Fiscal policy topics 1  Sources of Federal revenue and expenditures  Expansionary and contractionary fiscal policy  Spending multiplier  Tax multiplier  Automatic stabilizers  Budget deficits and the national debt  Long-term issues

Federal revenue 2

3  Three largest sources:  Individual income tax  Social security tax  Corporate income tax Top three combined account for 89% of federal revenue

Income tax 4  Individual income tax is a progressive tax:  Individuals with larger incomes pay a larger percent of income in tax  Individuals with smaller incomes pay a smaller percent of income in tax  Some individuals pay no tax, some have a negative tax rate

Income tax 5  Income tax due is based on taxable income.  To arrive at taxable income, start with your income and subtract deductions and exemptions.  One exemption is allowed for each person

Income tax 6  Example: Sheila is a single person with an income of $50,000 Gross Income$50,000 Standard deduction -$6,200 Exemption-$3,900 Taxable income$42,900

Income tax 7  How much federal income tax does Sheila pay?

Income tax brackets 8 Income Thresholds Taxable income Marginal tax rate Tax Up to $9,075 $9,07510%$907 $9,076-$36,900 $27,82515%$4,174 $36,901-$89,000 $6,00025%$1,500 $42,900$6,581  Sheila pays $6,581 in federal income tax

Income tax 9  Sheila’s average tax rate : $6,581 / $50,000 = 13.2%  Sheila’s marginal tax rate is 25%  She would pay 25% tax on any additional income

Federal expenditures 10

Federal expenditures 11  Four largest sources:  Medicare and Medicaid  Social security  National defense  Income security Top four account for 83% of federal expenditures. Medicare and Medicaid is the fastest growing component.

Expansionary and contractionary fiscal policy 12  What is the correct fiscal policy for  A recession?  An inflationary period?  Recession:  Increase government spending, and/or  Cut taxes  Inflation:  Cut government spending, and/or  Increase taxes

Recessionary gap 13 Real GDP Price level SRAS 0 Y* LRAS 0 AD 1 Y1Y1 P1P1 A Recessionary Gap

Expansionary fiscal policy 14 Real GDP Price level SRAS 0 Y* LRAS 0 AD 1 Y1Y1 P1P1 A AD 2 B P2P2 Increased government spending can pump up aggregate demand

Expansionary fiscal policy 15

Expansionary fiscal policy 16

Expansionary fiscal policy 17 Government spending would need to rise by $60.6 billion to cause output to increase by $200 billion. Consumption spending accounts for most of the increase in output.

Linkages – expansionary fiscal policy 18 Increased government spending or lower taxes Aggregate demand increases Output rises Unemployment rate falls Spending multiplier

Expansionary fiscal policy 19 What if the government cut taxes instead of increasing government spending? How much would tax revenue need to be reduced? We must use the tax multiplier to find out.

Tax multiplier 20

Tax multiplier 21

Tax multiplier 22 Example: We want output to rise by $200 billion. How much would tax revenue need to decline? $200 billion = * ∆T ∆T = $200 billion / = -$85.8 billion Taxes would need to be cut by $85.5 billion.

Government spending and tax revenue 23 We have found that to increase output by $200 billion we could  Increase government spending by $60.6 billion, or  Cut taxes by $85.5 billion. Why aren’t these figures the same?

Government spending and tax revenue 24 Y = C + I + G + NX If government spending rises by $1, how much does output rise immediately?

Government spending and tax revenue 25 Y = C + I + G + NX If government spending rises by $1, output rises by $1. Government spending is a direct component of aggregate demand.

Government spending and tax revenue 26 Y = C + I + G + NX C = a + b(Yd) If taxes are cut by $1, how much does output rise?

Government spending and tax revenue 27 Y = C + I + G + NX C = a + b(Yd) If taxes are cut by $1, output rises by $1*MPC. Taxes affect aggregate demand indirectly.

Contractionary fiscal policy 28 Suppose the economy is suffering from high inflation. Output is higher than potential output and unemployment is very low. Assume the inflationary gap equals $80 billion in output. The government can reduce the output gap by cutting government spending (or increasing taxes).

Inflationary gap 29 Real GDP Price level SRAS 0 Y* LRAS 0 AD 1 Y1Y1 P1P1 A Inflationary Gap

Contractionary monetary policy 30 Real GDP Price level SRAS 0 Y* LRAS 0 AD 1 Y1Y1 P1P1 A Inflationary Gap AD 2 P2P2 B Cuts in government spending can reduce aggregate demand

Expansionary monetary policy 31

Contractionary fiscal policy 32

Contractionary fiscal policy 33 Question: how much of a tax increase would be needed to reduce output by $80 billion? Assume the MPC = 0.7

Contractionary fiscal policy 34

Linkages – contractionary fiscal policy 35 Cuts in government spending or increased taxes Aggregate demand decreases Output decreases Price level declines Spending multiplier

Balanced budget multiplier 36 Suppose increased government spending is balanced by an equal increase in tax revenue. What is the effect on output?

