Fiscal Policy: Spending & Taxes FIN 30220: Macroeconomic Analysis

The US Government spent $3.70 Trillion dollars in That’s approximately $12,000 per person! Put another way, government spending is approximately a quarter of all domestic expenditures. GDP = $15.5T

While our government is bigger than some, it is much smaller than others Government as a % of GDP USAUSA

Dissecting the Federal Budget In 2012, The US Government spent $3.70T On Budget: $2.939T (80%) Off Budget: $761B (20%) + Total: $3.70T By law, the Social Security System and the US Postal Service must maintain separate budgets and, hence, are “off” the general budget Mandatory: $2.116T (58%) Discretionary: $1.344T (36%) + Total: $3.70T Interest: $240B (6%) Determined by Congress on an annual basis (ex: Defense) Determined by existing law (ex: Social Security, Medicare) Source: Office of Management and Budget

Timeline for the budget process FebruaryJanuaryMarchAprilMayJuneJulyAugustSeptemberOctober Fiscal Year Begins With the help of the office of management and budget (OMB), the president creates a budget proposal – sent to congress the first week of February With the help of the congressional budget office (CBO), the house and senate budget committees write their own budget proposals Differences between House/Senate proposals are worked out in conference committees – joint resolution presented and voted on Appropriations bills presented and voted on

The US Budget is officially titled a “Resolution of Congress” – it is not a Bill. So, what difference does it make? A resolution, once approved by both houses of congress, requires no presidential signature Further, a resolution is not a law and DOES NOT have to be obeyed! However, the budget itself does not allow the government to spend money. It only gives the government the authority to spend money. To actually spend money, the government must pass an appropriation bill. That is a law.

Note that authorized spending need not be appropriated in a given year, but can be carried forward, so actual outlays need not equal budget authority Defense Appropriations Bill (2012) Authorized: $700B Appropriated: $650B $50B of authorization remaining Defense Appropriations Bill (2013) Authorized: $750B Appropriated: $800B

The Government Uses “Baseline Budgeting” with a minimum 5 year cycle Current Year Horizon Years Budget Year This is what the government is currently spending Adjusted spending under the new law Anticipated spending

Therefore, a government cut is generally not really a cut! Consider the following example Current Year Horizon Years Budget Year Defense Appropriations Bill 2012 $700B $750B (+7%) $850B (+13%) $1,000B (+17%) $1,200B (+20%) 2013 $750B $800B (+6%) $900B (+12%) $1,150B (+16%) $1,350B (+17%) In government lingo, this would be called a $50B( 6%) cut to the defense budget!!

Financing The Government “In this world, nothing is certain, but death and taxes” Individual Income Taxes: $1,145B Corporate Income Taxes: $327B Social Insurance Taxes: $927B Other Revenues: $210B + Total: $2.609T 2012 On-Budget: $1.949T Off-Budget: $660B Income Tax Alternative Minimum Tax Estate Tax Off –Budget is essentially social security taxes

Who Pays Income Taxes? QuintileAverage Income % of Total Income % of Total Taxes Bottom 20%$13,0003%<1% 2 nd 20%$30,0008%2% Middle 20%$49,00014%13% 4 th 20%$72,00023%25% Top 20%$147,00050%60% Top 5%$254,00021%40% Top 1%$1,000,00015%30%

US Income Tax Rates (Single Filers) Taxable IncomeTax Rate $0 - $7,15010% $7,151 - $29,05015% $29,051 - $70,35025% $70,351 - $146,75028% $146,751 - $319,10033% $319, % Note: These Tax Brackets are annually indexed for inflation Standard Deduction: $5,000 Personal Exemption: $3,200 + $8,200Taxable Income = Gross Income - $8,200

Taxable IncomeTax Rate $0 - $7,15010% $7,151 - $29,05015% $29,051 - $70,35025% $70,351 - $146,75028% $146,751 - $319,10033% $319, % The Tax Brackets indicate marginal tax rates – i.e. the percentage of each additional dollar earned that gets paid in taxes Suppose that you earn $85,000 per year (single filer) Gross Income: $85,000 Standard Deduction: $5,000 Personal Exemption: $3,200 $76, Taxable Income $7,150 *.10 = $715 $21,900 *.15 = $3,285 $41,300 *.25 = $10,325 $6,450 *.28 = $1,806 + Tax Bill = $16,131 Your “Average Rate” = $16,131 $85,000 X 100 = 19%

