Chapter 11 fiscal policy, deficits, and debt ECON 201 Macroeconomics Chapter 11 fiscal policy, deficits, and debt

Learning Objectives The purposes, tools, and limitations of fiscal policy. The role of built-in stabilizers in moderating business cycles. How the standardized budget reveals the status of U.S. fiscal policy. About the size, composition, and consequences of the U.S. public debt.

Review Inflation –rise in the general price levels. Stagflation - period of inflation combined with stagnation (slow economic growth, rising unemployment, could include recession). Both inflation & stagnant business activity. Recession - decline in a country's real gross domestic product (GDP). Demand-Pull Inflation-Increases in the price level (inflation) resulting from an excess of demand over output at the existing price level (caused by an increase in aggregate demand).

Stabilize the Economy Please! One major function of the government is to stabilize the economy (prevent unemployment or inflation). Stabilization – achieved by manipulating the public budget—government spending and tax collections—to increase output and employment or to reduce inflation.

Fiscal Policy and the AD/AS Model Discretionary (active) fiscal policy - Deliberate manipulation of taxes and government spending by Congress to alter real domestic output and employment, control inflation, and stimulate economic growth.

Discretionary Initiated by the President, on the advice of the Council of Economic Advisers (CEA). “Discretionary” means the changes are at the option of the Federal government.

Council of Economic Advisers (CEA) CEA - established by the Employment Act of 1946. Provides President economic advice on domestic and international economic policy issues. CEA - 3 members, appointed by the President, by and with the advice and consent of the Senate.

Council of Economic Advisers (CEA) Visit their Website to learn more: http://www.whitehouse.gov/cea/

Fiscal Policy Choices (What to do?) Expansionary Fiscal Policy Used to combat a recession. Increase in government spending. Decrease in taxes. Combination of increased spending and reduced taxes. (If the budget was initially balanced, expansionary fiscal policy creates a budget deficit)

Expansionary Fiscal Policy Figure 11.1 Full $20 Billion Increase in Aggregate Demand $5 Billion Additional Spending AS Recessions Decrease Aggregate Demand P1 Price Level AD1 AD2 $490 $510 Real Domestic Output, GDP

Contractionary Fiscal Policy Used to combat demand-pull inflation. Decrease government spending Increase in taxes will reduce income and then consumption. Combined spending decrease and tax increase could have the same effect. When the economy faces demand-pull inflation, fiscal policy should move toward a government budget surplus (tax revenues in excess of government spending.

Contractionary Fiscal Policy Recessions Decrease Aggregate Demand $5 Billion Initial Decrease In Spending AS Price Level Full $20 Billion Decrease in Aggregate Demand P1 AD4 AD3 $510 $522 Real Domestic Output, GDP

Policy Options: G or T? Which to use ? (G) Government Spending Or (T) Taxes (Is the government too big or too small?)

Policy Options: G or T? Economists who believe there are unmet social & infrastructure needs favor: Higher Government spending during recessions. Higher Taxes during inflationary times if they are concerned about unmet social needs or infrastructure. (both expand size of govt.) Economists who think that the Govt. is too large and inefficient favor: Lower Taxes for recessions. Lower Government spending during inflationary periods when they think government is too large and inefficient. (both restrain govt. size)

Built-In Stability Wouldn’t that be nice? Built‑in stability - because net taxes (taxes minus transfers and subsidies) change with GDP. (taxes reduce incomes and therefore, spending) We Want -spending to rise when the economy is slumping and vice versa when the economy is becoming inflationary.

Built-In Stability Taxes automatically rise with GDP because incomes rise and tax revenues fall when GDP falls. Transfers and subsidies rise when GDP falls; when these government payments (welfare, unemployment, etc.) rise, net tax revenues fall along with GDP. Transfer payments (“negative taxes”) behave in the opposite way from tax revenues: Welfare goes down during economic expansion and up in economic contraction.

Automatic Stability? Size of automatic stability depends on responsiveness of changes in taxes to changes in GDP: The more progressive the tax system, the greater the economy’s built‑in stability.

Automatic Stability U.S. tax system reduces business fluctuations by as much as 8 to 10 percent of the change in GDP that would otherwise occur. Automatic stability reduces instability, but does not eliminate economic instability.

Automatic or Built–In Stabilizers A built-in stabilizer – anything that increases the government’s budget deficit (or reduces its budget surplus) during a recession and increases its budget surplus(or reduces its budget deficit) during an expansion without requiring explicit action by policymakers. (U.S. tax system) Govt. Budget Deficit- govt. spending in excess of tax revenues.

