 tax cuts stimulate consumer spending?
Were the 2001 Tax Cuts Spent or Saved?
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Fiscal Policy
Fiscal Policy
● fiscal policy
Changes in government taxes and
spending that affect the level of
GDP.
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Fiscal Policy
10.1
THE ROLE OF FISCAL POLICY
Fiscal Policy and Aggregate Demand
 FIGURE 10.1
Fiscal Policy in Action
Panel A shows that an increase in government spending shifts the aggregate demand curve from
AD0 to AD1, restoring the economy to full employment. This is an example of expansionary policy.
Panel B shows that an increase in taxes shifts the aggregate demand curve to the left, from AD0 to
AD1, restoring the economy to full employment. This is an example of contractionary policy.
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10.1
THE ROLE OF FISCAL POLICY
Fiscal Policy and Aggregate Demand
● expansionary policies
Government policy actions that lead
to increases in aggregate demand.
● contractionary policies
Government policy actions that lead
to decreases in aggregate demand.
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10.1
THE ROLE OF FISCAL POLICY
The Fiscal Multiplier
As the government develops policies to stabilize the economy, it needs to take the
multiplier into account. The total shift in aggregate demand will be larger than the
initial shift. As we will see later in this chapter, U.S. policymakers have taken the
multiplier into account as they have developed policies for the economy.
The Limits to Stabilization Policy
● stabilization policies
Policy actions taken to move the
economy closer to full employment
or potential output.
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10.1
THE ROLE OF FISCAL POLICY
The Limits to Stabilization Policy
LAGS
 FIGURE 10.2
Possible Pitfalls in Stabilization
Policy
Panel A shows an example of
successful stabilization policy. The
solid line represents the behavior of
GDP in the absence of policies.
The dashed line shows the behavior
of GDP when policies are in place.
Successfully timed policies help
smooth out economic fluctuations.
Panel B shows the consequences of
ill-timed policies. Again, the solid line
shows GDP in the absence of
policies and the dashed line shows
GDP with policies in place. Notice
how ill-timed policies make economic
fluctuations greater.
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10.1
THE ROLE OF FISCAL POLICY
The Limits to Stabilization Policy
LAGS
● inside lags
The time it takes to formulate
a policy.
● outside lags
The time it takes for the policy
to actually work.
FORECASTING UNCERTAINTIES
What makes the problem of lags even worse is that economists are not very
accurate in forecasting what will happen in the economy.
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10.2
THE FEDERAL BUDGET
Federal Spending
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10.2
THE FEDERAL BUDGET
Federal Spending
● discretionary spending
The spending programs that Congress
authorizes on an annual basis.
● entitlement and mandatory spending
Spending that Congress has authorized
by prior law, primarily providing support
for individuals.
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10.2
THE FEDERAL BUDGET
Federal Spending
● Social Security
A federal government program to
provide retirement support and a host
of other benefits.
● Medicare
A federal government health program
for the elderly.
● Medicaid
A federal and state government health
program for the poor.
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APPLICATION
1
INCREASING LIFE EXPECTANCY AND AGING POPULATIONS
SPUR COSTS OF ENTITLEMENT PROGRAMS
APPLYING THE CONCEPTS #1: Why are the United States
and many other countries facing dramatically increasing
costs for their government programs?
• Today, Social Security, Medicare, and Medicaid constitute approximately 9
percent of GDP.
• Experts estimate that in 2075 spending on these programs will be
approximately 21 percent of GDP.
How will our society cope with increased demands for these services?
Possible solutions:
• Leave the existing programs in place and just raise taxes to pay for them.
• The government should save and invest now to increase GDP in the future to
reduce the burden on future generations.
• Reform the entitlement systems, placing more responsibility on individuals and
families for their retirement and well-being.
• Reform the health-care system to encourage more competition to reduce
health-care expenditures.
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10.2
THE FEDERAL BUDGET
Federal Revenues
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10.2
THE FEDERAL BUDGET
Federal Revenues
SUPPLY-SIDE ECONOMICS AND THE LAFFER CURVE
● supply-side economics
A school of thought that emphasizes
the role that taxes play in the supply of
output in the economy.
● Laffer curve
A relationship between the tax rates and
tax revenues that illustrates that high
tax rates could lead to lower tax
revenues if economic activity is severely
discouraged.
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APPLICATION
2
THE CONFUCIUS CURVE?