Balanced budget multiplier 37

Balanced budget multiplier 38

Question Suppose I pay $15,000 income tax on a taxable income of $100,000. Therefore, my marginal tax rate is 15%. A) True B) False

Question To increase output by $50 billion, how much would taxes have to be cut? Assume the MPC = 0.8 Cut in taxes: $____ billion (leave out the negative sign)

Question To increase output by $50 billion, how much would government spending need to increase? Assume the MPC = 0.8 Increase in government spending: $____ billion

Fiscal policy issues 42 Conclusion: in the short-run, fiscal policy can shift aggregate demand in the desired direction. Three problems arise that cause complications.

Fiscal policy issues 43 1) Crowding out 2) Timing and policy lag 3) Negative supply shocks

Fiscal policy issues 44 Crowding out - occurs when increased government spending results in less private spending Two cases: how is the government spending paid for? 1) Higher taxes or 2) More borrowing?

A) Government spending funded by taxes 45 If government spends $100 million on new highways and increases taxes by $100 million, does net spending increase? It depends – would the private sector have spent the $100 million?

A) Government spending funded by taxes 46 If the private sector would have spent most (90%) of the $100 million, then the impact of $100 million in government spending would be very small.

A) Government spending funded by taxes 47 But what if confidence is low, and the private sector would NOT have spent most of the $100 million. In this case, the impact of $100 million in government spending would be much larger. Expansionary fiscal policy is effective when the private sector is afraid to spend money.

B) Government spending funded by borrowing 48 If government spends $100 million on new highways paid for by borrowing, does net spending increase? The public purchases more ($100 million) government bonds and fewer private bonds.

B) Government spending funded by borrowing 49 If the private bonds would have funded new factories, then investment spending falls. Also, interest rates rise when the government sells bonds, causing additional decline in investment spending.

B) Government spending funded by borrowing 50 What if the private sector would not have invested the money in new plant and equipment? That is, they see no reason to expand. This occurs during a recession. Thus, government borrowing is unlikely to crowd out private spending when the economy is in a recession.

Automatic stabilizers 51 Fiscal policy:  Increase G and reduce T in a recession  Cut G and raise T when inflation is the problem  Some of this occurs automatically, without additional action by Congress or the executive branch

Automatic stabilizers 52 In a recession, people lose jobs.  Payments for unemployment insurance rise  More households become eligible for low-income assistance (Medicaid, TANF, food stamps, other programs). Some begin social security payments.  Fewer taxes are collected Point: government spending rises and taxes decline during a recession

Automatic stabilizers 53 During an inflationary gap caused by high aggregate demand, unemployment is very low  Payments for unemployment insurance drop  Fewer households become eligible for low- income assistance (Medicaid, TANF, food stamps, other programs). Workers delay social security payments.  More taxes are collected Point: government spending declines and taxes rise when output > potential output

Automatic stabilizers 54 The rise of government spending during a recession and decline in an inflationary gap are examples of automatic stabilizers. The recession/inflation would be more severe without the automatic stabilizer.

Budget deficits 55 When government spending > tax revenue, the government has a budget deficit. When government spending < tax revenue, the government has a budget surplus. When government spending = tax revenue, the government budget is balanced.

Budget deficits 56 When the government budget is in deficit, the government borrows. When the government budget is in surplus, the government pays off some debt.

Budget deficits 57 Ideally,  budget deficits should occur during recessions  budget surpluses should occur during inflationary gaps  Result: the government budget balances in the long-run (but not every year)

Budget deficits as percent of GDP 58

Federal spending as percent of GDP 59

Federal revenue as percent of GDP 60

Federal spending and revenue as percent of GDP 61 Year SpendingRevenueDeficit %14.6% %17.4%-2.8

Budget deficits and debt 62 But policymakers tend to spend more (or cut taxes) in most years, both during recessions and expansions. Result: climbing national debt National debt is the sum of past budget deficits and surpluses

Budget deficits and debt 63 Example: Federal debt 2013: $12,300 billion Deficit end of 2013: $ 700 billion

Budget deficits and debt 64 Example: Federal debt 2013: $12,300 billion Deficit end of 2013: $ 700 billion Federal debt 2014: $13,000 billion

Budget deficits and debt 65 How much debt is too much?

Budget deficits and debt 66 How much debt is too much? Measures: Debt as percent of income Interest payments as percent of income

Federal debt as percent of GDP % in 2014

Interest payments as percent of GDP % in 2014

Budget deficits and debt 69 How much debt is too much? Do you have difficulty borrowing? Does the U.S. government have difficulty borrowing?

Budget deficits and debt 70 How is the debt paid back? The government must run budget surpluses.

Long-term forecast by Congressional Budget Office 71

Long-term budget issues 72 Mandatory spending – occurs without any action by Congress (Medicare, social security, Medicaid, income maintenance programs) Discretionary spending – Congress decides funding each year (defense, transportation, education, foreign aid, others)

Long-term budget issues 73 Goal: reduce the 2023 projected deficit of $6.3 trillion to zero How can we accomplish this goal?

Long-term budget issues 74 Goal: reduce the 2023 projected deficit of $6.3 trillion to zero How can we accomplish this goal? Cut spending? Increase taxes? A mix of the two?