Chapter 13 Fiscal Policy

Introduction When U.S. economic activity began to weaken in early 2008, the U.S. government gave lower- and middle- income households one-time payments called tax rebates. During the depths of the Great Recession in 2009, the government authorized another round of tax rebates. Why and how does the U.S. government sometimes seek to influence economic activity by varying expenditures and tax receipts? Reading this chapter will help you answer this questions.

Learning Objectives Use traditional Keynesian analysis to evaluate the effects of discretionary fiscal policy Discuss ways in which indirect crowding out and direct expenditure offsets can reduce the effectiveness of fiscal policy actions Explain why the Ricardian equivalence theorem calls into question the usefulness of tax changes

Learning Objectives (cont'd) List and define fiscal policy time lags and explain why they complicate efforts to engage in fiscal “fine tuning” Describe how certain aspects of fiscal policy function as automatic stabilizers for the country

Chapter Outline Discretionary Fiscal Policy Possible Offsets to Fiscal Policy Discretionary Fiscal Policy in Practice: Coping with Time Lags Automatic Stabilizers What Do We Really Know About Fiscal Policy?

Did You Know That ... A massive fiscal stimulus package approved by the U.S. Congress in early 2009 allocated nearly $600 billion directly to state governments during 2009 and 2010? In this chapter, you will learn about how variations in government spending and taxes affect real GDP and the price level.

Discretionary Fiscal Policy The discretionary changing of government expenditures or taxes in order to achieve national economic goals, such as: High employment (low unemployment) Price stability Economic growth

Discretionary Fiscal Policy (cont'd) An increase in government spending will stimulate economic activity Changes in government spending: Military spending Education spending Budgets for government agencies

Figure 13-1 Expansionary and Contractionary Fiscal Policy: Changes in Government Spending, Panel (a) If there is a recessionary gap in panel (a), fiscal policy can presumably increase aggregate demand

Figure 13-1 Expansionary and Contractionary Fiscal Policy: Changes in Government Spending, Panel (b) If there is an inflationary gap, fiscal policy can presumably decrease aggregate demand

Discretionary Fiscal Policy (cont'd) Questions Would the increase in government spending equal the size of the gap? What impact would expansionary fiscal policy have on the price level?

Why Not … end our economic troubles by borrowing to finance additional discretionary government spending? Almost all of the federal government’s revenues go toward funding nondiscretionary programs such as Social Security, Medicare, and Medicaid. Thus, since 2009, on average, the federal government has had to borrow more than 90 cents of every single dollar that it has committed to discretionary spending intended to stimulate economic activity. 12

Discretionary Fiscal Policy (cont'd) Change in taxes A rise in taxes causes a reduction in aggregate demand because it can reduce consumption spending, investment expenditures, and net exports

Figure 13-2 Contractionary and Expansionary Fiscal Policy: Changes in Taxes, Panel (a) In panel (a), the economy is initially at E1, where real GDP exceeds long-run equilibrium Contractionary fiscal policy can move aggregate demand to AD2 via a tax increase A new equilibrium is at E2 at a lower price level Real GDP is now consistent with LRAS

Figure 13-2 Contractionary and Expansionary Fiscal Policy: Changes in Taxes, Panel (b) In panel (b) with a recessionary gap (in this case $500 billion) taxes are cut AD1 moves to AD2 The economy moves from E1 to E2, and real GDP is now at $12 trillion per year We are at the long-run equilibrium level

Discretionary Fiscal Policy (cont'd) Question What would be the long-run impact of a tax cut on real GDP if the economy is at full-employment equilibrium?

Possible Offsets to Fiscal Policy Fiscal policy does not operate in a vacuum and important questions must be answered How are expenditures financed and by whom? If taxes are increased what does government do with the taxes? What will happen if individuals worry about increases in future taxes?

Possible Offsets to Fiscal Policy (cont'd) Crowding-out effect The tendency of expansionary fiscal policy to cause a decrease in planned investment or planned consumption in the private sector This decrease normally results from the rise of interest rates

Figure 13-3 The Crowding-Out Effect, Step by Step

Figure 13-4 The Crowding-Out Effect Due to crowding out, AD shifts inward to AD3

Possible Offsets to Fiscal Policy (cont'd) Ricardian Equivalence Theorem The proposition that an increase in the government budget deficit has no effect on aggregate demand Reason: people anticipate that a larger deficit today will mean higher taxes in the future and adjust their spending accordingly

Possible Offsets to Fiscal Policy (cont'd) Direct Expenditure Offsets Actions on the part of the private sector in spending income that offset government fiscal policy actions Any increase in government spending in an area that competes with the private sector will have some direct expenditure offset

Possible Offsets to Fiscal Policy (cont'd) The supply-side effects of changes in taxes Expansionary fiscal policy could involve reducing marginal tax rates Advocates argue this increases productivity since individuals will work harder and longer, save more, and invest more The increased productivity will lead to more economic growth

Possible Offsets to Fiscal Policy (cont'd) Supply-side effects of changes in taxes Lower tax rates lead to an increase in productivity because individuals will work harder and longer, save more, and invest more Increased productivity will in turn lead to more economic growth, thus higher real GDP Results: Lower marginal tax rates will not necessarily reduce tax revenues due to a larger tax base

Figure 13-5 Laffer Curve

Policy Example: Which Affects Real GDP More—Spending or Tax Cuts? Several economists have found that discretionary increases in government spending have significantly smaller effects on real GDP than do discretionary tax cuts: Each $1 in real government purchases generates a net increase in real GDP of only about $0.70 Each $1 tax cut brings about an increase in real GDP somewhere between $1.40 and $3.00 26

Discretionary Fiscal Policy in Practice: Coping with Time Lags Question Is the conduct of fiscal policy as precise as it appears? Answer The difficulty is that the conduct of fiscal policy involves a variety of lags.

