13 FISCAL POLICY Government Spending and Tax Policy Part 1

In this chapter: Look at the federal budget the recent history of outlays, receipts, deficits, and debt Explain the supply-side effects of fiscal policy –supply side economics Explain how fiscal policy choices redistribute benefits and costs across generations Review how fiscal stimulus is used to fight a recession

The Federal Budget Federal budget - annual statement of the federal government’s outlays and tax revenues. Has two purposes: 1. Finance federal government programs and activities 2. Achieve macroeconomic objectives Fiscal policy - use of the federal budget to achieve macroeconomic objectives, such as full employment, economic growth, and price stability.

Fiscal policy framework The Employment Act of 1946 Fiscal policy framework . . . it is the continuing policy and responsibility of the Federal Government to use all practicable means . . . to coordinate and utilize all its plans, functions, and resources . . . to promote maximum employment, production, and purchasing power.

The Federal Budget Receipts come from personal income taxes, Social Security taxes, corporate income taxes, and indirect taxes. Personal income taxes are the largest source of receipts. Outlays are transfer payments, expenditure on goods and services, and interest of the debt. Transfer payments are the largest item of outlays. http://federal-budget.insidegov.com/l/119/2016

The Federal Budget Surplus or Deficit Budget balance equals receipts minus outlays (T – (G + Transfers)) or ((T – Transfers) - G) If receipts (T) exceed outlays, the government has a budget surplus. If outlays exceed receipts, the government has a budget deficit. If receipts equal outlays, the government has a balanced budget. The budget deficit in fiscal 2016 was $587 billion. - It was $1,300 billion in 2010.

The Federal Budget 42.8% 33.5% 15.3% 8.4% 63.7% 24.8% 11.5%

The Federal Budget Revenues and outlays as percent of GDP – nominal terms.

The Federal Budget Government debt is the total amount that the government has borrowed. It is the sum of past deficits minus past surpluses. the federal government’s gross debt ... and net debt. https://www.treasurydirect.gov/govt/reports/pd/mspd/2017/opds102017.pdf http://ticdata.treasury.gov/Publish/mfh.txt

Debt and Capital Businesses use debt to buy assets that yield a return (hopefully greater than interest cost). The government uses debt to buy assets that yield a social return - hopefully greater than the interest cost. But, a lot of government debt is incurred to finance consumption and transfer payments with little or no social return. State government spending on highways, education, etc. yield a social return.

Effects of Fiscal Policy How do taxes on personal and corporate income affect real GDP? Some economist argue the effect to be large. They thus argue fiscal policy has important effects on employment, potential GDP, and aggregate supply -called supply-side effects. In chapter 6 we determined how full employment quantity of labor and potential GDP are determined. We first show the supply-side effect of the imposition of an income tax on the full employment quantity of labor and potential GDP change.

Supply-Side Effects of Fiscal Policy We start without taxes. Equilibrium employment is full employment at 250 million and ... the real GDP produced by the full-employment quantity of labor is potential GDP – chapter 6 stuff.

Supply-Side Effects of Fiscal Policy The Effects of an income Tax is to reduce the supply of labor. An income tax drives a wedge between the cost of labor to employers and employee take home pay. The supply of labor decreases because the tax decreases the after- tax wage rate reducing the incentive to work. This section builds on the micro chapters that discuss the effects of taxes. If your students have not yet done a micro course and you want to cover this material, you’ll need to take it slowly and carefully.

Supply-Side Effects of Fiscal Policy The before-tax real wage rate rises, but the after-tax real wage rate falls. The quantity of labor employed decreases. The gap created between the before-tax and after-tax wage rates is called the tax wedge. Note: This example uses a high tax rate, $15 tax on a $35 wage rate - a 43% tax rate. A lower tax rate would have a smaller affect.

Supply-Side Effects of Fiscal Policy When the quantity of labor employed decreases, … potential GDP decreases. The supply-side effect of the income tax is to decrease potential GDP and decrease aggregate supply. Estimates of potential GDP consider taxes currently in place.

Supply-Side Economics Proposes Lower Tax Rates Supply-siders feel income taxes weaken the incentive to work. They propose lowering income tax rates (t) to increase the incentive to work which increases the supply of labor and potential GDP. Lowering income taxes reverse everything on the previous slides. This is a long-run policy aimed at shifting the LAS to the right. Also propose lower corporate tax rates to increase incentive to invest. Big question is how large is the effect on SAS. No consensus on how strong the supply-side effect is. Classroom activity Check out Economics in Action: Some Real-World Tax Wedges

Keynesians and Supply Siders Compared

In the SR: T => Yd =>C => AD => Y Also P Keynesians argue lower tax rates increase AD: Chapter 10, 11 and 12 analysis. P LAS0 SAS0 P1 B P0 A AD1 AD0 Ypot Y1 Y In the SR: T => Yd =>C => AD => Y Also P

But, both the deficit and debt increase. Keynesians argue lower tax rates increase AD. Chapter 10, 11 and 12 analysis. SAS1 P LAS0 SAS0 P3 C P2 B P0 A AD1 AD0 Ypot Y In LR: Y returns to Ypot and the multiplier = 0. But, both the deficit and debt increase.

Supply siders say lower tax rates (t) shift AD right AND also shift LAS and SAS to the right C P4 D P2 B P0 A AD1 AD0 Ypot Ypot1 Y In LR, Ypot increases to Ypot1. P does not rise as much (P4) and the multiplier > 0. Also, (T = t x Y) as potential GDP increases , deficit does not increase as much.

Big Question – How large is the supply-side effect on AS? Larger supply effect P LAS0 LAS1 SAS0 P2 C P3 B P0 A AD1 AD0 Ypot Ypot1 Y