Chapter 30 Fiscal Policy, Deficits and Debt Government Spending and Taxing! Built-in automatic stabilizers The national budget deficit and national debt

Discretionary Fiscal Policy The deliberate/purposeful change in taxation and/or government spending by Congress (and the Pres) to increase GDP and employment control inflation stimulate economic growth Employment Act of 1946—it’s a law! Council of Economic Advisors Joint Economic Committee

Expansionary Fiscal Policy Typically occurs during recession and will result in a government budget deficit (G>T) 1) Increase G to increase GDP and employment. (remember the multiplier!) and/or 2) Cut T to increase C. Either of these actions, or both in combination, will shift AD to the right and EXPAND the economy.

Tax Reductions Typically during recession (horizontal range of AS) the change in GDP will equal: MPC/MPS x tax cut or MPC x tax cut x multiplier Example: .8/.2 x $10 mil = $40 mil or .8 x $10 mil x 5 = $40 mil (So, if govt. wants to increase C by a specific amount, it must cut taxes by more than C, because some of the tax cut will be saved.)

Try this problem: The economy is in recession, inflation is zero, and Q = $485 billion. Full employment GDP is $505 billion. MPC=.75 The govt. has passed a stimulus bill of $1.25 billion. How much should the govt. cut taxes? (you may use a calculator)

Contractionary Fiscal Policy Used to control demand-pull inflation In this situation, fiscal policy should move the govt. towards a budget surplus. 1) Decrease G and/or 2) Increase T (by more than desired change in C) Will shift AD to the left!

Try this problem: The economy is experiencing high inflation and is at full employment GDP. MPC = .8 How much will AD shift if G declines by $2 billion and T rises by $5 billion? What changes in your AD/AS model?

Nondiscretionary Fiscal Policy The economy has built-in automatic stabilizers. These stabilizers tend to move the budget toward a deficit during a contraction (G>T) or toward a surplus (T>G) during expansion without requiring action by Congress.

Taxes vary directly with GDP Net taxes = tax revenues less transfer payments and subsidies Graph:

Economic Importance Progressive Income Taxes reduce spending and decrease AD during expansion It is desirable to reduce spending when the economy is moving toward inflation and to increase spending when the economy is slumping. As GDP rises, T rises (automatically), which restrains economic expansion (and vice versa!)

Steepness of T Depends on the progressivity of the tax system. The more progressive, the greater the built-in stability. Tax brackets (7): 10%-37% (formerly 39.6%) Proportional tax system (flat tax) Regressive tax system (sales tax)

Actual vs. Full Employment Budget Graph again… Cyclical + Structural = Actual Budget Deficit How would a Balanced Budget Requirement affect the economy in a recession?

Identify: Is it Automatic or Discretionary; Expansionary or Contractionary ? 1. The government cuts personal income tax rates 2. The govt. eliminates favorable tax treatment on long-term capital gains. 3. Incomes rise; as a result, people pay a larger fraction of their income in taxes. 4. As a result of a recession, more families qualify for food stamps and welfare benefits. 5. The govt. eliminates the deductibility of mortgage interest expense for tax purposes. 6. The govt. launches a major new space program to explore Mars.

More scenarios… 7. The govt. raises Social Security & Medicare taxes. 8. Corporate profits increase; as a result, govt. collects more corporate income taxes. 9. The govt. reduces corporate income tax rates. 10. The govt. gives all its employees a large pay raise.

Fiscal Policy: Problems, Criticisms, Complications Problems of timing Recognition Lag—use of trailing economic indicators. (Forecasting tools not foolproof) Administration Lag—implementation Operational Lag—time between action and effect

Political Problems Other goals may take precedence. State and local finances offset federal fiscal policy. Expansionary bias Voters like tax cuts and govt. programs Political business cycle—elections rule.

Crowding Out Effect Expansionary fiscal policy creates a budget deficit that is financed by govt. borrowing. This increased borrowing may increase interest rates, which may lead to less private spending (I) Crowding out may be offset by ID shift to right, if public spending leads to greater confidence or expected returns.

Deficit and Debt Debt to the Penny (Daily History Search Application) Congressional Budget Office - Home Page Office of Management and Budget | The White House