Fiscal Policy Government spending & taxes

Government Spending Total government spending in the US is approximately $3.5T. ($2.5T Federal, $1T State/Local) – that’s around $10,000 per person!

Government Spending Total government spending in the US is approximately $3.5T. ($2.5T Federal, $1T State/Local) – that’s around $10,000 per person! Total government as a percentage of the economy is around 35%.

Government Spending Total government spending in the US is approximately $3.5T. ($2.5T Federal, $1T State/Local) – that’s around $10,000 per person! Total government as a percentage of the economy is around 35%. Government spending grows approximately 5% per year

Government Spending For budget procedures, government spending can be classified in two categories: –Discretionary (35%) –Mandatory (65%) The government follows baseline budgeting –Unless otherwise stated, baseline discretionary spending grows at the rate of inflation –Baseline mandatory spending growth is dictated by the spending rules

The Federal Budget:2003 Budget ItemAmount (Billions) PercentageAverage Growth Defense$37618%7% Other Discretionary$41619%3% Social Security$47422%5% Medicare/Medicaid$40819%10% Other Mandatory$30515%5% Interest on Debt$1617%4% Total$2,140100%5%

Financing government spending How does the government pay for its spending?

Financing government spending How does the government pay for its spending? –Taxes –Borrowing (selling bonds) –Printing money (seignorage)

Federal Taxes: 2003 SourceAmount (Billions)Percentage Income Taxes$84946% Corporate Taxes$1438% Payroll Tax$72640% Estate Taxes$201% Miscellaneous$985% Total$1, %

US Income Tax Rates BracketOld RateNew Rate $0 - $6,00015%10% $6,000 - $27,25015% $27,251 - $67,55028%25% $67,551 - $141,60031%28% $141,601 - $307,30036%33% $307, %35%

Who Pays Income Taxes? QuintileAverage Income % of Total Income % of Total Taxes Bottom 20%$13,0003%<1% 2 nd 20%$30,0008%2% Middle 20%$49,00014%13% 4 th 20%$72,00023%25% Top 20%$147,00050%60% Top 5%$254,00021%40% Top 1%$1,000,00015%30%

Government Borrowing In 2003, the federal government spent an estimated $2.14T while tax revenues were $1.853T

Government Borrowing In 2003, the federal government spent an estimated $2.14T while tax revenues were $1.853T $2.14 T: Outlays -$1.836: Taxes $ 304 B Deficit

Government Deficits In 2003, the federal government spent an estimated $2.14T while tax revenues were $1.853T $2.14 T: Outlays -$1.836: Taxes $ 304 B Deficit Of greater importance is the primary deficit. This represents spending on current programs in excess of current taxes –$304B = $143 (Primary Deficit) + $161 (Interest on Debt)

Government Borrowing The deficit represents new government borrowing (new government securities). This gets added on to previous borrowing (existing government securities) to make up the total – the government debt

Government Borrowing The deficit represents new government borrowing (new government securities). This gets added on to previous borrowing (existing government securities) to make up the total – the government debt Currently, government debt held by the public is approximately $3.9T (approximately $15,000 per person).

US Deficits/Debt

Deficits/Debt The absolute size of the US debt is irrelevant. What matters is the size of the debt relative to the size of the economy.

Deficits/Debt The absolute size of the US debt is irrelevant. What matters is the size of the debt relative to the size of the economy. Currently, the debt to GDP ratio is around 35% and has been steadily falling since WWII.

Debt/GDP Ratio

Sustainable deficits If GDP is growing, it is possible to run a deficit without increasing the debt to GDP ratio.

Sustainable deficits If GDP is growing, it is possible to run a deficit without increasing the debt to GDP ratio Growth of Debt/DGP = Primary Deficit/Total Debt + interest rate – growth of nominal income For example, our current primary deficit is $143B. Assuming a 4% interest rate and a 2% rate of economic growth Growth of Debt/GDP = ($143/$3900) + 4% - 2% = 2.04%

Seignorage Revenue The government also earns “revenue” by printing money. This is done by printing money and using that currency to buy back government debt.

Seignorage Revenue The government also earns “revenue” by printing money. This is done by printing money and using that currency to buy back government debt. For example, suppose that the government uses $100M worth of newly printed currency to buy back $100M worth of government debt. Assuming that there was initially $1B of currency in circulation, we know that eventually this will create a 10% price increase – thus reducing the purchasing power of every dollar in circulation by 10%. Seignorage Revenue = (inflation Rate)*(Monetary Base) The federal government currently collects ($700B)(2%) = $14B in seignorage revenue annually.