On Budget: $1.949T Off Budget: $660B Total: $2.609T 2012 Revenues + Total: $3.70T + On-Budget: $2.939T Off-Budget: $761B 2012 Expenditures The Government must make up the difference between taxes collected and spending on current programs by borrowing + On-Budget: - $990 Off-Budget: - $ Surplus/Deficit Total: - $1.091T This is the official deficit that’s reported In 2012, the government spent $2.939T on programs other than social security $1.949T Was paid for with current taxes In 2012, The Social Security Administration spent $761B on current benefits $990B was borrowed from the public $660B Was paid for with current taxes $101B was borrowed from the public

The US budget was essentially balanced until the early 1970’s Deficit/Surplus (Millions of Current Dollars)

Total Debt outstanding represents the cumulative effect of past deficits (stocks vs. flows)

What really matters is debt relative to ability to pay (GDP) While the US economy grew at an average rate of 6% (Nominal), growth of the debt has changed dramatically Debt growth at 2.5% per year Debt growth at 8.5% per year Debt as a Percentage of GDP

Can we sustain our current policies? Debt is manageable as long as it grows at a slower pace than income (i.e. we can grow out if it!) Total Debt Current Deficit + Interest Rate GPD Growth Growth of Debt $18T $500B Treasury Rate =.043 Our economy would need to grow at 4.2% (nominal) per year to sustain our current projected deficits (i.e. maintain a constant Debt/GDP ratio). Unfortuntnately, we are only growing at 3.8%

Can we sustain our current policies? Alternatively, let’s calculate the deficit that is sustainable (Debt/GDP is constant) Total DebtDeficit Nominal Interest Rate GPD Growth $18T 3.8% 1.5% Given the above numbers, we can sustain a $400B Deficit

Two arguments for Fiscal Policy Efficiency Efficiency refers to the collective well being of an economy. Equity Equity refers to the distribution of well being across individual in an economy. Can we use fiscal policy to increase aggregate income? (i.e. increase total welfare.) Can we use fiscal policy to redistribute income in a “fair” way?

Let’s suppose that the economy is currently at full employment (the unemployment rate is 5%) and GDP equals $15T. Government expenditures are currently $3T. $15T $3T$12T Note: None of the numbers here are calculated

Now, suppose that uncertainty about the future causes consumers and businesses to cut their planned expenditures by 10% $3T$10.8T $13.8T $1.2T As 8% output gap would be associated with a 8/2.5 = 3.2% rise in unemployment Okun’s Law: A 1% rise in unemployment translates to a 2.5% drop in GDP

$1.2T As 4% output gap would be associated with a 4/2.5 = 1.6% rise in unemployment The immediate impact would be a drop in the interest rate and production To get back to full employment, we need the interest rate to drop even farther…

The longer term impact would be an additional drop in the interest rate and a decrease in prices (i.e. deflation) Now we are back to full employment…but after a long, painful recession and prolonged deflation

$1.2T What if the government could move the IS curve back to the right by $1.2T. The could return the economy to full employment… We have a drop in demand of $1.2T We should increase government spending by $1.2T, right?

“If I Had a Hammer…” Suppose that the government pays $100 for a new hammer from the local hardware store Now, suppose that the hardware store owner takes his $100 in new income and spends $95 (95%) at the grocery store Now, suppose that the grocer owner takes his $95 in new income and spends $90.25 (95%) at the local tavern….. This will continue to ripple out…

“If I Had a Hammer…” Lets add up all the increases in income due to the initial government purchase of a $100 hammer Hardware Store: $100 Grocer: $95 Tavern: $ $ $81.45 Total: $2,000 The initial $100 increase in government spending raised total income by $2,000 (a factor of 20) Marginal Propensity to Consume

If the government bought $60B worth of hammers, that should do the trick! $1.2T $10.8T$3T So, with a MPC of 95% Before After $3.06T$11.94T

Let’s take the US Economy….we saw a rise in unemployment from 5% to 10% in this last recession. $1.75T 5% cyclical unemployment Multiply by 2.5 (Okun’s law) 12.5% drop in output The personal savings rate at the time was around 4% But the government stimulus plan was over $700B and nothing happened… $14T*(.125) = $1.75T

However, we need to be careful here…. We need the marginal propensity to consume, using the savings rate, we really have the average propensity to consume It could be Here, we have (at Y = $40,000) Average propensity to consume

However, we need to be careful here…. We need the marginal propensity to consume, using the savings rate, we really have the average propensity to consume Or, it could be Here, we have (at Y = $40,000) Average propensity to consume

“If I Had a Hammer…” Lets add up all the increases in income due to the initial government purchase of a $100 hammer Hardware Store: $100 Grocer: $95 Tavern: $ $ $81.45 Total: $2,000 The initial $100 increase in government spending raised total income by $2,000 (a factor of 20) Marginal Propensity to Consume What’s wrong with this argument?

