1. Fiscal Policy / Taxes / Public Finance / Deficits and Debt

2. Public finance – government’s taxing and spending policies
Fiscal policy – changing of taxes and spending to affect the level of output in the economy.
In general:
Expansionary : G > T (government spending is greater than tax revenue collected)
Contractionary: G < T

3. Historically
Pre 1930s: Sound Finance – government budget should always be balanced except in wartime.
So argue to finance government spending with taxes. This makes it harder to increase government spending – encourages more fiscal responsibility?
Ricardian equivalence theorem – deficits do not affect level of output in economy b/c people increase savings to pay future tax increases to pay for the deficit.
Ricardo felt that there was no difference in financing gov’t spending by selling bonds or raising taxes.

4. Historically Depression – 1930s
Give up principle of sound finance
Use gov’t spending to stimulate the economy
Gov’t work programs (Fed Emergency Relief Program, Works Progress Administration)
Keynes - Functional Finance – governments should make spending and taxing decisions on the basis of their effect on the economy, not based on principle of balanced budgets.
If spending too low, run a deficit / if spending too high, run a surplus

5. Macro Model Assumptions
Assumptions about Macro multiplier model that can lead to problems with fiscal policy:
Financing deficit doesn’t have offsetting effects
Crowding out – sell bonds to finance deficit, raise interest rates, discourage consumption and investment – increased gov’t spending can “crowd out” private spending
Gov’t knows what situation is
Lag time before we know what is going on (can be halfway into a recession before we know it)
Gov’t knows potential income level
Not easy to define - disagreements

6. Macro Model Assumptions
Gov’t is flexible in changing spending and taxes
Takes a lot of time for changes to pass through Congress, Senate, President
Budget planning process takes years
Size of debt doesn’t matter
Is a large national debt a problem – this is a complicated issue (we will get to later)
Fiscal policy doesn’t negatively affect other gov’t goals
Goals often conflict

7. Countercyclical vs. Procyclical
Countercylclical Fiscal Policy
Offset changes due to business cycle fluctuations (during recession - increase spending / expansion – decrease spending)
Procyclical Fiscal Policy – changes in spending and taxes that increase the cyclical fluctuations (State constitutions requiring balanced budgets)

8. Automatic Stabilizers
We have built fiscal policy into institutions
Automatic stabilizer – a gov’t policy or program that counteracts business cycle (countercyclical)
Unemployment insurance / Welfare system
When economy is slowing down, unemployment rate rises, unemployment insurance helps offset the decrease in income…government spending is automatically increased.
Tax system
When economy expands people pay higher taxes – partially offsets increase in income

9. Taxes Past 25 years – tax policy has dominated econonomic policy.
“no other issue clearly defines the differences between the two major political parties”
Taxes are government policies that directly affect all citizens
2.2 trillion in taxes in 2005
Magnitude suggests that taxes have an important effect on the economy
Alters the incentives associated with decisions – thus affecting actions people and businesses take
Distorts good economic choices?

10. Taxes
We have a “progressive tax system” – rate you pay increases as you make more money…”ability to pay” principle
Reagan – large cut in 1981, then the Tax Reform Act of 1986 (removed deductions and loopholes and decreased tax rates)
Supply-side economics: cut taxes and tax revenue will go up because economy will expand by more
Just increasing the debt and postponing taxes?
NY Times article illustrates the debate
Rates on high income raised in 1990 and 1993 to REDUCE BUDGET DEFICITS

11. TAXES
George W. Bush
Tax Cuts in 2001 – phased-in tax cuts in both income tax and estate tax (most expire in 2011)
2003 – reduced taxation of dividends and capital gains – increase incentive to invest
2004 – Fed tax revenue / GDP = 16%, lowest in 45 years
2005 – advisory panel report to overhaul the tax system completely

12. Deficits and Surpluses
Flow concepts
– large budget deficits
1998 – 2001 – budget surpluses
Long-run – surpluses are good because they provide additional saving
Short-run – whether we should have a deficit or surplus depends if we are above or below potential income

13. Deficits and Surpluses
How does the government finance a deficit?
Selling bonds to individuals and to the central bank
Can also print money – can cause serious inflation problems (this is usually a last resort)

14. Debt Accumulated deficits – accumulated surpluses Stock measure
NOTE: inflation can make size of debt smaller (if you owe $100, but there is 4% inflation, the $100 you owe is now only $96 in real value)

15. Debt Management
Treasury Department continually refinances its bonds that are coming due by selling new bonds
If there is a surplus, gov’t can retire some of the bonds.
Debt must be judged relative to Assets
Assets – workforce, resources, factories, housing, foreign assets, etc.
Deficits and increasing debt may not be all that bad if the spending is increasing assets

16. Government Debt is Different than Individual Debt
Government is ongoing (never has to pay back its debt)
Government can pay off a debt by creating money
75% of government debt is internal debt (owed to other governmental agencies and US citizens)
Paying interest is a redistribution among citizens of the country

17. Debt Burden
Measure debt relative to GDP – measures government ability to pay off a debt
debt service – interest rate on debt times total debt (amount of interest paid each year)
2006 gov’t paid $227 billion in interest

18. Social Security
Social Security System began with passage of Federal Insurance Contribution Act (FICA) in 1935
Employees and firms pay taxes, and in return employees get a pension after they retire
Pay as you go system
Designed to supplement private-sector pensions
1960s 40% workers covered by private pensions
Today, only 16% of workers covered by private pensions
Replaced with “defined-contribution” plans – 401(k)
Potential crisis – average worker (6% contributions for 35 years) will spend plan’s savings in 8.5 years

19. Social Security – Crisis?
Currently Social Security system is running a large surplus.
However, eventually, Social Security will be required to pay out an amount far greater than its revenue
1983 created the Social Security Trust Fund – holds bonds
Current estimates – surpluses will continue until around By 2040 Social Security trust fund will be used up.
What happens after that?
System will have to borrow, increase revenue, or reduce benefits

20. Medicare – Crisis? More so than Social Security
Recent changes will greatly increase costs in a few decades
2030 – 60 or 65 % of government budget will be spent on Social Security and Medicare

21. Solutions?
Real output per worker increases (so you are producing enough output for you plus people who are retired)
Current consumption comes from current output
Productivity growth
Privatizing Social Security?
Increase taxes on workers?
Cut benefits once baby boomers retire?
Make social security available only to those who need it?
Increase retirement age to 72? Its now

22. NEXT TIME Lets talk about Economic plans of presidential candidates
Obama
Clinton
McCain
HMWK: Write a two page essay discussing the differences between the three, end with which plan you think is best for the economy.
Economy, Taxes, Health Care, Immigration
All these can be economic issues!

23. Presentations (Optional)
Present one candidates economic proposals
Power point (10-15 minutes)
I’ll drop 1 hmwk and 1 quiz grade and give you extra 5% points on test grade if you do a presentation.
Can have teams up to 3 people.
me powerpoint and then you can use my computer