Managing Aggregate Demand: Fiscal Policy 11

Issues with Fiscal Policy Can the government manage the economy better than the self correction mechanism? Fiscal policy Government spending (G) and taxation (T) Intent is to steer/stabilize aggregate demand Debates over fiscal policy Multiplier effects of tax cuts (T) versus more spending(G) Multiplier effects of different tax cuts Incentive effects of different tax cuts

Income Taxes and the Consumption Schedule How do taxes effect equilibrium GDP? Disposable income (DI = Y-T) Amount actually available to consumers Principal determinant of consumer spending How does a change in taxes affect the consumption function?

Figure 1 How Tax Policy Shifts the Consumption Schedule Tax Cut C Real Consumer Spending C Tax Increase Real GDP

Income Taxes and the C Schedule A change in taxes has a multiplier effect on GDP Lower taxes increase GDP by a multiple of the tax change Higher taxes decrease GDP by a multiple of the tax change Difference between more government spending and lower taxes Higher spending increases real GDP directly Lower taxes increase real GDP indirectly

The Multiplier Revisited Increase in G example: ΔG = $1 million and MPC = 0.75 ΔY = $1,000,000 + $750,000 + $562,500 + . . . ΔY = $1 mill x [1 + 0.75 + 0.752 + . . . ] ΔY = $1 mill x 4 ΔY = $4 mill With a tax cut First round of spending is only $750,000 ΔY = $750,000 + $562,500 + . . . ΔY = $750,000 x 4 = $3 million The multiplier effect is smaller! Tax changes have a smaller multiplier effect than changes in spending

The Multiplier Revisited Income taxes and the multiplier Now suppose that the income tax rate (t) = 20%, i.e. t = 0.20 For every dollar of Y you earn, you must give $0.20 to the government. When G increases by $1 million, disposable income increases by $800,000 (NOT $1 million) You don’t get: ΔY = $1 mill x [1 + 0.75 + 0.752 + . . . ] You get : ΔY = $1 mill x [1 + 0.60 + 0.602 + . . .] 0.6 = 0.75 x (1 - 0.2) Multiplier = 1/(1 – 0.60) = 2.5 The formula for the spending multiplier becomes 1 1 −𝑚𝑝𝑐(1−𝑡)

The Multiplier Revisited Simple multiplier reduced by income tax Income tax reduces the fraction of each dollar of GDP consumers actually receive and spend We have now discussed three reasons why simple multiplier is simple Ignores variable imports – Chapter 9 Ignores price-level changes – Chapter 10 Ignores income tax – Chapter 11

Figure 2 The Multiplier in the Presence of an Income Tax 45° Real Expenditure C+I+G1+(X-IM) E1 7,000 C+I+G0+(X-IM) With tax rate of 20%, ΔY = $400 x 2.5 = $1000 $400 6,000 E0 Without taxes, ΔY = $400 x 4 = $1,600 Real GDP

The Multiplier Revisited Taxes modify the multiplier analysis Tax changes have a smaller multiplier effect than changes in spending Income tax reduces multipliers for both tax changes, and changes in spending

The Multiplier Revisited Automatic stabilizer Feature of economy that reduces its sensitivity to shocks: sharp increases or decreases in spending Acts as a shock absorber reducing the multiplier effect Personal income tax (which we just looked at), unemployment insurance

The Multiplier Revisited Government transfer payments Payments to individuals, not compensation for production DI = Y – Taxes + Transfer payments Transfer payments function as negative taxes Transfer payments have a smaller multiplier effect than spending . The multiplier formula for transfer payments is 𝑚𝑝𝑐 1−𝑚𝑝𝑐(1−𝑡)

Planning Expansionary Fiscal Policy Suppose that real GDP is below potential. What three policies would close the recessionary gap?

Planning Expansionary Fiscal Policy Suppose that real GDP is below potential. What three policies would close the recessionary gap? Expansionary fiscal policy Increase government purchases Reduce taxes Increase transfer payments

Figure 3 Fiscal Policy to Eliminate a Recessionary Gap 7,000 Potential GDP 7,000 Potential GDP Real Expenditure Real Expenditure 45° 45° Recessionary gap C+I+G1+(X-IM) F C+I+G0+(X-IM) E C+I+G0+(X-IM) 6,000 Real GDP Real GDP 6,000 (a) (b)

Planning Expansionary Fiscal Policy The previous slide showed a recessionary gap of $7,000. Suppose the MPC is 0.75 and t = 0.20. Expansionary fiscal policy What increase in G is needed to close the gap? What increase in transfer payments is needed to close the gap?