Time lags Recognition Time Lag Discretionary Fiscal Policy in Practice: Coping with Time Lags (cont'd) Time lags Recognition Time Lag The time required to gather information about the current state of the economy

Time lags Action Time Lag Discretionary Fiscal Policy in Practice: Coping with Time Lags (cont'd) Time lags Action Time Lag The time required between recognizing an economic problem and putting policy into effect Particularly long for fiscal policy which requires congressional approval

Time lags Effect Time Lag Discretionary Fiscal Policy in Practice: Coping with Time Lags (cont'd) Time lags Effect Time Lag The time it takes for a fiscal policy to affect the economy

Fiscal policy time lags are: Discretionary Fiscal Policy in Practice: Coping with Time Lags (cont'd) Fiscal policy time lags are: Long – a policy designed to correct a recession may not produce results until the economy is experiencing inflation Variable in length – they can be from 1-3 years, and the timing of the desired effect cannot be predicted Because fiscal policy time lags tend to be variable, policymakers have a difficult time fine-tuning the economy

Automatic Stabilizers Automatic or Built-In Stabilizers Changes in government spending and taxation that occur automatically without deliberate action of Congress The tax system Unemployment compensation Welfare spending

Automatic Stabilizers (cont’d) The Tax System Incomes and profits fall when business activity slows down, and the government’s tax revenues drop as well Some economists consider this an automatic tax cut, which therefore stimulates aggregate demand

Automatic Stabilizers (cont’d) Unemployment Compensation and Income Transfer Payments Unemployment compensation reduces changes in people’s disposable income. Their disposable income remains positive, although at a lower level In a recession, more people are eligible for income transfer payments and do not experience as dramatic a drop in disposable income

Automatic Stabilizers (cont’d) Stabilizing Impact The key impact of these systems is the ability to mitigate changes in disposable income, consumption, and the equilibrium level of GDP If disposable income is prevented from falling as much as it otherwise would in a recession, the downturn will be moderated

Figure 13-6 Automatic Stabilizers The automatic changes tend to drive the economy back toward its full-employment output level

What Do We Really Know About Fiscal Policy? Fiscal policy during normal times Congress ends up doing too little too late to help in a minor recession Fiscal policy that generates repeated tax changes (as has happened) creates uncertainty

What Do We Really Know About Fiscal Policy? (cont'd) Fiscal policy during abnormal times Fiscal policy can be effective The Great Depression—fiscal policy may be able to stimulate aggregate demand Wartime—during World War II real GDP increased dramatically

What Do We Really Know About Fiscal Policy? (cont'd) The “soothing” effect of Keynesian fiscal policy Should we encounter a severe downturn, fiscal policy is available Knowing this may reassure consumers and investors Stable expectations encourage a smoothing of investment spending

You Are There: Raising Tax Rates While Emerging from a Severe Recession In 2010, White House Budget Director Peter Orszag anticipated that the government’s tax revenues would fall short of its spending every year for the rest of the 2010s. Orszag also viewed that the only way to bring revenues and spending back into closer balance was to raise federal tax rates. He hoped that increased annual government spending would stimulate the economy sufficiently to make up for the contractionary effects of these higher tax rates.

Issues & Applications: Temporary Tax Rebates Prove to Be Nonstimulating Figure 13-7 shows that real disposable income rose after the one-time tax rebates in 2008 and 2009 but real consumption expenditure did not. 41

Figure 13-7 U.S. Real Disposable Personal Income and Real Personal Consumption Expenditures since January 2007 42

Possible explanations: Issues & Applications: Temporary Tax Rebates Prove to Be Nonstimulating (cont’d) Possible explanations: Many people who received the rebates used them to pay off debts instead of spending the funds on goods and services The government financed the rebates by borrowing, so a number of households responded by saving them (the Ricardian equivalence theorem) The tax rebates were temporary lump sums, not permanent reductions in income tax rates (supply-side economics) 43

Summary Discussion of Learning Objectives The effects of discretionary fiscal policy using traditional Keynesian analysis Increases in government spending and decreases in taxes increase aggregate demand Decreases in government spending and increases in taxes decrease aggregate demand

Summary Discussion of Learning Objectives (cont'd) How indirect crowding out and direct expenditure offsets can reduce the effectiveness of fiscal policy actions Deficits increase interest rates Some government spending replaces private spending If the Ricardian equivalence theorem is valid, a tax cut has no effect on total planned expenditures and aggregate demand

Summary Discussion of Learning Objectives (cont'd) Fiscal policy time lags and the effectiveness of fiscal “fine tuning” The time lags for fiscal policy are the recognition time lag, action time lag, and the effect time lag The time lags are long and variable Automatic stabilizers are changes in tax payments, unemployment compensation, and welfare payments that automatically change with the level of economic activity

Appendix D: Fiscal Policy: A Keynesian Perspective The traditional Keynesian approach to fiscal policy differs in three ways from that presented in Chapter 13: It emphasizes the underpinnings of the components of aggregate demand It assumes that government expenditures are not substitutes for private expenditures and that current taxes are the only taxes taken into account by consumers and firms It focuses on the short run and so assumes that as a first approximation, the price level is constant 47

Figure D-1 The Impact of Higher Government Spending on Aggregate Demand

Figure D-2 The Impact of Higher Taxes on Aggregate Demand

Appendix D: The Balanced-Budget Multiplier Balanced-budget increase in real spending The government increases spending by $1 and pays for it by raising current taxes by $1 Balanced-budget multiplier is equal to 1 50