1. FIN 30220: Macroeconomic Analysis
Fiscal Policy: Spending & Taxes

2. The US Government spent $4 Trillion dollars in FY2016
The US Government spent $4 Trillion dollars in FY That’s approximately $12,000 per person!
Put another way, government spending is approximately a quarter of all domestic expenditures.
GDP = $18T

3. While our government is bigger than some, it is much smaller than others
Government as a % of GDP
USA

4. Dissecting the Federal Budget
In FY2016, The US Government spent approximately $4T
Mandatory: $2,500B (58%)
On Budget: $3,050B (76%) +
Discretionary: $1,200B (36%)
Off Budget: $950B (24%) +
Interest: $300B (6%)
Total: $4,000B
Total: $4,000B
Determined by Congress on an annual basis (ex: Defense)
By law, the Social Security System and the US Postal Service must maintain separate budgets and, hence, are “off” the general budget
Determined by existing law (ex: Social Security, Medicare)
Source: Office of Management and Budget

5. Timeline for the budget process
With the help of the office of management and budget (OMB), the president creates a budget proposal – sent to congress the first week of February
Differences between House/Senate proposals are worked out in conference committees – joint resolution presented and voted on
January
February
March
April
May
June
July
August
September
October
Appropriations bills presented and voted on
Fiscal Year Begins
With the help of the congressional budget office (CBO), the house and senate budget committees write their own budget proposals

6. The US Budget is officially titled a “Resolution of Congress” – it is not a Bill. So, what difference does it make?
A resolution, once approved by both houses of congress, requires no presidential signature Further, a resolution is not a law and DOES NOT have to be obeyed!
However, the budget itself does not allow the government to spend money. It only gives the government the authority to spend money. To actually spend money, the government must pass an appropriation bill. That is a law.

7. Note that authorized spending need not be appropriated in a given year, but can be carried forward, so actual outlays need not equal budget authority
Defense Appropriations Bill (2015)
Authorized: $700B
Appropriated: $650B
$50B of authorization remaining
Defense Appropriations Bill (2016)
Authorized: $750B
Appropriated: $800B

8. The Government Uses “Baseline Budgeting” with a minimum 5 year cycle
Horizon Years
Current Year
Budget Year 1 2 3 4 5
Anticipated spending
This is what the government is currently spending
Adjusted spending under the new law

9. Therefore, a government cut is generally not really a cut
Therefore, a government cut is generally not really a cut! Consider the following example
Horizon Years
Defense Appropriations
Bill
Current Year
Budget Year 1 2 3 4 5
2015
$700B
$750B
(+7%)
$850B
(+13%)
$1,000B
(+17%)
$1,200B
(+20%)
2016
$750B
$800B
(+6%)
$900B
(+12%)
$1,150B
(+16%)
$1,350B
(+17%)
In government lingo, this would be called a $50B( 6%) cut to the defense budget!!

10. Financing The Government
“In this world, nothing is certain, but death and taxes”
Income Tax
Alternative Minimum Tax
Estate Tax
2016
Individual Income Taxes: $1,610B
Corporate Income Taxes: $433B
Social Insurance Taxes: $1,105B
Other Revenues: $282B +
Total: $3,430B
On-Budget: $2,630B
Off-Budget: $800B
Off –Budget is essentially social security taxes

11. Who Pays Income Taxes? Quintile Average Income % of Total Income
% of Total Taxes
Bottom 20%
$13,000 3%
<1%
2nd 20%
$30,000 8% 2%
Middle 20%
$49,000
14%
13%
4th 20%
$72,000
23%
25%
Top 20%
$147,000
50%
60%
Top 5%
$254,000
21%
40%
Top 1%
$1,000,000
15%
30%

12. US Income Tax Rates (Single Filers)
Taxable Income
Tax Rate
$0 - $7,150
10%
$7,151 - $29,050
15%
$29,051 - $70,350
25%
$70,351 - $146,750
28%
$146,751 - $319,100
33%
$319,101 +
35%
Note: These Tax Brackets are annually indexed for inflation
Standard Deduction: $5,000
Personal Exemption: $3,200 +
$8,200
Taxable Income = Gross Income - $8,200

