Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Reading Questions Extended ●Reading #1- What does the Laffer Curve illustrate? Use the concept of the Laffer Curve to explain why the anticipated accelerated tax burden may create major problems for the US in the foreseeable future.

11 Managing Aggregate Demand: Fiscal Policy Next, let us turn to the problems of our fiscal policy. Here the myths are legion and the truth hard to find. JOHN F. KENNEDY Managing Aggregate Demand: Fiscal Policy Next, let us turn to the problems of our fiscal policy. Here the myths are legion and the truth hard to find. JOHN F. KENNEDY

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Goal #1: ●Explain the role of taxes and government spending and impact on the GDP.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Income Taxes and the Consumption Schedule ●Disposable Income DI = Y – T ♦T = Taxes ♦Y = Gross Domestic Product ●Changes in taxes affect consumption ♦  taxes   DI   C ♦  taxes   DI   C ●Disposable Income DI = Y – T ♦T = Taxes ♦Y = Gross Domestic Product ●Changes in taxes affect consumption ♦  taxes   DI   C ♦  taxes   DI   C

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. The Multiplier Revisited ●  government purchases of goods and services   total spending directly through the G component of C + I + G + (X - IM). ●  taxes   total spending indirectly by lowering disposable income and, thus, reducing the C component of C + I + G + (X - IM). ●  government purchases of goods and services   total spending directly through the G component of C + I + G + (X - IM). ●  taxes   total spending indirectly by lowering disposable income and, thus, reducing the C component of C + I + G + (X - IM).

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. The Multiplier Revisited ●Tax Multiplier ♦Multiplier for  T < Multiplier for  G ■G affects AD directly ■T changes only disposable income ■Resulting  consumption <  disposable income ●Tax Multiplier ♦Multiplier for  T < Multiplier for  G ■G affects AD directly ■T changes only disposable income ■Resulting  consumption <  disposable income

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Using the Multiplier ●$30b. Recessionary gap (MPC=.9) ●$50b. Inflationary gap (MPC=.75) Graph What is the necessary change to G and T to fix each problem ●$30b. Recessionary gap (MPC=.9) ●$50b. Inflationary gap (MPC=.75) Graph What is the necessary change to G and T to fix each problem

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Planning Expansionary Fiscal Policy ●Three types of fiscal policy can be used to stimulate the economy: ♦  G ♦  T ♦  Transfer payments (same as G) ●Three types of fiscal policy can be used to stimulate the economy: ♦  G ♦  T ♦  Transfer payments (same as G)

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Where to Cut From “G”??? ●Roads & Transportation ●Military & Homeland Defense ●Research & Development (NASA) ●S.S. (Medicare & Medicaid) ●Welfare ●Unemployment ●Other ●Roads & Transportation ●Military & Homeland Defense ●Research & Development (NASA) ●S.S. (Medicare & Medicaid) ●Welfare ●Unemployment ●Other

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. How to Change “T”? ●Corporate Taxes ●Death Tax ●Capital Gains Tax ●Income Tax ●Corporate Taxes ●Death Tax ●Capital Gains Tax ●Income Tax

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Planning Contractionary Fiscal Policy ●Three types of fiscal policy can be used to slow the economy: ♦  G ♦  T ♦  Transfer payments ●Three types of fiscal policy can be used to slow the economy: ♦  G ♦  T ♦  Transfer payments

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Expansion With/Out Deficit ●  G with  T = ●  G with  T= ●  G with  T= ●  G with  T= ●  G with  T = ●  G with  T= ●  G with  T= ●  G with  T=

