13 FISCAL POLICY Government Spending and Tax Policy Part 2

Supply-Side Effects of Fiscal Policy What about Budget Deficits? Cut T and hold G fixed => increase in budget deficit Government needs to borrow more. The demand for loanable funds increases => interest rates increase => crowding out.

Private investment may be crowded out Without supply-side effect, interest rate increases to 5% real interest rate SLF D 5% A 4% DLF1 DLF0 $1.8 $2.0 loanable funds (Trillions$) Loanable Funds Market

Less crowning out with supply-side effect. With supply-side effect, interest rate does not increase as much real interest rate SLF D SLF lower tax rate 5% A C 4% DLF1 DLF0 $1.8 $2.0 2.1 loanable funds (Trillions$) Loanable Funds Market

The Supply-side Debate Before 1980 few economist paid attention to supply side effects. Reagan and supply siders argued the virtues of cutting taxes. They argued tax cuts would increase employment and growth AND argued tax revenues would increase and the budget deficit would decrease. Reagan cut taxes, the economy expanded but the budget deficit increased.

Generational Effects of Fiscal Policy - SKIP

The Social Security Time Bomb Social Security set up under the New Deal in the 1930s. In 2008, the first of the baby boomers started collecting Social Security and by 2030, all the baby boomers will have reached retirement age The population supported by Social Security will have doubled.

The Social Security Time Bomb The federal government has an obligation to pay To assess the full extent of the government’s obligations, economists use the concept of fiscal imbalance. Fiscal imbalance is the present value of the government’s commitments to pay benefits minus the present value of its tax revenues. Economists estimate the fiscal imbalance was $68 trillion in 2014. - 4 times 2014 GDP of $17 trillion.

The Social Security Time Bomb Alternative solutions: Raise Social Security taxes – raise tax rate and/or applicable income. Raise income taxes Cut Social Security Benefits Increase Eligibility Age – currently 67 Cut Federal Government discretionary spending. Print money – argh!

Fiscal Policy - Discretionary or Automatic Discretionary fiscal policy: ΔG or ΔT policy that is initiated by an act of Congress. This is what we’ve been talking about up to this point. Automatic fiscal policy is a policy action triggered by the state of the economy with no government action.

Automatic Fiscal Policy Two items in the federal government budget change automatically in response to the state of the economy: Tax revenues - we have an income tax system Unemployment benefits

Automatic Changes in Tax Revenues We have an income tax system. Congress sets the tax rate (t) that people must pay. Tax dollars paid depend on tax rates and incomes: T = t x Y. In an expansion, income increases, people automatically pay more taxes cooling down the increase in aggregate demand. In a recession, income decreases, people automatically pay less taxes encouraging spending which increases aggregate demand.

Unemployment Benefits The government has programs that automatically pay benefits (transfer payments) to qualified people and businesses. When the economy is in an expansion, unemployment falls, so unemployment benefits fall, decreasing aggregate demand. When the economy is in a recession, unemployment rises, unemployment benefits increase, increasing aggregate demand.

Automatic Stabilizers. These automatic changes are called Automatic Stabilizers. In a recession, government tax receipts decrease and outlays increase. So the budget provides an automatic stimulus that helps reduce the recessionary gap. In a boom, tax receipts increase and outlays decrease. So the budget provides automatic restraint that helps reduce the inflationary gap.

Fiscal Stimulus - Expansionary Fiscal Policy Discretionary Fiscal Policy Revisited. As discussed in Chapters 10, 11 and 12 Changes in government expenditure and taxes change aggregate demand and have multiplier effects. Two main fiscal multipliers are Government expenditure multiplier Tax multiplier Classroom activity Check out Economics in Action: The 2009 Fiscal Stimulus Package

Discretionary Fiscal Policy a recessionary gap - $1 trillion in this example. An increase in government expenditure or a tax cut increases aggregate expenditure. The multiplier process increases aggregate demand even more.

Which effect is stronger? But…….. an increase in government expenditure increases government borrowing increases the demand for loanable funds and raises the real interest rate. With the higher cost of borrowing, investment decreases, which partly offsets the increase in government expenditure – crowding out. Which effect is stronger? Statement page 339: “The consensus is that the crowding-out effect is strong enough to make the government expenditure multiplier less than 1”. Need to be careful here. What’s the Fed doing? If the Fed lets interest rates rise, the multiplier may be <1. If the Fed prevents interest rates from rising, multiplier >1.

