CH. 15: FISCAL POLICY Federal budget process and the recent history of expenditures, taxes, deficits, and debt Supply-side effects of fiscal policy on employment and potential GDP Effects of deficits on saving, investment, and economic growth Fiscal policy’s ability to redistribute benefits and costs across generations Fiscal policy and stabilization.

Elements of Fiscal Policy Federal budget annual statement of the federal government’s expenditures and tax revenues. Fiscal policy use of the federal budget to achieve macroeconomic objectives Employment Act of 1946 committed the government to work toward “maximum employment, production, and purchasing power.” Council of Economic Advisers monitors the economy and advises the President on economic policy.

Balancing Acts on Capitol Hill In 2004, the federal government planned taxes of 17.3 cents per dollar earned. spending of 20 cents per dollar earned. deficit of almost 3 cents per dollar earned. For most of the 1980s and 1990s, the government ran deficits. National debt is now about $13,000 per person.

The Federal Budget Process

Budget information is from www.publicagenda.org

Federal spending has grown

Spending as a % of GDP has been stable

..new records on $ value of deficits

…not a record as % of GDP

..new records on level of debt debtt= debtt-1+ deficitt-1

..not a record as % of GDP

More history from textbook

Who holds the debt?

Top tax rate has dropped over time

U.S. is a relatively low tax country

State and Local Budgets In 2002, when the federal government spent $2,000 billion, state and local governments spent almost $1,900 billion, mostly on education, protective services, and roads. State and local budgets are not used for stabilization purposes, and occasionally are destabilizing in recessions.

Supply Side Effects of Fiscal Policy A tax on labor income creates a tax wedge Taxes on consumption such as sales or value-added taxes add to the tax wedge indirectly.

The Supply Side: Employment and Potential GDP Does the Tax Wedge Matter? Potential GDP per person in France is 31 percent below that in the United States According to research by Edward Prescott, the entire difference is explained by the larger tax wedge in France.

U.S. taxes in international perspective

The Supply Side: The Laffer Curve An increase in the tax rate decreases employment. encourages tax evasion (both legal and illegal) could cause tax revenue to rise or fall.

The Supply Side: Investment, Saving, and Economic Growth The Sources of Investment Finance GDP = C + I + G + X – M. and GDP = C + S + T. From these two equations, I = S + T – G + M – X. The national income accounting identities. It is worth refreshing the student’s memory about the national income accounting identities used here.

The Supply Side: Inv & Saving I = S + M – X + T – G = PS + GS PS: private saving S: Private domestic saving (M-X) Foreign saving (i.e. borrowing from foreign co’s) GS: government saving Taxes-Government Spending-Transfers

The Supply Side: Inv & Saving Sources of funds for investment: Foreign sources have become larger. The government deficit has become a drain on investment.

The Supply Side: Inv & Saving Fiscal policy can influence investment in two ways: Taxes affect the incentive to save or invest Government saving—the budget surplus or deficit—is part of total saving

The Supply Side: Inv & Saving An income tax drives a wedge between the before-tax and after-tax interest rate and decreases saving supply. Saving Supply Interest rate Investment Demand

The Supply Side: Inv & Saving Increased taxes on business profits reduce investment demand. Saving Supply Interest rate Investment Demand

Policies to promote Investment Encourage savings Pensions IRAs MSAs Capital gains / dividends tax Encourage Investment Business tax rates Investment tax credits Accelerated depreciation

Policies to promote Investment Government Saving A government budget deficit is a decrease in total saving. crowding-out occurs if a government budget deficit decrease investment is called.

Crowding Out The Ricardo-Barro effect an increase in private saving by an amount equal to the government budget deficit. occurs if households recognize that a government budget deficit must be paid for by higher taxes in the future. Ricardian Equivalence: Deficit has no effect on interest rates or investment. The Ricardo-Barro effect. The Ricardo-Barro effect is hard for students to accept. Explain first that not even a $1s worth of Ricardo-Barro effect would occur if people had no foresight or if we were all going to die at the end of the current period. Then explain that the full effect would occur only if people had perfect foresight and lived for ever. Now point out that both of these situations are extremes and that reality lies between the two. A partial Ricardo-Barro effect means that some crowding occurs but the effect is smaller than that shown in Figure 31.11.

Stabilizing the Business Cycle Fiscal policy may seek to stabilize the business cycle work by changing aggregate demand. Discretionary fiscal policy is a policy action that is initiated by an act of Congress. Automatic fiscal policy (auto. Stabilizers) is a change in fiscal policy triggered by the state of the economy.

Stabilizing the Business Cycle Multiplier effects Government spending multiplier An increase in government purchases increases aggregate income, which induces additional consumption expenditure. The tax multiplier is the magnification effect of a change in taxes on AD. An increase in taxes decreases disposable income, which decreases consumption expenditure and decreases AD and real GDP.

Stabilizing the Business Cycle Limitations of Discretionary Fiscal Policy The use of discretionary fiscal policy is hampered by three time lags: Recognition lag Law making lag Impact lag

Stabilizing the Business Cycle Automatic Stabilizers Mechanisms that stabilize real GDP without explicit action by the government. Income taxes and transfer payments Government’s budget deficit also varies with this cycle. In a recession, taxes fall, transfer payments rise, and the deficit grows In an expansion, taxes rise, transfers fall, and deficit shrinks.

The budget and the business cycle

The budget and the business cycle Structural surplus or deficit surplus or deficit that would occur if the economy were at full employment and real GDP were equal to potential GDP. Cyclical surplus or deficit actual surplus or deficit minus the structural surplus or deficit; it is the surplus or deficit that occurs purely because real GDP does not equal potential GDP. Cyclical and structural budget balances. Cyclical and structural budget balances are a difficult concept for many students, but important because of the appropriate measure of fiscal stance. An effective way to help students see that tax revenues and expenditures will vary as depicted in Figure 31.9 (page 615/269) is to remind them that potential GDP corresponds to full employment, and employment (and thus the number of tax payers and recipients of unemployment compensation) changes when GDP varies.