Analysis of government expenditures From an analysis point of view, there are two types of government spending:

Analysis of government expenditures From an analysis point of view, there are two types of government spending: –Transfers (70%) –Government purchases (30%)

Analysis of government expenditures From an analysis point of view, there are two types of government spending: –Transfers (70%) –Government purchases (30%) The results also depend on the presence of nominal rigidities (i.e., classical vs. Keynesian)

Transfers For simplicity, assume that all government expenditures are financed by current tax revenues – (G-T) = 0

Transfers For simplicity, assume that all government expenditures are financed by current tax revenues – (G-T) = 0 By definition, transfer payments neither create nor destroy income, they only redistribute income. Therefore, they create both a positive income effect (whoever receives the benefits) and a negative income effect (whoever is taxed)

Transfers GroupLabor Supply ConsumptionSavings Taxed Beneficiary Net

Transfers GroupLabor Supply ConsumptionSavings TaxedIncrease BeneficiaryDecrease Net?

Transfers GroupLabor Supply ConsumptionSavings TaxedIncreaseDecrease BeneficiaryDecreaseIncrease Net???

Transfers In principle, anything can happen in response to a transfer payment. Everything depends on the reaction of the two groups. However, empirically lower income individuals have a much higher marginal propensity to consume (around.9) than to wealthier individuals (around.3)

Transfers GroupLabor Supply ConsumptionSavings TaxedIncreaseSmall Decrease Large Decrease BeneficiaryDecreaseLarge Increase Small Increase Net0IncreaseDecrease

Transfers: Classical Analysis The transfer creates no net effect on labor markets. Therefore, real wages, employment, and aggregate output are unchanged.

Transfers: Classical Analysis The transfer creates no net effect on labor markets. Therefore, real wages, employment, and aggregate output are unchanged. A decline in aggregate savings raises interest rates and lowers investment (government spending “crowds out investment”)

Transfers: Classical Analysis The transfer creates no net effect on labor markets. Therefore, real wages, employment, and aggregate output are unchanged. A decline in aggregate savings raises interest rates and lowers investment (government spending “crowds out investment”) Higher interest rates lower money demand which raises prices.

Transfers: Classical Analysis Using IS-LM-FE analysis. The drop in aggregate savings shifts IS to the right

Transfers: Classical Analysis Using IS-LM-FE analysis. The drop in aggregate savings shifts IS to the right Rising prices lowers real money balances which shifts LM to the left. The economy ends up at point A.

Transfers: Keynesian Analysis For the same reasons as before, Keynesian analysis would result in a rightward supply shift.

Transfers: Keynesian Analysis For the same reasons as before, Keynesian analysis would result in a rightward supply shift. However, without the price increase, the economy settles at the intersection of IS and LM – output (and employment) temporarily rise above the full employment level

Government Purchases Again, assume the budget is always balanced – (G-T) = 0 Government purchases involve the government using up resources to provide government goods and services. –Total Output = Private Output + Government Output

Government Purchases Again, assume the budget is always balanced – (G-T) = 0 Government purchases involve the government using up resources to provide government goods and services. –Total Output = Private Output + Government Output The important question here is: Is Government output valued at more or less than its cost? –Y ( Total) – G = C + I

Government Purchases Again, assume the budget is always balanced – (G-T) = 0 Government purchases involve the government using up resources to provide government goods and services. –Total Output = Private Output + Government Output The important question here is: Is Government output valued at more or less than its cost? –Y ( Total) – G = C + I If government output is valued at more (less) than cost, then the economy experiences a positive (negative) income effect

Government Purchases Conventional wisdom suggests that most government output is valued at or below cost. Why?

Government Purchases Conventional wisdom suggests that most government output is valued at or below cost. Why? –Public vs. Private goods

Government Purchases Conventional wisdom suggests that most government output is valued at or below cost. Why? –Public vs. Private goods With a negative income effect : –Labor Supply increases (output and employment increase) –Savings Falls (interest rates rise) –Consumption Falls

Government Purchases: Classical Analysis Higher employment shifts FE to the right while lower savings shifts IS to the right

Government Purchases: Classical Analysis Higher employment shifts FE to the right while lower savings shifts IS to the right Higher interest rates lower money demand, which raises prices and shifts LM to the left.

Government Purchases: Keynesian Analysis The Keynesian analysis still results in the IS and FE shift (although the FE shift is inconsequential) With fixed prices, there is no LM shift and the economy settles at the intersection of IS and LM

Summary Classical analysis generally presumes that government spending provides very little stimulus, but potentially large impacts on inflation and interest rates Keynesian analysis a larger stimulus from government spending with a smaller impact on inflation and interest rates.

