FISCAL POLICY 31 CHAPTER

Objectives After studying this chapter, you will able to  Describe the federal budget process and the recent history of expenditures, taxes, deficits, and debt  Examine the supply-side effects of fiscal policy on employment and potential GDP  Explain the effects of deficits on saving, investment, and economic growth  Explain how fiscal policy choices redistribute benefits and costs across generations  Explain how fiscal policy can be used to stabilize the business cycle

Balancing Acts on Capitol Hill In 2004, the federal government planned collect in taxes 17.3 cents of every dollar earned. The federal government planned to spend 20 cents out of each dollar earned. So the government planned a deficit of almost 3 cents per dollar earned. For most of the 1980s and 1990s, the government ran deficits, to the extent that the national debt is now about $13,000 per person. What are the effects of government deficits and debt?

The Federal Budget The federal budget is the annual statement of the federal government’s expenditures and tax revenues. Fiscal policy is the use of the federal budget to achieve macroeconomic objectives, such as full employment, sustained long-term economic growth, and price level stability.

The Federal Budget The Institutions and Laws Fiscal policy is made by the president and Congress. Figure 31.1 illustrates the timeline.

The Federal Budget Fiscal policy operates within the framework of the Employment Act of 1946, which committed the government to work toward “maximum employment, production, and purchasing power.” The President’s Council of Economic Advisers monitors the economy and advises the President on economic policy.

The Federal Budget Highlights of the 2004 Budget The projected fiscal 2004 Federal Budget has tax revenues of $1,955 billion, expenditures of $2,256 billion, and a projected deficit of $301 billion. Tax revenues come from personal income taxes, social insurance taxes, corporate income taxes, and indirect taxes. Personal income taxes followed by social insurance taxes are the two largest revenue sources.

The Federal Budget Expenditures are classified as transfer payments, purchases of goods and services, and debt interest. Transfer payments are by far the largest expenditure, and are sources of persistent growth in expenditures.

The Federal Budget The federal government’s budget balance equals tax revenue minus expenditure. If tax revenues exceed expenditures, the government has a budget surplus. If expenditures exceed tax revenues, the government has a budget deficit. If tax revenues equal expenditures, the government has a balanced budget.

The Federal Budget The Budget in Historical Perspective Figure 31.2 on the next slide shows the government’s tax revenues, expenditures, and budget surplus or deficit as a percentage of GDP for the period 1980–2004. The government had a deficit of 5.2 percent in The deficit declined and in 1998 to 2001, the government had a surplus. A deficit arose again in 2002 and 2003.

The Federal Budget

Figure 31.3 on the next slide shows the evolution of the components of tax revenues and expenditures as a percentage of GDP over the period 1983–2003. Tax revenues increased and expenditures decreased.

The Federal Budget

Government debt is the total amount that the government has borrowed—that the government owes. It is the accumulation of all past deficits.

The Federal Budget Figure 31.4 shows the evolution of the debt as a percentage of GDP since 1942.

The Federal Budget The U.S. Government Budget in Global Perspective Figure 31.5 compares government budget deficits around the world in The world as a whole that year had a government budget deficit of about 3.1 percent of world GDP.

The Federal Budget State and Local Budgets In 2002, when the federal government spent $2,000 billion, state and local governments spent almost $1,900 billion, mostly on education, protective services, and roads. State and local budgets are not used for stabilization purposes, and occasionally are destabilizing in recessions.

The Supply Side: Employment and Potential GDP Fiscal policy has important effects on employment and potential GDP called supply-side effects.

The Supply Side: Employment and Potential GDP Full Employment and Potential GDP Demand and supply in the labor market determine the full employment real wage rate and employment level. Figure 31.6(a) shows full employment in the labor market.

The Supply Side: Employment and Potential GDP The production function along with the level of employment at full employment determine potential GDP. Figure 31.6(b) shows potential GDP when full employment is 250 billion labor hours a year.

The Supply Side: Employment and Potential GDP The Effects of the Income Tax A tax on labor income influences potential GDP by changing the supply of labor and changing full employment equilibrium Figure 31.6(a) shows the effect of the income tax on the labor market.

The Supply Side: Employment and Potential GDP Figure 31.6(b) shows the effects of the income tax on potential GDP. Full employment decreases to 200 billion labor hours a year. At this level of employment, potential GDP decreases to $10 trillion.

