Fiscal Policy Fiscal economic

Government in the Economy Nothing arouses as much controversy as the role of government in the economy. Government can affect the macroeconomy in two ways: Fiscal policy is the manipulation of government spending and taxation. Monetary policy refers to the behavior of the Federal Reserve regarding the nation’s money supply.

What is Fiscal Policy? Fiscal policy is the deliberate manipulation of government purchases, transfer payments, taxes, and borrowing in order to influence macroeconomic variables such as employment, the price level, and the level of GDP

Government in the Economy Discretionary fiscal policy refers to deliberate changes in taxes or spending. The government can not control certain aspects of the economy related to fiscal policy. For example: The government can control tax rates but not tax revenue. Tax revenue depends on household income and the size of corporate profits. Government spending depends on government decisions and the state of the economy.

Net Taxes (T), and Disposable Income (Yd) Net taxes are taxes paid by firms and households to the government minus transfer payments made to households by the government. Disposable, or after-tax, income (Yd ) equals total income minus taxes.

Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow of Income

Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow of Income When government enters the picture, the aggregate income identity gets cut into three pieces: And aggregate expenditure (AE) equals:

The Budget Deficit A government’s budget deficit is the difference between what it spends (G) and what it collects in taxes (T) in a given period: If G exceeds T, the government must borrow from the public to finance the deficit. It does so by selling Treasury bonds and bills. In this case, a part of household saving (S) goes to the government.

Adding Taxes to the Consumption Function The aggregate consumption function is now a function of disposable, or after-tax, income.

Equilibrium Output: Y = C + I + G Finding Equilibrium for I = 100, G = 100, and T = 100 (All Figures in Billions of Dollars) (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) OUTPUT (INCOME) Y NET TAXES T DISPOSABLE INCOME Yd / Y - T CONSUMPTION SPENDING (C = 100 + .75 Yd) SAVING S (Yd – C) PLANNED INVESTMENT SPENDING I GOVERNMENT PURCHASES G PLANNED AGGREGATE EXPENDITURE C + I + G UNPLANNED INVENTORY CHANGE Y - (C + I + G) ADJUSTMENT TO DISEQUILIBRIUM 300 100 200 250 - 50 450 - 150 Output8 500 400 600 - 100 700 550 50 750 900 800 Equilibrium 1,100 1,000 850 150 1,050 + 50 Output9 1,300 1,200 + 100 1,500 1,400 1,150 1,350 + 150

Finding Equilibrium Output/Income Graphically

The Government Spending Multiplier The government spending multiplier is the ratio of the change in the equilibrium level of output to a change in government spending.

The Government Spending Multiplier Finding Equilibrium After a $50 Billion Government Spending Increase (All Figures in Billions of Dollars; G Has Increased From 100 in Table 25.1 to 150 Here) (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) OUTPUT (INCOME) Y NET TAXES T DISPOSABLE INCOME Yd / Y - T CONSUMPTION SPENDING (C = 100 + .75 Yd) SAVING S (Yd – C) PLANNED INVESTMENT SPENDING I GOVERNMENT PURCHASES G PLANNED AGGREGATE EXPENDITURE C + I + G UNPLANNED INVENTORY CHANGE Y - (C + I + G) ADJUSTMENT TO DISEQUILIBRIUM 300 100 200 250 - 50 150 500 - 200 Output8 400 650 - 150 700 600 550 50 800 - 100 900 950 1,100 1,000 850 Equilibrium 1,300 1,200 1,250 + 50 Output9

The Effect on GDP of an Increase in Government Spending $ C+I+G’+(X-M) 45o C+I+G+(X-M) G Simple government expenditures multiplier = GDP/G = 1/(1-MPC) GDP Real GDP

The Government Spending Multiplier

The Tax Multiplier A tax cut increases disposable income, and leads to added consumption spending. Income will increase by a multiple of the decrease in taxes. A tax cut has no direct impact on spending. The multiplier for a change in taxes is smaller than the multiplier for a change in government spending.

