FISCAL POLICY

1
FISCAL POLICY
ECONOMICS
What does it mean to me?
READ Krugman Sec 4, Mod 21 Mankiw Ch 34 DO
Morton Unit 3
2
READ Krugman Section 4, Module 21 Mankiw Chapter
33, 34, 35,
3
ModuleFiscal Policyand the Multiplier
21

• KRUGMAN'S
• MACROECONOMICS for AP

Margaret Ray and David Anderson
4
What you will learnin this Module

• Why fiscal policy has a multiplier effect
• How the multiplier effect is influenced by
  automatic stabilizers

Krugman, Sec 4 Mod 21
5
(No Transcript)
6
Fear the Boom and Bust
7
What you will learn in this chapter

• What fiscal policy is and why it is an important
  tool in managing economic fluctuations
• Which policies constitute an expansionary fiscal
  policy and which constitute a contractionary
  fiscal policy
• Why fiscal policy has a multiplier effect and how
  this effect is influenced by automatic
  stabilizers
• How to measure the government budget balance and
  how it is affected by economic fluctuations
• Why a large public debt may be a cause for
  concern
• Why implicit liabilities of the government are
  also a cause for concern

Krugman
8

• MONETARY POLICY
• (Federal Reserve)
• Expansionary
• Lower discount rate
• Lower reserve requirement
• Buy T-bills
• Contractionary
• Raise discount rate
• Raise reserve requirement
• Sell T-bills

• FISCAL POLICY
• (Federal Government)
• Expansionary
• Lower taxes
• Increase spending
• Contractionary
• Raise taxes
• Decrease spending

9
Fiscal Policy The Basics
Krugman
10
Sources of Tax Revenue in theUnited States, 2004
Krugman
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Government Spending in theUnited States, 2004
Krugman
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(No Transcript)
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The Government Budget and Total Spending
Fiscal policy is the use of taxes, government
transfers, or government purchases of goods and
services to shift the aggregate demand curve.
16
Unemployment and inflation are forms of economic
instability closely tied to long-term economic
growth. The INSTABILITY carries an enormous
cost--one that can be measured in economic as
well as human terms.
17
On one level, unemployment and inflation are
simply numbers that are collected, reported in
the press, or plotted on a graph.
On another level, they represent enormous
economic failures that waste the resources of the
nation and its people.
18

• In the early 1980s, the U.S. reduced personal
  income tax rates by some 25 percent, without
  offsetting decreases in government spending. By
  expanding the aggregate demand, this tax cut
  helped end the recession of 1980-81 and promoted
  growth of output and employment
• Earlier, during the Vietnam War, the U.S. placed
  a 10 percent surcharge--a tax added to taxes
  otherwise owed--on both corporate and personal
  income taxes. The idea was to reduce private
  spending and contain the demand-pull inflation it
  caused.
• In the mid-1990s, Japan instituted a massive
  government spending program to help move its
  economy out of recession.

19
Why doesnt government always match its increase
in spending with its increase in taxes? Under
what circumstances might government change
spending and taxation--or engage in FISCAL
POLICY. Do these policies work?
20
FISCAL POLICY is the manipulation of government
spending and taxes to stabilize domestic output,
employment, and the price level.
21
When Congressional leaders make changes in the
money circulation by adjusting taxes and
spending, they shift the aggregate-demand by
influencing the spending decisions of businesses
and consumers.
For instance, suppose the U.S. Department of
Defense places a 25B order for fighter jets from
Lockheed Martin. The order raises demand for
workers and other resources to produce the jets.
This results in an increase in the total quantity
of goods and services demanded at each price
level. This shifts the aggregate-demand curve to
the right.
22
The first emergence of fiscal actions on the
economy came during the depression of the
1930s. The EMPLOYMENT ACT OF 1946 committed the
Federal government to the promotion of fiscal
responsibility and economic stability by
providing efforts to promote employment. The act
also created the COUNCIL OF ECONOMIC ADVISORS to
assist the President on economic matters.
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DISCRETIONARY FISCAL POLICY is the deliberate
manipulation of taxes and government spending by
Congress to alter real GDP and employment,
control inflation, and stimulate economic growth.
Discretionary means that the change in taxes
and government spending are at the option of the
Federal government.