Tax multiplier The tax multiplier is the quantitative effect of a change in taxes on aggregate demand. “The demand-side effects of a tax cut are likely to be smaller than an equivalent increase in government expenditure”. That is the tax multiplier < government spending multiplier. This occurs because a change in government spending directly increases income, while a change in T affects Yd and not clear how much is spent. Classroom activity Check out Economics in Action: How Big Are the Fiscal Stimulus Multipliers?

Fiscal Stimulus and Aggregate Supply Do tax cuts have supply-side effects? Will labor supply increase? Will saving and investment increase? Will LAS shift to the right increasing growth and potential GDP? Fiscal policy in practice. Most economists acknowledge that, in principle, discretionary fiscal policy can be used for stabilization purposes, but in practice such stabilization is extremely difficult because of long legislative lags. It is worth reminding the students that the equilibrium in the AS-AD model takes time to work out. The multiplier is a long drawn out process. An increase in government expenditures shifts the AD curve rightward but the new equilibrium price level and real GDP take time to occur. It is also useful to discuss the differences between the potential of fiscal policy under a parliamentary system and under the more rigid U.S. system; the length of time it took the congress to pass the 2002 ‘stimulus’ package, compared to almost immediate executive-initiated changes to fiscal policy in Britain, make the point that discretionary fiscal policy is feasible under some governmental systems but only in extreme circumstances in the world’s largest economy.

Fiscal Stimulus and Aggregate Supply Do tax cuts have supply-side effects? Economics in Action, pp. 340 and 341, refers to three studies that indicate: “the supply-side effects of a tax cut probably dominate the demand-side effects and make the tax multiplier larger than the government expenditure multiplier.” This is what economist debate about. Also, you can see where politics can come into play? Fiscal policy in practice. Most economists acknowledge that, in principle, discretionary fiscal policy can be used for stabilization purposes, but in practice such stabilization is extremely difficult because of long legislative lags. It is worth reminding the students that the equilibrium in the AS-AD model takes time to work out. The multiplier is a long drawn out process. An increase in government expenditures shifts the AD curve rightward but the new equilibrium price level and real GDP take time to occur. It is also useful to discuss the differences between the potential of fiscal policy under a parliamentary system and under the more rigid U.S. system; the length of time it took the congress to pass the 2002 ‘stimulus’ package, compared to almost immediate executive-initiated changes to fiscal policy in Britain, make the point that discretionary fiscal policy is feasible under some governmental systems but only in extreme circumstances in the world’s largest economy.

Problems with using Fiscal Policy for Stabilization (1) Uncertainty about size of the multipliers Economists have diverging views about the size of the fiscal (government spending and tax) multipliers because there is insufficient empirical evidence on which to pin their size with accuracy. This makes it hard, if not impossible, to determine the amount of stimulus needed to close a given output gap. (2) Uncertainty about size of the output gap The actual output gap is not known and can only be estimated with error – What’s potential GDP? Its an estimate!

Problems with using Fiscal Policy for Stabilization (3) Time Lags The use of discretionary fiscal policy is also seriously hampered by three time lags: Recognition (information) lag - the time it takes to figure out that fiscal policy action is needed. Law-making (Implementation) lag - the time it takes Congress to pass the laws needed to change taxes or spending. Impact (Response) lag - the time it takes from passing a tax or spending change to its effect on real GDP being felt.

Attempts to stabilize the economy can prove destabilizing because of time lags. An expansionary policy that should have begun to take effect at point A does not actually begin to have an impact until point D, when the economy is already on an upswing. t0 to t1 is recognition lag, t1 to t2 is implementation, t2 to t3 is response lag. Hence, the policy pushes the economy to points E and F (instead of points E and F). Income varies more widely than it would have if no policy had been implemented.

Can Overshoot Real Income Target P AS G↑ by $200b I↑ Ptarget AD2 P0 AD1 AD0 Y Y0 Ytarget Target ΔY=400 Even if we know the size of the output gap and the multiplier, we can miss the target if not timed perfectly.