Fiscal Policy, the Budget, and the National Debt

1. Fiscal Policy, the Budget, and the National Debt • Fiscal Policy -- the Federal government changing its government position (G - T) in order to stabilize the economy.

2. The Federal Budget • Budget = Tax Revenues - Government Expenditure (over a given period) • Budget = Tax Revenues - (Government purchases of goods and services + Transfer Payments + Interest on the National Debt)

3. Budget Definitions • Budget < 0 -- Budget Deficit • Budget > 0 -- Budget Surplus • Budget = 0 -- Balanced Budget • Realistic Goal -- Balanced Budget when Y = YF.

4. The Federal Budget: 2000 (Billions of Dollars) • Tax Revenues = $2065.7 • Government Expenditure = $1813.9 • Budget = $251.8 • Source: Economic Indicators, May 2001

5. Breakdown of Tax Revenues • Personal Income Taxes = $1017.7 • Corporate Profits Taxes = $244.0 • Indirect Business Taxes = $108.4 • Contributions for Social Insurance = $695.6

6. Breakdown of Government Expenditure • Purchases of Goods and Services = $489.2 • Transfer Payments = $782.4 • Grants-in-aid to State and Local Governments = $108.4 • Net Interest Paid = $259.4 • Net Subsidies of Gov’t Enterprises = $38.4

7. The Budget: In Our Notation Recall variable definitions: -- T = net taxes = tax revenues - (transfer payments + interest on the national debt) -- G = government purchases of goods and services

8. The Budget and The Budget Position • Budget = T - G • Budget Position (or size of deficit) = G - T

9. The National Debt • The National Debt -- The total accumulated stock of debt owed by the government to its lenders. • Expanded by deficits, reduced by surpluses

10. National Debt -- Realistic Goal • Realistic Goal -- consider the Debt-Income Ratio= (National Debt)/(GDP). • Consumers are allowed a Debt-Income Ratio maximum of 2.0. • For the US in 2000 = ($3410.1)/($9963.1) = 0.342 • Conclusion – National Debt in US not a major concern.

11. The Income Tax and Automatic Stabilization • Automatic Stabilization -- due to the income tax system, taxrevenues change in directions that help to stabilize the economy, without any change in the tax structure (I.e. fiscal policy)

12. The Income Tax as an Automatic Stabilizer Y* (maybe > YF)  Tax Revenues helps to cool the economy Y* (maybe < YF)  Tax Revenues helps to stimulate the economy • Note -- all this takes place without any change in the tax structure, as prescribed by fiscal policy.

13. The Income Tax and the Budget Y*  Tax Revenues  T  (T - G) • A strong and growing economy improves the budget. Y*  Tax Revenues  T  (T - G) • A weak economy generates a lower budget.

14. Strategy of Fiscal Policy • Expansionary policies seek to induce more purchasing of goods and services by increasing (G - T) -- i.e. G or T. • Contractionary policies seek to induce less purchasing of goods and services by decreasing (G - T) -- i.e. G or T.

15. Specific Types of Fiscal Policy • Change Government Purchases of Goods and Services (G) -- Expansionary: G -- Contractionary: G • Change Transfer Payments (TP) -- Expansionary: TP -- Contractionary: TP

16. Tax Policy as Fiscal Policy • Change Marginal Tax Rate (t) -- Expansionary: t -- Contractionary: t • Change Autonomous Net Taxes (T0) – taxes that don’t depend upon income (e.g. sales taxes). -- Expansionary: T0 -- Contractionary: T0

17. Fiscal Policy in the AD-AS Model • Expansionary Fiscal Policy shifts the AD curve rightward, increases Y* and P*. • Contractionary Fiscal Policy shifts the AD curve leftward, decreases Y* and P*. • Note -- like monetary policy, fiscal policy is justified only from a short-run perspective.

18. Obstacles to Fiscal Policy Effectiveness • Difficulties in getting the proper policy passed through Congress and the president. • A tax cut that isn’t used for spending. AD curve does not shift rightward, no change in Y*. • Worries about the Federal Budget within a sluggish economy.

19. The Crowding Out Effect -- An Adverse “Side Effect” • The Crowding Out Effect -- Expansionary fiscal policy creates an increased need for more borrowing by the government. This financing increases the demand for financial capital. As a result, long-term interest rates (r*) rise and Investment (I*) decreases.

20. The Crowding Out Effect -- Fiscal Policy Effectiveness • Crowding Out Effect -- makes fiscal policy less effective than would be otherwise. • Decrease in investment to some extent offsets rise in (G - T). • Smaller shift in AD curve than would be without the crowding out effect.

21. Ways to Avoid the Crowding Out Effect • Bottom line -- get the supply of financial capital to shift rightward at the same time as when expansionary fiscal policy occurs. -- expansionary monetary policy -- increased private saving -- increase in foreign capital inflows

22. A Benefit of Government Debt Reduction • Consider the “Crowding Out Effect” in reverse. • Suppose that the government runs a budget surplus and uses it to reduce the national debt. • Demand for financial capital shifts leftward, r* decreases and I* increases, cushions some of the contraction.

23. Distinctive Fiscal Policy Actions in the US • World War II • The Kennedy-Johnson Tax Cut of 1964 • The Nixon Tax Increase of 1969 • The Reagan Economic Recovery and Tax Act of 1981 • Clinton Tax Increases of 1993 • Bush Tax Cut of 2001-02?