• We assume government spending does not in any way
  affect planned private spending
• We assume fiscal policy affects only the
  aggregate demand side of the macroeconomy it has
  no intended or unintended effects on aggregate
  supply.

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There are 2 types of Discretionary Fiscal Policy
used to control inflation, employment, and
stimulate economic growth. 1) Expansionary Fiscal
Policy used to reverse recession. 2)
Contractionary Fiscal Policy used to control
demand-pull inflation.
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In order to explain DISCRETIONARY FISCAL POLICY,
we must first learn about
MULTIPLIER EFFECT CROWDING OUT EFFECT MARGINAL
PROPENSITY to CONSUME MARGINAL PROPENSITY to SAVE
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Multiplier Effects of an Increase in Government
Purchases of Goods and Services

• Initial increase in spending
• Indirect effect of increased spending
• Remember the multiplier

Krugman, Sec 4 Mod 21
27
The MULTIPLIER is a change in a component of
aggregate expenditures leading to a larger change
in equilibrium GDP. Stated generally
Multiplier change in real GDP
initial change in
spending By rearranging the above equation, we
can also say that Change in GDP multiplier X
initial change in spending
28
The reduction in AD that results when a fiscal
expansion raises the interest rate is called the
CROWDING OUT EFFECT.
This happens as a result of rising incomes in
households. As incomes rise, people plan to buy
more goods and services, resulting in those
people holding more of their wealth in liquid
form. The combination of fiscal expansion
causing the rise in incomes raises the demand for
money.
29
When an increase in government purchases
increases AD.
The increase in spending increases money demand.
Which increases the equilibrium interest rate
Which in turn partly offsets the initial increase
in AD.
Price Level
MS
MS
r2
AD2
Interest Rates
r1
MD2
AD3
MD1
AD1
Quantity of Money
Quantity of Output
30
The MARGINAL PROPENSITY to CONSUME (MPC) is the
change in consumption as related to a change in
income. MPC change in consumption
change in income
The MARGINAL PROPENSITY to SAVE (MPS) is the
ratio of saving as related to a change in
income. MPS change in saving
change in income
The sum of MPC and MPS must always equal 1.
31
There is also a relationship between Marginal
Propensities (MPC and MPS) and the multiplier.
20
The initial change in investment spending of 5B
creates an equal 5B of new income in the first
round.
15.25
13.67
11.56
8.75
5
1 2 3 4 5
32
Assume this economy has an MPC .75.
In the 2nd round, households spend 3.75 (.75 x
5)
20
15.25
13.67
Round 3, spending increase by 2.81 (.75 x 3.75)
11.56
8.75
Round 4, by 2.11 (.75 x 2.81)
5
Round 5, by 1.58 (.75 x 2.81)
1 2 3 4 5
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Assume this economy has an MPC .75.
Once the entire process is complete, the
cumulation results in total change in income of
20B
20
15.25
13.67
11.56
8.75
Using the equation Multiplier 1
1 - MPC we find that the
multiplier is 4.
5
1 2 3 4 5
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Three points about the multiplier must be
made 1) Initial change in spending is usually
associated with investment spending because of
its volatility. But changes in consumption, net
exports, and government purchases can also lead
to the multiplier effect. 2) Initial change in
spending refers to an upshift or downshift of
the aggregate expenditures schedule due to an
upshift or downshift of one of its components. 3)
The multiplier works in both directions.an
increase in initial spending can create a
multiple increase in GDP or a decrease in
spending can be multiplied into a larger decrease
in GDP.
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ModuleEconomic Policy and the Aggregate
Demand-Aggregate Supply Model
20

• KRUGMAN'S
• MACROECONOMICS for AP

Margaret Ray and David Anderson
36
What you will learnin this Module

• How the AD-AS model is used to formulate
  macroeconomic policy
• The rationale for stabilization policy
• Why fiscal policy is an important tool for
  managing economic fluctuations
• Which policies constitute expansionary fiscal
  policy and which constitute contractionary fiscal
  policy

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Macroeconomic Policy

• Self-correction?
• Stabilization Policy

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Policy in the Face of Demand Shocks

• Negative Demand Shocks Positive Demand Shocks
• Why are they bad?
• Should policymakers counteract?

