Transcript O`Sullivan, Sheffrin, Perez: Economics: Principles, Applications, and

Fiscal Policy
PREPARED BY:
FERNANDO QUIJANO, YVONN QUIJANO,
KYLE THIEL & APARNA SUBRAMANIAN
© 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan • Sheffrin • Perez
chapter
15.1
THE ROLE OF FISCAL POLICY
• fiscal policy
Changes in government taxes and
spending that affect the level of GDP.
© 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan • Sheffrin • Perez
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chapter
15.1
THE ROLE OF FISCAL POLICY
Fiscal Policy and Aggregate Demand
▼ FIGURE 15.1
Fiscal Policy in Action
© 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan • Sheffrin • Perez
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chapter
15.1
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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chapter
15.1
THE ROLE OF FISCAL POLICY
The Fiscal Multiplier
The Limits to Stabilization Policy
• stabilization policies
Policy actions taken to move the economy
closer to full employment or potential output.
LAGS
 FIGURE 15.2
Possible Pitfalls in Stabilization Policy
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chapter
15.1
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
© 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan • Sheffrin • Perez
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chapter
15.2
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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chapter
15.2
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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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 healthcare expenditures.
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chapter
15.2
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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Extra Application 4
MOST AMERICANS FIND TAX SYSTEM UNFAIR
Fifty-eight percent of the American public believes the current U.S. income tax system is
unfair. The general consensus is that middle class individuals and small businesses pay
too much in taxes and that the wealthy and big businesses pay too little in taxes. The
overall opinion remains largely the same as it was two decades ago in spite of numerous
changes to the tax code.
• The poll results show that most people also believe the poor bear a larger tax burden
than they should.
• All of this information comes at a time when the current Bush administration is
attempting to make tax cuts for wealthier individuals, and also businesses,
permanent.
The Laffer curve shows the proposed relationship between
the tax rate expressed as a percentage and the total tax
revenues such percentages should generate. Tax revenues
are maximized at some rate T and begin to fall at higher tax
rates. If the Laffer curve is correct, total tax revenues may
fall if the tax rate gets too high because high tax rates
create disincentive to earn more money. Why work if the
government gets all your income in taxes?
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chapter
15.2
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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HOW GOVERNMENTS USE BUDGET BASELINES TO FORECAST DEFICITS
APPLYING THE CONCEPTS #2: How does the U.S. government make short- and long-term
budget projections?
When Congress and the president consider the proper course of fiscal policy, they want
to consider the future state of the budget.
• Will there be a deficit or surplus and how big will the deficit or surplus be?
To make these forecasts, it is necessary to make budget baselines-explicit assumptions
about what spending and tax policies will be in place.
For long-term forecasts the Congressional Budget Office (CBO) assumes:
• Mandatory spending will continue as required by law.
• Discretionary spending will remain constant in real terms.
For taxes, the CBO also makes its estimates based on current law:
• Even if most political observers believe that Congress will not let important tax
provisions expire, CBO is required to assume so in its budget baseline.
• CBO might project a balanced budget, but in reality Congress might reestablish the
tax cut, with a resulting budget deficit.
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chapter
15.2
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 also fall on businesses. 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
policy makers to take explicit action.
© 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan • Sheffrin • Perez
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15.2
THE FEDERAL BUDGET
Are Deficits Bad?
 Deficits financed by borrowing create debt that competes with corporate
debt and borrowing. This results in higher interest rates, crowding out
private investment demand. (G rises, but I falls.)
 Government borrowing requires the government to make interest
payments, which become part of future budgets, contributing to future
deficits.
 Deficits financed by money creation (by the Fed) ultimately results in
inflation. Eventually, the Fed will have to combat this inflation by reducing
the money supply growth, slowing the economy.
 Government borrowing and money creation both have an impact on
exchange rates, affecting the trade balance (NX, net exports).
© 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan • Sheffrin • Perez
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chapter
15.3
FISCAL POLICY IN U.S. HISTORY
The Depression Era
The Kennedy Administration
The Vietnam War Era
• permanent income
An estimate of a household’s long-run
average level of income.
The Reagan Administration
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SURVEYS SHOW MUCH OF THE 2001 TAX CUTS WERE SAVED
APPLYING THE CONCEPTS #3: How much did the 2001 tax cuts stimulate consumer spending?
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.
In 2001, approximately 90 million U.S. households received tax rebate checks from the
government.
To discover whether in practice households actually spent the tax cuts, a nationally
representative set of households were asked whether they were more likely to spend the
rebate or save it.
• Result: Less than 25 percent of households were likely to spend the rebate.
Reasons:
• Many households did not believe that they would receive future rebates of a similar
size.
• The large fall in the stock market in the two previous years may have made
households more financially tentative and inclined to save.
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chapter
15.3
FISCAL POLICY IN U.S. HISTORY
The Clinton and George W. Bush Administrations
 FIGURE 15.3
Federal Taxes, Spending,
and Deficits, 1996–2005
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