Chapter 15 Fiscal Policy

15.1 Understanding fiscal policy Fiscal policy is the use of government spending and revenue collection to influence the economy The fed govt spends about $250 million dollars every hour which accounts for $ 6 billion daily This amount of money has a tremendous impact on demand and supply in the economy Fiscal policies are used to achieve economic growth, full employment and price stability The govt deciding how much to spend and how much to tax are important decisions

The budget A new fed budget is prepared for each fiscal year The fiscal year is Oct 1 – Sept 30 Each fed budget takes about 18 months to prepare and goes through two branches of govt, many govt agencies and committee revision before it is finished Each federal agency will submit to the Office of Management and Budget how much they will need The OMB will review request and typically give less The OMB then combines all requests and forms the budget to send to Congress

Congress will initially have their Congressional Budget Office review the financial package Each house will break the budget into subject matter pieces and hold hearings and study if the budget should be passed or altered If all appropriations bills aren’t passed by Sept 30 and Congress and the Pres can’t agree on a temporary funding proposal then the govt will “shut down” Happens very infrequently

Expansionary vs. Contractionary policies Expansionary policies involve the govt trying to raise the level of output in the economy This is done to try to prevent a recession or to pull the country out of a recession To do this the govt can either increase govt spending or cut taxes If the govt buys more goods or services this in turn will create jobs If the fed govt cuts taxes then individuals have more money to go out and spend on goods which will also create jobs

Contractionary policies attempt to decrease total demand and thus reducing economic growth This is done during periods of high inflation (when there is too much money chasing too few products thus causing prices to rise sharply) Inflation cuts into individual purchasing power and eventually discourages economic growth and stability The govt can either spend less and thus will slow down GDP growth or they can tax more and thus do the same.

Limits of Fiscal Policy 1. Increasing or decreasing the amount of federal spending is hard to do 60% of the fed budget is made up entitlement programs and so only 40% of the total budget can be altered People tend to rally around programs effecting them and so the govt has a hard time cutting much 2. Predicting the economic future can be very challenging Ideally the govt would use fiscal policies before any big changes in GDP and that is difficult to achieve

3. Delayed results Once change in fiscal policy is made it could take over a year to see the result in the budget and then even longer to see how the change in spending/taxes affects the economy By the time the policy takes effect, the economy might be moving in another direction 4. Political Pressure Govt officials more often have an incentive to practice expansionary policies since these policies are popular with voters Contractionary policies are not very popular and elected officials may not want to make them (even if warranted)

5. Coordinating fiscal policy To work well various govt agencies and branches have to work well together The feds also need to be on the same page as the states and local govts and that isn’t always possible Ex: the Fed might cut taxes to promote growth while at the same time the states/local govt might hike up their prop/income taxes to balance the state budgets and thus GDP growth never takes place Another concern is that one area of the nation might need the US govt to create expansionary policies but another doesn’t and so who wins?

14. 2 Fiscal policy options Prior to 1930s classical economics ruled the nation Classical economics believes that in a free market people will act in their own self interest This self interest will cause prices to rise or fall so that supply and demand will always fall to equilibrium Free markets could and should regulate themselves with no government interference

The Great Depression challenged this thinking Classical economists believed that everything would work out in the end even during the perils of the Great Depression John Maynard Keynes felt differently – “In the long run we all are dead” He developed a new theory of economics in 1936 called Keynesian or demand-side economics His policy gives a government a much more prominent role in managing the economy

Keynesian economics Keynes focused on study supply and demand of the country as a whole (macro)vs. the study of individual habits (micro) He felt that the only way the country could get out of the depression was that someone would need to start spending and the only organization in that position was the US govt The govt could make up for the loss of consumer spending by buying up goods and services on its own This would encourage production and increase employment With people back to work, they could spend their wages on goods and services too …thus creating an ever expanding cycle of progress This was also called demand side economics

Keynesian economists see the economy composed of three sectors – individuals, business and the government and that the govt should always make up for changes in the other two This assumes a much more active role for the US govt The fed govt should keep track of total spending and as total spending begins to fall --- the govt can respond by increasing its own spending until the private sector increases or It can cut taxes FDR used this policy and put people to work building dams, schools, planting forests and painting murals

