Ch. 14: Fiscal Policy Federal budget process and recent history of outlays, tax revenues, deficits, and debts Supply-Side Economics Controversies on effects of deficits on investment, saving, and economic growth Redistribution of benefits and costs across generations Fiscal policy as a stabilization tool

Federal government spending for 2009 (ending in September 2009) is projected to be approximately $500 billion $1 trillion $2 trillion $3 trillion 20

In fiscal year 2009, the budget deficit is projected to be $500 billion $750billion $1 trillion $1.75 trillion 20

The Federal Budget and Fiscal Policy annual statement of the federal government’s outlays and tax revenues. Two purposes finance the activities of the federal government achieve macroeconomic objectives Fiscal policy the use of the federal budget to achieve macroeconomic objectives Employment Act of 1946 it is the continuing policy and responsibility of the Federal Government to use all practicable means . . . to coordinate and utilize all its plans, functions, and resources . . . to promote maximum employment, production, and purchasing power.

Timeline for Budget Process February to March  President submits budget request to Congress. May-August: House and Senate revise/amend proposals September  House-Senate conference committees resolve differences and agree on final versions of spending bills. President signs or vetoes final bills. October 1  Beginning of fiscal year. Congress passes continuing resolutions to maintain funding for any agencies affected by appropriations bills that have not been passed and signed by the beginning of the fiscal year.

The Council of Economic Advisers Fiscal Policy The Council of Economic Advisers Chaired by Christina Romer monitors the economy keeps the President and the public well informed about the current state of the economy forecasts of where it is heading. source of data that informs the budget-making process. Congressional Budget Office Forecasts effects of legislative changes on budget and economy

Federal Government Revenues

Federal Government Spending

Federal Deficits and Public Debt Budgett = revenuet –outlayst if Budgett > 0  budget surplus if Budgett < 0  budget deficit Debtt = Debtt-1 - budgett-1 Budget deficits increase debt Budget surpluses decrease debt The national debt clock

The Federal Budget

CBO PROJECTIONS OF OBAMA BUDGET

SOURCE: http://www. cbo

The National Debt

State and Local Budgets The total government sector includes state and local governments as well as the federal government. In 2008, when federal government outlays were about $3,200 billion, state and local outlays were a further $2,000 billion. Most of state expenditures were on public schools, colleges, and universities ($550 billion); local police and fire services; and roads. Most states have “balanced budget amendments”.

Supply-Side Economics Fiscal policy aimed at increasing LAS Income taxes affect LAS by affecting labor supply. Higher income taxes reduce labor supply & reduce LAS “Supply-siders” argue for low marginal tax rates. Graph the effect of an increase in income tax rate on before-tax real wage rate, after-tax real wage rate. Tax-wedge Equilibrium employment LAS

Effect of an increase in income tax rate

Tax Wedge Comparisons

In 2008, a single person with $10,000 of taxable income would pay federal income taxes of: $542 $937 $1526 $1924 20

In 2008, a single person with $100,000 of taxable income would pay federal income taxes of: $9,371 $14,268 $17,372 $21,978 20

In 2008, a single person with $1,000,000 of taxable income would pay federal income taxes of: $221,365 $328,597 $416,317 $527,102 20

Federal Income Tax Marginal Rates For recent tax rate schedules and a tax calculator, see: http://www.moneychimp.com/features/tax_brackets.htm

Top Marginal Tax Rates Source: http://www.taxpolicycenter.org/taxfacts/displayafact.cfm?Docid=213

Historical average tax rates in U. S Historical average tax rates in U.S. by Income Quintile: Income Tax Only .: Source: http://www.cbo.gov/doc.cfm?index=6133&type=0 Includes individual income tax only

“The lucky duckies” WSJ, November 2003. The most recent data from the IRS, in 2000, show that the top 5% coughed up more than half of total tax revenue. Specifically, we are talking about folks with adjusted gross incomes of $128,336 and higher being responsible for 56% of the tax take. Eyebrows raised? There's more. The top 50% of taxpayers accounted for almost all income tax revenue--96% of the total take. Source: http://www.opinionjournal.com/extra/?id=110002937

Share of Federal Income Taxes Paid by Quintile .: Source: http://www.cbo.gov/doc.cfm?index=6133&type=0 Includes individual income tax only