Tax Cuts As with government spending, there are two types of tax cuts:

Tax Cuts As with government spending, there are two types of tax cuts: Average rate cuts Marginal Rate cuts

Taxes: an example Suppose we have the following tax code: –$5,000 deduction –10% on all taxable income less than $20,000 –20% on all income greater that $20,000

Taxes: an example Suppose we have the following tax code: –$5,000 deduction –10% on all taxable income less than $20,000 –20% on all income greater that $20,000 You currently earn $55,000 (your taxable income is $50,000).

Taxes: an example Suppose we have the following tax code: –$5,000 deduction –10% on all taxable income less than $20,000 –20% on all income greater that $20,000 You currently earn $55,000 (your taxable income is $50,000). –Your marginal tax rate is the percentage of each additional dollar earned that is paid in taxes: in this case, your marginal rate is 20%

Taxes: an example Suppose we have the following tax code: –$5,000 deduction –10% on all taxable income less than $20,000 –20% on all income greater that $20,000 You currently earn $55,000 (your taxable income is $50,000). –Your marginal tax rate is the percentage of each additional dollar earned that is paid in taxes: in this case, your marginal rate is 20% –Your average rate is the percentage of your income paid in taxes. In this case, Tax Bill =.10(20,000) +.20(30,000) = $8,000 Average Rate = ($8,000/$55,000) =.145 = 14.5%

Taxes: An example Suppose that the standard deduction is increased to $15,000. –Your marginal rate is still 20% –Your new average rate is: Tax Bill =.10(20,000) +.2(20,000) = $6,000 Average Rate = ($6,000/$55,000) =.11 = 11%

Taxes: An Example Suppose that the government adopts a flat tax with a $23,000 deduction and a 25% flat rate:

Taxes: An Example Suppose that the government adopts a flat tax with a $23,000 deduction and a 25% flat rate: –Your marginal rate increases (to 25%)

Taxes: An Example Suppose that the government adopts a flat tax with a $23,000 deduction and a 25% flat rate: –Your marginal rate increases (to 25%) –Your new average rate is: Tax Bill = (.25)($32,000) = $8,000 Average Rate = (8,000/55,000) = 14.5%

Average Rates vs. Marginal Rates Recall that when we derived both labor supply and savings, we talked about both income and substitution effects: –Marginal rates influence substitution effects (people tend to do less of whatever is being taxed) –Average rates influence income effects (wealthier people tend to work less, consume more)

Example: A cut in marginal rates Suppose that the government cuts marginal rates across the board, but lowers the deduction in such a way that nobody’s tax bill changes (ie, average rates remain the same)

Example: A cut in marginal rates Suppose that the government cuts marginal rates across the board, but lowers the deduction in such a way that nobody’s tax bill changes (ie, average rates remain the same) Labor supply increases (an increase in take home pay raises the cost of leisure) – employment and income increase

Example: A cut in marginal rates Suppose that the government cuts marginal rates across the board, but lowers the deduction in such a way that nobody’s tax bill changes (ie, average rates remain the same) Labor supply increases (an increase in take home pay raises the cost of leisure) – employment and income increase Higher employment increases MPK – investment increases

Marginal Rate Cut: Classical Analysis The rise in employment shifts the FE curve to the right

Marginal Rate Cut: Classical Analysis The rise in employment shifts the FE curve to the right Higher investment shifts IS to the right

Marginal Rate Cut: Classical Analysis The rise in employment shifts the FE curve to the right Higher investment shifts IS to the right Prices fall – this raises real balances and shifts LM to the right

Marginal Rate Cut: Keynesian Analysis Again, the analysis leaves out the LM shift and looks for the intersection of IS and LM

Example: average rate cuts Now, consider an tax cut where marginal rates are unchanged, but everybody pays less total taxes – a good example would be the $500/person rebate awarded in 2002.

Example: average rate cuts Now, consider an tax cut where marginal rates are unchanged, but everybody pays less total taxes – a good example would be the $500/person rebate awarded in 2002 Since total taxes collected drops, two things happen: –Assuming that government spending in constant, the deficit (government borrowing) increases. –Households see an increase in their disposable income. Or do they?

Average rate cuts Suppose that the government lowers taxes by $1,000 per person. If government spending remains constant, how does this impact your wealth? (Assume an interest rate of 5%)

Average rate cuts Suppose that the government lowers taxes by $1,000 per person. If government spending remains constant, how does this impact your wealth? (Assume an interest rate of 5%) If the government repays this extra borrowing by raising your taxes next year, your taxes will have to increase by $1,050 (to repay the debt plus the 5% interest) Change in wealth = $ $1,050/(1.05) = 0 !!

