1 Ch. 10: The Federal Budget and Fiscal Policy James R. Russell, Ph.D., Professor of Economics & Management, Oral Roberts University ©2005 Thomson Business & Professional Publishing, A Division of Thomson Learning

2 Government Spending as a Percentage of GDP, 2003

3 Dollar Amounts Spent in Various Spending Programs, 2003 Spending Program CategoryBillions of Dollars National Defense$404 Social Security$471 Medicare$274 Medicaid$161 Unemployment Compensation$55 Food Stamps$25 Family Support$26 Child Nutrition$12 Veterans' Benefits$29 Federal Civilian Retirement Benefits$58 Administration of Justice$35 Science, space and technology$20 Agriculture$22 Net Interest on the Public Debt$153

4 Government Tax Revenues as a Percentage of GDP, 2003

5 Government Tax Revenues by Type of Tax, 2003 TaxBillions of Dollars Percentage of 2003 GDP Individual Income Tax$ Corporate Income Tax$ Social Security Taxes$ Other$1431.3

6 Government Tax Revenues in Billions of Dollars, Year Individual Income Tax Corporate Income Tax Social Security 2000$1,004$207$ $994$151$ $858$148$ $794$132$713

7 Income Tax Structure Progressive Income Tax: the tax rate increases as a person’s taxable income level rises. A progressive tax is usually capped at some tax rate. Progressive Income Tax: the tax rate increases as a person’s taxable income level rises. A progressive tax is usually capped at some tax rate. Proportionate Income Tax: the same tax rate is used for all levels. This is sometimes called a flat tax. Proportionate Income Tax: the same tax rate is used for all levels. This is sometimes called a flat tax. Regressive Income Tax: the tax rate decreases as a person’s taxable income level rises. Regressive Income Tax: the tax rate decreases as a person’s taxable income level rises.

8 Exhibit 1: Three Income Tax Structures

9 Who Pays the Tax? Income Group Group's Share of Total Income Group's Share of Federal Income Taxes Top 1 %17.5%33.9% Top 5 %32.0%53.3% Top 10 %43.1%64.9% Top 25 %65.2%82.9% Top 50 %86.2%96.1% Bottom 50 %13.8%3.9%

10 The Federal Budget Budget Deficit: government expenditures > tax revenues. Budget Deficit: government expenditures > tax revenues. Budget Surplus: government expenditures < tax revenues. Budget Surplus: government expenditures < tax revenues. Balanced Budget: government expenditures = tax revenues Balanced Budget: government expenditures = tax revenues

11 Projected U.S Budget Deficits Year Projected Budget Deficit (billions of dollars)

12 Deficits and the Public Debt Cyclical deficit: the part of the budget deficit that is a result of a downturn in economic activity. Cyclical deficit: the part of the budget deficit that is a result of a downturn in economic activity. Structural deficit: the part of the budget deficit that would exist even if the economy were operating at full employment. Structural deficit: the part of the budget deficit that would exist even if the economy were operating at full employment. Total Budget Deficit = Cyclical Deficit + Structural Deficit Total Budget Deficit = Cyclical Deficit + Structural Deficit Public debt: the total amount the federal government owes its creditors. Public debt: the total amount the federal government owes its creditors.

13 Fiscal Policy Fiscal Policy: changes in government expenditures and/or taxes to achieve particular economic goals, such as low unemployment, price stability, and economic growth.

14 Fiscal Policy Definitions Expansionary Fiscal Policy: Increases in government expenditures and/or decreases in taxes to achieve particular economic goals. Expansionary Fiscal Policy: Increases in government expenditures and/or decreases in taxes to achieve particular economic goals. Contractionary Fiscal Policy: Decreases in government expenditures and/or increases in taxes to achieve macroeconomic goals. Contractionary Fiscal Policy: Decreases in government expenditures and/or increases in taxes to achieve macroeconomic goals.

15 Fiscal Policy Definitions Discretionary Fiscal Policy: deliberate changes of government expenditures and/or taxes to achieve particular economic goals. Discretionary Fiscal Policy: deliberate changes of government expenditures and/or taxes to achieve particular economic goals. Automatic Fiscal Policy: changes in government expenditures and/or taxes that occur automatically without (additional) congressional action. Automatic Fiscal Policy: changes in government expenditures and/or taxes that occur automatically without (additional) congressional action.

16 Two Key Assumptions Only deal with discretionary fiscal policy. Only deal with discretionary fiscal policy. Any change in government spending is due to a change in government purchases and not to a change in transfer payments. Any change in government spending is due to a change in government purchases and not to a change in transfer payments.

