Economics: Principles and Applications, 2e by Robert E. Hall & Marc Lieberman © 2001 South-Western, a division of Thomson Learning

Fiscal Policy: Taxes, Spending, and the Federal Budget © 2001 South-Western, a division of Thomson Learning

Thinking About Spending, Taxes, and the Budget When examining budget-related figures over time, it is grossly misleading to use nominal figures, since the price level rises over time. © 2001 South-Western, a division of Thomson Learning

Thinking About Spending, Taxes, and the Budget Budget-related figures such as government spending or the national debt should be considered relative to a nation’s total income. This is why we should always look at these figures as percentages of GDP. © 2001 South-Western, a division of Thomson Learning

Spending, Taxes, and the Budget: Some Background Government SpendingGovernment Spending Federal Tax RevenuesFederal Tax Revenues The Federal Budget and the National DebtThe Federal Budget and the National Debt © 2001 South-Western, a division of Thomson Learning

Spending, Taxes, and the Budget: Some Background Three Categories of Government Spending Government PurchasesGovernment Purchases Transfer PaymentsTransfer Payments Interest on the National DebtInterest on the National Debt © 2001 South-Western, a division of Thomson Learning

Spending, Taxes, and the Budget: Some Background As a percentage of GDP, non-military government purchases have remained very low and stable. They have not contributed to growth in total government spending. © 2001 South-Western, a division of Thomson Learning

Spending, Taxes, and the Budget: Some Background As a percentage of GDP, military purchases have declined dramatically over the past several decades. They have not contributed to any growth in government spending. © 2001 South-Western, a division of Thomson Learning

Spending, Taxes, and the Budget: Some Background The decline in military spending in relation to GDP since the early 1960s has made huge amounts of resources available for other purposes. © 2001 South-Western, a division of Thomson Learning

Spending, Taxes, and the Budget: Some Background In recent decades, transfers have been the fastest-growing part of federal government spending and are currently equal to about 8 percent of GDP. © 2001 South-Western, a division of Thomson Learning

Spending, Taxes, and the Budget: Some Background Over the past several decades, and until the early 1990s, federal government spending as a percentage of GDP rose steadily. The main causes were increases in transfer payments and increases in interest on the national debt that exceeded the decreases in military spending. © 2001 South-Western, a division of Thomson Learning

Spending, Taxes, and the Budget: Some Background From 1992 to 1999, federal government spending as a percentage of GDP fell steadily, although it remained a higher percentage of GDP than in The main causes of the decline have been the continued sharp decreases in military spending and more modest decreases in transfer payments relative to GDP. © 2001 South-Western, a division of Thomson Learning

Spending, Taxes, and the Budget: Some Background Progressive Tax A tax whose rate increases as income increases. © 2001 South-Western, a division of Thomson Learning

Spending, Taxes, and the Budget: Some Background Average Tax Rate The fraction of a given income paid in taxes. Marginal Tax Rate The fraction of an additional dollar of income paid in taxes. © 2001 South-Western, a division of Thomson Learning

Spending, Taxes, and the Budget: Some Background The Social Security tax applies to wage and salary income only. The current tax rate is a flat 15.3 percent, subject to a salary cap. The Social Security tax is actually the largest tax paid by many Americans. © 2001 South-Western, a division of Thomson Learning

Spending, Taxes, and the Budget: Some Background Issues Regarding Other Federal Taxes Corporate Profits TaxCorporate Profits Tax Double TaxationDouble Taxation Excise TaxesExcise Taxes © 2001 South-Western, a division of Thomson Learning

Spending, Taxes, and the Budget: Some Background Federal revenue has trended upward from around 17 percent of GDP in 1959 to around 20 percent in © 2001 South-Western, a division of Thomson Learning

Spending, Taxes, and the Budget: Some Background Deficits--which add to the public’s holding of government bonds--add to the national debt. Surpluses--which decrease the public’s bond holdings--subtract from the national debt. © 2001 South-Western, a division of Thomson Learning

The Effects of Fiscal Changes in the Short Run How Economic Fluctuations Affect Spending, Taxes, and the Federal BudgetHow Economic Fluctuations Affect Spending, Taxes, and the Federal Budget Countercyclical Fiscal Policy?Countercyclical Fiscal Policy? © 2001 South-Western, a division of Thomson Learning

The Effects of Fiscal Changes in the Short Run In a recession, because transfers rise and tax revenue falls, the federal budget deficit increases (or the surplus decreases). In an expansion, because transfers decrease and tax revenue rises, the budget deficit decreases (or the surplus increases). © 2001 South-Western, a division of Thomson Learning

The Effects of Fiscal Changes in the Short Run Cyclical Deficit The part of the federal budget deficit that varies with the business cycle. Structural Deficit The part of the federal budget deficit that is independent of the business cycle. © 2001 South-Western, a division of Thomson Learning

The Effects of Fiscal Changes in the Short Run Many features of the federal tax and transfer systems act as automatic stabilizers. As the economy goes into a recession, these features help to reduce the decline in consumption spending, and they also cause the cyclical deficit to rise. © 2001 South-Western, a division of Thomson Learning

The Effects of Fiscal Changes in the Short Run As the economy goes into an expansion, these features help to reduce the rise in consumption spending, and they also cause the cyclical deficit to fall. © 2001 South-Western, a division of Thomson Learning

The Effects of Fiscal Changes in the Short Run Countercyclical Fiscal Policy Changes in taxes or government spending designed to counteract economic fluctuations. © 2001 South-Western, a division of Thomson Learning

The Effects of Fiscal Changes in the Short Run Reasons Against Countercyclical Fiscal Policy Timing ProblemsTiming Problems IrreversibilityIrreversibility The Fed’s ReactionThe Fed’s Reaction © 2001 South-Western, a division of Thomson Learning

The Effects of Fiscal Changes in the Long Run Impact of Large and Continuing Budget Deficits Government continually demands loanable funds.Government continually demands loanable funds. Lower investment spending causes the capital stock to grow more slowly.Lower investment spending causes the capital stock to grow more slowly. National debt--and annual interest payments on the national debt--grow.National debt--and annual interest payments on the national debt--grow. © 2001 South-Western, a division of Thomson Learning

The Effects of Fiscal Changes in the Long Run Impact of Large and Continuing Budget Surpluses Government continually supplies loanable funds.Government continually supplies loanable funds. Higher investment spending causes the capital stock to grow more rapidly.Higher investment spending causes the capital stock to grow more rapidly. National debt--and annual interest payments on the national debt--shrink.National debt--and annual interest payments on the national debt--shrink. © 2001 South-Western, a division of Thomson Learning

Were We Headed for a Debt Disaster? As long as the debt grows by the same percentage as nominal GDP, the ratios of debt to GDP and interest payments to GDP will remain constant. In this case, the government can continue to pay interest on its rising debt without increasing the average tax rate in the economy. © 2001 South-Western, a division of Thomson Learning