 Fiscal policy refers to the use of the spending and taxing powers of the federal government to manage aggregate demand, and thereby to stabilize the level of output, employment, and prices. Under the Employment Act of 1946, the Federal government is to promote “maximum production, employment, and purchasing power.”

AE AE = Y Y AE 1 AE 2 Y*YfYf GG Here we illustrate the use of G to stimulate AE and push the economy to full-employment Y f is potential GDP YY  Y =  G  c + m

Horizontal equity: Tax code should be written so that those in the same economic circumstances pay the same amount in taxes. Vertical equity: Tax code should be written so that those in different economic circumstances should pay an unequal amount in taxes. Ability to pay principle: Those with greater ability to pay taxes should pay more. Benefits received principle: Those who derive more benefits from government programs should pay more taxes. If Madonna or Bill Gates paid the same amount in taxes as an accountant or government employee, that would be vertically inequitable

Taxable income: Gross income - income exempt from taxes. Example: For single filers who use the 1040EZ: Average tax rate (ATR): Tax payments as a percent of taxable income. Marginal tax rate (MTR): The tax rate applied to the last dollar of taxable income.

 Note that ATR and taxable income move in same direction A progressive tax, such as the federal personal income tax upon which this example is based, is generally consistent with the principle of vertical equity

Payroll and sales taxes on grocery items, beer, and cigarettes are regressive

Federal personal Income Tax rates Under the 1993 Tax Reform Act (Married couple filing jointly)

DTaxes (TX) and Transfer Payments (TR) are called “automatic stabilizers” because they react to changes in national income in a way that increases the federal deficit (or reduces the surplus) in the event of an economic contraction or reduces the deficit (increases the surplus) when the economy is expanding. The automatic stabilizers make sure that Y D does not fall too much when national income is falling

Remember that the federal deficit or surplus is equal to the difference between G and Net Tax Receipts, where Net Taxes are equal to TX - TR D  Y  TX, for example D  Y  TX, and vice versa D  Y  TR, for example D  Y  TR, and vice versa  Note that claims for unemployment compensation and other assistance surges when unemployment rises.

National Income 0 G, TFull- employment G T = TX - TR YRYR Deficit Y R is the recession-level of national income

Let: AE denote aggregate demand Y is real GDP TX is tax payments TR is transfer payments Y D is personal disposable income Thus, in a closed economy we have: AE = C + I + G [1] It is also true that: Y D = Y - TX + TR [2] The full-employment model suggests that an increase in G must result in a compensating decrease in C or I--this is the “crowding out” effect Government can increase Y D by decreasing TX or increasing TR (reverse also holds true). Economists call transfer payments “negative taxes.”

Increased government spending crowds out investment Investment function  Allow for an increase in G finance by increased taxes (TX). Note that: Y D = Y - TX + TR Interest rate (r) 0 r1r1 r2r2 S function shifts left due to decrease in Y D I2I2 I1I1 S, I Crowding out