Built-In Stability Government Expenses, G and Tax Revenues, T Surplus Deficit GDP1 GDP2 GDP3 Real Domestic Output, GDP

Tax Progressivity How well do tax revenues respond to changes in GDP? Progressive tax system Proportional tax system Regressive tax system The more progressive a tax system, the greater the economy’s built-in stability.

Evaluating Fiscal Policy How to determine if discretionary fiscal policy is expansionary, neutral, or contractionary? Must adjust deficits & surpluses to eliminate automatic changes in tax revenues & compare the sizes of the adjusted budget deficits (or surpluses) to the levels of potential GDP.

Evaluating Fiscal Policy, cont. Standardized (full employment)Budget. Used to adjust Federal budget deficits & surpluses to eliminate the automatic changes in tax revenues. Measures what the Federal budget deficit or surplus would be with existing tax rates and Gov spending levels if the economy had achieved its full-employment level of GDP each year.

What??? Standardized Budget Compares actual government expenditures for each year with the tax revenues that would have occurred in that year if the economy had achieved full-employment GDP. Make Believe “at full employment”

Evaluating Fiscal Policy Government Expenses, G and Tax Revenues, T b a $500 G $450 c GDP2 GDP1 (Year 2) (Year 1) Real Domestic Output, GDP

Evaluating Fiscal Policy d Government Expenses, G and Tax Revenues, T $500 G $475 h $450 f $425 g GDP4 GDP3 (Year 4) (Year 3) Real Domestic Output, GDP

Recent U.S. Fiscal Policy Federal Deficits and Surpluses – 1990 - 2005 as a Percentage of Potential GDP (1) Year (2) Actual Deficit (-) or Surplus (+) (3) Standardized 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 -3.9% -4.4% -4.5% -3.8% -2.9% -2.2% -1.4% -0.3% +0.8% +1.4% +2.5% +1.3% -1.5% -3.4% -3.5% -2.6% -2.2% -2.5% -2.9% -2.1% -2.0% -1.2% -1.0% -0.4% +0.1% +1.1% -1.1% -2.7% -2.4% -1.8%

Problems, Criticisms and Complications Problems of timing Recognition lag: time between the beginning of a recession or inflation and the certain awareness that it actually happening. Administrative Lag: is the difficulty in changing policy once the problem has been recognized. Operational lag: is the time elapsed between change in policy and its impact on the economy.

Problems, Criticisms and Complications Political Considerations Government has other goals besides economic stability, and these may conflict with stabilization policy. War?? Elections???? Gas prices are down. A political business cycle may destabilize the economy: Election years have been characterized by more expansionary policies regardless of economic conditions.

Problems, Criticisms and Complications of Fiscal policy Future Policy Reversals – lesson here is: tax-rate changes that households view as permanent are more likely to alter consumption and aggregate demand than tax changes they view as temporary. Offsetting State & Local finance Crowding-out Effect

The Crowding‑Out Effect May be caused by fiscal policy and indicates that an expansionary fiscal policy may increase the interest rate and reduce investment spending. occurs when the gov expands borrowing to finance increased expenditure, or cuts taxes (i.e. is engaged in deficit spending) crowding out private sector investment by way of higher interest rates. Controversy on the subject, it is because of disagreements about how financial markets would react to more government borrowing.

The Public Debt Total accumulation of the deficits(minus surpluses) the Federal government has incurred through time. The public debt was $7.96 trillion in 2005. What is it today?

Total Debt: $7.96 Trillion 2005 Debt Held Outside The Federal Government and Federal Reserve (49%) Debt Held by the Federal Government and Federal Reserve (51%) Other – Including State and Local Governments U.S. Banks And other Financial Institutions 8% 8% 9% Federal Reserve 25% Foreign Ownership 42% U.S. Government Agencies 8% U.S. Individuals Source: U.S. Treasury

Interest charges are the main burden imposed by the debt. Interest on the debt was $184 billion in 2005. Fourth largest item in the Federal budget. Interest payments were 1.5 percent of GDP in 2005. The % is important b/c it represents the average tax rate necessary just to cover annual interest on the debt.

False Concerns False concerns about the federal debt include several popular misconceptions: Bankruptcy Refinancing Taxation Burdening Future Generations

Substantive Issues Repayment of the debt affects income distribution. Since interest must be paid out of government revenues, a large debt and high interest can increase tax burden and may decrease incentives to work, save, and invest for taxpayers.

More Substantive Issues A higher proportion of the debt is owed to foreigners (about 18 percent) than in the past, and this can increase the burden since payments leave the country. But Americans also own foreign bonds and this offsets the concern.

End CH 11