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Ch. 14: Fiscal Policy

Ch. 14: Fiscal Policy. Federal budget process and recent history of outlays, tax revenues, deficits, and debts Supply-Side Economics Controversies on effects of deficits on investment, saving, and economic growth Redistribution of benefits and costs across generations

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Ch. 14: Fiscal Policy

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  1. Ch. 14: Fiscal Policy • Federal budget process and recent history of outlays, tax revenues, deficits, and debts • Supply-Side Economics • Controversies on effects of deficits on investment, saving, and economic growth • Redistribution of benefits and costs across generations • Fiscal policy as a stabilization tool

  2. The Federal Budget and Fiscal Policy • Federal budget • annual statement of the federal government’s outlays and tax revenues. • Two purposes • finance the activities of the federal government • achieve macroeconomic objectives • Fiscal policy • the use of the federal budget to achieve macroeconomic objectives • Employment Act of 1946 it is the continuing policy and responsibility of the Federal Government to use all practicable means . . . to coordinate and utilize all its plans, functions, and resources . . . to promote maximum employment, production, and purchasing power.

  3. Timeline for 2007 Budget

  4. Fiscal Policy • The Council of Economic Advisers • monitors the economy • keeps the President and the public well informed about the current state of the economy • forecasts of where it is heading. • source of data that informs the budget-making process. • Congressional Budget Office • Forecasts effects of legislative changes on budget and economy

  5. Source of Revenues Revenues

  6. Composition of Outlays

  7. Federal Deficits and Public Debt • Budgett = revenuet –outlayst • if Budgett > 0  budget surplus • if Budgett < 0  budget deficit • Debtt = Debtt-1 - budgett-1 • Budget deficits increase debt • Budget surpluses decrease debt

  8. Revenues and Outlays

  9. The U.S. Government Budget in Global Perspective

  10. State and Local Budgets • In 2005, when federal government outlays were about $2,500 billion, state and local outlays were almost $1,700 billion. • Most state expenditures were on public schools, colleges, and universities ($550 billion); local police and fire services; and roads. • Greatest source of state revenue: income & sales taxes • Greatest source of local tax revenue: property & sales taxes • Many states (including Ohio) have a balanced budget amendment.

  11. Supply-Side Economics • Fiscal policy aimed at increasing LAS • Income taxes affect LAS by affecting labor supply. • Higher income taxes reduce labor supply & reduce LAS • “Supply-siders” argue for low marginal tax rates. • Graph the effect of an increase in income tax rate on • before-tax real wage rate, after-tax real wage rate. • Tax-wedge • Equilibrium employment • LAS

  12. Effect of an increase in income tax rate

  13. Tax Wedge Comparisons

  14. Federal Income Tax Marginal Rates: 2007

  15. Top Marginal Tax Rates Source: http://www.taxpolicycenter.org/taxfacts/displayafact.cfm?Docid=213

  16. Historical average tax rates in U.S. by Income Quintile: Income Tax Only .: Source: http://www.cbo.gov/doc.cfm?index=6133&type=0 Includes individual income tax only

  17. Share of Federal Income Taxes Paid by Quintile .: Source: http://www.cbo.gov/doc.cfm?index=6133&type=0 Includes individual income tax only

  18. The Supply-Side: The Laffer Curve. Tax Revenue Tax Rates

  19. Laffer Curve and Capital Gains Tax Source: http://time-blog.com/curious_capitalist/2008/01/do_capital_gains_tax_cuts_incr.html

  20. The Supply-Side: Investment and Saving • GDP = C + I + G + (X – M) • GDP = C + S + T  I + G + (X – M) = S + T • I = S + (T – G) + (M – X) Private saving PS = S + (M – X) Government Saving GS=T-G I = PS + GS

  21. The Supply-Side: Investment and Saving

  22. The Supply-Side: Investment and Saving • Fiscal policy influences investment and saving in two ways: • Taxes affect the incentive to save and change the supply of loanable funds. • Government saving is a component of total saving and the supply of loanable funds.