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Responding to Supply Shocks

• Supply shock
• Policy dilemma

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Fiscal Policy The Basics
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Taxes, Government Purchases of Goods and
Services, Transfers, and Borrowing
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Taxes, Government Purchases of Goods and
Services, Transfers, and Borrowing
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The Government Budget and Total Spending

• GDP C I G X - M
• The effect of taxes and transfers
• Effects on Investment

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Expansionary and Contractionary Fiscal Policy

• Expansionary Fiscal Policy
• increase G
• decrease T
• increase transfers

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Expansionary and Contractionary Fiscal Policy

• Contractionary Fiscal Policy
• decrease G
• increase T
• decrease transfers

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A Cautionary Note Lags in Fiscal Policy

• Time lags
• Recognition lag
• Decision lag
• Implementation lag
• Lags make decision making more difficult

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When recession occurs, an EXPANSIONARY FISCAL
POLICY may be in order.
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Suppose that a sharp decline in investment
spending has shifted AD from AD1 to AD2. Perhaps
profit expectations on investment projects have
dimmed, curtailing much investment spending and
reducing AD.
AS
PRICE
AD1
AD2
485 505 GDPf
REAL GDP (billions)
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Consequently, real GDP has fallen from 485b from
its near full-time level of 505b. Accompanying
this 20b decline in real output is an increase
in unemployment since fewer workers are needed to
produce the diminished output.
AS
This economy is experiencing recession and
cyclical unemployment.
PRICE
AD1
AD2
485 505 GDPf
REAL GDP (billions)
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What should the government do?
There are 3 main options 1) increase government
spending, 2) reduce taxes, 3) use some
combination of the two.
If the Federal budget is balanced at the onset,
fiscal policy during a recession or depression
should create a government BUDGET DEFICIT--or
government spending in excess of revenues.
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All things being equal, an increase in
government spending will shift the AD curve to
the right.
Suppose that recession prompts government to
initiate 5b of new spending on highways,
communications, and prisons, represented by the
dashed line. At EACH price level, the amount of
real output demanded is now 5b greater than that
demanded before the increase.
5 billion initial increase in spending
AS
PRICE
AD2
REAL GDP (billions)
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But the AD curve shifts rightward to AD1
aggregate demand increases by much more than the
5b in government purchases.
5 billion initial increase in spending
AS
This occurs because the multiplier process
magnifies the initial change in spending into
successive rounds of new consumption spending.
PRICE
AD2
REAL GDP (billions)
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If the economys MPC is .75 then the simple
multiplier is 4. The AD curve shifts right 4
times the 5b increase.
5 billion initial increase in spending
Because this particular increase in AD occurs
within the horizontal range of AS, real output
rises by the full extent of the
multiplier. Unemployment falls as firms call back
laid off workers.
AS
PRICE
Full 20 billion increase in aggregate demand
AD2
AD1
REAL GDP (billions)
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Another option for expansionary fiscal policy
would be tax reductions to shift the aggregate
demand curve rightward.
Suppose government cuts personal income taxes by
6.7 billion, which increases disposable income
by the same amount. Consumption will rise by 5
billion ( MPC of .75 X 6.67 billion), and
saving will go up by 1.67 billion ( MPC of .25
X 6.67 billion). In this case the horizontal
distance between AD2 and the dashed line
represents only the 5 billion initial increase
in consumption spending.
AS
PRICE
AD1
AD2
REAL GDP (billions)
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The aggregate demand curve eventually shifts
rightward by four times the 5 billion initial
increase in consumption produced by the tax cut.
Real GDP rises by 20 billion, implying a
multiplier of 4. Employment also increases
accordingly.
You may have also noted that a tax cut must be
somewhat larger than the proposed government
spending increase to achieve the same amount of
rightward shift in the aggregate demand curve.
This is part because part of a tax reduction
boosts SAVINGS, not consumption.
AS
PRICE
AD1
AD2
485b
505b
REAL GDP (billions)
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TO INCREASE INITIAL CONSUMPTION BY A SPECIFIC
AMOUNT, GOVERNMENT MUST REDUCE TAXES BY MORE THAN
THAT AMOUNT.
With an MPC of .75, taxes must fall by 6.67
billion for 5 billion of new consumption to be
forthcoming, because 1.67 billion is saved (not
consumed). If the MPC instead had been .6, then
an 8.33b reduction in tax collections would have
been necessary to increase initial consumption by
5b. The smaller the MPC, the greater the tax cut
needed to accomplish a specific initial increase
in consumption and a shift in the AD curve.
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Expansionary Fiscal Policy may also be initiated
by a combination of spending increases and tax
reductions.
