Transcript Chapter 12 - The Citadel

Chapter 12
The Fiscal Policy
Approach to
Stabilization
Introduction
In the early 2000s the Japanese
government sought to cut taxes and
increase spending. By early 2004 it
launched plans for increasing taxes then
in 2005 contemplated cutting them again.
In this chapter, you will learn about
policy time lags, which contributed to the
Japanese government’s on-again, offagain tax policies.
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13-2
Did You Know That...
• Since the early 2000s, total government
spending has increased at a rate of
about 8% per year?
• This is the largest annual rate of growth
since the 1940s and 1950s?
• There are consequences of higher
government spending for equilibrium
real GDP and the price level?
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13-3
Discretionary Fiscal Policy
• Discretionary Fiscal Policy
 The discretionary changes in government
expenditures and/or taxes in order to achieve
certain national economic goals is the realm of
fiscal policy.

High employment (low unemployment)

Price stability

Economic growth

Improvement of international payments balance
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13-4
Discretionary Fiscal Policy (cont'd)
• Fiscal Policy
 The discretionary changing of government
expenditures or taxes to achieve national
economic goals, such as high employment
with price stability
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13-5
Discretionary Fiscal Policy (cont'd)
• An increase in government spending
will stimulate economic activity
• Changes in government spending
 Military spending
 Education spending
 Budgets for government agencies
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13-6
Figure 13-1 Expansionary and
Contractionary Fiscal Policy: Changes in
Government Spending, Panel (a)
If there is a recessionary gap
in panel (a), fiscal policy can
presumably increase
aggregate demand
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13-7
Figure 13-1 Expansionary and
Contractionary Fiscal Policy: Changes in
Government Spending, Panel (b)
If there is an inflationary gap,
fiscal policy can presumably
decrease aggregate demand
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13-8
Discretionary Fiscal Policy (cont'd)
• Questions
 Would the increase in government
spending equal the size of the gap?
 What impact would expansionary fiscal
policy have on the price level?
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13-9
Figure 13-2 Contractionary and
Expansionary Fiscal Policy: Changes
in Taxes, Panel (a)
• In panel (a), the economy is
initially at E1, where real GDP
exceeds long-run equilibrium
• Contractionary fiscal policy can
move aggregate demand to
AD2 via a tax increase
• A new equilibrium is at E2 at a
lower price level
• Real GDP is now consistent
with LRAS
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13-10
Figure 13-2 Contractionary and
Expansionary Fiscal Policy: Changes
in Taxes, Panel (b)
• In panel (b) with a
recessionary gap (in this case
$500 billion) taxes are cut
• AD1 moves to AD2
• The economy moves from E1
to E2, and real GDP is now at
$12 trillion per year
• We are at the long-run
equilibrium level
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13-11
Discretionary Fiscal Policy (cont'd)
• Change in taxes
 A rise in taxes causes a reduction in
aggregate demand because it can reduce
consumption spending, investment
expenditures, and net exports.
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13-12
Discretionary Fiscal Policy (cont'd)
• Question
 What would be the long-run impact of a tax
cut on real GDP if the economy is at fullemployment equilibrium?
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13-13
Possible Offsets to Fiscal Policy
• Fiscal policy does not operate in a
vacuum and important questions must
be answered.
 How are expenditures financed and
by whom?
 If taxes are increased what does
government do with the taxes?
 What will happen if individuals worry about
increases in future taxes?
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13-14
Possible Offsets
to Fiscal Policy (cont'd)
• Crowding-Out Effect
 The tendency of expansionary fiscal policy
to cause a decrease in planned investment
or planned consumption in the private
sector; this decrease normally results from
the rise of interest rates.
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13-15
Figure 13-3 The Crowding-Out
Effect, Step by Step
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13-16
Figure 13-4
The Crowding-Out Effect
Expansionary policy causing
deficit spending initially shifts
from AD1 to AD2
Due to crowding out,
AD shifts inward to AD3
Equilibrium GDP
below full-employment
GDP—recessionary gap
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13-17
Possible Offsets
to Fiscal Policy (cont'd)
• Planning for the future:
the Ricardian equivalence theorem
 Ricardian Equivalence Theorem
 The
proposition that an increase in the
government budget deficit has no effect on
aggregate demand
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13-18
Possible Offsets
to Fiscal Policy (cont'd)
• Planning for the future:
The Ricardian equivalence theorem
 The reason for the offset
 People
anticipate that a larger deficit today will
mean higher taxes in the future and adjust their
spending accordingly.
