1 Fiscal Policy CHAPTER 27 © 2003 South-Western/Thomson Learning

2 Fiscal Policy Fiscal policy refers to government purchases, transfer payments, taxes, and borrowing as they affect macroeconomic variables such as real GDP, employment, the price level, and economic growth Two categories Automatic stabilizers Discretionary fiscal policy

3 Automatic Stabilizers Refer to revenue and spending items in the federal budget that automatically change with the ups and downs of the economy so as to stabilize disposable income and, hence, consumption and real GDP Federal income tax Reduces the drop in disposable income during recessions and reduces the jump in disposable income during expansions Once adopted, it requires no congressional action to operate year after year

4 Discretionary Fiscal Policy Requires ongoing congressional decisions involving the deliberate manipulation of government purchases, taxation, and transfers to promote macroeconomic goals such as full employment, price stability, and economic growth Clinton administration tax increases Bush’s 2001 tax cut

5 Fiscal Policy Using the income-expenditure framework, we will initially focus on the demand side to consider the effect of changes in government purchases, transfer payments, and taxes on real GDP demanded The short story is that at any given price level, an increase in government purchases or in transfer payments increases real GDP, and an increase in net taxes decreases real GDP, other things constant

6 Government Purchases Multiplier As long as consumption is the only spending component that varies with income, the multiplier for a change in government purchases, other things constant, equals Thus, we can say that for a given price level, and assuming that consumption varies with income

7 Change in Net Taxes A change in net taxes also affects real GDP demanded, but the effect is less direct Specifically A decrease in net taxes, other things constant, increases disposable income at each level of real GDP  consumption increases An increase in net taxes, other things constant, reduces disposable income at each level of real GDP  consumption decreases

8 Simple Tax Multiplier The effect of a change in net taxes on real GDP demanded equals the resulting shift in the consumption function times the simple spending multiplier  Therefore, the change in real GDP can be determined as MPC   1

9 Differences Two differences between the government-purchase multiplier and the simple tax multiplier The government-purchase multiplier is positive  an increase in government purchases leads to an increase in real GDP demanded. The net tax multiplier is negative  an increase in net taxes leads to a decrease in real GDP demanded The multiplier for a given change in government purchases is larger by 1 than the absolute value of the multiplier for an identical change in net taxes

10 Differences This latter difference occurs because changes in government purchases affect aggregate spending directly while the simple tax multiplier increases consumption indirectly by way of a change in disposable income In short, an increase in government purchases has a greater impact than an identical tax cut because some of the tax cut is saved

11 Fiscal Policy: Contractionary Gap What if policy makers overshoot the mark and stimulate aggregate demand more than needed to achieve potential GDP? In the short run, real GDP will exceed potential output In the long run, firms and resource owners will adjust to the unexpectedly high price level The short-run supply curve will shift back until it intersects the aggregate demand curve at potential output, increasing the price still further but reducing real GDP to potential output

12 Problems with Fiscal Policy Precise expansionary and contractionary fiscal policies are difficult to achieve, for their proper execution assumes that The relevant spending multiplier can be predicted accurately Aggregate demand can be shifted by just the right amount The potential level of output is accurately gauged Various government entities can somehow coordinate their fiscal efforts The shape of the short-run aggregate supply curve is known and remains constant

13 Multiplier and Time Horizon In the short run, the aggregate supply curve slopes upward  a shift in aggregate demand changes both the price level and the level of output  the simple multiplier overstates the amount by which output changes The exact change in equilibrium output depends on the steepness of the aggregate supply curve, which in turn depends on how sharply production costs increase as output expands

14 Multiplier and Time Horizon The steeper the short-run aggregate supply curve the less impact a given shift in the aggregate demand curve has on output and the more impact it has on the price level  the smaller the spending multiplier If the economy is already producing its potential, then, in the long run, any change in fiscal policy aimed at stimulating demand will increase the price level but will not affect output  spending multiplier is zero

15 Evolution of Fiscal Policy Prior to the Great Depression, public policy was shaped by the views of classical economists who generally believed that free markets were the best way to achieve national economic prosperity Economists believed that natural market forces, such as changes in prices, wages, and interest rates, would correct the problems of inflation and unemployment  no need for government intervention in the economy

16 Great Depression and World War II Keynesian theory and policy were developed to address the problem of unemployment arising from the Great Depression Keynes’s main quarrel with the classical economists was that prices and wages did not appear flexible enough to ensure the full employment of resources, e.g, they were sticky  natural forces would not return the economy to full employment in a timely fashion

17 Great Depression and World War II Keynes also believed business expectations might at times become so bleak that even very low interest rates would not spur firms to invest all that consumers might save The Great Depression continues to influence economic thought and policy solutions

18 Great Depression and World War II Three developments following the Great Depression bolstered the use of discretionary fiscal policy in the United States The influence of Keynes’s General Theory in which he argued that natural forces would not necessarily close a contractionary gap  government would have to increase aggregate demand so as to boost output and employment The demands of World War II greatly increased production and in the process eliminated cyclical unemployment during the war years

19 Great Depression and World War II The third development, largely a consequence of the first two, was the passage of the Employment Act of 1946, which gave the federal government responsibility for promoting full employment and price stability The combined impact of these factors led policy makers grew more receptive to the idea that fiscal policy could improve economic stability Additionally, the objective of fiscal policy was no longer to balance the budget but to promote full employment with price stability even if deficits occurred in the process

20 Automatic Stabilizers Automatic stabilizers smooth fluctuations in disposable income over the business cycle, thereby boosting aggregate demand during periods of recession and dampening aggregate demand during periods of expansion Two good examples of automatic stabilizers Progressive income tax Unemployment compensation

