CHAPTER 13: SECTION 1 Fiscal Policy Two Types of Fiscal Policy Fiscal policy deals with changes the government makes in spending or taxation to achieve particular economic goals. (See Transparency 13-1.) Transparency 13-1 Expansionary fiscal policy is an increase in government spending or a reduction in taxes. Contractionary fiscal policy is a decrease in government spending or an increase in taxes.

TRANSPARENCY 13-1: Two Types of Fiscal Policy

Expansionary Fiscal Policy and the Problem of Unemployment Government can use expansionary fiscal policy to decrease the unemployment rate. This is how it works: A high unemployment rate is the result of people not spending enough money in the economy. If the government increases spending or reduces taxes, or both, consumers will have more money to spend.

An increase in government spending will mean more spending in the economy. As a result of the increase in total spending, business firms will sell more goods. When business firms sell more goods, they have to hire more workers to produce the additional goods. The unemployment rate goes down because more people are working.

The Issue of Crowding Out Not all economists agree that it is that easy to lower the unemployment rate. They bring up the issue of crowding out. Crowding out occurs when increases in government spending lead to reductions in private spending. For example, if the government spends more on education, people may decide to spend less on education such as private schooling.

When increased spending by the government exactly equals reduced spending by citizens, there is complete crowding out. Incomplete crowding out occurs when the reduction in consumer spending is less than the increase in government spending. In this case, total spending in the economy increases.

Contractionary Fiscal Policy and the Problem of Inflation Inflation is the result of too much spending in the economy compared with the quantity of goods and services available for purchase. The government can slow inflation by reducing the amount that it spends. As a result of the decrease in total spending, firms initially sell fewer goods. To reduce unwanted inventory, firms lower prices.

Fiscal Policy and John Maynard Keynes John Maynard Keynes wrote one of the most influential economic treatises ever written. He disagreed with the classical school view of economics, which states that the economy is self-regulating. Keynes believed that a sick economy cannot always heal itself. When the economy cannot recover on its own, the government should step in and enact an expansionary fiscal policy to stimulate spending.

Fiscal Policy and Taxes After-tax income is the part of income that is left over after taxes are paid. If the government lowers taxes, more money is available from earnings and total spending increases. This leads to increased sales and hiring, reducing the unemployment rate. If the government raises taxes, the opposite occurs. After-tax income is reduced, decreasing spending and causing unemployment to increase. People are more willing to work when taxes are lower. If taxes were 100 percent of earnings, there would be no incentive to work.

Lower tax rates do not necessarily result in lower tax revenues for the government. Lower tax rates will likely give incentive to work more, and may result in increased spending, all of which provides tax revenue for the government. The Laffer curve, named after economist Arthur Laffer, shows the relationship between tax rates and tax revenues. According to the Laffer curve, as tax rates rise from zero, tax revenues rise, reach a maximum at some point, and then fall.

For example, as the tax rate rises from 10 percent to 20 percent, tax revenues might rise from $700 billion to $1,000 billion. (See Transparency 13-2(a)). However, as the tax rate continues to rise, from 80 percent to 90 percent, tax revenues might fall from $1,000 billion to $700 billion. (See Transparency 13-2(b).)Transparency 13-2(a)Transparency 13-2(b)

TRANSPARENCY 13-2: A Hypothetical Laffer Curve The Laffer curve, named after Arthur Laffer, shows the relationship between tax rates and tax revenues.