Average rate cuts Suppose that the government lowers taxes by $1,000 per person. If government spending remains constant, how does this impact your wealth? (Assume an interest rate of 5%) If the government repays this extra borrowing by raising your taxes in two years, your taxes will have to increase by $1, (to repay the debt plus the 5% interest compounded over two years) Change in wealth = $ $1,102.50/(1.05)^2 = 0 !!

Average rate cuts Suppose that the government lowers taxes by $1,000 per person. If government spending remains constant, how does this impact your wealth? (Assume an interest rate of 5%) In fact, as long as the government pays back that loan in your lifetime, your wealth will be unaffected. Why is this important?

Average rate cuts Suppose that the government lowers taxes by $1,000 per person. If government spending remains constant, how does this impact your wealth? (Assume an interest rate of 5%) In fact, as long as the government pays back that loan in your lifetime, your wealth will be unaffected. Why is this important? Remember, forward looking individuals should be basing labor and consumption decisions on wealth not income!!

Ricardian equivalence Ricardian equivalence states that if consumers are forward looking, then household behavior is determined by government spending, not the method of financing!

Ricardian equivalence Ricardian equivalence states that if consumers are forward looking, then household behavior is determined by government spending, not the method of financing! In the previous example, if Ricardian equivalence holds, then the impact of the tax cut would be:

Ricardian equivalence Ricardian equivalence states that if consumers are forward looking, then household behavior is determined by government spending, not the method of financing! In the previous example, if Ricardian equivalence holds, then the impact of the tax cut would be: –Government borrowing rises by $1000 per person –Private savings increases by $1000 per person –Consumption, Investment, Employment, and Output and interest rates are UNAFFECTED!

Suppose that households are “fooled” by the tax cut If households actually feel wealthier by a deficit financed cut in average tax rates, how will they respond?

Suppose that households are “fooled” by the tax cut If households actually feel wealthier by a deficit financed cut in average tax rates, how will they respond? –Labor supply decreases, lowering employment and output –Consumption rises (savings does not increase enough to compensate for higher government borrowing) – interest rates rise

Average rate cuts The drop in employment shifts the FE curve to the left

Average rate cuts The drop in employment shifts the FE curve to the left The rise in government borrowing shifts the IS curve to the right

Classical analysis Higher interest rates, along with lower output lower money demand. Higher prices reduces real balances – LM shifts left

Keynesian Analysis Keynesians ignore the FE shift – the economy settles at the intersection of IS and LM

Summary Classical analysis suggests that only cuts in marginal tax rates will provide stimulus to the economy Keynesian analysis suggests that all tax cuts can stimulate the economy – as long as households feel wealthier (i.e., Ricardian equivalence fails)

A final thought…. The preceding review of fiscal policy was based purely on positive analysis (what will happen). However, what if we studied fiscal policy using a normative analysis (what should happen). What normative criterion should we use?

A final thought…. The preceding review of fiscal policy was based purely on positive analysis (what will happen). However, what if we studied fiscal policy using a normative analysis (what should happen). What normative criterion should we use? –Efficiency: Any policy which raises total output increases efficiency

A final thought…. The preceding review of fiscal policy was based purely on positive analysis (what will happen). However, what if we studied fiscal policy using a normative analysis (what should happen). What normative criterion should we use? –Efficiency: Any policy which raises total output increases efficiency –Equity: An equitable policy improves “fairness”

Example: Jack and Jill Jack and Jill live on a desert island. The is a community well on the island that Jack and Jill use equally. The well costs $10,000 per year to maintain.

Example: Jack and Jill Jack and Jill live on a desert island. The is a community well on the island that Jack and Jill use equally. The well costs $10,000 per year to maintain. Jack Income = $20,000 Tax Paid = $2,000 (10%)

Example: Jack and Jill Jack and Jill live on a desert island. The is a community well on the island that Jack and Jill use equally. The well costs $10,000 per year to maintain. JackJill Income = $20,000Income = $100,000 Tax Paid = $2,000 (10%) Tax Pain = $8,000 (8%) As long as the well is valued collectively at more than $10,000, this policy is efficient – regardless of how the tax is split.

Example: Jack and Jill Jack and Jill live on a desert island. The is a community well on the island that Jack and Jill use equally. The well costs $10,000 per year to maintain. JackJill Income = $20,000Income = $100,000 Tax Paid = $2,000 (10%) Tax Pain = $8,000 (8%) As long as the well is valued collectively at more than $10,000, this policy is efficient – regardless of how the tax is split. Is this policy equitable?