Chapter 11 Managing Aggregate Demand: Fiscal Policy Next, let us turn to the problems of our fiscal policy. Here the myths are legion and the truth hard to find. JOHN F. KENNEDY

Roadmap AS- AD equilibriumChapter 8-10 establish the theoretical framework of the macro economy: AS- AD equilibrium government policyChapter turn to the government policy –Fiscal policy (Chapter 11) –Monetary policy (Chapter 12, 13) –Debate and trade-off (Chapter 14-16)

Question for This Chapter How do taxes (T) affect equilibrium GDP (Y)?

Tools of Fiscal Policy Government spendingGovernment spending (G) Income TaxIncome Tax (T) Government TransferGovernment Transfer (GT)

Income Taxes & Consumption Schedule TTax affects disposable income (DI = Y-T) –Real GDP (Y) –Taxes (T) 5

Income Taxes & Consumption Schedule Tax increase –Consumption schedule – shift downward –Total spending schedule – shift downward –Equilibrium GDP (demand side) – reduced Tax decrease –Consumption schedule – shift upward –Total spending schedule – shift upward –Equilibrium GDP (demand side) - increased 6

How tax policy shifts the consumption schedule Figure 1 7 Real GDP Real Consumer Spending C Tax Increase Tax Cut

The Multiplier Revisited GChange in government purchases G –Every dollar - spent –Multiplier effect ( ∆G/∆Y=1/(1-MPC) ) TChange in taxes T –Not every dollar is spent –Multiplier – smaller 8

The Tax Multiplier: Fixed Tax Increase in GIncrease in G by 1 million ∆Y= ^ ^3 + …… = 4 Decrease in TDecrease in T by 1 million ∆Y= ^ ^3 + …… = 0.75( ^2+0.75^3+……) = 0.75*4 = 3

The Tax Multiplier: Variable Tax Proportional income tax t=20% Increase in G by 1 million ∆Y = *(80%) + (0.75*80%)^2 + (0.75*80%)^3 + …… = ^2 +0.6^3 + ….. = 1/(1-0.6) = 2.5 ∆Y = 1/(1-(1-t)MPC)

The Multiplier Revisited Multiplier –Reduced by income tax –Income tax Reduces - fraction of each dollar of GDP –Consumers actually receive and spend Oversimplified formula 1/(1-MPC) –Overstates multiplier variable imports 1. Ignores variable imports (Chp. 9) price-level changes 2. Ignores price-level changes (Chp. 10) income tax 3. Ignores income tax 11

The multiplier in the presence of an income tax Figure Real GDP Real Expenditure 45° 6,000 C+I+G 0 +(X-IM) E0E0 C+I+G 1 +(X-IM) 7,000 $400 E1E1

The Multiplier Revisited Taxes – change multiplier analysis T –Fixed tax changes (T) - smaller multiplier effect Than changes in spending t –Variable income tax (t) - reduces multipliers for Tax changes Changes in spending 13

The Multiplier Revisited Automatic stabilizerAutomatic stabilizer –Feature of economy –Reduces its sensitivity to shocks Sharp increase/decrease in spending –Automatically – shock absorber Lower multiplier → less volatile –Example Personal income tax Personal income tax Unemployment insurance Unemployment insurance 14

The Multiplier Revisited Government transfer payments –Payments to individuals Not compensation for production –Add to income negative –Function as negative taxes –Net T = taxes - transfers 15

Planning Expansionary Fiscal Policy Expansionary fiscal policy –Raise government purchases (G↑) –Reduce taxes (T↓) –Increase transfer payments (GT↑) T↓ + GT↑ → Net T↓ → DI=Y - Net T increase → C ↑ AD = C + I +G + (X-IM) ↑ To close recessionary gap –Between actual and potential GDP 16

Fiscal policy to eliminate a recessionary gap Figure Real GDP Real Expenditure 45° 6,000 C+I+G 0 +(X-IM) 7,000 Potential GDP (a) Real Expenditure 45° 0 Real GDP 6,000 C+I+G 0 +(X-IM) 7,000 Potential GDP (b) C+I+G 1 +(X-IM) F E Recessionary gap

Expansionary fiscal policy Figure 4 18 Real GDP Price Level D0D0 D0D0 S S D1D1 D1D1 A E Rise in real GDP Rise in Price level

Planning Contractionary Fiscal Policy Contractionary fiscal policy –Reduce government purchases (G↓) –Increase taxes (T↑) –Reduce transfer payments (GT↓) AD = C + I + G + (X-IM) ↓ To close inflationary gap –Between actual and potential GDP Can avoid inflation 19

Choice: Spending Policy & Tax Policy G  T Policy Alternative: G  or T  Case 1: Fixed Taxes (MPC=0.75)Case 1: Fixed Taxes (MPC=0.75) –T  400  Y  1200 –G  400  Y  1600 Case 2: Variable Taxes (t=20%)Case 2: Variable Taxes (t=20%) –T  400  Y  750 –G  400  Y  1000 directlyindirectlyG↑ directly increases AD; T↓ indirectly increase AD through consumption 20

Choice: Spending Policy & Tax Policy Higher spending, or lower taxes, or a combination of these two tools theoretically will achieve –Same increase in AD curve –Same increases in real GDP and prices

Choice: Spending Policy & Tax Policy In practice, the choice depends on how large a public sector policy-makers want to create Conservatives  small government  advocate T  (recession) or G  (boom) Liberals  large government  advocate G  (recession) or T  (boom) 22

Some Harsh Realities Theory shows gov can drive GDP to any level they want by using fiscal policy Reality is more complicated –I, X-IM, C schedules Shift with –Expectations (often driven by policy itself), Technology, Events abroad, Other factors –Multipliers – not precisely known –Target - full-employment GDP dimly visible –Fiscal policies have time lags 23

