Chapter 17: Fiscal Policy and the Federal Budget zFiscal Policy -- the Federal government changing its government budget position (G - T) in order to stabilize the economy. zFiscal Policy, by its nature, alters the Federal Budget. This chapter also examines the Federal Budget, what it’s made up of, and when budget deficits can be a problem in the economy.

The Federal Budget zFederal Budget (or Budget) = Tax Revenues - Government Expenditure (over a given period). zFederal Budget (or Budget) = Tax Revenues - (Government Purchases of Goods and Services + Transfer Payments + Interest on the National Debt).

Budget Definitions zBudget < 0 -- Budget Deficit zBudget > 0 -- Budget Surplus zBudget = 0 -- Balanced Budget zRealistic Goal -- Balanced Budget when Y = Y F.

The US Federal Budget: 2003 (Billions of Dollars) zTax Revenues$ zGovernment Expenditure$ zFederal Budget -$406.5 zSource: Economic Indicators, October 2005.

Breakdown of Tax Revenues zPersonal Income Taxes = $801.8 zCorporate Profits Taxes = $217.4 zTaxes on Production and Imports (e.g. sales and excise taxes) = $94.0 zContributions for Social Insurance = $803.5 zOther = $58.1

Breakdown of Government Expenditure zPurchases of Goods and Services (G) = $725.7 zTransfer Payments = $ zInterest Payments = $221.5 zOther = $42.9 zSource: Economic Indicators, October 2005.

The Budget: In Our Notation Recall variable definitions: -- T = net taxes = tax revenues - (transfer payments + interest on the national debt) -- G = government purchases of goods and services

The Budget and The Budget Position zBudget = T - G zBudget Position (or size of deficit) = G - T

The National Debt zThe National Debt -- The total accumulated stock of debt owed by the government to its lenders (holders of government bonds). zExpanded by budget deficits, reduced by budget surpluses.

National Debt -- Realistic Goal zRealistic Goal -- consider the Debt-Income Ratio = (National Debt)/(GDP). zFor the US in 2004 = ($4295.5)/($ ) = zSource: Economic Indicators, October 2005.

The Income Tax and Automatic Stabilization zAutomatic Stabilization -- due to the income tax system, tax revenues change in directions that help to stabilize the economy, without any change in the tax structure (i.e. fiscal policy).

The Income Tax as an Automatic Stabilizer Y*  (maybe > Y F )  Tax Revenues  helps to cool the economy Y*  (maybe < Y F )  Tax Revenues  helps to stimulate the economy zNote -- all this takes place without any change in the tax structure, as prescribed by fiscal policy.

The Income Tax and the Federal Budget Y*   Tax Revenues   T   (T - G)  zA strong and growing economy improves the budget. Y*   Tax Revenues   T   (T - G)  zA weak economy generates a lower budget.

Strategy of Fiscal Policy zExpansionary policies seek to induce more purchasing of goods and services by increasing (G - T) -- i.e. G  or T . zContractionary policies seek to induce less purchasing of goods and services by decreasing (G - T) -- i.e. G  or T .

Specific Types of Fiscal Policy zChange Government Purchases of Goods and Services (G) -- Expansionary: G  -- Contractionary: G  zChange Transfer Payments (TP) -- Expansionary: TP  -- Contractionary: TP 

Tax Policy as Fiscal Policy zChange Marginal Tax Rates (t) -- Expansionary: t  -- Contractionary: t  zChange Tax Deductions -- Expansionary: Bigger Deductions -- Contractionary: Smaller Deductions zChange Indirect Business Taxes (e.g. Sales or Excise Taxes) -- Expansionary: Lower Taxes -- Contractionary: Raise Taxes

Fiscal Policy in the AD-AS Model zExpansionary Fiscal Policy shifts the AD curve rightward, increases Y* and P*. zContractionary Fiscal Policy shifts the AD curve leftward, decreases Y* and P*. zNote -- like monetary policy, fiscal policy is justified only from a short-run perspective.

Obstacles to Fiscal Policy Effectiveness zDifficulties in getting the proper policy passed through Congress and the president. zA tax cut that isn’t used for spending. AD curve does not shift rightward, no change in Y*. zWorries about the Federal Budget within a sluggish economy.

The Crowding Out Effect -- An Adverse “Side Effect” zThe Crowding Out Effect -- Expansionary fiscal policy creates an increased need for more borrowing by the government. This financing increases the demand for financial capital. As a result, long-term interest rates (r*) rise and Investment (I*) decreases.

The Crowding Out Effect -- Fiscal Policy Effectiveness zCrowding Out Effect -- makes fiscal policy less effective than would be otherwise. zDecrease in investment to some extent offsets rise in (G - T). zSmaller shift in AD curve than would be without the crowding out effect.

The Crowding Out Effect – Impeding Economic Growth zCrowding Out Effect  loss of Investment (I). zDecrease in Investment retards the buildup of the capital stock and possible implementation of new technology (i.e. Labor Productivity growth). zSmaller shifts in LAS curve, smaller increases in Y F.

Ways to Avoid the Crowding Out Effect zBottom line -- get the supply of financial capital to shift rightward at the same time as when expansionary fiscal policy occurs. -- expansionary monetary policy -- increased private saving -- increase in foreign capital inflows

Distinctive Fiscal Policy Actions in the US zWorld War II zThe Kennedy-Johnson Tax Cut of 1964 zThe Nixon Tax Increase of 1969 zThe Reagan Economic Recovery and Tax Act of 1981 zClinton Tax Increases of 1993 zBush Tax Cuts of zBush Tax Rebates of 2008 zObama Fiscal Stimulus Plan of 2009