13. Taxable Income
Tax Rate
$0 - $7,150
10%
$7,151 - $29,050
15%
$29,051 - $70,350
25%
$70,351 - $146,750
28%
$146,751 - $319,100
33%
$319,101 +
35%
The Tax Brackets indicate marginal tax rates – i.e. the percentage of each additional dollar earned that gets paid in taxes
Suppose that you earn $85,000 per year (single filer)
$7,150 * .10 = $715
$21,900 * .15 = $3,285
$41,300 * .25 = $10,325
$6,450 * .28 = $1,806
Gross Income: $85,000
Standard Deduction: $5,000
Personal Exemption: $3,200 - - +
Taxable Income
$76,800
Tax Bill = $16,131
$16,131
Your “Average Rate” =
X 100 = 19%
$85,000

14. The Government must make up the difference between taxes collected and spending on current programs by borrowing
2016 Expenditures
2016 Revenues
2016 Surplus/Deficit
On-Budget: $3,050B
On Budget: $2,630B
On-Budget: - $420 +
Off-Budget: $950B +
Off Budget: $800B +
Off-Budget: - $150
Total: $4T
Total: $3,430B
Total: - $570B
This is the official deficit that’s reported
In 2016, the government spent $3,050B on programs other than social security
$2,630B Was paid for with current taxes
$420B was borrowed from the public
In 2016, The Social Security Administration spent $950B on current benefits
$800B Was paid for with current taxes
$150B was borrowed from the public

15. The US budget was essentially balanced until the early 1970’s
Deficit/Surplus (Millions of Current Dollars)
$570B in 2016

16. Total Debt outstanding represents the cumulative effect of past deficits
Total ($20T)
Held By Public
($15T)

17. Debt/GDP What really matters is debt relative to ability to pay (GDP)
1946: 120%
2015: 100%
What really matters is debt relative to ability to pay (GDP)

18. Can we sustain our current policies?
Debt is manageable as long as it grows at a slower pace than income (i.e. we can grow out if it!)
Current Deficit
GPD Growth
+ Interest Rate
Total Debt
Growth of Debt
Our economy would need to grow at 4.6% (nominal) per year to sustain our current projected deficits (i.e. maintain a constant Debt/GDP ratio). Unfortunately, we are only growing at 3.5%
$570B
+ .015
= .046
$18T
Treasury Rate

19. Can we sustain our current policies?
Alternatively, let’s calculate the deficit that is sustainable (Debt/GDP is constant)
GPD
Growth
Nominal
Interest Rate
Deficit
Total Debt
$18T
3.5%
1.5%
Given the above numbers, we can sustain a $360B Deficit

20. Two arguments for Fiscal Policy
Efficiency
Efficiency refers to the collective well being of an economy.
Equity
Equity refers to the distribution of well being across individual in an economy.
Can we use fiscal policy to increase aggregate income?)
Can we use fiscal policy to redistribute income in a “fair” way?

21. Let’s suppose that the economy is currently at full employment (the unemployment rate is 5%) and GDP equals $15T. Government expenditures are currently $3T.
$12T
$3T
$15T
Note: None of the numbers here are calculated

22. Okun’s Law: A 1% rise in unemployment translates to a 2.5% drop in GDP
Now, suppose that uncertainty about the future causes consumers and businesses to cut their planned expenditures by 10%
$1.2T
$10.8T
$3T
$13.8T
Okun’s Law: A 1% rise in unemployment translates to a 2.5% drop in GDP
As 8% output gap would be associated with a 8/2.5 = 3.2% rise in unemployment

23. The immediate impact would be a drop in the interest rate and production
As 4% output gap would be associated with a 4/2.5 = 1.6% rise in unemployment
To get back to full employment, we need the interest rate to drop even farther…

24. The longer term impact would be an additional drop in the interest rate and a decrease in prices (i.e. deflation)
Now we are back to full employment…but after a long, painful recession and prolonged deflation

25. We should increase government spending by $1.2T, right?
What if the government could move the IS curve back to the right by $1.2T. The could return the economy to full employment…
We should increase government spending by $1.2T, right?
$1.2T
We have a drop in demand of $1.2T

