CHAPTER

1. 11 FISCAL POLICY CHAPTER

2. Objectives • After studying this chapter, you will able to • Describe the federal budget process • Describe the recent history of federal expenditures, tax revenues, and the budget deficit • Distinguish between automatic and discretionary fiscal policy • Define and explain the fiscal policy multipliers • Explain the effects of fiscal policy in both the short run and the long run • Distinguish between and explain the demand-side and supply-side effects of fiscal policy

3. Balancing Acts on Capitol Hill • In 2003, the federal government planned to spend 18 cents out of each dollar earned in the United States, and collect nearly as much in taxes. • How does that affect the economy? • For most of the 1980s and 1990s, the government ran deficits, to the extent that the national debt is now about $12,000 per person. • What are its effects, and how can deficits be avoided?

4. The Federal Budget • The federal budget is the annual statement of the federal government’s expenditures and tax revenues. • Fiscal policy is the use of the federal budget to achieve macroeconomic objectives, such as full employment, sustained long-term economic growth, and price level stability.

5. The Federal Budget • The Institutions and Laws • Fiscal policy is made by the president and Congress. • Figure 11.1 illustrates the timeline.

6. The Federal Budget • Fiscal policy operates within the framework of the Employment Act of 1946, which committed the government to work toward “maximum employment, production, and purchasing power.” • The President’s Council of Economic Advisers monitors the economy and advises the President on economic policy.

7. The Federal Budget • Highlights of the 2003 Budget • The projected fiscal 2003 Federal Budget has tax revenues of $2,080 billion, expenditures of $2,158 billion, and an original projected deficit of $78 billion. [By February, the projection was for a much larger deficit.] • Tax revenues come from personal income taxes, social insurance taxes, corporate income taxes, and indirect taxes. • Personal income taxes followed by social insurance taxes are the two largest revenue sources.

8. The Federal Budget • Expenditures are classified as: • 1. transfer payments, • 2. purchases of goods and services, and • 3. debt interest. • Transfer payments [mostly Social Security] are by far the largest expenditure, and are sources of persistent growth in expenditures.

9. The Federal Budget • The federal government’s budget balance equals tax revenue minus expenditure. • If tax revenues exceed expenditures, the government has a budget surplus [T>G]. • If expenditures exceed tax revenues, the government has a budget deficit [G>T]. • If tax revenues equal expenditures, the government has a balanced budget [T=G]. • Remember, T is defined as net taxes – tax minus transfers. G is Government purchases.

10. The Federal Budget • The Budget in Historical Perspective • Figure 11.2 on the next slide shows the government’s tax revenues, expenditures, and budget surplus or deficit as a percentage of GDP for the period 1983–2003. • The government had a deficit of 5.2 percent in 1983. • The deficit declined and in 1998 to 2001, the government had a surplus. • A deficit arose again in 2002 and 2003.

11. The Federal Budget

12. The Federal Budget • Figure 11.3 on the next slide shows the evolution of the components of tax revenues and expenditures as a percentage of GDP over the period 1983–2003. • Tax revenues increased and expenditures decreased.

13. The Federal Budget

14. The Federal Budget • Government debt is the total amount that the government has borrowed — that the government owes. It is the accumulation of all past deficits, less all past surpluses.

15. The Federal Budget • Figure 11.4 shows the evolution of the debt as a percentage of GDP since 1942.

16. The Federal Budget • The U.S. Government Budget in Global Perspective • Figure 11.5 compares government budget deficits around the world in 2001. • The world as a whole that year had a government budget deficit of about 1.5 percent of world GDP.

17. The Federal Budget • State and Local Budgets • In 2001, when the federal government spent $1,900 billion, state and local governments spent about $1,300 billion, mostly on education, protective services [police, fire services, prisons, etc], and roads. • Most states, and other lower levels of government, are not permitted to run deficits [they can borrow to finance capital spending, like roads]. State and local budgets, therefore, are not used for stabilization purposes, and occasionally become destabilizing in recessions.

18. Fiscal Policy Multipliers • Automatic fiscal policy is a change in fiscal policy triggered automatically by the state of the economy. • Discretionary fiscal policy is a policy action that is initiated by an act of Congress, taken deliberately. • To enable us to focus on the principles of fiscal policy multipliers, we first study discretionary fiscal policy in a model economy that has only “lump-sum” taxes. • Lump-sum taxes are taxes that do not vary with real GDP; actual examples would be a ‘head tax’ or property taxes.