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13-19
Possible Offsets
to Fiscal Policy (cont'd)
• Direct Expenditure Offsets
 Actions on the part of the private sector in
spending income that offset government
fiscal policy actions
 Any increase in government spending
in an area that competes with the
private sector will have some direct
expenditure offset.
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13-20
International Policy Example: Britain Pays
Up but Receives Little Economic Payoff
• The United Kingdom makes the third highest
net contribution to the EU budget, even
though EU expenditures contribute so little to
total planned spending in that nation.
• How do taxes that British residents pay to
fund their government’s contribution to the
EU budget affect aggregate demand in the
United Kingdom?
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13-21
Possible Offsets
to Fiscal Policy (cont'd)
• The supply-side effects of changes
in taxes
 Expansionary fiscal policy could involve
reducing marginal tax rates.
 Advocates
argue this increases productivity
since individuals will work harder and longer,
save more, and invest more.
 The
increased productivity will lead to more
economic growth.
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13-22
Possible Offsets
to Fiscal Policy (cont'd)
• Supply-Side Economics
 The suggestion that creating incentives for
individuals and firms to increase
productivity will cause the aggregate
supply curve to shift outward
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13-23
Possible Offsets
to Fiscal Policy (cont'd)
• Question
 Would a tax increase cause you to work
more or less?
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13-24
Figure 13-5 Laffer Curve
Tax rates and
tax revenues
rise together
Tax revenues
are at a maximum
Tax rates and tax
revenues fall
together
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13-25
Policy Example: A Laffer Curve in
the Mid-2000s?
• In 2003 Congress reduced the top tax
rate on corporate dividends and the tax
rate on capital gains along with cutting
personal income tax rates slightly.
• Many critics predicted that the federal
government’s tax revenues would
plummet after these rates were cut.
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13-26
Policy Example: A Laffer Curve in
the Mid-2000s? (cont'd)
• By the middle of 2006, after three years
of higher real GDP growth, total federal
income tax receipts from corporations
and individuals had increased by
nearly 40%.
• Why do you suppose it is difficult to
determine exactly which factors are
most responsible for the increase?
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13-27
Discretionary Fiscal Policy in Practice:
Coping with Time Lags
• Question
 Is fiscal policy as precise as it appears?
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13-28
Discretionary Fiscal Policy in Practice:
Coping with Time Lags (cont'd)
• Time lags
 Recognition Time Lag
 The
time required to gather information about
the current state of the economy
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13-29
Discretionary Fiscal Policy in Practice:
Coping with Time Lags (cont'd)
• Time lags
 Action Time Lag
 The
time required between recognizing an
economic problem and putting policy into effect

Particularly long for fiscal policy which requires
congressional approval
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13-30
Discretionary Fiscal Policy in Practice:
Coping with Time Lags (cont'd)
• Time lags
 Effect Time Lag
 The
time it takes for a fiscal policy to affect
the economy
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13-31
Discretionary Fiscal Policy in Practice:
Coping with Time Lags (cont'd)
• Fiscal policy time lags are long and a
policy designed to correct a recession
may not produce results until the
economy is experiencing inflation.
• Fiscal policy time lags are variable in
length (1–3 years), and the timing of the
desired effect cannot be predicted.
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13-32
Discretionary Fiscal Policy in Practice:
Coping with Time Lags (cont'd)
• Because fiscal policy time lags tend to
be variable, policymakers have a
difficult time fine-tuning the economy.
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13-33
Automatic Stabilizers
• Automatic or Built-In Stabilizers
 Changes in government spending and
taxation that occur automatically without
deliberate action of Congress
 The
tax system
 Unemployment
 Welfare
compensation
spending
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13-34
Figure 13-6 Automatic Stabilizers
The automatic changes
tend to drive the economy
back toward its fullemployment output level
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13-35
What Do We Really Know
About Fiscal Policy?
• Fiscal policy during normal times
 Congress ends up doing too little too late
to help in a minor recession.
 Fiscal policy that generates repeated
tax changes (as has happened)
creates uncertainty.
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13-36
What Do We Really Know
About Fiscal Policy? (cont'd)
• Fiscal policy during abnormal times
 Fiscal policy can be effective
 The
Great Depression—fiscal policy may be
able to stimulate aggregate demand.
 Wartime—during
World War II real GDP
increased dramatically.
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13-37
What Do We Really Know
About Fiscal Policy? (cont'd)
• The “soothing” effect of Keynesian
fiscal policy
 Should we encounter a severe downturn,
fiscal policy is available.
 Knowing
this may reassure consumers
and investors.

Stable expectations encourage a smoothing of
investment spending.