APPLYING THE CONCEPTS #2: How are tax rates and tax
revenues related?
While the idea that cutting tax rates might actually
increase tax revenue is often attributed to economist
Arthur Laffer, in fact, it is actually a much older idea
than that.
Yu Juo, one of the twelve wise men who succeeded Confucius in ancient
China, was asked what should be done in the case of a famine if the
government had insufficient funds. He replied that the tax rate should be
cut to 10 percent. Skeptical government bureaucrats did not have enough
funds at a 20 percent rate, so how could they cut it to 10 percent?
Yu Juo replied, “Cutting taxes and limiting your expenses allow people to
raise their standard of living. Afterwards, you will no longer need to worry
about famine and shortage.”
Revenue estimators in Washington, D.C, do not share entirely in Yu Juo’s
wisdom, but they do recognize that cutting tax rates will stimulate economic
activity.
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10.2
THE FEDERAL BUDGET
The Federal Deficit and Fiscal Policy
● budget deficit
The amount by which government
spending exceeds revenues in a given
year.
● budget surplus
The amount by which government
revenues exceed government
expenditures in a given year.
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10.2
THE FEDERAL BUDGET
Automatic Stabilizers
The increased federal budget deficit works through three channels:
1
Increased transfer payments such as unemployment insurance, food stamps,
and other welfare payments increase the income of some households, partly
offsetting the fall in household income.
2
Other households whose incomes are falling pay less in taxes, which partly
offsets the decline in their household income. Because incomes do not fall as
much as they would have in the absence of the deficit, consumption spending
does not decline as much.
3
Because the corporation tax depends on corporate profits and profits fall in a
recession, taxes on businesses also fall. Lower corporate taxes help to prevent
businesses from cutting spending as much as they would otherwise during a
recession.
● automatic stabilizers
Taxes and transfer payments that stabilize GDP
without requiring policymakers to take explicit action.
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10.2
THE FEDERAL BUDGET
Are Deficits Bad?
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10.3
FISCAL POLICY IN U.S. HISTORY
The Depression Era
During the 1930s, politicians did not believe in modern fiscal policy, largely because
they feared the consequences of government budget deficits. According to Brown,
fiscal policy was expansionary only during two years of the Great Depression, 1931
and 1936.
The Kennedy Administration
Although modern fiscal policy was not deliberately used during the 1930s, the growth
in military spending at the onset of World War II in 1941 increased total demand in the
economy and helped pull the economy out of its long decade of poor performance. But
to see fiscal policy in action, we need to turn to the 1960s. It was not until the
presidency of John F. Kennedy during the early 1960s that modern fiscal policy came
to be accepted.
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10.3
FISCAL POLICY IN U.S. HISTORY
The Vietnam War Era
● permanent income
An estimate of a household’s long-run
average level of income.
The Reagan Administration
The tax cuts enacted during 1981 at the beginning of the first term of President Ronald
Reagan were significant. However, they were not proposed to increase aggregate
demand. Instead, the tax cuts were justified on the basis of improving economic
incentives and increasing the supply of output.
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10.3
FISCAL POLICY IN U.S. HISTORY
The Clinton and George W. Bush Administrations
 FIGURE 10.3
Federal Taxes, Spending,
and Deficits, 1996–2006
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APPLICATION
3
WERE THE 2001 TAX CUTS SPENT OR SAVED?
APPLYING THE CONCEPTS #3: Did the 2001 tax cuts
stimulate consumer spending?
In 2001, approximately 90 million U.S. households received tax
rebate checks from the government.
According to conventional economic theory, a permanent cut in
taxes should largely be spent by households because it represents
a new permanent source of income for them.
To discover whether households actually spent the tax cuts, professors Matthew
Shapiro and Joel Slemrod decided to ask some of them.
• Result: Fewer than 25 percent of households were likely to spend the rebate.
Moreover, low-income households were no more likely to spend the rebate than
higher-income households.
These survey results may not reflect the actual behavior of consumers. The
Congressional Budget Office reviewed other studies that directly examined consumer
spending after the rebates.
• Result: Financially strapped households do spend any tax cuts they receive.
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KEY TERMS
automatic stabilizers
Laffer curve
budget deficit
Medicaid
budget surplus
Medicare
contractionary policies
outside lags
discretionary spending
permanent income
entitlement and mandatory spending
Social Security
expansionary policies
stabilization policies
fiscal policy
supply-side economics
inside lags
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