“If I Had a Hammer…” The government needs to pay for the hammer. Lets assume that the government taxes the local hardware store and then uses the $100 to buy the hammer. How does this change things? What does the government do with the hammer? Case #1: The government gives the hammer to the grocer across the street (transfer) Case #2: The government throws the hammer into the ocean (wasteful spending) Case #3: Derek Jeter signs the hammer (raising its value to $200) and gives it back to the hardware store (productive spending) Oops…wrong hammer!!

Public Goods have two distinct characteristics:  Non-Rivaled: Anyone can use a public good without affecting its use by others (zero marginal cost)  Non-Excludable: Its either very difficult or very costly to charge for usage of a public good Suppose that there are 10,000 people living in Springfield. Each resident is willing to pay up to $.10 to have a drinking fountain in town. The fountain would cost $500 to build. It would be difficult to charge people to use the fountain. Therefore, the private sector probably wouldn’t supply it. Here’s a chance for the government to step in and save the day! Why shouldn’t the government supply private goods?

Consider the Jones’: The Jones’ live in Buffalo NY. Mr. Jones works 40 hours per week at a local factory. They have an annual household income of $50,000. Jones’ Family Budget Income:$50,000 Taxes:$10,000 $40,000 Consumption:$30,000 Savings: $10,000 Remember…this is determined by the Jones’ wealth – not just current income Suppose that Obama announces that they will spend $200B on a bridge that will go halfway to Hawaii. Each household will be taxed $1,000 to pay for this project.

How should this spending plan influence the Jones’? Jones’ Family Budget Income:$50,000 Taxes:$11,000 $39,000 Consumption:$30,000 Savings: $9,000 Tax Increase of $1,000 This one time project should have a negligible impact on the Jones’ wealth and, hence a negligible impact on consumption Savings drops by $1000

So, the government raises spending by $1,000 per person, and household consumption is left unchanged (household savings drops by $1,000) $1,000 The IS curve moves to the right by $1,000 – i.e. the government multiplier equals 1

Suppose that the government decides to spend $1,000 wastefully every year… The IS curve moves to the right by $0– i.e. the government multiplier equals 0! Households adjust to the permanently lower income by spending less

Now, consider another spending plan…Obama decides to nationalize the cable industry. Everyone will receive government provided cable television. They can provide this service for $500 per year. Jones’ Family Budget Income:$50,000 Taxes:$10,000 $40,000 Consumption:$30,000 Savings: $10,000 Rent: $15,000 Food: $10,000 Transportation: $4,000 Cable TV: $1,000 How will this spending plan affect the Jones family?

How should this spending plan influence the Jones’? Jones’ Family Budget Income:$50,000 Taxes:$10,500 $39,500 Consumption:$29,000 Savings: $10,000 Extra Income: $500 Tax Increase of $500 Rent: $15,000 Food: $10,000 Transportation: $4,000 Cable TV: $0 If this is a one time increase in income, savings goes up. If it is permanent, consumption goes up by $500

Suppose that this one a one year program only…. The IS curve moves to the left by $500– i.e. the government multiplier is negative! Households put the income gain into savings

If this were a permanent program, households would feel free to spend the $500 savings. The IS curve doesn’t move…again, a government multiplier of zero!! Households put the income gain into consumption

The Simpson's live next door to the Jones’. Homer Simpson works at the local power plant. He earns $20,000 per year. Jones’ Family Budget Income:$50,000 Taxes:$10,000 $40,000 Consumption:$30,000 Savings: $10,000 Simpson’s Family Budget Income:$20,000 Taxes:$2,000 $18,000 Consumption:$15,000 Savings: $3,000 Suppose that the government offers a temporary $1,000 tax credit to lower income households. The program will cost the average upper income household $1,000

Jones’ Family Budget Income:$50,000 Taxes:$11,000 $39,000 Consumption:$30,000 Savings:$9,000 Simpson’s Family Budget Income:$20,000 Taxes:$1,000 $19,000 Consumption:$15,000 Savings:$4,000 Suppose that the government offers a temporary $1,000 tax credit to lower income households. The program will cost the average upper income household $1,000 $1,000 The Simpson’s put the tax credit in the bank. The Jones’ lower their savings to finance their higher tax bill

Suppose that the government offers a temporary $1,000 tax credit to lower income households. The program will cost the average upper income household $1,000 In principle, this should cancel out in the aggregate!