Planning Contractionary Fiscal Policy Suppose that real GDP is above potential. What do you do? Contractionary fiscal policy Reduce government purchases Increase taxes Reduce transfer payments How is this different than the self-correction mechanism? With self-correction, gap eliminated as inflation increases With policy, can limit inflation by reducing aggregate demand

Choice between Spending and Tax Policy Higher spending and lower taxes in AD-AS model Any combination will increase aggregate demand Lower spending and higher taxes in AD-AS model Any combination will decrease aggregate demand

Expansionary Fiscal Policy Figure 4 Expansionary Fiscal Policy AD1 SRAS AD0 Price Level A Rise in Price level E Rise in real GDP Real GDP

Choice between Spending and Tax Policy How do you decide which to use: T or G? Advocates of smaller government Private individuals and firms do things better than public sector Cut taxes to expand demand Cut spending to contract demand

Choice between Spending and Tax Policy Advocates of bigger government Need larger public sector, since important needs not met by private sector Increase spending to expand demand Increase taxes to contract demand

Some Harsh Realities Complications Expectations, technology, events abroad, and other factors constantly shift expenditure functions Multipliers not precisely known Full-employment GDP difficult to measure Fiscal policies act with time lags Politicians are in charge

Problems and Complication With Fiscal Policy 7,000 Potential GDP Real Expenditure 45° Full-employment GDP difficult to measure Recessionary gap is a guess C+I+G0+(X-IM) Expectations, technology, events abroad, and other factors constantly shift expenditure functions – AE is not stable or predictable Real GDP 6,000 (a)

Other issues to address when pursue expansionary policy Some Harsh Realities Other issues to address when pursue expansionary policy What are the long-run costs of large budget deficits How large is the inflationary cost

Supply-side Economics: Supply-Side Tax Cuts Central idea of supply-side economics Certain types of tax cuts increase aggregate supply Tax cuts increase the reward for working, saving, investing therefore results in greater incentive to work, save and invest SRAS shifts to the right

The Goal of Supply-Side Tax Cuts Greater aggregate supply will increase GDP and decrease the price level SRAS0 AD Price Level SRAS1 A B Real GDP

Supply-Side Tax Cuts Supply-side policies Lower personal income tax rates Reduce taxes on income from savings Reduce taxes on capital gains Reduce the corporate income tax Both AD and AS shift to the right If policies work may be able to avoid inflationary consequences of expansionary policy

A Successful Supply-Side Tax Reduction Price level at Point C is less than Point A AD1 SRAS0 AD0 Price Level SRAS1 A E C Real GDP

Supply-Side Tax Cuts Flies in the ointment Small magnitude of supply-side effects Incentive effects on savings likely to be small Demand-side effects Rather than working more, people spend more The shift in AS to the right may be small

A More Pessimistic View of Supply-Side Tax Cuts higher increase in price and lower increase in RGDP Price Level S1 C E Real GDP

Supply-Side Tax Cuts Flies in the ointment Problems with timing Effects on income distribution and increase inequality Losses of tax revenue increase budget deficit

Supply-Side Tax Cuts Conclusions Effectiveness of supply-side tax cuts depends on what kinds of taxes are cut Stimulate business investment – greater impact Increase aggregate supply more slowly than they increase aggregate demand Better for long-run growth policy than short-run stabilization policy

Supply-Side Tax Cuts Conclusions Demand-side effects are likely to overwhelm supply-side effects in the short run Likely to widen income inequalities Lead to larger budget deficits

Graphical Treatment of Taxes and Fiscal Policy Variable taxes are taxes that change with GDP Personal income tax, corporate income tax, sales tax Fixed taxes do not change with GDP Property taxes How do the different taxes change shifts in and slope of the consumption line?

Figure 9 The Consumption Schedule with Fixed vs. Variable Taxes Real Consumer Spending C2 Variable taxes flatten the consumption schedule Real GDP

Table 1 The Effects of an Income Tax on the Consumption Schedule

Table 2 The Relationship between Consumption and GDP

Table 3 Total Expenditure Schedule with a 20 Percent Income Tax

Figure 10 Income Determination with a Variable Income Tax 3,000 4,000 5,000 6,000 7,000 Real Expenditure 8,000 45° C+I+G+(X-IM) E 4,000 6,000 Real GDP 8,000

Algebraic Treatment of Fiscal Policy Find equilibrium GDP when: I = 900, G = 1,300, (X – IM) = -100, tax rate = 20% Y= C + I + G + (X – IM) T = 0.20Y C = 300 + 0.75DI DI = Y – T C = 300 + 0.75(Y – 0.20Y) = 300 + 0.60Y Y = 300 + 0.60Y + 900 + 1300 – 100 0.40Y = 2,400 Y = 6,000

Algebraic Treatment of Fiscal Policy Equilibrium condition Y = C + I + G + (X - IM) (1) Consumption function C = a + bDI (2) Disposable income DI = Y – T (3) Tax function T = T0 + tY (t is the tax rate) (4) Plug (3) and (4) into (2) C = a - bT0+ b(1-t)Y (5) Plug (5) into (1) Y = a - bT0+ b(1-t)Y + I + G + (X - IM)

Algebraic Treatment of Fiscal Policy Y = a - bT0+ b(1-t)Y + I + G + (X - IM) Finally, solve for Y What are the spending and tax multipliers with variable taxes?

Multipliers for Tax Policy What happens if the tax cut is $400, the MPC = 0.75 and t = 0.20?

Figure 11 The Multiplier for a Reduction in Fixed Taxes Real Expenditure 45° C1+I+G+(X-IM) 6,750 C0+I+G+(X-IM) 6,000 $ -400 x -1.875 Real GDP