The Tax Multiplier

The Effect on GDP of a Decrease in Taxes $ C’+I+G+(X-M) 45o C+I+G+(X-M) Simple tax multiplier = GDP/T = -MPC/(1-MPC) GDP Real GDP

The Balanced-Budget Multiplier The balanced-budget multiplier is the ratio of change in the equilibrium level of output to a change in government spending where the change in government spending is balanced by a change in taxes so as not to create any deficit.

The Balanced Budget Multiplier A factor that show that identical changes in government purchases and net taxes change real GDP demanded by that same amount

The Balanced-Budget Multiplier Finding Equilibrium After a $200 Billion Balanced Budget Increase in G and T (All Figures in Billions of Dollars; G and T Have Increased From 100 in Table 25.1 to 300 Here) (1) (2) (3) (4) (5) (6) (7) (8) (9) OUTPUT (INCOME) Y NET TAXES T DISPOSABLE INCOME Yd / Y - T CONSUMPTION SPENDING (C = 100 + .75 Yd) PLANNED INVESTMENT SPENDING I GOVERNMENT PURCHASES G PLANNED AGGREGATE EXPENDITURE C + I + G UNPLANNED INVENTORY CHANGE Y - (C + I + G) ADJUSTMENT TO DISEQUILIBRIUM 500 300 200 250 100 650 - 150 Output8 700 400 800 - 100 900 600 550 950 - 50 1,100 Equilibrium 1,300 1,000 850 1,250 + 50 Output9 1,500 1,200 1,400 + 100

Fiscal Policy Multipliers Summary of Fiscal Policy Multipliers POLICY STIMULUS MULTIPLIER FINAL IMPACT ON EQUILIBRIUM Y Government- spending multiplier Increase or decrease in the level of government purchases: Tax multiplier Increase or decrease in the level of net taxes: Balanced-budget multiplier Simultaneous balanced-budget increase or decrease in the level of government purchases and net taxes: 1

Fiscal Policy in Practice

Introduction Before the 1930s, fiscal policy was not explicitly used to influence the macroeconomy The classical approach implied that natural market forces, by way of flexible prices, wages, and interest rates, would move the economy toward its potential GDP Thus there appeared to be no need for government intervention in the economy Before the onset of the Great Depression, most economists believed that active fiscal policy would do more harm than good

The Great Depression and World War II Three developments bolstered the use of fiscal policy The publication of Keynes’ General Theory War-time demand on production helped pull the U.S. out of the Great Depression The Full Employment Act of 1946, which gave the federal government responsibility for promoting full employment and price stability

Automatic Stabilizers Structural features of government spending and taxation that smooth fluctuations in disposable income over the business cycle Examples include, Our progressive income system with its increasing marginal income tax rates Unemployment insurance Welfare spending

The Economy’s Influence on the Government Budget Fiscal drag is the negative effect on the economy that occurs when average tax rates increase because taxpayers have moved into higher income brackets during an expansion.

The Golden Age of Keynesian Fiscal Policy to Stagflation The Early 1960s provided support for Keynesian theories In particular, President Kennedy’s 1964 income tax cut did much to boost the economy and reduce unemployment However, the 1970s were marked by significant supply-side shocks (increases in oil prices in addition to crop failures) The economic ills brought about by these supply-side shocks to the economy could not be remedied by demand-side Keynesian economic theories

Lags in Fiscal Policy The time required to approve and implement fiscal legislation may hamper its effectiveness and weaken fiscal policy as a tool of economic stabilization In the case of an oncoming recession, it may take time to Recognize the coming recession Implement the policy Let the policy have its impact

Discretionary Policy and Permanent Income Permanent income is income that individuals expect to receive on average over the long run To the extent that consumers base spending decisions on their permanent income, attempts to fine-tune the economy through discretionary fiscal policy will be less effective

Budgets, Deficits, and Public Policy

The Government Budget A plan for government expenditures and revenues for a specified period, usually a year

The Federal Budget The federal budget is the budget of the federal government. The difference between the federal government’s receipts and its expenditures is the federal surplus (+) or deficit (-).