19. Fiscal Policy Multipliers • The Government Purchases Multiplier • The government purchases multiplier is the magnification effect of a change in government purchases of goods and services on equilibrium aggregate expenditure and real GDP. • A multiplier exists because government purchases are a component of aggregate expenditure; an increase in government purchases increases aggregate income, which induces additional consumption expenditure.

20. Fiscal Policy Multipliers • Figure 11.6 illustrates the government purchases multiplier in the aggregate expenditure diagram. • The government purchases multiplier is 1/(1 – MPC) where MPC is the marginal propensity to consume (absent induced taxes and imports).

21. Fiscal Policy Multipliers • The Lump-Sum Tax Multiplier • The lump-sum tax multiplier is the magnification effect a change in lump-sum taxes has on equilibrium aggregate expenditure and real GDP. • An increase in lump-sum taxes decreases disposable income, which decreases consumption expenditure and decreases aggregate expenditure and real GDP.

22. Fiscal Policy Multipliers • The amount by which a tax increase lowers consumption expenditure is determined by the MPC. • A $1 tax increase lowers consumption expenditure by $1 MPC, and this amount gets multiplied by the standard autonomous expenditures multiplier. • The lump-sum tax multiplier is therefore -[MPC/(1 – MPC)]. • It is negative because an increase in lump-sum taxes decreases equilibrium expenditure.

23. Fiscal Policy Multipliers • Figure 11.7 illustrates the effect of an increase in lump-sum taxes. • The lump-sum transfer payments multiplier and the lump-sum tax multiplier are the same except for their signs—the transfer payments multiplier is positive.

24. Fiscal Policy Multipliers • Induced Taxes and Entitlement Spending • Taxes that vary with real GDP are called induced taxes. • Most transfer payments are part of entitlement spending, and they vary with real GDP – they are induced, too. • During a recession, induced taxes fall and entitlement spending rises; and during an expansion, induced taxes rise and entitlement spending falls. For this reason, they are called automatic stabilizers. • Both effects also diminish the size of the government purchases and lump-sum tax multipliers.

25. Fiscal Policy Multipliers • The extent to which induced taxes and entitlement spending decrease the multiplier depends on the marginal tax rate, which is the fraction of an additional dollar of real GDP that flows to the government in net taxes. • The higher the marginal tax rate, the larger is the fraction of an additional dollar of income that flows to the government and the smaller is the induced change in consumption expenditure. • The smaller the induced change in consumption expenditure the smaller are the government purchases and lump-sum tax multipliers.

26. Fiscal Policy Multipliers • International Trade and Fiscal Policy Multipliers • Imports also decrease the fiscal policy multipliers. • The larger the marginal propensity to import, the smaller is the magnitude of the government purchases and lump-sum tax multipliers. The reason? If a bigger fraction of any change in disposable income is spent on imports, a smaller fraction is spent on US-produced output so generates more US GDP and income.

27. Fiscal Policy Multipliers • Automatic Stabilizers • Automatic stabilizers are mechanisms that stabilize real GDP without explicit action by the government. • Income taxes and most transfer payments are automatic stabilizers. • Because income taxes and most transfer payments change with the business cycle, the government’s budget deficit also varies with the business cycle. • In a recession, taxes fall, transfer payments rise, and the deficit grows; in an expansion, taxes rise, transfers fall, and the deficit shrinks.

28. Fiscal Policy Multipliers • Figure 11.8 shows the budget deficit over the business cycle for 1981–2001. • Recessions are highlighted.

29. Fiscal Policy Multipliers • The structural surplus or deficit is the surplus or deficit that would occur if the economy was at full employment and real GDP was equal to potential GDP. • The cyclical surplus or deficit is the actual surplus or deficit minus the structural surplus or deficit; that is, it is the surplus or deficit that occurs purely because real GDP does not equal potential GDP – i.e. because the economy is not at full employment.

30. Fiscal Policy Multipliers • Figure 11.9 illustrates the distinction between a structural and cyclical surplus and deficit. • In part (a), as real GDP fluctuates around potential GDP, a cyclical deficit or surplus arises.