26. Suppose that the government pays $100 for a new hammer from the local hardware store
Now, suppose that the hardware store owner takes his $100 in new income and spends $95 (95%) at the grocery store
Now, suppose that the grocer owner takes his $95 in new income and spends $90.25 (95%) at the local tavern…..
This will continue to ripple out…

27. “If I Had a Hammer…”
Lets add up all the increases in income due to the initial government purchase of a $100 hammer
Hardware Store: $100
Grocer: $95
Tavern: $90.25
$85.74
$81.45
The initial $100 increase in government spending raised total income by $2,000 (a factor of 20)
Total: $2,000
Marginal Propensity to Consume

28. If the government bought $60B worth of hammers, that should do the trick!
Before
$10.8T
$3T
$1.2T
After
$11.94T
$3.06T
So, with a MPC of 95%

29. Let’s take the US Economy…
Let’s take the US Economy….we saw a rise in unemployment from 5% to 10% during the last recession (Dec – June 2009).
Multiply by 2.5 (Okun’s law)
12.5% drop in output
$1.75T
5% cyclical unemployment
$14T*(.125) = $1.75T
The personal savings rate at the time was around 4% (i.e. a consumption rate of 96%)
But the government stimulus plan was over $700B and nothing happened…

30. However, we need to be careful here….
It could be
We need the marginal propensity to consume, using the savings rate, we really have the average propensity to consume
Here, we have (at Y = $40,000)
Average propensity to consume

31. However, we need to be careful here….
Or, it could be
We need the marginal propensity to consume, using the savings rate, we really have the average propensity to consume
Here, we have (at Y = $40,000)
Average propensity to consume

32. Now, let’s recalculate a stimulus package for the last recession.
Multiply by 2.5 (Okun’s law)
12.5% drop in output
$1.75T
5% cyclical unemployment
$14T*(.125) = $1.75T
With a marginal propensity to consume equal to .46
This is pretty close to the actual size of the stimulus package

33. However, there is a more fundamental problem
However, there is a more fundamental problem. Remember the argument behind the multiplier
Lets add up all the increases in income due to the initial government purchase of a $100 hammer
Hardware Store: $100
Grocer: $95
Tavern: $90.25
$85.74
$81.45
The initial $100 increase in government spending raised total income by $2,000 (a factor of 20)
Total: $2,000
Marginal Propensity to Consume
What’s the problem here?

34. “If I Had a Hammer…”
The government needs to pay for the hammer. Lets assume that the government taxes the local hardware store and then uses the $100 to buy the hammer. How does this change things?
Oops…wrong hammer!!
What does the government do with the hammer?
Case #1: The government gives the hammer to the grocer across the street (transfer)
Case #2: The government throws the hammer into the ocean (wasteful spending)
Case #3: Derek Jeter signs the hammer (raising its value to $200) and gives it back to the hardware store (productive spending)

35. Examples of productive spending can best be found in Public Goods (goods with two distinct characteristics)
Non-Rivaled: Anyone can use a public good without affecting its use by others (zero marginal cost)
Non-Excludable: Its either very difficult or very costly to charge for usage of a public good
Suppose that there are 10,000 people living in Springfield. Each resident is willing to pay up to $.10 to have a drinking fountain in town. The fountain would cost $500 to build.
It would be difficult to charge people to use the fountain. Therefore, the private sector probably wouldn’t supply it. Here’s a chance for the government to step in and save the day!
Why shouldn’t the government supply private goods?

36. Jones’ Family Budget Income: $50,000 Taxes: $10,000 $40,000
Consider the Jones’: The Jones’ live in Buffalo NY. Mr. Jones works 40 hours per week at a local factory. They have an annual household income of $50,000.
Jones’ Family Budget
Income: $50,000
Taxes: $10,000
$40,000
Consumption: $30,000
Savings: $10,000
Remember…this is determined by the Jones’ wealth – not just current income
Suppose that Trump announces that they will spend $200B on a bridge that will go halfway to Hawaii (i.e. the bridge has a final value of $0) . Each household will be taxed $1,000 to pay for this project.