  23. The Supply-Side: Investment and Saving • A tax on capital income decreases the supplyof loanable funds • a tax wedge is driven between the interest rate and the after-tax interest rate • Investment and saving decrease.

  24. The Supply-Side: Investment and Saving • Ricardo-Barro Equivalence • In above diagram, it is assumed that government budget does not shift PSLF curve. • Ricardo-Barro: • Larger deficits cause households to increase savings in order to cover future tax increases. • Net effect of larger deficit on SLF curve is zero because PSLF curve shifts right. • No effect on investment or interest rates • All increases in deficits are offset by increased saving (decreased consumption).

  25. Generational Effects of Fiscal Policy • Generational accounting is an accounting system that compares the present value of lifetime tax burden with the benefits of each generation. • Is the budget deficit a burden on future generations? • Is the deficit in the Social Security fund a burden? • Does it matter who owns the bonds that the government sells to finance its deficit?

  26. Generational Effects of Fiscal Policy • Generational Accounting and Present Value • Taxes are paid by people with jobs. Social security benefits are paid to people after they retire. • To compare the value of an amount of money at one date (working years) with that at a later date (retirement years), we use the concept of present value.

  27. Generational Effects of Fiscal Policy • The Social Security Time Bomb • Using generational accounting and present values, economists have found that the federal government is facing a Social Security time bomb! • In 2008, the first of the baby boomers will start collecting Social Security pensions and in 2011, they will become eligible for Medicare benefits. • By 2030, all the baby boomers will have retired and, compared to 2006, the population supported by Social Security will have doubled.

  28. Generational Effects of Fiscal Policy • Under the existing Social Security laws, the federal government has an obligation to pay pensions and Medicare benefits on an already declared scale. • Gokhale and Smetters estimated that the fiscal imbalance in Social Security / Medicare was $45 trillion in 2003—4 times the value of total production in 2003 ($11 trillion).

  29. Generational Effects of Fiscal Policy • Generational imbalance • division of the fiscal imbalance between the current and future generations, assuming that the current generation will enjoy the existing levels of taxes and benefits. • The bars show the scale of the fiscal imbalance.

  30. Generational Effects of Fiscal Policy • International Debt • In June 2006, the United States had a net debt to the rest of the world of $5.2 trillion. • Of that debt, $2.2 trillion was U.S. government debt. • Total U.S. government debt is $4.1 trillion. • More than half of the outstanding government debt is held by foreigners.

  31. Stabilizing the Business Cycle • Discretionary fiscal policy • action that is initiated by an act of Congress. • Automatic fiscal policy (Auto stabilizers) • fiscal policy triggered by the state of the economy.

  32. Stabilizing the Business Cycle • Discretionary Fiscal Stabilization • An increase in government expenditure or a tax cut increases aggregate demand. • The “multiplier process” increases aggregate demand further.

  33. Stabilizing the Business Cycle • A decrease in government expenditure or a tax increase decreases aggregate demand. • The multiplier process decreases aggregate demand further.

  34. Stabilizing the Business Cycle • Limitations of Discretionary Fiscal Policy • Recognition lag • time it takes to figure out that fiscal policy action is needed. • Law-making lag • time it takes Congress to pass the laws needed to change taxes or spending. • Impact lag • time it takes from passing a tax or spending change to its effect on real GDP being felt.

  35. Stabilizing the Business Cycle • Automatic Stabilizers • mechanisms that stabilize real GDP without explicit action by the government. • Taxes that rise and fall with GDP taxes and needs-tested spending are automatic stabilizers. • When real GDP decreases in a recession • wages and profits fall, so taxes fall • Needs-tested spending rises • Budget deficit grows (surplus shrinks)

  36. The Budget and the Business Cycle • Cyclical and Structural Balances • The structural surplus or deficit • the surplus or deficit that would occur if the economy were at full employment and real GDP were equal to potential GDP. • The cyclical surplus or deficit • the actual surplus or deficit minus the structural surplus or deficit; • the surplus or deficit that occurs purely because real GDP does not equal potential GDP.

  37. Stabilizing the Business Cycle

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