Fiscal policy Focus –Spending distinguish between purchases and spending or outlays or expenditures –Tax revenues distinguish between tax rates and tax revenues let t = tax rate, Y = income, then tax revenue is T = tY –Government debt Today’s topics: effect of deficit, debt, countercyclical policy, structural deficit, automatic stabilizers, rules versus discretion

29_02 Apr. 1Jan. 1, 1999Jan. 1, 2001July 1Oct. 1Jan. 1, 2000Apr. 1July 1Oct. 1 Fiscal year 2000 Supplementary budget or changes in economy may affect actual spending. Congress debates, modifies, and passes budget. President submits budget to Congress in early February. Fiscal year is over; spending and taxes are tabulated.

Federal budget summary (billions of dollars) Fiscal year 1998 versus 1995

Deficit versus debt When the government runs a deficit, it increases its debt When the government runs a surplus, it reduces its debt surplus (‘98) = debt (end ‘97) - debt (end ‘98) 70 = Government borrows by issuing bonds –and retires these bonds when in has a surplus

A graph of the deficit and the debt 29_ ,000 3,500 BILLIONS OF DOLLARS Debt Deficit ,500 2,000 1,500 1,

Debt as a share of GDP Debt/GDP can stay constant or even fall when there is a budget deficit Example –5% growth of GDP –then ratio stays constant if Debt/GDP = Debt(1.05)/GDP(1.05) thus $3.7 trillion times (.05) = $185 billion deficit Debt/GDP ratio falls with balanced budget

Ratio just starting to decline 

Long run effect of deficits or surpluses The long run effect of a lower deficit or higher surplus are those of a lower the share of G in GDP---use SAM –real interest rate lower –I/Y higher, leading to higher potential growth Short run negative effects can be mitigated by being gradual, being credible, and letting Fed join in (but this is an old issue, now...

The question is how to “use” the “projected” surplus Recent shift from deficit to surplus Leave it? Cut taxes? Increase spending? The social security problem –As baby boom generation retires, benefits will grow relative to payroll tax revenues –Will need to reduce benefits or increase taxes –Some suggest privatizing part of social security

Countercyclical fiscal policy Argues that increasing government spending or reducing taxes during a recession would mitigate the recession –Suggested by Keynes in 1930s (Keynesian policy) Rationale now for “fiscal stimulus” package in Japan Discretionary versus automatic

Use of countercyclical fiscal policy (G) to bring the economy back to potential 29_05 REAL GDP INFLATION PA ADI with increase in government purchases OldADI Potential GDP REAL GDP INFLATION PA ADI with decrease in government purchases OldADI Potential GDP

Use of countercyclical fiscal policy (taxes) to bring economy back to potential 29_06 REAL GDP INFLATION PA ADI with tax cut OldADI Potential GDP REAL GDP INFLATION PA ADI with tax increase OldADI Potential GDP

Case of good timing in using fiscal policy to hasten the return of real GDP back to potential GDP 29_08 REAL GDP INFLATION PA Potential GDP ADI without stimulus Path of economy without a fiscal stimulus Path of economy with a fiscal stimulus OldADI with stimulus

Effect of fiscal policy on the path of real GDP: good and bad timing

Effect of the economy on the budget deficit Budget deficit is cyclical –Deficit rises in recessions –Deficit falls during recoveries and expansions To see the reason look at tax revenues and expenditures

Government tax revenues depend on the state of the economy when real GDP grows more rapidly, tax revenues rise faster –more people working, higher incomes –people move into higher tax brackets when real GDP grows more slowly, tax revenues rise less rapidly –fewer people working, lower incomes –people may move into lower tax brackets

Expenditures also depend on the economy When real GDP grows less rapidly or falls, as in a recession, expenditures grow more rapidly –unemployment compensation rises –welfare payments go up –more people retire, increasing social security payments When real GDP grows more rapidly, as in a recovery, expenditures grow less rapidly

Net effect of real GDP on deficit deficit = government spending - tax revenue thus in a recession the deficit will rise, and in a recovery the deficit will fall Y  implies D  –government spending  and tax revenues  Y  implies D  –government spending  and tax revenues  Explains why “rosy scenarios” make the deficit look smaller

A NEW GRAPH to show the effect of real GDP on the deficit

The structural deficit The structural deficit is the deficit that would exist if real GDP = potential GDP Also called full employment deficit Purpose is to take out (control for) the effects of economic fluctuations in real GDP on the deficit Changing structural deficit requires –change in tax laws, size of government,...

Graphical illustration of the structural deficit

Automatic stabilizers The tendency for tax revenues to fall and government spending to rise in recessions can have a stabilizing effect on the economy –the changes offset decline in demand during recession (as with countercyclical policies) these changes are “automatic” –occur without executive or legal action –hence fewer lags, timing is better, overall effects can be very large

Automatic changes in revenues and expenditures due to recession (FY 1991) 29_01 BILLIONS OF DOLLARS Proposed Tax Revenue 1,400 1,054 ProposedActualProposed 270 ExpendituresDeficit 1,200 1, Actual 1,324 1,233 1,170 Actual

Rules versus discretion debate in fiscal policy Problems with discretion are mainly lags recognition, implementation, impact Rules  automatic stabilizers Johnson surcharge (1968) Bush stimulus package (1992) Clinton stimulus package (1993) Kennedy tax cut (1964) Reagan tax cut ( ) 

END OF LECTURE