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13-38
Issues and Applications: The Roller
Coaster of Japanese Tax Policy
• Between 2000 and 2002, the average rate of growth
in total expenditures on goods and services in Japan
was 0%.
• In an effort to boost aggregate demand amid a
slumping economy the Japanese government cut
taxes to spur growth.
• By the end of 2004 the Japanese government
found it was spending nearly twice as much as
it was receiving in tax revenues, financing the rest
by borrowing.
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13-39
Figure 13-7 Government Spending
and Tax Revenues in Japan
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13-40
Issues and Applications: The Roller
Coaster of Japanese Tax Policy (cont'd)
• Recognition lag
 The period between 2003 when aggregate
demand began to pick up and 2004 when
the government recognized it is called a
recognition lag.
• Action lag
 In 2004 the government began a plan
to phase in tax increases between 2005
and 2007.
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13-41
Issues and Applications: The Roller
Coaster of Japanese Tax Policy (cont'd)
• The roller coaster ride continues
 In 2005, the Japanese government
gradually phased in the first scheduled
tax increase.
 Spending fell and new information showed
total expenditures had increased at a rate
of less than 1% in 2005.
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13-42
Issues and Applications: The Roller
Coaster of Japanese Tax Policy (cont'd)
• The roller coaster ride continues
 Tax increases slated for 2006 and 2007
threatened to reduce aggregate demand
even further.
 During 2006 the Japanese government
began rethinking its policy options once
more and the cycle began anew.
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13-43
Introduction
In adopting the euro, European nations agreed
to abide by the Stability and Growth Pact.
The pact called for limitations on government
spending over tax collections to be no more
than 3% of GDP—yet many European
governments have since changed their tune.
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14-44
Did You Know That...
• Throughout the rest of this decade, the
U.S. federal government expects to run
annual budget deficits?
• The relationship between budget
deficits and macroeconomic
performance is somewhat elusive?
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14-45
Public Deficits and Debts:
Flows versus Stocks
• Government Budget Deficit
 Exists if the government spends more
than it receives in taxes during a given
period of time
 Is financed by the selling of government
securities (bonds)
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14-46
Public Deficits and Debts:
Flows versus Stocks (cont'd)
• The federal deficit is a flow variable,
one defined for a specific period of time,
usually one year.
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14-47
Public Deficits and Debts:
Flows versus Stocks (cont'd)
• If spending equals receipts, the budget
is balanced.
• If receipts exceed spending, the
government is running a budget surplus.
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14-48
Public Deficits and Debts:
Flows versus Stocks (cont'd)
• Balanced Budget
 A situation in which the government’s
spending is exactly equal to the total taxes
and revenues it collects during a given
period of time
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14-49
Public Deficits and Debts:
Flows versus Stocks (cont'd)
• Government Budget Surplus
 An excess of government revenues over
government spending during a given
period of time
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14-50
Public Deficits and Debts:
Flows versus Stocks (cont'd)
• Public Debt
 A stock variable
 The total value of all outstanding
government securities
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14-51
Government Finance: Spending
More than Tax Collections
• Since 1940, the U.S. federal
government has operated with a budget
surplus in 13 years.
• In all other years, the shortfall of tax
revenues below expenditures has been
financed with borrowing.
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14-52
Figure 14-1 Federal Budget Deficits
and Surpluses Since 1940
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14-53
Figure 14-2 The Federal Budget Deficit
Expressed as a Percentage of GDP
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14-54
Government Finance: Spending
More than Tax Collections (cont'd)
• The resurgence of federal
government deficits
• Question
 Why has the government’s budget recently
slipped from a surplus of 2.5% of GDP into
a deficit?
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14-55
Policy Example: Explaining a $109
Billion Deficit Projection Turnaround
• Why was the government’s 2005 deficit
projection off by $109 billion?
• Federal tax revenues turned out to be
more than 15% higher in 2005.
• Economic growth caused taxable
incomes, hence revenues, to be much
higher than anticipated.
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14-56
Evaluating the Rising Public Debt
• Gross Public Debt
 All federal government debt irrespective of
who owns it
• Net Public Debt
 Gross public debt minus all government
interagency borrowing
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14-57
Evaluating the Rising
Public Debt (cont'd)
• Some government bonds are held by
government agencies.
 In this case, the funds are owed from
one branch of the federal government
to another.
 To arrive at the net public debt, we
subtract interagency borrowings from the
gross public debt.
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14-58
Evaluating the Rising
Public Debt (cont'd)
• Tax revenues tend to be stagnant
during times of slow economic growth.
• Tax revenues grow more quickly when
overall growth enhances incomes.
• As long as spending exceeds revenues,
the budget deficit will persist.
