Fiscal Policy Chapter 31 Notes.

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Presentation transcript:

Fiscal Policy Chapter 31 Notes

The Federal Budget Federal Budget: An annual statement of the revenues, outlays, and surplus or deficit of the government of the United States Two Purposes To finance the activities of the federal government (only purpose until Great Depression) To achieve macroeconomic objectives (arose as a result of the Great Depression)

The Federal Budget Made by the President and Congress Proposed by President between the first Monday of January and the first Monday in February for the next fiscal year Passed by Congress Fiscal Year: October 1 – September 30 You can learn about the federal budget at budget.house.gov

Budget Balance = Tax Revenues – Government Expenditures

Budget Balance Budget Surplus: when tax revenues exceed government expenditures Balanced Budget: when tax revenues equal government expenditures Budget Deficit: when government expenditures exceed tax revenues

Sources of Government Revenue Tax Revenues (85%) Income Taxes Corporate Taxes Customs/Duties Excise Taxes Social Security Taxes Medicare Taxes Other Taxes Borrowing (15%)

From What Countries Does the US Borrow Money?

Breakdown of Government Expenditures US Treasury divides budget into three subcategories Mandatory Spending: spending on programs required by current law (Transfer Payments: Benefits and Welfare) Discretionary Spending: spending that can be adjusted yearly Interest on Debt

Calculate the Current Budget Balance Government Revenues Tax Revenues Borrowing Total Revenue Government Revenues Tax Revenues $3.18 trillion Borrowing $0.58 trillion Total Revenue $3.76 trillion Government Expenditures Discretionary $1.11 trillion Mandatory $2.45 trillion Interest on Debt $0.23 trillion Total Expenditures $3.79 trillion Government Expenditures Discretionary Mandatory Interest on Debt Total Expenditures Budget Balance $0.03 trillion Budget Balance

Budget Balances for US

During a recession, does the US government typically spend more? Trick question! The Budget Balance shows BOTH revenues and expenditures. It is unclear as to whether the government is increasing its expenditures (spending more on transfer payments) or just decreasing its revenues (lowering the tax rates or providing more tax breaks)

Trick question! The Budget Balance shows BOTH revenues and expenditures. It is unclear as to whether the government is increasing its expenditures (spending more on transfer payments) or just decreasing its revenues (lowering the tax rates or providing more tax breaks)

Fiscal Policy Fiscal Policy: The use of the federal budget to achieve the macroeconomic objectives of high and sustained economic growth and full employment Change in Government Expenditures (G) Change in Government Spending Change in Transfer Payments Change in Tax Revenues

The Keynesian View Fiscal stimulus (increase in government spending or a decrease in taxes) boosts real GDP and promotes employment Fiscal stimulus increases AD Remember, AD is affected by anything that affects GDP = C + I + G + NX Spending multiplier (1/MPS) and tax multiplier (MPC/MPS) grow GDP by more than just the change in spending Fiscal stimulus is a great way to combat recession

The Mainstream View Keynesians overestimate the multiplier effect of fiscal stimulus The effects of fiscal stimulus are too small and take too long to be useful Government stimulus crowds out consumption and investment expenditures

Government Expenditure Multiplier When government expenditures increase AD shifts right, increasing GDP As a result, C also increases Government Expenditure Multiplier = 1/MPS (same as the spending multiplier)

Government Expenditure Multiplier Example If the government increases expenditures on education by $10 billion and the MPC = 0.80, how much will GDP increase by?

Tax Multiplier A decrease in taxes increases disposable income, which increases C Tax multiplier = MPC/MPS

Tax Multiplier Example By how much would you have to decrease taxes in order to raise GDP by $10 billion if MPS = 0.20?