For transfers to make a difference at the aggregate level, we need different preferences (i.e. different marginal propensities to consume) MPC =.5 MPC =.9 $500 $100

So, the government raises spending by $1,000 per person, and household consumption increases by $400 (household savings drops by $400) The IS curve moves right! $400 +$900 -$500 $400

Lets look at a breakdown of Mr. Jones tax liability Income:$50,000 Taxes:$10,000 Tax Code Taxable IncomeTax Rate $0 - $10,00015% $10,000 - $30,00020% $30,000 - $50,00030% $30, % IncomeTax RateTax Paid $10,00015%$1,500 $20,00020%$4,000 $15,00030%$4,500 Standard Deduction = $5,000 Total: $10,000 Mr. Jones taxable income of $45,000 put him in the 30% tax bracket Mr. Jones’ average tax rate is 20%

Suppose the government passes a “middle class tax cut”. The top two brackets are reduced from 30% and 35% to 25% and 30%. Also, the standard deduction is lowered to $2,000. How does this impact Mr. Jones? Income:$50,000 Taxes:$10,000 Tax Code Taxable IncomeTax Rate $0 - $10,00015% $10,000 - $30,00020% $30,000 - $50,00025% $30, % IncomeTax RateTax Paid $10,00015%$1,500 $20,00020%$4,000 $18,00025%$4,500 Standard Deduction = $2,000 Total: $10,000 Mr. Jones taxable income of $48,000 put him in the 25% tax bracket Mr. Jones’ average tax rate is still 20%

Suppose the government passes a “upper class tax cut”. The top two brackets are reduced from 30% and 35% to 25% and 30%. Also, the standard deduction is lowered to $2,000. How does this impact Mr. Jones? IncomeTax RateTax Paid $10,00015%$1,500 $20,00020%$4,000 $18,00025%$4,500 Total: $10,000 IncomeTax RateTax Paid $10,00015%$1,500 $20,00020%$4,000 $15,00030%$4,500 Total: $10,000 Old Tax CodeNew Tax Code A drop in Mr. Jones’s marginal tax rate increases the incentive to work – labor supply increases. This should raise production

A cut in marginal tax rates that leaves average rates unchanged raises the economy’s capacity as employment rises. But what about expenditures? Capacity output increases from the tax cut A permanent tax cut will increase investment (because higher employment raises the productivity of capital)

Alternatively, suppose the government passes a “lower income class tax cut”. The bottom two brackets are reduced from 15% and 20% to 10% and 15%. The standard deduction is kept at $5,000. How does this impact Mr. Jones? Income:$50,000 Taxes:$8,500 Tax Code Taxable IncomeTax Rate $0 - $10,00010% $10,000 - $30,00015% $30,000 - $50,00030% $30, % IncomeTax RateTax Paid $10,00010%$1,000 $20,00015%$3,000 $15,00030%$4,500 Standard Deduction = $5,000 Total: $8,500 Mr. Jones taxable income of $45,000 put him in the 30% tax bracket Mr. Jones’ average tax falls to 17%

IncomeTax RateTax Paid $10,00015%$1,500 $20,00020%$4,000 $15,00030%$4,500 Total: $10,000 Old Tax CodeNew Tax Code IncomeTax RateTax Paid $10,00010%$1,000 $20,00015%$3,000 $15,00030%$4,500 Total: $8,500 Alternatively, suppose the government passes a “lower income class tax cut”. The bottom two brackets are reduced from 15% and 20% to 10% and 15%. The standard deduction is kept at $5,000. How does this impact Mr. Jones? If households are rational and forward looking, they should recognize that the tax cut will need to be repaid and thus will not feel better off… If households are not rational and forward looking, they will feel better off and work less

A tax cut will raise the deficit and increase government borrowing, but what about household savings? If households are rational and forward looking, they should recognize that the tax cut will need to be repaid and thus increase savings… expenditures (and, the IS curve are unaffected) If households are not rational and forward looking, they will increase expenditures (and, the IS curve shifts right)

Government Spending  If the government invests in purely wasteful spending, the multiplier effect is the largest, but should that justify spending money on stupid projects?  Effective spending (say, on public goods) could actually lower employment and output (i.e. a negative multiplier), but don’t we want our government spending our money wisely?  Transfers could give the economy a boost without wasting any resources. The bigger issue with transfers is economic equity Taxes  Taxes are an effective stimulus only if you can change marginal rates while leaving effective rates unchanged.  Recognize the impact any tax policy has on aggregate expenditures!