Government might increase its spending by 1.25
billion while reducing taxes by 5 billion. Can
you ascertain why this combination will produce
the targeted 5b initial increase in new spending.
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If the government increases its spending during
recession to assist the economy, the funds for
such expenditures must come from some source.
What source would have the greatest expansionary
effect?
Creating new money
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Contractionary Fiscal Policy is used to control
demand-pull inflation.
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AS
Suppose a shift of from AD3 to AD4 occurs in the
vertical range of AS, and boosts the price level
from P3 to P4. This increase may have resulted
from a sharp increase in investment or net export
spending. Using fiscal policy, the remedy used
to control this is opposite those used to control
recession.
P4
PRICE
AD4
P3
AD3
515b
REAL GDP (billions)
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What should the government do?
There are 3 main options 1) decrease government
spending, 2) increase taxes, 3) use some
combination of the two.
When the economy faces demand-pull inflation,
fiscal policy should move toward a government
BUDGET SURPLUS--tax revenues in excess of
government spending.
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Decreased government spending shifts the AD curve
leftward in its efforts to control demand-pull
inflation.
AS
P4
The dashed line represents 5 billion reduction
in government spending. Once the multiplier
effect is complete, the curve will move from AD4
to AD3. Assuming downward price flexibility, the
price level will return to P3 and real output
will remain constant. In the real world, prices
are sticky downward, so stopping inflation is a
matter of halting the rise in the price level,
not reducing it to a previous level.
PRICE
AD4
P3
AD3
515b
REAL GDP (billions)
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Increased taxes also shifts the AD curve leftward
in its efforts to control demand-pull inflation
by decreasing consumption.
AS
If the economy has an MPC of .75, government must
raise taxes by 6.67 billion to reduce
consumption by 5b. The 6.67 tax reduces saving
by 1.67 ( the MPS of .25 X 6.67b) and this
1.67b reduction in saving is not a spending
reduction. But the 6.67b tax increase also
reduces consumption spending by 5b ( the MPC of
.75 x 6.67), as shown by the dashed line. After
the multiplier process, AD will shift left by
20b ( multiplier of 4 X 5b).
P4
PRICE
AD4
P3
AD3
515b
REAL GDP (billions)
64
Contractionary Fiscal Policy may also be
initiated by a combination of spending decreases
and tax increases .
AS
P4
Why does a 2 billion decline in government
spending paired with a 4 billion increase in
taxes shift the aggregate demand curve from AD4
to AD3.
PRICE
AD4
P3
AD3
515b
REAL GDP (billions)
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Financing of Deficits and Disposing of Surpluses
The expansionary effect of deficit spending on
the economy depends on the method used to finance
the deficit. Similarly, the anti-inflationary
impact of the creation of a budget surplus
depends on what is done with the surplus.
There are two ways the government can FINANCE THE
DEFICIT 1) Borrowing When the government
borrows money, it competes with private business
borrowers for the funds. 2) Money creation
Creation of new money is a more expansionary (but
potentially more inflationary) way of financing
deficit spending than is borrowing.
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Demand-Pull inflation calls for fiscal action
which will result in a budget surplus. But the
anti-inflationary effect of this surplus depends
on what government does with it.
There are two ways the government can DISPOSE OF
THE SURPLUS 1) Debt Reduction To retire the
National Debt, the government buys back some of
its bonds in doing so, it transfers its surplus
tax revenues back into the money market. This
causes interest rates to fall and thus private
borrowing and spending to rise. 2) Impounding
Impounding the surplus funds and allowing them to
stand idle is a way for the government to extract
and withhold purchasing power from the
economy. Because there is no chance for the funds
to be spent, the impounding of a budget surplus
is more anti-inflationary than the use of the
surplus to retire the public debt.
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IS IT PREFERABLE TO USE GOVERNMENT SPENDING OR
TAXES TO ELIMINATE RECESSION AND INFLATION?
The answer depends upon ones view as to whether
the public sector is too large or too small.
Liberal economists, who think there are many
unmet social and infrastructure needs, usually
recommend that government spending be increased
during recessions. In times of demand-pull
inflation, they tend to recommend tax increases.
Conservative economists, who think the public
sector is too large and inefficient, usually
advocate tax cuts during recessions and cuts in
government spending during times of demand-pull
inflation.
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KRUGMANS Contractionary v Expansionary Policy
69
Expansionary and Contractionary Fiscal Policy
Expansionary Fiscal Policy Can Close a
Recessionary Gap
Krugman
70
Expansionary and Contractionary Fiscal Policy
Contractionary Fiscal Policy Can Eliminate an
Inflationary Gap
Krugman
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(No Transcript)
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The Multiplier Effect of an Increase in
Government Purchases of Goods and Services
Krugman
73
How Taxes Affect the Multiplier