21 Progressive Income Tax The progressive income tax relieves some of the inflationary pressures that might otherwise arise when output increases above its potential during an economic expansion Conversely, when the economy is in a recession, real GDP declines but taxes decline faster, so disposable income does not fall as much as real GDP  it cushions declines in disposable income, in consumption, and in aggregate demand

22 Unemployment Insurance During an economic expansion, unemployment insurance taxes flow from the income stream into the insurance fund, thereby moderating aggregate demand During a recession, unemployment payments automatically flow from the insurance fund to those who have become unemployed  increasing disposable income and consumption

23 From the Golden Age to Stagflation John F. Kennedy was the first president to propose a federal budget deficit to stimulate an economy by proposing a tax cut for the purpose of stimulating business investment, consumption, and employment Discretionary fiscal policy is a type of demand-management policy because the objective is to increase or decrease aggregate demand to smooth fluctuations

24 From the Golden Age to Stagflation However, the 1970s were different when the problem was stagflation  the double trouble of higher inflation and higher unemployment resulting from a decrease in aggregate supply Demand-management policies were ill suited to solving these problems because an increase in aggregate demand would worsen inflation, whereas a decrease in aggregate demand would worsen unemployment

25 Problems with Fiscal Policy Other concerns also caused economists and policy makers to question the effectiveness of discretionary fiscal policy The difficulty of estimating the natural rate of unemployment The time lags involved in implementing fiscal policy The distinction between current and permanent income Possible feedback effects of fiscal policy on aggregate supply

26 Natural Rate of Unemployment The unemployment rate that occurs when the economy is producing its potential GDP is called the natural rate of unemployment Before adopting discretionary policies, public officials must correctly estimate this natural rate

27 Lags in Fiscal Policy The time required approving and implementing fiscal legislation may hamper its effectiveness and weaken discretionary fiscal policy and may in fact do more harm than good Since a recession is not usually identified as such until at least six months after it begins, and since the eight recessions since 1949 lasted an average of 11 months, this leaves a narrow window in which to execute discretionary fiscal policy

28 Permanent Income The original belief was that given the marginal propensity to consume, a relationship that is among the most stable in macroeconomics, tax changes could increase or decrease disposable income to bring about any desired change in consumption A more recent view is that people base their consumption decisions not merely on changes in their current income but on changes in their permanent income

29 Permanent Income Permanent income is the income a person expects to receive on average over the long run Thus, changes in taxes that are regarded as temporary will not stimulate consumption and may render fiscal policy ineffective

30 Feedback Effects Fiscal policy may unintentionally affect aggregate supply For example, suppose the government increases unemployment benefits and finances these transfer payments with higher taxes on current workers. If the marginal propensity to consume is the same for both groups, the reduction in spending by those whose taxes increase should just offset the increase in spending by transfer recipients

31 Feedback Effects Thus, with a fiscal policy that focuses on aggregate demand, there should be no change in aggregate demand or on equilibrium real GDP But what of possible effects of these changes on the labor supply? The unemployed, who benefit from increased transfers, now have less incentive to find work

32 Feedback Effects Conversely, workers who find their after- tax wage reduced by the higher tax rates may be less willing to work In short, the supply of labor could decrease as a result of offsetting changes in taxes and transfers with the result that aggregate supply would decline  economy’s potential GDP would decline

33 Budget Deficits of the 1980s and 1990s The Reagan tax rate cut reflected a philosophy that reductions in tax rates would make people more willing to work and to invest because they could keep more of what they earned Lower taxes, would increase the supply of labor and the supply of other resources thereby increasing aggregate supply and the economy’s potential GDP

34 Supply Side Economics This supply-side theory held that enough additional real GDP would be generated by the tax cuts that total tax revenue would actually increase What actually happened? Taking 1981 to 1988 as the time frame, we can examine the effects of the 1981 federal income tax rate cut.

35 Supply Side Economics After the tax cut was approved but before it took effect, a recession hit the economy and the unemployment rate increased Between 1981 and 1988 employment climbed by 15 million and real GDP per capita increased by about 2.5% per year The stimulus from the tax rate cut helped sustain a continued expansion during the 1980s, the longest peacetime expansion to that point in history

36 Supply Side Economics Despite the growth in employment, government revenues did not expand to offset the combination of tax cuts and increased government spending Between 1981 and 1988, federal outlays grew an average of 7.1% while federal revenues averaged a 6.3% increase  the deficits accumulated into a huge national debt which doubled relative to GDP from 33% in 1981 to 64% in 1992

37 Political Business Cycles William Nordhaus developed a theory of political business cycles, arguing that incumbent presidents use expansionary policies to stimulate the economy, often only temporarily, during an election year That is, they try to increase their changes of reelection by pursuing policies that stimulate real GDP and reduce unemployment

38 Political Business Cycles The evidence to support the theory of political business cycles is not entirely convincing One problem is that the theory limits presidential motives to reelection, when in fact presidents may have other objectives

39 Political Business Cycles An alternative to this theory, and one that is supported by some evidence, is that Democrats care relatively more about unemployment and relatively less about inflation than do Republicans Democrats tend to pursue expansionary policies while Republicans tend to pursue contractionary policies

40 Balancing the Budget The combination of increased taxes imposed by the Clinton administration and a vigorous recovery fueled by growing consumer spending, rising business optimism, and the strongest stock market in history led to record budget surpluses However, by early 2001, U.S. economic growth was slowing, so that President George W. Bush pushed through across the board tax cuts

41 Balancing the Budget The terrorist attack on September 11, 2001 further depressed consumer confidence with the result that taxpayers spent only about one-fifth of the tax rebate checks Thus, additional stimulus programs were put in place