The Federal Budget Federal Government Receipts and Expenditures, 2000 (Billions of Dollars) AMOUNT PERCENTAGE OF TOTAL Receipts Personal taxes 1,010.1 49.6 Corporate taxes 193.2 9.5 Indirect business taxes 111.0 5.5 Contributions for social insurance 720.6 35.4 Total 2,034.9 100.0 Current Expenditures Consumption 514.1 26.9 Transfer payments 831.9 43.6 Grants-in-aid to state and local governments 274.2 14.4 Net interest payments 236.9 12.4 Net subsidies of government enterprises 52.5 2.7 1,909.6 Current Surplus (+) or deficit (-) (Receipts - Current Expenditures) + 125.3 Source: U.S. Department of Commerce, Bureau of Economic Analysis.

Composition of Federal Expenditures: Fiscal Year 1995

The Presidential Role in the Budget Process Early in this century, the president had very little involvement in the development of the federal budget By the mid-1970s the president had been given the resources to translate policy into a budget proposal to be presented to Congress Office of Management and Budget (1921) Employment Act of 1946 (Council of Economic Advisers)

The Presidential Role in the Budget Process (continued) The development of the president’s budget begins a year before it is submitted to Congress The presidents proposed budget (The Budget of the United States Government) is supported by the Economic Report of the President The budget is submitted in January for the upcoming fiscal year October 1-September 30

The Congressional Role in the Budget Process House and Senate budget committees review the president’s budget proposal An overall budget outline is approved by Congress (budget resolution) and given to the various congressional committees and subcommittees which authorize federal spending

Budget Deficits and Surpluses When budgeted expenditures exceed projected tax revenues, the budget is projected to be in deficit When projected tax revenues exceed budgeted expenditures, the budget is projected to be in surplus

The Federal Government Surplus (+) or Deficit (-) as a Percentage of GDP, 1970 I-2003 II

Problems with the Budget Process Continuing resolutions A continuing resolution is a budget agreement that allows agencies, in the absence of an approved budget, to spend at the rate of the previous year’s budget Continuing resolutions are implemented due to delays in the budget process or problems with content of the budget Overlapping committee authority Length of the budget process Uncontrollable budget items Overly detailed budget

Entitlement Programs Guaranteed benefits for those who qualify under government transfer programs such as Social Security and Aid to Families with Dependent Children These programs represent a major “fixed” element of the budget, unless laws are passed to change eligibility requirements

Suggestions for Budget Reform Biennial budget The elimination of line item details before Congress Congress would consider only the overall budget for a given agency, rather that detailed line items

Rationale for Budget Deficits Large capital projects (highways, etc.) The benefits from these project will benefit more than current taxpayers, so deficit financing is appropriate Major Wars Keynesian economics points to the use of deficits to stimulate the economy during periods of economic slowdown Automatic stabilizers tend to increase deficits, since during times of recession, taxes are reduced while unemployment insurance and welfare payments are increased

Budget Philosophies Annually balanced budget—Budget philosophy prior to the Great Depression; aimed at equating revenues with expenditures, except during times of war Cyclically balanced budget—Budget philosophy calling for budget deficits during recessions to be financed by budget surpluses during expansions Functional Finance—A budget philosophy aiming fiscal policy at achieving potential GDP rather than balancing budgets either annually or over the business cycle

Crowding Out and Crowding In Crowding out--When the government undertakes expansionary fiscal policy, interest rates increase due to competition for borrowed funds and increased transactions demand for money As a result, private investment is “crowded out” due to increases in public investment Crowding in—If expansionary fiscal policy raises the general level of prosperity in the economy, private investors may expect greater investment-related profits, causing private investment to increase

Deficits and Interest Rates Financing Deficits Taxes Bonds (borrowing) Printing Money Ricardian Equivalence

The Federal Deficit Versus the National Debt The federal deficit is a flow variable measuring the amount by which expenditures exceed revenues in a particular year The national debt is a stock variable measuring the accumulation of past deficits In the U.S., it took 200 years for the national debt to reach $1 trillion After the debt reached this level, it took only 15 years for the debt to reach the $5 trillion level

The Debt and Problems http://www.brillig.com/debt_clock/ Arguments about the Debt We have to pay it back We owe it to ourselves (much less so than years ago).