• Automatic Stabilizers
• Discretionary Fiscal Policy

The video on the next page is actually a Micro
concept but still applies here.
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(No Transcript)
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Differences in the Effect of Expansionary Fiscal
Policies
76
The Budget Balance as a Measure of Fiscal Policy
The budget balance is equal to government savings
and is defined by the following equation

• expansionary fiscal policies
• contractionary fiscal policies

T tax revenues Ggovernment spending TRtransfer
payments
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The U.S. Federal Budget Deficit and the Business
Cycle
Krugman
78
The U.S. Federal Budget Deficit and the
Unemployment Rate
Krugman
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What would the budget balance be if there were
neither a recessionary gap nor an inflationary
gap?
Cyclically adjusted budget balance is the
estimate of what the budget balance would be if
real GDP were exactly equal to potential output.
It takes into account the extra tax revenue the
government would collect and the transfers it
would save if a recessionary gap were
eliminated-- or the revenue the government would
lose and the extra transfers it would make if an
inflationary gap were eliminated.
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The Actual Budget Deficit Versus the Cyclically
Adjusted Budget Deficit
Krugman
81
Government Debt as a Percentage of GDP
Krugman
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U.S. Federal Deficit and the Federal Debt-GDP
Ratio since 1939
Krugman
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Japanese Deficits and Debt
Krugman
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IMPLICIT LIABILITIES are spending promises made
by governments that are effectively a debt
despite the fact that they are not included in
the usual debt statistics. Examples Medicare
Social Security
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The Implicit Liabilities of the U.S. Government
Krugman
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Multiplier Effects of Changes in Government
Transfers and Taxes

• Taxes and Transfers compared to Government
  Spending
• Transfers (payments by the government to
  households for which no good or service is
  provided in return)
• Tax cuts
• Taxes
• Lump-sum taxes (taxes that dont depend on the
  taxpayers income)

Krugman, Sec 4 Mod 21
87
How Taxes Affect the Multiplier

• The reliance of taxes on real GDP (ie IncTax Rev
  increases w/RGDP b/c depends on indiv
  income.Sales tax Rev increases w/RGDP b/c people
  w/more money buy more stuff..Corp profit taxes
  increase w/RGDP b/c profits increase w/people
  buying more stuff)
• Effect on the multiplier (effect reduce the size
  of the multiplier)
• Automatic stabilizers (affects RGDP as a
  consequence of how tax laws are written)
• Discretionary Fiscal Policy

