Introduction%20to%20fiscal%20policy

1
Introduction to fiscal policy
?Fiscal policy refers to the use of the spending
and taxing powers of the federal government to
manage aggregate demand, and thereby to stabilize
the level of output, employment, and prices.
Under the Employment Act of 1946, the Federal
government is to promote maximum production,
employment , and purchasing power.
2
Closing a recessionary gap
Yf is potential GDP
AE
AE Y
AE2
AE1
?G
?Y
Here weillustrate theuse of G to stimulate AE
andpush the economy to full-employment
Y
Y
Yf
1
?Y ?G ?
1 - c m
3
Principles of taxation

• Horizontal equity Tax code should be written so
  that those in the same economic circumstances pay
  the same amount in taxes.
• Vertical equity Tax code should be written so
  that those in different economic circumstances
  should pay an unequal amount in taxes.
• Ability to pay principle Those with greater
  ability to pay taxes should pay more.
• Benefits received principle Those who derive
  more benefits from government programs should pay
  more taxes.

If Madonna or Bill Gates paid the same amount in
taxes as an accountant or government
employee, that would be vertically inequitable
4
Definitions

• Taxable income Gross income - income exempt from
  taxes. Example For single filers who use the
  1040EZ

• Average tax rate (ATR) Tax payments as a percent
  of taxable income.
• Marginal tax rate (MTR) The tax rate applied to
  the last dollar of taxable income.

5
A progressive tax
?Note that ATR and taxable income move in same
direction
A progressive tax, such as the federal personal
income tax upon which this example is based, is
generally consistent with the principle of
vertical equity
6
A regressive tax
Payroll and sales taxes on grocery items, beer,
and cigarettes are regressive
7
Clintonomics
Federal personal Income Tax rates Under the 1993
Tax Reform Act (Married couple filing jointly)
8
Automatic stabilizers

• Taxes (TX) and Transfer Payments (TR) are called
  automatic stabilizers because they react to
  changes in national income in a way that
  increases the federal deficit (or reduces the
  surplus) in the event of an economic contraction
  or reduces the deficit (increases the surplus)
  when the economy is expanding.

The automaticstabilizers make sure that YD does
notfall too muchwhen national incomeis falling
9
Remember that the federaldeficit or surplus
isequal to the differencebetween G and Net Tax
Receipts,where Net Taxes are equal toTX - TR

• ?Y??TX, for example
• ?Y??TX, and vice versa
• ?Y??TR, for example
• ?Y??TR, and vice versa

?Note that claims for unemployment compensation
and other assistance surges when unemployment
rises.
10
YR is the recession-level of national income
G, T
Full-employment
T TX - TR
G
Deficit
0
YR
National Income
11
The public sector, aggregate demand, and
"crowding out."

• Let
• AE denote aggregate demand
• Y is real GDP
• TX is tax payments
• TR is transfer payments
• YD is personal disposable income

Thus, in a closed economy we have AE C I G
1 It is also true that YD Y - TX TR
2
The full-employment model suggests that an
increase in G must result in a compensating
decrease in C or I--this is the crowding out
effect
Government can increase YD by decreasing TX or
increasing TR (reverse also holds true).
Economists call transfer payments negative
taxes.
12
Increased government spending crowds out
investment
S function shifts left due to decrease in YD
Interest rate (r)
? Allow for an increase in G finance by increased
taxes (TX). Note that YD Y - TX TR
r2
r1
Investment function
0
I2
I1
S, I
Crowding out