Many people do not like when the govt shifts employment from private to public sector Many people argue that work relief jobs are less productive than private sector jobs because their goal is employment and not productivity Keynes also felt that contractionary fiscal policy could be used to limit inflation The govt could reduce inflation by either increasing taxes or reducing its own spending

Multiplier effect Though fiscal policy is difficult to control, it has proven to be a powerful tool due to the multiplier effect The multiplier effect – every one dollar spent on fiscal policies creates a greater than one dollar change in the national income The effects of changes in fiscal policy are multipled Spending an extra $10 billion to stimulate the economy can actually lead to increase of $50 billion in GDP Read 398 for a further explanation

Keynesian economists believe that a strong fiscal policy can achieve a more stable economy Since we began using this theory, the GDP still fluctuates from year to year, but not as much as before See chart on page 398

Supply-side economics Promotes a different approach to fiscal policy Supply-siders believe that taxes have a negative effect on the economy Supply siders try to increase economic growth by increasing aggregate supply vs. the govt changing aggregate demand Supply siders often used the Laffer curve to demonstrate the effects of taxes The Laffer curve illustrates that high tax rates may not bring in much revenue if these high tax rates cause economic activity to decrease See chart on 399

At a higher tax rate some might be discouraged from working so many hours and companies also might be discouraged from investing and increasing production A higher tax rate could cause a sharp drop in tax revenue Supply-siders believe that a tax cut increases total employment so much that the govt will actually collect more taxes at the new, lower rate.

Fiscal policy in the US Hoover was influenced by classical economists and believed that they economy would become sound again on its own FDR was much more willing to increase govt spending during the Depression and during WWII The additional demand for goods brought us out of the economic turmoil Congress created the CEA, the Council of Economic Advisors after WWII CEA is a group of three respected economists who would advise the president on economic policy Some presidents put in Keynesians and other put in supply-siders

Kennedy has a minor recession on his hands He was encouraged to cut tax rates to create full employment. He followed the Keynesian model He dropped the highest individual tax rate (then 90% and today less than 40%) and the highest corp tax rate (then 52% and today less than 35%) Supply-siders had a friend in Reagan He reduced taxes by 25% in three years. He did not believe that GOVT spending would get a country out of recession However, Reagan, Bush 41 and Clinton spent much more money than they took in.

15.3 Budget deficits and national debts The federal budget ideally would always be budget, but that almost never happens Surpluses while preferred are less seen compared to deficits A deficit can be caused by either increasing expenditures while not collecting more taxes or cut taxes while not cutting expenditures The deficit was $400 billion in 2004 It was ___________ in ___________. When the govt runs into a deficit it must find a way to pay for the extra expenditures

It can either create new money to pay for whatever is needed This can be done if the deficit is small otherwise inflation will result Too much money in the money supply chasing too few goods will cause prices to rise The other option the govt has is to borrow money They do this by selling bonds People and businesses buy US bonds because they are a good investment

The National Debt Every year that the US govt borrows money it adds to the national debt The national debt is now over $18 trillion dollars It was over $7 trillion in 2004 Typically, debt rises during wartime, when govt spending increases faster than taxation and then falls during peacetime In the 1980s we began running into huge debts even during peacetime Reagan brought record tax relief to the nation, but dramatically increased military spending at the exact time

Is debt a problem? 1. Having a national debt reduces funds available for businesses to invest Instead of taking money made and placing it into their own companies many companies take the safe investment and buy US bonds and thus limit their own growth For every dollar that is spent on a govt bond there is one less dollar invested in an American company This is called the crowding-out effect

2. The government has to pay back interest to all bond holders The more it borrows, the more it has to pay back Servicing the debt is required annually We spend over $250 billion a year just paying interest This is money that could be used to fund schools, health care, etc.

Efforts to reduce deficits Many national attempts have been made In 1995 a balanced budget amendment passed through the House and was one vote away from passing in the Senate Supporters believed it would cause the govt to be more disciplined Opponents worried that it would limit the government’s flexibility when dealing with economic crises. At the end of the 1990s the US had a surplus Created from lower spending and higher amount collected in taxes

Surpluses dried up quickly post 9/11 The war on terrorism, end of a stock market boom and a further cut on income taxes meant deficits returned