FISCAL POLICY

FISCAL POLICY – definitions Fiscal policy is the use of the government budget to influence the economy. In the US, fiscal policy is ultimately decided by Congress, with considerable input from the President. The budget is administered by the Treasury. The elements of the budget are: Government Spending Government Purchases (G) Transfer Payments (TP) Taxes (T) The Budget Balance (BB)

Taxes: Gross and Net Gross taxes (Tg) are the total taxes that the government takes from the private sector. Example: Suppose a household pays $5000 in taxes and receives $4000 in Social Security payments. The household’s net taxes – how much the household paid to the government – is $1000. Net taxes (Tn or just T) are gross taxes taken minus Transfers given back.

Taxes: Gross and Net Notice that, as a first approximation, an increase of Gross Taxes is the same as a decrease of Transfers In both cases there is an increase of Net Taxes; In the first case the government took more, in the second case they gave back less. Either way the government gets more, the private sectors get less.

Taxes: Gross and Net There are, however, important differences between changing Gross Taxes and changing Transfers. Transfers typically go to people with lower incomes while Taxes are paid by people with higher incomes. Those different types of people will likely respond differently. We will look at those differences later.

FISCAL POLICY – definitions The Budget Balance is the difference between Taxes and Gov’t Spending. BB = Tg – TP - G Using T to mean net taxes, with T = Tg – TP, we can say BB = T - G It is often more convenient to speak of the Deficit: Def = G – T (just the negative of BB)

THE BUDGET BALANCE – definitions There are three possibilities T > G. The government collects more than it spends. BB > 0. There is a budget surplus. 2. T 0. There is a budget deficit. 3. T = G. The government collects exactly what it spends. BB = 0. The budget is balanced.

THE BUDGET BALANCE – definitions There are therefore three ways to increase the budget deficit 1. Raise G, have the government buy more things In all three of these cases, we would expect a spending increase. In #1 it is the government spending more, and in #2 and #3 we would expect households to spend more. 2. Raise TP, increase the amount the government gives to people. 3. Lower taxes. Note that both #2 and #3 can be summarized as “reduce net taxes.”

Since a larger budget deficit should raise spending, increasing the deficit is therefore known as “expansionary fiscal policy.” 1. Higher / lower government purchases A budget surplus (or a smaller deficit) would require: 2. More / less transfer payments 3. Higher / lower taxes

4. We would expect reducing the deficit to result in more / less spending So reducing the deficit (or running a surplus) is called “contractionary fiscal policy.”