Government Expenditure vs. Tax Multiplier Anshula Venkataraman is working as chief economist at the congressional budget office of Herzoslovakia. The country is falling behind on its growth target and the finance minister, Corentin Denis, is sure he has to convince the congress to provide the required stimulus to the economy. Corentin met with Anshula and told her that according to his estimates the GDP must grow by at least $40 billion in order to achieve the target growth rate. The country is already running a budget deficit and Corentin has requested Anshula’s opinion on whether to decrease taxes or increase government expenditures in order to achieve the target with least increase in the budget deficit. An assistant of Anshula has estimated that the country has a marginal propensity to save of 0.25. Draft a response to Corentin’s request on behalf of Anshula.

Transfer Payments Multiplier The effect of a change in transfer payments on AD An increase in transfer payments increases disposable income, which increases C Transfer Payments Multiplier = -MPC/MPS (same as the tax multiplier, but in the opposite direction)

Balanced Budget Multiplier The effect on aggregate demand of a SIMULTANEOUS change in government expenditure and taxes that leaves the budget balance unchanged. What is the effect of a $1 increase in government spending and a $1 increase in taxes?

Balanced Budget Multiplier Example If government spending increases by $20 billion and tax revenues increase by $20 billion, what is the net effect on GDP given an MPC = 0.90?

Balanced Budget Multiplier If both government spending and taxes increase or decrease by the same amount, GDP will increase or decrease by the same amount as the change. Balanced Budget Multiplier = 1

Expansionary Fiscal Stimulus During a recession, the government can increase spending, decrease taxes, or increase transfer payments to increase AD until LR equilibrium is reestablished. GDP PL LRAS SRAS PL2 PL1 AD2 AD1 Y1 Y2

Contractionary Fiscal Policy If real GDP is above potential GDP (high inflation), the government can decrease spending, increase taxes, or decrease transfer payments to decrease AD until LR equilibrium is reestablished. GDP PL LRAS SRAS PL1 PL2 AD1 AD2 Y2 Y1

Automatic Fiscal Policy A fiscal policy action that is triggered by the state of the economy. Known as an Automatic Stabilizer. Ex: increase in unemployment  increase in transfer payments  increase in C  increase in AD  increase in GDP Ex: decrease in income  decrease in tax revenues  increase in disposable income  increase in C  increase in AD  increase in GDP

Induced Taxes Taxes that vary with real GDP An example of an automatic stabilizer As GDP increases, wages increase, which causes taxes on these wages to also increase (remember, the US has a progressive tax system)

Discretionary Fiscal Policy A fiscal policy action that is initiated by an act of Congress Requires a change in a spending program or in a tax law. Ex: Increase in defense spending or cuts in the income tax rate

The US Tax System You will not be tested directly on this, but I want to expose you to this since it will affect EVERY single one of you and most people have no idea how it works.

US Tax System Tax Brackets: Income brackets with varying marginal tax rates Marginal Tax Rate: the rate at a given dollar is taxed. Not all of your income is taxed equally. The US uses a progressive tax system, so each additional dollar gets taxed at a higher rate. Average Tax Rate: the average rate at which all your money is taxed as compared to your total income.

Average Tax Rate The percentage of your total income that is taxed. Liz earns $100,000 a year. Use the tax bracket table to identify her average tax rate.

2015 Tax Rates Marginal Tax Rate Lower Limit Upper Limit Average Tax Rate 10% $0 $9,225 15% $37,450 ? 25% $90,750 28% $189,300 33% $411,500 35% $413,200 39.6% - What are the highest and lowest average tax rates a person within a given tax bracket can pay?

Trump’s Tax Plan

Total Taxes Trump’s Proposal Will Trump’s tax bracket proposal benefit the rich, the poor, both, or neither? Income Total Taxes Old System Average Tax Rate Total Taxes Trump’s Proposal Average Taxes $5,000 $30,000 $53,000 $125,000 $250,000 $412,000 $500,000 $1,000,000

Tax Breaks Discretionary Fiscal Policy People claim tax breaks (deductions), which lower their taxable income, which could potentially drop them to a lower tax bracket. Marital Status Dependents Mortgage Interest Educational Loan Interest Typically the government grants tax breaks to incentivize the public to do things that it deems are socially beneficial.