Reducing the Deficit Line-item veto (signed into law in April 1996 struck by the Supreme Court in 1998) A provision to allow the president to reject particular portions of the budget rather than simply accept or reject the entire budget Balanced budget amendment Proposed amendment to the U.S. Constitution requiring a balanced federal budget

Size of Government

The Debt The federal debt is the total amount owed by the federal government. The debt is the sum of all accumulated deficits minus surpluses over time. Some of the federal debt is held by the U.S. government itself and some by private individuals. The privately held federal debt is the private (non-government-owned) portion of the federal debt.

The Federal Government Debt as a Percentage of GDP, 1970 I-2003 II The percentage began to fall in the mid 1990s.

The Economy’s Influence on the Government Budget The full-employment budget is what the federal budget would be if the economy were producing at a full-employment level of output.

The Economy’s Influence on the Government Budget The cyclical deficit is the deficit that occurs because of a downturn in the business cycle. The structural deficit is the deficit that remains at full employment.

Review Terms and Concepts automatic stabilizers balanced-budget multiplier budget deficit cyclical deficit discretionary fiscal policy disposable, or after-tax, income federal budget federal debt federal surplus (+) or deficit (-) fiscal drag fiscal policy full-employment budget government spending multiplier monetary policy net taxes privately held federal debt structural deficit tax multiplier

The Economy’s Influence on the Government Budget Automatic stabilizers are revenue and expenditure items in the federal budget that automatically change with the state of the economy in such a way as to stabilize GDP.

The Budget Deficits of the 1980s and 1990s The tax cuts of the early 1980s together with large increases government spending caused the annual government deficit and the national debt to grow significantly Although both fiscal policy measures stimulated the economy, the resulting tax revenues were not sufficient to manage the large government deficits

Fiscal Policy and the Natural Rate of Unemployment If there is a natural rate of unemployment, fiscal policy that increases aggregate demand will appear to succeed in the short run because output and employment will both expand But stimulating aggregate demand will, in the long run, result only in a higher price level, while the level of output will fall back to the economy’s potential

Feedback Effects of Fiscal Policy on Aggregate Supply Both automatic stabilizers and discretionary fiscal policy may affect individual incentives to work spend, save, and invest, though these effects are usually unintended

Appendix: The Government Expenditures and Tax Multipliers

Appendix: The Government Multiplier with Income Taxes

Appendix: The Multiplier with Income Taxes and Variable Imports

Appendix A: Deriving the Fiscal Policy Multipliers The government spending and tax multipliers algebraically:

Appendix A: Deriving the Fiscal Policy Multipliers The balanced-budget multiplier is found by combining the effects of government spending and taxes: increase in spending: - decrease in spending: = net increase in spending The balanced-budget multiplier equals one. An increase in G and T by one dollar each causes a one-dollar increase in Y.

Appendix B: The Case In Which Tax Revenues Depend on Income

Appendix B: The Case In Which Tax Revenues Depend on Income

Appendix B: The Case In Which Tax Revenues Depend on Income The Government Spending and Tax Multipliers Algebraically:

Appendix B: The Case In Which Tax Revenues Depend on Income The government spending and tax multipliers when taxes are a function of income are derived as follows:

A Contractionary Gap Can be Closed by Expansionary Fiscal Policy Potential output Price Level SRAS AD* AD Real GDP contractionary gap

An Expansionary Gap Can be Closed by Contractionary Fiscal Policy Potential output Price Level SRAS AD* AD Real GDP expansionary gap

The Leakages/Injections Approach Taxes (T) are a leakage from the flow of income. Saving (S) is also a leakage. In equilibrium, aggregate output (income) (Y) equals planned aggregate expenditure (AE), and leakages (S + T) must equal planned injections (I + G). Algebraically,