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NONDISCRETIONARY FISCAL POLICY BUILT-IN
STABILIZERS
89
Net tax revenues vary directly with GDP because
virtually any tax will yield more tax revenue as
GDP rises. When GDP expands and more goods and
services are purchased, revenues from corporate
income taxes and sales and excise taxes also
increase. Conversely, when GDP declines, tax
receipts from all those sources also decline.
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Transfer payments (or negative taxes) behave in
the opposite way from tax revenues.
Unemployment compensation payments, welfare
payments, and subsidies to farmers all DECREASE
during economic expansion and INCREASE during a
contraction.
91
This graph shows how the U.S. tax system creates
built-in stability. Tax revenues vary directly
with GDP, and government spending is assumed to
be independent of GDP. As GDP falls in a
recession, deficits will occur automatically and
will help alleviate that recession. As GDP rise
during expansion, surpluses will occur
automatically and will offset inflation.
Tax Revenues
Surplus
Government Spending
Deficit
Real Domestic Output
92
The economic importance of this direct
relationship between tax receipts and GDP is 1)
Taxes reduce spending and aggregate demand. 2) It
is desirable from the standpoint of stability to
reduce spending when the economy is moving toward
inflation and to increase spending when the
economy is slumping.
A built-in stabilizer is anything which increases
the governments budget deficit (or reduces its
budget surplus) during a recession and increases
its budget surplus (or reduces its budget
deficit) during inflation without requiring
explicit action by policymakers.
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As GDP rises during prosperity, tax revenues
automatically increase and, because they reduce
spending, they restrain the economic expansion.
Put another way, as the economy moves toward a
higher GDP, tax revenues automatically rise and
move the budget from deficit toward surplus.
Tax Revenues
Surplus
Government Spending
Deficit
Real Domestic Output
94
The steepness of T depends on the tax system
itself. In a PROGRESSIVE TAX SYSTEM, the average
tax rate (tax revenue/GDP) rises with GDP.
In a PROPORTIONAL TAX SYSTEM, the average tax
rate remains constant as GDP rises.
In a REGRESSIVE TAX SYSTEM, the average tax rates
falls as GDP rises.
Tax Revenues
(Tax Revenues)
THE MORE PROGRESSIVE THE TAX SYSTEM, THE GREATER
THE ECONOMYS BUILT-IN STABILITY.
T
Surplus
G
(Government Spending)
Deficit
Real Domestic Output
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Changes in public policies or laws which alter
the progressivity of the tax system affect the
degree of built-in stability.
For example In 1993, the Clinton administration
increased the highest marginal tax rate on
personal income from 31 to 39.6 percent and
boosted the corporate income tax 1 percentage
point to 35 percent.
These increases in tax rates raise the overall
progressivity of the tax system, slightly
bolstering the economys built-in stability.
96
However, built-in stabilizers can only diminish,
NOT correct, major changes in equilibrium GDP.
DISCRETIONARY FISCAL POLICY (changes in tax
rates and spending) may be needed to correct
inflation or recession of any appreciable
magnitude.
97
SO..
We have built-in stability because tax revenues
vary directly with GDP. But those automatic
increases or decreases in tax revenues mean that
the ACTUAL BUDGET in any particular year does not
tell us whether governments current
discretionary fiscal policy is expansionary,
neutral, or contractionary.
Heres why.
98
Suppose and economy is achieving full-employment
at GDPf.
Notice between spending line G and tax line T,
there is an actual budget deficit shown by
vertical distance ab.
Assume that investment spending plummets,
swamping the expansionary effect of this budget
deficit and causing a recession to GDPr.
Full-employment or structural deficit
T
Assuming the government takes no new
discretionary action, line G and T remain.
Expenditures
Tax Revenues
a
Government
G
With the economy at GDPr, tax revenues are lower
than before, while government spending remains
unaltered.
b
GDPr GDPf (year 2) (year 1)
GDPf
GDPr
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The budget deficit therefore rises to ec,
expanding from ab (ed)
by amount dc.
The added deficit of dc is called CYCLICAL
DEFICIT because it relates to the business cycle.
Full-employment or structural deficit
T
It is NOT the result of discretionary fiscal
actions by government rather, it is the
by-product of the economys slide into recession.
Expenditures
Tax Revenues
a
e
Government
G
d
b
c
Cyclical Deficit
GDPr GDPf (year 2) (year 1)
GDPf
GDPr
100
Thus, we cannot evaluate the governments fiscal
policy---the extent to which it is expansionary,
neutral, or contractionary--by looking ONLY at
the size of a current budget or surplus.
101
So How do we resolve the problem?
Economists do this by using the FULL-EMPLOYMENT
BUDGET.
Also called the STANDARDIZED BUDGET, it measures
what the Federal budget deficit or surplus would
be with existing tax and government spending
structures if the economy were at full employment
throughout the year.
102
Consider the graph once again. In
full-employment year 1, the full-employment
deficit is ab, the amount of actual deficit.
In year 2, however, the actual budget deficit of
ec overstates the full-employment deficit.
Specifically, the cyclical part of the deficit dc
Full-employment or structural deficit
must be subtracted from the actual deficit ec
T
Expenditures
Tax Revenues
a
e
to obtain the full-employment deficit, ed.
Government
G