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. The Choice Between Spending and Tax Policy ●The choice between G and T reflects a difference in opinion about the desirable size of the government sector. ♦Advocates of small government prefer: ■To lower T in order to stimulate output ■To lower G to control inflation ♦Advocates of big government prefer: ■There is nothing about an activist fiscal policy that implies a preference for big government. ●The choice between G and T reflects a difference in opinion about the desirable size of the government sector. ♦Advocates of small government prefer: ■To lower T in order to stimulate output ■To lower G to control inflation ♦Advocates of big government prefer: ■There is nothing about an activist fiscal policy that implies a preference for big government.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Some Harsh Realities ●A fiscal policy planner’s job is not simple. ♦Economic variables change continuously. ♦The “policy target” is constantly moving. ♦ Economists have only an uncertain knowledge of the value of the multiplier and the full- employment level of GDP. ♦Forecasts are uncertain and policies take time to work. ●A fiscal policy planner’s job is not simple. ♦Economic variables change continuously. ♦The “policy target” is constantly moving. ♦ Economists have only an uncertain knowledge of the value of the multiplier and the full- employment level of GDP. ♦Forecasts are uncertain and policies take time to work.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. The Idea Behind Supply-Side Tax Cuts ●Supply-side economics = idea that  taxes   AS  ♦  GDP ♦  price level ●Supply-side economics = idea that  taxes   AS  ♦  GDP ♦  price level

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. The Idea Behind Supply-Side Tax Cuts ●The tax cuts particularly favored are: ♦Lower personal income tax rates ♦Lower or even zero taxes on income from saving ♦Lower taxes on capital gains ♦Lower corporate income taxes ●The tax cuts particularly favored are: ♦Lower personal income tax rates ♦Lower or even zero taxes on income from saving ♦Lower taxes on capital gains ♦Lower corporate income taxes

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. The Idea Behind Supply-Side Tax Cuts ●Some Flies in the Ointment ♦The small magnitude of the likely effects ♦The large effects on aggregate demand ♦The problems in timing ■The supply effects will take a long time to occur ■The demand effects will take only a short time ♦The effects on income distribution ♦The loss of tax revenue ●Some Flies in the Ointment ♦The small magnitude of the likely effects ♦The large effects on aggregate demand ♦The problems in timing ■The supply effects will take a long time to occur ■The demand effects will take only a short time ♦The effects on income distribution ♦The loss of tax revenue

FIGURE 7: A More Pessimistic View of Supply-Side Tax Cuts Copyright © 2006 South-Western/Thomson Learning. All rights reserved. D 0 D 0 S 0 S 0 Price Level Real GDP E S 1 S 1 D 1 D 1 C

Appendix A: Graphical Treatment of Taxes and Fiscal Policy

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Graphical Treatment ●Fixed taxes = taxes that do not vary with GDP ♦  fixed tax  parallel shift down in the consumption function ●Fixed taxes = taxes that do not vary with GDP ♦  fixed tax  parallel shift down in the consumption function

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Graphical Treatment ●Variable taxes = taxes that do vary with GDP ♦Examples ■Personal income tax ■Corporate income tax ■Sales tax ♦  tax rate  flattens the consumption schedule ●Variable taxes = taxes that do vary with GDP ♦Examples ■Personal income tax ■Corporate income tax ■Sales tax ♦  tax rate  flattens the consumption schedule

FIGURES 1 and 8: Comparison of Fixed versus Variable Taxes Copyright © 2006 South-Western/Thomson Learning. All rights reserved. C Real Consumer Spending Real GDP C Real Consumer Spending Real GDP Variable tax cut Variable tax increase Fixed tax cut Fixed tax increase

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Graphical Treatment ●Changes in both fixed and variable tax ♦Cause a shift and change in the slope of the consumption function ●Changes in both fixed and variable tax ♦Cause a shift and change in the slope of the consumption function

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. TABLE 2: Consumption and GDP with Fixed versus Variable Tax

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. FIGURE 9: The Consumption Schedule, Fixed & Variable Taxes Copyright © 2006 South-Western/Thomson Learning. All rights reserved. C 1 Real Consumer Spending Real GDP C 2

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Graphical Treatment ●Tax Multipliers ♦Changes in government purchases have a larger effect on equilibrium GDP because they affect total spending directly. ♦Changes in taxes affect total spending indirectly by lowering disposable income and, thus, changing the C component of C + I + G + (X - IM). ●Tax Multipliers ♦Changes in government purchases have a larger effect on equilibrium GDP because they affect total spending directly. ♦Changes in taxes affect total spending indirectly by lowering disposable income and, thus, changing the C component of C + I + G + (X - IM).