37. Jones’ Family Budget Income: $50,000 Taxes: $11,000 $39,000
How should this spending plan influence the Jones’?
Jones’ Family Budget
Income: $50,000
Taxes: $11,000
$39,000
Consumption: $30,000
Savings: $9,000
Tax Increase of $1,000
This one time project should have a negligible impact on the Jones’ wealth and, hence a negligible impact on consumption
Savings drops by $1000

38. So, the government raises spending by $1,000 per person, and household consumption is left unchanged (household savings drops by $1,000)
$1,000
The IS curve moves to the right by $1,000 – i.e. the government multiplier equals 1

39. Suppose that the government decides to spend $1,000 wastefully every year…
The IS curve moves to the right by $0– i.e. the government multiplier equals 0!
Households adjust to the permanently lower income by spending less

40. How will this spending plan affect the Jones family?
Now, consider another spending plan…Trump decides to nationalize the cable industry. Everyone will receive government provided cable television. They can provide this service for $500 per year.
Jones’ Family Budget
Income: $50,000
Taxes: $10,000
$40,000
Consumption: $30,000
Savings: $10,000
Rent: $15,000
Food: $10,000
Transportation: $4,000
Cable TV: $1,000
How will this spending plan affect the Jones family?

41. Jones’ Family Budget Income: $50,000 Taxes: $10,500 $39,500
How should this spending plan influence the Jones’?
Tax Increase of $500
Jones’ Family Budget
Income: $50,000
Taxes: $10,500
$39,500
Consumption: $29,000
Savings: $10,000
Extra Income: $500
Rent: $15,000
Food: $10,000
Transportation: $4,000
Cable TV: $0
If this is a one time increase in income, savings goes up . If it is permanent, consumption goes up by $500

42. Suppose that this one a one year program only….
The IS curve moves to the left by $500– i.e. the government multiplier is negative!
Households put the income gain into savings

43. The IS curve doesn’t move…again, a government multiplier of zero!!
If this were a permanent program, households would feel free to spend the $500 savings.
The IS curve doesn’t move…again, a government multiplier of zero!!
Households put the income gain into consumption

44. Simpson’s Family Budget Income: $20,000 Taxes: $2,000 $18,000
The Simpson's live next door to the Jones’. Homer Simpson works at the local power plant. He earns $20,000 per year.
Simpson’s Family Budget
Income: $20,000
Taxes: $2,000
$18,000
Consumption: $15,000
Savings: $3,000
Jones’ Family Budget
Income: $50,000
Taxes: $10,000
$40,000
Consumption: $30,000
Savings: $10,000
Suppose that the government offers a temporary $1,000 tax credit to lower income households. The program will cost the average upper income household $1,000

45. Suppose that the government offers a temporary $1,000 tax credit to lower income households. The program will cost the average upper income household $1,000
Jones’ Family Budget
Income: $50,000
Taxes: $11,000
$39,000
Consumption: $30,000
Savings: $9,000
Simpson’s Family Budget
Income: $20,000
Taxes: $1,000
$19,000
Consumption: $15,000
Savings: $4,000
$1,000
The Simpson’s put the tax credit in the bank.
The Jones’ lower their savings to finance their higher tax bill

46. In principle, this should cancel out in the aggregate!
Suppose that the government offers a temporary $1,000 tax credit to lower income households. The program will cost the average upper income household $1,000
In principle, this should cancel out in the aggregate!

47. For transfers to make a difference at the aggregate level, we need different preferences (i.e. different marginal propensities to consume)
$500
$100
MPC = .5
MPC = .9

48. The IS curve moves right!
So, the government raises spending by $1,000 per person, and household consumption increases by $400 (household savings drops by $400)
$400
+$900
-$500
$400
The IS curve moves right!

49. Taxable Income Tax Rate $0 - $10,000 15% $10,000 - $30,000 20%
Lets look at a breakdown of Mr. Jones tax liability
Income: $50,000
Taxes: $10,000
Mr. Jones taxable income of $45,000 put him in the 30% tax bracket
Tax Code
Taxable Income Tax Rate
$0 - $10, %
$10,000 - $30,000 20%
$30,000 - $50,000 30%
$30, %
Income Tax Rate Tax Paid
$10,000 15% $1,500
$20,000 20% $4,000
$15,000 30% $4,500
Total: $10,000
Mr. Jones’ average tax rate is 20%
Standard Deduction = $5,000