Standard Deduction (Tax Break) Filing Status Deduction Single $6,300 Married or Widowed with Child $12,600 Head of Household (single, but with a dependent) $9,250 Reduces your taxable income. Taxable income = Income – Deduction

Tax Breaks Complete the Tax Breaks activity What are the effects of granting tax breaks? Do you believe tax breaks are beneficial? Explain.

Tax Breaks Lawmakers write tax breaks into the federal tax code Don’t need to be approved annually. Remain valid until modified by lawmakers Costs the government $1.22 trillion > Discretionary spending of $1.11 trillion The $50K Trick PlanetMoney, “The Long Run” 2:00 – 6:30

Tax Wedge The difference between the price paid by the buyer and the price received by the seller Income taxes create a tax wedge, which incentivizes people to work less. Taxes lower potential GDP. Taxes on consumption (sales taxes) also add to the tax wedge

Effect of Income Tax on Labor and Potential GDP W L GDP LS + T LS Y1 Y2 W2 W1 LD L2 L1 L2 L1

Sticky Prices The idea that in the short-run, prices (and wages) will not adjust downward. Keynesians believe that during a recession, unions will fight cuts to nominal wages, which leads to increased unemployment (LS > LD at a given wage) Additionally, Keynesians believe that because of sticky prices, during a recession, expansionary fiscal policy will have an impact on real GDP, but only a minimal impact on price levels.

**Interest Rates** If the government runs a budget deficit (engages in deficit spending), it funds most of its spending by borrowing money and SELLING bonds. Selling bonds decreases the money supply and increases the real interest rate, crowding out private investment and thus decreasing AD

Monetarist View of Fiscal Policy Remember, monetarism emphasizes the importance of controlling the money supply to control inflation. Typically critical of expansionary fiscal policy, arguing it will only cause inflation or crowding out, and therefore not help

Supply-Side Effects (Mainstream View) Def’n: The effects of fiscal policy on potential GDP and the economic growth rate Occur because the government provides goods and services that increase productivity Operate more slowly than demand-side effects emphasized by Keynesians Often ignored during recession because they act too slowly Considered more effective in the long run

Mainstream View Expansionary fiscal policy causes AD to increase. Government spending ALSO increases productivity by providing goods and services to the public, which causes SRAS to increase. GDP PL LRAS SRAS1 SRAS2 PL2 PL3 = PL1 AD2 AD1 Y1 Y2 Y3

Bias in Fiscal Policy Law-making time lag Shrinking area of law-maker discretion (increasingly difficult to cut budgets) Estimating potential GDP (don’t want to create inflation or cause a recession) Economic Forecasting

The Fiscal Ship Go to https://fiscalship.org/ Select three goals Scan through the various policies and determine how to lower the deficit while also meeting your policy goals. Record the three policies that have the greatest impact on your budget

Research Research one of the following recessions from US history. What was the unemployment rate? What was GDP when the recession started? What was the interest rate? Great Depression April 1960-February 1961 November 1973-March 1975 July 1990-March 1991 Great Recession What fiscal policies were implemented? Were the fiscal policies successful in helping ease the effects of the recession? Why or why not? What were the unemployment rate, level of GDP, and the interest rate after the recession? Is this consistent with the goals of the fiscal policies that were implemented?

Trump’s Budget Proposal http://federal-budget.insidegov.com/l/121/2018-Estimate Each group is responsible for picking a president to research. What did his federal budget look like? How was money earned and spent? Record

Income Tax = Disincentive to Work? Read and discuss the article “Do Higher Taxes Make Us Work Less?” Does an income tax really serve as a disincentive to work?

What’s the effect on the federal budget? What type of fiscal policy should be implemented if you want to decrease the budget deficit? What type of fiscal policy should be implemented if you want to decrease the budget surplus?