We note, then, that the full-employment deficit
for year 2 is the same as year 1 (edab).
d
b
c
Cyclical Deficit
By comparing these two full-employment deficits,
we see that government did not change its fiscal
policy between years 1 and 2.
GDPr GDPf (year 2) (year 1)
GDPf
GDPr
103
Proposed BALANCED BUDGET REQUIREMENT
The large annual budget deficits in the U.S.
during the past two decades have led many
Congressional leaders to support a constitutional
amendment requiring the Federal government to
balance its budget each year.
Such a mandate would virtually eliminate
discretionary fiscal policy as a tool for
stabilization, as it would force the government
to reduce spending or increase taxes during
recession.
Lets chart the effects of a requirement to
balance the budget..
104
Suppose that in year 1, the economy is operating
at full-employment level of GDPf. At this point,
the budget is balanced.
T
In year 2, the economy slides into recession with
real output decreasing to GDPrautomatically
decreasing tax revenues, creating a budget
deficit of ab.
G
a
deficit
b
GDPr GDPf (year 2) (year 1)
105
To comply with the balanced budget requirement,
the government must eliminate this defict in one
of three ways
T2
T1
1) Increasing tax revenues so that the tax line
shifts upward to T2, intersecting the G1 line at
point a.
G1
a
b
GDPr GDPf (year 2) (year 1)
106
OR 2) Reducing government spending so that the
government spending line shifts downward to G2
intersecting with T1 at point b.
T1
G1
a
G2
b
GDPr GDPf (year 2) (year 1)
107
OR 3) Increasing taxes and reducing government
spending in some combination to eliminate the
budget deficit.
T2
T1
G1
a
G2
b
GDPr GDPf (year 2) (year 1)
108
The problem with all three options is that they
are aspects of CONTRACTIONARY FISCAL POLICY.
They all reduce aggregate demand, which decreases
GDP. These actions further reduce real GDP and
tax revenues decline once again. Rather than
stabilizing the economy, a strict balanced-budget
requirement may force government to take action
which worsen the economy.
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110
PROBLEMS, CRITICISMS, COMPLICATIONS 1)
Recognition Lag time between beginning of
recession or inflation and the certain awareness
it is actually happening. 2) Administrative Lag
time that elapses between recognition of need for
fiscal action and time action is taken. 3)
Operational Lag time between the action taken
and the time that action affects output,
employment, or price level.
111
POLITICAL PROBLEMS 1) Governmental goals also
include concern with providing public goods and
services and redistributing income, not just
economic stability. 2) Fiscal policies of State
and Local governments are frequently
pro-cyclical---they worsen, rather than correct
recession or inflation. 3) Deficits may be
politically attractive and surpluses politically
painful. 4) Some economists contend that the
goal of politicians is not to act in the
interests of the national economy but, rather, to
get reelected. Politicians might manipulate
fiscal policy to maximize voter support, even
though their fiscal decisions destabilize the
economy.
112
The CROWDING-OUT Effect An expansionary fiscal
policy (deficit spending) will increase the
interest rate and reduce private spending,
weakening or canceling the stimulus of the fiscal
policy.
(i.e.) If the economy is in recession and
government enacts discretionary fiscal policy in
the form of increased government spending, it
will borrow the needed funds from the money
market.
This results in increased demand for money
The interest rate rises
Investment spending diminishes, as well as some
consumption spending (autos, boats on credit)
113
FISCAL POLICY and the NET EXPORT EFFECT
The net export effect may also work through
international trade to reduce the effectiveness
of fiscal policy. If the crowding-out effect,
during a period of expansionary fiscal policy,
boosts interest rates, reduces investment, and
weakens fiscal policy, then what effect would
these increased interest rates have on a nations
net exports?
114
Problem RECESSION, SLOW GROWTH
Problem INFLATION
Expansionary Fiscal Policy
Contractionary Fiscal Policy
Lower domestic interest rate
Higher domestic interest rate
Increased foreign demand for dollars
Decreased foreign demand for dollars
Dollar appreciates
Dollar depreciates
Net exports decline (aggregate demand decreases,
partially offsetting the expansionary fiscal
policy)
Net exports increase (aggregate demand increases,
partially offsetting the contractionary fiscal
