Transcript Ch12-- Fiscal Policy - Porterville College

Chapter 12
Fiscal Policy
Expansion and Contraction with
Fiscal Policy

Expansionary Policy (Stimulus)
–
Increase Government Purchases
Increase Transfer Payments
–
Reduce Taxes
–
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Expansion and Contraction with
Fiscal Policy

Contractionary Policy (Resist
inflation)
–
Reduce Government Purchases
Reduce Transfer Payments
–
Increase Taxes
–
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Demand-Side Policy: Increased
Spending Increases Aggregate
Demand: a la Keynes
Price Level
(c) Aggregate Demand and Supply in the
classical range of AS curve. (Prices rise
without significant improvements in output
and employment.)
AD1
AD
Y?
Real GDP
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Spending Multiplier

$1 Increased Spending is multiplied by the
Spending Multiplier

Spending Multiplier:
__1__
Leakages
Note: leakages are:
saving rate + import rate
(all stated in their decimal forms)
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Analysis of a
Tax-and-Spend
Policy
Government
increases
spending, but
finances it with
tax increases.
The increase in
spending shifts
AD to the right,
but the increase
in taxes reduces
the incentive to
work, shift AS to
the left.
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Ricardian Equivalence Thesis


If Government increases spending without
increasing taxes, consumers and firms recognize
that future taxes must rise. Therefore, they save
more now and reduce private spending. The
increased savings cancels out the increased
government purchases in their effect on AD.
Increased Govt. Spending will have no positive
impact on AD.
–
David Ricardo proposed this, and then rejected it in the
1800s. Some (few) economists now assert its relevance
again.
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Crowding Out

The issue of crowding out is usually
raised in the context of increased
government spending (G) financed by the
issue of debt. Essentially, the government
borrows the money it will spend.

The government’s demand for credit
drives up interest rates.
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Crowding Out (cont.)

Higher interest rates result in higher
financing costs for firms, and therefore
lower investment spending, offsetting
(partially or fully) the GDP gains from the
increase in government spending.

That is, private investment is “crowded
out” by debt-financed public (gov’t)
spending.
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Other implications of
Budget Deficits and National Debt



The crowding out of private investment means a
smaller future capital stock. This implies lower
output in the future.
Higher interest rates will also cause the currency
to appreciate, making foreign currencies and
goods cheaper. Imports increase, hence net
exports decrease, reducing GDP. This is
international crowding out.
The higher the national debt (rising because of
budget deficits), the higher the interest payments
(debt service) paid by the government.
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The Making of U.S. Fiscal Policy
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Complications of Fiscal Policy

Lag times
–
–
–
–

Recognition Lag
Policy decision Lag
Implementation Lag
Impact lag
A discretionary fiscal policy (one that is
NOT an automatic stabilizer) has such
long lag times as to be ineffective as a
response to cyclical macroeconomic
conditions.
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Complications of Fiscal Policy

Electoral incentives
–
Expansionary policy is easy
•
•
–
Contractionary policy is difficult
•
•
–
–
Tax cuts
Spending increases
Tax increases
Spending cuts
Bias for inflationary over-stimulation
Tendency to run deficits
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U.S. Government
Revenues and
Expenditures
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U.S. Government Expenditures
as a Percentage of GDP
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Updated National Debt/Deficit Data
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More
Updated
Data on
US Debt
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Fiscal Policy

Demand-side policies: policies designed
to stimulate or slow aggregate demand
(focusing on Consumption & Government
purchases).

Supply-side policies: policies designed to
stimulate or slow aggregate demand
(focusing on Investment).
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Fiscal Policy

Discretionary Fiscal Policy: changes
in government spending and/or
taxation aimed at achieving a policy
goal.

Automatic Stabilizer: an element of
fiscal policy that changes
automatically as income changes.
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Taxes

Two types of taxes:
–
direct taxes: on individuals and firms.
For example, personal income taxes,
business income taxes, SSI, FICA
–
indirect taxes: on goods and services.
For example, sales taxes, and valueadded taxes (VAT).
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Taxes

Three types of tax rate structures:
–
progressive tax: rate increases with higher
income; wealthy pay a higher percentage.
(examples: federal income tax, CA state income tax)
–
regressive tax: rate falls with higher income;
wealthy pay a lower percentage. (examples: SSI,
FICA, sales tax, gasoline tax, VAT)
–
proportional tax: rate is constant; everyone
pays the same percentage. (for example a 10% flat
tax – no real examples in US)
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Automatic Stabilizers

Progressive Taxes
–
As income falls, the tax rate also falls,
helping to maintain buying power,
hence maintaining aggregate demand
•
•
•
Income taxes
Corporate income taxes
Capital gains taxes
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Automatic Stabilizers

Transfer Payments: Insure that
buying power is not reduced at the
same rate as income
–
–
–
Unemployment insurance
Welfare
Subsidies (farm income supports, etc.)
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Demand-Side Policy:
Increased Spending
Increases Aggregate
Demand
Price Level
(c) Aggregate Demand and Supply in the
classical range of AS curve. (Prices rise
without significant improvements in output
and employment.)
AD1
AD
Y?
Real GDP
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Aggregate
Demand and
Supply
Equilibrium
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Central Government Spending by
Functional Category
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Central Government Tax Composition
by Income Group
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Central Government Tax Composition
by Income Group
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Supply-Side
Economics
and the
Laffer Curve
Taxes are a disincentive
to productive activity. As
marginal tax rates rise,
the disincentive effects
also grow, shrinking the
tax base. At marginal tax
rates greater than t, the
tax base shrinks at a
faster rate than the
increases in marginal tax
rate. The net result is
that increases in
marginal tax rates
beyond t result in
reduced tax revenues.
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The Laffer Curve and Public Policy

Reagan Administration argument: Taxes were too
high, reduce taxes and revenue will increase.
–
–
–

Reduced Corporate and higher income taxes
Increased Government spending
Result: Growing GDP, but with rising deficits, rising
debts
G.W. Bush Administration: Same argument, same
result
–
–
–
Reduced corporate and higher income taxes
Increased spending
Result: Growing GDP, but with rising deficits, rising
debts
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US Taxes In Comparison

Marginal Income Tax Rates:

US: 15% - 28%

Japan: 10% - 40%
UK: 10% - 40%
Germany: 23.9%-53%
France: 10.5% - 54%



(top bracket reduced in 2002 from 39.6%)
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