The Supply-Side: The Laffer Curve. Tax Revenue Tax Rates

As tax rates rise, taxable income may fall because The Laffer Curve As tax rates rise, taxable income may fall because People reduce work hours Tax avoidance increases Legal tax avoidance Charities Tax free bonds Pension saving Etc Illegal tax avoidance Under-report income Inflate deductions

Laffer Curve and Capital Gains Tax Source: http://time-blog.com/curious_capitalist/2008/01/do_capital_gains_tax_cuts_incr.html

According to the Laffer curve, if tax rates rise, tax revenue Will rise May rise or fall Will fall 20

The Supply-Side: Investment and Saving GDP = C + I + G + (X – M) GDP = C + S + T  I + G + (X – M) = S + T I = S + (T – G) + (M – X) Private saving PS = S + (M – X) Government Saving GS=T-G  I = PS + GS

The Supply-Side: Investment and Saving

The Supply-Side: Investment and Saving Fiscal policy influences investment and saving in two ways: Taxes affect the incentive to save and change the supply of loanable funds. Government saving is a component of total saving and the supply of loanable funds.

The Supply-Side: Investment and Saving A tax on capital income decreases the supply of loanable funds a tax wedge is driven between the interest rate and the after-tax interest rate Investment and saving decrease.

The Supply-Side: Investment and Saving Effect of a government budget deficit on saving and investment -- crowding out

The Supply-Side: Investment and Saving Ricardo-Barro Equivalence In above diagram, it is assumed that government budget does not shift PSLF curve. Ricardo-Barro: Larger deficits cause households to increase savings in order to cover future tax increases. Net effect of larger deficit on SLF curve is zero because PSLF curve shifts right. No effect on investment or interest rates All increases in deficits are offset by increased saving (decreased consumption).

Higher; more Higher; less Lower; more Lower; less Assume that deficits do not affect private saving. A larger budget deficit will lead to ___ interest rates and ___ investment Higher; more Higher; less Lower; more Lower; less 20

No change in; higher; less More; no change in; no change in. Assuming Ricardo-Barro effects, an increase in the federal budget deficit will lead to ___ private saving, ___ interest rates, and ____ investment. No change in; higher; less More; no change in; no change in. More; lower; more. None of the above 20

Stabilizing the Business Cycle Discretionary fiscal policy action that is initiated by an act of Congress. Automatic fiscal policy (Auto stabilizers) fiscal policy triggered by the state of the economy.

Stabilizing the Business Cycle Discretionary Fiscal Stabilization An increase in government expenditure or a tax cut increases aggregate demand. The “multiplier process” increases aggregate demand further. Size of multiplier is controversial.

Stabilizing the Business Cycle A decrease in government expenditure or a tax increase decreases aggregate demand. The multiplier process decreases aggregate demand further.

Stabilizing the Business Cycle Limitations of Discretionary Fiscal Policy Recognition lag time it takes to figure out that fiscal policy action is needed. Law-making lag time it takes Congress to pass the laws needed to change taxes or spending. Impact lag time it takes from passing a tax or spending change to its effect on real GDP being felt.

Stabilizing the Business Cycle Automatic Stabilizers mechanisms that stabilize real GDP without explicit action by the government. Taxes that rise and fall with GDP taxes and needs-tested spending are automatic stabilizers. When real GDP decreases in a recession wages and profits fall, so taxes fall Needs-tested spending rises Budget deficit grows (surplus shrinks)

The Budget and the Business Cycle Cyclical and Structural Balances Actual Budget = Cyclical Budget + Structural Budget The structural surplus or deficit 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 the surplus or deficit that occurs purely because real GDP does not equal potential GDP. Cyclical budget < 0 if GDP< potential GDP

Cyclical and Structural Budget

there would be a surplus There would be a deficit. If the structural budget is +$100 billion and the cyclical budget is -$300 billion, we can conclude that if the economy was at full employment: there would be a surplus There would be a deficit. There would be a balanced budget. 20

If the structural budget is +$100 billion and the cyclical budget is -$300 billion, we can conclude that the economy is currently producing ____ potential GDP above below at 20

As the economy recovers from the current recession, the actual budget deficit should Shrink as tax revenues rise and government spending falls Shrink as tax revenues and government spending fall Rise as tax revenues rise and government spending falls. None of the above. 20