The Supply Side: Employment and Potential GDP The gap between the before-tax wage rate and the after- tax wage rate is like a wedge and is called the tax wedge. Taxes on Expenditure and the Tax Wedge Taxes on consumption such as sales taxes add to the tax wedge. The reason is that a tax on consumption expenditure decreases the quantity of goods that an hour of labor can buy and is equivalent to an income tax.

The Supply Side: Employment and Potential GDP Some Real World Tax Wedges Figure 31.7 shows the tax wedges in the United States, the United Kingdom, and France.

The Supply Side: Employment and Potential GDP Does the Tax Wedge Matter? Potential GDP per person in France is 31 percent below that in the United States According to research by Edward Prescott, the entire difference is explained by the larger tax wedge in France.

The Supply Side: Employment and Potential GDP Tax Revenues and the Laffer Curve An increase in the tax rate decreases employment. If the decrease in employment is large, the total amount collected in taxes might decrease when the tax rate increases.

The Supply Side: Employment and Potential GDP Figure 31.8 shows the relationship between the tax rate and tax revenues—called the Laffer curve. In the United States, an increase in the tax rate would bring an increase in tax revenue. But perhaps not so in France.

The Supply Side: Employment and Potential GDP The Supply-Side Debate “Supply-siders,” economist who believe the supply-side effects to be large, first came to prominence during the early 1980s and were associated with the Reagan administration. At that time, they were regarded as extreme and branded “voodoo economists” by the first President Bush. Today, the supply side is the mainstream.

The Supply Side: Investment, Saving, and Economic Growth The Sources of Investment Finance A quick refresher of the national income accounting equations is needed. GDP = C + I + G + X – M. And GDP = C + S + T. From these two equations, you can see that I = S + T – G + M – X.

The Supply Side: Investment, Saving, and Economic Growth The equation I = S + T – G + M – X says that investment, I, is financed by: Private domestic saving, S, Foreign saving, M – X, Government saving, T – G

The Supply Side: Investment, Saving, and Economic Growth Call saving S plus foreign saving M – X private saving, PS. Then investment is financed by the sum of private saving and government saving. That is I = PS + T – G

The Supply Side: Investment, Saving, and Economic Growth If taxes exceed government purchases, T > G, the government has a budget surplus and government saving is positive. If taxes are less than government purchases, T < G, the government budget is in deficit and government saving is negative.

The Supply Side: Investment, Saving, and Economic Growth Figure 31.9 shows the contributions of the sources of investment finance from 1973 through Foreign sources have become larger. The government had a large deficit in 2003.

The Supply Side: Investment, Saving, and Economic Growth Fiscal policy can influence investment in two ways:  Taxes affect the incentive to save  Government saving— the budget surplus or deficit—is part of total saving

The Supply Side: Investment, Saving, and Economic Growth Taxes and the Incentive to Save A tax on interest income drives a wedge between the after-tax interest rate earned by savers and the before-tax interest rate paid by firms to finance investment. The effects of a tax on interest income are more serious than those on labor income because:  Lower investment slows the growth rate and has a cumulative effect on potential GDP  Inflation makes the effective tax rate on interest income high

The Supply Side: Investment, Saving, and Economic Growth Figure shows the effects of taxes on the incentive to save With no taxes, investment is $2 trillion and the interest rate is 3 percent a year.

The Supply Side: Investment, Saving, and Economic Growth An income tax drives a wedge between the before-tax and after-tax interest rate and decreases saving supply. Investment decreases to $1.8 trillion and the interest rate rises to 4 percent a year.

The Supply Side: Investment, Saving, and Economic Growth Government Saving Because government saving is part of total saving, the direct effect of a government budget deficit is a decrease in total saving. When total saving decreases, the real interest rate rises and the equilibrium quantity of investment decreases. The tendency fo a government budget deficit to decrease investment is called a crowding-out effect.

The Supply Side: Investment, Saving, and Economic Growth Figure illustrates the crowding out effect of an increase in the government budget deficit.

The Supply Side: Investment, Saving, and Economic Growth A government budget deficit also has an indirect effect that offsets the direct effect. The Ricardo-Barro effect is an increase in private saving by an amount equal to the government budget deficit. This effect occurs if households recognize that a government budget deficit must be paid for by higher taxes in the future.

Generational Effects of Fiscal Policy Is a budget deficit a burden on future generations? What is the full burden of existing government programs such as Social Security? To answer questions like these, we use a tool called generational accounting. This accounting system was developed by Alan Auerbach and Laurence Kotlikoff. Recent generational accounts have been constructed by Jagadeesh Gokhale and Kent Smetters.

