Fiscal Policy, the Budget, and the National Debt zFiscal Policy -- the Federal government changing its government position (G - T) in order to stabilize the economy.

The Federal Budget zBudget = Tax Revenues - Government Expenditure (over a given period) zBudget = Tax Revenues - (Government purchases of goods and services + Transfer Payments + Interest on the National Debt)

Budget Definitions zBudget < 0 -- Budget Deficit zBudget > 0 -- Budget Surplus zBudget = 0 -- Balanced Budget zRealistic Goal -- Balanced Budget when Y = Y F.

The Federal Budget: 2000 (Billions of Dollars) zTax Revenues = $ zGovernment Expenditure = $ zBudget = $251.8 zSource: Economic Indicators, May 2001

Breakdown of Tax Revenues zPersonal Income Taxes = $ zCorporate Profits Taxes = $244.0 zIndirect Business Taxes = $108.4 zContributions for Social Insurance = $695.6

Breakdown of Government Expenditure zPurchases of Goods and Services = $489.2 zTransfer Payments = $782.4 zGrants-in-aid to State and Local Governments = $108.4 zNet Interest Paid = $259.4 zNet Subsidies of Gov’t Enterprises = $38.4

The Budget: In Our Notation Recall variable definitions: -- T = net taxes = tax revenues - (transfer payments + interest on the national debt) -- G = government purchases of goods and services

The Budget and The Budget Position zBudget = T - G zBudget Position (or size of deficit) = G - T

The National Debt zThe National Debt -- The total accumulated stock of debt owed by the government to its lenders. zExpanded by deficits, reduced by surpluses

National Debt -- Realistic Goal zRealistic Goal -- consider the Debt-Income Ratio = (National Debt)/(GDP). zConsumers are allowed a Debt- Income Ratio maximum of 2.0. zFor the US in 2000 = ($3410.1)/($9963.1) = zConclusion – National Debt in US not a major concern.

The Income Tax and Automatic Stabilization zAutomatic Stabilization -- due to the income tax system, tax revenues change in directions that help to stabilize the economy, without any change in the tax structure (I.e. fiscal policy)

The Income Tax as an Automatic Stabilizer Y*  (maybe > Y F )  Tax Revenues  helps to cool the economy Y*  (maybe < Y F )  Tax Revenues  helps to stimulate the economy zNote -- all this takes place without any change in the tax structure, as prescribed by fiscal policy.

The Income Tax and the Budget Y*   Tax Revenues   T   (T - G)  zA strong and growing economy improves the budget. Y*   Tax Revenues   T   (T - G)  zA weak economy generates a lower budget.

Strategy of Fiscal Policy zExpansionary policies seek to induce more purchasing of goods and services by increasing (G - T) -- i.e. G  or T . zContractionary policies seek to induce less purchasing of goods and services by decreasing (G - T) -- i.e. G  or T .

Specific Types of Fiscal Policy zChange Government Purchases of Goods and Services (G) -- Expansionary: G  -- Contractionary: G  zChange Transfer Payments (TP) -- Expansionary: TP  -- Contractionary: TP 

Tax Policy as Fiscal Policy zChange Marginal Tax Rate (t) -- Expansionary: t  -- Contractionary: t  zChange Autonomous Net Taxes (T 0 ) – taxes that don’t depend upon income (e.g. sales taxes). -- Expansionary: T 0  -- Contractionary: T 0 

Fiscal Policy in the AD-AS Model zExpansionary Fiscal Policy shifts the AD curve rightward, increases Y* and P*. zContractionary Fiscal Policy shifts the AD curve leftward, decreases Y* and P*. zNote -- like monetary policy, fiscal policy is justified only from a short-run perspective.

Obstacles to Fiscal Policy Effectiveness zDifficulties in getting the proper policy passed through Congress and the president. zA tax cut that isn’t used for spending. AD curve does not shift rightward, no change in Y*. zWorries about the Federal Budget within a sluggish economy.

The Crowding Out Effect -- An Adverse “Side Effect” zThe Crowding Out Effect -- Expansionary fiscal policy creates an increased need for more borrowing by the government. This financing increases the demand for financial capital. As a result, long-term interest rates (r*) rise and Investment (I*) decreases.

The Crowding Out Effect -- Fiscal Policy Effectiveness zCrowding Out Effect -- makes fiscal policy less effective than would be otherwise. zDecrease in investment to some extent offsets rise in (G - T). zSmaller shift in AD curve than would be without the crowding out effect.

Ways to Avoid the Crowding Out Effect zBottom line -- get the supply of financial capital to shift rightward at the same time as when expansionary fiscal policy occurs. -- expansionary monetary policy -- increased private saving -- increase in foreign capital inflows

A Benefit of Government Debt Reduction zConsider the “Crowding Out Effect” in reverse. zSuppose that the government runs a budget surplus and uses it to reduce the national debt. zDemand for financial capital shifts leftward, r* decreases and I* increases, cushions some of the contraction.

Distinctive Fiscal Policy Actions in the US zWorld War II zThe Kennedy-Johnson Tax Cut of 1964 zThe Nixon Tax Increase of 1969 zThe Reagan Economic Recovery and Tax Act of 1981 zClinton Tax Increases of 1993 zBush Tax Cut of ?