17 Demand-Side Fiscal Policy A change in consumption, investment, government purchases, or net exports can change aggregate demand and therefore shift the AD curve. A change in consumption, investment, government purchases, or net exports can change aggregate demand and therefore shift the AD curve. A change in taxes can affect consumption or investment or both and therefore can affect aggregate demand. A change in taxes can affect consumption or investment or both and therefore can affect aggregate demand.

18 Exhibit 2: Fiscal Policy in Keynesian Theory: Ridding the Economy of Recessionary and Inflationary Gaps

19 Crowding Out Refers to a decrease in private expenditures that occurs as a consequence of increased government spending or the financing needs of a budget deficit. Refers to a decrease in private expenditures that occurs as a consequence of increased government spending or the financing needs of a budget deficit. –Direct substitution of public spending for private spending. –A drop in investment due to a higher interest rate from financing the deficit.

20 Crowding Out Complete Crowding Out: a decrease in one or more components of private spending completely offsets the increase in government spending. Complete Crowding Out: a decrease in one or more components of private spending completely offsets the increase in government spending. Incomplete Crowding Out: the decrease in one or more components of private spending only partially offsets the increase in government spending. Incomplete Crowding Out: the decrease in one or more components of private spending only partially offsets the increase in government spending.

21 Exhibit 3: Zero (No), Incomplete, and Complete Crowding Out

22 Exhibit 4: Expansionary Fiscal Policy (Government Spending Increases), Crowing Out, and Changes in Real GDP and the Unemployment Rate

23 The New Classical View of Fiscal Policy Current consumption will fall as a result of expansionary fiscal policy. Current consumption will fall as a result of expansionary fiscal policy. Deficits do not necessarily bring higher interest rates. Deficits do not necessarily bring higher interest rates.

24 Exhibit 5: The New Classical View of Expansionary Fiscal Policy

25 Lags And Fiscal Policy 1. The Data Lag 2. The Wait-And-See Lag 3. The Legislative Lag 4. The Transmission Lag 5. The Effectiveness Lag

26 Exhibit 6: Fiscal Policy May Destabilize the Economy

27 Self-Test How does crowding out question the effectiveness of expansionary demand-side fiscal policy? How does crowding out question the effectiveness of expansionary demand-side fiscal policy? According to new classical economists, how do individuals respond to larger deficits? What changes do they anticipate in the credit or loanable funds market as a result of a larger deficit? According to new classical economists, how do individuals respond to larger deficits? What changes do they anticipate in the credit or loanable funds market as a result of a larger deficit? How might lags reduce the effectiveness of fiscal policy? How might lags reduce the effectiveness of fiscal policy?

28 Supply-Side Fiscal Policy Ceteris Paribus, lower marginal tax rates increase the incentive to engage in productive activities relative to leisure and tax avoidance activities. Ceteris Paribus, lower marginal tax rates increase the incentive to engage in productive activities relative to leisure and tax avoidance activities. Marginal Tax Rate = (Δ Tax payment) Marginal Tax Rate = (Δ Tax payment) (Δ Taxable Income) (Δ Taxable Income) Average Tax Rate = Total tax payment Average Tax Rate = Total tax payment Taxable Income Taxable Income

29 Exhibit 7: The Predicted Effect of a Permanent Marginal Tax Rate Cut on Aggregate Supply

30 The Laffer Curve: Tax Rates and Tax Returns If income tax rates were lowered, would it increase or decrease tax revenue? If income tax rates were lowered, would it increase or decrease tax revenue? There are two tax rates at which zero tax revenues will be collected – 0 and 100%. There are two tax rates at which zero tax revenues will be collected – 0 and 100%. An increase in tax rates could cause tax revenues to increase. An increase in tax rates could cause tax revenues to increase. A decrease in tax rates could cause tax revenues to increase. A decrease in tax rates could cause tax revenues to increase. Tax revenues = (Tax base) x (the average Tax rate) Tax revenues = (Tax base) x (the average Tax rate)

31 Exhibit 8: The Laffer Curve

32 Exhibit 9: Tax Rates, the Tax Base, and Tax Revenues

33 Macroeconomics Intermission How Does the Economy Work? 1. Is it Self-regulating? 2. Is it Inherently unstable? 3. Will a fiscal policy have its intended effect?

34 Self-Test Give an arithmetical example to illustrate the difference between the marginal and average tax rates. Give an arithmetical example to illustrate the difference between the marginal and average tax rates. If income tax rates rise, will income tax revenue rise as well? If income tax rates rise, will income tax revenue rise as well?

35 Exhibit 10: Macroeconomists’ Views on Two Issues: How the Economy Works and the Effectiveness of Fiscal Policy

36 Coming Up (Ch. 11): More on Government Spending and Taxes: Beyond Fiscal Policy