31. Fiscal Policy Multipliers • In part (b), as potential GDP grows, a structural deficit becomes a structural surplus.

32. Fiscal Policy Multipliers and the Price Level • Fiscal Policy and Aggregate Demand • Figure 11.10 illustrates the effects of fiscal policy on aggregate demand. • An increase in government purchases shifts the AE curve upward and shifts the AD curve rightward.

33. Fiscal Policy Multipliers and the Price Level • The magnitude of the shift in the AD curve equals the government purchases multiplier times the increase in government purchases. • When lump-sum taxes decrease, the rightward shift in the AD curve equals the lump-sum tax multiplier times the reduction in taxes.

34. Fiscal Policy Multipliers and the Price Level • Expansionary fiscal policy, an increase in government expenditures or a decrease in tax revenues, shifts the AD curve to the right. • Contractionary fiscal policy, a decrease in government expenditures or an increase in tax revenues, shifts the AD curve to the left.

35. Fiscal Policy Multipliers and the Price Level • Figure 11.11(a) illustrates the effect of an expansionary fiscal policy on real GDP and the price level when real GDP is below potential GDP. • The rightward shift in the AD curve equals the multiplied increase in aggregate expenditure.

36. Fiscal Policy Multipliers and the Price Level • The increase in GDP is less than the multiplied increase in aggregate expenditure because the price level rises.

37. Fiscal Policy Multipliers and the Price Level • Fiscal Expansion at Potential GDP • Figure 11.11(b) illustrates the effects of an expansionary fiscal policy starting from a position of full employment.

38. Fiscal Policy Multipliers and the Price Level • In the long run, fiscal policy multipliers are zero because real GDP equals potential GDP and a change in aggregate demand changes the money wage rate, the SAS curve, and the price level.

39. Fiscal Policy Multipliers and the Price Level • Limitations of Fiscal Policy • Because the short-run fiscal policy multipliers are not zero, fiscal policy can be used to help stabilize the economy, and frequently is in countries with parliamentary systems of government [or other systems that allow the executive to control the budget]. • But in practice, fiscal policy is always hard to use, and in the US usually not feasible, because: • The legislative process is too slow to permit fiscal policy actions to be implemented when they are needed. • Potential GDP is very hard to estimate, so the wrong fiscal stimulus or restraint may be enacted.

40. Supply-Side Effects of Fiscal Policy • Fiscal Policy and Potential GDP • Potential GDP depends on the full-employment quantity of labor, which in turn is influenced by the income tax. • Figure 11.12 on the next slide illustrates the effect of the income tax in the labor market.

41. Supply-Side Effects of Fiscal Policy • The income tax decreases the aggregate supply of labor because it decreases the after-tax wage rate. • Because the income tax decreases the aggregate supply of labor, it raises the equilibrium wage rate, decreases employment, and decreases potential GDP.

42. Supply-Side Effects of Fiscal Policy • This supply-side effect of the income tax means that a cut in the income tax rate may increase potential GDP and may increase aggregate supply.

43. Supply Side Effects of Fiscal Policy • Figure 11.13 illustrates two views about the effects of a tax cut on real GDP and the price level. • A tax cut increases aggregate demand and the AD curve shifts rightward.

44. Supply-Side Effects of Fiscal Policy • Most economists believe that a tax cut has a small effect on aggregate supply [SAS0 to SAS1]. • So GDP increases and the price level rises.

45. Supply-Side Effects of Fiscal Policy • So-called supply-side economists think that a tax cut may increase aggregate supply by a large amount [SAS0 to SAS2] so that GDP can increase and the price level not change much (or maybe even fall).

46. Supply-Side Effects of Fiscal Policy • Fiscal Policy and Economic Growth • Fiscal policy also influences economic growth by changing the incentives to save, invest, and innovate. • These incentives work similarly to those in the labor market. • Fiscal policy almost always changes the distribution of income and wealth – the “after tax and transfers” distribution is different from the “before tax and transfers” one. • Fiscal policy can also influence growth and the well-being of future generations by crowding out investment and increasing foreign debt.

47. Supply-Side Effects of Fiscal Policy • Figure 11.14 illustrates some of these effects. • An increase in government purchases or a tax cut decreases world saving and increases the world equilibrium real interest rate.

48. Supply-Side Effects of Fiscal Policy • The increase in government purchases or a tax cut decreases domestic saving and increases international borrowing.