Some Harsh Realities Legislation level, lower unemployment rate through G↑ and T↓ –Long-run costs (Chp. 15) Running large budget deficits –Inflationary cost How large can we bear low unemploymenthigh inflation Seems for expansionary fiscal policy, we always face a dilemma b/w low unemployment and high inflation Any way out? 24

Idea Behind Supply-Side Tax Cuts Supply-side economicsSupply-side economics believes certain types of tax cuts supply –Increase aggregate supply Increase supply of labor & capital Reduce inflation Raise real GDP 25

Idea Behind Supply-Side Tax Cuts Examples of supply-side tax cuts personal income tax rate –  personal income tax rate  stimulate incentive of working, labor supply ↑ tax on income from saving –  tax on income from saving  more saving  more investment tax on capital gain –  tax on capital gain  stimulate investment and capital formation corporate income tax –  corporate income tax –With more labor and capital supply, AS curve ↑

The goal of supply-side tax cuts Figure 5 28 Real GDP Price Level D D S0S0 S0S0 A S1S1 S1S1 B

A successful supply-side tax reduction Figure 6 29 Real GDP Price Level D0D0 D0D0 S0S0 S0S0 E S1S1 S1S1 D1D1 D1D1 A C

Idea Behind Supply-Side Tax Cuts Undesirable side effects –Small magnitude of supply-side effects –Stronger demand-side effects possiblywork morecertainly spend more Tax cut may possibly induce individuals work more. But they will certainly spend more –Problems with timing Primary short-run effect on AD, effects on AS come later –Effects on income distribution Increase income equality –Losses of tax revenue, bigger deficit 30

A more pessimistic view of supply-side tax cuts Figure 7 31 Real GDP Price Level D0D0 D0D0 S0S0 S0S0 E S1S1 S1S1 D1D1 D1D1 C

Summary Tools of fiscal policy: G, T and Transfer smaller Multiplier for change in T is smaller than that for change in G reduces A proportional income tax t reduces multiplier negative Government transfer acts as a negative tax Recessionary gap can be cured by G↑ or T↓ Inflationary gap can be cured by G↓ or T↑ inflationdeficit Expansionary fiscal policy (G↑ or T↓) can raise inflation and create budget deficit Supply-side tax cuts Supply-side tax cuts push AS and hence avoid the undesirable results of expansionary policy

APPENDIX A Graphical treatment of taxes and fiscal policy Variable taxes –Vary with GDP –Personal income tax –Corporate income tax –Sales tax Fixed taxes –Don’t vary with GDP –Property taxes 33

How variable taxes shift the consumption schedule Figure 8 34 Real GDP Real Consumer Spending C Variable Tax Increase Variable Tax Cut

APPENDIX A Graphical treatment of taxes and fiscal policy Variable taxes –Flatten the consumption schedule Government purchases (goods & services) –Add to total spending - directly C + I + G + (X – IM) 35

APPENDIX A Graphical treatment of taxes and fiscal policy Higher taxes –Reduce total spending – indirectly Lower disposable income Reduce: C component of C + I + G + (X – IM) Government’s actions –Raise or lower equilibrium level of GDP –Depends on Spending Taxing 36

Consumption schedule with fixed vs. variable taxes Figure 9 37 Real GDP Real Consumer Spending C1C1 C2C2

Effects of an income tax on consumption schedule Table 1 38 (1)(2)(3)(4) Gross Domestic ProductTaxes Disposable Income (GDP minus Taxes)Consumption $4,500 5,000 5,500 6,000 6,500 7,000 7,500 $900 1,000 1,100 1,200 1,300 1,400 1,500 $3,600 4,000 4,400 4,800 5,200 5,600 6,000 $3,000 3,300 3,600 3,900 4,200 4,500 4,800

The relationship between consumption and GDP Table 2 39 With Fixed Taxes (T=$1,200) (from Table 1, Chapter 26) With a 20 percent Income Tax (from Table 1) YCYC $4,800 5,200 5,600 6,000 6,400 6,800 7,200 $3,000 3,300 3,600 3,900 4,200 4,500 4,800 $4,500 5,000 5,500 6,000 6,500 7,000 7,500 $3,000 3,300 3,600 3,900 4,200 4,500 4,800 Line C 1 in Figure 9Line C 2 in Figure 9

Total expenditure schedule with a 20% income tax Table 3 40 (1)(2)(3)(4)(5)(6) Gross Domestic Product Y Consumption C Investment I Government Purchases G Net Exports (X-IM) Total Expenditures C+I+G+(X-IM) $4,500 5,000 5,500 6,000 6,500 7,000 7,500 $3,000 3,300 3,600 3,900 4,200 4,500 4,800 $ $1,300 1,300 -$ $5,100 5,400 5,700 6,000 6,300 6,600 6,900

Income determination with a variable income tax Figure ,0000 6,000 Real GDP 8,000 3,000 4,000 5,000 6,000 7,000 Real Expenditure 8,000 45° C+I+G+(X-IM) E

APPENDIX A Multipliers for tax policy Tax multiplier for fixed taxes –Change in tax Change in consumer spending –Vertical shift of consumption schedule 42

The multiplier for a reduction in fixed taxes Figure Real GDP Real Expenditure 45° C 0 +I+G+(X-IM) 6,000 C 1 +I+G+(X-IM) 6,750 $300 billion

APPENDIX B Algebraic treatment of fiscal policy Y=C+I+G+(X-IM) C=a+bDI DI=Y-T T=T 0 +tY C=a-bT 0 +b(1-t)Y 44

APPENDIX B Algebraic treatment of fiscal policy 45