50. Taxable Income Tax Rate $0 - $10,000 15% $10,000 - $30,000 20%
Suppose the government passes a “middle class tax cut”. The top two brackets are reduced from 30% and 35% to 25% and 30%. Also, the standard deduction is lowered to $2,000. How does this impact Mr. Jones?
Mr. Jones taxable income of $48,000 put him in the 25% tax bracket
Income: $50,000
Taxes: $10,000
Tax Code
Taxable Income Tax Rate
$0 - $10, %
$10,000 - $30,000 20%
$30,000 - $50,000 25%
$30, %
Income Tax Rate Tax Paid
$10,000 15% $1,500
$20,000 20% $4,000
$18,000 25% $4,500
Total: $10,000
Mr. Jones’ average tax rate is still 20%
Standard Deduction = $2,000

51. Suppose the government passes a “upper class tax cut”
Suppose the government passes a “upper class tax cut”. The top two brackets are reduced from 30% and 35% to 25% and 30%. Also, the standard deduction is lowered to $2,000. How does this impact Mr. Jones?
Old Tax Code
New Tax Code
Income Tax Rate Tax Paid
$10,000 15% $1,500
$20,000 20% $4,000
$15,000 30% $4,500
Income Tax Rate Tax Paid
$10,000 15% $1,500
$20,000 20% $4,000
$18,000 25% $4,500
Total: $10,000
Total: $10,000
A drop in Mr. Jones’s marginal tax rate increases the incentive to work – labor supply increases. This should raise production

52. A cut in marginal tax rates that leaves average rates unchanged raises the economy’s capacity as employment rises. But what about expenditures?
A tax cut will increase investment (because higher employment raises the productivity of capital)
Capacity output increases from the tax cut

53. Taxable Income Tax Rate $0 - $10,000 10% $10,000 - $30,000 15%
Alternatively, suppose the government passes a “lower income class tax cut”. The bottom two brackets are reduced from 15% and 20% to 10% and 15%. The standard deduction is kept at $5,000. How does this impact Mr. Jones?
Mr. Jones taxable income of $45,000 put him in the 30% tax bracket
Income: $50,000
Taxes: $8,500
Tax Code
Taxable Income Tax Rate
$0 - $10, %
$10,000 - $30,000 15%
$30,000 - $50,000 30%
$30, %
Income Tax Rate Tax Paid
$10,000 10% $1,000
$20,000 15% $3,000
$15,000 30% $4,500
Total: $8,500
Mr. Jones’ average tax falls to 17%
Standard Deduction = $5,000

54. Alternatively, suppose the government passes a “lower income class tax cut”. The bottom two brackets are reduced from 15% and 20% to 10% and 15%. The standard deduction is kept at $5,000. How does this impact Mr. Jones?
Old Tax Code
New Tax Code
Income Tax Rate Tax Paid
$10,000 15% $1,500
$20,000 20% $4,000
$15,000 30% $4,500
Income Tax Rate Tax Paid
$10,000 10% $1,000
$20,000 15% $3,000
$15,000 30% $4,500
Total: $10,000
Total: $8,500
If households are rational and forward looking, they should recognize that the tax cut will need to be repaid and thus will not feel better off…
If households are not rational and forward looking, they will feel better off and work less

55. A tax cut will raise the deficit and increase government borrowing, but what about household savings?
If households are rational and forward looking, they should recognize that the tax cut will need to be repaid and thus increase savings… expenditures (and, the IS curve are unaffected)
If households are not rational and forward looking, they will increase expenditures (and, the IS curve shifts right)

56. A cut in average tax rates that leaves marginal rates unchanged actually lowers the economy’s capacity as employment falls while potentially raising expenditures
If households are not rational and forward looking, they will increase expenditures (and, the IS curve shifts right)
Capacity output increases from the tax cut

57. Government Spending
If the government invests in purely wasteful spending, the multiplier effect is the largest, but should that justify spending money on stupid projects?
Effective spending (say, on public goods) could actually lower employment and output (i.e. a negative multiplier), but don’t we want our government spending our money wisely?
Transfers could give the economy a boost without wasting any resources. The bigger issue with transfers is economic equity
Taxes
Taxes are an effective stimulus only if you can change marginal rates while leaving effective rates unchanged.