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14-59
Table 14-1 The Federal Deficit,
Our Public Debt, and the Interest
We Pay on It
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14-60
Figure 14-3 Net U.S. Public Debt
as a Percentage of GDP
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14-61
Net U.S. Public Debt
as a Percentage of GDP
• During World War II, the net public debt
grew dramatically.
• After the war
 It fell until the 1970s
 Started rising in the 1980s
 Declined once more in the 1990s
 And recently has been increasing again
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14-62
Evaluating the Rising
Public Debt (cont'd)
• The government must pay interest on
the public debt outstanding.
• The level of these payments depends
on the market interest rate.
• Interest payments as a percentage of
GDP are likely to rise in the future.
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14-63
Evaluating the Rising
Public Debt (cont'd)
• As more of the public debt is held by
foreigners, the amount of interest to be paid
outside the United States increases.
• Foreign residents, businesses and
governments hold nearly 50% of the net
public debt.
• Thus, we do not owe the debt just
to ourselves.
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14-64
Evaluating the Rising
Public Debt (cont'd)
• If the economy is already at full
employment, then further provision of
government goods will crowd out some
private goods.
• Deficit spending may raise interest
rates, which in turn will discourage
capital formation in the private sector.
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14-65
Evaluating the Rising
Public Debt (cont'd)
• Crowding-out may place a burden on
future generations.
 Increased present consumption may crowd
out investment and reduce the growth of
capital goods—which could reduce a
future generation’s wealth.
 Taxes may have to be increased; imposing
higher taxes on future generations in order
to retire the debt.
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14-66
Evaluating the Rising
Public Debt (cont'd)
• Paying off the public debt in the future
 If the debt becomes larger, each person’s
share would increase.
 Taxes would be levied, and may not be
assessed equally.
 A special tax could be levied based on a
person’s ability to pay.
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14-67
Evaluating the Rising
Public Debt (cont'd)
• Our debt to foreign residents
 We do not owe all the debt to ourselves.
 Future U.S. residents will be taxed to
repay principal and interest.
 Portions of U.S. incomes will be
transferred abroad.
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14-68
Evaluating the Rising
Public Debt (cont'd)
• If deficits lead to slower growth rates future
generations will be poorer.
• Both present and future generations will be
economically better off if…
 Government expenditures are really investments
 The rate of return on such public investments
exceeds the interest rate paid on the bonds
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14-69
International Example: Where Are Most
Treasury Securities Held Abroad?
• More than $2 trillion in U.S. Treasury
securities of the $5 trillion in net
outstanding debt is held outside the
United States.
• Japan accounts for more than one-third
of all foreign holdings of the U.S. net
public debt.
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14-70
Figure 14-4 The Distribution of Foreign
Holdings of U.S. Treasury Securities
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14-71
International Example: Where Are Most
Treasury Securities Held Abroad? (cont'd)
• For critical analysis:
 Why might the fact that market interest
rates in Japan have hovered very close to
0% during the 2000s help explain relatively
large holdings of U.S. Treasury securities
by residents of that country?
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14-72
Federal Budget Deficits
in an Open Economy
• Question
 Is there a connection between the U.S.
trade deficit and the federal government
budget deficit?
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14-73
Federal Budget Deficits
in an Open Economy (cont'd)
• We know what a budget deficit is, but a
trade deficit exists when the value of
imports exceeds the value of exports.
• Some say it appears that there is a
relationship between trade and budget
deficits; at least there is a statistical
correlation between the two.
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14-74
Figure 14-5
The Related U.S. Deficits
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14-75
Federal Budget Deficits
in an Open Economy (cont'd)
• As the government borrows funds to
finance the deficit, and domestic private
consumption does not decrease, then
some of these funds will be borrowed
from foreigners.
• The interest rate paid on bonds will
need to be high enough to attract
foreign investors.
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14-76
Federal Budget Deficits
in an Open Economy (cont'd)
• If foreigners are using the dollars they
hold to buy U.S. government bonds,
then they will have fewer dollars to
spend on U.S. exports.
• This shows that a U.S. budget deficit
can contribute to a trade deficit.
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14-77
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance
• Which government deficit is the
true deficit?
 The government may report distorted
measures of its own budget.
 Government
has not adopted a
business-like approach to tracking
its expenditures and receipts.
 Official
government “measures” yield
lowest possible deficits and highest
reported surpluses.
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14-78
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
• An operating budget includes current
outlays for on-going expenses, such as
salaries and interest payments.
• A capital budget, includes expenditures
on investment items, such as machines,
buildings, roads, and dams.
