1 Fiscal Policy © 2009, TESCCC

2 Fiscal Policy defined The government’s (Congress and the President) use of taxing and spending to promote economic growth and stability © 2009, TESCCC

3 History of Fiscal Policy Laissez-faire (classical economics) The Great Depression s WWII No need for government interference Market regulates itself Adam Smith, David Ricardo, Thomas Malthus are classical economists Challenged classical economics FDR increased government spending on programs to increase employment on public works to help stop the depression To prepare for war, U.S. increased production of war goods. Government spending increased dramatically which helped the country out of the depression. © 2009, TESCCC

4 History of Fiscal Policy 1960s1980s JFK proposed tax cuts to personal and business income taxes to increase aggregate demand. Government spending increased due to Vietnam War. Reagan passed a bill to reduce taxes by 25% over 3 years to fight stagflation (high unemployment + high inflation). Demand-side policies would not work, thus supply-side policies were introduced – known as Reaganomics. © 2009, TESCCC

5 Two branches of Fiscal Policy: 1. Demand side 2. Supply side © 2009, TESCCC

6 Demand-Side Economics Inspired by John Maynard Keynes during the Great Depression and is also called Keynesian Fiscal Policy Looks at changing aggregate demand which is either increasing or decreasing © 2009, TESCCC

7 Tools of Fiscal Policy 1. Taxing Policy of Government 2. Spending Policy of Government © 2009, TESCCC

8 Demand Side Fiscal Policy Keynes said that sometimes the market could not correct itself and the government needs to take a more active role in the economy. This increased role of government in the economy was something different from the Classical view. It was considered very radical for the time. © 2009, TESCCC

9 Limitations of Demand-Side Fiscal Policy 1.Not coordinated with monetary policy 2.Surplus budget unpopular and politicians lack the political will to carry it out 3.Time lags - Inside lags and outside lags 4.People are unpredictable - Economics is a social science so we are dealing with human behavior. 5.Doesn’t solve stagflation © 2009, TESCCC

10 Multiplier Effect The multiplier effect in fiscal policy states that for every one dollar change in taxing or government spending, it will create a greater change in the national income, either increasing or decreasing. © 2009, TESCCC

11 Fiscal Policy- Supply Side © 2009, TESCCC

12 Supply-Side Fiscal Policy Economic policies designed to stimulate output (GDP) and lower unemployment. To achieve this you increase aggregate supply (AS). Contemporary Supply - side was implemented in the 1980’s to deal with stagflation and is sometimes called “Reaganomics.” Goal is to give incentives to businesses to produce more (AS). © 2009, TESCCC

13 Principles of Supply Side 1.Tax cuts - encourage consumers to save so businesses have money to borrow for capital investment. 2.Government spending cuts especially on transfer payments where nothing is produced 3.Deregulate business Overall Less Government © 2009, TESCCC

14 Supply-Side Economics Stresses the influence of taxation on the economy. Supply-siders believe that taxes have a strong, negative influence on output Arthur Laffer came up with a theory concerning tax rates and tax revenues. It was called the Laffer Curve. Laffer said if you lower the tax rate we will see an increase in tax revenue. © 2009, TESCCC

15 Laffer Curve TaxRatesTaxRates 100% 0% Tax Revenues Govt will collect no revenue at 2 tax rates, 0% and 100%. With 100% tax rate, workers lose all incentive to work (no disposable personal income) and at 0% tax rate the government will collect 0 revenue © 2009, TESCCC

16 TaxRatesTaxRates 100% 0% Tax Revenues C Point C is the optimum tax rate. Higher tax rates decrease worker incentives. Below C we decrease the revenue. PROBLEM: We don’t know where we are on the curve. Laffer Curve © 2009, TESCCC

17 Limitations 1.Lack of experience- hasn’t been around long enough. 2.Don’t know where we are on Laffer Curve. 3.Makes Federal Income Tax less progressive and reduces the automatic stabilization and reduces many “safety net” programs. © 2009, TESCCC

18 DECIDING FISCAL POLICY Taxing & Spending © 2009, TESCCC

19 When the U.S. Government decides Fiscal Policy: They are deciding which goal to address at a given time – economic growth, stability or full employment. They must decide to tax or spend to address the problems in the economy. © 2009, TESCCC

20 Taxation Power to Tax – Article 1, Section 8, Clause 1 of the U.S. Constitution 16 th Amendment Limitations: –Purpose is for “the common defense and general welfare” –Federal taxes must be the same in every state –Government may not tax exports © 2009, TESCCC

21 Purposes of Taxation Raise revenue Regulate the economy (fiscal policy) Redistribution of income (transfer payments) Provide positive economic incentives Provide negative economic incentives © 2009, TESCCC

22 Types of Taxes or Tax Structures Progressive - takes larger percent of income from higher income groups- as income goes up tax rate increases example- Federal Income Tax © 2009, TESCCC

23 Types - Regressive Regressive- takes larger percent of income from the lower income group Example- sales tax, property tax, Social Security tax © 2009, TESCCC

24 Types - Proportional Proportional - takes the same per cent of income from all income levels Examples - some state income taxes & proposed flat tax © 2009, TESCCC

25 Who Bears the Burden of a Tax? To fully evaluate the fairness of a tax, it is important to think about who bears the final burden of the tax or the incidence of a tax. © 2009, TESCCC

26 Principles of Taxation 1. Benefits received- people who directly benefit or use the good or service should pay Example- Excise tax on gasoline used to build roads © 2009, TESCCC

27 2. Ability- to- pay- people who have more wealth or income should pay more. Example- Federal Income Tax © 2009, TESCCC

28 Top Federal Taxes Individual Income Tax Social Security Corporate Income Tax © 2009, TESCCC

29 Federal Taxes © 2009, TESCCC

30 FICA FICA=Social Security + Medicare FICA Taxable Wage Base or a cap—a maximum income level that can be taxed. All income above that level is not taxed for FICA, tax free. Employers match employee contributions. © 2009, TESCCC

31 State Taxes States receive most of their revenue from a Sales Tax. © 2009, TESCCC

32 Local Taxes Property Tax © 2009, TESCCC