Ch. 13: Fiscal Policy

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Ch. 13 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
• Fiscal policy as a stabilization tool

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The Federal Budget and Fiscal Policy

• Federal budget
• annual statement of the federal governments
  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.

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(Normal) Timeline for Budget Process
February to March President submits budget
request to Congress. May-August House and
Senate revise/amend proposals September House-Se
nate conference committees resolve differences
and agree on final versions of spending bills.
President signs or vetoes final bills. October
1 Beginning of fiscal year (10/1/2012 is
beginning of 2013 fiscal year). Congress
passes continuing resolutions to maintain funding
for any agencies affected by appropriations bills
that have not been passed and signed by the
beginning of the fiscal year.
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Fiscal Policy

• The Council of Economic Advisors
• Chaired by Alan Krueger
• keeps the President and public informed about the
  current state of the economy
• evaluates economic proposals
• Provides data to inform the budget-making
  process.
• Congressional Budget Office
• Forecasts effects of legislative changes on
  budget and economy

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Federal Deficits and Public Debt

• Budgett revenuet outlayst
• if Budgett gt 0 ? budget surplus
• if Budgett lt 0 ? budget deficit
• (outlays include interest on debt)
• Debtt Debtt-1 - budgett-1
• Budget deficits increase debt
• Budget surpluses decrease debt

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Revenues
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The Federal Budget
Outlays
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Baseline budget assume current tax and spending
laws remain unchanged.
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The National Debt
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State and Local Budgets

• The total government sector includes state and
  local governments as well as the federal
  government.
• In 2008, when federal government outlays were
  about 3,200 billion, state and local outlays
  were a further 2,000 billion.
• Most of state expenditures were on public
  schools, colleges, and universities (550
  billion) local police and fire services and
  roads.
• Most states have balanced budget amendments.

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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 (difference between before and after
  tax wage)
• Equilibrium employment
• LAS

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Effect of an increase in income tax rate
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Tax Wedge Comparisons
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Federal Income Tax Marginal Rates
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2011 Federal Income Tax Marginal Rates
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Share of income paid in taxes
Source http//www.cbo.gov/publications/collection
s/tax/2010/graphics.cfm
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Source http//www.cbo.gov/publications/collection
s/tax/2010/graphics.cfm
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Source http//www.cbo.gov/publications/collection
s/tax/2010/graphics.cfm
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Average Federal Tax Rate by Income Quintile,
1979-2007 (note all federal taxes included)
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The Supply-Side The Laffer Curve.
Tax Revenue
Tax Rates
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The Laffer Curve

• As tax rates rise, taxable income may fall
  because
• People reduce work hours
• Tax avoidance increases
• Legal tax avoidance
• Charities
• Tax free bonds
• Pension saving
• Capital gains versus income
• Illegal tax avoidance
• Under-report income
• Inflate deductions

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Laffer Curve and Capital Gains Tax
Laffer curve and corporate income tax rate tax
havens video
Source http//time-blog.com/curious_capitalist/20
08/01/do_capital_gains_tax_cuts_incr.html
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According to the Laffer curve, if tax rates rise,
tax revenue

1. Will rise
2. May rise or fall
3. Will fall

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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 GST-G
• ? I PS GS

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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.

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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.

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The Supply-Side Investment and Saving

• Effect of a government budget deficit on saving
  and investment -- crowding out

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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).

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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.

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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.
• Size of multiplier is controversial.

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Stabilizing the Business Cycle

• A decrease in government expenditure or a tax
  increase decreases aggregate demand.
• The multiplier process decreases aggregate demand
  further.

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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.

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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)

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The Budget and the Business Cycle

• Cyclical and Structural Balances
• Actual Budget Cyclical Budget Structural
  Budget
• 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 surplus or deficit that occurs purely because
  real GDP does not equal potential GDP.
• Cyclical budget lt 0 if GDPlt potential GDP

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Source http//www.cbo.gov/ftpdocs/120xx/doc12039/
01-26_FY2011Outlook.pdf
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Effects of economy on budget
Source http//www.cbo.gov/ftpdocs/120xx/doc12039/
01-26_FY2011Outlook.pdf
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Effects of economy on budget
Source http//www.cbo.gov/ftpdocs/120xx/doc12039/
01-26_FY2011Outlook.pdf
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Cyclical and Structural Budget
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