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14-79
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
• Capital budgeting theory
 For years, many economists have
recommended Congress create a capital
budget and remove investment outlays
from the operating budget.
 Opponents point out this would allow
the government to grow even faster than
at present.
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14-80
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
• Even without a distinction drawn
between the capital and operating
budgets, there is a discrepancy about
the true government deficit measure.
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14-81
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
• Pick a deficit, any deficit: deficit estimates are
produced both by
 The Office of Management and Budget
 The Congressional Budget Office
• They have different names
 “Baseline deficit”
 “Policy deficit”
 “On-budget deficit”
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14-82
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
• There is also some disagreement as
to whether the Social Security surplus
should be used to reduce current
deficit numbers.
• So keep in mind that any one specific
deficit measure you hear is based on a
definition and a set of assumptions with
which others may disagree.
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14-83
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
• Question
 How do higher deficits affect the economy in the
short run?
• Answers
 If the economy is below full-employment, the
deficit can close the recessionary gap.
 If the economy is already at full-employment, the
deficit can create an inflationary gap.
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14-84
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
• In the long run, higher government
budget deficits have no effect on
equilibrium real GDP.
• Ultimately, spending in excess of
receipts redistributes a larger share
of real GDP to government-provided
goods and services.
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14-85
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
• Thus, if the government operates with
higher deficits over an extended period
 The ultimate result is a shrinkage in
the share of privately produced goods
and services
 By continually spending more than it
collects, the government takes up a larger
portion of economic activity.
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14-86
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
• How could the government reduce all
its red ink?
 Increasing taxes for everyone
 Taxing only the rich
 Reducing expenditures
 Whittling away at entitlements
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14-87
Policy Example: How Rich Taxpayers
Avoid Part of a Tax-Rate Increase
• Many have proposed raising taxes on
the highest-income earners.
• Just like everyone else high-income
individuals respond to incentives.
• The richest tax payers could use
deferred compensation plans.
• These individuals would shift income
earned in current years to future years.
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14-88
Policy Example:
How Rich Taxpayers Avoid Part
of a Tax-Rate Increase (cont'd)
• Government estimates show increasing
the top bracket from 35% to 39.6%
would reduce total taxable income by
at least 4%.
• Projections show the increase would
give the highest income taxpayers a
greater incentive to incorporate and pay
lower corporate-profit tax rates.
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14-89
Policy Example:
How Rich Taxpayers Avoid Part
of a Tax-Rate Increase (cont'd)
• Thus, raising the income tax rate
by 4.6 percentage points would result
in less than a 4.6% increase in
government tax collections.
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14-90
Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
• In considering how expenditures
might be reduced, it is important to
look at entitlements.
• These are federal government
payments that are legislated obligations
and cannot be reduced or eliminated.
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Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
• Entitlements
 Guaranteed benefits under a government
program such as Social Security,
Medicare, or Medicaid
• Noncontrollable Expenditures
 Government spending that changes
automatically without action by Congress
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Figure 14-6 Components of Federal
Expenditures as Percentages of Total
Federal Spending
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Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
• Entitlements are the largest component
of the U.S. federal budget.
• To make a significant cut in
expenditures, entitlement programs
would have to be revised.
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Growing U.S. Government
Deficits: Implications for U.S.
Economic Performance (cont'd)
• Question
 What are the political costs of reducing
entitlement payments for Social Security,
Medicare, and Medicaid?
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Issues and Applications: Budget Deficit
Rules Made to Be Broken?
• Under the Stability and Growth Pact
each EU member nation agreed on
net public debt and annual budget
deficit percentages.
• Net public debt as a percentage of GDP
should be no higher than 60%, with the
annual budget deficit no higher than 3%
of GDP.
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Issues and Applications: Budget Deficit
Rules Made to Be Broken? (cont'd)
• All EU nations satisfied the 60%
constraint on net public debt as a
proportion of GDP.
• Several EU countries failed to satisfy
the 3% limitation on the ratio of the
budget deficit to GDP.
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Issues and Applications: Budget Deficit
Rules Made to Be Broken? (cont'd)
• During the 2000s, many nations were
experiencing deficits in excess of 3% of GDP
as economies slowed, entitlements grew, and
tax revenues were stagnant.
• Several governments that violated the 3%
limit did so hoping expansionary fiscal
policies would boost aggregate demand
and prevent recessions.
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Key Terms and Concepts
• automatic stabilizers
• budget surpluses
• consumption
• crowding out effect
• disposable income
• fiscal policy
• Investment
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
• Keynesian
economics
• marginal propensity
to consume (MPC)
• marginal propensity
to save (MPS)
• multiplier effect
• saving
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