policy)
115
SUPPLY-SIDE FISCAL POLICY
Supply-siders contend that changes in aggregate
supply must be recognized as active forces in
determining levels of inflation and unemployment.
Supply-side economists argue that the huge growth
of the US tax-transfer system (welfare,
subsidies, unemployment compensation) negatively
affects incentives to work, invest, innovate, and
assume entrepreneurial risk.
They believe that high taxes reduce the after-tax
rewards of workers and producers , making work,
innovation, investing, and risk bearing less
financially attractive.
116
To induce aggregate inputs of labor
Reduce taxes on incomes
Work is more attractive because of the increasing
opportunity cost of leisure
Individuals choose to substitute work for leisure
by
Making people willing to work harder
More hours worked per day
More people in labor force
Discouraging long periods of unemployment
Postpone retirement
117
The rewards for saving and investing are also
reduced by high tax rates.
A critical determinant of investment spending is
the expected after-tax return of that spending.
(High taxes on investment income will discourage
investment spending)
Therefore, if lower marginal tax rates encourage
saving and investing, workers will find
themselves with more technologically superior
machinery and equipment.
Labor productivity rises
Expanding aggregate supply
Unemployment and inflation low
118
TAX CUTS FOR THE RICH?? A different
perspective.
Ten men go out to dinner and the bill for all ten
equals 100. If they paid their bill the way we
pay our taxes FIRST FOUR pay nothing FIFTH pays
1 SIXTH pays 3 SEVENTH pays 7 EIGHTH pays
12 NINTH pays 18 TENTH pays 59
119
TAX CUTS FOR THE RICH?? A different
perspective.
They eat their dinner there every day until one
day the owner comes to them and says, You are
such good customers, Im going to reduce the
daily cost of your meal by 20. The group still
wanted to pay their bill the way we pay our taxes
do the first four men were unaffected. Should
the other 6 men divide the 20 savings between
them? 20 divided by 6 is 3.33, but if they
subtracted that from everyones share, the fifth
and sixth men would each end up being paid to eat
their meal.
120
TAX CUTS FOR THE RICH?? A different
perspective.
So, the restaurant owner suggested Paying their
bill the way we pay our taxes FIRST FOUR pay
nothing pay nothing FIFTH pay 1 pay
nothing SIXTH pays 3 2 SEVENTH pays
7 5 EIGHTH pays 12 9 NINTH pays
18 14 TENTH pays 59 49
121
TAX CUTS FOR THE RICH?? A different
perspective.
I only got a dollar out of the 20 declared the
SIXTH man. He pointed to the TENTH man, but he
got 10. Yeah, thats right, exclaimed the
FIFTH man, I only saved a dollar, too. The
wealthy get all the breaks! Wait a minute,
yelled the first FOUR MEN, We didnt get
anything at all. The system exploits the
poor. The first 9 men surrounded the TENTH and
beat him up.
122
TAX CUTS FOR THE RICH?? A different
perspective.
The next night, the TENTH man didnt show up for
dinner, so the nine sat down and ate without
him. But when it came to pay the bill, they
didnt have enough money between them for even
half the bill. THE PEOPLE WHO PAY THE HIGHEST
TAXES GET THE MOST BENEFIT FROM A TAX REDUCTION.
Tax them too much and they just might start
eating overseas where the atmosphere is somewhat
friendlier.
123
n
THE LAFFER CURVE
100 m 0
Arthur Laffer suggested that up to point m,
higher tax rates will result in larger tax
revenues. Tax revenues decline beyond some point
(m) because higher tax rates discourage economic
activity which diminishes the tax base.
m
l
Tax Revenue (dollars)
124
Supply-siders also claim that governments
regulatory involvement in the economy has
adversely affected productivity and long-run
aggregate supply. They claim that government
regulation 1) creates monopolies and cartels,
especially in transportation and communications,
and 2) increases the cost of doing business when
imposing industry response to pollution, product
safety, worker health and safety, and equal
access to job opportunities.
125
The Laffer Curve
http//www.pbs.org/newshour/bb/business/jan-june12
/makingsense_01-11.html
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Compiled by Virginia H. Meachum Coral Springs
High School Sources Principles, Problems, and
Policies, by Campbell McConnell Stanley
Brue Economics, by Krugman, Wells Principles of
Economics, by N. Gregory Mankiw Notes by Florida
Council on Economic Education and FAU Center for
Economic Education Notes by Foundation for
Teaching Economics