Generational Effects of Fiscal Policy Generational Accounting and Present Value Generational accounting calculates the present value of taxes and benefits and allocates those present values to different generations. The Social Security Time Bomb As the baby boom generation retires and begins to collect is Social Security and Medicare benefits, the payout by the federal government on these items will be much larger than it is today. At the same time, the taxes paid by the baby boomers will be lower than they are today.

Generational Effects of Fiscal Policy To assess the federal government’s obligations, we use the concept of fiscal imbalance, which is the present value of the government’s commitments to pay benefits minus the present value of its tax revenues. In 2003, fiscal imbalance in the United States is estimated to be $45 trillion.

Generational Effects of Fiscal Policy Generational Imbalance Generational imbalance is the division of fiscal imbalance between the current and future generations. It is estimated that under existing laws, the current generation will pay 43 percent of its own benefits. Future generations will pick up 57 percent of the tab!

Generational Effects of Fiscal Policy Figure shows an estimate of the sources of fiscal imbalance and its division between the current and future generations.

Generational Effects of Fiscal Policy International Debt Much of the public debt is held not by the public but by foreigners. This debt represents a potential drain on Americans. The scale of this debt in 2003 was about $4 trillion. Foreigners own more than 50 percent of U.S. government debt.

Stabilizing the Business Cycle Fiscal policy action that seek to stabilize the business cycle work by changing aggregate demand. These policy actions can be:  Discretionary  Automatic Discretionary fiscal policy is a policy action that is initiated by an act of Congress. Automatic fiscal policy is a change in fiscal policy triggered by the state of the economy.

Stabilizing the Business Cycle The Government Purchases Multiplier The government purchases multiplier is the magnification effect of a change in government purchases of goods and services on aggregate demand. A multiplier exists because government purchases are a component of aggregate expenditure; an increase in government purchases increases aggregate income, which induces additional consumption expenditure.

Stabilizing the Business Cycle The Tax Multiplier The tax multiplier is the magnification effect a change in taxes on aggregate demand. An increase in taxes decreases disposable income, which decreases consumption expenditure and decreases aggregate expenditure and real GDP.

Stabilizing the Business Cycle The Balanced Budget Multiplier The balanced budget multiplier is the magnification effect a simultaneous change in government purchases and taxes on aggregate demand. A $1 increase in government purchases increases aggregate demand initially by $1 but a $1 increase in taxes decreases consumption expenditure by less than $1 initially, so a $1 increase in both purchases and taxes increases aggregate demand.

Stabilizing the Business Cycle Discretionary Fiscal Stabilization In Figure 31.13, an increase in government purchases increases aggregate demand. A multiplier effect increases aggregate demand further. Real GDP increases and the price level rises.

Stabilizing the Business Cycle Discretionary Fiscal Stabilization In Figure 31.14, a decrease in government purchases decreases aggregate demand. A multiplier effect decreases aggregate demand further. Real GDP decreases and the price level falls.

Stabilizing the Business Cycle Limitations of Discretionary Fiscal Policy The use of discretionary fiscal policy is hampered by three time lags:  Recognition lag  Law making lag  Impact lag

Stabilizing the Business Cycle Automatic Stabilizers Automatic stabilizers are mechanisms that stabilize real GDP without explicit action by the government. Income taxes and transfer payments are automatic stabilizers. Because income taxes and transfer payments change with the business cycle, the government’s budget deficit also varies with this cycle. In a recession, taxes fall, transfer payments rise, and the deficit grows; in an expansion, taxes rise, transfers fall, and deficit shrinks.

Stabilizing the Cycle Figure shows the budget deficit over the business cycle for 1981– Recessions are highlighted.

Stabilizing the Business Cycle The structural surplus or deficit is the surplus or deficit that would occur if the economy were at full employment and real GDP were equal to potential GDP. The cyclical surplus or deficit is the actual surplus or deficit minus the structural surplus or deficit; that is, it is the surplus or deficit that occurs purely because real GDP does not equal potential GDP.

Stabilizing the Business Cycle Figure illustrates the distinction between a structural and cyclical surplus and deficit. In part (a), as real GDP fluctuates around potential GDP, a cyclical deficit or surplus arises.

Stabilizing the Business Cycle In part (b), as potential GDP grows, a structural deficit becomes a structural surplus.

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